Edited version of your written advice

Authorisation Number: 1051464883960

Date of advice: 14 December 2018

Ruling

Subject: Compensation – inappropriate advice – compensation for loss – interest – CGT - assessable recoupments – ordinary income

Question 1

Is the interest component of the compensation included in Individual A’s assessable income in the year it was received?

Answer

Yes.

Question 2

Is the compensation received for interest paid on an inappropriate investment loan included in Individual A and Individual B’s assessable income in equal shares in the financial year it was received?

Answer

Yes, to the extent that deductions were claimed for the interest.

Question 3

Is the compensation received for break costs/fees paid on an inappropriate investment included in Individual A and Individual B’s assessable income in equal shares in the financial year it was received?

Answer

Yes, to the extent that deductions were claimed for the fees.

Question 4

Is the compensation received for break costs/fees paid on an inappropriate investment a recoupment of the cost base of the investment?

Answer

Yes, to the extent that the fees were included in the cost base of the investment.

Question 5

Is the amount you received to compensate you for the (interest) income you would have earned if you had of been given appropriate advice assessable as ordinary income?

Answer

Yes.

Question 6

Is the compensation received for the capital loss made on the XXX investment treated as additional capital proceeds received for the disposal of the investment?

Answer

Yes.

This ruling applies for the following periods

Financial year ended 30 June 2017

The scheme commenced on

1 July 20XX

Relevant facts

Individual A and Individual B obtained financial advice from a Financial Planner.

The Financial Planner recommended that they:

1. withdraw $X from their savings and borrow a further $Y using a margin lending facility and invest it in AAA in Individual A’s name only, and

2. borrow $Z using a 100% investment loan and invest it in BBB in joint names.

Individual A and Individual B followed the advice.

The financial advice was reviewed and it was concluded that some aspects were not appropriate.

It was considered that appropriate advice would have been:

1. to invest personal funds of $C only in AAA and not borrow funds using a margin lending facility to increase the initial investment. The amounts used to pay the interest on the lending facility should have been directed to savings, and

2. to not invest in BBB at all as their cash flow did not support the recommendation. The funds used to pay the interest on the investment loan could have been directed towards savings.

The review compared Individual A and Individual B’s actual position (based upon their following the inappropriate advice) to the position they would have been in had they received appropriate advice and services, and made a compensation offer

In respect to the AAA investment, the amount of compensation was calculated by comparing the expenses/losses on the investment + margin loan against the expenses/losses on what was considered a suitable alternative, an investment of $C + no margin loan. The compensation amount was reduced by additional fees that would have been payable on the suitable alternative.

In respect to the BBB investment, the amount of compensation was calculated by comparing the excess of the interest on the investment loan, break costs/fees and interest that could have been earned on (what was considered) the appropriate alternative against the capital gain received from the BBB investment and compensation already paid.

Individual A and Individual B accepted the offer of compensation.

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 10-5

Income Tax Assessment Act 1997 Subdivision 20-A

Income Tax Assessment Act 1997 subsection 20-20(2)

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 subsection 104-10(1)

Income Tax Assessment Act 1997 subsection 104-10(3)

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 subsection 116-20(1)

Income Tax Assessment Act 1997 subsection 110-45(3)

Income Tax Assessment Act 1997 subsection 110-55(6)

Reasons for decision

Ordinary income

Your assessable income includes income according to ordinary concepts, which is called ordinary income (section 6-5 of the ITAA 1997).

Ordinary income has generally been held to include 3 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.

An amount paid to compensate for loss generally acquires the character of that for which it is substituted (FC of T v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443; 10 ATD 82). Compensation payments which substitute income have been held by the courts to be income according to ordinary concepts (FC of T v. Inkster 89 ATC 5142; (1989) 20 ATR 1516 and Tinkler v. FC of T 79 ATC 4641; (1979) 10 ATR 411).

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. Included in this list are Subdivision 20-A (recoupment) and section 102-5 (capital gains).

Assessable recoupments

Subdivision 20-A of the ITAA 1997 provides that certain amounts received by way of insurance, indemnity or other recoupment are assessable income if the amounts are not income under ordinary concepts or otherwise assessable.

Subsection 20-20(1) of the ITAA 1997 provides that an amount is not an assessable recoupment to the extent that it is ordinary income, or it is statutory income because of a provision outside of Subdivision 20-A.

An amount received by way of insurance or indemnity is an assessable recoupment if it is paid for a deductible expense and the deduction can be claimed in the current year or in an earlier income year (subsection 20-20(2) of the ITAA 1997). [Current year means the income year for which you are working out your assessable income and deductions].

Capital Gains

You make a capital gain or capital loss as a result of a capital gains tax (CGT) event happening (section 102-20 of the ITAA 1997. For most CGT events, your capital gain or loss is the difference between your capital proceeds and the cost base or reduced cost base of your CGT asset.

