Settlements and compensation after the Banking Royal Commission: what about the tax?

By Andrew O’Bryan

It’s been almost two years since the Banking Royal Commission and Commissioner Hayne’s report which was released on 4 February 2019 (the Hayne Report). The Commission involved case studies, public hearings, inquiries, and the final report, on misconduct in the financial services industry.

We continue to hear about the impact of the Commission. The practices in the industry have changed, and these changed practices have led to compensation being paid. These payments are usually compensation of some sort, a confidential deal to settle the matter. They might also be a payout, the settlement of a claim where it’s simply a reputational risk to pursue the matter further.

It is apparent that not a lot of thought was given to the tax consequences, if any, of such settlements, and now there is some catching up to be done.

The Hayne Report concludes:

Failings of organisational culture, governance arrangements and remuneration systems lie at the heart of much of the misconduct examined in this Commission. Improvements in the culture of financial services entities, their governance arrangements and their remuneration systems should reduce the risk of misconduct in future.^[1]

A number of situations where compensation would be paid were identified in the report, such as fees wrongly being charged, poor financial advice, and taking money as payment for services that were not provided. We’ve recently seen some of these paid out. Some interesting ones are in the case studies below.

The character of the payment

The tax treatment of a payment depends on its character. What might at first brush be simple – for example, lost interest that would have been taxable if it had been received, would still be taxable as ordinary income – can become complex, especially when your client might receive a ‘catch all’ compensation amount, covering more than one issue. Further complexities may arise where the payment is replacing an amount the person would have received from the financial institution, but is being paid by a separate entity, or the financial institution in a separate capacity. This changes the character of the payment, and the tax consequence of the payment.

The first step in considering the tax consequence of a compensation payment is to consider the underlying asset to which the compensation payment relates. A ‘look through’ approach is used to determine what the underlying asset is – this is the asset that is disposed of, has been damaged, reduced in value – it is essentially the event which has caused the right to seek compensation. This is consistent with the ATO’s view set out in TR 95/35: Income tax: capital gains: treatment of compensation receipts.

ATO guidance

The ATO has issued guidance in relation to some forms of compensation payments for individuals and super funds, and is in the process of providing more guidance, hopefully by December 2020. The current guidance highlights that tax treatment of a payment made by a financial institution to a taxpayer will follow the character of a payment.

Some of the key points from the guidance are summarised below.

For individuals

The guidance also outlines that where compensation relates to more than one investment, it will need to be apportioned. The ATO guidance for individuals doesn’t outline tax consequences if the investment is held on revenue account, or in a separate entity (such as a trust).

For superannuation funds

The guidance is helpful, however, we expect there will be many circumstances where a compensation amount will not fit into any of the categories outlined, because of the entity receiving the compensation, the entity paying the compensation, or where the compensation relates to a completely different right to compensation – for example, where the financial institution chooses to make the payment out of a sense of goodwill, or in response to its corporate social responsibility.

More advice is set to be issued later this year (by December), which will include where individuals receive underpaid credit interest, and the withholding and reporting obligations of financial institutions as a result of the Hayne Report. The latter will be particularly relevant for taxpayers, as we understand financial institutions will be required to report most compensation payments made to their customers, to the ATO. This means data matching may be used to ensure taxpayers then include these amounts as income in their income tax returns (or even in pre-filled returns). It is also unclear whether the guidance will apply to the 2019-2020 financial year, or from the current, 2020-2021 financial year.

Case studies

We have seen some recent examples of compensation payments being paid in return for a release being signed, for mistakes and bad practices by the financial institution. It’s also becoming a common theme that tax consequences haven’t been considered – or are ignored – because it makes the release more simple.

Example 1: TPD insurance which didn’t actually cover the taxpayer’s occupation

A taxpayer holds a superannuation policy which includes total and permanent disablement (TPD) insurance. The taxpayer suffers an injury, and makes a claim under the policy. The claim is denied on the basis that their occupation is a ‘non insurable option under the policy’.

