Taxation of Settlement Sums and Awards for Damages

Being involved in prolonged litigation or a protracted dispute can be a significantly stressful period of your life. After a lengthy legal battle, you may be in receipt of a substantial lump sum settlement payment, or an award of damages in your favour following a judgment. Although you may wish to enjoy the fruits of a favourable outcome, it is important to be aware of the tax implications of those hard-earned monies as they can often be forgotten at the end of a dispute.

The receipt of a lump sum of money (or other property) following settlement of a litigated matter, or a judgment, can result in the imposition of income tax, capital gains tax (CGT), and goods and services tax (GST). The fundamental question to determine the appropriate tax treatment of an award of damages or a settlement sum is  “What was the amount paid for?”

Taxing the Gains – Income Tax

The fundamental question is whether your settlement or judgment money qualifies as income. The Income Tax Assessment Act 1997 (Cth) deals with the treatment of income based on ordinary concepts or statutory income. If the amount you’ve received is akin to ordinary income, it’s going to attract the attention of the Australian Tax Office.

For example, a claim to recover unpaid earnings from your employer, then the monies you would receive on a successful outcome would attract income tax, as it is of the same character as income.

Capital Gains Tax in Litigation

CGT is another consideration when it comes to a settlement or a judgement. CGT will generally apply if a CGT event occurs with respect to a CGT asset, which results in a capital gain. When you dispose of a CGT asset through a CGT event, it may be the case that CGT will apply. In the context of litigation, examples of a CGT asset include, but are not limited to:

1. An asset, such as a property, shares, or goodwill of a business, which is the subject of the litigation or dispute;
2. Any terms of settlement of litigation which give rise to legal rights;
3. The cause of action, or the issues in dispute, which give rise to the litigation; and
4. A judgment debt or rights arising from a judgment.

The CGT treatment of a settlement sum, award for damages, or disposal of a CGT asset during litigation, is not a one-size-fits-all answer and it depends on the facts and the specific CGT event in question.  Expert advice is essential in this nuanced area.

The effect of GST on settlement sums

Suppose you or your business are registered for GST, and the settlement money relating to your dispute is in respect of your business’s activities or of your enterprise. In that case, GST might be imposed on the settlement sum.

Not all settlement and judgment monies you may obtain give rise to a tax liability. In certain personal injury or defamation proceedings, the money received may not attract tax liability. However, suppose you are involved in legal proceedings or a dispute. In that case, it’s vital to understand the possible tax implications on any settlement sum received or an award of damages following litigated proceedings. If you think this article might be relevant to you, please contact our team today.