Edited version of private advice

Authorisation Number: 1012622144569

Ruling

Subject: General insurance proceeds and life insurance proceeds

All legislative references are to the ITAA 1997 unless otherwise specified

Issue 1 Question 1

Is Company X required to include the amount received under the general insurance policy covering the destroyed asset in its assessable income under section 6-5 or Subdivision 20 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Issue 1 Question 2

Is the lessee able to deduct in full the amount it will pay to the lessor to cover the payout of the lease over the destroyed asset under section 8-1 or section 25-110 of the ITAA 1997?

Answer

Yes

Issue 1 Question 3

Is Company X able to deduct in full the amount it will pay to the lessee to cover the payout of the lease over the destroyed asset under section 8-1 or section 25-110 of the ITAA 1997?

Answer

Yes

Issue 1 Question 4

Is the lessee required to include the amount it will receive from Company X to cover the lease payment over the destroyed asset in its assessable income under section 6-5 of the ITAA 1997?

Answer

Yes

This ruling applies for the following period:

Year ending 30 June 2014

The scheme commences on:

1 July 2013

Issue 2 Question 1

Is the lessee able to deduct the amount applied by the lessor to reduce the balance due on all remaining leases to nil under section 8-1 or section 25-110 of the ITAA 1997?

Answer

No

Issue 2 Question 2

Is the executrix of the estate of B required to include the amount received from the lessor, the difference between the life insurance proceeds and the lease payout amount on all remaining assets, in its assessable income under section 6-5 or section 15-2 of the ITAA 1997?

Answer

No

This ruling applies for the following period:

Year ending 30 June 2014

The scheme commences on:

1 July 2013

Issue 3 Question 1

Is the lessee deemed to have acquired the assets at their market value under section 40-185 of the ITAA 1997?

Answer

No

This ruling applies for the following period:

Year ending 30 June 2014

The scheme commences on:

1 July 2013

Relevant facts and circumstances

The lessee and Company X were owned byB and B.

The lessee is in the business of hiring out leased assets.

Company X carries on a business with the assets leased by the lessee from the lessor. It paid the lessee hiring fees for the use of these assets.

The lessee and the lessor entered into a separate lease agreement for each of the leased assets. The lease agreements set out the obligations of the lessee and provided that, in the event of a total loss of the insured goods, the lessee must pay to the lessor the balance due on the leases.

At the end of the lease term, the assets would be transferred to the lessee at their residual values. This was the understanding of the parties; the contracts did not oblige the parties to do so.

The lessee took out a general insurance policy for each of the assets as per the terms of the lease agreement. Both the lessor and Company X were named as "The Insured" with the lessor being the first loss payee - a term used to describe a common practice which serves to protect the interest of a lessor when there is finance on the insured goods.

However, it was the understanding of the parties that Company X would be responsible for the insurance premiums and any insurance proceeds belonged to Company X, with the requirement that the lease be terminated out of these proceeds (referred to as the informal agreement for the purpose of this ruling). Company X has claimed the payments as operating expenses.

There is no written agreement to formalise this arrangement.

B arranged a life insurance policy on his life at about the same time as the leases were entered into. Company X has paid the premiums in relation to this policy.

The life insurance policy owner and beneficiary was the lessor.

The intention was to ensure that if something happened to B, there would be sufficient money available for the lessee to pay out the remaining leases.

B died recently and one of the leased assets was destroyed.

As per the informal agreement and the subsequent instruction of the lessor to the insurer, Company X has received the payout for the destroyed asset. A sufficient amount out of the proceeds has been paid out by Company X on the remaining lease of this asset.

The lessor, as the sole owner and beneficiary of the life insurance policy, has also received the proceeds.

The final payout on all remaining leases is less than the insurance proceeds received.

The lessor has decided to:

• finalise the outstanding leases on the remaining asset, so that there is no amount owing by the lessee or Company X to the lessor; and

• pay the surplus of the insurance proceeds to the estate of B (the difference between the life insurance policy and the amount required to pay out the remaining leases).

After the lease amounts have been paid out on the remaining assets, the lessor will transfer the ownership of the assets to the lessee.

Relevant legislative provisions

Section 6-5 of the ITAA 1997

Section 6-10 of the ITAA 1997

Section 8-1 of the ITAA 1997

Section 15-2 of the ITAA 1997

Division 40 of the ITAA 1997

Subdivision 20-A of the ITAA 1997

Section 25-110 of the ITAA 1997

Reasons for decision

Issue 1

Question 1

In order to determine whether Company X is assessable on the insurance proceeds under section 6-5 or Subdivision 20-A, it is necessary to first consider who is entitled to the money due to the unusual structure of the lease and insurance arrangements.

