Edited version of private advice

Authorisation Number: 1051533917791

Date of advice: 21 June 2019

Ruling

Subject: Compensation

Question 1:

Is the amount of indebtedness released by the Deed of Settlement additional capital proceeds for the sale of your investments in the relevant income year?

Answer:

Yes.

Question 2:

Is any amount of indebtedness released an assessable recoupment under section 20-20 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

No.

Question 3:

Is an interest deduction allowable in respect of future interest payments on the amount of the remaining debt that relates to the investments, even though the underlying investments are no longer held?

Answer:

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX to Year ended 30 June 20XX

The scheme commenced on

1 July 20XX

Relevant facts

You and your spouse (you) received financial advice from an advisor.

On the advice of the advisor and with their assistance, at various times, you applied for loans from a bank.

The loans were used to purchase investments.

As at XX/XX/XXXX the amounts owing that related to the investments were $X ($X principal and $X capitalised interest) and $X ($X principal and $X capitalised interest) respectively.

The returns generated by the investments were no longer available to you to apply towards meeting, or were insufficient to meet, repayment obligations under the loan agreements.

You submitted a draft Statement of claim to the bank on XX/XX/XXXX in which you claimed that you relied on representations made by the bank when investing in the investments and varying your loan to make the investments. You also claimed that the representations amounted to misleading and deceptive conduct by the bank which resulted in you suffering loss and damage.

You and the bank have participated in a dispute resolution process as set out in the Deed of Settlement.

As a result of participating in the scheme, the parties have agreed by way of Deed of Settlement dated XX/XX/XXXX that you were to pay the following amounts to the bank:

(a)  $X within X days of signing;

(b)  $X within X years and X days of signing (Balance Payment); and

(c)  monthly interest payments on the Balance Payment commencing on XX/XX/XXXX until repayment occurs,

(collectively, the Settlement Sum).

The parties also agreed that full payment of the Settlement Sum would be accepted as full and final settlement of all matters between you and the bank.

Effectively, the Deed of Settlement operates to reduce the amount you owe from $X to $X resulting in a debt forgiveness of $X (Forgiven Amount).

There was no documentation prepared or calculations carried out evidencing the amount of loss and damage that was supplied to the bank or prepared by you prior to mediation. The $X loan that remained was determined based on a combination of:

1. the amount that you were reasonably likely to be able to service; and
2. the amount that the bank were willing to forgive.

You have disposed of all your investments.

The capital loss previously made by you in respect of the investments was $X.

The Forgiven Amount was less than the amount owing that related to the investments.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 103-10

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 20-20

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

All legislative references that follow are to the ITAA 1997.

Question 1

The amount of debt forgiven by the bank to settle your claim against them for loss suffered in relation to the investments for which you allege they provided inappropriate advice, is not considered to be income according to ordinary concepts.

The capital gains tax (CGT) implications also require consideration.

Section 103-10 states that if money is applied for your benefit, including by discharging all or part of a debt you owe, the CGT provisions apply to you as if you had received the money.

Therefore, for CGT purposes, you are treated as if you had received the Forgiven Amount.

Taxation Ruling TR 95/35 discusses the CGT 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 as follows:

The 'look-through' approach is 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. It is also referred to in this Ruling as the underlying asset approach.

'Underlying asset' is also defined in paragraph 3 of TR 95/35 as follows:

The underlying asset is the asset that, using the 'look-through' approach, is disposed of or has suffered permanent damage or has been permanently reduced in value because of some act, happening, transaction, occurrence or event which has resulted in a right to seek compensation from the person or entity causing that damage or loss in value or against any other person or entity.

If there is more than one underlying asset, the relevant underlying asset is the asset which leads directly to the payment of the amount of compensation. For example, if a taxpayer receives an amount of compensation for the destruction of his or her truck, the truck is the underlying asset.

The alleged inappropriate advice and subsequent loss suffered was in relation to the investments. Therefore, applying the 'look-through' approach, the most relevant asset to which the compensation most directly relates is the investments.

Where the underlying asset for which the compensation relates has been disposed of, the compensation is considered to be additional capital proceeds for the disposal.

As you have disposed of your investments you will have to apportion the Forgiven Amount between each investment and recalculate the capital gain/loss made on the disposals to take into account the additional amount of capital proceeds received.

Question 2

The first condition that must be met for an amount to be an assessable recoupment under section 20-20 is that it is an 'amount you have received'.

As mentioned previously, section 103-10 deems a reduction in debt owed to be an amount received for CGT purposes. However, there is no equivalent provision that operates to deem a reduction in debt owed to be an amount received for the purpose of assessable recoupments under section 20-20.

As you have not received an amount, the amount of debt forgiven is not an assessable recoupment under section 20-20.

Even if a forgiven debt was considered to be an amount you have received for assessable recoupment purposes, it is not considered that the other requirements have been met for an amount to be an assessable recoupment under either subsection 20-20(2) or (3).

For an amount to be an assessable recoupment under subsection 20-20(2), it must be received 'by way of insurance or indemnity'. The majority judgement in the Federal Court in the case Batchelor v. Commissioner of Taxation [2014] FCAFC 41 considered that:

Generally speaking a payment will not be regarded as an indemnity (whether the word is taken alone or in combination in the composite phrase "by way of insurance or indemnity ") unless the entitlement to its receipt precedes the event in respect of which it is paid.

It is not considered that the Forgiven Amount was received by way of insurance or indemnity and therefore subsection 20-20(2) does not apply.

For an amount to be an assessable recoupment under subsection 20-20(3), it must relate to a deduction allowable under one of the provisions listed in section 20-30. None of the provisions listed in section 20-30 are relevant in the present case and therefore subsection 20-20(3) does not apply.

Question 3

Section 8-1 generally allows a deduction for interest on a loan used to derive assessable income.

Taxation Ruling TR 2004/4 Income Tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities (TR 2004/4) considers the deductibility of interest expenditure after the cessation of the relevant income earning activities, specifically at paragraphs 40 to 50.

At paragraph 44 of TR 2004/4, reference is made to court cases Full Federal Court in FC of T v. Brown 99 ATC 4600; (1999) 43 ATR 1 (Brown) and FC of T v. Jones 2002 ATC 4135; (2002) 49 ATR 188 (Jones), where the court held, in both instances, that interest incurred on loans continued to be deductible despite the cessation of the relevant income earning activities. Even though Brown and Jones involved taxpayers who carried on a business, the ATO accepts that the same principle should apply to income earning activities that do not constitute a business, such as passive investments.

A key factor in determining the deductibility of interest incurred after the income earning activities have ceased is whether or not the continuing liability to interest is seen as a burdensome legacy of the past (suggestive of a continuing nexus with prior assessable income) or whether the liability is seen to be associated with present or future advantages (suggestive of a broken nexus).

The nexus between the interest expense and the relevant income earning activities will be broken where:

·         the taxpayer has the ability to repay the loan but chooses not to do so, or

·         the taxpayer makes a conscious decision to extend the loan in order to derive an ongoing commercial advantage unrelated to the prior income earning activities which resulted in the debt.

In your case, your continuing liability to interest is seen as a burdensome legacy of the past. It is a direct result of you having invested in and you making a loss when the investments were disposed of. It is accepted that you are not keeping the remaining debt that relates to the previous investments on foot for purposes unrelated to the former investments.

Therefore, you are entitled to a deduction in respect of future interest payments on the amount of the remaining debt that relates to the investments, even though the underlying investments are no longer held.