Edited version of the private advice

Authorisation Number: 1052170247204

Date of advice: 18 September 2023

Ruling

Subject: Compensation - other

Question 1

Is the principal component of the compensation payment that Taxpayer X ("the Taxpayer") received in the year ended 30/06/20ZZ for the settlement of a class action brought against Y Limited, taxable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) or under the capital gains tax provisions of Part 3-1 of the Income Tax Assessment Act 1997 (ITAA 1997) and in what income year is it taxable?

Answer

The principal component is taxed as a capital gain. The capital gain is taxable in the 20ZZ income year.

Question 2

Is the interest component of the compensation payment the Taxpayer received in the year ended 30/06/20ZZ for the settlement of a class action brought against Y Limited, taxable as ordinary income under section 6-5 of the ITAA 1997 or under the capital gains tax provisions of Part 3-1 of the ITAA 1997 and in what income year is it taxable?

Answer

The interest component is taxed as ordinary income. The interest is taxable in the 20ZZ income year.

This ruling applies for the following periods:

Year ended 30/06/20CC & Year ended 30/06/20ZZ

The scheme commences on:

DD/EE/20YY

Relevant facts and circumstances

In 20XX, the Taxpayer acquired shares in Y Limited. In the year ended 30/06/20CC the Taxpayer sold all their shares in Y Limited, incurring a loss.

On DD/EE/20YY, a class action was commenced by Z Pty Ltd (the Applicant) in the Federal Court of Australia against Y Limited (the Respondent). Lawyers acting on behalf of the Applicant and all of the Group Members (of whom the Taxpayer was one) commenced the class action on behalf of those (being the Applicant and the Group Members) who acquired ordinary shares in Y Limited during a certain period and consequently suffered loss or damage in connection to the pleaded conduct of Y Limited.

The Taxpayer was advised that the parties to the class action had agreed to a proposed settlement of the case, under which Y Limited would pay (without admission of liability) an amount in full and final settlement of the claims of the Applicant and Group Members in the class action.

The Federal Court ordered that the settlement of the Proceeding be approved on the terms set out in a Deed of Settlement and a Settlement Distribution Scheme (the SDS). The formula under which the settlement sum was calculated was kept confidential.

In the year ended 30 June 20ZZ, the Taxpayer received a Remittance Notice, which advised that under the SDS for the Y Limited Class Action the Taxpayer was entitled to a Final Distribution Amount consisting of a principal component and an interest component.

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 Part 3-1 (section 102-5)

Reasons for decision

Question 1

Is the principal component of the compensation payment that Taxpayer X (the Taxpayer) received in the year ended 30/06/20ZZ for the settlement of a class action brought against Company Y, taxable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) or under the capital gains tax provisions of Part 3-1 of the ITAA 1997 and in what year is it taxable?

Summary

The principal component is taxed as a capital gain. The capital gain is taxable in the 20ZZ income year.

Detailed reasoning

Ordinary Income

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a taxpayer includes income according to ordinary concepts (ordinary income). 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.

Various factors may be relevant in determining whether a receipt is of an income or of a capital nature. The Full High Court identified these factors as relevant in GP International Pipecoaters Pty vs FC of T 90 ATC 4413 at p 4420:

"To determine whether a receipt is of an income or capital nature, various factors may be relevant. Sometimes, the character of receipts will be revealed most clearly by their periodicity, regularity or recurrence; sometimes, by the character of a right or thing disposed of in exchange for the receipt; sometimes, by the scope of the transaction, venture or business in or by reason of which money is received and by the recipient's purpose in engaging in the transaction, venture or business. The factors relevant to the ascertainment of the character of a receipt of money are not necessarily the same as the factors relevant to the ascertainment of the character of its payment."

The compensation the Taxpayer received was not income from rendering personal services, income from property or income from carrying on a business. The payment is also a one-off payment and thus it does not have an element of periodicity, recurrence or regularity.

A compensation amount generally bears the character of that which it is designed to replace. If the compensation is paid for the loss of a capital asset or for a reduction in the value of a capital asset, then it will be regarded as a capital receipt and not ordinary income.