The general insurance policy covers the contingency of total or partial loss of the leased asset. One notable feature of the arrangement is that whilst the policy was taken out by the lessee pursuant to the lease agreement, the lessee is not listed on the policy. Both the lessor and Company X are named as "The Insured" with a financial interest in the asset. The lessor is a first loss payee - a term used to describe a common practice which protects the interest of a lessor when there is finance on an insured item.

The applicant claims that the insurance policy was set up incorrectly and did not reflect the intention of the parties involved. According to the applicant, the parties were of the understanding that the proceeds belonged to Company X with the requirement that the lease be terminated out of these proceeds."

This was in addition to the requirement that Company X paid the insurance premiums.

The purpose of the insurance was to allow the lessee to pay out the balance due on the lease in the event of a total or partial loss of the asset. The events which have occurred since the lease was taken out correspond to the terms of this informal agreement. Company X, as the operator, has paid the insurance premiums and claimed the payments as operating expenses. The insurer has paid to Company X the insurance proceeds under the instruction of the lessor and Company X has applied the proceeds to pay out the remaining lease on the destroyed asset. These facts are in line with the intention of the parties as asserted.

We have considered the alternative view that legally the insurance proceeds belong to the lessor as it is the first loss payee and should therefore be assessed on the receipt. If this view were accepted, then there would have been no need for Company X to pay out the remaining lease as the proceeds would have covered the lost asset, otherwise it would have resulted in the undesirable outcome of double-taxation where the lessor would be assessable on the insurance proceeds and again on the lease payout. We do not accept that this alternative approach is correct or appropriate.

Viewing the arrangement objectively, the facts and the informal agreement tend to support the conclusion that Company X was the intended owner of the insurance proceeds who had the obligation to transfer to the lessee the money needed to pay out the lease. Accordingly, Company X is considered to be the legal owner of the money received under the insurance policy covering the destroyed asset.

Assessable recoupment

Subdivision 20-A operates to include in assessable income certain amounts received by way of insurance, indemnity or other recoupment. Subdivision 20-A does not apply, however, to amounts that are ordinary income or that are included in assessable income by any other provision.

Subsection 20-25(1) defines recoupment to include any kind of reimbursement, refund, insurance, indemnity or recovery, or a grant in respect of the loss or outgoing.

Under paragraph 20-20(2)(b), recoupment of a loss or outgoing received by way of insurance or indemnity is only an assessable recoupment if the taxpayer can deduct an amount for the loss or outgoing for the current year, or has deducted or is able to deduct an amount for it for an earlier income year, under any provision of the ITAA 1997.

As determined in Question 3 below, Company X is entitled to claim the amount out of the insurance proceeds it will pay to the lessee to cover the payout of the lease over the destroyed asset under section 8-1. The money received under the insurance policy is therefore a recoupment of a deductible outgoing. It follows that it is an assessable recoupment to Company X for the purpose of subsection 20-20(2).

Ordinary income

Section 6-5 includes in assessable income receipts which can be categorised as income according to ordinary concepts.

An amount will generally be the income of a taxpayer in any of the following situations:

• if the taxpayer is carrying on a business and the gain arises from a transaction which is made in the ordinary course of business;

• if the taxpayer is carrying on a business and the gain arises from a transaction which is outside the ordinary course of business but is nevertheless closely connected to the business;

• if the taxpayer is carrying on a business and the gain arises from a transaction which is not in the ordinary course of business and is not closely connected to the business, but the taxpayer made the gain from a profit-making undertaking or scheme. That is, the transaction was entered into for a profit-making purpose.

The amount received under the general insurance policy was not received in the ordinary course of business by Company X or to compensate Company X for loss of income. It was paid to Company X to discharge its obligation to the lessee as per the informal agreement regarding the destruction of the leased asset. The receipt was outside the ordinary course of Company X's business and did not result from a profit-making undertaking or scheme but, nevertheless, was closely connected to its business. Accordingly, the insurance proceeds constitute ordinary income under section 6-5.

As the insurance proceeds are assessable income under section 6-5, it is not assessable to Company X under Subdivision 20-A as an assessable recoupment.

Question 2

Section 25-110

Section 25-110 provides a deduction for capital expenditure incurred to terminate a lease. The amount of the deduction is 20% of the expenditure in the income year in which the lease is terminated and in each of the next four years: subsection 25-110(2).

