Edited version of your written advice

Authorisation Number: 1012794036363

Ruling

Subject: Assessability of settlement payment

Question 1

Can the amount you received as a compensation payment by way of Deed of Release be regarded as a windfall gain?

Answer

No

Question 2

Is the amount you received as a compensation payment by way of Deed of Release regarded as a capital receipt, and therefore any corresponding capital gain made from the payment will be included in your assessable income?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 2014

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

In 20XX, you commenced legal proceedings for damages against two other parties.

The proceedings alleged breach of retainer, breach of duty of care and breach of fiduciary duty in relation to work performed these parties in respect of a previous business matter involving you and these two parties.

The two parties denied all allegations made against them in the Proceedings.

In 20YY, the parties held a formal mediation at which they, without admission of liability, agreed to resolve the proceedings and entered into a Heads of Agreement.

A Deed of Release, signed by all parties, agreed to pay you a settlement sum, being full settlement and discharge of all causes of action, claims and rights asserted in the proceedings or which you might have asserted in the proceedings arising out of the facts and circumstances in which the proceedings were brought."

You commenced these proceedings in 20XX against the parties with no certainty of the result and refer to the action taken as a "high risk gamble", which could have gone either way, however; you won the gamble.

You state that you are treating the receipt of the payment as a "windfall" and not assessable income for you and ask if you are correct in doing so.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 108-5

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

Windfall gains

Windfall gains are generally not income according to ordinary concepts. They lack the regularity or periodicity of income and are not usually an inherent part of any occupation or business activity.

According to ordinary concepts the average person would regard a windfall gain as an unexpected bonus or luck and not of an income nature. The most common examples of gains that are windfall gains and not income according to ordinary concepts are winnings in a lottery or a game with prizes.

In your case, you did not receive this payment as a result of a lottery win or a prize in a game. Whilst it is acknowledged that you may not have expected a court to rule in your favour and you may not have expected the other parties to agree to a settlement payment to you, it was the result of a legal proceeding, initiated by you, to gain compensation for a wrong-doing against you.

The settlement payment you received cannot be considered to be a windfall gain.

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.

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.

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.

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.

You received an amount in full and final resolution of your claim, as entered into on a Heads of Agreement and ensuing Deed of Settlement. CGT event C2 occurred at the time you disposed of the CGT asset of your right to seek compensation.

Subsection 104-25(3) of the ITAA 1997 provides that you make a capital gain from CGT event C2 if the capital proceeds from the ending are more than the asset's cost base. You make a capital loss if those capital proceeds are less than the asset's reduced cost base. The cost base of the asset (the right to seek compensation) will be the acquisition cost of the asset, plus any legal costs associated in bringing the action against the negligent party.

Accordingly, the amount you received on disposal of your CGT asset is regarded as a capital receipt and will be assessable under the CGT provisions. Any capital gain made from the event will be included in your assessable income in the year of receipt.