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Ruling

Subject: Income Tax - Assessable Income-compensation receipts

Question 1

Is the insurance compensation receipt received in respect of permanent damage to a commercial rental property eligible for treatment under Subdivision 110-A of the Income Tax Assessment Act 1997 (ITAA 1997) as discussed in Taxation Ruling TR 95/35 (TR 95/35)? Specifically does the compensation receipt have the effect of reducing the cost base of the commercial rental property for capital gains tax (CGT) purposes?

Answer

Yes. The insurance compensation receipt is eligible for treatment under TR 95/35 and it reduces the cost base of the commercial rental property.

Question 2

If, and when, expenditure is incurred to repair the commercial rental property, please confirm that the treatment under section 110-25 of the ITAA 1997 and as discussed in TR 95/35 is to add the expenditure to the cost base of the commercial rental property for CGT purposes and that no deduction is available for the eligible repair expenditure?

Answer

Yes. Expenditure incurred on repairs is treated in accordance with the guidelines provided in TR 95/35 and no deduction is available.

This ruling applies for the following period:

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commences:

During the year ended 30 June 2012

Relevant facts and circumstances

The taxpayer owns a commercial rental property (the property).

The freehold land on which the building is constructed was owned by the taxpayer prior to 20 September 1985 and is therefore a pre-CGT asset.

The commercial building was constructed subsequent to 20 September 1985 and constitutes a separate CGT asset from the freehold land under the operation of the CGT provisions.

The property has been tenanted at all times during the period of ownership by the taxpayer.

During the particular year the property sustained a significant amount of damage as a result of a natural disaster.

The taxpayer engaged the services of an independent third party to assess the damage to the property.

The report concluded that the property sustained significant damage as a result of the natural disaster and gave a quotation for anticipated costs for repairing the damage and restoring the property to its original condition.

The property was insured and a claim for compensation was submitted to the insurer based on estimates to repair the property as noted above.

The insurance provider agreed to settle the claim on the basis of the report prepared plus associated costs and an insurance payout was received by the taxpayer during the recent income tax year.

Taxpayer utilised a portion of the insurance payout to attend to urgent repairs on the property. The remaining portion of the insurance payout has yet to be expended on repairs to the property.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 6-5(1)

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 Subdivision 20-A

Income Tax Assessment Act 1997 Division 43

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 section 104-155

Income Tax Assessment Act 1997 subsection 108-55(2)

Income Tax Assessment Act 1997 subsection 110-40(3)

Income Tax Assessment Act 1997 section 110-25

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 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 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 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, 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

Question 1

Summary

Compensation payments received in relation to permanent damage to or a permanent reduction in the value, of an underlying asset will be treated as a recoupment of all or part of the acquisition cost of the asset. That is, you reduce the cost base by the amount of compensation received.

Detailed reasoning

In accordance with section 6-5 of the ITAA 1997 assessable income includes income according to ordinary concepts which is called ordinary income. If you are an Australian resident your assessable income includes ordinary income derived directly or indirectly from all sources whether in or out of Australia during the income year.

Relevant factors in determining whether the compensation payments are ordinary income are determined by the character of the payment in the hands of the recipient.

Characteristics of income that have evolved from case law include receipts that:

· are earned

· are expected

· are relied upon

· have an element of periodicity, recurrence or regularity.

The insurance compensation receipt was not earned, and although the circumstances, that is, the natural disaster which caused damage to the property, resulted in a payment which was expected and relied upon, the payment was not one which can be attributed to the day to day carrying on of the business. The payment also has no element of periodicity, recurrence or regularity. Therefore, the character of the payment is not ordinary income under subsection 6-5(1) of the ITAA 1997.

Section 6-10 of the ITAA 1997 includes in your assessable income amounts that are not ordinary income but are included in your assessable income by provisions about assessable income which are called statutory income. The income received in the form of a compensation receipt or recoupment must be considered under those provisions.

