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Ruling

Subject: Compensation payment

Question 1

Is the compensation payment you received in the 2011-12 financial year for the settlement of a class action brought against a company, assessable as ordinary income?

Answer:

No

Question 2

Is the compensation payment you received in the 2011-12 financial year for the settlement of a class action brought against a company, assessable as a capital gain?

Answer:

No

Question 3

Should the cost base of the shares in question be reduced by the amount of compensation received for paying excessive consideration for the shares?

Answer:

Yes

Question 4

Should the capital loss you incurred on the disposal of the shares be reduced by the amount of compensation received in respect of the shares?

Answer:

Yes

Question 5

How do you claim the amount of withholding tax on the interest earned on your compensation payment?

Answer:

Invalid - general information on reporting withholding tax provided

This ruling applies for the following period

Year ended 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts and circumstances

The arrangement that is the subject of the private ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are:

· your application for a private ruling.

· letter from the class action lawyers detailing your settlement payment.

· Notice of court approval of the settlement of the class action (including loss assessment formula calculation)

Prior to December 2010, a class action against a company was filed on behalf of entities who acquired an interest in securities of the company between a particular period.

The class action alleged that the failure of a company to disclose price sensitive information in various speech and statements was misleading or deceptive and in contravention of the Corporations Act, the ASIC Act, the Trade Practices Act and/or the ASX Listing Rules.

As a result, the plaintiffs in the class action acquired their shares in the company at a time when the value at which the shares were traded on the ASX being higher than their true value.

The plaintiffs further claimed that they would not have acquired the shares if they had known about the contraventions.

Consequently, the plaintiffs have suffered:

· loss of the difference between the price paid and the true value as at the date of the acquisition; or

· loss of the difference between the price paid and either the sales price or the market value as at a particular date.

You received a compensation payment on the settlement of the class action case against the company.

The compensation payment was calculated under the loss assessment formula noted at schedule A of the settlement distribution scheme. This was based on your purchases of the company's shares during the relevant period.

You disposed of all your shares in the company and realised a capital loss.

You do not carry on a business of share trading.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 104-10

Reasons for decision

Summary

The compensation payment you received is considered a capital receipt and not ordinary income. This is because the compensation payment was paid in relation to a capital asset, and was not to compensate for a loss of income.

The payment is considered to be compensation for paying an excessive amount for an asset (the shares). Therefore, the compensation payment is treated as a recoupment of the cost base of the shares. Accordingly, no capital gain or loss arises in respect of that asset until you actually dispose of the underlying asset.

As you have already disposed of the shares in question, and incurred a capital loss, the capital loss incurred will need to be reduced by the amount of the compensation received. You should keep a record of the reduction in the capital loss to ensure that the correct amount of capital losses are carried forward to any future years

Detailed reasoning

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 the acquisition of the shares at an inflated price. As you are not carrying on a share trading business, your shares are considered a capital asset.

Accordingly, as the compensation was paid in relation to your capital asset it is regarded as a capital receipt and not ordinary income. Therefore, the compensation payment 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. Section 102-20 of the ITAA 1997 provides that 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 108-5 of the ITAA 1997 provides that a CGT asset is any kind of property; or a legal or equitable right that is not property.

Taxation Ruling TR 95/35 discusses the capital gains tax implications for compensation receipts. Paragraph 70 of TR 95/35 provides that in determining the most relevant asset in respect of which the compensation has been received, it is often appropriate to adopt a 'look-through' approach to the transaction which generates the compensation receipt.

The 'look-through' approach is defined in paragraph 3 of TR 95/35 to be:

…the process of identifying the most relevant asset. It requires an analysis of all of the possible assets of the taxpayer in order to determine the asset to which the compensation amount is most directly related.

The transaction which generated the compensation receipt is the acquisition of the shares. Applying the 'look-through' approach to the acquisition of shares, the most relevant asset to which the compensation most directly relates is the shares in the company. The compensation was for the acquisition of the shares at an inflated price. The compensation was calculated based on the date and the number of shares bought and sold.

Paragraph 10 of TR 95/35 provides that: 

If a taxpayer is compensated for having paid excessive consideration to acquire an asset, the amount referable to the overpayment represents a recoupment of all or part of the total acquisition costs of the asset.

Therefore, 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 you actually dispose of the underlying asset.

Capital gains tax consequences on the disposal of the CGT asset (shares)

Section 104-10 of the ITAA 1997 provides that CGT event A1 occurs when your ownership in a CGT asset (e.g. shares) is transferred to another entity. The time of the event is when you enter into a contract for the disposal, or, if there is no contract, the time of disposal is taken to be the time when the change in ownership occurs.

In your case, you have disposed of a CGT asset (the shares). Therefore CGT event A1 has happened in the year the ownership was transferred and the capital gains tax provisions will apply.

In your case, it has already been established that you have received compensation for paying excessive consideration to purchase the shares between the relevant period. The compensation amount received is considered a recoupment of the cost base of the asset and therefore the cost base of the asset (the shares) should be reduced by the amount received as compensation.

Accordingly, as you have already disposed of the shares and incurred a capital loss, you will need to adjust the amount of capital losses you have available to carry forward for future years.