Edited version of your private ruling

Authorisation Number: 1012438714431

Ruling

Subject: Compensation income

Questions and answers:

1. Will the portion of the compensation payment relating to the loss in value of your investment be assessable as ordinary income for income tax purposes?

No.

2. Did you make a capital loss when you disposed of your investment?

Yes.

3. Will the non-financial loss portion of the compensation payment be assessable for income tax purposes?

No.

4. Will the interest portion of the compensation payment be assessable for income tax purposes?

Yes.

This ruling applies for the following period

Year ending 30 June 2013

The scheme commenced on

1 July 2012

Relevant facts and circumstances

You placed funds in a managed investment (the investment) recommended by a financial adviser which decreased in value and were subsequently frozen.

You lodged a complaint with the Financial Ombudsman Service (FOS) seeking compensation for the loss in value of your investment due to the conduct of the adviser and the financial services provider (FSP).

The FOS found that the adviser and FSP had breached their responsibilities as at a certain date.

The FOS determined that the FSP should pay you compensation comprising of components for the loss in value of your investment, 'non-financial' loss and interest.

You signed an agreement accepting the compensation.

Part of the determination and agreement was that you would give up your rights to the frozen investment to the FSP on receipt of the compensation payment from the FSP.

The FOS determination states that interest was to be calculated from the date of the breach until the time the payment was made to you to ensure that the 'real value of the compensation was maintained'.

The FOS determination states that the interest amount calculated was to be based on the value of your investment at the time of the breach.

The FOS determination states that it may award compensation for 'non-financial' loss where there has been an unusual degree or extent of physical inconvenience, time taken to resolve the situation or interference with the applicant's expectation of enjoyment or peace of mind.

In relation to compensation for non-financial loss, the FOS determination notes that you referred to the 'financial strain and stress' you felt in relation to your investment loss and dealings with the FSP.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10

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

Reasons for decision

Will the portion of the lump sum compensation payment relating to the loss in value of your investment be 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).

An amount paid as compensation generally acquires the character of that for which it is substituted. If a lump sum payment is paid for the loss of a capital asset or amount then it will be regarded as a capital receipt and not ordinary income.

In your case, you received a lump sum payment to compensate you for the loss in value of your investment, that is, a loss of your investment capital.

Therefore, the lump sum payment is a capital receipt and is not assessable (taxable) as ordinary income.

Did you make a capital loss when you disposed of your investment?

Capital gains tax (CGT) is the tax you pay on a capital gain. You make a capital gain, or a capital loss, as a result of a CGT event happening to a CGT asset you own. The most common event is CGT event A1 which happens when you dispose of an asset such as a house, a shareholding or a managed fund investment.

A capital gain, or capital loss, is the difference between what it cost you to get an asset and what you received when you disposed of it.

Taxation Ruling TR 95/35 Income tax: capital gains; treatment of compensation receipts (TR 95/35) deals with the capital gains treatment of compensation receipts. An amount paid as compensation generally acquires the character of that for which it is substituted. Therefore, a compensation payment that is a substitute for an asset, such as a managed fund, will be treated as part of that asset for capital gains purposes.

Where compensation is received for the permanent damage or reduction in value of an asset there will be no capital gain or loss made until the asset is disposed of. The compensation amount received is treated as a recoupment of all or part of the original acquisition cost of the asset.

In your case, you placed funds in an investment which decreased in value and was subsequently frozen. You accepted a lump sum payment to compensate you for the loss in value of your investment and in exchange you gave up your rights to the frozen investment.

Therefore, you disposed of your managed investment when you gave up your rights to it which is CGT event A1. You made a capital loss as the amount you received for your investment by way of compensation was less than what you originally invested.

You made a capital loss on your investment and will not have to pay tax on the lump sum payment you received.

Additional information

When you make a capital loss, you cannot claim it against the other income on your income tax return but you can use it to reduce a capital gain you have in the same income year. If you don't have a capital gain in the same income year you can generally carry the capital loss forward on your income tax return and deduct it against any capital gain you have in future years.

Non-financial loss portion of the compensation payment

Is the non-financial loss portion of the lump sum compensation payment assessable as ordinary income?

As previously mentioned, the assessable income of a taxpayer includes income according to ordinary concepts and an amount paid as compensation generally acquires the character of that for which it is substituted.

If a lump sum payment is paid for the loss of a capital asset or amount then it will be regarded as a capital receipt and not ordinary income.

In your case, the lump sum payment you received for non-financial loss is compensation for a personal wrong you suffered.

The lump sum payment is a capital receipt and is not ordinary income. Therefore the amount is not assessable (taxable) as ordinary income.

Is the non-financial loss portion of the lump sum compensation payment assessable as a capital gain?

Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but may be assessable under another provision are called statutory income.

Receipt of a lump sum payment may give rise to a capital gain (statutory income). However paragraph 118-37(1)(b) of the ITAA 1997 disregards payments or receipts for capital gains purposes where the amount relates to compensation or damages a person receives for any personal wrong, injury or illness.

In your case, the lump sum payment you received for non-financial loss is compensation for a personal wrong you suffered.

Therefore, the payment will not be assessable as a capital gain and will not be taxable.

Interest portion of the compensation payment

Is the interest portion of the lump sum payment assessable as ordinary income?

As previously mentioned, the assessable income of a taxpayer includes income according to ordinary concepts.

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.

Interest income is an example of ordinary income as it is expected, relied on and has an element of periodicity, recurrence or regularity.

In your case, you received a lump sum payment to compensate you for the interest you could have earned on your investment. Although the payment may have been expected and relied upon, it was not earned and was received in a lump sum.

However, as previously mentioned, an amount paid as compensation generally acquires the character of that for which it is substituted. As such, paragraph 26 of TR 95/35 states that where interest is awarded as part of a compensation amount it will be regarded as ordinary income, not a capital receipt. It will be taxable in the same way as periodic interest income is.

This is confirmed in ATO Interpretive Decision ID 2003/404 Income Tax - Assessable income: lump sum compensation - pre-judgment interest - non personal injury. Where compensation is not paid for personal injury and the interest calculation is based on an amount identifiable before the judgment or determination is made, the interest will be assessable as ordinary income.

In your case, the interest amount calculated was based on the value of your investment at the time of the FSP's breach. Therefore, the interest component of the compensation payment you received is assessable (taxable) income and will have to be included on your income tax return.

We acknowledge your particular personal circumstances; however the Commissioner of Taxation has no discretion or power to exempt individual taxpayers from paying tax where the law says it must be paid.

Although the interest amount you received relates to several income years, the full amount is assessable in the current year as it only became payable to you as a result of the determination and agreement that occurred in this income year. The full amount of the interest component should be included in your income tax return for the relevant income tax year.

Summary

The amount you received to compensate you for the loss in value of your investment will result in a capital loss and will not be taxable, and the amount you received to compensate you for non-financial loss is not taxable. However, the amount you received to compensate you for loss of interest is taxable in the current income tax year.