FEDERAL COURT OF AUSTRALIA Sommer v Commissioner of Taxation [2002] FCA 1205 INCOME TAX – objection by a taxpayer to a Private Ruling that a lump sum paid in settlement of claims under a Professional Income Replacement policy is assessable income – whether the lump sum paid in consideration of the cancellation of the policy was in substance a sum paid in settlement of the taxpayer's claims for income replacement – whether lump sum paid was assessable income Income Tax Assessment Act 1997 (Cth) ss 6-5 and 15-30 Commissioner of Taxation v McMahon (1997) 79 FCR 127 – cited Allied Mills Industries Pty Ltd v Commissioner of Taxation (1989) 20 FCR 288 – applied Reuter v Federal Commissioner of Taxation (1980) 93 ATC 5030 - cited Federal Commissioner of Taxation v CSR Ltd (2000) ATC 4710 - cited Carapark Holdings Limited v The Commissioner of Taxation (1967) 115 CLR 653 - applied Commissioner of Taxation v Smith (1981) 147 CLR 578 – applied Coward v Federal Commissioner of Taxation (1999) ATC 2166 - distinguished Henry Jones (IXL) Ltd v Commissioner of Taxation (1991) 31 FCR 64 – cited Federal Commissioner of Taxation v Inkster 89 ATC 5142 – cited Federal Commissioner of Taxation v The Myer Emporium Limited (1987) 163 CLR 199 – cited Van den Berghs Ltd v Clark [1935] AC 431 - cited Bennett v Federal Commissioner of Taxation (Cth) (1947) 75 CLR 480 - cited STEVEN JULIUS SOMMER v THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA V 1011 OF 2001 MERKEL J 27 SEPTEMBER 2002 MELBOURNE IN THE FEDERAL COURT OF AUSTRALIA VICTORIA DISTRICT REGISTRY V 1011 OF 2001 ON APPEAL FROM THE TAXATION APPEALS DIVISION OF THE ADMINISTRATIVE APPEALS TRIBUNAL CONSTITUTED BY A SENIOR MEMBER BETWEEN: STEVEN JULIUS SOMMER APPLICANT AND: THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA RESPONDENT JUDGE: MERKEL J DATE OF ORDER: 27 SEPTEMBER 2002 WHERE MADE: MELBOURNE THE COURT ORDERS THAT the application be dismissed with costs. Note: Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules. IN THE FEDERAL COURT OF AUSTRALIA VICTORIA DISTRICT REGISTRY V 1011 OF 2001 ON APPEAL FROM THE TAXATION APPEALS DIVISION OF THE ADMINISTRATIVE APPEALS TRIBUNAL CONSTITUTED BY A SENIOR MEMBER BETWEEN: STEVEN JULIUS SOMMER APPLICANT AND: THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA RESPONDENT JUDGE: MERKEL J DATE: 27 SEPTEMBER 2002 PLACE: MELBOURNE REASONS FOR JUDGMENT 1 The applicant has appealed to the Court pursuant to s 44 of the Administrative Appeals Tribunal Act 1975 (Cth) on a question of law from a decision of the Administrative Appeals Tribunal ("the AAT") affirming a decision of the respondent ("the Commissioner") to disallow the applicant's objection to a private ruling issued by the Commissioner pursuant to Pt IVAA of the Taxation Administration Act 1953 (Cth) ("the TA Act"). 2 The applicant, a medical practitioner, applied to the Commissioner for a ruling pursuant to s 14ZAF of the TA Act as to whether an amount of $140,000 ("the settlement amount") received in the year of income ended 30 June 2000 from Australian Casualty Company Ltd ("the insurer"), pursuant to terms of settlement between himself and the insurer, was assessable income. The Commissioner made a private ruling in accordance with s 14ZAR of the TA Act that the settlement amount is assessable income. The applicant objected to the ruling pursuant to s 14ZAZA of the TA Act but the objection was disallowed. As a result of the objection the applicant's right to object against an assessment relating to the matter ruled upon is limited to grounds that "neither were, nor could have been, grounds for the taxation objection against the ruling": see s 14ZVA of the TA Act. 3 The applicant applied to the AAT to review the decision of the Commissioner disallowing his objection. The AAT, in affirming the Commissioner's decision, concluded that the settlement amount was assessable income as it was paid in settlement of the applicant's right to income under a Professional Income Replacement policy with the insurer ("the policy"). The applicant appealed to the Court on the ground that the AAT erred in law in arriving at that conclusion. 4 It is common ground that the AAT is confined and limited to the facts ruled upon by the Commissioner and that the Court is likewise confined and limited: see Commissioner of Taxation v McMahon (1997) 79 FCR 127. Those facts can be briefly stated as follows. The applicant was, until 1996, employed as a qualified medical practitioner specialising in stress management. He had an annually renewable Professional Income Replacement policy with the insurer. The policy, inter alia, provided that the insurer would pay to the applicant, in the event that he was totally or partially disabled from being able to work as a medical practitioner, a monthly benefit of $4,000. Since 1996 the applicant was unable to work as a result of total or partial disability. He made a claim on his insurer for payment of the monthly benefits but the insurer denied liability. The applicant commenced a proceeding in which he claimed $96,000, being 24 months at $4,000 per month for the period from August 1996 to July 1998, and a right to continuing payments of $4,000 per month from August 1998 until the applicant was able to return to work. He also claimed interest on the outstanding amounts payable. 