Edited version of your private ruling

Authorisation Number: 1012524208393

Ruling

Subject: Taxation of compensation payment received

Question 1

Is the payment you received to settle your legal action assessable income?

Answer 1

No.

Question 2

Is the payment you received to settle your legal action assessable as a capital gain?

Answers 2

Yes.

This ruling applies for the following period:

Year ended 30 June 2013

The scheme commences on:

1 July 2012

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:

· the application for private ruling dated mid-2013, and,

· the deed of settlement signed by you.

You were the owner of a property and you borrowed money from a finance lender and you mortgaged the property to secure the funds.

In 20XX the finance lender exercised their right as mortgagee and took possession of the property and a short time late they sold it by auction.

You alleged that the finance lender owed you certain monies following them taking possession of the property and selling it.

You commenced a legal action against the finance lender to recover the funds that you considered you were entitled to.

The finance lender denied that you were entitled to any funds.

To avoid the cost of litigation you reached a negotiated agreement with the finance lender and you also agreed to discontinue all action. You signed a deed of settlement in 2013.

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

Reasons for decision

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 you 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.

In your case, the payment you have received was not from rendering personal services, income from property or income from carrying on a business. Although the payment may have been expected and relied upon, it was not earned and was received in a lump sum.

Therefore, the compensation payment is not assessable ordinary income under section 6-5 of the ITAA 1997. However, it may be assessable as a capital gain under the capital gain tax provisions.

Capital gains tax (CGT)

Capital gains tax (CGT) is the tax you pay on certain capital gains that 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.

In most cases a capital gain arises when the capital proceeds you receive exceed the associated costs.

A CGT asset is any kind of property; or a legal or equitable right that is not property.

In your situation, you had an intangible asset in the form of a legal right to seek compensation.

For you, this asset came into existence in 20XX when the finance lender took possession of your property and you perceived there was a wrongdoing on their part that would be remedied by you exercising your right to seek compensation.

Taxation Ruling TR 95/35 discusses the capital gains tax implications for compensation receipts and this is relevant to your situation.

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.

When applying this 'look-through' approach to your settlement payment, the transaction which generated the compensation receipt for you was you exercising your right to seek compensation for your loss following the loss of your property.

You disposed of your asset, which was your right to seek compensation, in mid-2013 when you entered into the agreement with the finance lender and signed the deed of settlement.

Section 104-25(1) of the ITAA 1997 provides that a CGT C2 event happens when your ownership of an intangible CGT asset ends by the asset being surrendered discharged or cancelled.

The cost base of this asset that you surrendered is taken to be at least valued the same as the settlement amount, and for you this result in no capital gain or loss following your settlement of your legal action.

Therefore, as there is no capital gain to you following your settlement with your finance lender, you have no liability for capital gains tax.

Further issues for you to consider