Edited version of private ruling

Authorisation Number: 1011632360025

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Ruling

Subject: Capital gains tax (CGT) - Storm Financial

Issue 1

1. Is your half share of the equity component of the compensation payment that you received additional capital proceeds?

Yes.

2. Is your half share of the negative equity repaid by borrower, (also identified as a loan repayment on the variable rate margin loan) of the compensation amount that you received additional capital proceeds?

Yes.

This ruling applies for the following period

Year ended 30 June 2008.

Year ended 30 June 2009.

The scheme commenced on

1 July 2007.

Issue 2

Is your half share of the interest component (interest on equity amount) and (interest on negative equity amount repaid) of the compensation amount that you received assessable as income?

Yes.

This ruling applies for the following period

Year ended 30 June 2011.

The scheme commenced on

1 July 2007.

Issue 3

1. Is your half share of the refund of pre-paid interest in the year ended 30 June 2009 which was claimed as a deduction in the previous year, assessable as income?

No.

2. Is your half share of the write off (principal reduction write-off of a certain amount) of interest charged (of a certain amount) that was capitalised have the affect of reducing the interest charged amount for the year ended 30 June 2009?

Yes.

3. Is your half share of the interest paid (early termination interest adjustment) appearing on the fixed rate margin loan, allowable as a deduction as interest incurred in gaining or producing assessable income?

Yes.

This ruling applies for the following period

Year ended 30 June 2009.

The scheme commenced on

1 July 2007.

Relevant facts and circumstances

You and your spouse were clients of Storm Financial Limited (Storm) and received financial advice from Storm.

On the advice of Storm and with Storm's assistance you applied for a margin loan from the Commonwealth Bank of Australia's (CBA) Colonial Geared Investments division. The margin loan was approved by Colonial Geared Investments and the margin loan was advanced to you. The margin loan was secured by various stocks and investments purchased with the proceeds of the margin loan. The security may have included units in a Storm branded index fund for which the responsible entity was the CBA or one of its related bodies corporate.

Your investments with Storm were sold by the bank or its related bodies corporate.

You have, either directly or through your lawyers Slater & Gordon made a claim against the bank for compensation concerning the circumstances of the margin loan and/or the security and repayment of indebtedness under the margin loan.

The parties have participated in a dispute resolution process known as the Storm Resolution Scheme (the scheme) on the terms set out in the Borrower Deed.

By participating in the scheme the parties agreed to:

· the payment of the Settlement Sum by the bank to you

· the closure of variation of the margin loan as set out in the Deed, and

· the releases which are set out in the Deed.

In a letter from the Commonwealth Bank of Australia (CBA) titled Details of Proposal and Settlement Deed the CBA confirmed details of your entitlement under the settlement deed.

You have accepted the CBA's offer and executed the Deed of Settlement in the financial year ended 30 June 2011.

The Deed provided for a settlement amount of $A+B+C+D+E which comprised:

Amongst other transactions listed in the Margin Loan Statement dated June 2009 from Colonial Geared Investments under the Variable Rate Margin Loan category are the following transactions:

Refund of prepaid interest

Loan repayment (principal reduction)

Principal reduction write-off

Interest charged (interest capitalised)

Fixed Rate Margin Loan category the following transaction:

Early termination interest adjustment

You have included copies of the following listed documents, these documents form part of and are to be read with these facts:

· An attachment to the private ruling application provides the following:

o an extract from the Commonwealth Bank Group - Details and Settlement Deed proposal detailing the Settlement Amount

o an analysis of the Variable Rate Margin Loan Account

o an analysis of the Fixed Rate Margin Loan Account

o an analysis of the Capital Gains Tax Statement - Colonial, and

o an analysis of the Capital Gains Tax Statement - MLC

· Margin Loan Statement of a certain date from Colonial Geared Investments.

· Strom Financial Index Sharemarket Funds - 2008/09 Capital Gains Taxation Information Statement.

· MLC MasterKey Unit Trust - Annual Taxation Statement - capital gains summary for withdrawal of units for the year ended 30 June 2009.

· email from your chartered accountant of a certain date confirming acceptance of the CBA offer and the date the Deed of Settlement was executed.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Subsection 6-5(1)

Income Tax Assessment Act 1997 Subsection 6-5(2)

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Subsection 104-25(1)

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 116-20.

Reasons for decision

Issue 1

Question 1 and 2

Summary

Your half share of the equity components of the compensation payment that you received is considered additional capital proceeds.

Detailed reasoning

CGT consequences - equity component

The general CGT provisions are set out in Part 3-1 of the ITAA 1997. Under the CGT provisions a taxpayer 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 (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 subsection 160M(7) - (section 104-155 of the ITAA 1997).

(TR 95/35 provides legislative reverences that relate to the Income Tax Assessment Act 1936, The equivalent provisions in the ITAA 1997 are cited where appropriate.)

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

In TR 95/35 the term 'underlying asset' is used. The underlying asset is defined in TR 95/35 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.

If there is more than one underlying asset, the relevant underlying asset is the asset which leads directly to the payment of the amount of compensation. For example, if a taxpayer receives an amount of compensation for the destruction of his or her truck, the truck is the underlying asset.

