Edited version of private ruling

Authorisation Number: 1011630682542

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Ruling

Subject: Capital gains tax - compensation payment

Question 1:

Is the equity component of the margin loan offer amount that you received additional capital proceeds?

Answer 1:Yes.

Question 2:

Is the interest component (interest on equity amount) of the margin loan offer amount, that you received assessable as income?

Answer 2: Yes.

Question 3:

Is the refund of pre-paid interest of a certain amount in the year ended 30 June 2009 which was claimed as a deduction in the previous year, assessable as income?

Answer 3: No.

Question 4:

Is the interest capitalised of a certain amount in the year ended 30 June 2009, allowable as a deduction as interest incurred in gaining or producing assessable income?

Answer 4: Yes.

Question 5:

Does the refund of interest of a certain amount in the year ended 30 June 2009, reduce the amount of interest capitalised that can be claimed as a deduction by that certain amount?

Answer 5: Yes.

Question 6:

Is the interest paid (early termination interest adjustment) appearing on the fixed rate margin loan, allowable as a deduction as interest incurred in gaining or producing assessable income?

Answer 6: Yes.

This ruling applies for the following period:

Year ended 30 June 2008.

Year ended 30 June 2009.

Year ended 30 June 2010.

Year ended 30 June 2011.

The scheme commences on:

1 July 2007.

Relevant facts and circumstances

You and your spouse were clients of X and received financial advice from X.

On the advice of X and with X's assistance you applied for a margin loan from Y. The margin loan was approved by Y and the margin loan was advanced to you. The margin loan was secured by various stocks and investments purchased with the proceeds of the margin loan. The security may have included units in an index fund for which the responsible entity was Y or one of its related bodies corporate.

Your investments with X were sold by Y or its related bodies.
You have, either directly or through your lawyers made a claim against Y for compensation concerning the circumstances of the margin loan and/or the security and repayment of indebtedness under the margin loan.

The parties have participated in a dispute resolution process

By participating in the scheme the parties agreed to:

· the payment of the settlement sum by Y to you;

· the closure of variation of the margin loan as set out in the Deed, and

· the releases which are set out in the Deed.

In the deed of settlement Y confirmed details of your entitlement under the settlement deed.

The Deed provided for a settlement amount and an equity component You have included copies of certain documents, which form part of the facts:

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Subsection 6-5(1)

Income Tax Assessment Act 1997 Subsection 6-5(2)

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Subsection 104-25(1)

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 116-20

Reasons for decision

Question 1

Summary

The equity component, ($A) of the margin loan offer amount that you received is considered additional capital proceeds.

Detailed reasoning

Capital gains tax (CGT) consequences - equity component

The general CGT provisions are set out in Part 3-1 of the ITAA 1997. Under the CGT provisions a taxpayer will make a capital gain or loss only if a CGT event happens.

To determine if a CGT event happens in respect of a compensation payment it is necessary to consider the nature of the asset to which the compensation payment relates.

The Commissioner's policy on the treatment of compensation payments is set out in Taxation Ruling TR 95/35 (capital gains: treatment of compensation receipts).

· TR 95/35 states that the particular asset for which compensation has been received by the taxpayer may be:

· an underlying asset;

· a right to seek compensation; or

· a notional asset in terms of subsection 160M(7) - (section 104-155 of the ITAA 1997).

(TR 95/35 provides legislative reverences that relate to the Income Tax Assessment Act 1936. The equivalent provisions in the ITAA 1997 are cited where appropriate.)

In determining which is the most relevant asset it is often appropriate to adopt a 'look through' approach to the transaction or arrangement which generates the compensation receipt.

In TR 95/35 the term 'underlying asset' is used. The underlying asset is defined in TR 95/35 as:

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.

Taxation Ruling TR 97/3 also discusses compensation and deals with compensation received by landowners from public authorities. It explains at paragraph 2 that it extends the application of TR 95/35 and should be read in conjunction with that ruling.

Paragraphs 4 to 8 of TR 97/3 discuss the compensation received from a public authority for the compulsory acquisition of an easement and states that:

4. Compensation in respect of an easement created by statute in favour of a public authority cannot be said to have been received for the grant of the easement. The Land Acquisition (Just Terms Compensation) Act 1991 (NSW) and similar Acts in other jurisdictions enable public authorities to take land or an interest in land (including an easement) for specified purposes and confer on the affected landowner a right to compensation. In these circumstances, the landowner cannot be said to have created an asset as required for subsection 160M(6) of the Act (now includes 104-35 of the ITAA 1997) to apply. The easement is created by operation of the relevant statute and is vested in the public authority. This constitutes a compulsory acquisition of the easement.

