Edited version of your written advice

Authorisation Number: 1013065224518

Date of advice: 8 August 2016

Ruling

Subject: Lump sum payment under a deed of release

Question 1

Is the lump sum payment your clients received assessable as ordinary income?

Answer

No.

Question 2

Is the capital gain made as a result of the lump sum payment disregarded?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2015

The scheme commences on:

1 July 2014

Relevant facts and circumstances

Your Clients received a lump sum payment under a deed of release as a result of a claim for compensation for investment losses from financial advisors in regards to a superannuation account.

The deed of release discharges the advisors from all suits, claims, demands, actions, causes of action, losses, liabilities, damages, costs and expenses in relation to the settlement sum.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5.

Income Tax Assessment Act 1997 Section 6-10.

Income Tax Assessment Act 1997 Section 118-305

Reasons for decision

Summary

The lump sum payment your clients received in respect of the loss incurred by the superannuation fund investments is not ordinary income.

Additionally, as the lump sum payment was made in respect of the permanent reduction in value of their right to a capital amount payable from the superannuation fund, any capital gain or loss made from the payment is disregarded.

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 they 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.

The compensation payment Your Clients received is not earned by them as it does not relate to services performed. The payment is also a one-off payment and thus it does not have an element of recurrence or regularity. Although the payment can be said to be expected, and perhaps relied upon, this expectation does not arise from a relationship to personal services performed.

The compensation payment relates to their superannuation investments and is capital in nature. Accordingly, the payment is not ordinary income and is therefore not assessable under section 6-5 of the ITAA 1997.

Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but are included in assessable income by another provision, are called statutory income. Capital gains are included as assessable income under section 102-5 of the ITAA 1997.

Statutory income - capital gains

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts states that the particular asset for which compensation has been received may be:

• an underlying asset;

• a right to seek compensation; or

• a notional asset in terms of section 104-155 of the ITAA 1997.

Why the payment was made is an important factor in determining whether an asset has been disposed of for capital gains tax purposes. In determining which is the most relevant asset, it is often appropriate to adopt a 'look through' approach to the transaction or arrangement which generates the compensation receipt.

As outlined in the ruling, the Commissioner adopts an ''underlying asset'' approach to determine the asset to which the compensation amount is most directly related. In concluding that the underlying asset is the most relevant asset to which an amount of compensation relates, a person must be able to show that the compensation receipt has a direct and substantial link with the underlying asset. If 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 of compensation, the taxpayer is not able to demonstrate that link. It follows that the compensation cannot be directly related to that asset. In those cases, the most relevant asset may be the right to seek compensation, or the notional asset.

Paragraph 3 of TR 95/35 states that permanent damage or reduction in value does not mean everlasting damage or reduced value, but refers to damage or a reduction in value which will have permanent effect unless some action is taken by the taxpayer to put it right.

In this case, the underlying asset is Your Clients' right to a capital amount payable out of a superannuation fund. As a result of the actions of their financial advisor, there was a reduction in the value of their superannuation fund.

Paragraph 9 of TR 95/35 states that compensation received has no CGT consequences if the underlying asset which has suffered permanent damage or a permanent reduction in value was acquired before 20 September 1985 or is any other exempt CGT asset.

The value of their superannuation will always be lower than what it could have been had the loss not occurred. Therefore, it is considered that there has been a permanent reduction in value of Your Clients' right to a capital amount payable out of their superannuation fund.

Subsection 118-305(1) of the ITAA 1997 disregards any capital gain or loss if you make it from a CGT event in relation to any of the following:

• a right to an allowance, annuity or capital amount payable out of a superannuation fund;

• a right to an asset of such a fund;

• a right to any part of such an allowance, annuity, capital amount or asset.

The compensation Your Clients received was in relation to the permanent reduction in value of their right to a capital amount payable out of their superannuation fund. Therefore, any capital gain or loss they made is disregarded under section 118-305 of the ITAA 1997.