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Can you claim tax on your compensation pay-out?

Mark Chapman
·Director Of Tax Communications, H&R Block
·6-min read
(Source: Getty)
(Source: Getty)

Life doesn’t always go to plan. Some time, through no fault of your own, you can be affected by events outside your control that conspire to throw a spanner in the works.

In these sorts of situations, it is quite possible that you’ll receive compensation to cover you for the economic or personal loss arising from the event.

A common question is whether such compensation is taxable. Here’s my guide to some of the common situations where people get a compensation payout and the tax consequences that can arise.

More from Mark Chapman:

Compensation for mis-sold financial advice

Since the recent Banking Royal Commission, there has been a spike in compensation payments paid to investors by financial institutions.

But did you know that these payments could be taxable?

The way tax law applies to such payments is complicated because different tax treatments apply to different types of compensation. For example, compensation for interest that you have lost will be taxable (on the basis that the interest – if you’d receive it – would also have been taxable).

Compensation for fees paid to advisers who gave dodgy advice would be taxable if you claimed a tax deduction for the original fees but NOT taxable if you didn’t claim a tax deduction.

Compensation for an investment that you have since sold, will need to be added to the sale proceeds from the original investment – which could involve extra Capital Gains Tax and amending a previously lodged tax return.

That’s three examples of wildly differing tax treatments and there are others – this really only skims the surface!

Whilst it might seem glib to simply say ‘seek advice’, that is actually the best guidance in this situation. Not only do different tax treatments apply to different payments, many people will also receive compensation for more than one fault.

In that case, they need to be able to split out the different elements and work out the different tax treatments on each. So, talk to a tax adviser and in addition make sure you get and keep detailed paperwork identifying exactly what you are being paid out for.

Also, don’t forget that if the payout you receive is taxable, you may be able to claim a deduction for any fees you incurred in getting it (such as lawyers fees).

Personal injury compensation

If you receive compensation from your employer which relates to the loss of wages or income only, then the amount will be taxable, irrespective of whether the amounts are paid to you as a lump sum or on a periodic basis.

This is because the compensation is being provided as a substitute for a taxable income – your wages or salary – which no longer exists, so it takes the same character.

Any legal fees which you incur in claiming such compensation would generally be tax deductible.

However, if your claim relates to any wrong or personal injury suffered in your occupation and you agree to a settlement, or a court orders in your favour, the compensation you receive will be tax free, whether paid as a lump sum or on a periodic basis.

Personal injury includes physical injury, psychological damage and mental injury, whilst “wrong” includes defamation, breach of privacy, sexual harassment, unlawful discrimination and wrongful dismissal.

Any legal fees which you incur in claiming such compensation would generally NOT be tax deductible.

Compensation for wrong or personal injury doesn’t need to be included in your tax return but any income generated by the compensation once you have it (such as bank interest) is taxable and does need to be disclosed.

If the payout you receive contains elements of both compensation for wrong/personal injury and loss of income, you may need to allocate it between the two elements. In many cases, a court order awarding the compensation will set out the split in writing.

Compensation for property damage

We live in a country that is prone to natural disasters. From fires, to floods, to howling winds, there is a risk that if you own property, for instance a rental property or a business premises, you could one day find that your hard earned investment has been reduced to rubble or ashes.

If that happens, you may receive compensation, often in the form of insurance payouts.

Payouts that relate to loss of income (for instance rental income or business income if the property is used to run a business) are taxable and must be included in your tax return. Payments that relate to the costs of repairing a damaged property will also be taxable although you may be able to claim a corresponding deduction for repair costs incurred.

Where your investment or business property is completely destroyed, insurance payouts are treated differently. The destruction of your property is, in effect, treated in the same way as the sale of your property and gives rise to a Capital Gains Tax (CGT) event.

The amount of insurance proceeds received is treated the same way as proceeds arising on sale, meaning that you then need to work out your capital gain or loss and include it in your tax return.

A capital gain will arise if your insurance payout is more than the cost of the destroyed property. A capital loss will arise if the insurance payout if less than the cost of the destroyed property.

If you make a capital loss, this can only be offset against a capital gain. If you don’t have a capital gain in the same year, you’ll need to carry the loss forward until a capital gain arises in a future year.

The date that the CGT event occurs is not generally the date the property was destroyed (unless you don’t receive a payout at all). Instead, the CGT event happens when you receive your insurance payout in respect of the destruction of your property, which may not be the same year that the destructive event occurred.

If your property is not completely destroyed but is substantially damaged, the payout will not give rise to an immediate capital gain. Instead, the CGT cost of the property will be reduced by the amount of the payout, potentially increasing the CGT liability that will arise when the property is sold in the future.

In addition to insurance payouts, different levels of government (state, federal or local) will also often provide payments to affected individuals and businesses. Whilst usually taxable, there are situations – like the 2019/20 bushfires – where the such payments have been specifically made tax-free.

You can’t rely on this always being the case; for instance, more recent support payments made to individuals and businesses to compensate for the effects of Covid-19 are taxable.

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