5. The compensation received by a landowner from a public authority that compulsorily acquires an easement is not excluded from the scope of TR 95/35 by paragraph 2 of that Ruling which states that:

This Ruling does not consider:

* .....

* amounts received for the grant of easements, profits a prendre and licences - these are covered in detail in Taxation Ruling IT 2561 and in Taxation Determinations TD 93/235 and TD 93/236'.

6. A strict application of Part IIIA would require the compensation received from a public authority to be treated as consideration in respect of the disposal by the landowner of the right to compensation. However, TR 95/35 focuses on the asset to which the compensation receipt most directly relates. In the case of easements acquired under statute and the consequential disposal of the right to compensation, the most relevant asset is the landowner's pre-existing land with its rights of ownership including, for example, a right to exclude all others. This right to exclude all others is forfeited in part when the easement comes into existence. The loss of part of this right constitutes the disposal of part of the underlying asset (the land) for Part IIIA purposes (paragraph 160M(3)(b) (now 104-25(1) of the ITAA 1997), subsection 160M(1) (now 104-10(2) and 109-5(1) of the ITAA 1997) and section 160R (now 108-5(2)(a) of the ITAA 1997).

7. Paragraph 4 of TR 95/35 states that:

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.

8. Applying this approach, an amount of compensation received by a landowner for the loss of part of the rights of ownership is accepted as being consideration received in respect of the part disposal of the underlying asset (the land). The amount is not consideration for disposal of the right to seek compensation.

The ruling also considers a number of other circumstances when a landowner grants an easement on their land and in all but one instance the amount received is treated as consideration in respect of the part disposal of the land.

To the extent that the payment relates to the disposal of an underlying asset, CGT event A1 under section 104-10 of the ITAA 1997 happens.

This case

You and your spouse were clients of X. You and your spouse applied for and were granted a margin loan from the Y. The margin loan was used to acquire various stocks and investments. It may have included units in an X branded index fund for which the responsible entity was Y or one of its related bodies..

Some time later Y determined that you and your spouse's historical current loan to security ratio had exceeded its historical margin call loan-to-security ratio. Y did not sell your investments until after it determined that your loan had exceeded its loan to security ratio.

Either, you and your spouse, or through your lawyers, have made a claim against Y for compensation concerning the circumstances surrounding the margin call and/or the security and the repayment of indebtedness under the margin call. Y issued a letter to you offering details of the proposal and settlement deed. The settlement deed agreed to pay you and your spouse compensation of $A and interest of $D.

On the facts of this case, it is considered that the compensation received had a direct and substantial link with the underlying asset (the investments). Accordingly, in line with the guidelines provided in paragraph 4 of TR 95/35 and TR 97/3 it is considered that the compensation amount was received as part of the underlying asset and it was not received for the disposal of any other asset, such as the right to seek compensation. The amount of $A is therefore accepted as consideration received for the disposal of the underlying assets and CGT event A1 in section 104-10 of the ITAA 1997 occurred when you investments were sold.

Note: As the equity component of the margin loan offer amount ($A) is considered additional capital proceeds you will need to amend any capital gain or capital loss made in relation to the CGT events that happened when your investments were sold by Y or its related body corporate. You will need to apportion the additional capital proceeds, firstly in line with your ownership interest in the original investments sold by X, (you jointly owned the investments with your spouse) and then secondly on a pro-rata basis to every CGT event that happened.

Question 2

Summary

The interest component, ($D- interest on equity amount) of the margin loan offer amount that you received is assessable as income.

Detailed reasoning

This is a question of whether the interest paid by the Y is assessable to the taxpayer. This is discussed in paragraph 26 of TR 95/35 when it 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.

In this instance the interest is separately identified and segregated out of the lump sum and as such is assessable income of the taxpayer under the general income provisions in section 6-5 of the ITAA 1997.

Note: The interest amount will need to be apportioned in line with your ownership interest in the original investments sold by X, (i.e. interest income is apportioned between you and your spouse).

Question 3

Summary

The refund of pre-paid interest in the year ended 30 June 200 9 which was claimed as a deduction in the previous year will not be assessable as income.

Detailed reasoning

The general deduction provisions contained in the section 8-1 of the ITAA 1997 allow a deduction for all losses and outgoings to the extent to which they:

· are incurred in gaining or producing assessable income (the first limb), or

· are necessarily incurred in carrying on a business for the purpose of gaining or producing such income (the second limb).

Where a taxpayer receives a refund of an item for which a deduction has previously been allowed, the question of the proper treatment of the refund for tax purposes resolves itself in consideration of the character of the receipt itself.

Section 6-5 of the ITAA 1997 advises that the assessable income of a resident taxpayer includes income according to ordinary concepts (ordinary income) derived directly or indirectly from all sources.

