Edited version of your written advice

Authorisation Number: 1012694973445

Ruling

Subject: Assessability of settlement payment

Question 1

Is the payment you received for the final settlement of a complaint made against your financial advisor assessable as ordinary income?

Answer

No.

Question 2

Is the payment you received for the final settlement of a complaint made against your financial advisor assessable as a capital gain?

Answer

Yes.

Question 3

Will your cost base include your medical expenses?

Answer

No.

Question 4

Are you able to include your medical expenses in the calculation for a net medical expenses tax offset?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2013

The scheme commenced on

1 July 2012

Relevant facts and circumstances

You applied for a private ruling before you received your tax assessments.

The ruling asked the Commissioner to exempt you from paying tax on a sum of money you received from your financial advisor as settlement. Details of the settlement payment are as follows:

• Your financial advisor/planner advised you to get an interest only loan to build a portfolio of managed funds. You followed the advice.

As your family grew you needed to do some renovations and additions to your house so the advisor arranged for you another loan. At the same time the financial planner advised you that it was time to review your investment portfolio and advised you to take one more investment.

He advised you to borrow additional funds for a Hedge Fund for a stipulated amount of years term. You pointed out that the sum of money was too much to borrow, especially when one of you was working part time, but he insisted and persuaded you and you went ahead with it because he was the expert who you were paying to advise you.

By the second repayment two years later, you came into financial difficulties. When the third payment was due the financial advisor was nowhere to be found. Nobody from the company advised you that the advisor was no longer licensed or working for the company. You complained to the company and they made an investigation and concluded that you were wrongly advised and there were concerns about the validity of the Statement of Advice that financial advisor had prepared.

Based on your earnings you should not have been advised to take on the loan for the hedge fund. The company approached you and offered you a small sum of money as a resolution to the problem. You refused to accept the offer. You sought legal advice.

Your lawyers found that the advice had many shortcomings.

It became clear to you that the advice given to you was more based on the financial advisor's interest rather than his clients'. After further negotiations and with the assistance of your legal team, the company offered you a sum of money. This was much less than the lawyers had calculated. You agreed to the sum because of the cost of the legal advice and the stress on the family and signed the Deed of Settlement. This settlement was achieved with financial and emotional costs on your family.

In the document the company did not admit any liability. You also agreed not to pursue the matter any further or to discuss it with a third party.

Clause 3 of the Deed advises:

3. RELEASE

Upon exchange by the parties of duly executed copies of this deed, the Clients immediately release xxxxxxx and its officers, agents, divisions, successors, assignees and authorised representatives from and against all and any actions, suits, claims, damages, costs or expenses of any kind whatsoever connected with the Claim.

Although the company did not provide you with a statement to explain how they finally arrived at the amount you believe it was a compromise on their part for the wrong advice from their advisor which caused you great financial and emotional distress and for the lack of customer care by the company which resulted in financial losses and stress for you.

To achieve the resolution you had to secure the services of a lawyer specialising in these types of cases. You incurred costs in relation to these services. These were claimed in your return.

You also needed professional medical and relationship help because of the emotional distress. The total cost for the counselling could not be claimed through Medicare or your health fund. You received a rebate from Medicare for the cost of a psychologist. One of you also attended many consultations with the family GP and was on medication due to the stress.

You received the money from the company but still have to make payments to the investment fund until the fund matures.

It took one year to come to a resolution and required days off work to consult with lawyers and to attend meetings with the company, all of which were many kilometres from your home. You also spent many hours locating information, receipts and documents to prove your case.

You were advised that your ruling application was invalid.

You included the amounts paid to you as settlement in your income tax returns for the year ended 30 June 2013.

You understand that you did not word your application for a private ruling correctly and you would like to have it reconsidered.

If you do not have to pay tax on the compensation payment then you would like to have your tax reassessed for that year.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 159P(4)

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 10-5

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 104-25
Income Tax Assessment Act 1997 Paragraph 108-5(1)(b)

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Subdivision 115-A

Reasons for decision

Assessable income

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) explains your assessable income 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 amount you received was not income from rendering personal services, income from property or income from carrying on a business. The payment was also a one off payment and thus it does not have an element of recurrence or regularity.

Compensation income

A compensation amount generally bears the character of that which it is designed to replace. If the compensation is paid for loss of income, it will be assessable as ordinary income. 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 an amount in full and final resolution of your claim after raising concerns with your financial planner about the investment advice you had received from them. The company did not admit any liability but made the offer to you to resolve the claim. A Deed of Settlement was signed by you.

For advice on such payments we look to Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts. This ruling considers the capital gains tax (CGT) consequences and whether the amount should be included in the assessable income of the recipient.

Paragraph 3 of TR 95/35 contains relevant definitions as follows:

Compensation receipt

A compensation receipt, or compensation, includes any amount (whether money or other property) received by a taxpayer in respect of a right to seek compensation or a cause of action, or any proceeding instituted by the taxpayer in respect of that right or cause of action, whether or not:

• in relation to any underlying asset;

• arising out of Court proceedings; or

• made up of dissected amounts.

Look-through approach

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.

Right to seek compensation

The right to seek compensation is the right of action arising at law or in equity and vesting in the taxpayer on the occurrence of any breach of contract, personal injury or other compensable damage or injury. A right to seek compensation is an asset for the purposes of Part IIIA. The right to seek compensation is acquired at the time of the compensable wrong or injury, and includes all of the rights arising during the process of pursuing the compensation claim. The right to seek compensation is disposed of when it is satisfied, surrendered, released or discharged.

