Edited version of private ruling

Authorisation Number: 1011684340706

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Ruling

Subject: Storm Financial collapse

Issue 1

Question

Is the compensation amount treated as additional capital proceeds in respect of the disposal of your investments with Storm Financial Limited?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2009

Year ended 30 June 2010

The scheme commences on:

1 July 2008

Issue 2

Question 1

Is the refund of unused prepaid interest assessable income?

Answer

No.

Question 2

Are you entitled to a deduction in respect of the interest paid?

Answer

Yes.

Question 3

Is the interest credited to you assessable income?

Answer

Yes.

Question 4

Are you entitled to a deduction in respect of the break costs?

Answer

Yes.

Question 5

Is the interest correction amount assessable income?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2009

The scheme commences on:

1 July 2008

Issue 3

Question

Are you entitled to a deduction for the interest incurred in respect of your new home loan?

Answer

No.

This ruling applies for the following period:

Year ending 30 June 2011

The scheme commences on:

1 July 2008

Relevant facts and circumstances

You were a client of Storm Financial Limited (Storm) and received financial advice from Storm.

On the advice of Storm and with their assistance, at various times you applied, for one or more home loans from the Commonwealth Bank of Australia (CBA) retail division.

At various times, the CBA's retail division approved home loan applications and advanced funds to you under the loans (herein referred to separately and collectively as the home loan).

You did not claim any deductions in respect of interest for the home loan.

The home loan was secured by a registered mortgage over land.

Proceeds of the facilities comprising the home loan were used from time to time by you to purchase investments on the advice of Storm. The funds advanced under the home loan may have been combined with (geared through) a margin lending facility provided by a third party.

The investments may have included units in a Storm badged index fund for which the responsible entity was a CBA party.

Later, the returns generated by the investments ceased to be available to you to apply towards meeting, or were insufficient to meet, repayment obligations under the home loan.

You have, either directly, or through your solicitors, or both, made a claim against the CBA for compensation concerning the circumstances of the home loan, the investments and/or the repayment of indebtedness under the home loan.

The parties have participated in a dispute resolution process known as the Storm Resolution Scheme (the scheme) on the terms set out in the Borrower Deed.

As a result of their participation in the scheme and the CBA's construction of a proposal, the parties have agreed upon:

(a) the release and waiver of certain amounts of indebtedness owed by you to the CBA; and/or

(b) the closure, variation of replacement of the current loan on the terms of this Deed; and/or

(c) the payment of certain amounts to you by the CBA; and

(d) the releases which are set out in the Deed.

The Deed provided for a settlement amount.

You accepted the CBA's offer and executed the Deed of Settlement some time during the 2010 income year.

Under the Deed:

· part of the settlement amount was applied towards your home loan;

· your existing loans were closed and all liabilities under these loans were discharged and extinguished in full; and

· a new home loan was approved.

· you received a cash payment as part of the settlement amount.

Part of your investments with Storm included a margin loan with Macquarie Bank Limited (Macquarie). 100% of this loan was used for Storm investments. In the 2009 income year, under the margin loan you:

· received a refund of an amount of unused prepaid interest,

· incurred an amount of interest,

· were credited with an amount of interest,

· incurred break costs and

· were credited with a correction of interest.

You previously claimed deductions for interest that was incurred only on this margin loan.

You have provided copies of the following documents:

· the CBA Storm Resolution Scheme Deed of Settlement,

· the Macquarie Margin Lending statement,

· Storm Financial Index Share market Funds 2008/09 Tax Return Information Statements,

· Analysis summary of the scheme,

· CBA Home Loan Summary statements,

· Macquarie cash management trust account statement,

· Letter from CBA confirming the new loan details and

· Home loan statement in respect of the new home loan.

These documents form part of, and are to be read in conjunction with, your application for a private ruling.

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 8-1,

Income Tax Assessment Act 1997 Section 10-5,

Income Tax Assessment Act 1997 Section 20-25,

Income Tax Assessment Act 1997 Section 104-10,

Income Tax Assessment Act 1997 Section 104-25,

Income Tax Assessment Act 1997 Section 108-5 and

Income Tax Assessment Act 1997 Section 116-20.

Reasons for decision

Issue 1

Is the compensation amount treated as additional capital proceeds in respect of the disposal of your investments with Storm Financial Limited?

The general CGT provisions are set out in Part 3-1 of the Income Tax Assessment Act 1997 (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 references 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 were a client of Storm. You applied and were granted home loans from the CBA's retail division. Proceeds of the home loans were used to acquire investments on the advice of Storm. These investments included a margin loan with Macquarie. The returns generated by these investments were no longer available to you to apply towards meeting, or were insufficient to meet, repayment obligations under the home loan.

