Edited version of private ruling

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Ruling

Subject: Treatment of ex gratia payment

Question 1

Will the ex gratia payment made to you by a financial planning institution be assessable as ordinary income?

Answer

No.

Question 2

Will the ex gratia payment made to you represent payment for a permanent reduction in the value of a post-capital gains tax (CGT) underlying asset and as such should the total acquisition cost of the post-CGT asset be reduced?

Answer

Yes

This ruling applies for the following period

1 July 2010 to 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts

You invested funds with a financial planning institution.

In your discussions with their advisors you indicated you wanted a low risk choice of assets. You signed the documents to invest your money and then discovered that the money had not been invested according to your wishes.

You had kept notes of your discussions with the advisors which showed your strong objections to the choices proposed by the planners. Your investment fell dramatically and you sought compensation from the bank as they had not properly assessed your risk profile and recommended investments that were not appropriate to your risk profile.

After discussions with the bank they have made a settlement offer to you. The settlement offer is a once and for all lump sum ex gratia payment on a without prejudice and without any admission of liability basis.

The settlement amount has been calculated as if you had invested in the low risk option. If this had occurred your portfolio, at the date of the settlement offer, would be of a higher value and your losses would have been reduced.

You have indicated that you will use the lump sum payment for day to day expenses.

You still hold the investments.

Reasons for decision

Ordinary Income

Subsection 6-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997) defines assessable income as including income according to ordinary concepts (ordinary income).

There are a number of factors from case law which can assist in determining whether a particular receipt is ordinary income. These include:

· whether the payment is the product of any employment, services rendered, or any business

· the quality or character of the payment in the hands of the recipient

· the form of the receipt, that is, whether it is received as a lump sum or periodically and

· the motive of the person making the payment. Motive, however, is rarely decisive as in many cases a mixture of motives may exist.

Considering these four factors in your circumstances it is considered that the payment is not ordinary income as:

· there is no connection between any employment or services rendered by you and the payment made

· the payment will be paid as a lump sum and once and for all, and

· the payment will redress the situation which arose due to the incorrect placement of some of your funds.

Whilst you have indicated that you will use the lump sum for day to day expenses it is not considered that this factor would make the payment ordinary income.

Accordingly, the ex gratia payment is not assessable income under section 6-5 of the ITAA 1997 as it is not considered to be ordinary income.

Question 2

Capital Gains Tax (CGT)

The general capital gains tax (CGT) provisions are set out in Part 3-1 of the ITAA 1997. Under the CGT provisions you will make a capital gain or loss only if a CGT event happens.

To determine if a CGT event happens in respect of a compensation payment it is necessary to consider the nature of the asset to which the compensation payment relates.

The Commissioner's policy on the treatment of compensation payments is set out in Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts. TR 95/35 states that the particular asset for which compensation has been received by the taxpayer may be:

· an underlying asset;

· a right to seek compensation; or

· a notional asset in terms of section 104-155 of the ITAA 1997.

In determining which is the most relevant, it is often appropriate to adopt a 'look through' approach to the transaction or arrangement which generates the compensation receipt.

Paragraph 3 of TR 95/35 defines the term 'underlying asset' as:

the asset that, using the 'look-through' approach, is disposed of or has suffered permanent damage or has been permanently reduced in value because of some act, happening, transaction, occurrence or event which has resulted in a right to seek compensation from the person or entity causing that damage or loss in value or against any other person or entity.

Where the compensation is not for loss or destruction of the underlying asset but is for permanent damage to, or permanent reduction in the value of, the underlying asset, paragraph 6 and 7 of TR 95/35 states:

If an amount of compensation is received by the taxpayer wholly in respect of permanent damage suffered to a post-CGT underlying asset of the taxpayer or for a permanent reduction in the value of a post-CGT underlying asset of the taxpayer, and there is no disposal of the underlying asset at the time of the receipt, we consider that the amount represents a recoupment of all or part of the total acquisition costs of the asset.

Accordingly, the total acquisition costs of the post-CGT asset should be reduced in terms of section110-25 of the ITAA 1997 by the amount of the compensation.  No capital gain or loss arises in respect of that asset until the taxpayer actually disposes of the underlying asset. 

Because a CGT event did not occur in respect of the asset, no capital gain or loss arises in respect of the compensation payment. However, subsection 110-55(6) of the ITAA 1997 which relates to the general rules about the 'reduced cost base' of a CGT assets states:

Expenditure does not form part of the reduced cost base to the extent of any amounts you have received as recoupment of it. However, this rule does not apply to the extent that the amounts are included in your assessable income.

It is considered that under the "look through" approach the underlying asset in your case is the units in the property trusts and that there has been a permanent reduction in the value of the asset (the property trust units). As you still hold the property trust units the compensation amount you will receive will be applied to reduce the CGT cost base of the property trust units. This will effect the CGT calculations when you dispose of the property trust units.

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