(1) Annuities

ITAA97 s10-5; ITAAA36 s27H

Ordinary income may be exerted in many ways, most commonly from personal exertion, from property and from business. Income from property is defined in s6(1) ITAA36 as being all income that is not income from personal exertion.

Income from property is a receipt severed from the property from which it is derived. It is derived and generated without active labour or business input by the owner of the property, and for that reason is often described as “passive income”.

Four common examples of income from property include:

Interest – income derived from the use of money.
Annuities – an income stream generally purchased in return for the transfer of funds or property.
Rent – is the price paid for the right to use another person’s property, whether that property island, machinery, equipment, a motor vehicle or other goods.
Royalties – are generally the amounts paid for the use or exploitation of another person’s property, whether tangible (eg a copper mine) or intangible (eg copyright in a film).

What constitutes an annuity

There is no definition of an annuity in the Act.  Annuities are expected periodic payments, which have either been given to or purchased by the recipient.

The essential characteristic of an annuity, particularly if it is a purchased annuity, is that the capital amount paid from the annuity is lost, and what is effect you have received for your capital are contractual rights, in the form of a sense of periodical payments.

The nature of an annuity is income. What you have done is bargained to transfer a capital amount into an income stream; ANZ Savings Bank v Commissioner of Taxation. The difficulty in the area of annuities arises where you dispose of an asset in return for a series of payments. The issue is whether what comes back to you for your capital asset is:
• an annuity;
• a capital sum to be paid in instalments, or
• a capital sum payable in instalments, with interest. 

Under a purchased annuity, a taxpayer transfers funds or property to an annuity provider in exchange for a right to an annuity. Annuity transactions are commonly divided into two types:

• Private annuities – which arises from a transaction between the annuity purchaser and a private provider who agrees to provide an annuity for that particular annuitant.
• Institutional annuity – arises from a transaction between the annuity purchaser and an institution such as an insurance company, superannuation fund, or similar financial institution that offers annuities to the public at large as part of its business.

Taxpayers who receive superannuation pensions or ETP annuities that are first payable on or after 1 July 1983 are required to include such payments less any “deductible amount” in their assessable incomes under s27H ITAA36. 

Private and institutional annuities can be offered as fixed term annuities, payable for a specified number of years, or as life annuities, payable for the life of the annuitant. 

Baron Watson in Foley v Fletcher gave a definition of an “annuity”.  This has been adopted by Australian courts:

 “annuities mean, that where the annuity may be purchased with money the capital is gone and ceases to exist, and consequently, the person to be charged [tax] is the person receiving the annuity, that is, the year sum, year by year … No capital is taxed there, because the principle has been converted into an annuity, and the annuity is chargeable [to tax].

Treating the entire amount of each payment as ordinary income would, however, lead to a significant injustice in the case of purchased annuities because taxpayers would be assessed on the whole of their return without any recognition of the capital invested to acquire the right to an annuity or of the fact that part of each payment merely represents a return of capital. 

In Australian tax law, a formula is used to exclude the capital portion of each annuity payment from assessable income (the “recovery of capital” exclusion). The formula, found in s27H ITAA36, applies to superannuation pensions and annuities that have been purchased by the individual. The effect of s27H is to include only part of each annuity payment in assessable income.

Legislation has long since overturned the judicial rule in party by allowing a taxpayer to reduce the amount of income by allowing for the cost of the annuity (it is not, however, a deduction in the sense of Div 8 of the ITAA97). 

The reduction formula, in s27H of the ITAA36, is not based on the actual proportions or estimated proportions of interest in each payment.  Instead, the taxpayer is allowed to pro-rate the capital (called the “undeducted purchase price”) over each payment and reduce each annuity payment by an equal amount.  In the case of a life annuity, the deductible amount is calculated as if the taxpayer were going to live the exact period estimated by the Commonwealth actuary.

Significance of a “fixed gross sum”

To encourage taxpayers to take superannuation pensions or ETP annuities in preference to lump sum ETPs on retirement, the following tax concessions are provided:

• Rebate -  A rebate is available to taxpayers who are at least 55 years of age and receive “rebatable superannuation pensions” or “rebatable ETP annuities”.

• Pension RBL - Taxpayers who take at least 50% of their retirement benefits in the form of “complying pensions or annuities” which meet the pension and annuity RBL standards prescribed in the SISR are allowed to measure their benefits against the “pension RBL”, this allows them to receive a greater amount of concessionally taxed benefits. 

