Tax treatment of lump sum settlement payments – draft released

Tax Alert - February 2016

By Emma Marr and Patrick McCalman

Taxpayers who enter into settlement agreements without specifically apportioning payments between capital and revenue amounts may face an uphill battle if they seek to treat receipts as non-taxable, following the release by Inland Revenue of a draft interpretation statement on the tax treatment of lump sum settlement payments.

In PUB00246 Income Tax – Treatment of Lump Sum Settlement Payments, the Commissioner concludes that if there is no reasonable and objective basis for apportioning a sum received under a settlement agreement, the entire amount will be treated as revenue and will therefore be taxable. 

This position reflects the Commissioner’s view that two Australian decisions to the contrary would not be followed in New Zealand. The two cases in question (McLaurin v FCT[1] and Allsop v FCT[2]), which held that a settlement payment that cannot be apportioned should be treated as capital, are decisions by the highest Australian court, and have stood unchallenged for 50 years.  Inland Revenue take the view that McLaurin and Allsop contradict two decisions from the United Kingdom (Wales v Tilley[3] and Carter v Wadman[4]), on the tax treatment of settlement payments, that the UK decisions are more consistent with New Zealand case law on apportionment, and accordingly McLaurin and Allsop are not good law in New Zealand.

We are disappointed with this conclusion.  While McLaurin and Allsop have not been applied in New Zealand, their application was considered in Sayer v CIR (1999) 19 NZTC.  The High Court, presented with the principles in McLaurin and Allsop, considered that the principles in those cases could be applicable in the appropriate circumstances. In contrast, we are not aware of (and the Inland Revenue does not cite) any New Zealand authority which favours the United Kingdom over Australian authorities.  Further, we do not actually consider that the Australian and United Kingdom authorities are inconsistent with each other.  All the cases have a central principle that a settlement payment should be apportioned between its capital and revenue elements where there is a reasonable basis for doing so – it is just that in the United Kingdom cases cited, the Courts were able to find that basis.  The United Kingdom cases do not, therefore, in our opinion contradict the principle in McLaurin and Allsop that a sum that cannot be apportioned should be treated as capital 

In our view the Commissioner’s approach is unprincipled and it is unfortunate that important matters of tax law are subject to what appears to be an arbitrary (and revenue-friendly) conclusion by the Commissioner on the precedential value of Australian case law.   We are even more persuaded in this view when one considers that the Australian cases are decisions of Australia’s highest court and have stood unchallenged for over 50 years.  In this regard, as the Commissioner has done elsewhere where there are capital receipts that she wishes to assess (cf Wattie and lease inducements) we feel she might be better served to advance law change to address this issue than adopt an interpretation which stands in direct conflict with existing Australian authority and is equally as arbitrary in seeking to fully assess non-apportioned sums as the position she seeks to criticise.

That said, the reality is that taxpayers faced with the receipt of such sums will find little joy in arguing the position on the application of the Australian authority with Inland Revenue.  Although some may be willing to test the position through the New Zealand courts, for those who are not we recommend that, where possible, settlement agreements include an apportionment of settlement payments.  If it is not practicable to include this formally in the settlement agreement, taxpayers should try to retain contemporaneous supporting documents that will support their claim to apportionment.

This does not resolve the common situation of lump sum payments that reflect a compromise arising from the negotiations of the parties, and that genuinely cannot be apportioned between capital and revenue components.  If the draft interpretation statement is finalised in its current form, taxpayers should be prepared for the Commissioner to challenge taxpayers that treat un-apportioned settlement payments as capital receipts. 

For further information, please contact your usual Deloitte tax advisor.


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