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Ruling

Subject: Disposal of a capital gains tax asset

Question 1:

Was the Settlement Sum a Capital Gains Tax (CGT) asset?

Answer:

Yes.

Question 2:

Did the signing of the Deed of Settlement constitute CGT event C2?

Answer:

Yes.

Question 3:

Did the signing of the Deed of Settlement on 19 December 2011 constitute the time of the CGT event?

Answer:

Yes.

Question 4:

Should the income tax, loan interest, accounting costs and legal costs you incurred in relation to the CGT event C2 be included in the cost base or the reduced CGT cost base of the CGT asset?

Answer:

Yes.

Question 5:

Did you make a capital loss from CGT event C2?

Answer:

Yes.

This ruling applies for the following period:

Year ended 30 June 2012

The scheme commences on:

1 July 2011

Relevant facts and circumstances

In income year 20XX and subsequent years, you and another party received financial advice from your accountant in relation to your financial affairs which subsequently proved to be incorrect.

The advice you received resulted in you incurring income tax, loan interest and accounting costs over and above that which you should have incurred.

You commenced legal proceedings against your accountant to seek compensation for the additional tax, loan interest and accounting costs you incurred as a result of the incorrect advice under breach of contract, negligence and section 251M of the Income Tax Assessment Act 1936.

You incurred legal costs in pursuing your claim against your accountant.

You subsequently settled the matter with your accountant.

The settlement agreement was signed in 20XY.

The terms of the settlement agreement were that you would release your accountant from any further legal action in exchange for the settlement amount.

You have provided details of the cost base amounts of which you have a 50% share.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 104-25.

Income Tax Assessment Act 1997 section 104-25(1)(b).

Income Tax Assessment Act 1997 section 104-25(2).

Income Tax Assessment Act 1997 section 104-25(3).

Income Tax Assessment Act 1997 section 108-5(1)(b).

Income Tax Assessment Act 1997 section 110-25.

Reasons for decision

Question 1:

Paragraph 108-5(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997) states that a Capital Gains Tax (CGT) asset includes legal and equitable rights that are not property. Legal and equitable rights are also intangible assets in terms of subsection 104-25(1) of the ITAA 1997. The right to seek compensation is an example of a legal or equitable right and is also an intangible asset.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts deals with the tax treatment of compensation receipts. It specifies a 'look through' approach to identify whether the compensation is in relation to an underlying asset. Where there is no relevant underlying asset, the ruling states that the compensation relates to the disposal by the taxpayer of the right to seek compensation.

Paragraph 3 of TR 95/35 confirms that the right to seek compensation is a CGT asset. It describes the right as:

….the right of action arising at law or in equity and vesting in the taxpayer on the occurrence of any breach of contract, personal injury or other compensable damage or injury. A right to seek compensation is an asset for the purposes of Part IIIA. The right to seek compensation is acquired at the time of the compensable wrong or injury, and includes all of the rights arising during the process of pursuing the compensation claim. The right to seek compensation is disposed of when it is satisfied, surrendered, released or discharged.

You consider that the settlement amount you received constitutes a CGT asset 'disposal of the right to seek compensation'. You state you were given financial advice by your accountant which subsequently proved to be incorrect. The advice you received resulted in you incurring financial losses by way of additional income tax, loan interest, accounting costs and legal costs. You took legal action against your accountant in order to seek compensation for the losses you incurred.

From the information provided, the legal action you took constituted your right to seek compensation and is an asset for CGT purposes.

Question 2

Section 104-25 of the ITAA 1997 specifies that CGT event C2 will occur when an intangible asset is cancelled, surrendered or has a similar ending. Specifically, subparagraph 104-25(1)(b) of the ITAA 1997 states that CGT event C2 happens if ownership of an intangible CGT asset ends by being released, discharged or satisfied.

You state that the legal action you took constituted a CGT event C2.

In your situation, you took legal action against your accountant which constituted your right to seek compensation which is an intangible asset. You subsequently signed a settlement agreement with your accountant which satisfied your legal claim in full.

From the information provided, the signing of the settlement agreement constituted CGT event C2.

Question 3

Subsection 104-25(2) of the ITAA 1997 states that the time of a CGT event C2 is when a contract is entered into that results in the asset ending.

You signed a settlement agreement with your accountant in 20XY which satisfied your legal claim in full.

From the information provided, the time of the CGT event was 20XY.

Question 4

Paragraph 3 of TR 95/35 states that the right to seek compensation is acquired at the time of the compensable wrong or injury, and includes all of the rights arising during the process of pursuing the compensation claim. Any capital gain or loss resulting from disposal of the right is calculated using the cost base of the right.

Section 110-25 of the ITAA 1997 lists the elements that form the cost base of a CGT asset, and guidance relating specifically to the calculation of the cost base of a right to seek compensation is provided in paragraphs 11 to 12, 99 to 104 and 283 to 287 of TR 95/35.

Paragraph 12 of TR 95/35 states that the cost base includes the total acquisition costs incurred as a result of the right to seek compensation arising. There must also be a direct and substantial link between the expenditure or outgoing and the arising of the right to seek compensation (paragraph 103 of TR 95/35).

You state that the time of the compensable wrong is in the 20XX income year which is the first income year in which the incorrect advice was provided by the accountant, and that there is a direct and substantial link between the expenditure or outgoing and the arising of the right to seek compensation.

Paragraph 104 of TR 95/35 states:

If the right to seek compensation arises in respect of a monetary loss of the taxpayer (e.g., in respect of a claim for breach of contract, as a result of which the taxpayer must incur additional expenditure) the amount of that loss is included in the cost base of the right to seek compensation for that loss. It is an amount which the taxpayer has paid or is required to pay in respect of the acquisition of the right to seek compensation for having to incur the expenditure.

From the above it is accepted that the cost base or reduced cost base in relation to the right to seek compensation comprises the acquisition cost, which includes the loss or losses incurred by the taxpayer, plus incidental costs such as legal fees, incurred by the taxpayer in pursuing any legal action.

You consider that the cost base of the CGT asset should include the income tax, loan interest, accounting costs and legal costs you incurred as a direct result of the incorrect advice you received.

You have provided the cost base amounts of which you have a 50% share.

From the figures provided, the acquisition cost is considered to be $X being 50% of the additional income tax, loan interest and accounting costs you incurred in relation to the right to seek compensation; plus incidental costs, of $Y being 50% of the legal costs you incurred in pursuing the claim against your accountant.

Therefore, based on the information provided, the cost base or reduced cost base of your right to seek compensation is $Z.

Question 5

The capital proceeds from a CGT event, the right to seek compensation, consist of the compensation you receive in respect of the event occurring. You will make a capital gain if the capital proceeds from the ending of your right to seek compensation are greater than your cost base. You will make a capital loss if the capital proceeds are less than the asset's reduced cost base (subsection 104-25(3) of the ITAA 1997).

From the information provided, your share of the capital proceeds was $X and the reduced cost base was $Y. Therefore, you made a capital loss of $Z in relation to CGT event C2.

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