Edited version of your written advice

Authorisation Number: 1012837094005

Date of advice: 10 July 2015

Ruling

Subject: whether a settlement sum is deductible under section 8-1 or section 40-880.

Question 1

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) in respect to the full amount of the settlement sum?

Answer

No

Question 2

Are you entitled to a deduction under section 40-880 of the ITAA 1997 in respect to the settlement sum?

Answer

Yes

This ruling applies for the following period

Year ended 30 June 2015

The scheme commenced on

1 July 2014

Relevant facts

General

You and another entity entered into a partnership agreement and operated a business.

Disputes and differences arose between you and the other partner and those disputes and differences have resulted in the other partner commencing arbitration proceedings against you and action in the Courts after numerous events and actions occurred.

As a result of those numerous events and actions the other partner suffered loss and damage and was entitled to equitable compensation.

You agreed to pay a settlement sum to settle the matters.

Assumptions

Nil

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 40-880

Reasons for decision

Question 1

Summary

The amount you paid to your former partner is considered an undissected lump sum and is capital in nature. It is therefore not deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

Subsection 8-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) states you can deduct from your assessable income any loss or outgoing to the extent that:

(a) It is incurred in gaining or producing your assessable income; or

(b) It is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

Subsection 8-1(2) of the ITAA 1997 states however, you cannot deduct a loss or outgoing under this section to the extent that:

(a) It is a loss or outgoing of capital, or of a capital nature; or

(b) It is a loss or outgoing of a private or domestic nature; or

(c) It is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or

(d) A provision of this Act prevents you from deducting it.

Below are common law cases which outline the treatment of lump sum payments:

McLaurin

In McLaurin v FC of T (1961) 104 CLR 381; 34 ALJR 463, the amount of £12,350 was received by the taxpayer from the NSW Railways in full settlement of a claim for damages to the taxpayer's grazing property by a fire which commenced on railway land. The taxpayer's claim was for an amount of £30,240 based on a number of heads of damage. The valuer employed by the Railways had computed by reference to the various items an amount of £12,350 which, however, had been offered to and accepted by the taxpayer as a lump sum without his knowing how it had been made up. Of the total amount of £12,350, the Commissioner included in the taxpayer's income the amount of £10,640.

It was held by Dixon CJ, Fullagar and Kitto JJ that the Commissioner was not entitled to divide up the amount of £12,350 into the amounts which had formed its components in the valuer's computation and to bring into charge, for income tax purposes, the amount allowed by the valuer in respect of those items which were of an income nature. The court said it made no difference that the taxpayer, because of the course the discussions had followed, was in a position to make a confident guess as to the amount allowed for each item. All the taxpayer had to do was to weigh £12,350 against the entirety of his claim, and accept it or reject it as a whole. To accept the lump sum was not to assent to any figure in respect of any individual item of his claim.

In pointing out that while apportionment was permissible in some instances, but not in a case such as that under consideration, the court said (104 CLR at p 391):

``It is true that in a proper case a single payment or receipt of a mixed nature may be apportioned amongst the several heads to which it relates and an income or non-income nature attributed to portions of it accordingly: Texas Co (Australasia) Ltd v FC of T (1940) 63 CLR 382 at p 466; Ronpibon Tin No Liability v FC of T (1949) 78 CLR 47 at p 55; National Mutual Life Association of Australasia Ltd v FC of T (1959) ALR 467 at p 478. But while it may be appropriate to follow such a course where the payment or receipt is in settlement of distinct claims of which some at least are liquidated, cf Carter v Wadman (1946) 28 TC 41, or are otherwise ascertainable by calculation: cf Tilley v Wales (1943) AC 386, it cannot be appropriate where the payment or receipt is in respect of a claim or claims for unliquidated damages only and is made or accepted under a compromise which treats it as a single, undissected amount of damages. In such a case the amount must be considered as a whole: Du Cros v Ryall (1935) 19 TC 444 at p 453.''

The court also rejected a submission that the amount was in the nature of compensation to the taxpayer for loss of opportunity to use his grazing property to its full capacity, and therefore it should be considered as possessing in his hands the same character as the profits would have had which the fire prevented him from making. In this regard, the court said that it was impossible to see a basis in fact for the contention that the £12,350 was in truth of the nature of compensation for loss of profits. The fire caused the taxpayer losses of sheep and cattle, and damage to wool on surviving sheep; it put him to expense for the eradication of rabbits; it also caused losses of or damage to capital assets such as pastures, fencing and buildings. But the whole of the damage was compensated for by the one entire sum; and it was simply not true that that sum took the place of assessable income in the taxpayer's hands.

