Edited version of your written advice

Authorisation Number: 1013082095480

Date of advice: 1 September 2016

Ruling

Subject: Settlement payments

Question 1

Are the settlement payments assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Are the settlement payments assessable under the capital gains tax provisions?

Answer

Yes.

This ruling applies for the following periods

Year ended 30 June 2014

Year ended 30 June 2015

The scheme commenced on

1 July 2013

Relevant facts

Entity A carried on a business. The business had been trading at the leased premise for several years.

Problems arose with the premises and entity A asked the landlord to repair the premises. The problem was rectified but the work did not fix the cause of the problem.

Later further problems arose.

The business was forced to close.

A dispute arose with the landlord for not properly maintaining the property and the continuation of the lease.

The landlord failed to remedy the problem and complete the repairs. Entity A confirmed the termination of the lease.

Entity A sought payment from the landlord for the associated costs and damage and loss.

The landlord paid an agreed settlement sum for breach of lease.

Entity A sought indemnity under a business insurance policy for suffered losses and damages.

Under the claim with AIG, the insurer will indemnify the Trust for physical loss or property damage.

The insurer paid some money.

Entity A sought payment from the insurance provider.

The insurer agreed to pay Entity A a settlement sum. Entity A agreed to release and forever discharge the insurer from all claims, actions, suits, demands, charges, costs and expenses in connection with the problems.

Relevant legislative provisions

Income tax Assessment Act 1997 Section 6-5

Income tax Assessment Act 1997 Section 104-25

Reasons for decision

Ordinary assessable 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.

In Scott v. FC of T (1966) 14 ATD 286, Windeyer J expressed the view that whether or not a particular receipt is income depends upon its quality in the hands of the recipient.

The compensation payment received was not earned by entity A as it does not relate to services performed. Although the settlement payments relate to the business, the payments are not from the income earning activities from carrying on the business. The payments are also one-off payments and thus do not have an element of recurrence or regularity. Although the payments can be said to be expected, and perhaps relied upon, this expectation arises from the landlord's breach of lease and the investment in insurance, rather than from a relationship within which services are performed.

The compensation sought from the landlord and insurance company related to various losses and damages suffered. The business was forced to close. The compensation relates to the loss of the leased premises used by entity A to run their business, that is, the profit yielding structure was lost. Such a loss is capital in nature.

Although the request for compensation referred to the loss of business revenue and the amount of income that would have been earned, such a reference does not change the nature of the compensation payment received. The payments received were in full settlement of all claims made.

Entity A received settlement payments. Although the lump sum payments may include an amount for lost revenue, the payment is a full and final settlement of the claims and rights with the landlord and insurance company. The undissected lump sum settlement payments received relate to the damage and business interruption and subsequent closure of the business and are capital in nature. Accordingly, it is not regarded as ordinary income and is therefore not assessable under subsection 6-5(2) of the ITAA 1997.

Statutory income

Statutory income is not ordinary income, but is included in assessable income by specific provisions of the income tax law (section 6-10 of the ITAA 1997).

These specific provisions are listed in section 10-5 of the ITAA 1997 and include capital gains, which are included in assessable income by virtue of the capital gains tax (CGT) provisions.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts considers the CGT consequences for compensation payments. Why the payment was made is an important factor in determining whether an asset has been disposed of for capital gains tax purposes.

TR 95/35 discusses the various scenarios, including:

• disposal of the underlying asset,

• compensation for permanent damage to, or permanent reduction in value of, the underlying asset, and

• disposal of the right to seek compensation.

If the amount of compensation received is an undissected lump sum, the whole amount is treated as being consideration received for the disposal of the right to seek compensation.

In this case entity A was leasing the premises and was not the owner of the premises. The compensation is not considered to relate to the disposal of an underlying asset. Rather, the most relevant asset is the right to seek compensation.

Capital gain

Your assessable income includes your net capital gain for the income year (subsection 102-5(1) of the ITAA 1997). You make a capital gain or loss as a result of a CGT event happening (section 102-20 of the ITAA 1997).

CGT event C2 happens if your ownership of an intangible CGT asset ends in certain ways, including being released or cancelled (subsection 104-25(1) of the ITAA 1997). The time of the event is when you enter into the contract that results in the asset ending, or if there is no contract, when the asset ends (subsection 104-25(2) of the ITAA 1997).

A CGT asset is any kind of property or a legal or equitable right that is not property (section 108-5 of the ITAA 1997).

In this case, the right to seek compensation is an intangible CGT asset (acquired at the time of the compensable wrong) and the ownership of that asset ended when entity A accepted the compensation settlement payment. At that time CGT event C2 happened.

The capital proceeds from a CGT event are the total of the money received, or are entitled to receive, in respect of the event happening, and the market value of any other property received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event) (section 116-20 of the ITAA 1997).

In this case, the capital proceeds will include the compensation paid by the landlord and insurance company.

The cost base of the right to seek compensation is determined in accordance with the provisions of section 110-25 of the ITAA 1997. The first element includes in the cost base any consideration in respect of the acquisition of the right to seek compensation (subsection 110-25(2) of the ITAA 1997).

If the right to seek compensation arises in respect of a monetary loss, the amount of that loss is included in the cost base of the right to seek compensation for that loss. Legal costs associated with the claim form part of the cost base.

As entity A acquired the right to seek compensation more than 12 months before the CGT event, they are able to apply the 50% general discount to the capital gain.