Disclaimer
This edited version has been archived due to the length of time since original publication. It should not be regarded as indicative of the ATO's current views. The law may have changed since original publication, and views in the edited version may also be affected by subsequent precedents and new approaches to the application of the law.

You cannot rely on this record in your tax affairs. It is not binding and provides you with no protection (including from any underpaid tax, penalty or interest). In addition, this record is not an authority for the purposes of establishing a reasonably arguable position for you to apply to your own circumstances. For more information on the status of edited versions of private advice and reasons we publish them, see PS LA 2008/4.

Edited version of your written advice

Authorisation Number: 1013123027708

Date of advice: 17 November 2016

Ruling

Subject: Compensation payment

Question 1

Is your compensation payment regarded as ordinary assessable income?

Answer

No.

Question 2

Is the compensation payment assessable under the capital gains tax (CGT) provisions?

Answer

Yes.

Question 3

Are you entitled to the 50% capital gains discount?

Answer

Yes.

This ruling applies for the following periods

Year ending 30 June 201X

Year ending 30 June 201X

The scheme commenced on

1 July 201X

Relevant facts

You jointly borrowed money to invest on advice of a professional.

The investments were negatively geared and you were claiming interest deductions on the borrowed investment funds.

A new professional subsequently advised you to sell the investment and to use the proceeds to pay down the loan and then draw down to invest the money into a superannuation product as a non-concessional contribution.

The professional then commenced a small superannuation pension amount in order to access future Centrelink benefits for starting a pension before a future date. You were not eligible for these benefits and the advice was incorrect.

The sale of the investment brought about a large capital gain. It also denied you an ongoing deduction for the interest on the loan. The professional had incorrectly advised you that you could continue to claim the interest on the loan.

The pension received from the new Superfund also has ongoing adverse tax consequences.

You were made aware of the above consequences when you were completing your 201X tax return in or around mid-late 201X.

You then began to ask questions to your initial professional to no avail. This professional subsequently left the firm. Questions continued to be asked, however, it was not until earlier this year a new officer took on your complaint and confirmed that the firm had been negligent in their advice and as a result you had suffered a loss on the bringing forward of the capital gain and a financial loss in not being able to claim the interest deductions.

You had originally planned to sell of the investment once you retired and on a lower income.

You received compensation in the 201X-1X financial year under a Relevant Deed. The settlement sum included an amount for your cost to obtain a private ruling.

The firm agreed that you were financially disadvantaged in the following ways:

You may receive further compensation in the 201X-1X financial year if you have to pay tax on the initial compensation amount.

Under the Relevant Deed you release and forever discharge the firm from any liability and from all claims, suits, causes of action or demands, arising out of, in relation to or in connection with the Advice and Complaint with the exception of any unpaid taxation loss referred to in clause 3.2.

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 104-25

Income Tax Assessment Act 1997 section 108-5

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.

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 Scott v. FC of T (1966) 14 ATD 286, Windeyer J expressed the view that whether or not a particular receipt is income depends upon its quality in the hands of the recipient.

The compensation payment received was not earned by you as it does not relate to services performed. Although the settlement payment relates to your investments, the payment is not a revenue receipt directly related to your investments. The payment is not a payment for lost income. The payment is also a one-off payment and thus does not have an element of recurrence or regularity. Although the payment can be said to be expected, and perhaps relied upon, this expectation arises from the incorrect advice provided by your financial advisor.

Considering the full circumstances of your compensation, the payment is not regarded as ordinary income and is therefore not assessable under subsection 6-5(2) of the ITAA 1997.

Statutory income

Amounts that are not ordinary income, but are included in your assessable income by another provision are called statutory income (section 6-10 of the ITAA 1997).

The provisions dealing with statutory income are listed in section 10-5 of the ITAA 1997. The relevant provision included in this list is section 102-5 of the ITAA 1997 (capital gains).

Capital gains tax provisions

Your assessable income includes your net capital gain for the income year (subsection 102-5(1) of the ITAA 1997). 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.

Why the payment was made is an important factor in determining whether an asset has been disposed of for capital gains tax purposes.

TR 95/35 discusses the various scenarios, including:

The transaction which generated your compensation receipt is the inappropriate advice that caused you to sell your investment and invest in superannuation. The sale of the investments did not result in a capital loss. In your case it is not considered that the investment or superannuation suffered permanent damage as a result of the incorrect advice. Rather the relevant CGT asset in your case is the right to seek compensation. The payment received was in full settlement of all claims made.

Your right to seek compensation is an intangible CGT asset (acquired at the time of the compensable wrong) and your ownership of that asset ended when you accepted the compensation. At that time CGT event C2 happened.

CGT event C2 happens if your ownership of an intangible CGT asset ends in certain ways, including being released or cancelled (subsection 104-25(1) of the ITAA 1997). The time of the event is when you enter into the contract that results in the asset ending, or if there is no contract, when the asset ends (subsection 104-25(2) of the ITAA 1997).

In your case, the compensation payment represents capital proceeds for your CGT C2 event. As the compensation paid belongs to both of you, the capital gain is apportioned accordingly.

As you acquired the right to seek compensation more than 12 months before the CGT event, you are able to apply the 50% general discount to the capital gain.

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).