5 On 23 July 1999 the applicant settled his dispute with the insurer at the pre-trial conference. The terms of settlement were as follows: "Terms of Settlement 1. Without admission of liability and in consideration for the cancellation of the policy of insurance upon which the plaintiff's claim is based the defendant shall pay to the plaintiff the sum of $140,000. 2. Payment of the above amount shall be made within 14 days from the date hereof by cheque payable to the plaintiff and to be given to the plaintiff's solicitor. 3. The policy the subject of the action, being Policy 2159093, is cancelled with immediate effect and the plaintiff shall enjoy no further rights under the policy. 4. The defendant shall pay the plaintiff's costs of the action in the agreed sum of $10,000, payable together with the capital sum. 5. Upon payment of the capital sum and the costs the proceedings shall be dismissed with no order as to costs. The solicitors for the parties shall execute an order pursuant to order 43 Rule 16 of the Rules of the Supreme Court to give effect hereto." 6 The applicant argued before the AAT that the settlement amount was a payment of capital as it was paid in consideration of the cancellation of the policy and the consequential surrender by the applicant of all further rights under the policy. The applicant also argued that, even if part of the consideration was paid in settlement of the applicant's income replacement claim, the lump sum payment received on settlement represented an undissected aggregation of both income and capital components with the consequence that the entire sum is on capital account. 7 The respondent argued before the AAT that the settlement amount was paid in settlement of the applicant's claims for the monthly income replacement benefits provided by the policy. The Commission argued that the settlement amount, being in satisfaction of an entitlement to income, was itself income. 8 The AAT stated at [9] of its decision: "It is clear that an undissected lump sum containing both income and capital components without any apportionment between the two components is of a capital nature (McLaurin v Federal Commissioner of Taxation (1961) 104 CLR 381, Allsop v Federal Commissioner of Taxation (1965) 113 CLR 341). It is equally clear that payments of monthly sums under the relevant policy, if received by the applicant, would have constituted assessable income (Commissioner of Taxation v Smith (1980-1981) 147 CLR 578). Further, where a taxpayer is paid a lump sum amount in satisfaction of a right to income (whether past or in the future), that amount is itself income." 9 After considering the terms of the policy and the surrounding circumstances, the AAT affirmed the decision under review stating: "11. …It would seem that this is … a case where it is appropriate to consider the whole of the circumstances leading to the payment of the settlement sum. Prior to the date of the settlement and subsequent receipt of the lump sum, Dr Sommer was claiming some three years of monthly payments of $4000 per month. On the information set out in the application for ruling this total amount to July 1999 would have been $144,000 (36 months at $4000 from August 1996). It appears that the sum paid on settlement was very close, if not precisely, the entitlement under the policy to the date of settlement . Given it was a contested matter between Dr Sommer and the insurance company, it is not unreasonable to regard the amount paid as being in consideration of all entitlements to monthly payments up to the date of settlement in consideration of no further claims being made thereafter. 12. On balance I am of the opinion that the lump sum of $140,000 was paid in settlement of a right to income and the respondent was correct in his ruling that, on the facts given to him, the $140,000 is assessable income. No objection was taken to the second part of the ruling relating to refunds of social security payments and it is unnecessary for me to deal with that part of the ruling." 