Edited version of your written advice

Authorisation Number: 1051212956063

Date of Advice: 11 April 2017

Ruling

Subject: Income tax: Capital Gains

Question 1

Did the taxpayer make a capital loss for the year ended 30 June 2016 as a result of a CGT event C2 happening under section 104-25 of the Income Tax Assessment Act 1997?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 2016

The scheme commences on:

During the 2016 income year

Relevant facts and circumstances

The Taxpayer was the primary director of the Company from its date of registration.

Although the Company previously had other directors from its date of registration, the Taxpayer became the sole director of the Company during the 2012 calendar year.

The Company was insured by the Insurers under a Directors and Officers liability policy.

The Company went into receivership and administration during the 2012 calendar year and external administrators were appointed.

During the 2014 calendar year, the external administrators became the Liquidators of the Company.

The Liquidators of the Company then made a claim for payment against the Taxpayer (as director of the Company).

The Taxpayer settled the claim for a Settled Sum as per the terms of a Deed of Settlement with the Liquidators of the Company (the Liquidators' Settlement) in relation to any such claims made against the Taxpayer and the former directors of the Company.

The whole Settled Sum was paid to the Liquidators of the Company on behalf of the Taxpayer by Entity A in its capacity as trustee of the Taxpayer Trust.

The Taxpayer is the sole shareholder and sole director of Entity A.

The Taxpayer was also the only named beneficiary of the Taxpayer Trust at the time the payment of the Settled Sum was made.

Payment of the Settled Sum was made for the benefit of the Taxpayer at the Taxpayer's direction in order to settle claims made against the Taxpayer.

None of the former directors of the Company contributed to the payment of the Settled Sum.

The Taxpayer made a claim for payment of the Settled Sum and certain costs from the Insurers under the Directors and Officers liability policy during the 2014 calendar year (the Indemnity Claim).

The Insurers refused to indemnify the Taxpayer in respect of the Indemnity Claim.

The Taxpayer then initiated legal proceedings in respect of the Indemnity Claim against the Insurers during the 2014 calendar year.

The Taxpayer and the Insurers settled the Indemnity Claim under a Deed of Release and Agreement during the 2015 calendar year, in which the Insurers agreed to pay the Taxpayer a sum of money (the Insurers' Settlement).

The Insurers' Settlement was paid to the Taxpayer during the financial year ended 30 June 2016.

The Settled Sum paid by the Taxpayer under the Liquidators' Settlement was greater than the sum of money received by the Taxpayer under the Insurers' Settlement.

The Taxpayer incurred legal fees and expenses in connection with the negotiation and drafting of the Deed of Release and Agreement entered into with the Insurers as well as in the negotiation of the Deed of Settlement entered into with the Liquidators of the Company.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 104-25(1)

Income Tax Assessment Act 1997 subsection 104-25(2)

Income Tax Assessment Act 1997 subsection 104-25(3)

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 paragraph 108-5(1)(b)

Income Tax Assessment Act 1997 Division 110

Income Tax Assessment Act 1997 subsection 110-25(1)

Income Tax Assessment Act 1997 subsection 110-25(2)

Income Tax Assessment Act 1997 subsection 110-25(3)

Income Tax Assessment Act 1997 subsection 110-25(4)

Income Tax Assessment Act 1997 subsection 110-25(5)

Income Tax Assessment Act 1997 subsection 110-25(6)

Income Tax Assessment Act 1997 section 110-35

Income Tax Assessment Act 1997 subsection 110-55(1)

Income Tax Assessment Act 1997 subsection 110-55(2)

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 subsection 116-20(1)

Income Tax Assessment Act 1936 Part IIIA

Reasons for decision

Summary

The Taxpayer made a capital loss for the year ended 30 June 2016 as a result of a CGT event C2 happening under section 104-25 of the ITAA 1997 on the compromise of the right to seek compensation from the Insurers.

This C2 event included a reduced cost base which comprised of the monies paid by the Taxpayer to the Liquidators of the Company to settle claims made against the Taxpayer and the associated legal fees and expenses pursuant to subsection 110-55(1) of the ITAA 1997.

Detailed reasoning

CGT Asset

The term CGT asset is defined in section 108-5 of the ITAA 1997 to mean:

(a) Any kind of property; or

(b) A legal or equitable right that is not property.