The Taxpayer received compensation in respect of loss or damage in connection with their ownership of shares in Y Limited. The compensation was paid in relation to a capital asset and accordingly, it is regarded as a capital receipt and not ordinary income. Therefore, the compensation payment is not assessable as ordinary income under section 6-5 of the ITAA 1997.

Subsection 6-10(2) of the ITAA 1997 includes in assessable income amounts that are called statutory income. Section 10-5 of the ITAA 1997 contains a list of provisions under which statutory income is included in assessable income. Included in this list are net capital gains under section 102-5 of the ITAA 1997. Thus, net capital gains form part of statutory income and are to be included in the Taxpayer 's assessable income for the income year.

TR 95/35

TR 95/35 Income tax: capital gains: treatment of compensation receipts (TR 95/35) discusses the capital gains tax (CGT) consequences for a person who receives an amount as compensation.

TR 95/35 outlines five different types of compensation receipts and their CGT treatment, with the five being the following:

•                Compensation for the disposal of an underlying asset

•                Compensation for permanent damage to, or permanent reduction in the value of, the underlying asset

•                Compensation for excessive consideration

•                Disposal of the right to seek compensation

•                Disposal of a notional asset

Capital Gains Tax - Look Through Approach

Paragraph 70 of TR 95/35 states 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 of the possible assets of the taxpayer in order to determine the asset to which the compensation amount is most directly related."

The transaction which generated the compensation receipt is the acquisition of the shares in Y Limited. The compensation paid under the settlement deed was in respect of loss or damage to the shares.

Paragraph 11 of TR 95/35 sets out the following:

"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. Accordingly, any capital gain arising on the disposal of that right is calculated using the cost base of that right."

In this case the loss assessment formula was kept confidential so it is not known how the settlement sum was calculated. The class action was settled and consequently there was no finding by the Court of misconduct by Y Limited. The payment by Y Limited was made without any admission of liability.

Under these circumstances, and noting that the appropriate treatment of compensation in respect of the settlement of shareholder class actions has not been concluded by the courts, the Commissioner considers it more appropriate to treat the payment the Taxpayer received as the disposal of the right to seek compensation.

With this approach, the compensation would be added to the net capital gain or would reduce the net capital loss for the current income year. This approach is practical and minimises compliance costs.

Question 2

Is the interest component of the compensation payment the Taxpayer received in the year ended 30/06/20ZZ for the settlement of a class action brought against Y Limited, taxable as ordinary income under section 6-5 of the ITAA 1997 or under the capital gains tax provisions of Part 3-1 of the ITAA 1997 and in what income year is it taxable?

Summary

The interest component is taxed as ordinary income. The interest is taxable in the 20ZZ income year.

Detailed reasoning

Subsection 6-5(1) of ITAA 1997 defines 'assessable income' as follows:

"Your assessable income includes income according to ordinary concepts, which is called ordinary income."

The legislation does not provide any specific guidance on what is meant by "income according to ordinary concepts". The Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 4) of 1996 (Cth) states that it has been left to the courts to develop principles for determining what is "ordinary income".

An award of compensation made to a taxpayer may include an amount of interest.

Paragraph 26 of TR 95/35 states that:

"Interest awarded as part of a compensation amount is assessable income of the taxpayer under the general income provisions. If the taxpayer receives an undissected lump sum compensation amount and the interest cannot be separately identified and segregated out of that receipt, no part of that receipt can be said to represent interest. If the compensation cannot be dissected it is likely that the whole amount relates to the disposal of the right to seek compensation."

Furthermore, paragraph 246 of TR 95/35 states that:

"It is a question of fact to be determined in each case whether any part of the compensation received by a taxpayer is in the nature of interest. We consider that any amount which is in the nature of interest, and which can be identified as interest, and whether paid as part of the compensation or separately, constitutes assessable income of the taxpayer under the general income provisions. It may also represent part of the consideration for the disposal of either the underlying asset or the right to seek compensation. Subsection 160ZA(4) would then apply to prevent any double taxation of that amount."

Rather than being an undissected lump sum amount, the Taxpayer received a remittance notice which has clearly identified and stated the amount of the interest component in the compensation payment. Thus, it would be classified as ordinary income and assessable in the 20ZZ income tax return under 6-5 of the ITAA 1997.

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