Subdivision 20-A of the ITAA 1997 deals with insurance, indemnity and other recoupments. A 'recoupment' of a loss or outgoing is defined in subsection 20-25(1) of the ITAA 1997 to include any kind of recoupment, reimbursement, recovery, refund, insurance or indemnity.

Subsection 20-20(1) of the ITAA 1997 does not exclude the insurance compensation from being an assessable recoupment. However subsection 20-20(2) of the ITAA 1997 states that an amount you have received as recoupment of a loss or outgoing is an assessable recoupment if you received the amount by way of insurance or indemnity and you can deduct an amount for the loss or outgoing under any provision of the Act.

Paragraph 20-20(2)(b) of the ITAA 1997 requires a connection between the deduction and the loss or outgoing for which the taxpayer had been recouped. This issue is discussed in paragraph 11 of Taxation Determination TD 2006/31 which considers the phrase 'for the loss or outgoing' in the context of subsection 20-20(3) of the ITAA 1997. The 'loss or outgoing' referred to in paragraph 20-20(2)(b) of the ITAA 1997 would extend to a loss incurred as a result of the destruction of capital works.

The insurance proceeds were received for significant damage to capital assets being buildings and property and, therefore, as discussed in Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443; 10 ATD 82 and as is ordinarily the case, the amount paid to compensate for the loss acquires the character of that for which it is substituted. The insurance proceeds are therefore capital in nature, and there is no provision outside of Subdivision 20-A of the ITAA 1997 which specifically include the insurance proceeds in the taxpayer's assessable income.

Subsection 20-20(2) of the ITAA 1997 states that an amount you have received as recoupment of a loss or outgoing is an assessable recoupment if you received an amount by way of an insurance indemnity and you can deduct an amount for the loss or outgoing for the current year or earlier year under any provision of the Act.

The taxpayer cannot deduct an amount for the loss for which the insurance proceeds are received because the repair work required is capital in nature therefore the insurance proceeds received for the destruction of the capital works are not an assessable recoupment under section 20-20 of the ITAA 1997.

As it has been determined that the insurance compensation received is not assessable income it must be considered under the general CGT provisions which are set out in Part 3-1 of the ITAA 1997. Under the CGT provisions, you will make a capital gain or loss only if a CGT event happens.

To determine if a CGT event happens in respect of a compensation payment it is necessary to consider the nature of the asset to which the compensation payment relates with reference to the income tax legislation and the Commissioner's guidelines on the treatment of compensation payments.

The guidelines are set out in TR 95/35 which states that the particular asset for which compensation has been received by the taxpayer may be:

· an underlying asset;

· a right to seek compensation; or

· a notional asset in terms of section 104-155 of the ITAA 1997 (in relation to trusts)

Paragraph 3 of TR 95/35 provides helpful definitions for some of the key terms used in the ruling. In determining the most relevant asset for which the compensation was paid, the look-through approach 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.

Another key term defined is 'underlying asset' as the asset that, using the 'look-through' approach, is disposed of or has suffered permanent damage or has been permanently reduced in value because of some act, happening, transaction, occurrence or event which has resulted in a right to seek compensation from the person or entity causing that damage or loss in value or against any other person or entity.

As outlined in the 'facts', an independent assessment was made for the property damage and the insurance paid was an amount less than the estimate for repairs and restoration. The underlying asset for which the compensation has been awarded is the property comprising commercial buildings and land and little or no value has been attributed to the right to seek compensation or a notional asset.

Another defined term is 'permanent damage or reduction in value' which does not mean everlasting damage or reduced value, but refers to damage or reduction in value which will have a permanent effect unless some action is taken by the taxpayer to put it right.

In accordance with subsection 108-55(2) of the ITAA 1997 where a building or structure is contracted to be constructed, or where there is no contract is actually constructed after 20 September 1985 on land that you acquired before 20 September 1985, the building or structure can be taken to be a separate asset from the land.

Therefore, for CGT purposes there are two assets which suffered damage because the land and building are considered to be separate assets. One asset is the land which was purchased prior to 20 September 1985 and is therefore a pre-CGT asset. The other is the commercial building which was constructed on the land subsequent to 20 September 1985.

