Edited version of your written advice

Authorisation Number: 1012832039524

Date of advice: 3 July 2015

Ruling

Subject: Compensation payment

Question 1

Should the capital gain or loss you made on the disposal of the property in the relevant financial year, be recalculated to account for the reduction in the cost base of the property brought about by the interim compensation payment you received in 20XX?

Answer:

Yes

This ruling applies for the following period(s)

Year ended 30 June 2014

The scheme commences on

1 July 20XX

Relevant facts and circumstances

You and your spouse owned a property.

Your property was damaged.

You made a claim for compensation.

You received an amount of compensation in the 20XX financial year.

The property was sold in the relevant financial year.

You did not hold insurance on the property.

In your original claim, you requested an amount over various heads of loss.

The defendants' solicitors made a compensation offer removing various heads of loss.

You negotiated further, on a lump sum basis, and eventually settled on an amount.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Reasons for decision

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.

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.

Compensation payment - assessable under the capital gains tax (CGT) provisions

Taxation Ruling TR 95/35 discusses the capital gains tax treatment of 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.

Paragraph 3 of TR 95/35 at paragraph 3 states;

The underlying asset is 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.

…Permanent damage or reduction in value does not mean everlasting damage or reduced value, but refers to damage or a reduction in value which will have permanent effect unless some action is taken by the taxpayer to put it right.

Paragraph 6 of TR 95/35 provides that;

If an amount of compensation is received by a taxpayer wholly in respect of permanent damage suffered to a post-CGT underlying asset of the taxpayer or for a permanent reduction in the value of a post-CGT underlying asset of the taxpayer, and there is no disposal of that underlying asset at the time of the receipt, we consider that the amount represents a recoupment of all or part of the total acquisition costs of the asset.

Accordingly, the total acquisition costs of the post-CGT asset should be reduced…by the amount of the compensation. No capital gain or loss arises in respect of that asset until the taxpayer actually disposes of the underlying asset. If, in the case of a post-CGT underlying asset, the compensation amount exceeds the total unindexed acquisition costs… of the underlying asset, there are no CGT consequences in respect of the excess compensation amount.

Paragraph 188 to 194 of TR 95/35 provide the following advice on ascertaining whether an amount is capital or relates to income

Whether a receipt constitutes income or capital in the hands of the taxpayer depends on the circumstances of the receipt and the reasons why it was paid to the taxpayer ( FC of T v. Slaven 84 ATC 4077; (1984) 15 ATR 242).

In McLaurin v. FC of T (1961)104 CLR 381, the High Court considered the case of a taxpayer who had commenced an action to recover damages caused by a fire originating on the defendant's land. The taxpayer had supplied the defendant with a list setting out particulars of damage. On the basis of its own list of particulars of damage, the defendant offered the taxpayer a lesser amount as a lump sum in full settlement of his claim, and the taxpayer accepted the sum without knowing the basis of calculation of the sum offered. The Commissioner sought to assess the taxpayer on that portion of the lump sum which was of an income nature as based on the defendant's list of particulars.

The High Court held that the lump sum was not assessable income because the settlement offer was for a single undissected amount rather than for a total of itemised amounts, and that it would have been unacceptable to determine the character of the receipt in the hands of the recipient by taking into account the uncommunicated reasoning of the payer.

The Court stated that no apportionment is appropriate if the receipt is in respect of a claim or claims for unliquidated damages only and is made or accepted under a compromise which treats it as a single undissected amount of damages.

Paragraph 18 of TR 95/35 states:

If the amount of compensation received is an undissected lump sum, the whole amount is treated as being consideration received for the disposal of the right to seek compensation.

Importantly however, as noted in paragraphs 77 and 82 of TR 95/35:

…Only if the insurance or settlement proceeds do not relate to the disposal of part or all of any underlying asset is it necessary to consider the policy rights or the right to seek compensation as the relevant asset.

In concluding that the underlying asset is the most relevant asset to which an amount of compensation relates, the taxpayer must be able to show that the compensation receipt has a direct and substantial link with the underlying asset. If an asset has not been disposed of and has not been permanently damaged or permanently reduced in value by the happening or event which generated the amount of compensation, the taxpayer is not able to demonstrate that link. It follows that the compensation cannot be directly related to that asset. In those cases, the most relevant asset may be the right to seek compensation, or the notional asset.

Application to your circumstances

Capital or ordinary income

Your statement of claim, detailed several heads of losses, however, the offer from the defendants, did not agree to pay for certain losses and particular amounts. You continued to negotiate a figure on a lump sum basis with the defendants and agreed to settle on an amount.

Under the circumstances of the particular negotiation processes involved and the relative weightings of the various components, it can reasonably be concluded that the whole of the amount received relates to the real property - and no other component. Whilst alternative apportionment approaches could imply a small non-land component, the above outcome is considered appropriate in this situation.

'Look-through' approach

Ordinarily, where no other circumstances indicate otherwise, when a lump sum is received, the whole amount is treated as being consideration received for the disposal of the right to seek compensation. However, applying the 'look-through' approach in this instance reveals that the most relevant asset to which the compensation most directly relates is the property.

The compensation was for loss of and/or damage to the property. It is considered that your claim, the settlement sum and damage done to the property are inextricably linked.

Accordingly, it is accepted that the compensation was received for the permanent damage to, or reduction in value of, a post-CGT underlying asset (the property). When there is no disposal of the underlying asset at the time of compensation, the compensation is considered a recoupment of part or all the acquisition costs of the underlying asset and while the cost base of the asset would need to be reduced, there would be no immediate CGT liability.

However, in your case, as the asset has been disposed of before the compensation amount was received, you will need to re-calculate any capital gain (or loss) you made on the disposal of the property in the relevant income year to take into account the reduction in the cost base of the asset.

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