• Tax exemption - Superannuation funds that have commenced to pay a pension are exempt from tax on income derived from assets used to pay the pension. 

In the case of payments relating to assets acquired before the introduction of CGT, the entire proceeds of each payment may be tax-free. This result is quite different from the tax treatment of annuity payments, which may be assessable in full if the taxpayer is unable to ascertain an undeducted purchase price. Although the correct characterization of the transaction appears to be an instalment sale can be difficult, the tax consequences may be significant. 

Egerton-Warburton & Ors v DFCT (1934)

Facts: the taxpayer was a farmer who sold his farm to his sons.  Payment for the farm was to be $1,200 pa for the duration of his life, and after this death payment of $1,000 pa for his wife for the rest of her life and a lump sum to his daughters and grandchildren. 

Issue: whether the taxpayer was assessable on the $1,200 pa or were they capital receipts for the sale of the property.  The Commissioner argued it was an annuity and therefore assessable.

Held: The High Court said the payments were an annuity, of an income nature.  They said what the taxpayer had bargained for was an income stream, and rejected the argument that it was capital, because they said, there was no definite price being paid for the property. (This is important in working out if it is an annuity – if the amount is open-ended, taxpayer has a problem). Court said he had not sold the farm, he had used the farm to purchase an annuity, ie uncertain what you get back.

In ascertaining a payment’s true nature, Rich, Dixon and McTiernan JJ pointed out in Egerton-Warburton & Ors v DFC of T that in each case it is necessary to determine whether the taxpayer has sold property in return for:
(i) an annuity – in which case the annuity will be taxable;
(ii) a capital sum to be pain in instalments, as in Foley v Fletcher – in which case the payments are capital, not ordinary income, or
what looks like an annuity, but is in fact payment of a capital sum spread over a period together with interest – in which case the interest, but not the capital investments, will be taxable (Secretary of State in Council of India v Scoble & Ors). 

In endeavouring to distinguish between annuities and instalments of capital, the courts have often placed considerable weight on whether or not the parties’ agreement stipulates a “fixed gross sum” as the foundation of the agreed price. In Egerton-Warburton & Ors v DFC of T the High Court held that since there was no fixed gross sum or definite purchase price – because the total amount payable would vary depending upon how long the taxpayer lived – the £1,200 payment received each year for the duration of the taxpayer’s life was not an instalment of a capital price, but rather an assessable annuity payment.

Just v FCT (1949)

Facts: a third party created a “rent charge” over certain premises, entitling Just to receive 90% of the rent for the premises.

Held: In the High Court, Webb J indicated that if the £17,500 stipulated in the parties’ agreement had been the purchase price of the land rather than merely its value for stamp duty purposes, he might have characterized the payment as instalments of the purchase price plus interest on the balance outstanding.  However, in the absence of a fixed gross sum, his Honour held the amount to be assessable income: the substance of the transaction was that “the Just’s had bargained to have not a capital sum but an income.” 

The whole of an annuity is income, but s27H is a statutory provision which excludes what is called “the deductible amount”.  It is a bad use of terminology, it is not deductible, is actually part of the gross amount of the payment which is not included in your assessable amount. 

IRC v Ramsay [1935]

Facts: Ramsay purchased a dental practice for £15,000, the contract providing that the agreed price was to be met by the purchaser paying a £5,000 lump sum immediately, plus an annual payment for each of the next 10 years equal to 25% of that year’s net profits from the practice.  This was so even if the sums paid might total more than the balance of £10,000.  Ramsay argued that the 10 payments of 25% were annual payments in the nature of income, which he would therefore be entitled to deduct from his total income in calculating his liability to surtax.

Held: The UK Court of Appeal unanimously held that the 10 annual payments were not annuities, but were instalments of the balance of purchase price outstanding.  Their Lordships were influenced by the presence and dominant role of the fixed gross sum of £15,000 stipulated in the contract as the purchase price.  The provision for instalments of varying amounts which in the aggregate might amount to either more or less than £10,000 simply meant that Ramsay might in the end have to pay a total sale price of more or less than £15,000. 

Ramsay’s case can thus be characterized as one in which the parties had agreed that the obligation to pay a specified purchase price could be satisfied by payment of a lump sum plus a series of variable instalments which were expected in the aggregate to approximate £15,000, but might in fact total more or less. That is, the operation of the agreement was governed by a fixed gross sum, even though the purchase price itself was not precisely fixed.