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The issue is whether the amount received as compensation for the cancellation of

an agreement is ordinary income or capital income. under ITAA97 s 6-5, A

compensation is deemed to be ordinary if it arise from loss of income or simply

put the amount if earned would have been included in assessable income for the

purpose of taxation. On the other hand, under ITAA97 section 6-10 and section

15-30, an ordinary income or the compensation payment would be assessed as

statutory income if it arise from losing the right to earn profit and is not assessable

under ordinary income.

In order to determine whether the compensation amount is ordinary assessable

income or Capital income some rules established by case law need to be

examined. The general rule that has been established by case law is:

1. Compensation paid for cancelation or variation of a commercial

contract :

When Tax payers suffer losses be it commercial or other kinds, they will

be compensated. The tax treatment of compensation amount depends on

what the compensation is received for. Based on Allman’s principles

compensation payment for income lost was a replacement for income that

would have been earned. It is reasonable to assume that Ajax Ltd has paid

the amount $ 100000 as compensation for cancellation of contract. Given

that Ajax Ltd ended 16 years of professional relationship and cancelled a

contract which still had four years to run indicates that the amount paid

can only be compensation as a result of contract termination.

2. Compensation is paid in the ordinary case of the business:

Edwards Jones & Associates’s is an accounting organization with number

of business contracts and Ajax ltd is one of it’s contract that is cancelled. It

is reasonable to assume that in that contract there was a clause that said

that says that the party that cancels has to pay other party compensation.

3. The loss does not conduct the structure of the tax payers business:

The termination of contract did not destroy the structure and earning

capacity of Edwards Jones & Associates’. According to the principle of

Heavy Mineral’s case, the compensation made for termination of contract

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will be a substitute for income, where the profit making structure of the

business is intact. If the business’s profit making structure is permanently

terminated, the income will be of capital nature (Glenboig case). Where

the cancelled contract does not terminate profit making of the business

permanently, or is one of many profit making components of the business,

the compensation will be substitute for income. Although the contract

provides 40% of Edwards Jones & Associates income it does not restrict

them from entering into other contracts. However, the cancellation of

contract has created a “hole in profit” and has temporarily impaired

income earning on Edwards Jones & Associates’. According to Allied

mills (1986) case principle, compensation of agency contract not affecting

profit making structure of a firm is income in nature.

Taking the above factors into consideration it can be concluded that the

compensation amount is ordinary income in nature. This is illustrated in Phillips

principle which states that payments received as compensation must be regarded

as of the same nature as the payments which they replace. The cancellation of

contract has affected future profit of Edwards Jones & Associates which they

would have earned had the contract not been cancelled. Following the principles

of Liftronic Pty Ltd v FC of T 96 ATC 4425, a hole in profit is income in nature.

The structure of the business is unaffected. Hence, the compensation will be

assessable ordinary income.

References

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Barkoczy, S. 2014. ”Foundation Of Taxation Law”, 6 th edn, cch Australia

Limited, Australia.

Barkoczy, S. 2014. ”Core Tax Legislation and Study Guide”, 17 th edn, cch

Australia limited, Australia.

Allman vs FC of T 98 ATC 2142, Paragraph: 12.8

Allied Mills Industries pty Ltd FC of T 89 ATC 4345, Paragraph: 12.8, 12.9

Glenboig Union Fireclay Co Ltd v IRC (1922) 12 TC 427, Paragraph: 12.8, 12.9

Liftronic pty Ltd v FC of T 96 ATC 4425, Paragraph: 12.8

Phillips; C of T (Vic) v (1936) 55 CLR 144, Paragraph: 12.8

Heavy Minerals pty Ltd v FC of T (1966) 115 CLR 512, Paragraph: 12.8, 12.9

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