There are many forms of compensation payouts which may be awarded to taxpayers. This can include compensation in relation to personal injury or illness, damage to reputation, damage to property, lost employment, lost opportunity, or loss of income and/or financial support.
The tax treatment of compensation payouts can be complex and is often uncertain. However, the best place to start is to consider what the compensation is replacing. This is referred to as the replacement principle. The premise of the replacement principle is that tax treatment of the compensation payout should match the tax treatment of the thing being replaced / compensated for.
Therefore, if the payout compensates for a loss of income, the payment will be treated as ordinary income which is assessable under section 6-5 of the Income Tax Assessment Act 1997 (ITAA). Conversely, if the payout compensates for a loss of something that is capital in nature, the payment will be a capital receipt and therefore not ordinary income and not assessable for the taxpayer under section 6-5 of the ITAA. Capital receipts will often be subject to and taxed under the CGT regime.
There are of course many exceptions in the tax law that specifically govern the tax treatment of certain amounts (without the need to consider the income/capital distinction). Therefore, certain payments received by a taxpayer may be treated as assessable income under the tax law despite being substantially capital in nature or vice versa.
As an example of the replacement principle in action, take Stephen who injures his leg at work and receives $500,000 as compensation for lost income and $300,000 as compensation for the physical injury sustained. In this example, $500,000 is compensation directed at replacing lost income and is therefore ordinary income for Stephen which he is assessed on. The $300,000 compensation is directed at replacing his capacity to work and is therefore capital in nature and subject to tax under the CGT regime.
It is helpful to understand a few further fundamental tax concepts before proceeding to consider the tax treatment of the different types of compensation payouts.
Firstly, compensation which is received by the taxpayer can be characterised in any of the following ways:
- Ordinary income under section 6-5 of the ITAA
- Statutory income which the tax law makes specifically assessable income
- Statutory exempt income which the tax law specifically excludes from assessable income.
- A capital receipt
- An exempt capital receipt whereby the tax law ensures that a certain capital gain or loss is disregarded
Ordinary and statutory income
Ordinary and statutory income will be included in the taxpayer’s tax return as assessable income. Assessable income is one of the key components to determine a taxpayer’s tax payable or refundable for an income year. Remember the following basic tax equations:
- Taxable income = Assessable income less allowable deductions.
- Ultimate tax payable / refundable = (taxable income x tax rate) less tax offsets and credits*
*This formula is simplified. For example, it does not include consideration of HELP, TSPL repayments, or the Medicare levy or surcharge.
Exempt income is not included in the taxpayer’s assessable income under a provision of the tax law which specifically excludes it.
Capital receipts will generally be subject to CGT. The capital gain will be added together with other capital gains made during the course of the income year. There is then a net capital gain calculation performed in accordance with the formula expressed in section 102-5 of the ITAA. It is the net capital gain (not necessarily the gross capital gain made in respect the payout) that will be added to assessable income and which is subject to tax.
You may ask: if a capital receipt is ultimately treated as assessable income, why does it matter if compensation received is treated as capital or ordinary income? Well, one of the advantages of a capital receipt is that the capital gain (depending on the relevant CGT event) may discounted by 50% if the relevant taxpayer is an individual, trust or partner in a partnership.
The small business CGT concessions also provide a potential avenue to further discount a capital gain. A capital gain may also be more valuable than ordinary income as a capital loss can only be soaked up (and thereby the benefit of the capital loss attained) by a capital gain and not by ordinary income.
Exempt capital receipt
An exempt capital receipt is excluded from CGT in that any capital gain or loss from the receipt is disregarded.
Keep in mind that if an amount is assessable (either as ordinary income or statutory income) and subject to CGT, any the capital gain will be reduced by the amount of income assessed as ordinary or statutory income. This prevents a double-taxation outcome on a single receipt.
