ap_ann01

Annuity and Pension income

Compensation payments: are they income or capital?

What is an annuity? The Common Law view!

We are going to be looking at a couple of definitions provided by the Income Tax Assessment Act, shortly, so just to establish a common law view, let's define an annuity as a series of payments

payable for the remainder of the life of the recipient

or for a fixed term.

Here is a brain teaser for you…

If you sell your car for 24 monthly payments of $1,000, do those instalments of the sale price of your car represent an annuity?

Hint - Refer CCH Master Tax Guide paragraph 11-280!

The general principal is that where annual payments are made in liquidation of a principal sum, they do not constitute annuities.

The question that must be answered is whether the transaction entered into is

a repayment of a principal sum with interest, or

a contract for an annuity where the capital paid is replaced by payments of an income nature.

Taxation Determination TD 95/26 states that when a taxpayer purchases an annuity, the principal used to purchase the annuity ceases to exist, as it has been transformed into an income source. Annuity payments are not derived from the money paid for the annuity; they are derived solely from the annuity contract.

Yet another brain teaser for you ….

Mr Clarke invested $50,000 life insurance, for the acquisition of a participating policy termed a "Variable Income Annuity". This is defined as a policy by the terms of which the owner of the policy is entitled to a share in surpluses or profits which may be distributed by a body corporate carrying on life insurance business.

During the year Mr Clarke received annuity payments totalling $8,333. In addition, the sum of $4,443, which was described, as "interest".

Mr Clarke paid the insurance company $50,000 as the purchase price for the policy. In return he was to receive monthly payments of $833.34 for five years (i.e. $50,000):

During the life of the policy there was to be a series of credits and debits made by the insurance company in its accounts which on the termination of the policy would give rise to an entitlement in Mr Clarke to receive a net amount from The insurance company. Until that time Mr Clarke had no entitlement to receive from The insurance company any moneys except the monthly payments of annuity of $833.34 each.

Upon the termination of the policy there would be in effect a taking of accounts by the insurance company. A balancing of the benefits against the administrative and other expenses would then take place, producing a final figure as the policy's cash value at the date of termination, a figure which could not be ascertained prior to that time. Mr Clarke was not entitled to receive any of the gross amounts credited by the insurance company to either the Investment Account or the insurance company Growth Account, nor was he under an obligation or liability to pay to the insurance company any of the amounts debited.

Nor was the amount of $4,443 credited to Mr Clarke.

Hint - Refer CCH Master Tax Guide paragraph 11-280!

Should the $4,443 be included in Mr Clarke's assessable income?

In no sense can it be said that Mr Clarke derived the sum of $4,443 during the year of income. He had a contractual right, which required the insurance company to adhere to its obligations of

crediting the Investment Account at the end of each year with the appropriate amount of interest and of

crediting the Investment Account and the insurance company Growth Account with various monies in accordance with the conditions of the policy.

The insurance company was entitled to debit the Investment Account with various administrative charges. But until the termination of the policy Mr Clarke had no rights to receive or to have held on his behalf any monies except the annuity payments.

The foregoing details of Clarke's case (Refer CCH Master Tax Guide paragraph 11-280) have been included to give you some idea of the complex issues that can arise when endeavouring to ascertain whether annuity type payments should be included in assessable income.

So complex do some annuity payments become (often for reasons of tax planning to avoid or delay income tax) that a specific provision was inserted into the Assessment Act to specifically include in assessable income certain annuity type payments arising from deferred interest securities. You will find details in the topic in interest income or you can refer to CCH Master Tax Guide paragraph 11-280, 300 and 10-490 for details of Division16E of Part III of the 1936 Assessment Act

Compensation payments: are they income or capital?

This label can be used to return pensions other than those received from the Government. These often take the form of annuities, and we will deal with the concept of superannuation and other annuities in the next topics.

But there is another type of pension that you may come across.

It is the receipt of compensation payments in respect of some injury.

But there is often a classification problem encountered in dealing with such receipts - are the receipts of income or receipts of capital?

Receipts, which take the place of income foregone, are income.

There are other forms of compensation, for the loss of earning capacity - these are in the nature of capital. You can read about these in the topic on assessable income