In this case, the right to seek compensation from the Insurers is a legal right that meets the definition of a CGT asset pursuant to paragraph 108-5(1)(b) of the ITAA 1997.

Taxation Ruling TR 95/35 (TR 95/35) explains the right to seek compensation is acquired for CGT purposes at the time of the compensable wrong or injury and includes all the rights arising during the process of pursuing the compensation claim. Furthermore, the right to seek compensation is disposed of when it is satisfied, surrendered, released or discharged.

Paragraph 69 of TR 95/35 recognises three types of particular assets that compensation may be received for as follows:

1. An underlying asset

2. A right to seek compensation, and

3. A notional asset

In relation to compensation received under a policy of insurance, paragraph 183 of TR 95/35 states the following:

185. The insured's right of indemnity under the policy is an asset, and for the purposes of this Ruling, falls within the definition of a right to seek compensation. This right of indemnity is acquired by the insured when the triggering event of the policy occurs (e.g., the motor vehicle accident).

In this case the right to seek compensation was acquired when the Taxpayer entered into the Liquidators' Settlement. It follows then that the right included all of the rights which arose during the process of pursuing the claim against the Insurers, including the right to sue the Insurers when they subsequently disallowed the Taxpayer's claim made under the insurance policy.

CGT Event

Subsection 104-25(1) of the ITAA 1997 provides that CGT Event C2 happens if your (the taxpayer's) ownership of an intangible CGT asset ends by the asset:

(a) Being redeemed or cancelled; or

(b) Being released, discharged or satisfied; or

(c) Expiring; or

(d) Being abandoned, surrendered or forfeited or;

(e) If the asset is an option-being exercised; or

(f) If the asset is a convertible interest-being converted.

By entering into the Deed of Release and Agreement with the Insurers, the Taxpayer surrendered the right to seek compensation from the Insurers. In doing so the Taxpayer triggered CGT Event C2.

Subsection 104-25(2) provides for the timing of the CGT event which in this case is the entry into the Deed of Release and Agreement for the Insurers' Settlement. It follows that any capital gain or loss arising must be taken into account in determining the Taxpayer's taxable income in the year ended 30 June 2016.

Subsection 104-25(3) makes provision for the calculation of the capital gain or capital loss made on the ending of an asset. It states that the taxpayer makes a capital gain if the capital proceeds from the ending are more than asset's cost base. On the other hand the taxpayer makes a capital loss if those capital proceeds are less than the asset's reduced cost base.

Capital Proceeds

Section 116-20 of the ITAA 1997 sets out the general rules about capital proceeds. There are some modifications to these general rules, however none of them are relevant in the circumstances of this case.

Subsection 116-20(1) provides that the capital proceeds from a CGT event are the total of:

(a) The money you (the Taxpayer) have received, or are entitled to receive, in respect of the event happening; and

(b) The market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).

In this case, the Taxpayer received a sum of money from entering into the Deed of Release and Agreement for the Insurers' Settlement. It follows that this sum of money was the capital proceeds which flowed from the ending of the asset.

Cost Base

Division 110 of the ITAA 1997 sets out the general rules about cost base and reduced cost base of a CGT asset.

Subsection 110-55(1) of the ITAA 1997 provides that the reduced cost base of a CGT asset consists of 5 elements and subsection 110-55(2) provides that all the elements (except the third one) of the reduced cost base of a CGT asset are the same as those for the cost base.

As the third element of reduced cost base is not something which is relevant in these circumstances the same analysis applies to the determination in this case of what is the cost base as applies to the determination of what is the reduced cost base.

Subsection 110-25(1) of the ITAA 1997 provides that the cost base of a CGT asset consists of 5 elements.

Subsections 110-25(2), (3), (4) (5) and (6) set out, respectively, the first, second, third fourth and fifth elements of a CGT asset's cost base.

Subsection 110-25(2) states that the first element of a cost base is a total of:

(a) The money you paid, or are required to pay, in respect of acquiring it; and

(b) The market value of any other property you gave, or are required to give, in respect of acquiring it (worked out as at the time of the acquisition).

