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  • General information applying to agribusiness MIS

    Legal action, including class actions

    Due to the collapse of several MISs in recent years, legal actions have commenced in relation to a number of schemes.

    This information is a general guide to the tax treatment of money paid or received in relation to a legal action you are involved in.

    Legal expenses

    Legal expenses incurred in relation to managing your income-producing investments are generally deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

    For legal expenses to constitute an allowable deduction, they must be shown to be incidental or relevant to the production of your assessable income. Legal expenses are generally deductible if they arise from the day-to-day activities of your income-producing activities.

    However, under section 8-1 of the ITAA 1997, you cannot deduct legal expenses relating to:

    • acquiring, preserving or increasing the value of the investment assets
    • disputing legal rights associated with loans
    • claiming compensation for tax advice in relation to entering the investment.

    Case law indicates legal costs incurred in fending off the threatened cessation of the profit-yielding subject or business is not deductible under section 8-1 of the ITAA 1997.

    Disputing loans or termination of leases

    If you are undertaking, or have undertaken, legal action arguing the loans should never have been put in place, or leases in relation to the scheme should never have been terminated, you cannot claim a deduction for related legal costs.

    Our view is that expenditure on legal action relating to loans or the termination of leases is capital in nature.

    The payments you make to the law firm undertaking the legal action on your behalf are capital, as they relate to preserving or increasing the value of the investment assets or disputing legal rights associated with loans.

    If the legal action is seeking to release you from the obligation to repay your loan, you are seeking an enduring advantage, which is capital in nature.

    Therefore, the expenditure is not deductible under section 8-1 of the ITAA 1997.

    Taxpayer was carrying on a business and the legal action is regarding loans

    If you were carrying on a business, as identified in the relevant ATO product ruling, and the legal action relates to disputing your loan, you may be entitled to deductions for capital expenditure incurred under section 40-880 of the ITAA 1997.

    The deductions will only be allowed under section 40-880 if the business activity meets the requirements of section 35-10(2A) of the ITAA 1997. Where your business activity does not satisfy the requirements of section 35-10(2A), the deductions will be denied.

    Section 35-10(2A) stops an individual from claiming a deduction for capital expenditure incurred in relation to a former business activity – unless, in any income year, including the income year the business activity ceased, the taxpayer satisfies the income requirement (broadly that your income is less than $250,000) and the business passed one of these tests:

    • it produces assessable income of at least $20,000
    • it produced a profit in three of the past five years
    • it uses real property or an interest in real property worth at least $500,000 on a continuing basis
    • it uses other assets worth at least $100,000 on a continuing basis
    • the ATO exercised discretion under section 35-55 of the ITAA 1997
    • the individual satisfied the Division 35 primary production or professional arts business exemption.

    The test in section 35-10(2A) is met if the business activity satisfied one of the requirements in one or more income years prior to the cessation of the business activity.

    Taxpayer was not carrying on a business, or the legal action relates to termination of a lease

    If you were not carrying on a business, or your legal action relates to the termination of a lease, you are not entitled to a deduction under section 40-880 of the ITAA 1997.

    In these instances, the capital asset is the right to preserve or increase the value of the investment assets or disputing legal rights associated with your loan.

    Legal expenses you incur taking this action are not deductible under section 8-1 or section 40-880 of the ITAA 1997. Legal fees and charges connected with these proceedings form part of the cost base of this capital asset for CGT purposes.

    Legal action relates to seeking damages from promoter/financial adviser

    If you invested in a collapsed MIS and you take legal actions seeking damages against the entities and directors of the entities which issued the prospectus or product disclosure statement (PDS) for the MIS, you cannot claim a deduction for related legal expenses.

    In these instances, the capital asset may be the right to preserve or defend legal title to the investment assets or the right to sue for breach of contract.

    Legal expenses you incur in taking such action are not deductible under section 8-1 or section 40-880 of the ITAA 1997. Legal fees and charges connected with these proceedings form part of the cost base of this capital asset for CGT purposes.

    Money paid to solicitors or other legal advisors for legal action are not incurred at the time of payment, if the money is held in a trust account.

    Once you receive an invoice for work conducted, the fee has been incurred.

    See also:

    Settlement of legal action

    What is the character of settlement monies you receive

    The character of monies you receive under a settlement depends on what the payment represents.

    If the payment you receive is for loss of income, the character of the monies is revenue and needs to be included in your assessable income.

