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Ruling

Subject: Assessability of an undissected insurance receipt

Question 1

With regard to a business that ceased as a result of a natural disaster, is the receipt of an insurance payment described as 'advance for stock' considered assessable income under section 70-115 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

With regard to a business that ceased as a result of a natural disaster, is the receipt of an undissected insurance payment described as a 'general advance on claim to satisfy an overdraft expense and creditors' considered ordinary assessable income under section 6-5 of the ITAA 1997?

Answer

No.

Question 3

With regard to a business that ceased as a result of a natural disaster, is the receipt of an undissected insurance payment described as a 'general advance on claim to satisfy an overdraft expense and creditors' considered assessable under the capital gains tax (CGT) provisions of the ITAA 1997?

Answer

Yes

Question 4

With regard to a business that ceased as a result of a natural disaster, is the receipt of an undissected insurance payment described as an 'unspecified payment' considered ordinary assessable income under section 6-5 of the ITAA 1997?

Answer

No

Question 5

With regard to a business that ceased as a result of a natural disaster, is the receipt of an undissected insurance payment described as an 'unspecified payment' considered assessable under the CGT provisions of the ITAA 1997?

Answer

Yes

Question 6

With regard to a business that ceased as a result of a natural disaster, is the receipt of an undissected insurance payment described as a 'final payment in settlement of buildings, debris, contents, stock and business interruption claims' considered ordinary assessable income under section 6-5 of the ITAA 1997?

Answer

No

Question 7

With regard to a business that ceased as a result of a natural disaster, is the receipt of an undissected insurance payment described as a 'final payment in settlement of buildings, debris, contents, stock and business interruption claims' considered assessable under the CGT provisions of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 2011

Year ended 30 June 2012

Relevant facts and circumstances

The Partnership consists of two married couples, couple A and couple B.

The Partnership conducted a business (the original business) up until the year ended 30 June 2012 at which time the business was destroyed by a natural disaster.

The premises from which the original business was operated was owned by another entity associated with couple A.

The original business has not re-opened since the natural disaster and will not resume trading.

Couple A have commenced trading via a new entity in a premises provided under a government relief package.

As couple B have resolved not to re-commence business and have withdrawn from all related activities the Partnership has been dissolved.

Insurance payments were received by both the Partnership in relation to the business and the owner of the premises. This ruling pertains to the payments received by the Partnership only.

During the course of telephone conversations the applicants advised the following:

The business operator from the original building was the Partnership.

The building from which the current business commenced to be operated by the new entity is on loan from the local community.

Insurance was paid to the building owner in respect of the buildings.

Insurance was also paid to the Partnership in respect of the business. Some of the payments were undissected amounts with no specification provided by the insurance company as to whether they were in satisfaction of heads of claim relating to loss of earnings or capital. Some of the insurance proceeds covered numerous heads of claim and some of them had no accompanying explanation at all.

The payments to the business were split 50/50 between the couple A and couple B after outstanding debts were satisfied.

Other than satisfying debts the Partnership has undertaken no further activity since the natural disaster. It was basically dissolved and couple B will have no further involvement in the operations of any business activities.

To date the insurance payouts have been spent on outstanding debts and living expenses.

Couple A are associated with the new business entity.

The 'advance for stock' was self explanatory.

The 'advance for business debts' receipt relates to an overdraft and various creditors liabilities. There was no apportionment between these heads of claim.

The 'unspecified payment' was an amount which may have related to debris removal however there is no documentation confirming what it was for. The insurance company simply credited the Partnerships account.

In accordance with the 'Form of Release - Insurance Claims' the 'final payment' was made in settlement of all outstanding amounts for buildings, debris, contents, stock and business interruption claims. A portion went to the building owner, with the remainder split between the Partners. There was no apportionment between these heads of claim.

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 10-5.

Income Tax Assessment Act 1997 Section 15-30.

Income Tax Assessment Act 1997 Section 104-25.

Income Tax Assessment Act 1997 Section 102-5.

Income Tax Assessment Act 1997 Paragraph 104-25(1)(b).

Income Tax Assessment Act 1997 Subsection 104-25(2).

