Edited version of your written advice

Authorisation Number: 1013121740324

Date of advice: 10 November 2016

Ruling

Subject: Capital loss

Question 1

Is the interest component of your settlement payment regarded as ordinary assessable income?

Answer

Yes.

Question 2

Is the remainder of your settlement payment regarded as ordinary assessable income?

Answer

No.

Question 3

Did a capital gains tax (CGT) event occur when you entered into a settlement agreement?

Answer

Yes.

Question 4

Does a portion of your legal fees incurred form part of your cost base for CGT purposes?

Answer

Yes.

Question 5

Can any capital loss be offset against your capital gain in the 20YY-ZZ financial year?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20ZZ

The scheme commenced on:

1 July 20XX

Relevant facts

You invested money with the agreement that you would receive some interest per annum. The associated business was later wound up.

You asked for the money to be returned, however your requests were ignored.

You sought legal assistance and took the matters to court. It took several years to finally win. Legal expenses were incurred.

Pursuant to the Terms of Settlement you were to receive X equal monthly instalments.

You were also to receive legal costs up to a specified amount.

You are not in the business of lending money.

You have not made any capital gains since this event. You have made a capital gain in the 20YY-ZZ financial year.

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.

Income Tax Assessment Act 1997 Section 104-25.

Income Tax Assessment Act 1997 Section 110-45.

Reasons for decision

Ordinary assessable income

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.

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

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, part of the settlement payment you received was for interest from your initial investment. As interest is regarded as ordinary assessable income, the relevant portion of the settlement payment is also regarded as ordinary assessable income and therefore assessable under section 6-5 of the ITAA 1997 in the year of receipt.

The remainder of the settlement payment is not earned by you as it does not relate to services performed or from carrying on a business. Although the payment can be said to be expected, and perhaps relied upon, this expectation arises from your investment and subsequent court action. This portion of the settlement payment is not considered to be ordinary income and therefore is not assessable under section 6-5 of the ITAA 1997.

This portion of the payment is capital in nature. Therefore the capital gains tax (CGT) provisions need to be considered.

Capital gains tax provisions

Section 102-20 of the ITAA 1997 states that a capital gain or capital loss is made only if a CGT event happens. The gain or loss is made at the time of the CGT event.

As a result of you entering into the arrangement with entity A, it is considered that you acquired contractual rights. These contractual rights are CGT assets (section 108-5 of the ITAA 1997).

Section 104-25 of the ITAA 1997 provides that CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset being abandoned, surrendered or forfeited or being released, discharged or satisfied. 

The time of a CGT event C2 is when you enter into the contract that results in the asset ending (for example, a settlement deed) or, if there is no contract, when the asset ends.

You make a capital loss from CGT event C2 happening if your capital proceeds from the event are less than the asset's reduced cost base.

In your case you had money invested in a business. As the associated payments were not made, you sought legal action. It is considered that in agreeing to the Terms of Settlement, a CGT C2 event occurred.

The reduced cost base of your CGT asset includes the initial payment as well as a portion of the associated legal costs incurred.

As your legal expenses relate both to ordinary income and a capital settlement, you will need to apportion the expenses using a reasonable basis. The portion that relates to the interest income is an allowable deduction in the year incurred. Apportionment is a question of fact and involves a determination of the proportion of the expenditure that is attributable to each purpose. 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 and capital portion. One way to apportion your expenses is according to the dollar value of the ordinary assessable amount as compared to the total amount being sought. The relevant percentage that relates to your capital investment can then be used in calculating your cost base.

Please note that any recouped legal costs do not form part of your reduced cost base (section 110-45 of the ITAA 1997).

A net capital loss is not deductible from your assessable income. However, it can generally be offset against capital gains made in later income years. To the extent that a net capital loss cannot be used to offset capital gains in an income year, it can be carried forward to a later income year.

In your case, your C2 capital loss occurred in a prior financial year. As you did not have any capital gains in that year or the next few years, your capital loss was carried forward. You have now made a capital gain in the 20YY-ZZ financial year. Therefore your C2 capital loss can be used to reduce your capital gain.

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