Allsop

In Allsop v FC of T (1965) 113 CLR 341; 14 ATD 62, the taxpayer carried on the business of transporting goods by road and over some years he paid the NSW Government amounts totalling £54,869 by way of prescribed fees for permits pursuant to legislation. The fees were allowed as deductions. A Privy Council decision held that the fees were not legally payable and the taxpayer commenced an action in the NSW Supreme Court seeking recovery of the total sum paid.

As a result of negotiations, a deed of release was executed by the taxpayer. This deed recited the nature of the taxpayer's claim, that the NSW Government denied all liability to repay the moneys claimed and that it had been agreed between the parties that, without any admission of liability, the NSW Government would pay to the taxpayer the sum of £37,500 in full satisfaction and discharge of a variety of claims that he had or might possibly have against the NSW Government. The taxpayer's objection against the assessability of the amounts so received by him was upheld by the Full High Court.

Barwick CJ and Taylor J said that the primary question was whether the payment to the appellant of the sum of £37,500 constituted, in the circumstances, a refund of part of the fees which had been paid by him and, in their opinion, it did not. Their Honours said that, during the period in question, there had been unlawful interference with the taxpayer's business operations and that he had valid claims against the government. The amount payable upon the execution of the release was not only for a release of his claim in respect of fees paid but also for his release of all claims for anything done in purported pursuance of the relevant legislation. The amount paid was payable as an entire sum by way of compromise of all claims and no part of it could be attributed solely to a refund of the fees paid by the taxpayer for permits. Thus, there was no warrant for regarding the amount paid, or part of it, as an income receipt.

Spedley Securities

The McLaurin and Allsop cases were followed in FC of T v Spedley Securities Limited 88 ATC 4126, the Full Federal Court finding that there was no basis for dissection or apportionment of a lump sum, the ingredients of which had not been identified but which had been found to include compensation for injury to a capital asset (ie the goodwill of the recipient). The Spedley Securities case concerned a merchant bank which was assessed on a lump sum payment of $200,000 paid to it by a company under a deed of discharge after an agreement between Spedley and that company was terminated. Under the terminated agreement, Spedley was to secure $65m by way of loan for a mining enterprise to be carried on in Australia by the company. There was evidence of concern by Spedley's principals of damage to its international reputation resulting from the termination of the agreement. The Commissioner argued that the lump sum was paid, not for loss of reputation, but for loss of commission and was assessable.

The Full Federal Court held that the deed of discharge related to all possible claims by the taxpayer arising out of the termination of the agreement. The assertion that part of the lump sum must have represented agreed commission was not convincing; the most that could be said was that part of the agreed commission may have played a part in arriving at the figure of $200,000. In addition, there was evidence that the payment was, at least in a substantial part, recompense for damage to Spedley's reputation. What was received was a lump sum, the ingredients of which were not identified but which included compensation for injury to a capital asset. There was no basis for dissection or apportionment and the whole receipt should be treated as capital.

Allied Mills

McLaurin, Allsop and Spedley Securities were further considered in Allied Mills Industries Pty Ltd v FC of T 89 ATC 4365 where a lump sum received as compensation for termination of agreement was held to be assessable. The taxpayer acted as sole distributor for a biscuit manufacturer. Under the distribution agreement, the taxpayer also had residual manufacturing rights in the event that the agreement was terminated. When the manufacturer decided to rationalise its product range and take over the distribution itself, it paid the taxpayer a lump sum of $372,700 as compensation for termination of the distribution agreement. Although the agreement had contributed substantially to the taxpayer's profits, the taxpayer agreed to the termination because it wanted to retain the manufacturer as a major customer for raw materials supplied by the taxpayer. The Full Federal Court held that the lump sum was assessable as ordinary income (see also 19-085). The court also held that the lump sum was not a payment of a mixed nature capable of apportionment (at pp 4372-4373):

``In the present case there was a single payment of $372,700. Although the sum was paid and received as compensation for termination of the appellant's sole distributorship and its residual contingent manufacturing rights... we do not regard it as a payment of a mixed nature capable of apportionment in the sense in which McLaurin, Allsop and Spedley speak. The residual manufacturing rights were elements in the sole distributorship of the appellant or ancillary to it. There was a single payment received in compensation for the termination of the arrangements... which is properly characterised as a payment for the loss of profits caused by the termination.''

Lump sum damages, or a lump sum out-of-court settlement, representing compensation for losses of an income nature only, will be assessable in accordance with ordinary principles.

