Edited version of private advice

Authorisation Number: 1051840007799

Date of advice: 19 May 2021

Ruling

Subject: Capital gains tax - compensation

Question 1

Will the proceeds from your claim against your former legal advisers for breach of retainer and negligence be treated as capital in nature and be subject to the capital gains tax provisions?

Answer

Yes

Question 2

Will the capital gain from the CGT event be disregarded under paragraph 118-37(1)(a) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 3

Will the legal costs incurred in making the claim form part of the cost base when calculating the capital gain?

Answer

Yes

Question 4

Will the 50% CGT discount in Division 115 of the ITAA 1997 apply to the capital gain?

Answer

Yes

This ruling applies for the following periods:

Year ending 30 June 20xx

Year ending 30 June 20xx

Year ending 30 June 20xx

Year ending 30 June 20xx

The scheme commences on:

1 December 20xx

Relevant facts and circumstances

You are the Executor and sole beneficiary of the Deceased Estate of your late spouse (Estate).

In about 19xx, Company A (the Company) took out a life insurance policy (Policy) on the life of your late spouse.

The Company paid the premiums on the Policy until about 20xx, from which date your late spouse began paying the premiums from own funds.

Following the death of your spouse, a dispute arose between the Estate and the Company in relation to the beneficial ownership of the Policy.

In 20xx, you and the Company jointly obtained an independent legal opinion from Senior Counsel on the beneficial ownership of the Policy (Opinion). The Opinion concluded that the beneficial owner of the Policy was the Estate.

You and the Company jointly obtained a neutral evaluation from Senior Counsel who had provided the Opinion (Evaluation). The Evaluation concluded that the beneficial owner of the Policy was the Estate.

In 20xx, you and the Company entered into a Deed of Indemnity.

The Deed of Indemnity required the Company to make a claim upon the Policy and account to you for the whole of the proceeds of the Policy.

The Company's claim upon the Policy was accepted and the proceeds of the Policy were paid into the trust account of your former lawyer's firm.

In later 20xx, you and the Company entered into a Development Agreement and Succession Deed (Development Agreement).

The Development Agreement provided that you would provide a loan to the Company.

The Development Agreement provided that the funds to be loaned would be sourced from the proceeds of the Policy held on trust by your former lawyer.

The Development Agreement contemplated that you would make an application in the Court for a declaration confirming that the Estate and/or you were beneficially entitled to the proceeds of the Policy.

The Development Agreement provided that upon determination of the contemplated Court proceedings, the parties would undertake all necessary steps to effect transfer of the proceeds of the Policy to the party nominated by the Court as entitled to the proceeds.

The Development Agreement provided that "all prior deeds in relation to the subject matter are merged in and superseded by this deed".

You were advised by your former lawyers in relation to the Development Agreement.

In 20xx, you applied to the Court for a declaration to the effect that the Estate was beneficially entitled to the proceeds of the Policy.

The Court declared that you were entitled to the relief you sought based on the binding nature of the Deed of Indemnity.

In 20xx, the Company filed an appeal against the decision (Appeal).

In 20xx, the Court of Appeal allowed the Company's appeal and declared that the Company was legally and beneficially entitled to the whole of the proceeds of the Policy.

The Court of Appeal held that the Deed of Indemnity was merged in and superseded by the provisions of the Development Agreement, by operation of the Entire Agreement Clause in the Development Agreement, and thus was not determinative of the Estate's entitlement to the proceeds of the Policy.

In 20xx, you commenced proceedings against your former lawyers, alleging professional negligence.

In 20xx, Amended Statement of Claim was filed in the Court.

You incur legal costs in the legal action against your former lawyers.

As at the date of this ruling, no decision has been made in relation to the legal action. You expect to receive an amount of compensation which exceeds the cost base resulting in a capital gain.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997section 104-25

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 115-10

Income Tax Assessment Act 1997 section 118-37

Income Tax Assessment Act 1936 former subsection 160ZB(1)

Reasons for decision

Question 1

Section 6-10 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that a taxpayer's assessable income includes statutory income amounts that are not ordinary income but are included in assessable income by another provision. Net capital gains are included as assessable income under subsection 102-5(1) of the ITAA 1997.

Section 102-20 of the ITAA 1997 provides that you make a capital gain or loss as a result of a CGT event happening to an asset in which you have an ownership interest.

Under section 108-5 of the ITAA 1997 a CGT asset is any kind of property, or a legal or equitable right that is not property. CGT assets include part of or an interest in property or a legal or equitable right that is not property.

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 redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered, forfeited or expiring. 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. You make a capital gain if the capital proceeds from the ending are more than the asset's cost base. You make a capital loss if those proceeds are less than the asset's reduced cost base.

Taxation ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts discusses the CGT implications for compensation receipts. Why the payment was made is an important factor in determining whether an asset has been disposed of for CGT purposes.

