Edited version of your private ruling

Authorisation Number: 1012135884109

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Subject: compensation payment

Question 1

For the purpose of calculating your net capital gain under part 3-1 of the ITAA 1997, were you carrying on a business in partnership?

Answer:

Yes

Question 2

Is your share of the compensation payment received for the disposal of your 'right to seek compensation' assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

No

Question 3

Is your share of the compensation payment received for the disposal of your 'right to seek compensation' assessable under the capital gains tax (CGT) provisions of the ITAA 1997?

Answer:

Yes

Question 4

Will the legal expenses incurred in pursuing your right to seek compensation form part of the cost base of the CGT asset?

Answer:

Yes

Question 5

Are you entitled to apply the 50% discount to the capital gain made on disposal of the 'right to seek compensation' CGT asset?

Answer: Yes

This ruling applies for the following period

Year ended 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts and circumstances

You and your two siblings commenced a business in a shopping complex. A business name was registered.

You state that all three of you entered into an oral agreement to form a partnership and share all profits and losses of the business equally.

You brother made a capital contribution to the business, but did not work in the business.

You sister worked part time in the business, and made contributions towards business expenses on a regular basis.

You worked full time in the business, and made contributions towards the business expenses.

You (and your siblings) did not draw a wage from the business as it did not make enough money.

A business bank account was set up, with access and power to operate the account shared between you and your sister.

All decisions relating to the day-to-day running of the business were made by you and your sister. All major decisions in relation to the business were made by all three of you.

The assets used in the business were purchased from money contributed by all three siblings.

The lease of the business premises was in your name.

Shortly after your business commenced a similar business commenced next door. You believed that there was a clause in your lease agreement that prevented a similar business from opening in the same shopping complex. However, on checking the lease, you found that no such clause existed. On contacting your solicitor, he admitted that he had made a mistake when preparing the lease documentation.

On further legal advice you decided to sue your solicitor for professional negligence.

You provided a copy of a statement of claim detailing how you believed that the commencement of the similar business next door to your business resulted in your business suffering substantial losses.

You continued to operate your business (at a loss) until the end of your lease agreement. At the end of your lease agreement, your business ceased to operate.

Several years later, you decided to settle your case against your solicitor out of court.

In the 2011 financial year, you signed a deed of release with your solicitor. The deed of release provided that your solicitor admitted no liability, but agreed to pay you a sum of money to release him from any further claims or proceedings in relation to the matter.

Later in the 2011 financial year, you received a compensation payment and subsequently paid all legal expenses incurred in pursuing the compensation.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 100-40

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 106-5

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Section 115-25

Income Tax Assessment Act 1997 Section 995-1

Reasons for decision

Summary

You are considered to be carrying on a business in partnership with your two siblings. Accordingly, the compensation payment received should be apportioned in accordance with your partnership agreement.

The compensation payment is not assessable as ordinary income. However, it is assessable under the capital gains tax provisions as you acquired a Capital Gains Tax (CGT) asset (the 'right to seek compensation') when it became evident that negligence on behalf of your solicitor had occurred. You then disposed of the 'right to seek compensation' asset when the deed of release was executed to settle the matter out of court, thereby triggering CGT event C2.

You may include your share of the legal expenses incurred in respect of pursuing your 'right to seek compensation' in calculating the cost base of the asset.

You are entitled to apply the 50% discount to your share of the capital gain.

Detailed reasoning

Carrying on a business in partnership

The term 'partnership' is defined in section 995-1 of the Income Tax Assessment Act 1997 (ITAA 1997) as an association of persons (other than a company) carrying on a business as partners or in receipt of ordinary income or statutory income jointly.

The existence of a partnership is evidenced by the actual conduct of the parties towards one another and towards third parties during the course of carrying on business. The relevant factors are:

· the mutual assent and intention of the parties (which is the essential, but not only, relevant factor to indicate the existence of a partnership)

· joint ownership of business assets

· registration of business name

· joint business account and the power to operate it

· extent to which parties are involved in the conduct of the business

· extent of capital contributions

· entitlements to a share of net profits

· business records.

In your case;

you state that there was an oral agreement in place between yourself and your two siblings whereby you agreed to from a partnership business to run a coffee shop.

· the agreement you had in place provided that you would share the profits and losses of the business equally.

· it was well known that you were all in business together.

· the assets for the business were purchased using money provided by all three siblings.

· the business name was registered.

· a business bank account was opened and could be accessed and operated by two of the siblings of the partnership.

· you worked full time in the business and your sister worked part time. Your brother did not work in the business as he was overseas.

