Edited version of your private ruling

Authorisation Number: 1012605869036

Ruling

Subject: Capital gains tax treatment of compensation receipts

Question

Is the lump sum settlement amount received by the Partnership a capital gains tax (CGT) asset for the purposes of Division 108 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following period:

Year ending 30 June 2012

The scheme commences on:

1 July 2011

Relevant facts and circumstances

1. A farming business is operating as a partnership, known as X ("the Partnership");

2. The Partnership is composed of X individuals (the "partners").

3. The partners to the Partnership are Australian residents for income tax purposes;

4. The farmland is owned by X;

5. There is an implied lease between the owners of the farmland, and the Partnership.

6. A fire on the farm property caused damage to livestock, crop, fencing, and farming machinery, as well as substantial damage to the underlying land;

7. The initial claim for the damage to the farm property was calculated by reference to discrete heads of loss, and amounted to $xx, exclusive of GST, and inclusive of costs and interest;

8. Following an informal conference, a settlement was reached, and an undissected settlement amount of $xx (plus costs of $xx) was awarded to the Partnership;

9. As stated by Y (representatives for the Partnership) in their letter dated xx/yy/zzzz:

We confirm that no inference can be drawn from the settlement sum as to how much was allowed in relation to each head of claim, including interest.

Relevant legislative provisions

Section 116-40 of the Income Tax Assessment Act 1997

Division 108 of the Income Tax Assessment Act 1997

Section 108-5 of the Income Tax Assessment Act 1997

Reasons for decision

Issue

Capital gains tax treatment of compensation receipts

Question

Is the lump sum settlement amount received by the Partnership a capital gains tax (CGT) asset for the purposes of Division 108 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

The compensation payment is an undissected lump sum, and the Partnership's lawyers have confirmed that it is incapable of being allocated to specific heads of loss, on any reasonable basis.

Therefore, the compensation payment relates to the disposal of the right to seek compensation, and in this instance, the relevant CGT asset is the 'right to seek compensation' or the 'right to give up the right to seek compensation'.

Detailed reasoning

Is the lump sum compensation payment an asset for CGT purposes?

Taxation ruling TR 95/35 income tax: capital gain: treatment of compensation receipts (TR 95/35) sets out the Commissioner's views on the capital gains tax (CGT) implications of compensation payments under the corresponding provision of the Income Tax Assessment 1936 (ITAA 1936).

Notwithstanding the provisions referred to in TR 95/35, the ruling continues to be binding on the Commissioner, to the extent that the Income Tax Assessment Act 1997 (ITAA 1997) provisions express the same idea as those referred to in the ITAA 1936.

The effect of TR 95/35, as applied to the ITAA 1997, is that if compensation relates to a number of heads of claim, section 116-40 of the ITAA 1997 requires the taxpayer to apportion the compensation on a 'reasonable basis' to each of those claims.

However, TR 95/35 also states that, if the taxpayer cannot, or does not, make a reasonable estimate, valuation, or calculation of the amounts that are reasonably attributable to each claim, the ATO will make the allocation using the information that is available in relation to those claims.

Apportionment of receipts

In some circumstances a single receipt of a mixed capital and income nature may be apportioned between capital and ordinary income respectively. Such a receipt cannot, however, be thus apportioned where the payment is in respect of a claim, or claims, for unliquidated damages only, and is made under a compromise that treats it as a single, undissected amount of damages.

Where the compensation receipt is a lump sum that includes unliquidated damages, the question is whether, from the matrix of surrounding facts, there is any basis for apportionment.

The CGT provisions treat the right to sue for damages (or the right to give up the right to sue) as an asset, which can be disposed of by obtaining an award of damages, or by accepting a settlement amount. Paragraph 3 of TR 95/35 defines an undissected lump sum compensation receipt as:

Any amount of compensation received by the taxpayer where the components of the receipt have not been and cannot be determined or otherwise valued or reasonably estimated.

Paragraph 69 of TR 95/35 states that the particular asset of which compensation has been received by the taxpayer may be:

1. An underlying asset;

2. A right to seek compensation; or

3. A notional asset.

The 'underlying asset' approach

As explained at paragraph 70 of TR 95/35, in determining what the most relevant asset is, it is often appropriate to adopt a 'look through' approach to the transaction or arrangement that generates the compensation receipt.

Paragraph 82 of TR 95/35 elaborates by stating that the taxpayer must be able to show that the compensation receipt has a 'direct and substantial link' with the underlying asset.