Income Tax Assessment Act 1997 Paragraph 108-5(1)(b).

Income Tax Assessment Act 1997 Section 118-37.

Income Tax Assessment Act 1997 Paragraph 118-37(1)(b).

Income Tax Assessment Act 1997 Section 118-300.

Income Tax Assessment Act 1997 Subsection 118-300(1).

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 of the ITAA 1936 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 of the ITAA 1936, 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

All subsequent legislative references are to the ITAA 1997 unless otherwise stated:

Ordinary income

Section 6-5 deals with receipts of ordinary income. It does not operate to include amounts of a capital nature in a taxpayer's assessable income.

Ordinary income has generally been held to include income from rendering personal services, income from property and income from carrying on a business. Other characteristics of income that have evolved from case law include receipts that:

· are earned,

· are expected,

· are relied upon, and

· have an element of periodicity, recurrence or regularity.

 A compensation amount generally bears the character of that which it is designed to replace. If the compensation is paid for the loss of a capital asset or amount then it will be regarded as a capital receipt and not ordinary income. However, if the compensation receipt substitutes for income then the courts have held that it be considered income under ordinary concepts.

Statutory income

Section 6-10 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 lists those other provisions and includes:

· compensation for lost trading stock (section 70-115)

· amounts received by way of insurance or indemnity payments in respect of a lost amount (section 15-30), and

· capital gains (section 102-5).

Section 70-115 provides that your assessable income includes an amount that you receive by way of insurance or indemnity for a loss of trading stock, and which is not assessable as ordinary income under section 6-5.

Section 15-30 provides that your assessable income includes an amount you receive by way of insurance or indemnity for the loss of an amount if the lost amount would have been included in your assessable income, and the amount you receive is not assessable as ordinary income under section 6-5.

Section 102-5 provides that your assessable income includes your net capital gain for the income year.

Replacement principle (look-through approach)

A factor which helps determine whether a compensation receipt is ordinary income is the 'replacement principle'. This principle is that receipts are income if they replace an item of income and are capital if they replace an item of capital. It applies mainly to lump sum payments because periodical and regular compensation payments can usually be inherently characterised as ordinary income.

Undissected or composite payments

An exception to the replacement principle is undissected or composite payments. In some instances the nature of a lump sum compensation payment cannot be identified, or alternatively, it may contain known components that cannot be separately identified and quantified as being in the nature of either income or capital. Under these circumstances Taxation Determination TD 93/58 provides that the payment will be placed on capital account. However, to the extent that a portion of the payment is identifiable and quantifiable as income TD 93/58 provides that this component will be assessed as such.

Use of receipt

The use to which you put the compensation receipt is not a relevant factor when determining its character.

A legal or equitable right is a CGT asset

Paragraph 108-5(1)(b) specifically includes a legal or equitable right within the definition of a CGT asset.

Right to seek compensation is a CGT asset

Paragraph 3 of Taxation Ruling 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.

Compensation received under a policy of insurance

Paragraph 183 of TR 95/35 provides that compensation received under an insurance policy also relates to a right to seek compensation.

CGT event C2

Section 104-25 discusses CGT event C2 which refers to cancellation, surrender and similar endings. Subparagraph 104-25(1)(b) states, in part, that CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset being discharged or satisfied.

Subsection 104-25(2) 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.

CGT exemption

Division 118 addresses exemptions in relation to the CGT provisions.

Section 118-37 specifically addresses compensation and damages. It provides that certain capital gains or capital losses are disregarded. Paragraph 118-37(1)(b) provides that a capital gain or a capital loss you make from a CGT event which relates directly to compensation or damages received by you for any wrong, injury or illness you or your relative suffers personally is disregarded.

Section 118-300 specifically addresses insurance policies. Subsection 118-300(1) contains a table and Item 2 of this table outlines circumstances under which capital gains arising from general insurance policies for property may be disregarded. It does however limit the exemption specifically to property in relation to which any capital gain or loss would be inherently disregarded under some other exemption provision.

There are no other relevant exemption provisions which need be examined for the purposes of this ruling.

