Edited version of your written advice

Authorisation Number: 1012847038173

Date of advice: 28 July 2015

Ruling

Subject: Court awarded settlement

Question 1

Is the repayment of the principal amount assessable income?

Answer

No.

Question 2

Is the amount received as interest assessable income?

Answer

Yes.

Question 3

Is the interest received eligible for a lump sum in arrears tax offset?

Answer

No.

Question 4

Are a portion of the legal fees incurred an allowable deduction?

Answer

Yes.

Question 5

Are a portion of the court awarded costs assessable income?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2014

The scheme commences on:

1 July 2013

Relevant facts and circumstances

Your sibling borrowed money from your parents to purchase a house.

Your parents passed away before your sibling could repay the loan.

You inherited the mortgage receivable on your parent's death.

Your sibling passed away.

You took legal action to recover the outstanding mortgage after it was defaulted.

A court order was issued for the payment of:

• principal

• interest

• costs

You incurred legal fees of more than you were awarded.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5.

Income Tax Assessment Act 1997 Section 6-10.

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Subsection 20-20(2).

Income Tax Assessment Act 1936 Subsection 159ZR(1).

Reasons for decision

Loan repayment

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a resident taxpayer includes the ordinary income derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Generally speaking, a receipt will be income according to ordinary concepts if it is a receipt arising out of a taxpayer's employment or business activities. 

Section 6-10 of the ITAA 1997 provides that a taxpayers assessable income includes statutory income amounts that are not ordinary income but are included in assessable income by another provision.

In your case, a loan that your parents made to your sibling will be repaid to you.

The amount of repayment of a loan would be considered to be a receipt of a capital sum. The repayment is neither ordinary income as defined in section 6-5 of the ITAA 1997 nor is it statutory income as defined in section 6-10 of the ITAA 1997.

Accordingly the amount of the repaid loan is not assessable income.

Interest received

Interest income is regarded as ordinary income and therefore assessable under subsection 6-5(2) of the ITAA 1997.

It is not relevant in determining the assessability of the interest, where the original funds were sourced. Therefore, you are assessable on the interest you will receive under the court order.

Lump sum payment - interest

Subsection 159ZR(1) of the Income Tax Assessment Act 1936 lists the type of payments that are eligible for the lump sum payment in arrears (LSIA) Tax Offset. That subsection does not include interest income as eligible income.

Therefore an LSIA Tax Offset cannot apply to the interest payments received.

Legal fees

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital, domestic or private nature, then the expenses incurred in gaining the advantage will also be of a capital, domestic or private nature.

In this case, you incurred legal fees to recover the outstanding mortgage after it was defaulted. A court order was issued for payment of the principal amount, interest and costs. The repayment of the principal amount is not assessable to you. Therefore, legal expenses relating to obtaining these payments are not deductible. However, the interest income is assessable income. Therefore, the portion of the legal expenses incurred in obtaining the interest owed to you, is deductible.

Recoupment

Legal cost payments or awards are made to reimburse the legal costs incurred in engaging legal proceedings. A settlement sum paid in respect of a claim for legal costs is for the purpose of indemnifying the successful party for the professional legal expenses incurred in bringing the legal action to the point at which it is settled.

As stated above, legal costs take their character as an outgoing of capital or revenue nature from the cause or purpose of incurring the expenditure. If the advantage to be gained is of a revenue nature, then the costs incurred in gaining the advantage will also be of a revenue nature.

A court ordered award or settlement sum identifiable as an amount paid in relation to legal costs may be an assessable recoupment if the recipient's underlying legal costs were deductible.

Subsection 20-20(2) of the ITAA 1997 provides that an amount you have received as a recoupment of a loss of outgoing is an assessable recoupment if:

• you received the amount by way of insurance or indemnity, and

• you can deduct an amount for the loss or outgoing for the current year, or you have deducted or can deduct an amount for it in an earlier income year, under any provision of this Act.

If an amount is recouped by way of settlement of a claim for legal costs, it will be an assessable recoupment under subsection 20-20(2) of the ITAA 1997 where the purpose of the settlement is to indemnify the recipient for professional legal costs actually incurred in the conduct of the litigation, where the legal costs were deductible.

You instigated legal action seeking repayment of a loan that your sibling took out from your parents. The court awarded you the repayment of the principal amount, interest incurred on the loan, and costs. In this case, you are entitled to claim the portion of legal expenses that relates to the interest portion of your settlement. You are therefore required to include the same portion of the contribution towards your legal expenses as an assessable recoupment.

Apportionment of recoupment and legal expenses

As your recoupment is not fully assessable and your legal expenses are not fully deductible, you will need to apportion both the recoupment and the expenses using a reasonable basis. Apportionment is a question of fact and involves a determination of the proportion of the expenditure that is attributable to deductible purposes. The Commissioner believes that the method of apportionment must be fair and reasonable in all the circumstances.

Where legal expenses are not broken up into the relevant parts by your solicitor, you will need to calculate the deductible portion. One way to apportion your expenses is according to the dollar value of the assessable amount as compared to the total amount being sought. The relevant percentage that relates to your assessable income can then be applied to the legal expenses incurred.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).