Edited version of your written advice

Authorisation Number: 1012764753993

Ruling

Subject: Compensation

Question 1

Is the compensation payment assessable as ordinary income?

Answer

No.

Question 2

Does the compensation payment relate to the right to seek compensation?

Answer

Yes.

Question 3

If the answer to question 3 is no, does the compensation payment relate to the underlying assets?

Answer

Not required.

Question 4

Can you apply the 50% discount to the capital gain?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2015

The scheme commences on

1 July 2014

Relevant facts and circumstances

The arrangement that is the subject of the private ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are:

• the proposed Deed of Settlement.

You and your spouse were clients of a company.

You and your spouse sought financial planning advice and were provided services including the preparation and provision of investment strategies.

You and your spouse financed managed investments in the 2007-08 financial year.

The total initial investment was $X and the current value is approximately $Y.

You and your spouse still hold the investments.

During 2013, you and your spouse complained about the appropriateness of the advice, the representations made by the company and their failure to disclose risks.

In 2013 you and your spouse commenced proceedings in the Court. The dispute will be resolved on the execution of the proposed Deed of Settlement.

The Deed of Settlement will be executed in the 2014-15 financial year.

The company have agreed to pay an amount to you and your spouse in full and final settlement of the dispute and all claims made against them. This amount includes all costs associated with the action.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 subsection 104-25(3)

Income Tax Assessment Act 1997 section 104-155

Income Tax Assessment Act 1997 section 108-5

Reasons for decision

Question 1

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 received by the taxpayer 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 and your spouse received compensation for the investment advice that resulted in financial loss. Accordingly, as the compensation was paid in relation to a capital asset 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.

Question 2

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.

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).

In determining 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.

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 capital gains tax. 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. This disposal triggers a CGT event C2.

Paragraphs 283 and 284 and 285 of TR 95/35 provide the following example:

283. On 4 July 1989 Marty acquired a rental property. In January 1990 Marty decided to sell the property. On 15 March 1990 Waldo indicated to Marty that he was willing to buy the property for $200,000. On 20 March 1990 Marty engaged his solicitors, Legal Eagles, to act for him in the sale. Legal Eagles had also acted for Marty when he purchased the property. On 10 July 1990 contracts were exchanged with a requirement that the sale be settled one year later on 10 July 1991. The sale was not finalised on 10 July 1991 because of a delay in receiving a clearance from one of the local authorities. Waldo later exercised his right under the contract to repudiate the contract and claimed a refund of his deposit.

284. On 24 October 1991 Marty commenced legal action against Legal Eagles seeking damages for their negligence in not ensuring that the certificate was received by the proposed settlement date. On 20 December 1991 Legal Eagles advised Marty they were willing to negotiate a settlement. On 17 January 1992 Marty accepted and received compensation of $95,000 in settlement of his claim against Legal Eagles. At this date Marty had not sold the property.

Note: no part of the $95,000 represents a repayment of the deposit paid by Waldo.

285.

While it is acknowledged that you and your spouse's particular circumstances differ from those provided in the above example, the principles of identifying the underlying asset remain the same.

Application to your circumstances

In this case, you and your spouse will receive a lump sum compensation payment in relation to the advice provided by a financial planner. As with the example, the relevant asset is not the investments as the value of the funds were not damaged by the actions of the financial advisor. The lump sum payment was made to compensate you and your spouse for the inappropriate advice.

Therefore, we consider that you and your spouse have disposed of your right to seek compensation. When you and your spouse enter into the Deed of Settlement CGT event C2 will happen. You and your spouse will make a capital gain if the proceeds from the ending of your right to seek compensation are more than the cost base of the asset under subsection 104-25(3) of the ITAA 1997.

Question 3

Not required.

Question 4

You can use the discount method to calculate your capital gain if:

• you are an individual, a trust or a complying superannuation entity

• a CGT event happens to an asset you own

• the CGT event happened after 11.45am (by legal time in the ACT) on 21 September 1999

• you acquired the asset at least 12 months before the CGT event, and

• you did not choose to use the indexation method.

In this case we accept that you and your spouse have held the relevant asset for at least 12 months. Therefore, you and your spouse are entitled to apply the 50% discount.

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