The CBA with you and/or with your solicitors have made a claim against the CBA for compensation concerning the circumstances surrounding the repayment of indebtedness under the home loans. The parties have reached a settlement. Under the settlement the parties have agreed upon the renegotiation of indebtedness under the home loans into a new home loan. The new home loan is for a lesser amount that the previous loan. The difference between the old loans and the new home loan is a certain amount. As part of the settlement you also received a cash payment. These amounts are considered to be compensation.

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 $230,000.00 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 your investments were sold.

Please note that because you have received additional capital proceeds in respect of previous CGT events this may mean you will need to adjust any capital gains or capital losses that you included in the 2008-09 and 2009-10 income years.

Issue 2

1. Is the refund of unused prepaid interest assessable income?

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income or, in carrying on a business for the purpose of gaining or producing such income.

Where a taxpayer receives a refund of an item for which they have previous claimed a deduction, it is necessary to consider the character of the receipt in order to establish the taxation implications.

Section 6-5 of the ITAA 1997 provides 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 of the ITAA 1997 provides 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 specified in section 10-5 of the ITAA 1997. Included in this list are recoupments.

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

In your case, while the refund of prepaid interest fits the definition of a recoupment as defined in section 20-25 of the ITAA 1997, it is not assessable.

The refund of unused prepaid interest is not an assessable recoupment as it does not relate to a deduction for which recoupments become assessable.

The amount that you received as a refund of unused prepaid interest does not fall within the concepts of either ordinary or statutory income. Therefore the amount will not be included as assessable income.

You may choose to amend your previous income tax assessments to exclude any deductions you may have previously claimed in respect of the interest.

2. Are you entitled to a deduction in respect of the interest paid?

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 and your spouse borrowed funds to purchase investments. A nexus existed between the interest expense incurred and the assessable income earned. This nexus remains unbroken and therefore the interest expense will be deductible under section 8-1 of the ITAA 1997.

3. Is the interest credited to you assessable income?

Interest that you receive is assessable as ordinary income in accordance with 6-5 of the ITAA 1997. Therefore the interest credited is required to be included in your assessable income.

4. Are you entitled to a deduction in respect of the break costs?

Break costs are a form of penalty interest. Taxation Ruling TR 93/7 provides guidance on whether penalty interest payments are deductible. Penalty interest payment refers to an amount payable by a borrower under a loan agreement in consideration for the lender agreeing to accept an early repayment of a loan.

TR 93/7 provides that a penalty interest payment is generally deductible under section 8-1 of the ITAA 1997 if:

(a) the loan moneys were borrowed for the purpose of gaining or producing assessable income or for use in a business carried on for that purpose; and

(b) the payment is made in order to rid the taxpayer of a recurring obligation to pay interest on the loan, where such interest would itself have been deductible if incurred.

In your situation, the break costs were incurred on a loan that was purely for investment purposes. You and your spouse would have been entitled to deductions on the interest incurred in respect of this loan. Therefore the amount that you incurred in break costs is deductible under section 8-1 of the ITAA 1997.

5. Is the interest correction assessable income?

As previously stated, interest that you receive is assessable as ordinary income in accordance with 6-5 of the ITAA 1997. Therefore the interest correction is required to be included in your assessable income.

Issue 3

Are you entitled to a deduction for the interest incurred in respect of your new home loan?

Taxation Ruling TR 95/25 provides the Commissioner's view regarding the deductibility of interest expenses. TR 95/25 states that the deductibility of interest depends upon satisfying, or being able to show, that the expense has sufficient connection with the operations of activities which directly gain or produce a taxpayer's assessable income. In other words, the interest must be incurred in relation to property which is held for income producing purposes.

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. The 'use' test, established in Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion.

On the basic of the decision of the Full Federal Court in FC of T V. Roberts; FC of T v Smith (1992) 37 FCR 246; 92 ATC 4380; (1992) 23 ATR 494 interest on a new loan will be deductible if the new loan is used to repay an existing loan which was being used for income producing purposes at the time the new loan was obtained. As the new loan has the same character as the existing loan, the interest on the new loan has the character of an income producing expenses.

Taxation Ruling TR 2000/2 provides the Commissioners view on the deductibility of interest on money drawn down under a line of credit facility. Any further borrowing under a line of credit facility represents new borrowings. Consequently, where the new funds are used for income producing purposes, for example, to purchase shares, the accrued interest expense is deductible under section 8-1 of the ITAA 1997. However if the further borrowing is used for private purposes, no deduction is allowed.

In your case, you were previously claiming deductions in respect of the margin loan through Macquarie. This margin loan is separate to the home loans that were entered into with CBA which have now been renegotiated into the new home loan. There is no nexus between the margin loan with Macquarie and the new home loan with the CBA. The new loan relates to your home loan only and this is considered to be for private purposes. Accordingly you are not entitled to claim deductions under 8-1 of the ITAA 1997 in respect of the interest incurred on the loan.