    If the payment you receive is compensation for giving up your rights to preserve or defend legal title to the investment assets or to dispute your loan, the character of the monies is capital. It needs to be included as capital proceeds in working out your capital gain or loss. The relevant CGT event will generally be in relation to cancellation, surrender or forfeiture of rights (CGT event C2).

    See also:

    Reimbursement of legal expenses

    The character of monies you receive as reimbursement of legal expenses depends on the nature of the legal expenses.

    Generally, the character of the reimbursements is capital. It needs to be included as capital proceeds in working out your capital gain or loss realised on the extinguishment/cancellation of your right to take legal action (a CGT asset) on the settlement/finalisation of legal action. This is regardless of whether you previously claimed a deduction for these expenses under section 40-880 of the ITAA 1997.

    Where you have not previously claimed a deduction for these legal expenses, the amount of the legal expenses you paid forms part of the cost base of the CGT asset, used in working out your capital gain or loss on disposal of that CGT asset.

    Where you claimed a deduction for the legal fees as a capital expense under section 40-880 of the ITAA 1997, the amount you previously claimed is not included in the cost base of the CGT asset, used in working out your capital gain or loss on disposal of that CGT asset.

    See also:

    Repayment of loans

    As part of the settlement of your legal action you may have been offered options regarding payment of your outstanding loan.

    If you choose a loan option that includes a discount, the debt forgiveness rules will apply. The net forgiven amount needs to be applied to reduce certain deductions and losses available to you.

    Note: the amounts you repay on your loan are not deductible – with the possible exception of the interest component.

    As part of the settlement, if any interest payable by you was waived, and you already claimed a tax deduction for that interest, you need to include the waived amount in your assessable income.

    See also:

    Working out your capital gain or loss from a settlement

    Where the amount you receive from a settlement of legal action is capital in nature, you need to include this amount as capital proceeds, for working out your capital gain or loss realised on the extinguishment/surrender of your right to take legal action (that right being a CGT asset) on the settlement/finalisation of legal action.

    To work out whether you made a capital gain or loss, you need to determine the cost base of obtaining the capital proceeds.

    Where the legal expenses for the legal action were not deductible, they form part of the cost base of the CGT asset. Where a deduction was claimed for legal expenses as capital expenditure under section 40-880 of the ITAA 1997, the amount claimed does not form part of the cost base of the CGT asset.

    A capital gain or loss is calculated as the difference between your capital proceeds and the cost base.

    Note: fees for participating in the scheme which were previously deductible do not form part of the cost base for working out your capital gain or loss in respect of the legal action.

    See also:

    Examples – working out your capital gain or loss from a settlement

    Example 1

    Mr Green receives a capital payment, which includes reimbursement of all of his legal expenses. He has not previously claimed a deduction for these expenses.

    • He receives $20,000 as his share of the settlement of a class action regarding his investment in a MIS
    • He has previously paid $15,000 in legal expenses towards the class action, but did not claim a tax deduction for these expenses
    • The $20,000 includes a reimbursement of $15,000 for legal expenses paid
    • The amount Mr Green needs to include in his assessable income as a capital gain is $5,000.

    This is calculated as:

    • Capital proceeds – $20,000
    • Less cost base – ($15,000)
    • Gross capital gain – $5,000.
    End of example

     

    Example 2

    Mr Brown receives a capital payment, which includes reimbursement of some of his legal expenses. He has not previously claimed a deduction for these expenses.

    • He receives $20,000 as his share of the settlement of a class action regarding his investment in a MIS
    • He has previously paid $15,000 in legal expenses towards the class action, but did not claim a tax deduction for these expenses
    • The $20,000 includes a reimbursement of $10,000 of the legal expenses paid
    • The amount Mr Brown needs to include in his assessable income as a capital gain is $5,000.

    This is calculated as:

    • Capital proceeds – $20,000
    • Less cost base – $15,000
    • Gross capital gain – $5,000.
    End of example

     

    Example 3

    Ms White receives a capital payment, which includes reimbursement of legal expenses. She has previously claimed a deduction for these expenses under section 40-880 of the ITAA 1997.

    • Ms White receives $20,000 as her share of the settlement of a class action regarding her investment in a MIS
    • She has paid $15,000 in legal expenses towards the class action. She has already claimed a tax deduction of $15,000 for these expenses under section 40-880 of the ITAA 1997
    • The amount Ms White needs to include in her assessable income as a capital gain is $20,000.

    This is calculated as:

    • Capital proceeds – $20,000
    • Less cost base – $0
    • Gross capital gain – $20,000.
    End of example

    See also:

    Settlement of a compensation claim against your adviser

    Background

    Due to the collapse of several MIS in recent years, some participants have taken legal action to seek compensation for a monetary loss in respect of the professional advice that influenced their decision to invest.

