Capital gains tax: How changes to exemptions on compensation or damages could benefit taxpayers

The capital gains tax laws are voluminous and complicated. But they also contain benefits for taxpayers.

Legislation introduced in Federal Parliament last week – the Tax and Superannuation Laws Amendment (2014 Measures No 7) Bill 2014 – will amend the tax law to ensure that CGT exemption is available in respect of compensation or damages received by:

• a trustee (other than a trustee of a complying super fund) for a wrong or injury a beneficiary suffers in their occupation, or a wrong, injury or illness a beneficiary or their relative suffers personally – and a beneficiary that subsequently receives a distribution that is attributable to such compensation or damages from the trustee;
• a taxpayer for a policy of insurance on the life of an individual or an annuity instrument if the taxpayer is the original owner of the policy or instrument; and
• a trustee of a complying super fund for a policy of insurance for an individual’s illness or injury.

The government said it was intended that trustees or beneficiaries who receive compensation or damages in respect of certain events (such as an injury an individual suffers at work) or in respect of certain policies of insurance (such as illness, injury or death) not be subject to CGT.

However, the express wording of the relevant provisions in the tax law had created uncertainty about this treatment. It was also intended that insurance policies held by complying superannuation funds for injuries and illnesses suffered by an individual not be subject to CGT. So the legislation now introduced seeks to implement those original intentions.

Read more: Capital gains tax on investment property explained

Under the proposed changes, a capital gain or loss made by a trustee in relation to compensation or damages for any wrong or injury a beneficiary of the trust suffers in their occupation, or any wrong, injury or illness a beneficiary of the trust or their relative suffers personally, will be disregarded. Further, a capital gain or loss made by a beneficiary will also be disregarded if the trustee of a trust then distributes money, property or other CGT assets to the beneficiary attributable to the compensation or damages received by the trustee.

Take the following example.

Robert is the beneficiary of ABC trust, which was established after Robert fell off a roof whilst working for Roofing Inc and suffered serious injuries. Patrick, as trustee of ABC trust, seeks compensation on behalf of Robert from Roofing Inc’s insurance company, and receives compensation for the accident.

Under the proposed law, the capital gain made by Patrick in relation to the compensation received will be disregarded.

Assume Robert recovers from his injuries, but requires substantial further medical and other support. Patrick, as trustee of ABC trust, distributes the compensation to Robert to assist in paying his hospital bills. Any capital gain made by Robert in relation to the compensation received will be disregarded.

The bill also proposes that a capital gain or capital loss made from a CGT event happening to an interest in a policy of insurance on the life of an individual or an annuity instrument is disregarded by the original owner of the policy or instrument.

Another example will help explain this.

Fred holds a life insurance policy from an insurance company. Fred passes away and his wife Jane, as executor of his estate, receives $200,000 from the insurance company in respect of the policy. Jane, as executor of Fred’s estate pays $50,000 to Alice, a beneficiary of Fred’s estate. The payment to Alice is attributable to the amount received by Fred’s estate in respect of the life insurance policy.

Any capital gain made by Alice, as a beneficiary of Fred’s estate, will be disregarded.

The amendments will apply retrospectively in relation to CGT events happening in the 2005-06 and later income years i.e. generally from 1 July 2005. Accordingly, the tax law has also been amended to ensure that taxpayers are given sufficient time to seek an amendment to previous assessments (as the amendment period will otherwise have expired in some cases), if required in these circumstances.

The government says the amendments are consistent with the administrative practice of the Commissioner of Taxation and ensure that taxpayers that could have benefited by relying on the Commissioner’s administrative practice are not disadvantaged by the changes.

The bill will not be debated until after Parliament resumes in February 2015, but the changes are welcome.