· you and your brother provided capital contributions to the business.

· the decisions on the day-to-day running of the business were made by you and your sister (as your brother lived overseas). Any major decisions were made by all three siblings together.

· no wages were drawn from the business as the business did not make enough money to support paying wages and business expenses as well.

· you did not keep accurate records for the business.

Based on the information provided, we consider that you and your two siblings were carrying on a business in partnership.

Compensation payment - assessable as ordinary income

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a taxpayer includes income according to ordinary concepts (ordinary income).

Ordinary income has generally been held to include 3 categories, namely 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.

The compensation received by the taxpayer was not income from rendering personal services, income from property or income from carrying on a business.

The payment is also a one off payment and thus it does not have an element of 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.

You received compensation for errors made by your solicitor in drawing up the lease. These errors related to the business premises and had a profound effect on the profitability of your business.

As the compensation relates to the business premises, it is considered to be a capital receipt and is not ordinary income. Therefore the compensation is not assessable ordinary income under section 6-5 of the ITAA 1997.

Compensation payment - assessable under capital gains tax provisions

Capital gains tax (CGT) is the tax you pay on certain gains you make. You make a capital gain or capital loss as a result of a CGT event happening to an asset in which you have an ownership interest (section 102-20 of the ITAA 1997).

A CGT asset is any kind of property; or a legal or equitable right that is not property (section 108-5 of the ITAA 1997).

When you receive an amount of money as a result of a judgement from a court action or you receive an amount of money for settling your dispute out of court, you are disposing of an asset which is the right to seek compensation and a CGT event C2 occurs (section 104-25 of the ITAA 1997).

Taxation Ruling TR 95/35 discusses the capital gains tax implications for compensation receipts and provides the following information.

Right to seek compensation

The right to seek compensation is the right of action arising at law or in equity and vesting in the taxpayer on the occurrence of any breach of contract, personal injury or other compensable damage or injury. A right to seek compensation is an asset for the purposes of Part IIIA. 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. The right to seek compensation is disposed of when it is satisfied, surrendered, released or discharged.

Disposal of the right to seek compensation

If the amount of compensation is not received in respect of any underlying asset, the amount relates to the disposal by the taxpayer of the right to seek compensation. Accordingly, any capital gain arising on the disposal of that right is calculated using the cost base of that right. Refer to Example 8 in this Ruling.

In your case, a CGT event C2 occurred as there has been a release, discharge or satisfaction of the right, the date of the event is when you signed the deed of settlement.

For most CGT events the capital proceeds are the money you receive or are entitled to receive from the event (section 100-40 of the ITAA 1997). In your case, the capital proceeds are your share of the compensation received.

Cost base

Section 110-25 of the ITAA 1997 provides that the cost base of the asset is the sum of money, and the market value of any property given as consideration, for the creation or acquisition of the asset. This would include any legal fees incurred in respect of pursuing your right to seek compensation (i.e., legal fees that relate specifically to the proceedings against your solicitor).

50% discount

A 50% discount may be applied to a discount capital gain realised by an individual. In order to be considered a discount capital gain, the asset that gave rise to the capital gain must have been owned for a period of at least 12 months prior to the CGT event (section 115-25 of the ITAA 1997). Taxation Ruling TR 95/35, at paragraph 153, provides that the date of acquisition of the asset (the right to seek compensation) is the date the breach of contract, or wrong, occurred.

In your case, you initially sought legal advice to write up the lease documents in relation to your business in 1994. It was at this time that your solicitor failed to include a clause relating to the restrictions on a similar store to open in the same centre. Later, a similar store opened up in the same centre. You continued to operate the store until your lease expired. You commenced legal proceedings against your solicitor in 1997. It can therefore be concluded that the erroneous advice (i.e. the negligence) and subsequent loss of income occurred more than 12 months prior to the CGT event that occurred in the 2010-11 financial year (when you signed the deed of release to settle the matter out of court). Therefore, the 50% discount can be applied to your capital gain.

Calculation of capital gain

Section 106-5 of the ITAA 1997 discusses capital gains in relation to partnerships. It provides that any capital gain from a CGT event happening to a partnership asset is made by the partners individually, with each partner's gain calculated by reference to the partnership agreement, or partnership law if there is no agreement. Each partner has a separate cost base for the partner's interest in the CGT asset of the partnership. The gain is calculated by allocating an appropriate share of the capital proceeds (the compensation payment) from the event and the incidental costs that relate to the event (the legal expenses incurred).

As it has been established that the capital gain, in this situation, is considered a discount capital gain, you may apply the 50% discount to your share of the capital gain as calculated above.