Compensation receipts: taxation of amounts paid in respect of personal injury

To what extent is compensation received by the taxpayer, in respect of a payment for personal injury, assessable as either ordinary or statutory income?

The taxation treatment of compensation relating to personal injury differs depending on the nature of the compensation. Compensation for loss of income will be assessable under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997). The reimbursement of medical expenses is private in nature and is therefore not assessable. Amounts of compensation received in respect of personal injury are exempt from the application of the capital gains tax provisions under paragraph 118-37(1)(b) of the ITAA 1997.

The taxpayer suffered health problems as a result of the negligence of another person. The taxpayer required hospitalisation and was unable to work for some time. When the taxpayer returned to work, the taxpayer could not operate heavy machinery and was placed on light administrative duties at a reduced salary. After a few months, the taxpayer found that their health did not allow them to carry out administrative duties and they resigned.

The taxpayer took legal action against the person who was negligent in causing their health problems and obtained an out-of-court settlement. The amount received was reasonably allocated by the taxpayer to the following components: • Loss of income • Reimbursement of medical expenses • Other payments relating to their personal injury

The assessable income of a resident of Australia includes ordinary and statutory income, derived directly and indirectly from all sources in or out of Australia.

In order to determine the taxation treatment of a compensation payment, the nature of the compensation payment must be examined, as a compensation amount generally bears the character of that which it is designed to replace ( Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443; (1952) 10 ATD 82).

Compensation receipts which substitute for income have been held by the courts to be income under ordinary concepts. As such, the amount received to compensate for loss of income will be subject to tax under the ordinary income provisions of section 6-5 of the ITAA 1997.

Medical expenses are private expenditure of the taxpayer. Therefore, reimbursement of this amount does not give rise to assessable income.

Amounts received in respect of personal injury which are not for reimbursement of medical expenses, or direct compensation for loss of income, will usually be capital in nature and are potentially taxable as statutory income under the capital gains tax provisions of the ITAA 1997.

Taxation Ruling TR 95/35 deals with the capital gains treatment of compensation receipts. The ruling advocates a 'look-through' approach, which identifies the most relevant asset to which the compensation amount is most directly related. Paragraph 11 of TR 95/35 states that if an amount is not received in respect of an underlying asset, the amount relates to the disposal by the taxpayer of the right to seek compensation.

As the amount received by the taxpayer is not in respect of any underlying asset, the whole of the settlement amount is treated as capital proceeds from a CGT event (CGT event C2) happening to the taxpayer's right to seek compensation.

However, paragraph 118-37(1)(b) of the ITAA 1997 disregards a capital gain made from a CGT event where the amount relates to compensation or damages received for any 'wrong, injury or illness you.....suffer personally'.

In this case, the taxpayer will be assessable only in respect of the amount received to compensate for the loss of income.