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Ruling

Subject: Compensation payment

Question 1

Is the compensation payment you received for the settlement of a class action brought against Company X assessable as ordinary income?

Answer: No

Question 2

Is the interest earned on the compensation payment you received for the settlement of a class action brought against Company X assessable as ordinary income?

Answer: Yes

Question 3

Is the compensation payment you received for the settlement of a class action brought against Company X assessable as a capital gain?

Answer: No

Question 4

Should the cost base of the shares in question be reduced by the amount of compensation received?

Answer: Yes

This ruling applies for the following period:

Year ended 30 June 2012

The scheme commenced on:

1 July 2011

Relevant facts and circumstances

A class action against Company X was filed on behalf of entities who acquired an interest in securities of Company X between two particular dates.

The class action alleged that the failure of Company X to disclose price sensitive information was misleading or deceptive.

As a result, the plaintiffs in the class action acquired their shares in Company X at a time when the value at which the shares were traded on the ASX was higher than their true value.

You received a compensation payment on the settlement of the class action case against Company X. This payment included interest earned on the settlement amount.

The compensation payment was calculated under a loss assessment formula which was approved by the Federal Court. This was based on your purchases of the Company X shares during the relevant period.

You still hold your shares in Company X.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 108-5

Reasons for decision

Summary

The compensation payment you received is considered a capital receipt and not ordinary income. This is because the compensation payment was paid in relation to a capital asset, and was not to compensate for a loss of income.

The payment is considered to be compensation for paying an excessive amount for an asset (the shares). Therefore, the compensation payment is treated as a recoupment of the cost base of the shares. Accordingly, no capital gain or loss arises in respect of that asset until you actually dispose of the underlying asset.

The interest you received is assessable as ordinary income and should be included in your 2011-12 income tax return.

Detailed reasoning

Compensation payment - assessable as ordinary income

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a taxpayer includes income according to ordinary concepts (ordinary income). Ordinary income has generally been held to include 3 categories, namely income from rendering personal services, income from property and income from carrying on a business.

Other characteristics of income that have evolved from case law include receipts that:

· are earned;

· are expected;

· are relied upon; and

· have an element of periodicity, recurrence or regularity.

The compensation you received was not income from rendering personal services, income from property or income from carrying on a business. The payment is also a one off payment and thus it does not have an element of recurrence or regularity.

A compensation amount generally bears the character of that which it is designed to replace. If the compensation is paid for the loss of a capital asset or amount then it will be regarded as a capital receipt and not ordinary income.

You received compensation for the acquisition of the shares at an inflated price. The compensation was paid in relation to a capital asset and accordingly, it is regarded as a capital receipt and not ordinary income. Therefore, the compensation payment is not assessable ordinary income under section 6-5 of the ITAA 1997.

Interest - assessable as ordinary income

Interest income is ordinary income. The payment you received included an amount of interest that had accrued on the settlement sum. This amount is assessable under section 6-5 of the ITAA 1997.

Compensation payment - assessable under capital gains tax provisions

Capital gains tax (CGT) is the tax you pay on certain gains you make. Section 102-20 of the ITAA 1997 provides that you make a capital gain or capital loss as a result of a CGT event happening to an asset in which you have an ownership interest. Section 108-5 of the ITAA 1997 provides that a CGT asset is any kind of property; or a legal or equitable right that is not property.

Taxation Ruling TR 95/35 discusses the capital gains tax implications for compensation receipts. Paragraph 70 of TR 95/35 provides that in determining the most relevant asset in respect of which the compensation has been received, it is often appropriate to adopt a 'look-through' approach to the transaction which generates the compensation receipt.

The 'look-through' approach is defined in paragraph 3 of TR 95/35 to be:

…the process of identifying the most relevant asset. It requires an analysis of all of the possible assets of the taxpayer in order to determine the asset to which the compensation amount is most directly related.

The transaction which generated the compensation receipt is the acquisition of the shares. Applying the 'look-through' approach to the acquisition of shares, the most relevant asset to which the compensation most directly relates is the shares in Company X. The compensation was for the acquisition of the shares at an inflated price. The compensation was calculated based on the date and the number of shares bought and sold.

Paragraph 10 of TR 95/35 provides that: 

If a taxpayer is compensated for having paid excessive consideration to acquire an asset, the amount referable to the overpayment represents a recoupment of all or part of the total acquisition costs of the asset.

Therefore, the cost base of the shares should be reduced by the amount of the compensation. No capital gain or loss arises in respect of that asset until you actually dispose of the underlying asset.

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