Tax Implications of Compensation for Sophie Jones and Kate

This case study examines the tax implications for Sophie Jones, an Australian resident operating a beauty clinic, and her client Kate, who suffered permanent scars from a laser treatment. The analysis delves into the tax treatment of various compensation amounts, including Sophie's compensation for reputation loss, income loss due to machine replacement, and legal fees, as well as Kate's payments for pain and suffering, medical expenses, and interest. The study applies the Income Tax Assessment Act 1997 and relevant rulings to determine whether these compensations are classified as ordinary income, statutory income, or capital receipts. Key considerations include the distinction between compensation for loss of income versus loss of reputation, the treatment of legal fees reimbursement, and the taxability of personal injury awards and interest. The analysis references legal precedents to provide a comprehensive understanding of the tax implications in this scenario.

Question 1
Issue
Sophie Jones is an Australian Resident who owns and operates a business of beauty clinic. The
principal business is of laser cosmetic procedures. The business has been running well and the
reputation of Sophie is strong in the market. Sophie has recently made a purchase of machinery
from a resident vendor Fracpro Pty Limited for laser cosmetics and has used the same for treatment
of her client Kate post taking a training session on usage of equipment.
Kate, client of Sophie Jones is the first customer on which the equipment has been used for laser
treatment. However, on account of such treatment, Kate has developed permanent scars. Both, Kate
and Sophie on account of such issue has failed a suit against the domestic company and the
following expenses have been incurred/ amount has been recovered on account of law suit:
Sophie
(a) Lump Charges for excessive reputation loss amounting to $ 100,000;
(b) Income loss compensation because of the machine replacement amounting to $20,000;
(c) Legal fees payment amounting to $ 7,000.
Kate
(a) Amount paid for pain and suffering amounting to $ 120,000;
(b) Amount paid for medical and surgery cost for cosmetic amounting to $ 50,000;
(c) Amount paid for interest amounting to $ 8,000.
Law & Application
Sophie
To understand the implication of the current situation, one needs to understand the definition of
compensation which means something, typically money which is generally awarded to someone in
recognition of loss, injury or suffering. It is distinct from non-taxable refund and one has to classify
whether the compensation shall be categorised as ordinary income or statutory income in terms of
Income Tax Assessment Act, 1997.
In terms of law and various judicial precedents, any amount if any in the form of compensation an
individual received for the loss of any income is not specifically exempt, rather the same shall be
bought under the net of income tax. If the compensation received by the individual exceeds the
expected net loss after deduction of taxes, then such income shall be treated as taxable.
Further, it has been held by Federal Court (Sackville J) that any income received as a compensation
for the defamation proceedings shall not be treated as ordinary income for the purpose of tax under
Section 6(5) of the Income Tax Assessment Act, 1997, even though such income has been computed
with reference to the lost income. Thus, on the basis of the above, it may be concluded that
compensation for loss of income shall be bought to tax under ITAA, 1997.
Also, under FCT v Sydney Refractory Surgery Centre Pty Ltd [2008] FCAFC 190; (2008) 73 ATR 28, it
has been held that any amount received in the form of compensation for defamation of loss of
personal reputation cannot be treated as ordinary receipt under Income Tax Assessment Tax, 1997.
Further, the Federal Court held that payment of loss of business reputation was akin to payment for
good will and shall be treated as capital receipt. The court also deliberated t hat

tax treatment of the payment had to be determined having regard to the cause of action in respect
of which the damages were paid, rather than the way the damages had been calculated. (Geoffrey
Clews, 2019)
Accordingly, any income which has been received pertaining to loss of income shall be a considered
as a receipt of an income shall be treated as income receipt and shall be chargeable to tax as
ordinary income/ statutory income and income received for damage of reputation shall be
considered as capital receipt. However, there are precedents wherein it has been held that
compensation for loss of earning capacity has been treated as capital receipt and the same has been
taxed as statutory income.
For legal fees, there have been various judicial precedents which states that if the expenditure
incurred for legal fees is allowed as deduction in terms of Section 8(1) of the Income Tax Assessment
Act, 1997, the receipt of reimbursement of such expenses shall be treated as ordinary income to the
extent deduction is allowed. Similar view has been held in the ruling TR 2012/8 wherein the Hon’ble
court held that
5. Where a deduction for legal costs is available to the recipient under section 8-1, a settlement or
award in respect of legal costs will be included in the recipient's assessable income as an assessable
recoupment under Subdivision 20-A. ( Australian Taxation Office, 2019)
Kate
In terms of Section 6-5 of Income Tax Assessment Act, 1997 assessable income of a taxpayer shall
include income according to ordinary receipts. Further ordinary income shall encompass the
following:
(a) Income arising from providing personal services;
(b) Property income;
(c) Profit arising from carrying of business.
Further, income should have the following characteristics
(a) They must be earned;
(b) Must be expected;
(c) Which also can be relied upon and ;
(d) Have an element of periodicity, recurrence or regularity.
Since, payment for personal injury is not received for rendering any personal service nor does it
contain and property income or income from any business, the same cannot be treated as ordinary
income. Further, the payment is one off and does not have regularity.
Also, in terms of Advice with authorisation no. 1013041829626 dated 30 June, 2016, it has been
stated that a compensation generally bears the character of the underlying which is bears to replace.
If any amount of compensation paid for income loss then it shall be treated as ordinary income or if
sought to replace any capital asset then it will be considered as a receipt which is capital in nature. It
has been further advised that compensation for personal injury and loss of earning capacity shall be
regarded as being capital in nature.

