Assessability of compensation payment received by Australian resident from the United Kingdom

Is a compensation payment awarded by a United Kingdom (UK) court for personal injury, loss of earnings, loss of earning capacity and interest thereon, which is received by an Australian resident taxpayer, wholly or partly assessable under section 6-5 or section 6-10 of the Income Tax Assessment Act 1997 (ITAA 1997)?

The part of the compensation payment that relates to loss of earnings and interest on that component is assessable under subsection 6-5(2) of the ITAA 1997. The remainder of the payment is not assessable.

The taxpayer is an Australian resident.

The taxpayer was involved in a non-work related car accident in the UK.

The taxpayer was awarded a compensation payment by a UK court comprising components for: • general damages (including reimbursement of private expenses) • interest on general damages • loss of earnings • interest on loss of earnings, and • loss of earning capacity.

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year.

Ordinary income has generally been held to include 3 categories, namely, income from rendering personal services, income from property and income from carrying on a business.

Other characteristics of income that have evolved from case law include receipts that: • are earned • are expected or relied upon • have an element of periodicity, recurrence or regularity • replace income.

A compensation amount generally bears the character of that which it is designed to replace. If the compensation is paid for the loss of a capital asset or amount, then it will be regarded as a capital receipt and not ordinary income.

The compensation that the taxpayer received for loss of earnings is to replace income that would have been earned, expected, relied upon and would have had an element of periodicity, recurrence or regularity. In Keily v. Commissioner of Taxation (Cth) (1983) 32 SASR 494; 83 ATC 4249; (1983) 14 ATR 156, it was said that payments paid to replace income are also considered to be income.

The part of the compensation payment that the taxpayer received in relation to personal injury (including reimbursement of private expenses) was not earned as it does not relate to services performed. The payment is also a one off payment, and thus it does not have an element of recurrence or regularity. Although the payment can be said to be expected, and perhaps relied upon, this expectation arises from the pain, suffering and medical treatment required resulting from the injury, rather than from a relationship to personal services performed.

Similarly, the part of the compensation payment that relates to loss of earning capacity is not income from rendering personal services, income from property or income from carrying on a business. The payment is also a one off payment and thus it does not have an element of recurrence or regularity.

Taxation Ruling IT 2193 deals with the issue of compensation of the loss of earning capacity. Although the discussion is in the context of compensation for motor vehicle accidents, the discussion is relevant to other types of compensation payments. IT 2193 makes it clear that compensation for loss of earning capacity will not lose its character as a capital receipt, simply because the amount of compensation is calculated by reference to the amount of income that would have been earned.

Accordingly, only the part of the compensation payment that relates to loss of earnings is ordinary income of the taxpayer and will be assessable under subsection 6-5(2) of the ITAA 1997, subject to the operation of an applicable double tax agreement (see below).

The treatment of pre-judgment interest included in a compensation payment differs, depending on the nature of the damages to which the interest relates.

The receipt of pre-judgment interest in the context of personal injury is considered to be capital in nature (refer ATO Interpretative Decision ATO ID 2002/473 and Whitaker v. Federal Commissioner of Taxation (1998) 82 FCR 261; 98 ATC 4285; (1998) 38 ATR 219 ( Whitaker's Case )).

In Whitaker's Case , Black CJ distinguished payments for interest relating to payments for personal injury to those payable in other contexts, such as commercial situations involving payments for lost income: In other contexts the characterisation of an amount ordered to be paid as "interest" as compensation for the loss or detriment suffered by a person by being kept out of his or her money would point to an amount receivable as income rather than as capital...I would add that the position here differs greatly from [that] situation in which interest is payable as the price of being kept out of a specific or calculable principal sum...

Therefore, the receipt of interest as part of a compensation payment for personal injury or loss of earning capacity is to be contrasted with a situation where the interest relates to a compensation payment made to replace lost wages and is calculated as the price of being kept out of a specific principal sum.

In the taxpayer's case, pre-judgment interest was calculated in relation to each of the components of the compensation payment.