For expenditure to be within the scope of section 25-110, it must be capital in nature and result in the termination of a lease under one of the following two circumstances:

• in the course of carrying on a business, or

• in connection with ceasing to carry on a business.

The asset was used by Company X in carrying out its business activities. The loss of the asset subsequently led to the termination of the lease under the terms of the agreement. The lease was therefore terminated in the course of carrying on a business.

The critical question to consider is whether the termination payment is of a revenue or capital nature.

In Brisbane Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 at 213-14, Viscount Cave LC outlined the characteristics of capital expenditure:

But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason … for treating such an expenditure as properly attributable not to revenue but to capital.

In Colonial Mutual Life Assurance Society Ltd v. Federal Commissioner of Taxation (1953) 89 CLR 428; (1953) 10 ATD 274 Fullager J stated that, at page 454, the questions which commonly arose were:

1. What is the expenditure or loss really for?

2. Is the expenditure really for, in truth and in substance, a capital asset?

In another leading case on the distinction between income and capital Sun Newspapers Limited v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 23; (1938) 1 AITR 403, Dixon J considered that the difference between capital and revenue expenses was reflected in the relationship of the expenditure to the business structure itself or to the business operations. Dixon J stated that there were three matters to be considered when deciding whether expenditure incurred was revenue or capital in nature:

…(a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adapted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so at to secure future use or enjoyment.

The same issue was also examined in Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 8 ATD 190; (1946) 3 AITR 436. The Court established, amongst other things, that the nature or character of the expenses follows the advantage which 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 be capital in nature. If the advantage gained is of a revenue nature, then the expenses incurred in gaining the advantage will also be of a revenue nature.

The payout of the lease did not bring into existence an asset or an advantage for the enduring benefit of a trade. The asset has been completely written off and the expenditure was made solely to terminate the lease to satisfy a presently existing liability. It replaces the monthly lease payments which would have been required if the lease had run its course. As the monthly lease payments were revenue in nature the termination payment would take on the same character and be a revenue item. It is therefore not deductible under section 25-110.

Section 8-1

Section 8-1 allows a general deduction for losses or outgoings incurred in gaining or producing assessable income, or necessarily incurred in carrying on a business for the purpose of gaining assessable income, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

To be deductible under section 8-1, two essential conditions must therefore be satisfied:

• the taxpayer must have incurred the expense, and

• the expenditure must not be of a capital, private or domestic nature.

It has already been determined that the expenditure is not of a capital nature. It remains to be decided whether the lessee has incurred the expense.

Section 8-1 requires that for an outgoing or loss to be deductible, it must be 'incurred'. There is no statutory definition of the term 'incurred". A broad definition is contained in Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions, which states at paragraph 5 "you incur an outgoing at the time you owe a present money debt that you cannot escape".

Paragraph 6 of TR 97/7 provides guidelines in defining whether and when a loss or outgoing has been incurred. It points out that it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future.

A key requirement for expenditure to be deductible under section 8-1, as explained in numerous court cases and subsequent guidance on whether and when a loss or outgoing has been incurred, is for the existence of a presently existing liability, a concept not dissimilar to the "money debt that you cannot escape", referred to in TR 97/7.

As noted in Question 1, contrary to the terms of the lease agreement, the lessee was not listed on the insurance policy and it did not pay for the premiums. However, this anomaly is not considered an impediment to the legal rights and obligation of the lessee. The lessee had the legal obligation to comply with the terms of the lease agreement. The loss of the asset set off the lessee's obligation to pay the balance due on the remaining lease. Failure to do so would have exposed the lessee to potential legal proceedings instituted by the lessor. This obligation was thus a presently existing liability that the lessee could not escape.

On the other hand, how the lessee satisfied its presently existing liability is not an issue. It is irrelevant whether the lessee paid out the remaining lease itself or sourced the fund through a third party. Its obligation was fully discharged when the money was paid to the lessor.

In conclusion, the money paid to terminate the lease over the destroyed asset is not capital expenditure to which section 25-110 applies. It is deductible under the general deduction provision of section 8-1.

Question 3

As determined in Question 2, the amount required to pay out the lease on the destroyed asset is of a revenue nature and it is therefore not deductible capital expenditure under section 25-110.

Question 2 further explains that for an amount to be deductible under section 8-1, the taxpayer must have incurred the expense. Under the informal agreement, the parties (the lessor, the lessee and Company X) were of the understanding that Company X would:

• be responsible for the payment of the insurance premiums;

• receive any proceeds from the general insurance policies; and

• pay out the lease from any proceeds received from the general insurance policies.

