Edited version of your written advice

Authorisation Number: 1051238357815

Date of advice: 20 June 2017

Ruling

Subject: Assessable recoupment

Question 1

Is the base compensation amount awarded by the Financial Ombudsmen Service an assessable recoupment under subdivision 20-A of the Income Tax Assessment Act 1997?

Answer

Yes

This ruling applies for the following period:

Year ending 30 June 2017

The scheme commences on:

2017

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Facts

You entered into a managed investment scheme for which the responsible entity was Project Limited in the 20XX-0Y financial year.

The name of the scheme was The Project.

There was a Product Ruling for the scheme (PR 2007/12) which was withdrawn in 20ZZ.

You formed a partnership with XX in which you jointly acquired The Project for a GST inclusive cost of $X.

XX had a share in the partnership while you held the remaining share.

You and XX acquired your interest in The Project by obtaining a loan for the full purchase price from a financial institution.

The amounts you borrowed and the other expenses incurred were deducted under the partnership.

The Project wound up in 20XY and was deregistered by ASIC the same year.

In 20ZZ you took action to obtain compensation for the financial advice provided to you under the Financial Ombudsmen Service ('FOS’) scheme.

A Determination of Dispute was made by FOS in 20XZ.

FOS determined that you received and relied upon financial advice from the advisor.

FOS determined that the financial advisor made inadequate enquiries into your circumstances, particularly to tolerance to risk and therefore made inappropriate advice.

FOS determined that you would not have entered into the investment if you had received appropriate advice and that the financial advisors breach was the cause of your loss.

FOS determined that your loss should be assessed on a 'no transaction’ basis and was assessed on benefits versus expenses analysis.

This involved a determination of the costs incurred in entering the scheme minus any benefit that had been gained by being in the scheme.

The compensation was related to expenses you had deducted in the partnership.

You accepted the determination in 20XZ.

Assumption

You will receive a share of the compensation due to the share you have in the partnership.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 118-20

Income Tax Assessment Act 1997 subdivision 20-A

Reasons for decision

Summary

The compensation amount you will receive under the deed of settlement relates to the disposal of the right to seek compensation by you which resulted in CGT event C2 happening pursuant to section 104-25 of the Income Tax Assessment Act 1997 ('ITAA 97’). The compensation amount did not arise from any permanent damage to, or reduction in the value of, the underlying asset, being the investments in the Project.

The amount paid to compensate you for the 'monetary loss’ incurred in relation to the Project falls within the meaning of an indemnity. As the compensation amount, in whole recouped expenditure for which you have claimed a tax deduction, this amount will constitute an 'assessable recoupment’.

The assessable recoupment provisions take precedence over the CGT provisions.

Detailed reasoning

The compensation amount you will receive under the deed of settlement relates to the disposal of the right to seek compensation by you, which resulted in CGT event C2 happening pursuant to section 104-25 of the Income Tax Assessment Act 1997 (ITAA 97). The compensation amount did not arise from any permanent damage to, or reduction in the value of the investments in the Project and the compensation amount is for the disposal of the right to seek compensation.

However section 118-20 ITAA 97 has the function of reducing capital gains if the amount is otherwise assessable, such as with an assessable recoupment.

'Recoupment’ and 'assessable recoupment’

Subdivision 20-A applies where a taxpayer has received an amount as recoupment of a deductible loss or outgoing. The effect of Subdivision 20-A is to include the recouped amount in your assessable income to the extent the loss or outgoing has or can be deducted.

What is considered to be an 'assessable recoupment’ is set out in section 20-20 as follows:

Insurance or indemnity

(2) An amount you have received as *recoupment of a loss or outgoing is an assessable recoupment if:

(a) you received the amount by way of insurance or indemnity; and

(b) you can deduct an amount for the loss or outgoing for the ^* current year, or you have deducted or can deduct an amount for it for an earlier income year, under any provision of this Act.

Other recoupment

(3) An amount you have received as *recoupment of a loss or outgoing (except by way of insurance or indemnity) is an assessable recoupment if:

(a) you can deduct an amount for the loss or outgoing for the *current year; or

(b) you have deducted or can deduct an amount for the loss or outgoing for an earlier income year;

under a provision listed in section 20-30.

Whether the compensation amount received by you would fall within the meaning of an 'assessable recoupment’ is limited to an amount received by way of insurance or indemnity. This is because none of the provisions listed in the table in subsection 20-30(1) apply to your circumstances.

There is no evidence that you received the compensation amount by way of insurance. Thus, it must be considered if the amount was received by way of 'indemnity’.