    The potential implications of you agreeing to a settlement of that legal action are outlined below.

    Generally:

    • you would have or can claim a tax deduction for all or most of the initial expenditure and the ongoing expenditure, incurred in respect of the MIS investment
    • you would not have a capital outlay for acquiring your MIS
    • you may have entered into a loan to borrow funds to invest in the MIS.

    The initial and ongoing expenditure incurred in respect of the MIS investment, and the interest on any MIS loan, are referred to as the MIS expenditure.

    To identify the MIS expenditure for which you could have or can claim a tax deduction, look up the product ruling for your MIS investment on our Legal Database.

    The monetary loss you suffered (which gave rise to the legal action) is the loss you incurred from acting on advice you received to invest in the MIS. This includes the:

    • MIS expenditure
    • costs you incur taking legal action against your adviser – such as legal and accounting fees.

    The monetary loss is not the amount owing on any MIS loan.

    For the purpose of determining income tax implications of a settlement of the legal action, the monetary loss will not include non-deductible initial capital expenditure paid to acquire your MIS investment.

    Generally, where the legal action is ends with a settlement, the settlement you receive is for the disposal of the right to seek compensation. It is not for the loss of the MIS investment itself.

    This is regardless of whether:

    • the amount of the settlement reflects the amount payable to extinguish your MIS loan
    • a condition of the settlement requires the settlement monies be applied to extinguish the MIS loan.

    You may also receive settlement monies to compensate you for any legal and accounting expenses incurred in pursuing your claim and for any tax payable as a consequence of entering the settlement.

    The character of settlement monies you receive

    Assessable recoupment

    Settlement monies for the disposal of your right to seek compensation will include a recoupment of MIS expenditure for which you have or can claim a tax deduction. You must include the amount of this recoupment in your assessable income.

    Legal or accounting expenses incurred in pursuing your compensation claim, and any tax payable as a consequence of entering the settlement are not deductible. They may be taken into account in calculating any capital gain. Money received as reimbursement of them are not included in your assessable income.

    Capital gain

    The character of the monies you receive in settlement of a claim against your adviser for compensation is capital in nature.

    Your right to seek compensation is a CGT asset. By entering a deed of settlement, you end your right to seek compensation.

    Capital proceeds

    When calculating any capital gain you make, generally, the total amount of monies you receive from the settlement are your capital proceeds.

    Cost base

    As the right to seek compensation arose due to of a monetary loss, the amount of that loss is included in the cost base of the right to seek compensation for that loss, when calculating your capital gain. For guidance, refer to paragraph 104 of TR 95/35.

    Care needs to be taken in relation to the amount of that monetary loss for which you have or can claim a deduction:

    • the cost base of a CGT asset generally excludes any deductible expenditure associated with acquiring that CGT asset
    • where you received a recoupment of deductible expenditure, the cost base of the CGT asset includes deductible expenditure, to the extent that the recoupment is included in your assessable income. This avoids double taxation.

    Any recouped expenditure not included in your assessable income is not included in the cost base.

    The deductible expenditure equal to the amount that you are required to include in your assessable income as an assessable recoupment is included in the cost base of your right to seek compensation.

    The amount of non-deductible expenditure incurred for legal and accounting expenses in pursuing your legal action are incidental costs of bringing your right to seek compensation to an end. They are included in the cost base of your right to seek compensation.

    No amount can be included in the cost base of this right in relation to tax you may have to pay as a result of entering the settlement.

    The capital outlay for acquiring your MIS investment is not included in the cost base of the right to seek compensation.

    Any capital outlay for acquiring an MIS investment forms the cost base of the MIS investment itself, for separately determining any capital loss incurred due to the MIS investment being terminated.

    CGT discount

    A 50% CGT discount may apply to any capital gain made from the right to seek compensation coming to an end, where the right to seek compensation was held for more than 12 months.

    The acquisition date of the right to seek compensation will generally be the date you entered into the MIS, following the advice of your adviser.

    Commercial debt forgiveness

    Where you have received a discount on the repayment of any MIS loan, you also have to consider the commercial debt forgiveness rules.

    Examples – how much to include in your assessable income

    Example 1: All initial MIS expenditure is deductible

    Mr Brown acquires an MIS investment with an initial cost of $120,000.

