Edited version of private advice

Authorisation Number: 1012632488003

Ruling

Subject: Compensation settlement

Question 1

Whether any part of the amount of paid to the trust during the year pursuant to the Deed of Settlement represents:

• Ordinary income pursuant to section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997);

• An assessable recoupment pursuant to Subdivision 20-A of the ITAA 1997; or

• Is otherwise assessable as statutory income?

Answer

No part of the amount is ordinary income pursuant to section 6-5 of the ITAA 1997 or an assessable recoupment pursuant to Subdivision 20-A of the ITAA 1997. However, it is capital proceeds for an assessable capital gain.

Question 2

Whether a CGT event resulting in a capital gain occurs for the trust during the year ended 30 June 2013 as a result of the settlement implemented pursuant to the terms of the deed?

Answer

CGT event C2 happened as a result of entering into the Deed of Settlement pursuant to section 104-25 of the ITAA 1997.

Question 3

If an amount is assessable to the trust as ordinary or statutory income and a CGT event occurs as a result of the terms of the Deed of Settlement, the extent to which section 118-20 of the ITAA 1997 will operate to ensure that the same amount is not taxed twice?

Answer

Question is not applicable.

This ruling applies for the following periods:

2013 income year

The scheme commenced:

During the 2012 income year.

Relevant facts and circumstances

A testamentary trust was created under the will of a deceased person.

A trustee has been appointed to administer this trust. The trustee charges fees for services rendered in that capacity.

The trust derives income from passive investments and does not carry on business activity.

The trust has claimed deductions under section 8-1 of the ITAA 1997 for the fees that were charged on revenue account, as management fees.

An income beneficiary under the will initiated legal action against the trustee, alleging various breaches of its duty.

The trustee strongly denied these allegations.

The parties were able to settle their dispute and the legal action was discontinued. The terms of settlement were contained in a Deed of Settlement.

Pursuant to deed, the trustee agreed to:

• A revised fee structure;

• A continuation of the standard fees at the rates previously charged; and

• As a goodwill gesture, make an ex gratia payment of an amount to the trust in respect of fees charged to mid-2010.

The trust has accounted for this amount on the basis that a proportion is charged to trust capital and the remainder is on revenue account in accordance with the Deed of Settlement.

The receipt of the amount did not result in the reduction of the cost base of any CGT asset held by the trust.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 Subdivision 20-A

Income Tax Assessment Act 1997 section 20-20

Income Tax Assessment Act 1997 section 20-30

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 subsection 108-5(1)

Reasons for decision

Question 1

For an amount to be regarded as an assessable recoupment under section 20-20 of the ITAA 1997 it must be:

(a) An amount received by way of insurance or indemnity as a recoupment of a loss or outgoing deducted under any provision of the ITAA; or

(b) An amount received as recoupment (other than by way of insurance or indemnity) of a loss or outgoing deductible in the current income year or deductible in an earlier income year if it was deducted under a provision of the tax law listed in the table set out in section 20-30 of the ITAA 1997.

It is considered that the conditions for paragraph (a) are not present in relation to the ex gratia payment because it was not received by way of insurance or indemnity. The conditions for paragraph (b) are not present because the losses or outgoings for management fees were deducted under section 8-1 of the ITAA 1997, which is not listed in the table to section 20-30 of the ITAA 1997.

Therefore, no part of the ex gratia payment is regarded to be an assessable recoupment pursuant to Subdivision 20-A of the ITAA 1997.

As to whether any part of the ex gratia payment could be regarded to be ordinary income for the purposes of section 6-5 of the ITAA 1997, the High Court has held in FCT v Rowe (1997) 35 ATR 432 that there is no general principle of Australian tax law to the effect that amounts received by way of reimbursement or compensation for deductible expenses are assessable. A receipt must be income according to ordinary concepts to be assessable (or specifically made assessable by legislation) and an amount is not income simply because it is a recoupment of a deductible expense.