Types of Compensation Payouts
Negative covenant compensation
A negative covenant is essentially where the taxpayer receives compensation for agreeing not to do something. For example, a footy player agreeing with their club not to sign with a competing team, or a retailer agreeing not to sell products from a certain supplier. These agreements for restraints are generally capital in nature and taxed under the CGT regime, usually by the triggering of CGT event D1.
Remember that only incidental costs can be used to reduce a gain under CGT event D1. Also remember that CGT event D1 is discountable (other than for a company) if 12-month holding rule and the other eligibility criteria are satisfied.
Compensation for loss of trading stock
Payment/s to compensate for loss or damage to trading stock is ordinary income and is also specifically assessable under the trading stock provisions within the ITAA.
Compensation for loss of depreciation assets
Compensation received in respect of the loss or destruction of a depreciating asset triggers a balancing adjustment event. The insurance recovered in respect of the loss or damage will affect the amount deductible or assessable.
For example, if the proceeds (i.e. termination value) exceeds the remaining tax value (i.e. adjustable value) of the asset, the compensation will result in assessable income for the taxpayer for difference in values.
Conversely, if the termination value is exceeded by the adjustable value of the asset, the compensation will result in a deduction available to the taxpayer for the difference in values.
Compensation for loss of CGT asset
The taxation of payments to compensate for the loss of a CGT asset is particularly complex. The tax position can be broadly summarised as follows:
If compensation is received in respect of the disposal of an underlying asset, the compensation is deemed to be included in the consideration received on the disposal of the asset. Generally, depending on the specific CGT event of relevance, the consideration received (plus other capital proceeds) less the cost base of the underlying asset will determine the taxable capital gain for the taxpayer in respect of the disposal of the underlying asset. If the consideration (plus other capital proceeds) is less than the reduced cost base, a capital loss will result. There may also be roll-over relief available in respect of cash or a replacement asset received to enable the taxpayer to defer any capital gains tax.
If compensation is received by a taxpayer in respect of damage suffered to an underlying CGT asset and there is no disposal of that asset at the time of payment, the amount is treated as a recoupment of part of the acquisition cost of the asset. That is, the cost base of the underlying asset should be reduced by the amount of compensation received. In this way, there is no immediate tax consequence in respect of the compensation other than a lowered cost base which will lead to increased capital gains on the future disposal of the asset.
If compensation is received in satisfaction of the taxpayer’s right to seek compensation (not in respect of an underlying asset), the occurrence of the breach is treated as the acquisition of a CGT asset (being the right to seek compensation). A CGT event occurs once compensation is received in satisfaction or surrender of the right to seek compensation. Depending on the specific CGT event, any capital gain arising on the disposal of that right is generally calculated as capital proceeds less the cost base of that right.
Compensation for compulsory acquisition
Subdivision 124-B of the ITAA provides roll-over relief for the disposal of non-depreciating capital assets which have been compulsorily acquired. For example, where land is resumed by government and compensation is received. For relief to be available, the compensation must be spent on acquiring a replacement asset within one-year before or after disposal. The capital gain is disregarded if all the compensation received is spent to buy a replacement. Alternatively, if the taxpayer does not use all the compensation to buy a replacement asset, CGT will apply in respect of the unspent amount (the excess).
Compensation which is exempt from CGT
Where a payment received relates to an underlying CGT that is exempt from CGT e.g. a taxpayer’s main residence, there is generally no CGT consequence to receiving a compensation payment in respect of that asset.
Compensation which is exempt income
Division 51, 54 & 59 of the ITAA address forms of compensation that are specifically exempt income or non-assessable non-exempt income.
This includes certain compensation receipts related to:
- Defence force service
- Interest on a judgement debt relating to personal injury
- Compensation on certain structured settlements and orders for personal injury compensation
- Certain native title payments
- Certain mining payments for the benefit of indigenous persons
Apportionment of compensation
If a payment relates to multiple assets and / or classes of assets, an apportionment of the compensation between those should occur, if possible. For example, if a building is burned down simultaneously destroying trading stock, depreciable capital assets and non-depreciable capital assets, the compensation should be allocated appropriately between these assets and forms of assets. The respective tax treatment relevant to each asset should then be applied.