Taxation Ruling TR 97/3 also discusses compensation and deals with compensation received by landowners from public authorities. It explains at paragraph 2 that it extends the application of TR 95/35 and should be read in conjunction with that ruling.

Paragraphs 4 to 8 of TR 97/3 discuss the compensation received from a public authority for the compulsory acquisition of an easement and states that:-

4. Compensation in respect of an easement created by statute in favour of a public authority cannot be said to have been received for the grant of the easement. The Land Acquisition (Just Terms Compensation) Act 1991 (NSW) and similar Acts in other jurisdictions enable public authorities to take land or an interest in land (including an easement) for specified purposes and confer on the affected landowner a right to compensation. In these circumstances, the landowner cannot be said to have created an asset as required for subsection 160M(6) of the Act (now includes 104-35 of the ITAA 1997) to apply. The easement is created by operation of the relevant statute and is vested in the public authority. This constitutes a compulsory acquisition of the easement.

5. The compensation received by a landowner from a public authority that compulsorily acquires an easement is not excluded from the scope of TR 95/35 by paragraph 2 of that Ruling which states that:

'This Ruling does not consider:

* .....

* amounts received for the grant of easements, profits a prendre and licences - these are covered in detail in Taxation Ruling IT 2561 and in Taxation Determinations TD 93/235 and TD 93/236'.

6. A strict application of Part IIIA would require the compensation received from a public authority to be treated as consideration in respect of the disposal by the landowner of the right to compensation. However, TR 95/35 focuses on the asset to which the compensation receipt most directly relates. In the case of easements acquired under statute and the consequential disposal of the right to compensation, the most relevant asset is the landowner's pre-existing land with its rights of ownership including, for example, a right to exclude all others. This right to exclude all others is forfeited in part when the easement comes into existence. The loss of part of this right constitutes the disposal of part of the underlying asset (the land) for Part IIIA purposes (paragraph 160M(3)(b) (now 104-25(1) of the ITAA 1997), subsection 160M(1) (now 104-10(2) and 109-5(1) of the ITAA 1997) and section 160R (now 108-5(2)(a) of the ITAA 1997).

7. Paragraph 4 of TR 95/35 states that:

If an amount of compensation is received by a taxpayer wholly in respect of the disposal of an underlying asset, or part of an underlying asset, of the taxpayer the compensation represents consideration received on the disposal of that asset. In these circumstances, we consider that the amount is not consideration received for the disposal of any other asset, such as the right to seek compensation.

8. Applying this approach, an amount of compensation received by a landowner for the loss of part of the rights of ownership is accepted as being consideration received in respect of the part disposal of the underlying asset (the land). The amount is not consideration for disposal of the right to seek compensation.

The ruling also considers a number of other circumstances when a landowner grants an easement on their land and in all but one instance the amount received is treated as consideration in respect of the part disposal of the land.

To the extent that the payment relates to the disposal of an underlying asset, CGT event A1 under section 104-10 of the ITAA 1997 happens.

This case

You and your spouse were clients of Storm. You and your spouse applied for and were granted a margin loan from the CBA's Colonial Geared Investments division. The margin loan was used to acquire various stocks and investments. It may have included units in a Storm branded index fund for which the responsible entity was the CBA or one of its related bodies such as Colonial First State.

Some time later the CBA determined that you and your spouse's historical current loan to security ratio had exceeded its historical margin call loan-to-security ratio. The CBA did not sell your investments until after it determined that your loan had exceeded its loan to security ratio.

Either, you and your spouse or through your lawyers Slater & Gordon you and your spouse have made a claim against the CBA for compensation concerning the circumstances surrounding the margin call and/or the security and the repayment of indebtedness under the margin call. You and your spouse were made an offer by the CBA and in a letter from the CBA titled Details of Proposal and Settlement Deed the CBA confirmed that it had received your executed Deed of Settlement and all related loan documentation in relation to your acceptance of the Bank's Proposal under the scheme. The settlement deed agreed to pay you and your spouse compensation of $A +$C and interest of $D + $E.

On the facts of this case, it is considered that the compensation received had a direct and substantial link with the underlying asset (the investments). Accordingly, in line with the guidelines provided in paragraph 4 of TR 95/35 and TR 97/3 it is considered that the compensation amount was received as part of the underlying asset and it was not received for the disposal of any other asset, such as the right to seek compensation. The amount of $A + $C is therefore accepted as consideration received for the disposal of the underlying assets and CGT event A1 in section 104-10 of the ITAA 1997 occurred when you investments were sold.

Note: As the compensation amount of $A + $C is considered additional capital proceeds you will need to amend any capital gain or capital loss made in relation to the CGT events that happened when your investments were sold by the bank or its related body corporate. You will need to apportion the additional capital proceeds, firstly in line with your ownership interest in the original investments sold by Storm, (you jointly owned the investments with your spouse) and then secondly on a pro-rata basis to every CGT event that happened.

Issue 2

Summary

Your half share of the interest component ($D - interest on equity amount and $E - interest on negative equity amount repaid) of the compensation amount that you received is assessable as income.