Indemnity

The word 'indemnity' is not defined in the ITAA 1997 and so it must take its ordinary meaning.

According to the Macquarie Dictionary, 'indemnity’ is:

1. protection or security, as by insurance, against damage or loss.

2. compensation for damage or loss sustained.

3. something paid by way of such compensation.

In Batchelor v. Commissioner of Taxation [2014] FCAFC 41; 2014 ATC 20-450 ('Batchelor’), Edmonds and Pagone JJ stated in paragraph 13:

Generally speaking a payment will not be regarded as an indemnity (whether the word is taken alone or in combination in a composite phrase “by way of insurance or indemnity”) unless the entitlement to its receipt precedes the event in respect of which it is paid. An ex gratia payment, for example, is not apt to be regarded as indemnification of a loss or outgoing notwithstanding that its receipt may be said, from the point of view of economic equivalence, to compensate the recipient for a loss which had been suffered or an outgoing which had been incurred, Similarly, a refund would not ordinarily be regarded as an indemnification notwithstanding that its receipt may be said to have rendered a taxpayer harmless, from an economic point of view, for an antecedent loss or outgoing.

In the Supreme Court of South Australia case Goldsbrough Mort & Co Limited v FC of T, 76 ATC 4343 ('Goldsbrough Mort’), Walters J stated the following:

In my view, the word 'indemnity' in sec 26(j) [now sections 20-20, 20-35 and 20-40 of the ITAA 1997] is not so entirely a special word that there can be attributed to it any one particular meaning, or any one comprehensive definition. I think that the word is capable of being construed so as to contrast a receipt, of the kind now under consideration, with a receipt under a 'contract of indemnity'; that the receipt here is no less a receipt 'by way of indemnity... in respect of any loss or outgoing' because it has not been received under a contract of indemnity. I cannot accept the notion that 'the terms of sec 26(j) suggest that it is concerned with a contract of insurance or indemnity giving security or protection against contingent hurt'. I think it would be wrong to give the words of the section such a narrow interpretation. And if I may respectfully adopt the words of Herron J (as he then was) in Williamson and Anor v Commr for Railways (1959) 76 WN (NSW) 648, at p 664, 'the word ''indemnity'' in sec 26(j) is not used as limited to merely contractual indemnity, that is, as limited to receipts which are of the same character as ''insurance''.

Walters J., following the judgement of Kitto J. in FC of T v. Wade (1951) 84 CLR 105; [1951] HCA 66, held that the meaning of 'indemnity’ was not limited to amounts received under a contract of indemnity entered into to provide protection against contingent loss or damage and extended to amounts received as compensation for loss or damage already incurred irrespective of whether there was a contract of indemnity.

This view drew support in Batchelor, first by the AAT and subsequently by Wigney J. in the Full Federal Court. Relevantly, Wigney J viewed (at 74) that the ordinary meaning of 'indemnity’ was wide enough to encompass both the protection against loss that might occur in the future and compensation for loss or damage that might have occurred in the past. Further, Wigney J stated (at 77):

In my respectful opinion, Hunt J was wrong to confine the meaning of the word “indemnity” to an obligation to compensate for the losses than may occur in the future. Nothing in the context of s 26(j), or the statutory context, supported or required the narrow meaning given to it by his Honour. Nor is a narrow construction warranted in the context of s 20-20(2).

The reasoning and decision in Goldsbrough Mort were relied upon by the AAT in the recent case Falk v. FC of T [2015] AATA 392; 2015 ATC 10-395 (Falk), in which the taxpayer was reimbursed the cost of legal expenses for which he had previously claimed a tax deduction.

However, in Falk, it was determined that the payment to the taxpayer in that case did not have the character of an ex gratia payment. It was stated at paragraphs 64 to 66 that:

Mr Raphael referred the Tribunal to the definition of an 'act of grace payment' in Butterworths Australian Legal Dictionary:

Strictly speaking, there is no legal liability on the part of the government to make payment, but if a person has been unfairly disadvantaged by some act of the government, recompense is considered appropriate. The relevant circumstances may arise where a public servant has given incorrect advice which has caused loss to a person, or when the application of relevant legislation would have anomalous, unjust, or otherwise unacceptable consequences. Also known as an 'ex gratia payment'^]

We take it to be common ground between the Commissioner and Dr Falk that, had the facts been that the receipt of $500,350.33 by Dr Falk was simply in settlement of his claim for costs in the AIRC, then the payment would be assessable as statutory income because it would have been a payment made by way of indemnity.