The ensuing events reflected the intention of the parties. Upon the loss of the leased asset, Company X received the insurance proceeds as agreed. Company X transferred a sufficient amount to the lessee so that the balance of the remaining lease payments on the destroyed asset could be paid in full in accordance with the terms of the lease. The payment by Company X to the lessee of a sufficient amount to pay the remaining lease payments is an expense incurred by Company X in the course of carrying on its business and it is not of a capital or private nature. As such, the payment is deductible under section 8-1.

Question 4

Section 6-5 provides that the assessable income of a resident taxpayer includes the ordinary income derived directly or indirectly from all sources.

As explained in Question 1 above, an amount received by a taxpayer who carries on a business will generally be income in any one of the following three situations:

• it arises from a transaction which is made in the ordinary course of business;

• it arises from a transaction which is outside the ordinary course of business but is nevertheless closely connected to the business

• it arises from a transaction which is not in the ordinary course of business and is not closely connected to the business, but the taxpayer made the gain from a profit-making undertaking or scheme, that is, the transaction was entered into for a profit-making purpose

The lessee has the obligation to pay out the remaining lease on the destroyed asset. Company X in turn, is required as per the informal agreement to provide the fund out of the insurance proceeds to enable the lessee to satisfy its lease commitments. The obligations of both parties arise from transactions that were made in the ordinary course of their respective business. The money received by the lessee is therefore assessable as ordinary income under section 6-5.

Issue 2

Life insurance proceeds

Question 1

The applications of section 25-110 and section 8-1, and the meaning of "incurred" have already been examined in Issue 1, Question 2 above.

The intention of the life insurance policy was to ensure that should something happen to B, the insurance payout would be sufficient to cover the termination of the remaining leases. Whilst the lessee has the legal obligation to meet the payments, it has not paid or incurred any of the expenses. The payment comes out of the life insurance proceeds received by the lessor, the sole policy owner and beneficiary, and will be applied to terminate all leases on the remaining assets as intended. As the lessee has not incurred any expenditure, it is not entitled to a deduction under section 25-110 or section 8-1.

Question 2

Section 6-5

Ordinary income under section 6-5 includes income from rendering personal services, income from property and income from carrying on a business.

The surplus (the difference between the life insurance proceeds and the lease payments including the residual values) from the lessor does not exhibit any of the characteristics of ordinary income. As it is to be provided by the lessor voluntarily under no obligation, it is relevant to consider the nature of the receipt and whether it constitutes a gift.

An amount received as a gift or prize will be assessable income if it is:

• income in the ordinary sense of the word (ordinary income) - subsection 6-5(1); or

• an amount or benefit that through the operation of the provisions of the tax law is included in assessable income (statutory income) - subsection 6-10(1).

Generally, a gift or prize is regarded as a personal windfall gain and not as ordinary income unless the taxpayer has received the prize or gift because of, in respect of, or in relation to any income-producing activity of the taxpayer.

ATO Interpretative Decision ATOID 2002/644 Income Tax: Assessability of Prize provides guidelines in determining whether a prize or gift is ordinary income. It highlights the following factors that need to be taken into account:

• how, in what capacity, and for what reason the recipient received the prize or gift (Squatting Investment Co Ltd v. Federal Commissioner of Taxation (1953) 86 CLR 570, (1953) 5 AITR 496; (1953) 10 ATD 126 (Squatting Investment Case)

• whether the prize or gift is of a kind which is a common incident of the recipient's calling or occupation ( Scott v. Federal Commissioner of Taxation (1966) 117 CLR 514; (1966) 10 AITR 367; (1966) 14 ATD 286 (Scott's Case)

• whether the prize or gift is made voluntarily

• whether the prize or gift is solicited ( Hayes v. Federal Commissioner of Taxation (1956) 96 CLR 47; (1956) 6 AITR 248; (1956) 11 ATD 68 (Hayes' Case ) and Scott's Case )

• whether the prize or gift can be traced to gratitude engendered by some service rendered by the recipient to the prize or gift donor (Squatting Investment Case )

• the motive of the prize or gift donor (though this factor is rarely decisive in itself) (Hayes' Case); and

• whether the recipient relies on the prize or gift for regular maintenance of themselves and any dependants (Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 AITR 443; (1952) 10 ATD 82 (Dixon's Case ) and FC of T v. Blake (1984) 75 FLR 315; (1984) 15 ATR 1006; 84 ATC 4661).

Each of these factors as applicable to the present case is considered:

How, in what capacity, and for what reason the recipient received the prize or gift?