Where the relevant payment can be dissected into its income and capital components, the income components (such as interest on the principal sum) will be assessable income. However, where lump sum damages are a lesser amount received in settlement of an unliquidated claim covering both income and capital elements but cannot be dissected into those elements, the whole amount is treated as capital.

The treatment of undissected amounts was clearly favourable to taxpayers before the advent of CGT. However, the CGT provisions now 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. Generally there will be a better CGT outcome if the amount received can be attributed at least partly to an "underlying asset" (e.g. damaged property) rather than solely to the asset embodied in the right to sue. If the amount is an undissected amount and the taxpayer cannot make a reasonable estimate of the income and capital components, the whole amount will be taken to relate to the disposal of the taxpayer's right to sue which is capital.

Unliquidated means sums of money not established in advance by the contracting parties as a compensation for a breach of contract, but determined by a court after such breach occurs.

From the decisions of the High Court in McLaurin v FC of T (1961) 12 ATD 273 and Allsop v FC of T (1965) 14 ATD 62, no apportionment of the kind made in Wales v Tilley and Carter v Wadman may be made where a payment is in respect of a claim for unliquidated damages only and is accepted under a compromise settlement which treats it as a single undissected amount of damages.

From common law cases it is clear that no apportionment can be made where a payment is made of a claim for unliquidated damages only and is accepted under a compromise settlement which treats it as a single amount of damages

Subsection 40-880(1) of ITAA 1997 states the object of this section is to make certain business capital expenditure deductible over 5 years if:

(b) a deduction is not denied by some other provision; and

You can deduct, in equal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur:
(a) in relation to your business; or

(b) in relation to a business that used to be carried on; or

(c) in relation to a business proposed to be carried on; or

(d) to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business.

Limitations and exceptions

You can only deduct the expenditure, for a business that you carry on, used to carry on or propose to carry on, to the extent that the business is carried on, was carried on or is proposed to be carried on for a taxable purpose.

You can only deduct the expenditure, for a business that another entity used to carry on or proposes to carry on, to the extent that:

(a) the business was carried on or is proposed to be carried on for a taxable purpose; and
(b) the expenditure is in connection with:

(i) your deriving assessable income from the business; and

(ii) the business that was carried on or is proposed to be carried on.

You cannot deduct anything under this section for an amount of expenditure you incur to the extent that:

(a) it forms part of the cost of a depreciating asset that you hold, used to hold or will hold; or

(b) you can deduct an amount for it under a provision of this Act other than this section; or

(c) it forms part of the cost of land; or

(d) it is in relation to a lease or other legal or equitable right; or

(e) it would, apart from this section, be taken into account in working out:

(i) a profit that is included in your assessable income (for example, under section 6-5 or 15-15); or

(ii) a loss that you can deduct (for example, under section 8-1 or 25-40); or

(f) it could, apart from this section, be taken into account in working out the amount of a capital gain or capital loss from a CGT event; or

(g) a provision of this Act other than this section would expressly make the expenditure non-deductible if it were not of a capital nature; or

(h) a provision of this Act other than this section expressly prevents the expenditure being taken into account as described in paragraphs (a) to (f) for a reason other than the expenditure being of a capital nature; or

(i) it is expenditure of a private or domestic nature; or

(j) it is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income.

The exceptions in paragraphs (5)(d) and (f) do not apply to expenditure you incur to preserve (but not enhance) the value of goodwill if the expenditure you incur is in relation to a legal or equitable right and the value to you of the right is solely attributable to the effect that the right has on goodwill.

You cannot deduct an amount under paragraph (2)(c) in relation to a business proposed to be carried on unless, having regard to any relevant circumstances, it is reasonable to conclude that the business is proposed to be carried on within a reasonable time.

You cannot deduct anything under this section for an amount of expenditure that, because of a market value substitution rule, was excluded from the cost of a depreciating asset or the cost base or reduced cost base of a CGT asset.

You cannot deduct anything under this section for an amount of expenditure you incur:

(a) by way of returning an amount you have received (except to the extent that the amount was included in your assessable income or taken into account in working out an amount so included); or

(b) to the extent that, for another entity, the amount is a return on or of:

(i) an equity interest; or

(ii) a debt interest that is an obligation of yours.

In relation to your case you incurred the expenditure of the settlement sum which was paid to your former partner. This amount is considered capital and to be in relation to your business. The business was conducted for a taxable purpose. None of the exceptions under sections 40-880(3) to 40-880(9) apply. You are therefore entitled to claim a deduction for the settlement sum under section 40-880 of the ITAA 1997 commencing in the 2014-15 financial year.