All too often, litigants and their lawyers either fail to understand (or conveniently forget) the unescapable reality that in Australia, almost everything is taxed – after all, Australia is a highly taxed country by world standards.
Whilst personal injury compensation damages (and any prejudgment interest on such damages) is not subject to tax (probably for political reasons), business people and litigation involving non-personal injury is fair game to the ATO and surprise, surprise, tax law in respect of compensation receipts is complicated and can be uncertain.
The information provided below is general and must not be relied upon as advice because every litigation award or settlement is different. Because of the complexity in this area of tax law, the tax implications associated with large awards or settlements often require the preparation and lodgment with the ATO of a private ruling application by the successful litigant. The average size compensation payment and the nature of the litigation itself do not normally require a private ruling application.
However, it is not unusual for the ATO to undertake a review of a settlement amount in respect of litigation that is conducted in the public domain or which receives the attention of the press. If the litigation proceeds are not returned for tax purposes correctly (or at all) and this results in a ATO review or audit, there will likely be administration penalties imposed by the ATO, being a 25% penalty for taxpayer (or tax agent carelessness) and 50% penalty for taxpayer (or tax agent recklessness).
In most circumstances, the ATO can amend a litigant’s income tax returns for a period of up to 4 years after a litigation case ends. CharterLaw anticipates that as the ATO widens its tax net, its focus on litigation recoupments between parties in commercial litigation will increase as will its review and audit activity.
General Principles relating to the taxation of compensation receipts
A compensation receipt takes on the tax character of the item it replaces. As such, under the common law
- if a compensation receipt replaces what would have been income it will be assessable as income, and
- if a compensation receipt replaces capital gain, the compensation receipt will be assessable under the capital gains tax (“CGT”) regime.
As such determine whether the receipt is income or capital and then once this is completed, the relevant taxation treatment must be ascertained. In determining the relevant taxation treatment, the CGT provisions in the Tax Act have a major impact.
As a general rule, where a contract entered into in the ordinary course of business is breached, any compensation awarded (or agreed) will be regarded as income and taxed accordingly. Conversely, where the breach of contract affects the capital structure of a taxpayer’s assets, any compensation awarded (or agreed) will be regarded as consideration on disposal (of part of or the whole of) the entire asset.
Lump sum damages (un-dissected damages) – special issues
Before the introduction of capital gains tax (CGT) in 1985 and the assessable recoupment provisions in the late 1990’s, the tax position in respect of lump sum damages was fairly straight forward. Either
- lump sum damages awarded by a court or a lump sum settlement payment was assessable income in accordance with ordinary principles, or
- where a lump sum compensation payment could not be dissected or apportioned or was for a lesser amount then the whole of the claim, the whole un-dissected amount would be treated as non-assessable capital (High Court in the case McLaurin v FCT).
It now seems to be accepted that a lump sum compensation amount can be apportioned or dissected into capital and income elements if there is an appropriate basis for doing so (FCT v. Northumberland Development Co decision). Where an assessable recoupment is involved, the assessable recoupment provisions in the 1997 Tax Act requires a reasonable allocation calculation to be undertaken.
Not every recoupment of an allowable deduction is assessable income
The general law established position is that not every amount previously claimed as a tax deduction becomes assessable income if it is recouped. The High Court in The Federal Commissioner of Taxation v Rowe, rejected the existence of any general principle in taxation law bringing to tax an amount received by a taxpayer which compensates the taxpayer for an amount that had expressly been allowed as a deduction. More recently, the Full Federal Court in Batchelor v FCT has accepted that a payment which has the practical effect of compensating a taxpayer for an amount previously claimed as a deduction, will not necessarily make the amount assessable as income.
There is however a statutory exception that if the recoupment occurs by way of insurance or pursuant to a pre-existing indemnity, then the general exclusionary rule does not apply and the recoupment amount is assessable income. Not every statutory recoupment pursuant to a pre-existing indemnity is assessable, only those identified in what is known as the section 20-30 Table in the 1997 Tax Act.
Capital gain tax treatment of litigation proceeds
The ATO has issued a 95 page detailed ruling setting out the CGT treatment of recouped damaged and compensation. Under this ruling, the ATO will always consider that a compensation receipt will fall within one of three categories:
- the first category applies where the compensation receipt relates to an underlying asset. This is by far the most common category and is discussed further below:
- the second category applies where the compensation receipt relates to the disposal by the taxpayer of the right to seek compensation. This is essentially a default category which applies if the first category does not apply. If it applies, then the taxable CGT event is the disposal that arises when the compensated party confers a release of its claim against the wrongdoer and the CGT proceeds is the settlement amount paid. If the underlying asset if actually disposed of as part of the settlement, then normally the ATO applies the second category treatment; and
- the third category applies where the compensation receipt arises from the disposal of a notional asset. This very rarely ever has any application.
Under the indirect or underlying asset approach, the nature of the compensation receipt and what gave rise to the entitlement to receive it is examined. Where the amount was received in relation to an underlying asset (which has been acquired, disposed of, damaged, reduced in value or otherwise affected), the compensation receipt is attributed to that asset.
The effect of the underlying asset approach is to treat the compensation receipt as a recoupment of part of or the entire cost base of the underlying assets. Because the amount of the compensation receipt is treated as a recoupment to the cost base, there is no CGT disposal. If there is no CGT disposal then there is no CGT event and this means there is no capital gain to tax. This means that the asset must not be sold in order for the underlying asset approach to be adopted. Thus, the underlying asset approach treats the compensation receipt as a recoupment of part or the whole of the cost base of the underlying asset.
As you can see from above, not all compensation receipts of a capital nature are however subject to tax and this is the case where the relevant underlying CGT asset is an exempt asset or where there has been no disposal but the replacement of an asset or the recovery of damage done to an asset.