Worker compensation payments for lost wages e.g. weekly Workcover payments will be ordinary income and fully assessable. However, an award to compensate for loss of physical capacity e.g. the loss of a limb, will be a capital receipt and will not be ordinary income.
Personal injury compensation
Personal injury compensation will generally be a capital receipt. However, section 118-37 of the ITAA provides an exemption from CGT for the receipt (other than any component that relates to loss of earnings) meaning the compensation is usually tax-free.
To receive the CGT-exempt treatment for compensation received from a structured settlement or a structured order, a number of tests must applied in respect of each component of the compensation to determine if that component should indeed be tax-free. The requirements to obtain tax-free status are complex and vary depending on whether the component of the compensation being considered relates to a compulsory payment or an optional component.
Note that if a settlement payment has a personal injury component and the quantity of that component cannot be distinguished / determined, no part of the total payout will be eligible for the CGT exemption.
Compensation from an insurer under an income protection policy
Payment/s received to compensate for lost income under income protection insurance will be ordinary income and fully assessable to the taxpayer.
Compensation from an insurer under an accident and disability policy
Certain periodic payment/s from insurers related to personal accidents and disability will be assessable if they replace lost earnings. Otherwise, if they are to compensate for something capital, such as an individual’s lost physical capacity, the receipt will also be capital in nature. The personal injury exemption in section 118-37 may apply to disregard any capital gain from the compensation receipt/s.
Compensation from an insurer under a life assurance or life insurance policy
Payment/s under a life assurance or life insurance policy are generally capital in nature and not ordinary or statutory income. The receipt is also generally not taxed under the CGT regime with any capital gain being specifically disregarded for CGT purposes.
However, if the policy provides payment of a pension or an annuity (or enables this option), the compensation may be assessable to the recipient. Similarly, where the holder a life policy controls the way funds are invested, the income credited to the investor may be assessable.
Compensation from an insurer under a TPD and critical illness policy
Same as above. However, these payouts can be taxable if the policy is owned by a third party.
Insurances held within a super fund
Note that insurance payouts may be subject to tax if the policy is held within the taxpayer’s super fund. For example, where the insurer makes payment to the fund and the fund thereafter provides the payment to a non-dependant. The taxation of super death benefits is discussed in other Bristax articles.
Undissected lump sums
As previously established, the general premise of the replacement principle means compensation which relates to lost income is ordinary income. Conversely, if the compensation relates to the loss of a capital structure or capital advantage, the payment will be capital and likely taxed under the CGT regime.
Problematic to the replacement principle is the situation where a taxpayer receives a general payment which involves a loss to income and capital, and which does not clearly distinguish or quantify the loss related to these income and capital components. If the payout is not possible to dissect, the whole amount will be treated as capital and subject to CGT because of the triggering of CGT event C2, D1 or H2. Remember that the CGT provisions consider the right to sue a CGT asset which can be disposed by obtaining an award or by accepting a settlement offer.
Consider James who sues another person for damages sustained due to the breach of contract. James seeks compensation to replace both lost capital and lost income. He receives a financial settlement in a lump sum to address the entirety of these matters. If that lump sum is not explicitly dissected (and not reasonably capable of being dissected into its components) the entire lump sum will be treated as a capital receipt for James. The capital receipt will trigger a CGT event and result in a taxable capital gain.
Compensation from an insurer under a policy related to directors and employees
Payments under an accident policy in respect of directors and other employees will generally be ordinary income if the insurance compensates for lost profits. The payment will more likely be a capital receipt if the insurance is intended to guard against capital losses.
Employment Termination Payments
See our Employment Termination Payment article for details of the tax treatment of ETPs.
Interest on Compensation
With exceptions, interest which accrues on underlying compensation amounts will generally be assessable income to the taxpayer regardless of the tax treatment of the underlying compensation amount.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.