Edited version of private advice

Authorisation Number: 1052099142644

Date of advice: 8 May 2023

Ruling

Subject: Compensation payment

Question 1

Is your share of the lump sum payment of $XXX you received assessable under section 6-5 of the Income Tax Assessment Act 1997(ITAA 1997) as ordinary income?

Answer

No.

Question 2

Is your share of the lump sum payment you received assessable under the Capital Gains Tax (CGT) provisions?

Answer

Yes.

Question 3

Will the capital gain from the CGT event be disregarded?

Answer

No.

Question 4

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

Answer

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You are professionals.

A third party used your professional work without permission in the 20XX income year.

A deed of agreement was executed in the 20XX income year.

You received a settlement payment.

The deed of agreement was executed fewer than 12 months after the unpermitted use of your work.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 1-3(2)

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Subsection 110-25(3)

Income Tax Assessment Act 1997 Section 110-35

Income Tax Assessment Act 1997 Subdivision 115-A

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

Income Tax Assessment Act 1997 Paragraph 118-37(1)(a)

Reasons for decision

Section 6-5 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.

The ITAA 1997 does not provide specific guidance on the meaning of ordinary income. However, a substantial body of case law exists which identifies its likely characteristics. Amounts that are periodic, regular, or recurrent and relied upon by the recipient for their regular expenditure are likely to be ordinary income, as are amounts that are the product of any employment of, or services rendered by, the recipient.

Further, amounts which compensate for lost income or serve as a substitute for other income are themselves income according to ordinary concepts. However, 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, you have received a one-off payment, which bears none of the characteristics of ordinary income as it lacks any element of periodicity, recurrence, or regularity, and nor has it been paid to compensate you for loss of income; rather it is a payment received to surrender your right to seek compensation for inappropriate advice.

Accordingly, the lump sum payment is a capital receipt and not assessable as ordinary income under section 6-5 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. Included in this list is section 102-5 (capital gains).

Capital gain tax provisions

Section 102-5 of the IAA 1997 provides that your assessable income includes a net capital gain (if any) for the income year. A capital gain or loss is made only if a CGT event happens (section 102-20). For most CGT events, your capital gain is the difference between your capital proceeds and 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. 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 the possible assets of the taxpayer to determine the asset to which the compensation amount is most directly related. It is also referred to as the underlying asset approach.

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).

If the amount of compensation is not received in respect of any underlying asset, the amount relates to the disposal by the taxpayer of the right to seek compensation.

CGT event C2 happens when the ownership of an intangible CGT asset ends by the asset being released, discharged, or satisfied. 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).

In your case, the relevant asset is the right to seek compensation and a CGT event C2 happened on the signing of the deed, which resulted in the release, discharge, satisfaction or surrender of your dispute.

The lump sum you have received will be assessable under the capital gains tax provisions and the legal expenses you have incurred will 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.

CGT exemptions

Under paragraph 118-37(1)(a) of the ITAA 1997 a capital gain is disregarded if it is 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 it 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 where the ITAA 1936 'expressed an idea in a particular form or words' and the ITAA 1997 'appears to have expressed the same idea in a different form of words 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 new provision was to be any different to the old 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.

In your case, you have received a settlement payment in full and final settlement of a dispute in relation to the use of your professional work.

The matter was conciliated, and all parties came to an agreement in relation to the settlement figure by negotiation. You did not suffer the wrong in the course of your occupation and you did not suffer the wrong to your person.

Therefore, paragraph 118-37(1)(a) of the ITAA 1997 does not apply to your situation and there are no other provisions within the tax legislation that would allow you to disregard your capital gain.

Discount capital gains

Subdivision 115-A of the ITAA 1997 provides the conditions for a discount capital gain.

You make a discount capital gain if the following requirements are satisfied:

•         you are an individual

•         a CGT event happens to a CGT asset of yours after 11:45am (by legal time in the Australian Capital Territory) on 21 September 1999

•         you acquired the CGT asset at least 12 months before the CGT event, and

•         you do not choose to use the indexation method.

For Australian resident individuals the discount percentage is 50%. However, you can only reduce your capital gain after applying all your capital losses for the year and any unapplied net capital losses from earlier years.

TR 95/35 discusses the meaning of the right to seek compensation and when it is acquired. The right to seek compensation is acquired at the time of the compensable wrong or injury. In your case the compensable wrong or injury occurred when MG reproduced your artistic work without permission in May 2021.

As CGT event C2 occurred in January 2021 when you executed the deed of agreement you did not meet the condition to acquire the CGT asset at least 12 months before the CGT event. Therefore you are not entitled to reduce your capital gain by 50% using the discount method under Division 115.

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