Guidance on the status and binding effect of public rulings where the law has been repealed or repealed and rewritten is contained in Taxation Ruling TR 2006/10, paragraphs 32 and 49-51.

TR 95/35 discusses the various scenarios. Relevantly, it includes disposal of the right to seek compensation.

Application to your circumstances

In this case, you and the Company entered into a Development Agreement and you were advised by your former lawyer in relation to the Development Agreement. Following the Development Agreement, you applied to the Court for a declaration to the effect that the Estate was beneficially entitled to the proceeds of the Policy and the Court declared that you were entitled to the relief you sought based on the binding nature of the Deed of Indemnity.

However, the Company filed an appeal and it was allowed on the basis that the Deed of Indemnity was merged in and superseded by the provisions of the Development Agreement, by operation of the Entire Agreement Clause in the Development Agreement, and thus was not determinative of the Estate's entitlement to the proceeds of the Policy.

You commenced proceedings against your former lawyers, alleging professional negligence and the Amended Statement of Claim was filed in the Supreme Court. According to the Amended statement of Claim, your former lawyers acted as the solicitors for you, failed to recognise that the Development Agreement did not expressly refer to the Deed of Indemnity and failed to advise on the effect of the Development Agreement in relation to the Company's obligation to account for the whole of the proceeds of the Life Insurance Policy pursuant to the Deed of Indemnity.

When a court order is made or an out of court settlement is reached, you dispose of your right to seek compensation. This is generally at the final point of settlement of the claim, whether in the course of Court proceedings, or in an out of Court arrangement. The time of disposal is generally determined to be the time of entering into the settlement agreement and receiving the compensation (paragraph 158 of TR 95/35).

Any amounts of compensation received as a result of your legal action will be subject to the CGT provisions.

Question 2

Paragraph 118-37(1)(a) of the ITAA 1997 states that:

A capital gain or loss you make from a CGT event relatedly directly to any of these is disregarded:

(a)  compensation or damages you receive for:

                                      i.        any wrong or injury you suffer in your occupation; or

                                     ii.        any wrong, injury or illness you or your relative suffers personally;......

Wrong you suffer personally

Subsection 160ZB(1) of the Income Tax Assessment Act 1936 (ITAA 1936) which was re-written as paragraph 118-37(1)(a) of the ITAA 1997 sheds light on what is meant by a wrong you suffer personally.

Former subsection 160ZB(1) of the ITAA 1936 stated:

A capital gain shall not be taken to have accrued to a taxpayer by reason of the taxpayer having obtained a sum by way of compensation or damages for any wrong or injury suffered by the taxpayer to his or her person or in his or her profession or vocation and no such wrong or injury, or proceeding instituted or other act done or transaction entered into by the taxpayer in respect of such a wrong or injury, shall be taken to have resulted in the taxpayer having incurred a capital loss.

(emphasis added)

Subsection 1-3(2) of the ITAA 1997 provides that if the ITAA 1936 'expressed an idea in a particular form of words' and the ITAA 1997 'appears to have expressed the same idea in a different form of words in order to use a clearer or simpler style', the ideas are not be taken to be different just because different forms of words were used.

There is nothing in an Explanatory Memorandum or any other extrinsic material in relation to the remaking of subsection 160ZB(1) of the ITAA 1936 into paragraph 118-37(1)(a) of the ITAA 1997 that indicates that the meaning or effect of the re-written provision was to be any different to the former provision.

Therefore, it is considered that a wrong suffered personally by a taxpayer means a wrong suffered 'to his or her person'.

Negligence is a failure to take reasonable care over something. It is a breach of duty of care which results in damage, loss or injury to a person.

It could be argued that the negligence by your former lawyers in providing incorrect advice or information was a wrong that you suffered personally. However, the meaning of 'wrong' must be considered in the context of the words around it which are 'injury' and 'illness' in relation to paragraph 118-37(1)(a) of the ITAA 1997 and 'injury suffered by the taxpayer to his or her person' in relation to the former subsection 160ZB(1) of the ITAA 1936.

Compensation for any wrong or injury suffered by a company does not fall within the scope of the exemption. We consider that the use of 'his or her' in connection with the taxpayer suggests that the application of subsection 160ZB(1) is intended to be limited to taxpayers who are natural persons. Similarly, we consider that compensation received by a trustee in his or her capacity as trustee does not fall within the scope of subsection 160ZB(1). Of course, amounts received by the trustee in respect of the surrender of a personal injury claim of the trustee continue to be exempt (TR 95/35 paragraph 216).Taking into account this context, it is considered a wrong suffered personally for the purposes of paragraph 118-37(1)(a) of the ITAA 1997 would include, for example, defamation, as this is a wrong suffered by the taxpayer to his or her person but would not include negligence that causes financial loss as unlike defamation, injury or illness, it is not a wrong suffered by a taxpayer to his or her person.