Detailed reasoning

This is a question of whether the interest paid by the CBA is assessable to the taxpayer. This is discussed in paragraph 26 of TR 95/35 when it states that:-

Interest awarded as part of a compensation amount is assessable income of the taxpayer under the general income provisions. If the taxpayer receives an undissected lump sum compensation amount and the interest cannot be separately identified and segregated out of that receipt, no part of that receipt can be said to represent interest. If the compensation cannot be dissected it is likely that the whole amount relates to the disposal of the right to seek compensation.

In this instance the interest is separately identified and segregated out of the lump sum and as such is assessable income of the taxpayer under the general income provisions in section 6-5 of the ITAA 1997.

Note: The interest amount will need to be apportioned in line with your ownership interest in the original investments sold by Storm, (that is, interest income is apportioned between you and your spouse).

Issue 3

Question 1

Summary

Your half share of the refund of pre-paid interest in the year ended 30 June 2009 which was claimed as a deduction in the previous year will not be assessable as income.

Detailed reasoning

The general deduction provisions contained in the section 8-1 of the ITAA 1997 allow a deduction for all losses and outgoings to the extent to which they:

· are incurred in gaining or producing assessable income (the first limb), or

· are necessarily incurred in carrying on a business for the purpose of gaining or producing such income (the second limb).

Where a taxpayer receives a refund of an item for which a deduction has previously been allowed, the question of the proper treatment of the refund for tax purposes resolves itself in consideration of the character of the receipt itself.

Section 6-5 of the ITAA 1997 advises that the assessable income of a resident taxpayer includes income according to ordinary concepts (ordinary income) derived directly or indirectly from all sources.

Relevant factors in determining whether a payment is ordinary income include:

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

· whether the payment is expected and relied upon

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

· whether the payment is received as a lump sum or periodically, and

· the motive of the person making the payment, although this is rarely decisive by itself.

Section 6-10 of the ITAA 1997 advises that your assessable income includes statutory income amounts that are not ordinary income but are included in assessable income by another provision. A comprehensive listing of the relevant statutory provisions is given in section 10-5 of the ITAA 1997. Included in the list is assessable recoupment.

Assessable recoupment, Division 20 of the ITAA 1997 operates to include a recouped amount as assessable income where the recoupment reverses the affect of previous income tax deductions in certain circumstances.

In your case, the refund of pre-paid interest fits the definition of a recoupment as defined in section 20-25 of the ITAA, however it is not considered an assessable recoupment.

You have not received an assessable recoupment because pre-paid interest is not listed in the table of deductions at section 20-30 of the ITAA 1997 as a deduction for which recoupment's are assessable.

In your case, the refund of pre-paid interest was a result of the early repayment of your investment loan and the subsequent collapse of one of the finance companies.

The refunded amount does not fall within the concepts of ordinary income neither is it statutory income. Therefore, the amount will not be included in your assessable income.

You may choose to amend your income tax return for the year ending 30 June 2008 to reflect the reduction to the deduction you have already claimed.

Question 2

Summary

Your half share of the write off (principal reduction write-off of a certain amount) of interest charged (of a certain amount) that was capitalised has the affect of reducing the interest charged amount for the year ended 30 June 2009.

Detailed reasoning

In your case the write off of interest charged that has been capitalised has the affect of reducing the deduction for interest incurred in gaining or producing assessable income by the amount written off.

Question 3

Summary

Your half share of interest paid (early termination interest adjustment) appearing on the fixed rate margin loan, is allowable as a deduction as interest incurred in gaining or producing assessable income.

Detailed reasoning

The deductibility of interest on borrowed funds is determined by the use of the borrowed money. If the money is used to buy income producing assets, then the interest expense is an allowable deduction.

In FC of T v. Brown 99 ATC 4600, (1999) 43 ATR 1 (Browns case) the Full Federal Court held that a taxpayer may still be entitled to a deduction for recurrent interest expenses incurred after an income-producing activity has ceased provided the occasion of the interest expense arose out of the taxpayers previous income-earning activities. In Browns case, the Full Federal Court stated that the occasion for the recurring payments of interest was to be found in the original loan agreement (carrying with it the obligation to pay interest over the term of the loan) entered into by the taxpayer. The Full Federal Court found that the ceasing of the income-producing activity did not operate to break this nexus.

However, the nexus between the interest expense and the relevant income earning activities will be broken where:

· the taxpayer has the ability to repay the loan but chooses not to do so, or

· the taxpayer makes a conscious decision to extend the loan in order to derive an ongoing commercial advantage unrelated to the prior income earning activities which resulted in the debt.

In your situation, you borrowed funds to purchase a portfolio of managed investments to earn assessable income. A nexus existed between the interest expense incurred and the assessable income earned. Due to a downturn in the market your portfolio was terminated. You will use the money from the closure of the managed funds to repay a portion of the borrowed money, however an amount will still be outstanding.

As you are unable to repay the loan, the nexus between the ongoing interest expenses and the assessable income earned is not considered to be broken. Thus, the payment of the interest expenses will be deductible under section 8-1 of the ITAA 1997.

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