Edited version of private advice

Authorisation Number: 1051575544689

Date of advice: 11 October 2019

Ruling

Subject: Compensation - inappropriate advice

Question 1

Is the component of the compensation you received that relates to the return of capital on the investment (due to inappropriate advice) considered additional capital proceeds for the disposal of the investment?

Answer

Yes.

Question 2

Is the interest component of the compensation you received assessable as ordinary income?

Answer

Yes.

This ruling applies for the following periods

Year ended 30 June 2017

Year ended 30 June 2018

The scheme commences on

1 July 2016

Relevant facts and circumstances

The deceased passed in XXXX.

The deceased obtained financial advice in XXXX.

The deceased followed the advice provided and established an Investment (the investment).

You redeemed the investment on DD/MM/YYYY as part of the administration of the Estate.

A review of the financial advice provided was undertaken and it was determined that the advice provided was potentially inappropriate.

You received an offer in which you would be paid $X by way of compensation which consisted of $Y for the difference in investment performance and $Z in interest.

You accepted the offer and received the payment in the year ended 30 June 20XX.

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 104-10(1)

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

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

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. Interest is ordinary income.

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 $X in relation to inappropriate advice provided to the deceased in relation to the investment.

The payment is made up of two components, a return of capital of $Y and interest on this amount of $Z.

Ordinary income

The interest component of the payment is ordinary income and is included in your assessable income in the year ended 30 June XXXX.

Capital gains tax

The remainder of the payment received, representing the return of capital, does not have any of the characteristics of ordinary income and was not paid to substitute income. Therefore, this component of the payment is not assessable as ordinary income. 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 representative of the financial institution which caused the deceased to invest in the investment. Applying the look-through approach, the most relevant asset to which this compensation is directly related is the investment.

CGT event A1 happened when you disposed of the investment in the financial year ended 30 June 20XX. The remainder of the payment received is considered to be 'additional capital proceeds' for the redemption of the investment. This means that the capital gain or capital loss made on the disposal of the investment will need to be recalculated.