The tax treatment of compensation payments can be a tricky and complex area to navigate. The starting point is to look at what the payment is compensating for and whether the payment is income or capital in nature.
Is the payment compensation for injury? Is the payment compensation for loss of income? Is the payment compensation for loss of an asset?
A compensation payment for injury may be in part for a loss of income which will be ordinary income and taxable and also in part as compensation for the physical injury sustained which will be capital and fall under the CGT regime. A CGT exemption may be available for the capital component of the compensation payment under S118 ITAA1997.
A compensation payment under an income protection policy will generally be classified as ordinary income as it’s replacing income. There may be a situation whereby a compensation payment is agreed upon with an insurer for a lump sum payment in settlement of an income protection policy. This situation can make determining the tax treatment a little more difficult.
A compensation payment for loss of an asset, for example insurance proceeds on a property burning down in a fire, will generally be capital and fall under the CGT regime.
These are merely a few examples of the types of compensation payments which can be received. If you are potentially going to receive a compensation payment, feel free to get in touch with us to ensure you are informed of the potential tax implications and that the payment is classified and dissected correctly to ensure the best tax outcome is achieved.