The capital proceeds from a CGT event include the money you have received, or are entitled to receive, in respect of the event happening (subsection 116-20(1) of the ITAA 1997).

The cost base/reduced cost base rules are found in Division 110 of the ITAA 1997. Expenditure does not form part of any element of the cost base or reduced cost base to the extent of any amount you have received as recoupment of it, except so far as the amount is included in your assessable income (subsection 110-45(3) and subsection 110-55(6)).

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts considers the CGT consequences for a taxpayer in receipt of compensation, and whether the amount should be included in the assessable income of the recipient under the CGT provisions.

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 (paragraph 70 of TR 95/35).

The ‘look-through’ approach is 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 in this Ruling as the underlying asset approach (paragraph 3 of TR 95/35).

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 (paragraph 3 of TR 95/35).

Treatment of compensation if a CGT event happens (disposal of the asset)

CGT event A1 happens when you dispose of a CGT asset (subsection 104-10(1) of the ITAA 1997). The time of the event is when you enter into a contract for the disposal, or, if there is no contract, the time of disposal is taken to be the time when the change in ownership occurs (subsection 104-10(3)).

If an amount of compensation is received by a taxpayer wholly in respect of the disposal of an underlying asset, or part of an underlying asset, of the taxpayer the compensation represents consideration received on the disposal of that asset. In these circumstances, we consider that the amount is not consideration received for the disposal of any other asset, such as the right to seek compensation (paragraph 4 of TR 95/35).

The compensation may form part or all of the consideration in respect of the disposal of the underlying asset, and may be received by the taxpayer before or after the actual disposal of the underlying asset (paragraph 144 of TR 95/35). For example, litigation may result in compensation for losses arising from an investor's former investments.

Application to your circumstances

The compensation contains three components:

1. interest on the AAA compensation

2. compensation for BBB investment, and

3. compensation for AAA investment

Each of these components will be considered separately.

Interest on the AAA compensation

Interest income is ordinary income and is included in assessable income in the year it is received.

As the interest component of the payment relates only to the compensation for the AAA investment and this was held in Individual A’s name only, this amount is included in Individual A’s assessable income in the financial year it was received.

Compensation for BBB investment

The advice review concluded that the recommendation to invest in BBB was not appropriate as you had insufficient cash flow at the time to support the additional loan repayments. The funds used to pay the interest on the investment loan could have been directed towards your savings.

In respect to the BBB investment, you received compensation which was calculated by comparing the excess of the interest on the investment loan, break costs/fees and interest you would have earned if given appropriate advice against the income received from the investment and compensation already paid. As the compensation relates to three components it needs to be apportioned between them.

As noted above, an amount paid to compensate for loss generally acquires the character of that for which it is substituted.

The interest income that would have been earned if the interest repayments associated with the BBB investment were invested in a cash account is considered to replace an amount that would have been assessable as ordinary income if it had been earned. It is therefore included in assessable income under section 6-5 of the ITAA 1997.

The ‘interest paid’ component and the ‘break costs/fees’ component of the compensation were not paid to substitute income and do not have any of the other characteristics of ordinary income and as such are not assessable under section 6-5 of the ITAA 1997.

Therefore, consideration needs to be given to the assessable recoupment provisions in Subdivision 20-A of the ITAA 1997.

Both Individual A and Individual B claimed deductions for the interest expenses incurred on the margin loan used to invest in BBB. As such, the ‘interest paid’ component is an assessable recoupment, and is included in assessable income in the year the compensation was received.

As neither Individual A nor Individual B claimed a deduction for the break costs/fees in the year they were incurred the amount received for this expense is not an assessable recoupment. The amount will also not represent a recoupment of the cost base used to calculate their capital gains as the break costs/fees were not included in the cost base.

As such, there are no tax consequences for receiving the break costs/fees component of the compensation.

The assessable components of the compensation for the BBB investment are assessable 50% to each Individual A and Individual B.

Compensation for AAA investment

The compensation received for the AAA investment does not have any of the characteristics of ordinary income, was not paid to substitute income and was not paid to compensate for a deductible expense. As such, this amount is not assessable under either section 6-5 or Subdivision 20-A of the ITAA 1997. As such, consideration needs to be given to the capital gains tax provisions.

The act or transaction which generated this compensation amount is the alleged inappropriate advice which caused Individual A to borrow funds and invest in AAA. Applying the look-through approach, the most relevant asset to which this compensation is most directly related is the AAA investment.

CGT event A1 happened when Individual A disposed of the AAA investment. The compensation for the AAA investment is treated as additional ‘capital proceeds’ for the redemption of that investment. This means that the capital loss made on the disposal needs to be recalculated in accordance with the method statement in section 102-5 of the ITAA 1997.

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