In any event we would so conclude. Reading the passage in its context, the Tribunal is satisfied that Edmonds and Pagone JJ [in Batchelor] were referring to an ex gratia payment only in the sense conveyed by the Butterworths' definition: that is a payment made for reasons otherwise than on account of a legal liability (emphasis added).

The ATO’s Decision Impact Statement to the decision in Falk noted, in part, that:

The question of whether a payment received as compensation for past losses, can be received 'by way of indemnity', despite there being no obligation to make good the loss at the time it was suffered was raised by the conflicting authorities of Walters J in Goldsborough Mort & Co Ltd v. FCT (1976) 14 SASR 591 (preferred by the Commissioner) and Hunt J in Commercial Banking Company of Sydney Ltd v. Federal Commissioner of Taxation (1983) 70 FLR 433 (preferred by Dr Falk).

Having considered those authorities, together with the decision at first instance in Batchelor and Commissioner of Taxation [2013] AATA 93, and on appeal to the Full Court of the Federal Court at (2014) 219 FCR 453, and the decision of Mason CJ, Brennan, Deane, Dawson and McHugh JJ in the High Court in Cachia v. Hanes (1994) 179 CLR 403, the Tribunal concluded (at [55]) that Walter J's views in Goldsbrough Mort correctly stated the law. That is a payment received as compensation for past losses, can be received 'by way of indemnity', despite there being no obligation on the payer to make good the loss at the time it was suffered.

The payments made under the deed of settlement are considered to constitute compensation for a 'no transaction’ claim, being the outgoings incurred by you as a consequence of your financial planner’s advice. It is acknowledged that there was 'no obligation on the payer to make good the loss at the time it was suffered’. However, as per the decision in Goldsborough Mort, this is not a requirement for a payment to be an indemnity.

Further, it is not apt to describe the amount received by you as an ex gratia payment. There must be something about the quality of the amount received which might be regarded as being by way of indemnity. In the present case the payment to you was not an amount from a person who was obliged to make good a loss occasioned by another. The amount received was consideration to compromise the legal actions you took against your financial advisers. It was not a mere refund or reimbursement, and is to be characterised as some form of compensation for loss or damage.

The payments can be characterised as being to 'compromise’ the claim for compensation for allegedly inappropriate advice, and to release the financial planners 'in relation to all actions and claims arising from’ the Project investments.

It is our view that the compensation amount paid under the terms of the deed of settlement was not an ex gratia payment, and falls within the meaning of an indemnity and therefore meets the first requirement of an assessable recoupment in paragraph 20-20(2)(a).

The second requirement in paragraph 20-20(2)(b) is that:

…you can deduct an amount for the loss or outgoing for the current year, or you have deducted or can deduct an amount for it for an earlier income year, under any provision of this Act.

The compensation amount paid pursuant to the deed of settlement was intended to pay the balances of the losses you had incurred in taking out the loan to pay for the investment.

The purpose in you obtaining the loan was to pay for the initial (mainly deductible) cost of entering into the Project investment.

Hence, the portion of the compensation amount that recoups the deductible expenditure incurred through the use of the loan funds would be considered an assessable recoupment, and is to be included in your assessable income pursuant to subsection 20-35(1). Given the extent to which you were able to claim a tax deduction for your initial expenditure in relation to the Project investment, it is our view that this assessable recoupment amount is likely to constitute the whole of the compensation amount.

Interaction of the CGT and recoupment provisions

Pursuant to the operation of subsection 20-20(1):

An amount is not an assessable recoupment to the extent that it is ^*ordinary income, or it is ^*statutory income because of a provision outside this Subdivision.

In Batchelor, Deputy Professor Deutsch states:

On the conclusion which I have reached, that the amount of $47,927 is not assessable income on ordinary principles under s 6-5 but is assessable income under s 20-20, the amount of the capital gain that would otherwise be included is reduced effectively to zero by the inclusion in the cost base of the full amount.

An amount is to be included in a taxpayer’s assessable income first as an assessable recoupment before consideration of the capital gains provisions, with the expenditure to which the assessable recoupment relates then being included in the cost base of the CGT asset.

As such, in working out for the purposes of section 20-20 whether an amount has been included in assessable income under another provision, you don't consider the CGT provisions. The CGT provisions are always residual.

Further it cannot be said that a capital gain, per se, is ever included in assessable income. It is only a net capital gain which is so included.

Thus, pursuant to the application of the law outlined above, to the extent to which the compensation payment represents an assessable recoupment, it will be assessed under subdivision 20-A rather than under the CGT provisions.