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Edited version of your written advice
Authorisation Number: 1013054189388
Date of advice: 20 July 2016
Ruling
Subject: Lump sum payment
Question 1
Is your compensation payment regarded as ordinary assessable income?
Answer
No.
Question 2
Should your share of the payment received be treated as capital proceeds for the investments?
Answer
Yes.
This ruling applies for the following period
Year ending 30 June 2016
The scheme commenced on
1 July 2015
Relevant facts
You and your spouse were awarded an amount of compensation.
The amount was awarded to you on the basis that you had been given inappropriate financial advice by entity A and had sustained significant financial losses.
You agreed to have the money paid directly to entity B.
The losses you sustained were as a result of the following:
• inappropriate financial advice by entity A to take out a margin loan to buy shares based on an existing share portfolio and the failure to manage the loan and the portfolio,
• advice to take out loans to invest in various investments which resulted in the loss of the money when the company failed.
The investment companies are now in liquidation.
You remain liable to repay your loans in relation to the investments.
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
Compensation payment
Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources, whether in or out of Australia, during the income year.
Ordinary income has generally been held to include three 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.
For income tax purposes, an amount paid to compensate for a loss generally acquires the character of that for which it is substituted (Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 AITR 443; 10 ATD 82). Compensation payments which substitute income have been held by the courts to be income under ordinary concepts (Federal Commissioner of Taxation v. Inkster (1989) 24 FCR 53; (1989) 20 ATR 1516; 89 ATC 5142, Tinkler v. FC of T (1979) 10 ATR 411; 79 ATC 4641, and Case Y47 (1991) 22 ATR 3422; 91 ATC 433).
On the other hand, 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.
In your case, the payment is capital in nature and therefore not assessable as ordinary income. However, as the payment is capital in nature, the capital gains tax (CGT) provisions need to be considered.
It is acknowledged that you did not receive the money, however for income tax purposes, it is taken to be income as soon as it is applied or dealt with in any way on your behalf or as your direct (subsections 6-5(4) and 6-10(3) of the ITAA 1997).
Therefore as you agreed to pay the amount to entity B, it is considered for tax purposes that you have received the income.
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 states that a capital gain or capital loss is made only if a CGT event happens. For most CGT events, your capital gain is the difference between your capital proceeds and the cost base of your CGT asset.
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 Income tax: capital gains: treatment of compensation receipts 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. It is also referred to as the underlying asset approach.
'Underlying asset' is also defined in paragraph 3 of TR 95/35 as:
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.
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.
The transaction which generated your compensation receipt is the alleged inappropriate advice that caused you to increase your borrowing by taking additional loans to purchase further investments. The investments lost significant value and resulted in a capital loss. Applying the 'look-through' approach, the most relevant asset to which the compensation most directly relates is your investments.
Treatment of compensation if a CGT event previously occurred
In your case, your investments have made capital losses and you received the compensation after the relevant CGT event. As your compensation for losses arose from your former investments, your compensation payment is treated as additional 'capital proceeds' for the previous redemption or ending of your investments. This means that the capital loss made for the previous CGT event needs to be recalculated. The calculation will be for the CGT event that occurred in that tax year and not the year of income the proceeds were obtained in.
As you have advised that a net capital loss resulted from your investments, you will need to adjust the amount of any capital losses you have available to carry forward for future years.
You should keep a record of the reduction in the capital loss (as a result of the compensation received) to ensure that the correct amount of capital losses are carried forward to any future years.
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