Edited version of private ruling

Authorisation Number: 1011716666959

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Ruling

Subject: Financial company collapse

Issue 1

Question

Is the equity component of the compensation payment that you received additional capital proceeds?

Answer: Yes.

This ruling applies for the following periods:

Year ended 30 June 2009

Year ended 30 June 2010

The scheme commences on:

1 July 2008

Issue 2

Question

Will the interest component of the compensation payment be assessable income?

Answer: Yes.

This ruling applies for the following period:

Year ended 30 June 2010

The scheme commences on:

1 July 2009

Issue 3

Questions

1. Is your share of the refund of unused prepaid interest assessable income?

Answer: No.

2. Are you entitled to a deduction in respect of your share of the capitalised interest paid?

Answer: Yes.

3. Are you entitled to a deduction in respect of your share of the early termination interest adjustment?

Answer: Yes.

This ruling applies for the following period:

Year ended 30 June 2009

The scheme commences on:

1 July 2008

Relevant facts and circumstances

You and your spouse were clients of Company X and received financial advice from Company X.

On the advice of Company X and with Company X's assistance, at various times you and your spouse applied for one or more home loans from Bank Y's retail division and one or more margin loans from Bank Y's geared investments division.

At various times, Bank Y's retail division approved the home loan application/s and advanced funds to you and your spouse under one or more loans (herein referred to as the home loan). The home loan is/was secured by one or more registered mortgages over certain properties.

Proceeds of the facilities comprising the home loan were used from time to time by you and your spouse to purchase various investments on the advice of Company X, which were then offered by you to Bank Y (together with investments to be purchased with the proceeds of the proposed margin loan) as part of the security for the proposed margin loan/s (the ML security).

BankY approved the margin loan application/s and a margin loan/s was advanced to you and your spouse against the ML security.

Proceeds of the home loan were used from time to time by you and your spouse to purchase additional ML security on the advice of Company X, which in turn was used to increase the borrowings under the margin loan.

The ML security may have included units in a Company X-badged index fund for which the responsible entity was a Bank Y party.

The Bank Y notified you and your spouse and/or Company X of the ML security value and the Loan-to-Security ratios of the margin loan from time to time.

Between 2008 and the effective date, one or more (but not necessarily all) of the following occurred in relation to the margin loan:

(a) the Current Loan-to-Security ratio of the margin loan exceeded the Base Loan-to-Security ratio of the margin loan;

(b) the margin loan went into margin call when the Current Loan-to-Security ratio of the margin loan exceeded the margin call Loan-to-Security ratio;

(c) Bank Y notified Company X, as your agent, of the margin call;

(d) the margin loan went into default;

(e) you and your spouse converted some, or all, of the ML security held as securities or units in managed funds into cash held in a cash account as ML security;

(f) you and your spouse sold some, or all, of the ML security to repay indebtedness under the margin loan;

(g) Bank Y sold some, or all of the ML security and applied the proceeds to repay indebtedness under the margin loan;

(h) the margin loan was repaid, including through the breakage of any fixed rate component of the margin loan;

(i) break costs were charged to the margin loan by Bank Y in relation to the breakage of a fixed rate component of the margin loan;

(j) one or more of the index funds comprising the ML security was suspended and/or closed by the relevant responsible entity;

(k) the margin loan was closed;

(l) the ML security sale proceeds were insufficient to cover your indebtedness under the margin loan and there remains money owing by you and your spouse to Bank Y under the margin loan.

Returns generated by the ML security are no longer available to you and your spouse to apply towards meeting, or are insufficient to meet, repayment obligations under the home loan or (if different) the Current loan.

You and your spouse have, either directly or through your lawyers made a claim against Bank Y for compensation concerning the circumstances of the home loan, the margin loan, the security, the repayment of indebtedness under the margin loan and/or the repayment of indebtedness under the home loan.

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

As a result of their participation in the scheme and Bank Y's construction of a proposal, the parties have agreed upon:

(a) the release and waiver of certain amounts of indebtedness owed by you and your spouse to Bank Y; and/or

(b) the closure, variation or replacement of the Current loan and/or the margin loan as set out in the Deed; and/or

(c) the payment of certain amounts to you and your spouse by Bank Y; and

(d) the releases which are set out in the Deed.

The total equity component of the settlement amount is a certain amount.

The total interest component of the settlement amount is a certain amount.

In addition, an amount was written off the home loan.

The total amount of the settlement was used to offset you and your spouse's total indebtedness. As the value of the settlement exceeded you and your spouse's indebtedness you received a cash amount which represented the surplus.

In the 2009 income year, under the margin loan you:

· received a refund of prepaid interest,

· incurred capitalised interest and

· incurred early termination interest.

