Edited version of your private ruling

Authorisation Number: 1012570878021

Ruling

Subject: Compensation payment

Question 1

Does the compensation payment form part of your ordinary assessable income?

Answer

No.

Question 2

Is the compensation payment assessable under the capital gains tax provisions?

Answer

Yes.

Question 3

Are you entitled to claim a deduction for the legal expenses that you incurred?

Answer

No.

This ruling applies for the following period

Year ended 30 June 2014

The scheme commenced on

1 July 2013

Relevant facts

You were an employee.

You contacted your employer regarding your wish to transfer your superannuation contributions and earnings from the default fund to the cash option.

A few months later your employer advised you to contact entity A directly.

Sometime later, entity A received switch instructions from you.

The switch from the default option to the cash option took place.

The default fund suffered investment losses during the relevant period.

As a result you sought compensation for the loss suffered as a result of the delay in the advice provided by your employer.

Your employer offered you an amount as compensation. The settlement offer was on the condition that you cease any claim or proceedings in relation to the matter.

You sought advice in relation to the offer.

You signed a Release and Indemnity form and received your settlement payment in the relevant income year.

The amount of compensation was determined after taking into account all relevant information, including the lost superannuation calculations.

You incurred legal expenses in relation to the above matters.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 6-5

Income Tax Assessment Act 1997 subsection 6-10

Income Tax Assessment Act 1997 subsection 8-1

Reasons for decision

Ordinary income

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes the ordinary income they derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Ordinary income has generally been held to include three 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.

For income tax purposes, an amount paid to compensate for a loss generally acquires the character of that for which it is substituted (Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 AITR 443; 10 ATD 82).

Compensation payments which substitute income have been held by the courts to be income under ordinary concepts (Federal Commissioner of Taxation v. Inkster (1989) 24 FCR 53; (1989) 20 ATR 1516; 89 ATC 5142, Tinkler v. FC of T (1979) 10 ATR 411; 79 ATC 4641, and Case Y47 (1991) 22 ATR 3422; 91 ATC 433).

However, 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.

Taxation Determination TD 93/58 explains the circumstances in which a lump sum compensation/settlement payment is assessable, and states that such a payment is assessable income:

· if the payment is compensation for loss of income only (even when the basis of the calculation of the lump sum cannot be determined), or

· to the extent that a portion of the lump sum payment is identifiable and quantifiable as income. This will be possible where the parties either expressly or impliedly agree that a certain portion of the payment relates to a loss of an income nature.

You received your compensation payment as a result of lodging a claim for defective administration.

These payments were not earned by you as it does not relate to services performed 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. Although the payment can be said to be expected, and perhaps relied upon, this expectation arises from the defective administration, rather than from a relationship to personal services performed.

The payment for defective administration and losses in your superannuation account are regarded as capital in nature.

Your compensation payment does not lose its character as a capital receipt, even though it was calculated by reference to your lost superannuation benefits.

It is considered that no component of the amount you received was received to compensate you for loss of income. Therefore, your compensation is not assessable as ordinary income under section 6-5 of the ITAA 1997.

However, as the compensation is capital in nature, it is also necessary to consider the capital gains tax provisions.

Statutory income

Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but are included in assessable income by another provision, are called statutory income and are also included in assessable income.

These specific provisions are listed in section 10-5 of the ITAA 1997. The list includes capital gains, which are included in assessable income by virtue of the capital gains tax (CGT) provisions.

A capital gain or capital loss may arise if a CGT event happens to a CGT asset. Section 108-5 of the ITAA 1997 states that a CGT asset is any kind of property, or a legal or equitable right that is not property.

Taxation Ruling TR 95/35 considers the CGT consequences for a person who receives an amount as compensation. The ruling states that a right to seek compensation is an asset for the purposes of the CGT provisions, and that a right to seek compensation is:

· acquired at the time of the compensable wrong or injury, and

· disposed of when it is satisfied, surrendered, released or discharged.

In your case, a CGT event C2 occurred when your compensation was finalised.

No exemption applies in your specific circumstances.

Please note, the legal costs incurred form part of the cost base when calculating your capital gain/loss. Please also note that Division 115 of the ITAA 1997 allows a 50% CGT discount for individuals who own a CGT asset for more than 12 months.

Legal expenses

Section 8-1 of the ITAA 1997 allows a deduction for a loss or an outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature.

For legal expenses to constitute an allowable deduction, it must be shown that they are incidental or relevant to the production of the taxpayer's assessable income. Also, in determining whether a deduction for legal expenses is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature and the associated expenses will generally not be deductible.

The success or failure of the legal action does not determine the deductibility of the legal expenses incurred.

Legal expenses are generally deductible if they arise out of the day to day activities of the taxpayer's business (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169 (the Herald and Weekly Times Case)) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v. FC of T 80 ATC 4542; (1980) 11 ATR 276).

Taxation Determination TD 93/29 states: 

If the legal action goes beyond a claim for a revenue item such as wages, and constitutes an action for a breach of the contract of employment, the legal costs would not be deductible because they are capital in nature. For example, legal expenses relating to an action for damages for wrongful dismissal are not deductible.

Although your legal expenses do not relate to wrongful dismissal, the principles outlined above are relevant. In your case you incurred legal expenses in relation to defective administration from your previous employer. As outlined above, the compensation payment received is capital in nature.

Although the payment you received is subject to tax under the CGT provisions and is included as assessable income, this does not change the character of the payment.

Legal expenses incurred in relation to your compensation do not relate to your previous employment duties. Such expenses are not deductible as they are capital in nature. Therefore no deduction is allowable under section 8-1 of the ITAA 1997 for the associated legal expenses.