The cost base of a right to seek compensation is outlined in paragraphs 94 to105 of TR 95/35. Although the ruling cites reference to the application of the former CGT provisions contained in Part IIIA of Income Tax Assessment Act 1936 (ITAA 1936) the ruling is equally applicable to the relevant re-written CGT provisions in the ITAA 1997.

Paragraph 96 of TR 95/35 states that there are a number of views on the potential width of the expression 'consideration in respect of the acquisition of an asset'. A narrow or strict interpretation of the expression effectively limits its application to the initial purchase cost of an asset.

The Commissioner's view is expressed in paragraph 98 of TR 95/35 as being that it is appropriate that a wider view be taken of what money, property or money and property falls within the cost base because it is paid or given in respect of the acquisition of the asset.

Paragraph 101 of TR 95/35 provides that broadly speaking, money, property, or money and property come within the cost base and are regarded as paid or given in respect of the acquisition of the asset if there is some direct and substantial link between the money or property and the acquisition of the asset.

Paragraphs 103 to 105 of TR 95/35 state the following:

103. On this wider interpretation of paragraph 160ZH(1)(a), expenditure or an outgoing forms part of the cost base of a right to seek compensation if there is a direct and substantial link between the expenditure or outgoing and the arising of the right to seek compensation.

104. If the right to seek compensation arises in respect of a monetary loss of the taxpayer (e.g., in respect of a claim for breach of contract, as a result of which the taxpayer must incur additional expenditure) the amount of that loss is included in the cost base of the right to seek compensation for that loss. It is an amount which the taxpayer has paid or is required to pay in respect of the acquisition of the right to seek compensation for having to incur the expenditure.

105. Similarly, if the taxpayer is insured under a contract of indemnity insurance and is liable to pay a claim covered by that policy (e.g., for a claim for negligent advice against the taxpayer), the amount of the claim paid by the taxpayer is included in the cost base of the taxpayer's right to claim against the insurer for indemnity under the policy. Refer to paragraphs 183 to 187 of this Ruling.

The Commissioner's view is confirmed in paragraph 186 of TR 95/35 which states that the amount which the insured is required to pay to the claimant forms part or all of the total acquisition costs of the right of the insured to seek compensation under the indemnity from the insurer.

In the circumstances of this case, the Taxpayer paid the Settled Sum to settle claims made against the Taxpayer. There is a direct and substantial link between the Settled Sum paid by the Taxpayer under the Liquidators' Settlement (in the Taxpayer's capacity as director of the Company) and the acquisition of the asset (being the right to seek compensation for the Director and Officers liability insurance cover to the Company). It follows then that the Settled Sum paid by the Taxpayer under the Liquidators' Settlement would be included in the first element of the cost base of that asset.

Subsection 110-25(3) of the ITAA 1997 states that the second element of a cost base is the incidental costs you incurred.

Section 110-35 of the ITAA 1997 lists the categories of incidental costs that are included in the second element of cost base that are incidental costs a taxpayer has incurred:

(a) To acquire a CGT asset; or

(b) That relate to a CGT event.

The majority of the ten categories listed in section 110-35 comprise costs which would be incurred in acquiring tangible assets. The first of the categories includes remuneration for the services of a legal adviser.

It follows then that legal fees incurred in the negotiation and drafting of the Deed of Release and Agreement entered into with the Insurers as well as the legal fees incurred in the negotiation of the Deed of Settlement entered into with the Liquidators of the Company would be included in the second element of the cost base of the asset.

The Taxpayer did not incur any expenses relating to the third element (subsection 110-25(4) of the ITAA 1997), or the fourth element (subsection 110-25(5) of the ITAA 1997) of the cost base.

Subsection 110-25(6) of the ITAA 1997 states that the fifth element is capital expenditure incurred to establish, preserve or defend your title to the asset or a right over the asset.

In this case, any legal expenses incurred by the Taxpayer in taking proceedings against the Insurers would qualify as a fifth element capital expenditure and accordingly these costs would be included in the cost base of the right to seek compensation for the purpose of calculating the capital loss made by the Taxpayer on compromising the right the Taxpayer had against the Insurers.

Conclusion

As the Settled Sum paid by the Taxpayer under the Liquidators' Settlement was greater than the sum of money received by the Taxpayer under the Insurers' Settlement, the Taxpayer made a capital loss for the year ended 30 June 2016 on the compromise of the right to seek compensation from the Insurers.