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Edited version of your written advice
Authorisation Number: 1013019536665
Date of advice: 17 May 2016
Ruling
Subject: Compensation
Question 1
Is the compensation payment received for the settlement of a class action brought against entity A assessable as ordinary income?
Answer
No.
Question 2
Should the cost base of the shares be reduced by the amount of the compensation received?
Answer
Yes.
This ruling applies for the following period:
Year ended 30 June 2015
The scheme commenced on
1 July 2014
Relevant facts.
Entity B owns shares in entity A. Entity B still owns the shares as at 30 June 2015.
Entity B was part of a Class action against entity A. The class action occurred as it was alleged that entity A failed to adequately disclose particular information. This affected the shareholders decision making in regards to the way they managed their shareholding. The shareholders suffered loss and damage.
A settlement was approved by the court.
As a result you received a compensation payment.
Relevant legislative provisions
Income Tax Assessment Act 1997 Section 6-5
Income Tax Assessment Act 1997 Paragraph 110-45(3)
Detailed reasoning
Ordinary income
Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes the 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.
The compensation received was not income from rendering personal services, income from property or income from carrying on a business. The payment is also a one off payment and thus it does not have an element of recurrence or regularity.
A compensation amount generally bears the character of that which it is designed to replace. 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.
Entity B received compensation for the acquisition of the shares at an inflated price. The compensation was paid in relation to a capital asset and accordingly, it is regarded as a capital receipt and not ordinary income. Therefore, the compensation payment is not assessable as ordinary income under section 6-5 of the ITAA 1997.
Capital gains tax provisions
Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts outlines 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.
The transaction which generated the compensation receipt is the acquisition of the shares. Applying the 'look-through' approach to the acquisition of shares, the most relevant asset to which the compensation most directly relates is the shares in entity A. The compensation was for the acquisition of the shares at an inflated price.
Paragraph 10 of TR 95/35 provides that:
If a taxpayer is compensated for having paid excessive consideration to acquire an asset, the amount referable to the overpayment represents a recoupment of all or part of the total acquisition costs of the asset.
Therefore, the cost base of the shares should be reduced by the amount of the compensation. No capital gain or loss arises in respect of the shares until they are actually sold or another CGT event occurs in relation to the shares.