Edited version of private advice

Authorisation Number: 1051567203337

Date of advice: 16 August 2019

Ruling

Subject: Income - lump sum - compensation - inappropriate advice

Question 1

Will your share of the compensation payment that relates to the capital loss made on the investment product (due to inappropriate advice) be treated as additional capital proceeds for the disposal of the investment?

Answer

Yes.

Question 2

Will your share of the compensation payment received for income you would have earned (if you had received appropriate advice) be assessable as ordinary income?

Answer

Yes.

This ruling applies for the following period

Year ending 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

Financial advice

You obtained financial advice from a former ABC Financial Planning (ABC) representative in February 20XX.

The representative recommended that you establish three funds within the L Plan (L), one for each family member, as follows:

·   F: $XX,XXX

·   O: $XX,XXX; and

·   S: $XX,XXX

The investments

You followed the advice and three L funds were established on XX February 20XX.

You became concerned about the performance of the L funds as their balances were dropping.

On XX October 20XX, you redeemed the following L funds:

·   F: closing balance $XX,XXX; and

·   O: closing balance $XX,XXX.

You redeemed the L fund established for S on XX June 20XX, with the closing balance of $XX,XXX.

You suffered an overall loss (i.e. combined) of $X,XXX

Review of advice and services

You made a claim, through your lawyers Lawyers, under A Review Program, in respect of the advice provided in 20XX by the former representative of ABC.

You claimed that the advice provided was inappropriate for your needs and claimed compensation of $XX,XXX representing the difference in the performance of the L fund and an appropriate investment product, plus interest on the calculated difference.

ABC agreed to resolve the claims and offered the settlement sum of $XX,XXX to you in full and final settlement of your claim. You accepted the offer, signing the letter of agreement in the financial year ended 30 June 20XX.

You assert that the $XX,XXX payment is made of the following components:

·   Reimbursement of capital loss incurred $X,XXX

·   Compensation for inappropriate advice $X,XXX

·   Loss of income (interest) $X,XXX

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 10-5

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 section 102-20

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

Income Tax Assessment Act 1997 subsection 104-10(1)

Income Tax Assessment Act 1997 subsection 104-10(3)

Reasons for decision

Ordinary Income

Your assessable income includes income according to ordinary concepts, which is called ordinary income (section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)).

Ordinary income has generally been held to include 3 categories, namely, income from rendering personal services, income from property and income from carrying on a business.

Other characteristics of income evolved from case law include receipts that:

·   are earned

·   are expected

·   are relied upon, and

·   have an element of periodicity, recurrence or regularity.

An amount paid to compensate for loss generally acquires the character of that for which it is substituted (FC of T v. Dixon (1952) 86 CLR 540: (1952) 5 ATR 443; 10 ATD 82). Compensation payments which substitute income have been held by the courts to be income according to ordinary concepts (FC of T v. Inkster 89 ATC 5142; (1989) 20 ATR 1516 and Tinkler v. FC of T 79 ATC 4641; (1979) 10 ATR 411).

Statutory income

Amounts that are not ordinary income but are included in your assessable income by another provision are called statutory income (section 6-10 of the ITAA 1997).

The provisions dealing with statutory income are listed in section 10-5 of the ITAA 1997. Included in this list is section 102-5 (capital gains).

Capital Gains

You make a capital gain or capital loss as a result of a capital gains tax (CGT) event happening (section 102-20 of the ITAA 1997). For most CGT events, your capital gain or loss is the difference between your capital proceeds and the cost base or reduced cost base of your CGT asset.

The capital proceeds from a CGT event include the money you have received, or are entitled to receive, in respect of the event happening (subsection 116-20(1) of the ITAA 1997).

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts considers the CGT consequences for a taxpayer in receipt of compensation and whether the amount should be included in the assessable income of the recipient under the CGT provisions.

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 (paragraph 70 of TR 95/35).

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 (paragraph 3 of TR 95/35).

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 (paragraph 3 of TR 95/35).

Treatment of compensation if a CGT event happens (disposal of the asset)

CGT event A1 happens when you dispose of a CGT asset (subsection 104-10(1) of the ITAA 1997). The time of the event is when you enter into a contract for the disposal, or, if there is no contract, the time of disposal is taken to be the time when the change in ownership occurs (subsection 104-10(3) of the ITAA 1997).

If an amount of compensation is received by a taxpayer wholly in respect of the disposal of an underlying asset, or part of an underlying asset of the taxpayer, the compensation represents consideration received on the disposal of that asset. In these circumstances, we consider that the amount is not consideration received for the disposal of any other asset, such as the right to seek compensation (paragraph 4 of TR 95/35).

The compensation may form part of or all of the consideration in respect of the disposal of the underlying asset, and may be received by the taxpayer before or after the actual disposal of the underlying asset (paragraph 144 of TR 95/35). For example, litigation may result in compensation for losses arising from an investor's former investments.

Application to your circumstances

In your case, you received a payment of $XX,XXX from ABC in relation to inappropriate advice provided in relation to your L fund investments.

You assert that the $XX,XXX payment is made up of three components, return of capital, compensation for inappropriate advice and loss of income (interest).

Ordinary income

Compensation payments which substitute income, such as interest have been held by the courts to be income according to ordinary concepts. As such the loss of income component of the payment ($X,XXX) would be considered ordinary income in the year ended 30 June 20XX.

As you held these investments jointly, your share of this interest amount is included in your assessable income.

Capital gains tax

The remainder of the payment received, the return of capital ($X,XXX) and compensation for inappropriate advice ($X,XXX) components, do not have any of the characteristics of ordinary income and was not paid to substitute income. These components of the payment are not assessable as ordinary income under section 6-5 of the ITAA 1997. As such, consideration needs to be given to the capital gains tax provisions.

The act or transaction which generated this compensation payment is the alleged inappropriate advice provided by the former representative of ABC which caused you to invest in the L fund. Applying the look-through approach, the relevant asset to which this compensation is most directly related is the L fund.

CGT event A1 happened when you disposed of the L funds, two in the financial year ended 30 June 20XX and the other in the financial year ended 30 June 20XX. The remainder of the payment received will be treated as 'additional capital proceeds' for the redemption of the investments.