A client settles a dispute for $1.5 million. If tax unexpectedly consumes a third of the settlement payment, the client will no doubt expect their solicitor to pay the shortfall. This article looks at four common ways tax might impact on settlements.
Advise or refer before the client accepts
Practitioners should ensure that clients receive appropriate advice about the tax consequences of a settlement before entering into a binding settlement agreement.
In the lead-up to a mediation or settlement conference, consider what the likely settlement might include. If it includes terms that move an asset, real property, a company payment or a trust entitlement, consider and advise on the likely tax consequences if you have the expertise to do so. If not, consider the following:
- Confirm in writing that the retainer does not extend to tax advice and recommend the client obtain advice from a tax lawyer or an accountant on tax treatments of likely assets in any settlement scenarios. Suggested wording is set out below.
Suggested wording
“Our retainer does not extend to advice on the taxation consequences of the proposed settlement, including capital gains tax, income tax, GST, duty and Division 7A of the Income Tax Assessment Act 1936 (Cth). Before attending the mediation/settlement conference, we suggest you obtain advice from a tax lawyer or an accountant on the after tax effect of the possible settlement scenarios we have discussed including [set out likely outcomes].
Please acknowledge in writing that you have received this advice, and confirm whether you will obtain that advice or instruct us to proceed without it.
- Confirm what advice the client has obtained before attending the mediation or settlement conference.
- If other scenarios not covered by the advice arise during negotiations, you will need to adjourn the discussions so that tax advice can be obtained by the client prior to documenting a settlement.
The terms of settlement aren’t determinative of the tax treatment
The tax character of a settlement is determined by the whole deal, not by the label in the settlement agreement. In Sladden v Commissioner of Taxation [2024] FCAFC 122, a settlement was negotiated and documented in a deed of release. Sladden contended to the Commissioner of Taxation that the settlement sum was not assessable as ordinary income.
The Administrative Appeals Tribunal (AAT) rejected Sladden’s submission that the nature of the consideration for which the settlement sum was to be paid was to be determined entirely by the terms of the deed of release. The AAT held that the terms of the deed were not determinative of the issue, and the Federal Court agreed.
Four common ways tax can impact on settlements
Payments from a private company
A payment, asset transfer or debt forgiveness from a private company to a party or their associate can be a deemed unfranked dividend under Division 7A of the Income Tax Assessment Act 1936 (Cth).
For example, Rufus and Florence’s private company (Sage Co) purchased a share portfolio in 2005 for $300,000. By 2025 at divorce, the portfolio was worth $2 million. Pursuant to settlement terms, Sage Co transferred the portfolio to Florence. Capital Gains Tax (CGT) rollover applies to disregard Sage Co's capital gain on the transfer. However, the transfer itself could constitute a deemed unfranked dividend of $2 million to Florence under Division 7A. Florence now faces a potential marginal rate tax bill on the full market value received, which might have been avoided with better structuring.
Land transfer duty
In Victoria, land transfer duty is assessed on the greater of the consideration and the unencumbered market value of dutiable property under the Duties Act 2000 (Vic). A transfer for no or reduced consideration still attracts duty at market value.
Whilst there is a duty exemption under section 43 of the Duties Act 2000 (Vic) for certain family law transfers, this exemption does not extend to general commercial settlements between former business partners or co-owners who are not spouses or transfers that fall outside the strict terms of the exemption.
CGT
The LPLC has received claims where a practitioner acted in a family law settlement and did not consider or advise on CGT.
In one claim involving a financial agreement, a related third party had to transfer an investment property to the client, and the solicitor did not consider or advise on CGT. The client alleged the tax liability could have been reduced or avoided with advice prior to the transfer.
In another claim, the orders required investment properties to be sold and "net" proceeds split equally, but did not say whether "net" meant before or after CGT. The former partner argued for the split before CGT so the other party was liable for the tax. That party then demanded the amount of the tax from their solicitor, alleging negligent drafting.
Goods and Services Tax (GST)
GST can apply where the settlement has a sufficient nexus with a taxable supply (ATO GST Ruling GSTR 2001/4). Practitioners should make sure the settlement agreement deals with which party is liable to bear any GST to prevent unintended tax liabilities for their clients.
Conclusion
Tax issues can materially change the commercial value of a settlement. Before recommending that a client accept any offer involving a payment, asset transfer, debt forgiveness or property transaction, practitioners should pause to identify possible tax consequences and ensure they are addressed before the agreement becomes binding.
If the practitioner has the expertise to provide the advice, they should do so. If not, confirm that providing such advice is outside the retainer and recommend that the client obtain specialist tax advice.