Accordingly, the pre-judgment interest that relates to the loss of earnings is interest that is considered to be ordinary income and will be assessable under section 6-5 of the ITAA 1997, subject to the operation of an applicable double tax agreement (see below).

Section 6-10 of the ITAA 1997 provides that a taxpayer's assessable income includes statutory income amounts that are not ordinary income but are included in assessable income by another provision.

Section 10-5 lists those provisions about statutory income. Included in this list is section 102-5 of the ITAA 1997 which deals with capital gains.

Taxation Ruling TR 95/35 deals with the capital gains tax (CGT) treatment of compensation receipts. Compensation resulting from personal injury represents a disposal of an asset for CGT purposes. The disposal of an asset gives rise to a CGT event.

However, paragraph 118-37(1)(b) of the ITAA 1997 disregards payments or receipts for the purposes of CGT, where the amount relates to compensation or damages a person received for any personal wrong, injury or illness.

The capital receipts received by the taxpayer for personal injury (including reimbursement of expenses), loss of earning capacity and interest on those components, are amounts to which paragraph 118-37(1)(b) of the ITAA 1997 apply. Therefore, any capital gain or loss that the taxpayer has made in relation to these receipts will not be assessable under section 6-10 of the ITAA 1997.

In determining liability to Australian tax on foreign sourced income it is necessary to consider not only the income tax laws but also any applicable double tax agreement contained in the International Tax Agreements Act 1953 (the Agreements Act).

Section 4 of the Agreements Act incorporates that Act with the Income Tax Assessment Act 1936 (ITAA 1936) and ITAA 1997 so that those Acts are read as one.

Schedule 1 to the Agreements Act contains the double tax agreement between Australia and the UK (the UK Agreement). Schedule 1A to the Agreements Act contains the Protocol to the UK Agreement (the Protocol). The UK Agreement and the Protocol operate to avoid the double taxation of income received by Australian and UK residents.

The UK Agreement does not contain an Article dealing with compensation receipts, nor does it contain an Article dealing with income not expressly mentioned in the Agreement. Accordingly, the part of the compensation payment that relates to loss of earnings may be taxed in Australia and in the UK.

Article 9(1) of the UK Agreement specifies that the UK tax on interest (on bonds, debentures or on any other form of indebtedness) derived and beneficially owned by an Australian resident shall not exceed 10% of the gross amount of the interest.

The interest awarded to the taxpayer in respect of loss of earnings may be taxed in Australia and in the UK. However, the tax in the UK may not exceed 10% of the gross amount.

Article 19(2) of the UK Agreement specifies that subject to the Australian tax law, UK tax paid by an Australian resident in accordance with the UK Agreement in respect of income or gains sourced in the UK, shall be allowed as a credit against Australian tax payable in respect of that income.

Subsection 160AF(1) of the ITAA 1936 provides that where the assessable income of a resident contains foreign sourced income and foreign tax has been paid on that income, a foreign tax credit will be allowed. The foreign tax credit allowed against Australian income tax is the lesser of: • the amount of that foreign tax paid, reduced in accordance with any relief available to the taxpayer under the law relating to that tax, or • the amount of Australian tax payable in respect of the foreign income.

As the taxpayer is a resident of Australia, the UK interest that relates to the payment for loss of earnings received by the taxpayer forms part of their assessable income under subsection 6-5(2) of the ITAA 1997. Where UK tax has been paid in relation to the interest income, a foreign tax credit will be allowed. Note: Where the UK tax paid on the interest is less than the Australian tax payable, the taxpayer will be entitled to a full credit for the UK tax paid. Where the UK tax paid is greater than the Australian tax payable, the taxpayer is only entitled to a credit equal to the value of the Australian tax payable and cannot recover any excess UK tax paid. However, under section 160AFE of the ITAA 1936, any excess foreign tax credit can be carried forward for a maximum of five years for application against any future tax payable on the taxpayer's foreign income of the same class.