Relevant factors in determining whether a payment is ordinary income include:

· whether the payment is the product of any employment, services rendered, or any business;

· whether the payment is expected and relied upon;

· the character of the payment in the hands of the recipient;

· whether the payment is received as a lump sum or periodically; and

· the motive of the person making the payment, although this is rarely decisive by itself.

Section 6-10 advises that your assessable income includes statutory income amounts that are not ordinary income but are included in assessable income by another provision. A comprehensive listing of the relevant statutory provisions is given in section 10-5. Included in the list is assessable recoupment.

Assessable recoupment; Division 20 of the ITAA 1997 operates to include a recouped amount as assessable income where the recoupment reverses the affect of previous income tax deductions in certain circumstances.

In your case the refund of pre-paid interest fits the definition of a recoupment as defined in section 20-25 of the ITAA however it is not considered an assessable recoupment.

You have not received an assessable recoupment because pre-paid interest is not listed in the table of deductions at section 20-30 of the ITAA 1997 as a deduction for which recoupments are assessable.

In your case the refund of pre-paid interest was a result of the early repayment of your investment loan and the subsequent collapse of one of the finance companies.

The refunded amount does not fall within the concepts of ordinary income neither is it statutory income. Therefore the amount will not be included in your assessable income.

You may choose to amend your income tax return for the year ending 30 June 2008 to reflect the reduction to the deduction you have already claimed.

Question 4

Summary

The interest capitalised of a certain amount in the year ended 30 June 2009, is allowable as a deduction as interest incurred in gaining or producing assessable income.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature.

Taxation Ruling TR 95/25 deals with deductibility of interest. Whether interest has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put.

Taxation Ruling TR 97/7 deals with the meaning of incurred and states that you generally incur an outgoing at the time you owe a present money debt that you cannot escape. TR 97/7 further states that a taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitively committed in the year of income.

In Hart v. Federal Commissioner of Taxation (2002) 121 FCR 206; 2002 ATC 4608; (2002) 50 ATR 369 it was held that compound interest, as with ordinary interest, derives its character from the use of the original borrowings.

In your case it is considered that the interest is incurred when it is charged to the loan account, even if it remains unpaid. Therefore, the full amount of interest on the loan will be incurred in gaining or producing your assessable income and is an allowable deduction under section 8-1 of the ITAA 1997. Effectively you are entitled to a deduction for interest on the unpaid interest, as all of the interest is still considered to be incurred in gaining or producing your assessable income.

Note: The interest amount will need to be apportioned in line with your ownership interest in the original investments sold by X, (i.e. the interest deduction is apportioned between you and your spouse).

Question 5

Summary

The refund of interest of a certain amount in the year ended 30 June 2009 will reduce the amount of interest capitalised that can be claimed as a deduction by that certain amount.

Detailed reasoning

In your case the refund of interest charged has the affect of reducing the deduction for interest incurred in gaining or producing assessable income by the amount refunded.

Question 6

Summary

The interest paid (early termination interest adjustment) appearing on the fixed rate margin loan, is allowable as a deduction as interest incurred in gaining or producing assessable income.

Detailed reasoning

The deductibility of interest on borrowed funds is determined by the use of the borrowed money. If the money is used to buy income producing assets, then the interest expense is an allowable deduction.

In FC of T v. Brown 99 ATC 4600, (1999) 43 ATR 1 (Browns case) the Full Federal Court held that a taxpayer may still be entitled to a deduction for recurrent interest expenses incurred after an income-producing activity has ceased provided the occasion of the interest expense arose out of the taxpayers previous income-earning activities. In Browns case, the Full Federal Court stated that the occasion for the recurring payments of interest was to be found in the original loan agreement (carrying with it the obligation to pay interest over the term of the loan) entered into by the taxpayer. The Full Federal Court found that the ceasing of the income-producing activity did not operate to break this nexus.

However, the nexus between the interest expense and the relevant income earning activities will be broken where:

-         the taxpayer has the ability to repay the loan but chooses not to do so, or

-         the taxpayer makes a conscious decision to extend the loan in order to derive an ongoing commercial advantage unrelated to the prior income earning activities which resulted in the debt.

In your situation, you borrowed funds to purchase a portfolio of managed investments to earn assessable income. A nexus existed between the interest expense incurred and the assessable income earned. Due to a downturn in the market your portfolio was terminated. You will use the money from the closure of the managed funds to repay a portion of the borrowed money; however an amount will still be outstanding.

As you are unable to repay the loan, the nexus between the ongoing interest expenses and the assessable income earned is not considered to be broken. Thus, the payment of the interest expenses will be deductible under section 8-1 of the ITAA 1997.

Note: The interest amount will need to be apportioned in line with your ownership interest in the original investments sold by X, (i.e. the interest deduction is apportioned between you and your spouse).