Edited version of your private ruling

Authorisation Number: 1012491285540

Ruling

Subject: Settlement payment

Question

Does all or part of the settlement amount form part of your assessable income?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2013

The scheme commences on:

1 July 2012

Relevant facts and circumstances

You are in the business of developing, manufacturing and selling a product.

You entered into a distribution contract with Company X where Company X would be the exclusive distributor of your products in Australia.

Company Y also entered into a contract with Company X in relation to other products.

You and Company Y took legal action against Company X as they breached the contracts.

As part of the legal action you sought damages for:

· losses on the shortfall on products not purchased

· losses relating to sales you would have made to Company X during the remaining period of the contract

· reimbursement for promotional materials which were no longer useable due to the breach.

Company X lodged a counterclaim against you and Company Y.

During the relevant financial year you, Company Y, and Company X reached a settlement of all claims and disputes. The settlement was embodied in a Deed of Settlement and Guarantee which was later varied. Under the settlement and its variation you were to receive:

· a contribution to your legal expenses, and

· an ex-gratia payment made to resolve the aspects of the dispute.

The settlement payment was paid in instalments.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 6-5(2)

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 10-5

Income Tax Assessment Act 1997 Subsection 20-20

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 108-5

Reasons for decision

Summary

The payment you received upon settlement forms part of your assessable income. The ex-gratia payment is subject to capital gains tax. The contribution to your legal expenses is assessable to the extent that the legal expenses are deductible.

Detailed reasoning

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year.

The term 'ordinary income' is not defined but its meaning has evolved and certain tests have been established to determine whether the receipts can be deemed as ordinary income. Generally, ordinary income refers to receipts that have an element of periodicity, recurrence or regularity. Typical examples include salaries, wages, rental income, dividends, interest and proceeds from carrying on a business.

Whilst the settlement amount was paid in instalments, this is viewed as not being sufficient to give the payment an element of periodicity. It is considered that the settlement payment does not constitute ordinary income.

Section 6-10 of the ITAA 1997 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.

Section 10-5 of the ITAA 1997 lists those provisions about statutory income. The most relevant sections in relation to your situation are:

· section 20-20 of the ITAA 1997 in relation to the contribution to your legal expenses, and

· section 102-5 of the ITAA 1997 in relation to the ex gratia payment.

Contribution to legal expenses

Taxation Ruling TR 2012/8 discusses the assessability of amounts received to reimburse legal costs. Whilst the ruling focusses on disputes concerning termination of employment the principles and discussions contained within the ruling can be applied to your situation.

Legal cost payments or awards are made to reimburse the legal costs incurred in engaging legal proceedings. A settlement sum paid in respect of a claim for legal costs is for the purpose of indemnifying the successful party for the professional legal expenses incurred in bringing the legal action to the point at which it is settled.

Legal costs take their character as an outgoing of capital or revenue nature from the cause or purpose of incurring the expenditure. If the advantage to be gained is of a revenue nature, then the costs incurred in gaining the advantage will also be of a revenue nature.

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income or a provision of the taxation legislation excludes it.

A court ordered award or settlement sum identifiable as an amount paid in relation to legal costs may be an assessable recoupment if the recipient's underlying legal costs were deductible.

Subsection 20-20(2) of the ITAA 1997 provides that an amount you have received as a recoupment of a loss of 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 for the current year, or you have deducted or can deduct an amount for it in an earlier income year, under any provision of this Act.

If an amount is recouped by way of settlement of a claim for legal costs, it will be an assessable recoupment under subsection 20-20(2) of the ITAA 1997 where the purpose of the settlement is to indemnify the recipient for professional legal costs actually incurred in the conduct of the litigation, where the legal costs were deductible.

You instigated legal action seeking compensation for past and future lost sales income and reimbursement for wasted promotional materials. If received, the compensation amounts would have been assessable to you. Thus, you are entitled to claim deductions for the legal expenses incurred in taking this action.

As the settlement provided for a contribution towards your legal expenses and the legal expenses were deductible, this contribution is an assessable recoupment.

Ex gratia payment

Section 102-5 of the ITAA 1997 provides that a taxpayer's assessable income includes the amount of any capital gains. Section 102-20 of the ITAA 1997 provides that a capital gain is only made if a capital gains tax (CGT) event happens. A CGT event is generally something that happens in relation to a CGT asset.

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. The wide definition of the term 'asset' in section 108-5 of the ITAA 1997 would include the right to seek compensation. This is reinforced by Taxation Ruling TR 95/35 when it states:

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 the CGT provisions.

The ex gratia payments you received are for a final settlement to resolve the disputes between yourself and Company X. The CGT asset to which your payments relate is the right to seek compensation.

According to section 104-25 of the ITAA 1997, CGT event C2 occurs in relation to a right to seek compensation. You will make a capital gain if the capital proceeds from the ending of your right to seek compensation are more than the cost base of the asset.

Taxation Ruling TR 95/35 provides guidance on the calculation of the cost base of the right to seek compensation. Generally, the cost base is its acquisition cost plus any incidental costs. In your case incidental costs would include the legal fees and charges associated or connected with any legal action taken to obtain the settlement payments.

The cost base does not include any expenditure which has been or can be deducted. However, where Division 20 of the ITAA 1997 reverses the deduction by including the amount in your assessable income, that is, as an assessable recoupment, you can include the amount of the assessable recoupment in calculating the cost base of the asset.

The legal expenses to be included in the cost base calculations is an amount equal to the assessable recoupment.

Therefore, a capital gain will be made if the ex gratia payment exceeds the incidental costs associated with receiving the payment. The net capital gain will form part of your assessable income in the relevant financial year.