    The product ruling for this MIS states he can have or claim a tax deduction for:

    • $120,000 for the initial MIS expenditure
    • ongoing MIS expenditure for rent of $1,000 per year
    • interest on the loan used to pay initial and ongoing MIS expenditure.

    After five years, the MIS collapses. Mr Brown's MIS investment has no value and terminates. He does not receive any capital proceeds for the termination of his MIS investment.

    Mr Brown borrowed the funds to pay the initial and ongoing MIS expenditure. He has incurred $40,000 interest on the loan.

    The total amount of MIS expenditure he has or can claim a tax deduction for is $165,000.

    The amount he needs to pay to extinguish his loan under a discount offer is $140,000.

    Mr Brown receives $150,000 in settlement monies for ending his right to seek compensation for the monetary loss. This is composed of:

    • $140,000 in respect of the initial and outgoing MIS expenditure – this is required to use to extinguish the loan
    • $8,000 for reimbursement of legal and accounting expenses incurred in pursuing his claim
    • $2,000 for any tax payable due to entering the settlement.

    The actual legal and accounting costs Mr Brown incurs in pursuing his claim is a total of $8,000.

    None of the settlement monies relate to the termination of his MIS investment.

    He incurs no other costs.

    Mr Brown needs to include in his assessable income:

    Assessable recoupment

    $140,000 is a recoupment of MIS expenditure for which Mr Brown has or can claim a tax deduction. It must be included in his assessable income as an assessable recoupment.

    The expenditure for legal and accounting expenses in pursuing his claim is capital in nature and not deductible. No part of the $10,000 is an assessable recoupment. These costs form part of the incidental costs of his right to seek compensation.

    Capital gain on ending your right to seek compensation

    • Capital proceeds – $150,000 total settlement monies
    • Cost base – ($140,000) deductible expenses equal to assessable recoupment
    • Incidental costs – $8,000) (See Note 1)
    • Capital gain – $2,000

    Note 1: The amount of tax payable as a result of the settlement is not included in the cost base. Where the amount received under the settlement includes a provision for legal and accounting expenses, the full amount is included in the capital proceeds. Only the amount actually incurred for legal and accounting expenses is included in the cost base.

    A 50% CGT discount may apply to any capital gain made.

    Capital gain or loss on the termination of the MIS investment

    As Mr Brown did not make a capital outlay to acquire his MIS investment and did not receive any capital proceeds from the termination of the investment, he does not make a capital gain or loss on the termination of his MIS investment.

    Commercial debt forgiveness

    Where you received a discount on the repayment of the loan, you have to consider the commercial debt forgiveness rules.

    End of example

     

    Example 2: Some of the initial MIS expenditure is capital and not deductible

    Mr Black acquires a MIS investment, with the facts the same as Example 1, except:

    • $5,000 of his initial MIS expenditure is capital and not deductible
    • total MIS expenditure for which he has or can claim a tax deduction is $160,000.

    Mr Black needs to include in his assessable income:

    Assessable recoupment

    As for Example 1 – $140,000 must be included in his assessable income as an assessable recoupment.

    Capital gain on ending the right to seek compensation

    As for Example 1 – nil capital gain or loss, assuming the amount of settlement monies for incidental costs equals the amount incurred for these costs.

    Capital loss on the termination of the MIS investment

    • Capital proceeds – $0 no amount is received for the termination of his MIS investment
    • Cost base – ($5,000) non-deductible capital expenditure on entry into MIS
    • Capital loss – ($5,000).

    This capital loss is not deductible against your assessable income, but may be offset against any capital gains you make in the income year your MIS investment was terminated, or a later income year.

    Commercial debt forgiveness

    As for Example 1 – consider Discounts for repayment of loans

    End of example

    If you are still uncertain about your situation

    Where your specific circumstances are not covered above, or you are still uncertain about how this information applies to you, you can apply for a private ruling.

    See also:

    Discounts for repayment of loans

    If you financed the purchase of your interest in a MIS with a loan from a related party or arm’s length third party financier, the debt you owe to the financier constitutes a commercial debt for the purposes of the commercial debt forgiveness rules contained in Division 245 of the ITAA 1997.

    Where a financier offers you a discount on the outstanding loan, the commercial debt forgiveness rules apply. You have to apply any ‘net forgiven amount’ to reduce certain specified amounts you could otherwise use to reduce your taxable income.

    If you are a partner in a partnership, the commercial debt forgiveness rules may also impact the other partners of that partnership.

