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Ruling

Subject: Income Tax: Assessable income: legal settlement

Question 1

Is income tax payable on monies received in settlement of a dispute in terms of section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

If income tax is not payable on monies received in settlement of a dispute in terms of section 6-5 is there any other provision of the ITAA 1997 under which income tax would be payable?

Answer

No

Question 3

Is income tax payable on interest received in settlement of a dispute in terms of section 6-5 of the ITAA 1997?

Answer

Yes

This ruling applies for the following period

Income year ending 30 June 2012

The scheme commenced on

Income year ending 30 June 2012

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5.

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it.

The Company participated in a class action in relation to purchases made by the Company.

The settlement amount was calculated by a formula based on amounts actually paid for purchases made by the Company over a period of time in order to calculate the amount overcharged during that time.

The Company received payment as the result of the successful class action comprised of the share of settlement and interest.

Upon finalisation of the settlement scheme members of the group participating in the class action were barred from making or pursuing any claim arising out of the subject matter of the settlement. No value has been directly attributed to the 'covenant not to sue' set out in the settlement deed.

In accordance with the settlement deed the settlement payment was made in full and final satisfaction of the claims made for overcharge, interest and costs.

Question 1

Summary

The monies received for payment of a class action settlement are assessable as ordinary income of the Company.

Detailed reasoning

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year. Ordinary income is income according to ordinary concepts in accordance with subsection 6-5(1) of the ITAA 1997.

Income according to ordinary concepts has been held by the courts to include income from the rendering of personal services, income from property and income from carrying on of a business.

The Company is a consumer of products in which the supplying companies were allegedly involved in illegal price-fixing activities. The Company participated in a class action against the companies involved.

Monies received as a result of the class action were awarded in reparation for what the Company had previously overpaid for purchases.

The settlement transaction entered into was directly connected to carrying on the business as the class action was intrinsically connected to purchases made by the business.

As found in the court case known as Warner Music Australia Pty Ltd v. Federal Commissioner of Taxation (1996) 70 FCR 197; 96 ATC 5046; (1996) 34 ATR 171 which Hill J stated:

The taxpayer made a gain when it was released from its sales tax liabilities…This gain was made on revenue account because it was an incidence of the taxpayer's business of selling goods. The fact that gains of this type are infrequent or unusual did not mean that the gain was abnormal in a manner which put it on capital account.

The class action took place in the course of carrying on a business even if the transaction is outside the ordinary course of the Company's business. As the Full High Court found in FC of T v. The Myer Emporium Ltd (1987) at 163 CLR 199; 87 ATC 4363; 18 ATR 693 (Myer)

If the profits be made in the course of carrying on a business that in itself is a fact of telling significance. It does not detract from its significance that the particular transaction is unusual or extraordinary, judged by reference to the transactions in which the taxpayer usually engages, if it be entered into in the course of carrying on the taxpayer's business.

Because the settlement was made in full satisfaction of claims for overcharge, interest and costs the income is assessable in terms of section 6-5 of the ITAA 1997.

Question 2

Summary

The right to seek compensation is an intangible asset which is satisfied by the asset being surrendered or forfeited. No value has been attributed to the covenant not to sue included in the settlement deed therefore no capital gains tax (CGT) is payable.

Detailed reasoning

Section 6-10 of the ITAA 1997 provides that a taxpayer's assessable income includes statutory income amounts that are not ordinary income but are included in assessable income by another provision of the tax law.

Section 10-5 of the ITAA 1997 lists those other provisions of the law and they include capital gains.

Paragraph 108-5(1)(b) of the ITAA 1997 specifically includes a legal or equitable right within the definition of a CGT asset. A taxpayer's right to seek compensation is therefore classified as an intangible CGT asset.

Section 104-25 of the ITAA 1997 discusses CGT event C2 which refers to cancellation, surrender and similar endings. Paragraph 104-25(1)(d) of the ITAA 1997 states, in part, that CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset being surrendered or forfeited. Subsection 104-25(2) of the ITAA 1997 states that the time of the 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.

The right to seek compensation is acquired at the time of the compensable wrong or injury, and includes all of the rights arising during the process of pursuing the compensation claim. In this case the compensable wrong was the overcharging for products through a price fixing arrangement.

The Company's right to compensation was disposed of when it agreed to the terms of the settlement in which all claims, causes of action and demands in the present and future were released in satisfaction of paragraph 104-25(1)(b) of the ITAA 1997 The disposal of the right to seek compensation occurred on the date on which the parties signed the Settlement Deed.

The 'covenant not to sue' is a term or condition of the settlement which adds finality to the dispute rather than being the subject of the settlement and does not give rise to an additional payment in its own right. Therefore no CGT is payable.

Question 3

Summary

Income received in the nature of interest is assessable in terms of section 6-5 of the ITAA 1997.

Detailed reasoning

Interest awarded as part of compensation is interest within the general meaning of that term. It represents assessable income of the taxpayer even when the judgment provides only for a single lump sum which would otherwise be a capital receipt as discussed in the Federal Wharf Co Ltd v. DFC of T (1930) 44 CLR 24; 1 ATD 70 (Federal Wharf).

In the Federal Wharf case, the taxpayer received compensation on the compulsory acquisition of his property under the Harbours Act 1913 (South Australia). The relevant legislation provided for an additional amount by way of interest to be calculated from the time when the Minister entered into occupation, to the time of the payment of the compensation, and provided that the interest would be added to the compensation. The taxpayer argued that the interest component was in substance part of the compensation intended to rehabilitate the taxpayer.

Rich J In the Federal Wharf case, in considering whether the amount was of a capital or income nature, identified four criteria:

that the sum was calculated and payable in respect of time;

that the time started when the owner was deprived of the profitable enjoyment of his property;

that the time ended with the payment of the compensation which represented the capital of the property; and

that the interest was calculated on the sum ascertained to represent the capital value of the property of which the owner had been deprived.

In applying these criteria, Rich J found that the character of the interest payable under this legislation was that of recompense for loss of the use of the capital during a period of time in which it would earn income.

Monies deposited in the settlement distribution funds were deposited in interest bearing accounts during the processing of the claims. In accordance with court orders part of the interest was used to pay for the costs of administering the scheme and the remaining interest has been divided proportionally between the class action members.

The interest received was the Company's share of the net interest accrued on the settlement distribution fund and is therefore considered to be received for the loss of capital during the period for which the funds were deposited in anticipation of settlement. Amounts received are therefore assessable in terms of section 6-5 of the ITAA 1997.