You have provided copies of the following documents:

· the Bank Y Company X Resolution Scheme Deed of Settlement,

· a letter from Bank Y confirming the settlement,

· statements from Bank Y relating to the variable rate margin loan and the fixed rate margin loan for the year ended 30 June 2009,

· transaction histories for managed investments,

· capital gains tax (CGT) statement for Investment A,

· CGT statement for unit trust,

· transaction history for Investment B for a period of time,

· analysis of all of the above showing:

· the redemption proceeds on the variable rate margin loan equals the total of the sale proceeds on the CGT statements

· the loans transactions balance,

· Bank Y statement of account,

· email from Bank Y,

· Bank Y loan statement,

· the final statement for the margin loan and

· email from lawyers

These documents form part of, and are to be read in conjunction with, your application for a private ruling.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5,

Income Tax Assessment Act 1997 Section 6-10,

Income Tax Assessment Act 1997 Section 8-1,

Income Tax Assessment Act 1997 Section 10-5,

Income Tax Assessment Act 1997 Section 20-25,

Income Tax Assessment Act 1997 Section 104-10,

Income Tax Assessment Act 1997 Section 104-25,

Income Tax Assessment Act 1997 Section 108-5 and

Income Tax Assessment Act 1997 Section 116-20.

Reasons for decision

Issue 1

Is the equity component of the compensation payment that you received additional capital proceeds?

The general CGT provisions are set out in Part 3-1 of the Income Tax Assessment Act 1997 (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 references 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 Company X. You and your spouse applied and were granted a margin loan from Bank Y's geared investments division. The margin loan was used to acquire various stocks and investments. It may have included units in a Company X branded index fund for which the responsible entity was Bank Y or one of its related bodies.

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

Bank Y with either you and your spouse, or with your solicitors, have made a claim against Bank Y for compensation concerning the circumstances surrounding the margin call and/or the security and the repayment of indebtedness under the margin call. Bank Y issued a letter to you and your spouse offering details of the proposal and settlement deed. The settlement deed agreed to pay you and your spouse compensation and interest.

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. Your share of the amount 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 your investments were sold.

Please note that because you have received additional capital proceeds in respect of previous CGT events this will mean you will need to adjust any capital gains or capital losses that you included in the 2008-09 and 2009-10 income years.

Issue 2

Will the interest component of the compensation payment be assessable income?

The taxation treatment of the interest component of the payment that you and your spouse received 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 under the general income provisions in section 6-5 of the ITAA 1997. Your share of the interest component will need to be included as assessable income in your 2009-10 income tax return.

Issue 3

1. Is your share of the refund of unused prepaid interest assessable income?

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income or, in carrying on a business for the purpose of gaining or producing such income.

Where a taxpayer receives a refund of an item for which they have previous claimed a deduction, it is necessary to consider the character of the receipt in order to establish the taxation implications.

Section 6-5 of the ITAA 1997 provides 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 provides 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 specified in section 10-5 of the ITAA 1997. Included in this list are recoupments.

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

In your case, while the refund of prepaid interest fits the definition of a recoupment as defined in section 20-25 of the ITAA 1997, it is not assessable.

The refund of unused prepaid interest is not an assessable recoupment as it does not relate to a deduction for which recoupments become assessable.

Your share of the amount that you and your spouse received as a refund of unused prepaid interest does not fall within the concepts of either ordinary or statutory income. Therefore the amount will not be included as assessable income. You may choose to amend your income tax assessment for the year ending 30 June 2008 to exclude any deduction you may have previously claimed in respect of the interest.

2. Are you entitled to a deduction in respect of your share of the capitalised interest paid?

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 and your spouse borrowed funds to purchase investments. A nexus existed between the interest expense incurred and the assessable income earned. This nexus remains unbroken and therefore your share of the interest expense is deductible under section 8-1 of the ITAA 1997.

3. Are you entitled to a deduction in respect of your share of the early termination interest adjustment?

Early termination interest is a form of penalty interest. Taxation Ruling TR 93/7 provides guidance on whether penalty interest payments are deductible. Penalty interest payment refers to an amount payable by a borrower under a loan agreement in consideration for the lender agreeing to accept an early repayment of a loan.

TR 93/7 provides that a penalty interest payment is generally deductible under section 8-1 of the ITAA 1997 if:

(a) the loan moneys were borrowed for the purpose of gaining or producing assessable income or for use in a business carried on for that purpose; and

(b) the payment is made in order to rid the taxpayer of a recurring obligation to pay interest on the loan, where such interest would itself have been deductible if incurred.

In your situation, the early termination interest was incurred on a loan that was purely for investment purposes. You and your spouse would have been entitled to deductions on the interest incurred in respect of this loan. Therefore your share of the amount that you and your spouse incurred in early termination interest is deductible under section 8-1 of the ITAA 1997.

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