Edited version of your written advice

Authorisation Number: 1013119790985

Date of advice: 3 November 2016

Ruling

Subject: Compensation payments

Question

Is any part of the lump sum payment received as a compensation payment made to a self-managed superannuation fund (the Fund) assessable income of the Fund?

Answer

Yes

This ruling applies for the following period

Year ended 30 June 20YY

The scheme commenced on

1 July 20XX

Relevant facts and circumstances

The Fund is a self-managed superannuation fund which was established by several Trustees who are also the Fund's members some years ago on the advice of a financial advisor (the Financial Advisor).

On the advice of the Financial Advisor a member relinquished their super pension and transferred those benefits into the Fund and another member also rolled over their superannuation into the Fund.

The Financial Advisors provided the Trustees on-going financial investment advice and other advice since 20ZZ.

The Trustees were dissatisfied with the investment advice and other advice provided by the Financial Advisors and in 20XX lodged a complaint (the Complaint) with an independent dispute resolver (the Arbitrator).

Documentation from the Arbitrator, which was provided by the applicant for this ruling and as trustee, states the issues raised included:

● the assets of the Fund should have been invested more conservatively, initially and on an ongoing basis and in a conservative manner consistent with the members' risk profile to provide sufficient income to meet their retirement income needs.

● the advice provided by the Financial Advisor in relation to a member of the Fund was not appropriate for the member's circumstances.

The Complaint was considered by the Arbitrator and recommended a settlement.

A final settlement was entered into between the Applicants and the Financial Advisor as shown in a Settlement Deed (the Deed).

In the accordance with the Deed the amount the Financial Advisor was to pay the Applicants was determined which comprised an amount plus interest at compounded annual rate from a date.

In the Deed it also stated, amongst other matters:

Upon payment of the Amount, the Applicants fully and finally release the Financial Advisors together with its predecessors, successors, representatives… from any and all claims relating to or arising out of the Dispute including, without limitation, the establishment of the Fund and all aspects of its operation, and any financial advice the Financial Advisors provided to the Applicants. The Applicants also waive any right to challenge the Recommendation or to assert that the Financial Advisors should pay them any amount which is different to the Amount.

An amount (the compensation payment) was paid to the Applicants in their capacity trustees of the Fund.

You have confirmed that the compensation payment was directly deposited to a newly created bank account (the Account) which is held by the Applicants as trustees for the Fund.

Documentation has been provided to support this claim by way of correspondence between yourselves, the Financial Advisors and the Arbitrator in support of the claim that the payment was for compensation due to losses suffered in the Fund.

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 102-5

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Subdivision 110-A

Reasons for decision

Summary

The lump sum payment the Fund received in respect of the loss incurred in relation to the Fund investments is considered to be a capital payment.

The interest component of the lump sum payment is considered to be ordinary income.

Detailed Reasoning

Ordinary income

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes the ordinary income they 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.

The compensation payment the Fund received is not earned by the Fund as it does not relate to services performed. The payment is also a one off payment and thus it does not have an element of recurrence or regularity. Although the payment can be said to be expected, and perhaps relied upon, this expectation does not arise from a relationship to personal services performed.

The compensation payment relates to the Fund member's superannuation investments and is capital in nature. Accordingly, the payment is not ordinary income and is therefore not assessable under section 6-5 of the ITAA 1997.

Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but are included in assessable income by another provision, are called statutory income. Capital gains are included as assessable income under section 102-5 of the ITAA 1997.

Statutory income - capital gains

Section 102-5 of the ITAA 1997 provides that a taxpayer's assessable income includes a net capital gain. 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.

A CGT asset is defined in paragraph 108-5(1) (b) of the ITAA 1997 as including a legal or equitable right that is not property. Taxation Ruling 95/35 Income tax: capital gains: treatment of compensation receipts considers the capital gains tax consequences for the recipient of an amount as compensation.

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 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.

 Applying the 'look-through' approach, the most relevant asset to which the compensation most directly relates is your right to seek compensation.

The right to seek compensation is acquired at the time of the compensable wrong or injury and includes all the rights arising during the process of pursuing the compensation claim. The right to seek compensation is disposed of when it is satisfied, released or discharged.

CGT event C2 happens when the ownership of an intangible CGT asset ends by the asset being satisfied or surrendered. A C2 event can apply where there is a “release” or “discharge” of a right to sue on the settlement of a legal dispute (See Re Coshott and FCT [2014] AATA 622). When an undissected lump sum compensation payment is received the whole amount is treated as consideration for the disposal of the right to seek compensation.

Any capital gain or loss arising on the disposal of that right is calculated using the cost base of that right. The cost base of the right to seek compensation is determined in accordance with the provisions of subdivision 110-A of the ITAA 1997. Expenditure or an outgoing forms part of the cost base of a right to seek compensation if there is a direct and substantial link between the expenditure or outgoing and the arising of the right to seek compensation.

In your case, the relevant asset was the right to seek compensation in respect of the investment advice and actions of the Financial Advisors. A CGT event occurred when you entered into the settlement and disposed of the right to seek compensation. The settlement sum is the consideration of the disposal of the right to seek compensation.

In relation to the interest component of the lump sum payment it is ordinary income for the purposes of sub section 6-5(1) of the ITAA 1997.

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