In accordance with paragraph 83 of TR 95/35, if the compensation receipt relates to more than one relevant asset, the compensation needs to be apportioned between those assets. Similarly, if the amount received is for a number of heads of claim (e.g. lost profits, interest and punitive damages) the amount also needs to be apportioned between the items.

Undissected lump sum compensation amounts

As explained at paragraph 188 of TR 95/35, whether a receipt constitutes income or capital in the hands of the taxpayer depends on the circumstances of the receipt, and the reasons why it was paid to the taxpayer.

As discussed at paragraph 190 of TR 95/35, it has been argued that 'the mere fact that compensation has been awarded as a lump sum, and has not been dissected into its component elements', is a sufficient reason to treat the whole receipt as one of capital.

However, the ATO does not accept the above argument per se. In the Commissioner's view, the facts and circumstances surrounding the receipt may still enable an apportionment of the lump sum payment on a 'reasonable basis' into its constituent elements.

Can the lump sum payment be apportioned on a reasonable basis?

The case of McLaurin v. FC of T (1961) 104 CLR 381 (the "McLaurin case") is discussed at paragraphs 190 to 194 of TR 95/35. In that case the taxpayer accepted the defendant's offer of a lesser amount as a lump sum in full settlement of his claim. However, the taxpayer accepted the sum without knowing the basis of the final calculation. The Commissioner sought to assess the taxpayer on that portion of the lump sum that was of an income nature, based on the defendant's list of particulars.

The High Court in the McLaurin case held that the lump sum was not assessable income because the settlement offer was for a single undissected amount, rather than for a total of itemised amounts, and that it would have been unacceptable to determine the character of the receipt in the hands of the recipient by taking into account the uncommunicated reasoning of the payer.

The court stated that no apportionment is appropriate if the receipt is in respect of a claim, or claims, for unliquidated damages only, and is made, or accepted, under a compromise that treats it as a single undissected amount of damages.

However, the court also stated that a single receipt of a mixed nature may be apportioned across the several heads to which it relates, and an income or non-income nature may be attributed to those heads of claim. This apportionment may be done if the amount is 'in settlement of distinct claims of which some at least are liquidated', or are otherwise ascertainable by calculation.

Paragraph 196 of TR 95/35 explains that the Commissioner does not consider the relevant case law to preclude a proportionate approach to identifying and allocating amounts of compensation to the various heads of claim if the taxpayer receives a single undissected lump sum in satisfaction of those claims.

What if the lump sum payment is unable to be allocated on any reasonable basis?

As discussed at paragraph 204 of TR 95/35, if the compensation payment is unable to be allocated on any reasonable basis (for example, because there is insufficient information on the claims made, or the basis of acceptance of the compensation) the Commissioner considers that the whole amount of the compensation must relate to the disposal of the right to seek compensation.

Therefore, if the compensation relates to a number of heads of claim, or causes of action, but the individual components of the compensation cannot be determined or estimated, no part of the compensation can be said to relate to any particular claim.

In the above circumstances, the Commissioner treats damages as being capital proceeds for the release, discharge or satisfaction of the cause of action within the meaning of CGT event C2. Example 13 in TR 95/35 provides helpful guidance, as detailed below:

Example 13 (variation of example 3)

294. The same facts as in Example 3 except that on 10 March 1993 Benny simply accepts a lump sum of $100,000 to settle the matter without any reference to the components of the payment. Benny does not provide a reasonable break-up of this payment, and does not furnish particulars of his claim for compensation.

Therefore, in accordance with the above, where there is no underlying asset to which the compensation relates, the Commissioner treats the compensation as relating to the disposal of an asset consisting of the "right to seek compensation".

The right to seek compensation is the right of action, arising at law or in equity, which vests with the taxpayer on the occurrence of any breach of contract, personal injury, or other compensable damage or injury, and is a 'CGT asset' for the purposes of Part 3-1 of the ITAA 1997, and more specifically, section 108-5 of the ITAA 1997.

Application to the Partnership

The lawyers for the taxpayer have confirmed that 'no inference can be drawn from the settlement sum as to how much was allowed in relation to each head of claim, including interest'. Therefore, as the settlement deed does not apportion the damages between the difference heads of claim, the Commissioner's view at paragraph 205 of TR 95/35 applies, as detailed below:

If the compensation is unable to be allocated on any reasonable basis (for example, because there is insufficient information on the claims made or the basis of the acceptance of the compensation) we consider that the whole amount of compensation must relate to the disposal of the right to seek compensation.

Therefore, in accordance with the above, and based on the relevant facts, the underlying asset approach cannot be applied to this situation, and the most relevant asset would be the 'right to seek compensation'.