    Calculating your net forgiven amount

    1. Calculate the value of the debt at the forgiveness time under section 245-55 of the ITAA 1997. Generally, this is the market value of the debt at the forgiveness time.
    2. Calculate the amount of consideration given for the forgiveness under section 245-65 of the ITAA 1997. Generally, this is the amount you pay to the financier in full satisfaction of the outstanding loan principal.
    3. Subtract the consideration given (step 2) from the value of the debt (step 1) to arrive at the gross forgiven amount.
    4. Reduce the gross forgiven amount (step 3) by any amounts which, as a result of the forgiveness, are taken into account in arriving at your taxable income under section 245-85 of the ITAA 1997.

    Applying the ‘net forgiven amount’ to reduce certain deductions and losses

    You must apply your total net forgiven amount for the financial year (the sum of the net forgiven amount calculated for all debts forgiven during the financial year) to reduce the amounts listed below.

    You can choose the relevant loss, item of expenditure or asset against which your total net forgiven amount is to be applied and the amount to be applied.

    Your total net forgiven amount must be applied to the maximum extent possible within each class in successive order, following on from the previous four steps.

    1. Deductible tax losses carried forward from prior financial years.
    2. Net capital losses carried forward from prior financial years.
    3. Deductible expenditure listed in the table to subsection 245-145(1) of the ITAA 1997. For MIS participants, this includes expenditure incurred in borrowing money to produce assessable income deductible under section 25-25 of the ITAA 1997.
    4. The cost bases or reduced cost bases of certain CGT assets specified in section 245-175 of the ITAA 1997.

    Any part of your total net forgiven amount remaining after being applied against all available losses, items of expenditure or assets is disregarded, unless you are a partner in a partnership.

    See also:

    Example – working out and applying your 'net forgiven amount' on a discounted loan principal

    Example: Calculating the net forgiven amount

    Ms Rose borrows $100,000 to acquire an MIS interest and claims a deduction of $100,000 for the MIS expenses paid with the borrowed funds.

    The current outstanding loan is $200,000 ($80,000 principal and $120,000 of interest).

    The financier offers Ms Rose a 15% discount off the loan balance and accepts a payment of $170,000 in full and final satisfaction of the loan agreement.

    The $30,000 difference is forgiven by the financier. In this example, the payment of $170,000 consists of $68,000 principal and $102,000 interest.

    Ms Rose also has a carried forward tax loss of $5,000 and a carried forward capital loss of $5,000 from a past income year.

    She has no deductible expenditure listed in the table to subsection 245-145(1) of the ITAA 1997, or any cost bases or reduced cost bases of certain CGT assets specified in section 245-175 of the ITAA 1997.

    Ms Rose calculates the net forgiven amount using the following steps:

    Step 1: Calculate the gross forgiven amount of the principal component of the loan by subtracting the amount of principal you are required (after the discount) to pay from the amount of principal you owed before the discount:

    • $80,000 debt before discount − $68,000 now payable = $12,000 gross forgiven amount.

    Step 2: Calculate the net forgiven amount by subtracting any amount included in assessable income or any reduction in a deduction that was otherwise deductible as a result of the debt forgiveness. In this example, the amount subtracted is nil:

    • $12,000 gross forgiven amount − $0 = $12,000 net forgiven amount.

    Step 3: Carried forward tax losses must be applied to the net forgiven amount to reduce the carried forward tax losses to nil:

    • $12,000 − $5,000 = $7,000 remaining net forgiven amount before capital losses.

    Step 4: Carried forward capital losses must be applied to the remaining net forgiven amount to reduce the carried forward capital losses to nil:

    • $7,000 − $5,000 = $2,000 remaining net forgiven amount.

    Step 5: Unless you are a partner in a partnership, the remaining net forgiven amount of $2,000 is not included in your assessable income – it is disregarded.

    See also:

    End of example

    Partners in partnerships

    If you are a partner in a partnership, any part of your total net forgiven amount for the financial year remaining after being applied against all your available losses, items of expenditure, and/or assets, flows through for application against the tax balances of the other partners.

    See also:

    Interest waived on loans

    The obligation to pay some or all of the interest accrued on loans may be waived by the lender. For example, as part of a class action settlement, the financier may forego some or all of the unpaid interest accumulated on your loan.

    If any interest you owe on your loan has been waived and you have already claimed a tax deduction for this interest, you need to include the amount of waived interest in your assessable income for the year it is waived.

    If any interest you owe on your loan is waived and you have not claimed it as a tax deduction, do not include the amount of interest waived as income. You do not claim a deduction for the amount of interest waived.

    See also:

      Last modified: 01 Aug 2017QC 21849