The owners of the lessor do not consider it fair that their company should profit from B's death as a result of the insurance amount being in excess of the payout value of the leases on the remaining assets. The applicant claims that B's death has, and will continue to have, a major impact on the business and the estate's ability to manage the business into the near future.

Whether the prize or gift is of a kind which is a common incident of the recipient's calling or occupation?

It is a private and personal transaction and is not attributable to services (if any) provided by the estate or its associates.

Whether the prize or gift is made voluntarily

The payment is made voluntarily by the lessor. There is no obligation for the lessor to give the insurance surplus to anyone.

Whether the prize or gift is solicited

There is no evidence to support this premise.

Whether the prize or gift can be traced to gratitude engendered by some service rendered by the recipient to the prize of gift donor

The estate has not provided any service to the lessor. Neither has its associates, the lessee or Company X, provided any service that would have generated gratitude from the lessor. Their dealings have been limited to the leasing and operating of the assets on a commercial basis.

The motive of the prize or gift

The motive appears to be altruistic, in view of the expressed concerns of the lessor over the difficulties encountered by the estate upon the death of B.

Whether the recipient relies on the prize or gift for regular maintenance of themselves and any dependants

The payment will be a significant financial contribution in assisting the estate.

On the basis of the answers to these eight questions, it is reasonable to conclude that the money transfer proceeds from the detached and disinterested generosity of the lessor and not income according to ordinary concept under section 6-5.

Section 15-2

Section 15-2 applies to cover the value of all gratuities and benefits given or granted to a taxpayer in respect of, or for or in relation directly or indirectly to, any employment of or services rendered by the taxpayer.

There is no evidence of any employer/employee relationship, directly or indirectly, between the two parties or their associates. The payment does not fall into the categories of items referred to in subsection 15-2(1).

Issue 3

Question 1

An asset is a depreciating asset if it has a limited effective life and it is reasonable to expect that the asset will decline in value over the time it is used: section 40-30.

The assets in questions are depreciating assets for Division 40 purposes.

The first element of cost of a depreciating asset is either the amount specified in the table in subsection 48-180(2) or the amount the taxpayer is taken to have paid under section 40-185.

Section 40-185 contains the general rule for working out the amount the taxpayer is taken to have paid in relation to the asset. The general rule applies only if the specific rules in the tables in subsections 40-180(2) or 40-190(3) do not apply.

The first element of cost is worked out when the taxpayer begins to hold the depreciating asset.

Item 8 in the table of subsection 40-180(2) states:

You started to *hold the asset under an *arrangement and

(a) there is at least one other party to the arrangement with whom you did not deal at *arm's length; and

(b) apart from this item, the first element of the asset's cost would exceed its *market value

Item 9 in the table of subsection 40-180(2) states:

You started to *hold the asset under an *arrangement that was private or domestic in nature to you (for example, a gift)

Where item 8 or item 9 applies, the cost is taken to be the market value at the time the taxpayer started to hold it.

The lessor is not related to or associated with the lessee or its associates. There is no evidence to suggest that the transactions are not at arm's length or of a private or domestic in nature. The transfer of the assets is not a gift either as they will be transferred to the lessee at their residual values as outlined in the lease agreements. The consideration, however, is not coming from the lessee, but rather it is coming from the proceeds of the life insurance policy.

Accordingly, neither Item 8 nor Item 9 of subsection 40-180(2) applies to deem the cost of the aircraft to be their market value.

None of the other items in the table of subsection 40-180(2) is considered relevant to the arrangement.

As the specific rules in subsection 40-180(2) do not apply, the cost of the assets is to be determined under the general rule of subsection 40-185(1).

40-185(1)

This Division applies to you as if you had paid, to ^*hold a ^*depreciating asset or for an economic benefit for such an asset, the greater of these amounts:

(a) the sum of the amounts that would have been included in your assessable income because you started to hold the asset or received the benefit, or because you gave something to start holding the asset or receive the benefit, if you ignored the value of anything you gave that reduced the amount actually included; or

(b) the sum of the applicable amounts set out in this table in relation to holding the asset or receiving the benefit

The relevant item in the table of subsection 40-185(1) is Item 1 where the cost is the amount paid by the taxpayer. Note 1 underneath the table states that Item 1 includes not only amounts actually paid but also amounts taken to have been paid.

The lessee is not paying for the asset; the lease termination amount is being met by the life insurance proceeds. However, for the purpose of Division 40, the lessee is taken to have paid the residual value for the acquisition. The first element of cost of the assets is their residual value.