10 It is common ground that the applicant's appeal raises a question of law namely, whether the settlement amount is income under ss 6-5 or 15-30 of the Income Tax Assessment Act 1997 (Cth). The applicant claims that the AAT erred in law in two respects. The first was that it erred in having regard to the surrounding circumstances, rather than confining itself to the terms of settlement, which provided that the consideration received was in consideration of the cancellation of the policy. The second error of law said to have been made by the Tribunal was its reliance upon the statement of principle that: "In all cases a lump sum paid in satisfaction of a right to income will always be income." 11 In characterising a payment made under an agreement the terms of the agreement must be examined together with the circumstances surrounding its execution, its operation and the receipt of the money in question: see Allied Mills Industries Pty Ltd v Commissioner of Taxation (1989) 20 FCR 288 ("Allied Mills") at 309. In some cases the court has treated an agreement under which an amount, sought to be characterised by the Commissioner as income, is paid as part of the matrix of facts constituting the relevant circumstances to be taken into account in characterising the payment (see for example Allied Mills at 310-312 and Reuter v Federal Commissioner of Taxation (1980) 93 ATC 5030 at 5036). In other cases the characterisation of the payment has been able to be determined from the agreement, it being accepted that it is not a sham (see for example Federal Commissioner of Taxation v CSR Ltd (2000) ATC 4710 at 4723). 12 In the present case the terms of the agreement refer to the relevant surrounding circumstances. Clauses 1 and 3 of the terms of settlement provide that the applicant shall enjoy no further benefits under the cancelled policy and cl 5 requires that upon payment of the settlement amount the applicant's proceeding, in which he is claiming payment of the income replacement benefits payable under the policy, be dismissed. Accordingly, it is difficult for the applicant to argue that the surrounding circumstances are not relevant to the characterisation of the settlement amount. In my view, the true nature and proper characterisation of the settlement amount is to be determined by having regard to the policy, the applicant's claims under the policy, the terms of settlement which, inter alia, settled those claims and the rights the applicant will be surrendering upon the cancellation of the policy. 13 The policy provided for benefits of $4,000 per month during the period of the applicant's total or partial disability. The insurance was renewable annually upon payment of the premium until the applicant turns 65. However, Pt 9 of the policy provided, in effect, that payment of the annual premium was not a pre-condition for liability for a continuing total disability which began three months before the end of a policy year for which benefits are payable under the policy. The policy also provided for minimum payments of the monthly benefits in respect of death and particular categories of disability, none of which were applicable to the applicant. The policy covered rehabilitation and hospitalisation expenses but no such expenses were claimed by the applicant. 14 The only claim made by the applicant was for income replacement benefits of $4,000 per month payable as from August 1996. That claim, which was for past and future benefits, was settled by the terms of settlement. Two aspects of the terms confirm that that is so. The first is that the proceeding in which the claim is made is to be dismissed upon payment of the settlement amount (see cl 5). The second is that it appears to have been the clear intention and agreement of the parties that, as a result of the cancellation of the policy, the applicant was not entitled to receive any further benefits under the policy (see cll 1 and 3), which benefits included the past and future benefits he had claimed. The applicant had not made or threatened to make any other claims under the policy. Thus, it is clear from the terms of settlement and the claims settled by those terms that the fundamental element in the payment of the settlement amount was that it settled the past and future income replacement claims of the applicant. 15 It is well established that, in general, insurance monies are received on revenue account where the purpose of the insurance was to fill the place of the revenue receipt which the event insured against has prevented from arising: see Carapark Holdings Limited v The Commissioner of Taxation (1967) 115 CLR 653 at 663. Thus, amounts payable under a policy that provides a monthly indemnity against income loss arising from inability to earn are of a revenue character: see Commissioner of Taxation v Smith (1981) 147 CLR 578 at 583-584. The applicant relied on the decision of the Administrative Appeals Tribunal in Coward v Federal Commissioner of Taxation (1999) ATC 2166 at 2178-2180, which treated a lump sum redemption payment, calculated by reference to weekly amounts of compensation, as on capital account. However, the capital element in that case arose because the lump sum redemption payment was held to be in respect of a loss of earning capacity, rather than in respect of the loss of earnings, and was therefore a payment of capital. See also Federal Commissioner of Taxation v Inkster 89 ATC 5142 at 5159-5160. 