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Ruling

Subject: Assessability of a compensation receipt

Question

Is a payment received in compensation for professional negligence, where that payment represents reimbursement of income tax incurred, considered to be assessable?

Answer

Yes. It is assessable as a capital gain.

This ruling applies for the following period:

1 July 2011 to 30 June 2012.

The scheme commences on:

1 July 2011.

Relevant facts and circumstances

The taxpayers received capital gains tax advice from their tax agent to the effect that the specific asset would qualify as an active asset. When the error was subsequently discovered it was too late for the taxpayers to undertake any tax planning to mitigate the resulting capital gains tax (CGT).

They subsequently took legal action against the tax agent. The action resulted in a payment of damages equivalent to a reimbursement of the income tax paid.

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 102-5,

Income Tax Assessment Act 1997 Section 104-25 and

Income Tax Assessment Act 1997 Section 108-5.

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA of the ITAA 1936 to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part. If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: 'Part IVA: the general anti-avoidance rule for income tax'.

Reasons for decision

Unless otherwise stated, all references in the following Reasons for Decision are to the Income Tax Assessment Act 1997 (ITAA 1997).

Summary

Section 102-5 provides that capital gains are included in assessable income. Paragraph 108-5(1)(b) specifically includes a legal or equitable right within the definition of a CGT asset.

The disposal of such a right falls under CGT event C2. The net capital gain is the difference between the consideration received (the compensation paid) and the cost base of the asset (the additional tax incurred).

Detailed reasoning

Apart from ordinary income which is made assessable under section 6-5, section 6-10 provides that assessable income includes amounts made assessable by specific statutory provisions. Section 102-5 provides that capital gains are included in assessable income. Therefore, any net capital gain that you make is included in your assessable income, unless it is covered by one of the available exemptions.

In establishing whether a capital gain has been incurred, it is necessary to identify the asset involved. Taxation Ruling TR 95/35 directs us to look for an underlying asset when compensation is involved. The relevant CGT asset in your case is your right to seek damages in respect of the incorrect advice which you received.

Paragraph 108-5(1)(b) specifically includes a legal or equitable right within the definition of a CGT asset. Paragraph 3 of TR 95/35 confirms that the right to seek compensation is a CGT asset. It states that it is the right of action arising at law or in equity and vesting in the taxpayer on the occurrence of any breach of contract. It is acquired at the time of the compensable wrong and is disposed of when it is satisfied, surrendered, released or discharged. Therefore, in terms of paragraph 108-5(1)(b), your right to seek compensation is confirmed as being a CGT asset.  

Section 104-25 discusses CGT event C2 which refers to cancellation, surrender and similar endings. CGT event C2 occurs if your ownership of an intangible CGT asset ends by the asset being disposed of in the circumstances listed in subsection 104-25(1). In the terms stated in paragraph 3 of TR 95/35, the disposal of your asset would constitute a C2 event.

Subsection 104-25(2) states that the time of such an event is: (a) when you enter into the contract which results in the asset ending; or (b) if there is no contract when the asset ends. When your advisor is found negligent, or otherwise accepts liability, your right to seek damages is effectively discharged or satisfied at that time. Upon your agreement to surrender the right and receive payment in consideration you have disposed of the CGT asset for the purposes of subsection 104-25(2).

The consideration received is the amount paid to you in satisfaction of your claim for reimbursement of the tax payable. The cost base of the asset is the additional tax incurred. If the compensation received exactly equals the tax payable the capital gain will be nil, as the consideration received will equal the cost base of the asset. To the extent of any disparity between the two amounts, a capital gain or loss will arise.