A receipt must take on the characteristics of income in the recipient's hands.

Some of the factors that have evolved from case law that may indicate whether an item has the characteristics of ordinary income include (with comment on the characteristics of the ex gratia payment):

• The item is received periodically or regularly.

• The ex gratia payment was a one-off payment to be made within 14 days of entering into the settlement agreement;

• The receipt is derived from disposing of a right or advantage as part of the process by which the profit-earning structure or organisation operates to obtain regular returns:

• The trust did not use its profit-earning structure to make a return of the amount of the ex gratia payment;

• The item is a "flow" detached from the asset or activity which generated it:

• The ex gratia payment did not arise from the use of any assets or activity involving any of the assets of the trust.

• The payment is made by force of a contractual or other legal obligation and not voluntarily:

• This was not applicable with respect to the ex gratia payment. It was made voluntarily by the trustee to settle the legal dispute.

• The item (eg compensation) replaces lost income or revenue assets.

• The payment was not replacing any lost income or revenue assets.

It is concluded that no part of the ex gratia payment is income under ordinary concepts for the purposes of section 6-5 of the ITAA 1997.

Question 2

To consider whether an amount received by way of compensation is subject to the capital gains provisions of the tax law regard must be had to the Commissioner's Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts (TR 95/35). While this ruling refers to the capital gains provisions of the Income Tax Assessment Act 1936 (ITAA 1936) the principles of that ruling are still applicable to the CGT provisions of the ITAA 1997.

Relevantly under this ruling, the Commissioner considers that when examining a compensation receipt to see if the capital gains provisions are applicable we are to consider whether the receipt was made in respect of permanent damage to or permanent reduction in value of an underlying asset. If there is no such underlying asset then the receipt must be for the disposal of the right to seek compensation, - refer to paragraph 11 of TR 95/35.

It is considered that in the present case there was no damage to an underlying asset that can be identified and that the relevant asset is the right to seek compensation. Such a right is defined in paragraph 3 of TR 95/35 to be:

Right to seek compensation

The right to seek compensation is 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.

It follows that such a right is a CGT asset under subsection 108-5(1) of the ITAA 1997 because legal or equitable rights that are not property are CGT assets under paragraph 108-5(1)(b) of the ITAA 1997.

As the right to seek compensation is an intangible CGT asset receipt of an amount of money to cease pursuing that right would represent the end of the ownership of that asset. In terms of the ITAA 1997 the consequences of the ending of that ownership constitutes a CGT event C2 under section 104-25 of the ITAA 1997.

Subsection 104-25(1) of the ITAA 1997 provides:

104-25(1) CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset:

(a) being redeemed or cancelled; or

(b) being released, discharged or satisfied; or

(c) expiring; or

(d) being abandoned, surrendered or forfeited; or

(e) if the asset is an option - being exercised; or

(f) if the asset is a convertible interest - being converted.

The timing of the CGT event would be when the parties entered into the settlement agreement per subsection 104-25(2) of the ITAA 1997.

The amount of the ex gratia payment would be the capital proceeds for the purposes of section 116-20 of the ITAA 1997.

The cost base of the right to seek compensation is limited to any outlays the trust may have incurred in acquiring the right to seek compensation. However this would not include any expenses incurred by the trustee in defending the legal action.

The capital gain may also qualify for the general CGT discount of 50% under section 115-100 of the ITAA 1997. The conditions for such a discount to apply seem to be present:

• The entity making the capital gain is a trust - section 115-10 of the ITAA 1997;

• The capital gain has not resulted from one of the CGT events listed in subsection 115-25(3) of the ITAA 1997; and

• The relevant CGT asset had been held by the entity for greater than 12 months - subsection 115-25(1) of the ITAA 1997. As the ex gratia payment was said to be for the period ending mid-2010 and the CGT event occurred in late-2012 it can be inferred that the trust had held the right to seek compensation from the trustee for a period greater than 12 months.

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