If there is more than one underlying asset, the relevant underlying asset is the asset which leads directly to the payment of the amount of compensation. In this case it is evident that the underlying asset is the commercial building.

Paragraphs 6 to 9 of TR 95/35 provide the following guidelines on the treatment of compensation for permanent damage to or permanent reduction in the value of the underlying asset:

If an amount of compensation is received by the 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 the underlying asset at the time of the receipt it is considered that the amount represents a recoupment of all or part of the total acquisition costs of the asset.

Accordingly, the total acquisition costs of the post-CGT asset should be reduced in terms of section 110-25 of the ITAA 1997 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 total acquisition costs effectively reduces those costs by the amount of the recoupment as if those costs had not been incurred.

Compensation received by a taxpayer has no CGT consequences if the underlying asset which has suffered permanent damage or a permanent reduction in value was acquired before 20 September 1985 or is any other exempt CGT asset. The portion of the compensation receipt allocated to the damage to the land which is a pre-CGT asset will have no effect on the value of that land for CGT purposes.

The taxpayer has received a compensation payment for the permanent damage and reduction in the value of the property and Subdivision 110-A of the ITAA 1997, which relates to the general rules about the 'cost base' of a CGT asset states that expenditure does not form part of any element of the cost base to the extent of any amount you have received as recoupment of it, except so far as the amount is included in your assessable income.

As discussed in TR 95/35 the insurance compensation payment received for the 'permanent' damage and reduction to the value of the property is treated as a 'recoupment' therefore the legislation applies to reduce the cost base of the property by the amount of that payment.

Question 2

Summary

Expenditure incurred on repairs to the property in relation to the event for which insurance compensation was received are not deductible however the expenditure will form part of the cost base of the property under Subdivision 110-A of the ITAA 1997 and as discussed in TR 95/35.

Detailed reasoning

Section 25-10 of the ITAA 1997 allows a deduction for the cost of repairs to premises used for income producing purposes. However subsection 25-10(3) of the ITAA 1997 precludes a deduction for repairs where the expenditure is of a capital nature.

Section 25-10 of the ITAA 1997 allows a deduction for expenditure incurred for repairs to premises or plant that you held or used solely for the purpose of producing assessable income. The word 'repair' is not defined within the tax legislation. Accordingly it takes its ordinary meaning. 'Repair' involves a restoration of a thing to a condition it formerly had without changing its character as discussed in W Thomas & Co v FC of T (1965) 115 CLR 58; (1965) 14 ATD 78; (1965) 9 AITR 710. In this context it is restoration of efficiency in function rather than exact repetition of form or material that is significant. Whether or not work done is properly described as a repair is a question of fact and degree.

Expenditure will be on capital account if it is for alterations that go beyond fixing damage accumulated during a taxpayer's use of an asset in producing income as discussed in BP Oil Refinery (Bulwer Island) Ltd v FC of T 92 ATC 4031; (1992) 23 ATR 65.

The repairs were required to be carried out on the property because of the major damage. The repairs were not required as the result of damage accumulated during the use of the property as an income producing asset. The degree of damage and resultant repair work required would indicate that the repairs or restoration are capital in nature. As discussed in ATO Interpretative Decision ATO ID 2011/82 the insurance proceeds are found to not be an assessable recoupment because the relevant loss or outgoing for which the taxpayer had been compensated was the destruction of capital works.

Division 43 of the ITAA 1997 generally allows a deduction for certain capital expenditure on assessable income producing buildings and other capital works in which the cost is amortised over a prescribed period of time.

The costs incurred in repairing the capital assets are not deductible however they would form part of the cost base of that asset under section 110-25 of the ITAA 1997.

The inclusion of the cost of repairs/restoration in the cost base of the property does not preclude a deduction under Division 43 of the ITAA 1997. However, any deduction claimable under that section is included when calculating the value of the cost base of the capital asset on disposal.

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