A complaint is made (timing: before the Hayne Report) that the superannuation fund incorrectly attributed their occupation under the policy, to a similar, but excluded, occupation. The superannuation fund then makes an offer to the taxpayer (timing: following the Hayne Report) to resolve the matter – and for the amount that would have been covered had the claim been accepted, and the signing of a deed of release.

The terms of the settlement make it clear that this is not compensation in the form of an accretion, or payout, from their superannuation fund, and was not being paid by their superannuation fund (instead, the trustee in its own capacity). The compensation is not a TPD payment, it is the disposal of the right to seek compensation in settlement of:

• bad administration on the part of the trustee of the superannuation fund by providing the taxpayer with a policy for an occupation which was excluded, and not disclosing this to the taxpayer; and 
• the failure of the trustee to resolve the complaint within a certain time frame.

In this case, it means that the compensation payment is a taxable capital gain to the taxpayer. It’s a CGT event C2 – the right to compensation being released, discharged or satisfied. The time of the CGT event is when the compensation proceeds are actually received. Provided that the taxpayer held the right to seek compensation for more than 12 months, they should be for the 50% CGT discount.

This example highlights the need to consider not only the underlying asset of the payment (here, the TPD insurance), but also, what the deed of release specifically stated about the nature of the payment being made, and who was paying the compensation. It would have been a different outcome had the superannuation fund paid out the compensation or the payment was made as a TPD entitlement.

Example 2: Preparing for retirement based on incorrect superannuation benefit calculations

A taxpayer holds a superannuation policy and receives annual statements showing a healthy and growing balance. The taxpayer gets closer to retirement and commences taking steps for their retirement plans – purchases a new property, sells some other property, promises to buy their partner a car, makes some gifts.

It is then discovered that the superannuation fund has miscalculated the taxpayer’s member balance, which was about half of what it was thought to be. This is despite reviews of the member benefit statements a few years before retirement showing no issues.

The error was put down to the superannuation fund incorrectly accounting for a transfer from weekly to monthly payroll. The superannuation fund confirmed their calculations were incorrect, and offered compensation. Like the example above, the compensation is offered to be paid by the trustee of the superannuation fund in its own capacity.

In this case, the compensation payment is a capital payment which is a CGT event C2. The exemption in section 118-305 would apply, if the payment is made ‘out of a superannuation fund’. However, if it is paid by the trustee of the superannuation fund, in its own capacity, and not as trustee, it is unlikely to be exempt. This highlights the nuances in a settlement; and the difference between a compensation payment being characterised as an assessable capital gain or an exempt amount.

Example 3: '… in line with community expectations…'

A financial institution has an agreement in place with a referrer, for the payment of a ‘referral fee’ on the recommendation of their clients to the financial institution. Their clients may engage the financial institution for investment management and advice.

In light of the Hayne Report, the financial institution has advised the referrer that it will pay an amount to the firm, in the form of a settlement, to effectively ‘cancel’ their referral relationship, which has been in place for many years.

Interestingly, the financial institution cited the reason for the cancellation as being ‘in line with community expectations.’ It may better have been described as being in line with the findings of the Royal Commission!

We’ve also started seeing similar arrangements where accountants and financial planners are being paid a lump sum to cancel their right to receive an annual rebate, an amount that would usually be ordinary income.

What to do?

The case studies highlight two important issues:

• the ‘look through’ approach doesn’t always work, particularly when the payment is being made in settlement of bad administration generally, and not in replacement of the underlying asset to which the compensation relates. It is particularly important to look at the terms of the deed of release – this will dictate the terms of the settlement; and
• the party paying the compensation may not be the same party that would have been responsible for payment of the underlying asset. This may be more common in superannuation type cases where the trustee itself pays out a settlement, instead of in its capacity as trustee of the superannuation fund.

If your client has received a compensation payment, then the first step is to consider the underlying asset. What is the payment replacing?

Our advice is to always get advice! Some matters can be resolved simply; in other cases, a private ruling may be the best approach. Either way, the case studies above highlight the complexities of taxing compensation payments. While the taxpayer may be relieved to have received some form of compensation, a subsequent tax bill makes that compensation a little less sweet.

[1] Page 409.