Assessability of a lump sum compensation payment received for cessation of an assessable allowance

Does a lump sum payment received by a taxpayer, as compensation for the cessation of an assessable allowance, form part of their assessable income under subsection 25(1) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Yes. A lump sum payment received by a taxpayer as compensation for the cessation of an assessable allowance forms part of their assessable income under subsection 25(1) of the ITAA 1936.

The taxpayer carries on a business.

The taxpayer had for many years received an allowance from another entity. The allowance was paid to defray certain of the taxpayer's operational costs. The taxpayer had correctly included this allowance in their assessable income in prior years.

The other entity decided to cease paying the allowance to the taxpayer. The taxpayer and the other entity signed a deed under which the taxpayer agreed to accept a lump sum payment as compensation for the cessation of the allowance.

The lump sum was received by the taxpayer in the 1995-96 income year.

Subsection 25(1) of the ITAA 1936 provides that the assessable income of a resident taxpayer includes gross income derived directly or indirectly from all sources whether in or out of Australia. Gross income in subsection 25(1) of the ITAA 1936 means income according to ordinary concepts and usages.

The allowances paid to the taxpayer were received in the course of, and as an ordinary incident of, the conduct of their business. These amounts were income according to ordinary concepts and formed part of the taxpayer's assessable income in the years in which they were received.

The general principle of classifying compensation payments is the replacement principle, that is compensation payments will be income where they replace revenue items and they will be capital where they replace capital items. An amount paid to compensate for loss generally acquires the character of that for which it is substituted ( Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443; 10 ATD 82). Compensation payments which substitute income have been held by the courts to be income under ordinary concepts ( FC of T v. Inkster 89 ATC 5142; (1989) 20 ATR 1516; Tinkler v. FC of T 79 ATC 4641; (1979) 10 ATR 411).

The allowance had been returned as assessable income in previous years by the taxpayer. The compensation payment made to the taxpayer was to replace this income amount. It did not seek to compensate the taxpayer for the surrender of abandonment of part of it's business and therefore was not a payment of a capital nature.

Accordingly, the lump sum payment received by the taxpayer as compensation for the cessation of an allowance is assessable under subsection 25(1) of the ITAA 1936. (Note: the lump sum payment may also have been assessable under paragraph 26(g) of the ITAA 1936 as a bounty or subsidy)