16 The fact that the payment of the monthly benefits in the present case is made in one lump sum does not change the revenue character of the receipt if it was essentially designed to compensate the applicant in respect of his income replacement claims or was a payment in substitution for those claims: see Allied Mills at 310-312 and Henry Jones (IXL) Ltd v Commissioner of Taxation (1991) 31 FCR 64 at 78-79 and 80. The Federal Commissioner of Taxation v The Myer Emporium Limited (1987) 163 CLR 199 at 218 is of no assistance to the applicant because, as the Commissioner contended, the applicant in the present case did not assign any underlying property rights or any contractual rights against the insurer. Rather, he received a payment pre-conditioned upon cancellation of the policy and settlement of his claims for the income replacement benefits provided by the policy. 17 When monies are received in consideration of surrendering a benefit to which the recipient is entitled under a contract, the inquiry as to whether the receipt is of capital or of income requires consideration of the "congeries of rights" which the recipient enjoyed under the contract and which, for a price, were surrendered: see Van den Berghs Ltd v Clark [1935] AC 431 at 443, Bennett v Federal Commissioner of Taxation (Cth) (1947) 75 CLR 480 at 485 and Allied Mills at 299. 18 As explained above, the valuable rights surrendered by the applicant related to his claim be paid monthly disability benefits payable under the policy. The applicant argued that the settlement amount was paid in consideration of the cancellation of the policy which resulted in the surrender of the applicant's right to renew the policy and to obtain future benefits. The rights surrendered were said to be valuable and of a capital nature. However, the applicant's argument that such rights were valuable was not supported by the material before the Commissioner when he made the private ruling. The argument is also not supported by the terms of the policy itself. The right of renewal from year to year is subject to payment of the annual premium, which, in general, could be expected to be commensurate with the risk insured against. Thus, it is not self evident that the right of annual renewal was a valuable right which was surrendered by the cancellation of the policy. The applicant also sought to rely upon the loss of particular benefits payable under the policy, other than in respect of income replacement, such as minimum benefits for death and particular disabilities and indemnity for rehabilitation and hospitalisation expenses. However, no claims of that kind had been made or threatened by the applicant. Thus, there is an air of unreality and artificiality about the applicant's contention that there was a capital element involved in the cancellation of the policy, and therefore in the settlement amount. 19 The substance and the commercial reality of the settlement was that it was a full and final settlement of the dispute between the applicant and the insurer in relation to the applicant's past and future claims to be entitled to income replacement benefits as a result of his total or partial disability since August 1996. As explained above, it is well established that a payment in settlement of such claims is a payment on revenue account. 20 As I am not satisfied that the settlement amount related to claims, entitlements or benefits of an income and capital nature the question of apportionment, which arose in cases such as McLaurin v Federal Commissioner of Taxation (1961) 104 CLR 381, Allsop v Commissioner of Taxation (1965) 113 CLR 341 and Commissioner of Taxation v Northumberland Development Co Pty Ltd (1995) 59 FCR 103, does not arise in the present case. 21 Accordingly, on the material before the Commissioner the AAT was entitled to conclude that the settlement amount was, in substance, a payment in satisfaction of the applicant's claims to receive past and future income replacement benefits and it did not err in law in affirming the Commissioner's ruling that the settlement amount was assessable income. 22 For the above reasons the appeal of the applicant is to be dismissed with costs. I certify that the preceding twenty-two (22) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Merkel. Associate: Dated: 26 September 2002 Solicitor for the Applicant: Mr L Baring of Maddocks Counsel for the Respondent: Mr T Murphy Solicitor for the Respondent: ATO Legal Practice Date of Hearing: 17 September 2002 Date of Judgment: 27 September 2002