Edited version of private advice

Authorisation Number: 1012623020460

Ruling

Subject: Compensation

Question 1

Should a reasonable apportionment of the compensation payment received be treated as additional capital proceeds for the investments already disposed of in the 2008-09 financial year?

Answer:

Yes.

Question 2

Should a reasonable apportionment of the compensation payment received be treated as a recoupment of the cost base of the investments that you still hold?

Answer:

Yes.

This ruling applies for the following period

Year ended 30 June 2013

The scheme commenced on

1 July 2012

Relevant facts

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:

• your application for a private ruling

• letters from your financial advisor

• letter of complaint to your financial advisor

• Deed of Settlement

You engaged the financial services of entity A.

You paid money to entity A to invest in managed funds. You were later advised to increase your borrowings to purchase further investments.

You were later subject to a margin call. Some of your investments were suspended. You sold some of your investments in the 2008-09 financial year.

The managed funds lost significant value resulting in a carry forward net capital loss in the 2008-09 financial year. You also derived assessable income from your investment portfolio.

You believe that the losses were a direct result of the advice or lack thereof that you had received from entity A.

You lodged a complaint with entity A. You calculated your loss on investments and requested a settlement for your loss plus the original capital investment amount. You requested that the settlement value to be recalculated at the time of settlement according to the value of your investments.

A settlement was agreed on and an amount was received shortly after. This amount was a full and final settlement of all claims made against entity A arising out of and in any way connected with their advice and actions.

The compensation was paid as a direct result of the reduction in value of the managed funds and the subsequent capital loss that arose on the disposal of the assets.

You have carried forward capital losses for the 2009-10, 2010-11 and 2011-12 financial years.

You still have some money invested in managed funds.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 108-5

Reasons for decision

Compensation payment

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes ordinary income 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).

On the other hand, 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 settlement payment is capital in nature and therefore not assessable as ordinary income. However, as the payment is capital in nature, the capital gains tax (CGT) provisions need to be considered.

Capital gains tax provisions

Capital gains tax (CGT) is the tax you pay on certain gains you make. Section 102-20 of the ITAA 1997 states that a capital gain or capital loss is made only if a CGT event happens. 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 capital gains tax 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 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 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.

The transaction which generated your compensation receipt is the alleged inappropriate advice that caused you to increase your borrowing by taking additional loans to purchase further investments. The managed funds lost significant value and resulted in a capital loss. Applying the 'look-through' approach, the most relevant asset to which the compensation most directly relates is the Navigator Personal Investments. The compensation amount received was calculated based on the lost value of your investments.

Treatment of compensation if a CGT event occurs (disposal of the asset)

Section 104-10 of the ITAA 1997 provides that CGT event A1 occurs when your ownership in a CGT asset is transferred to another entity. The time of the event is when you enter into a contract for the disposal, or, if there is no contract, the time of disposal is taken to be the time when the change in ownership occurs.

Paragraph 4 of TR 95/35 states that:

If an amount of compensation is received by a taxpayer wholly in respect of the disposal of an underlying asset, or part of an underlying asset, of the taxpayer the compensation represents consideration received on the disposal of that asset. In these circumstances, we consider that the amount is not consideration received for the disposal of any other asset, such as the right to seek compensation.

In some cases, you may receive additional 'capital proceeds' after the CGT event has occurred, including in a later financial year. For example, compensation may be offered and accepted after the CGT event has occurred, or litigation may result in compensation for losses arising from an investor's former investments. In this situation, your receipts from compensation payments can reasonably be treated as additional 'capital proceeds' for the previous redemption of your investments. This means that the capital gain or capital loss made for the previous CGT event needs to be recalculated. The calculation will be for the CGT event that occurred in that tax year and not the year of income the extra proceeds were obtained in.

In your case, your managed funds had made capital losses on the disposal of some of the investments in the 2008-09 financial year. Therefore CGT event A1 happened in the 2008-09 financial year. In addition, you still retain ownership of some of the investments.

Accordingly, you will need to apportion the amount received as compensation between the investments sold and the remaining investments still held.

The amounts apportioned to the sale of your investments in the managed fund will need to be included as additional capital proceeds in the 2008-09 financial year.

As you have advised that a net capital loss resulted in the 2008-09 financial year, you will need to adjust the amount of capital losses you have available to carry forward for future years.

Treatment of compensation if a CGT event has not occurred

If a CGT event hasn't occurred for a particular investment asset - for example, an investment is still held - any compensation amounts you received are still taken into account for capital gains tax purposes. This will be the case even if the asset is of no current value.

If the compensation can be reasonably related to investment assets, the cost bases of the relevant assets are reduced by the amount of compensation received. The receipt of the compensation does not create a CGT event for the investment assets.

In your case, you still hold some of the relevant investments in the investment.

Accordingly, the amount of the compensation payment that you have apportioned to the investments still held, will be considered amounts related to the recoupment of the cost base of the assets and therefore the cost base of the asset should be reduced by the amount received as compensation.

No CGT event will occur for these remaining investments until they are sold.