This interpretation is supported by TR 95/35 which contains two examples that deal with compensation for negligence that resulted in financial loss (examples 8 and 28). In example 8, the taxpayer was assessed on the compensation as a capital gain on the disposal of their right to seek compensation and no CGT exemptions (including former subsection 160ZB(1) of the ITAA 1936 or paragraph 118-37(1)(a) of the ITAA 1997) were considered to apply.

In example 28 at paragraph 333 of TR 95/35, the end result was that there was no capital gain but this was because of reasons other than the 'wrong suffered personally' exemption provided for by the former subsection 160ZB(1) of the ITAA 1936 or paragraph 118-37(1)(a) of the ITAA 1997. In that example it states that if any amount of the compensation had been for inconvenience or personal suffering then that amount would be exempt from CGT under the 'wrong suffered personally' exemption. However, as the whole amount of the compensation was for a financial loss caused by negligence the 'wrong suffered personally' exemption did not apply.

Therefore, it is not considered that the negligence by your former lawyers that caused you financial loss is a wrong you suffered personally for the purposes of the exemption under subparagraph 118-37(1)(a)(ii) of the ITAA 1997.

Wrong you suffer in your occupation

TR 95/35 expresses the view that the exemption in former subsection 160ZB(1) of the ITAA 1936 (rewritten as paragraph 118-37(1)(a) of the ITAA 1997) will only apply where an individual receives compensation for a wrong or injury suffered to his or her person or in his or his occupation, profession or vocation.

While paragraph 214 of TR 95/35 states that the terms 'to his or her person' and 'in his or her vocation' should be read as widely as possible, the intention of the 'wide' interpretation was to cover the full range of employment and professional type claims; for example to include claims for discrimination, harassment, victimisation, wrongful dismissal, and defamation as well as personal injury or illness.

The negligent provision of incorrect advice or information by your former lawyers that you suffered is very different to wrongs such as discrimination, harassment, victimisation, wrongful dismissal and defamation which a person can suffer 'in' their occupation, profession or vocation.

In your circumstances you would not be eligible for an exemption under paragraph 118-37(1)(a) of the ITAA 1997.

Therefore, any capital gain you make from CGT event C2 will not be disregarded under paragraph 118-37(1)(a).

Question 3

The cost base of an asset (e.g. right to seek compensation) is determined by the rules in section 110-25 of the ITAA 1997.

Legal fees and charges connected with the proceedings and incurred during the course of proceedings would form part of the second element incidental cost base of the asset under subsection 110-25(3) and section 110-35 of the ITAA 1997.

The right to seek compensation as an asset does not get a deemed market value cost base (TR 95/35 paragraph 113). In other words, the market value substitution rule in section 112-20 of the ITAA 1997 does not apply to the taxpayer having the right to seek compensation.

The consideration in respect of the acquisition of the right to seek compensation includes the costs incurred as a result of which the right to seek compensation arose. This would include any legal expenses incurred in respect of pursuing the right to seek compensation, that is, legal expenses that relate specifically to the claim for compensation.

In this case, the legal expenses incurred in securing the compensation payment from your former legal advisers will be included in the cost base of your right to seek compensation.

Question 4

Subdivision 115-A of the ITAA 1997 provides for the conditions for a discount capital gain. Relevantly, the conditions include that the capital gain must be made by an individual, a complying superannuation entity, a trust or a life insurance company. The capital gain must result from a CGT event happening after 11:45am on 21 September 1999 and must not have an indexed cost base. Also, the gain must result from a CGT event happening to an asset that was acquired at least 12 months before the CGT event.

The discount percentage for an amount of a discount capital gain is 50% subject to certain conditions - section 115-100(a) of the ITAA 1997.

TR 95/35 (paragraphs 167 and 168) explains that the creator of the asset is deemed to acquire the asset and to have owned it immediately before the vesting time. At the vesting time, the taxpayer acquires the asset from the creator and is deemed to commence to own the asset. For example, for a right to seek compensation this is at the time of breach.

Paragraph 170 of the TR 95/35 provides that the asset is disposed of by the taxpayer on the release, discharge, satisfaction, or surrender of his or her right to seek compensation.

Application to your circumstances

In this case, you acquired a right to seek compensation due to your former legal advisers alleged negligence in the provision of Development Agreement. This right became apparent when the Court of Appeal allowed the Company's appeal and declared that the Company was legally and beneficially entitled to the whole of the proceeds of the Policy.

You have commenced proceedings against your legal advisers, alleging professional negligence. CGT event C2 happens when the claim is satisfied, that's when the you are awarded with compensation by the Court.

This right exists for a period of more than 12 months; therefore, you are entitled to apply the 50% CGT discount to reduce your capital gain.

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