Cost base of CGT asset 'right to seek compensation'

For the purposes of calculating the cost base of a receipt under an insurance policy where the separate components cannot be identified and quantified and the relevant asset is therefore the right to seek compensation, paragraph 12 states, in part the following:

The consideration in respect of the acquisition of the right to seek compensation… includes the total acquisition costs incurred as a result of which the right to seek compensation arose.

Paragraph 104 goes on to state:

If the right to seek compensation arises in respect of a monetary loss of the taxpayer … the amount of that loss is included in the cost base of the right to seek compensation for that loss. It is an amount which the taxpayer has paid or is required to pay in respect of the acquisition of the right to seek compensation for having to incur the expenditure.

Cost base of an underlying CGT asset which can be identified and quantified

Where you are able to identify and quantify the underlying asset to which the insurance payment relates, the cost base of each asset will not be the 'right to seek compensation', it will instead consist of the cost or value of that underlying asset in addition to other expenditure incurred under the various cost base elements.

Balancing adjustment for depreciable assets which can be identified and quantified

For depreciable assets there may not be CGT consequences. Instead a balancing adjustment may need to be calculated.

Application to your circumstances:

Question 1

The insurance receipt pertaining to 'loss of stock' is considered assessable income either under the general provisions of section 6-5 or the specific provisions of section 70-115.

Note that the cost of the lost trading stock for which the insurance proceeds have been received may be claimed as a deduction against this income.

Questions 2, 4 & 6

The subsequent three insurance receipts described separately by you as:

· general advance on claim to satisfy an overdraft expense and creditors

· unspecified payment, and

· final payment in settlement of buildings, debris, contents, stock and business interruption claims

· are not considered to be assessable under section 6-5.

None of these receipts possess the necessary characteristics usually associated with ordinary income. They are not derived from rendering personal services and are not income from property or carrying on a business. They are not earned or expected and do not have an element of periodicity, recurrence or regularity.

A compensation amount generally bears the character of that which it is designed to replace. None of the three payments can be clearly identified as containing quantifiable components pertaining to items of a revenue nature.

Further, as the components of the three receipts cannot be either identified and/or quantified they cannot be said to be in relation to a 'lost amount' which 'would have been included in your assessable income' and therefore are not assessable as statutory income under section 15-30.

Questions 3, 5 & 7

CGT and Right to seek compensation

As the components of these three insurance receipts cannot be separately identified and quantified the replacement principle (look-through approach) does not apply. They are all considered undissected (or composite) payments. In accordance with TD 93/58 they are all therefore placed on capital account.

Compensation received under an insurance policy which cannot be identified as relating to a specific underlying asset instead relates to a right to seek compensation, which in itself is a separate CGT asset in accordance with paragraph 108-5(1)(b).

The occasion of the natural disaster and subsequent damage to your business gave rise to this right to seek compensation and in accordance with section 104-25 a CGT event C2 happened when the insurance company satisfied its obligation under this arrangement.

The exemption provision under section 118-37 only applies to individuals suffering wrong, injury or illness and the exemption for insurance policies under section 118-300 only applies if there is an underlying asset which is specifically disregarded under another exemption provision. As neither of these conditions is satisfied in this instance and there are no other exemption provisions within Division 118 which apply the capital gains in relation to these three payments will not be disregarded.

Cost base of right to seek compensation

You may calculate your cost base in accordance with the general cost base rules under Division 110 and with reference to paragraph 104 of TR 95/35 pertaining to the right to seek compensation.

Cost base if you are able to identify and quantify the underlying assets

If you are able to identify and quantify the components of the insurance receipts as relating to specific underlying assets (as opposed to the right to seek compensation) either from information provided by the insurance company or by means of your insurance claim form, then your cost base will be calculated with reference to the value of these various assets with the insurance proceeds being apportioned between them. Other expenses incurred under the various cost base elements may be included.

Balancing adjustment for depreciable assets

However, for depreciable assets such as contents the CGT provisions may not apply. There may instead need to be a balancing adjustment calculation.

Note: As none of the insurance payments that are the subject of this ruling were specifically made by the insurance company in respect of the cessation or 'loss of the business' (as per your application form) this specific question was not addressed.