Further, in terms of Taxation Ruling 95/35 any settlement for personal injury claim represent the
disposal of an asset, Further, in terms of part 3-1 of the ITAA 1997, any asset which is disposed off
give rise to a Capital Gain Tax Event. However, paragraph 118-37(1)(a) of the ITAA 1997 disregards
payments or any amount received for the purpose of CGT provisions where any amount paid relates
to compensation or damages you received for any wrong, injury or illness suffered. (Coomonwealth
of Australia, 2019)
Payment of ongoing medical and surgery cost
For taxability of reimbursement, there have been various judicial precedents which states that if the
expenditure incurred for any reimbursement is allowed as deduction in terms of Section 8(1) of the
Income Tax Assessment Act, 1997, the receipt of reimbursement of such expenses shall be treated
as ordinary income to the extent deduction is allowed. Similar view has been held in the ruling TR
2012/8 wherein the Hon’ble court held that
5. Where a deduction for legal costs is available to the recipient under section 8-1, a settlement or
award in respect of legal costs will be included in the recipient's assessable income as an assessable
recoupment under Subdivision 20-A.
Also, the expenditure incurred for cosmetic surgery is not allowed under the Income Tax Assessment
Act, 1997 shall not be allowed as deductible expense under section 8-1 of the Act. (Australian
Taxation Office, 2019)
Interest on Personal injury award
In terms of ruling 95/35, it has been held by the Federal Court that any amount of interest if any
received by an individual on the compensation for personal injury shall be treated as assessable
income under income tax act and accordingly shall be taxed as ordinary income. It has been further
held that if such income is in seperable from the compensation then such amount of an income shall
be considered as receipt which is capital in nature. The relevant excerpt of the ruling has been
presented as under:
6. Interest awarded as part of a compensation amount is assessable income of the taxpayer under
the general income provisions. If the taxpayer receives an undissected lump sum compensation
amount and the interest cannot be separately identified and segregated out of that receipt, no part
of that receipt can be said to represent interest. If the compensation cannot be dissected it is likely
that the whole amount relates to the disposal of the right to seek compensation. (Australian Taxation
office, 2019)
Conclusion
Based on above discussion, a view may be taken that the compensation received by Sophie for
damage of reputation may not be chargeable to tax. However, any income received for
compensation of loss shall be treated as statutory income and shall be charged to tax under ITAA,
1997. Further, cost for legal fees shall not treated as income since the expense incurred will be
allowed as deduction.
In case of Kate, compensation for personal injury will not be treated as income under the act. Also,
the expenditure reimbursed will not be treated as income as the same is not allowed as deduction
under the act. For interest, it will be taxable as ordinary income.

References
Australian Taxation Office. (2019, September 11). Taxation Ruling. Retrieved from www.ato.gov.au:
https://www.ato.gov.au/law/view/print?DocID=TXR/TR20128/NAT/ATO/00001
Australian Taxation office. (2019, September 11). Income tax: capital gains: treatment of
compensation receipts. Retrieved from www.ato.gov.au:
https://www.ato.gov.au/law/view/document?docid=TXR/TR9535/NAT/ATO/00001
Australian Taxation Office. (2019, September 11). Taxation Ruling. Retrieved from www.ato.gov.au:
https://www.ato.gov.au/law/view/print?DocID=TXR/TR20128/NAT/ATO/00001
Coomonwealth of Australia. (2019, Septembeer 11). Australian Taxation. Retrieved from
www.ato.gov.au:
https://www.ato.gov.au/law/view/view.htm?docid=EV/1013041829626&PiT=99991231235
958
Geoffrey Clews. (2019, September 11). www.taxcounsel.co.nz. Retrieved from
www.taxcounsel.co.nz:
https://www.taxcounsel.co.nz/Resources/Australian+Tax+Case+Notes/Defamation+Damage
s+Not+T