Underlying asset

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.

Undissected lump sum compensation receipt

An undissected lump sum compensation receipt is 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 70 of TR 95/35 states that in determining the most relevant asset in respect of which the amount has been received, it is appropriate to adopt a 'look-through' approach to the transaction which generates the receipt.

Paragraph 82 provides advice on cases where an asset has not been disposed of and has not been permanently damaged or permanently reduced in value by the happening or event which generated the amount paid. In such instances there is no direct link to an asset and accordingly, the most relevant asset may be the right to seek compensation.

The amount you received in settlement and in agreement to the above was not received in respect of any underlying asset; the amount related to the disposal of your right to seek compensation.

Paragraph 108-5(1)(b) of the ITAA 1997 specifically includes a legal or equitable right within the definition of a CGT asset. Your right to seek compensation is therefore a CGT asset.

Accordingly, as the amount you received was paid in relation to your capital asset it is regarded as a capital receipt and not ordinary income. Therefore, the payment is not assessable ordinary income under section 6-5 of the ITAA 1997.

Capital gains tax

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

Section 10-5 of the ITAA 1997 lists those provisions about assessable income. The most relevant section in relation to your settlement amount is section 102-5 of the ITAA 1997, which deals with capital gains and explains that a taxpayer's assessable income includes the amount of any such amounts. 

Section 102-20 of the ITAA 1997 provides that a capital gain is made only if a capital gains tax (CGT) event happens. A CGT event is generally something that happens in relation to a CGT asset. 

CGT event C2 contained in section 104-25 of the ITAA 1997 happens when the ownership of an intangible CGT asset ends by the asset being satisfied or surrendered. This occurred when you signed the Deed of Settlement with the company and surrendered your right to seek compensation.

Paragraph 3 of TR 95/35 explains that the right to seek compensation is acquired at the time of the compensable wrong or injury. You acquired your right to seek compensation when you were inappropriately advised and there were concerns about the validity of the Statement of Advice that had been prepared for you.

You subsequently signed a Deed of Settlement with the company in full and final resolution of your claim. By signing the deed you immediately released the financial planner:

…from and against aIl and any actions, suits, claims, damages, costs or expenses of any kind whatsoever connected with the Claim.

The amount you received are your capital proceeds in respect of the CGT event.

Cost base

Section 110-25 advises that the cost base of a CGT asset is made up five elements. The elements include the amount paid in order to acquire the asset in question, plus most other incidental costs incurred along the way to maintain, preserve or dispose of the asset.

The five elements are:

1. The money paid, or required to be paid, in respect of acquiring the CGT asset, or the market value of any other property given, or required to be given, in respect of acquiring the CGT asset.

2. Incidental costs of acquiring the asset, or costs in relation to the CGT event.  These costs include stamp duty, legal fees, agent's commission, fees paid for professional services.

3. Non-capital costs incurred in connection with ownership, for example, interest, rates, land tax, repairs and insurance premiums (provided that these expenses have not, or could not, have been claimed as a 'deduction', for example, rental deduction). They also include non-deductible interest on loans used to finance capital expenditure incurred to increase an asset's value.

4. Capital expenditure incurred to increase the value of the asset, for example, extensive renovations undertaken to the CGT asset.

5. Capital expenditure incurred to preserve or defend the title or rights to the asset.

Should a capital loss be made in relation to the sale of the property, the third element is excluded from the cost base. The resulting cost base is known as a reduced cost base.

Please note that expenditure is not included in the cost base to the extent that:

• it is allowable as a deduction; or

• there is a non-assessable recoupment in respect of the expenditure.

TR 95/35 provides guidance on the calculation of the cost base of the right to seek compensation. 

You did not pay anything to acquire the right to seek compensation.  However, incidental costs would include the legal fees and charges associated or connected with any legal action taken to obtain the payment.

CGT discount

Since you acquired your CGT asset more than twelve months prior to potentially disposing of it (by way of accepting the settlement offer), you will be entitled to use the CGT discount method when calculating the net capital gain that you make from disposing of your right to seek compensation. For individuals, the discount percentage is 50%. As such, the net capital gain that is assessable to each of you will be half of the total capital gain.

Medical expenses

Medical expenses are characterised as being of a private and domestic nature. When reviewing the criteria of each element of an asset's cost base, there is no provision for the inclusion of such expenses.

Accordingly your medical expenses are not included in the cost base of your right to seek compensation.

Net medical expenses tax offset

Net medical expenses are your total medical expenses less refunds from Medicare and private health insurers which you, or someone else, received or are entitled to receive.

The term medical expenses is defined in subsection 159P(4) of the Income Tax Assessment Act 1936 (ITAA 1936). It covers payments to doctors, nurses, chemists, dentists and optometrists. It also includes payments for therapeutic treatment administered by the direction of a legally qualified medical practitioner.

Medical expenses do not include contributions to a private health insurer, travel or accommodation expenses associated with medical treatment, or inoculations for overseas travel.

For the year ended 30 June 2013 the medical expenses tax offset is available if the amount of medical expenses (reduced by any entitlement to reimbursement from a health fund or government authority) exceeds $2,120. The maximum tax offset is 20% of the amount by which the net medical expense exceeds $2,120.

Conclusion

The amounts you each received in final settlement are assessable as a capital gain. After calculating your cost base, your net capital gain should be included at question 18 of your income tax return for the year ended 30 June 2013.

Your medical expenses cannot be included in the cost base of your right to seek compensation. You may be entitled to a net medical expenses tax offset, depending on your total net medical expenses for the year ended 30 June 2013.