Edited version of your private ruling

Authorisation Number: 1012598224967

Ruling

Subject: Compensation payments

Question 1

Is the lump sum compensation payment you received assessable as ordinary income?

Answer

No.

Question 2

Do the capital gains tax (CGT) provisions apply to the lump sum compensation payment received?

Answer

Yes.

Question 3

Does the compensation payment reduce the cost base of the asset that was the subject of the claim for compensation?

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 and your spouse sought financial advice from a financial planner.

You accepted the advice given and entered into an investment strategy whereby you invested a sum of money in a range of investments.

The investments were funded by investment loans with financial institutions.

Since the initial investment you have declared income and claimed deductions in relation to the investment portfolio in your income tax returns.

In order to meet the interest payments you had to extend your loan with one of the financial institutions.

Over a period of time the value of the underlying investments had fallen to below their original cost.

Sometime later you made a complaint to the financial planner that the investment strategy was very high risk and inappropriate for unsophisticated investors of modest means.

You then signed a deed of release with the financial planner. The deed of release provided that the financial planner admitted no liability, but agreed to pay you a sum of money to release them from any further claims or proceedings in relation to the matter. You were paid the sum of money soon after.

You used the proceeds to pay out your loan with a financial institution. You then sold all but one of the underlying investments in your portfolio. The proceeds from these sales were used to pay down a loan from a financial institution.

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

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).

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.

The compensation received 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.

You received compensation for incorrect advice made by your financial planner in relation to your investment portfolio.

As the compensation relates to your investment portfolio, it is considered to be a capital receipt and is not ordinary income. Therefore the compensation is not assessable ordinary income under section 6-5 of the ITAA 1997.

Capital gains

CGT is the tax you pay on certain gains you make. Section 102-20 of the ITAA 1997 provides that you make a capital gain or capital loss as a result of a CGT event happening. For most CGT events, your capital gain is the difference between your capital proceeds and the cost base of your 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.

Taxation Ruling TR 95/35 discusses the CGT implications for compensation receipts. 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 'look-through' approach is 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. It is also referred to in this Ruling as the underlying asset approach.

'Underlying asset' is also defined in paragraph 3 of TR 95/35 as:

The underlying asset is 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.

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. For example, if a taxpayer receives an amount of compensation for the destruction of his or her truck, the truck is the underlying asset.

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, we consider 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.

In your case, the underlying asset is the value of the investment portfolio and as a result of the actions of your financial advisor the value of the asset was reduced. Although in the future the value of your assets may have increased to the point where it exceeds what it was before the loss occurred, the value of your portfolio will always be lower than what it could have been had the loss not occurred. Therefore, it is considered that there has been a permanent reduction in value of your investment. As such the cost base of the investment is reduced by the compensation you received.

The rulings in the register have been edited and may not contain all the factual details relevant to each decision. Do not use the register to predict ATO policy or decisions.