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Ruling

Subject: Capital Gains Tax - Assessability of a compensatory payment

Question 1:

Is the compensation amount which you received assessable as income under either section 6-5 or section 6-10 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

No.

Question 2:

Does a capital gains tax (CGT) event happen upon the receipt of such a compensation payment?

Answer:

No. The receipt of the payment does not trigger a CGT event. However, the compensation reduces the cost base of the asset for CGT purposes.

This ruling applies for the following periods:

1 July 2008 to 30 June 2009.

The scheme commences on:

1 July 2008.

Relevant facts and circumstances

The taxpayers invested in various projects. The investments were rendered virtually valueless due to the collapse of the entity in question. It is not clear whether any amounts will ultimately be recovered from these investments. The investments have a 25 year term.

The taxpayers pursued a compensation claim against their adviser for information not being provided. Ultimately the matter was settled in favour of the taxpayers in the form of an ex gratia payment without any admission of liability on the part of the adviser.

The adviser had by this time become insolvent and the agreed settlement amount was paid by the insurer. It was paid in one lump sum amount and the taxpayers signed a release agreeing not to make any further claims.

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

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

Where a taxpayer receives an amount of compensation in respect of permanent damage to or reduction in the value of an underlying asset and there is no disposal of that underlying asset at the time of the receipt, the amount represents a recoupment of all or part of the total acquisition costs of the asset. The total acquisition costs of the asset should be reduced by the amount of the compensation.

No capital gain or loss arises in respect of that asset until the taxpayer actually disposes of the underlying asset. The adjustment of the costs effectively reduces the original cost base by the amount of the recoupment and consequently increases any capital gain or reduces any capital loss incurred at the time of eventual disposal.

Detailed reasoning

Assessable income is made up of ordinary income under section 6-5 and statutory income under section 6-10. Subsection 6-5(1) defines ordinary income as income 'according to ordinary concepts' which does not include capital receipts.

Section 6-10 provides that assessable income includes statutory income which constitutes amounts made assessable by specific statutory provisions. Such a provision is section 102-5 which provides that capital gains are included in assessable income.

In establishing whether a capital gain has been incurred, it is necessary to identify the asset involved. In respect of payments made by way of compensation, Taxation Ruling TR 95/35 directs us to identify the underlying asset (referred to as the "look-through approach").

The relevant CGT asset in the present case is the underlying investments. Whilst the compensation was ultimately received for the failure to disclose information, the practical effect of that failure was that you paid more for the investment than it was worth as a result of not having that information available to you. It is considered that the amount which you received is to compensate for that overpayment.

The compensation amount has been received as a consequence of a reduction in value of the asset although as yet there has been no disposal. TR 95/35 discusses, at paragraphs 6 to 9 and also at paragraphs 146 to 152, the treatment of compensation for permanent damage to, or permanent reduction in the value of, the underlying asset where there has been no disposal of that asset. It states at paragraph 6:

If an amount of compensation is received by a taxpayer wholly in respect of permanent damage suffered to a post-CGT underlying asset of the taxpayer or for a permanent reduction in the value of a post-CGT underlying asset of the taxpayer, and there is no disposal of that underlying asset at the time of the receipt, we consider that the amount represents a recoupment of all or part of the total acquisition costs of the asset.

The ruling goes on to state that no capital gain or loss arises in respect of that asset until the taxpayer actually disposes of the underlying asset. The direct impact of the receipt of the compensation payment is an adjustment of the costs which effectively reduces the original total acquisition costs by the amount of the recoupment.

Whilst you retain the investments, regardless of their worth, no CGT event will have occurred. When a CGT event ultimately does occur, through disposal or some other event, the cost base of the asset will be the cost of the relevant investments reduced by the value of the compensation payment. Any capital gain would then be assessed by deducting the adjusted cost base from any consideration received. The practical effect of the adjustment is to increase any capital gain or reduce any capital loss incurred.