Edited version of private advice

Authorisation Number: 1051601327790

Date of advice: 31 October 2019

Ruling

Subject: Compensation - deficient advice provided by a solicitor

Question 1

Is the lump sum payment received assessable as ordinary income?

Answer

No

Question 2

Is the lump sum payment received assessable under the capital gains tax (CGT) provisions?

Answer

Yes

Question 3

Do any of the CGT exemptions apply?

Answer

No

This ruling applies for the following period:

Year ended 30 June 2019

The scheme commences on:

1 July 2018

Relevant facts and circumstances

You were advised verbally by your solicitor to sell your shares. You had a net capital gain the 2016-17 financial year which resulted in a tax debt.

You sent a letter of demand for the breach of duty via your solicitor which alleged that your solicitor had provided deficient advice. After mediation you accepted the offer of compensation for an agreed amount.

You accrued legal expenses.

Reasons for Decision

Summary

The lump sum payment does not have the characteristics of income according to ordinary concepts and therefore is not assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997).

The lump sum payment is considered to be capital in nature and assessable under the capital gains tax provisions as capital proceeds from the disposal of your right to seek compensation.

The Commissioner does not consider that any part of the capital gain can be disregarded as the exemptions contained in sections 118-37 and 118-305 of the ITAA 1997 do not apply.

Detailed reasoning

Ordinary income

Section 6-5 of the ITAA 1997 provides that the assessable income of a taxpayer includes income according to ordinary concepts (ordinary income).

Based on case law, it can be said that ordinary income generally includes receipts that are earned, expected, relied upon, and have an element of periodicity, recurrence or regularity.

In your situation you have accepted a settlement payment as a result of incorrect information being provided to you by your solicitor regarding the sale of shares. The payment is not earned by you as it does not relate to services performed or to your employment duties with your employer.

The payment is also a one off payment and it does not have an element of recurrence or regularity. It does not have the character of income.

Considering the full circumstances, the payment is not regarded as ordinary income and is therefore not assessable under section 6-5 of the ITAA 1997.

Capital proceeds

Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but are included in assessable income by another provision, are called statutory income. Capital gains are included as assessable income under section 102-5 of the ITAA 1997.

Paragraph 108-5(1)(b) of the ITAA 1997 specifically includes a legal or equitable right within the definition of a CGT asset. A taxpayer's right to seek compensation is therefore classified as an intangible CGT asset.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts discusses the capital gains tax implications for compensation receipts. Why the payment was made is an important factor in determining whether an asset has been disposed of for capital gains tax purposes.

TR 95/35 discusses the various scenarios, including:

·        disposal of the underlying asset,

·        compensation for permanent damage to, or permanent reduction in value of, the underlying asset, and

·        disposal of the right to seek compensation.

The transaction which generated your compensation receipt is as a result of the actions undertaken by your solicitor, who you believe provided negligent financial advice to you and your agents. The relevant CGT asset in your case is the right to seek compensation. The payment received was in full settlement of the claims made.

Your right to seek compensation is an intangible CGT asset (acquired at the time the right arose to take action against your solicitor for providing the incorrect advice) and your ownership of that asset ended when you accepted the lump sum to settle your claim. At that time CGT event C2 happened. CGT event C2 happens if your ownership of an intangible CGT asset ends in certain ways, including being released or cancelled (subsection 104-25(1) of the ITAA 1997). In your case, the lump sum payment represents capital proceeds for your CGT C2 event.

CGT exemptions

The CGT exemptions that require consideration in this case are those provided by paragraph 118-37(1)(a) and section 118-305 of the ITAA 1997.

Under paragraph 118-37(1)(a) of the ITAA 1997 a capital gain is disregarded if it is compensation or damages you receive for:

'(i) any wrong or injury you suffer in your occupation; or

(ii) any wrong, injury or illness you or your relative suffers personally'.

Wrong you suffer personally

Subsection 160ZB(1) of the Income Tax Assessment Act 1936 (ITAA 1936) which was re-written as paragraph 118-37(1)(a) of the ITAA 1997 sheds light on what is meant by a wrong you suffer personally.

Subsection 160ZB(1) of the ITAA 1936 stated:

A capital gain shall not be taken to have accrued to a taxpayer by reason of the taxpayer having obtained a sum by way of compensation or damages for any wrong or injury suffered by the taxpayer to his or her person or in his or her profession or vocation and no such wrong or injury, or proceeding instituted or other act done or transaction entered into by the taxpayer in respect of such a wrong or injury, shall be taken to have resulted in the taxpayer having incurred a capital loss.

(emphasis added)

Subsection 1-3(2) of the ITAA 1997 states that where the ITAA 1936 'expressed an idea in a particular form of words' and the ITAA 1997 'appears to have expressed the same idea in a different form of words in order to use a clearer or simpler style', the ideas are not be taken to be different just because different forms of words were used.

There is nothing in an Explanatory Memorandum or any other extrinsic material in relation to the remaking of subsection 160ZB(1) of the ITAA 1936 into paragraph 118-37(1)(a) of the ITAA 1997 that indicates that the meaning or effect of the new provision was to be any different to the old provision.

Therefore, it is considered that a wrong suffered personally by a taxpayer means a wrong suffered 'to his or her person'.

Negligence is a tort so is a legal wrong. It is a failure to take reasonable care to avoid causing injury or loss to another person.

It could be argued that the negligence by your solicitor in providing incorrect information was a wrong that you suffered personally. However, the meaning of 'wrong' must be considered in the context of the words around it which are 'injury' and 'illness' in relation to paragraph 118-37(1)(a) of the ITAA 1997 and 'injury suffered by the taxpayer to his or her person' in relation to subsection 160ZB(1) of the ITAA 1936.

Taking into account this context, it is considered a wrong suffered personally for the purposes of paragraph 118-37(1)(a) of the ITAA 1997 would include, for example, defamation, as this is a wrong suffered by the taxpayer to his or her person but would not include negligence that causes financial loss as unlike defamation, injury or illness, it is not a wrong suffered by a taxpayer to his or her person.

This interpretation is supported by TR 95/35 which contains two examples that deal with compensation for negligence that resulted in financial loss (examples 8 and 28). In example 8, the taxpayer was assessed on the compensation as a capital gain on the disposal of their right to seek compensation and no CGT exemptions (including subsection 160ZB(1) of the ITAA 1936/paragraph 118-37(1)(a) of the ITAA 1997) were considered to apply.

In example 28 at paragraph 333 of TR 95/35, the end result was that there was no capital gain but this was because of reasons other than the wrong suffered personally exemption provided for by subsection 160ZB(1) of the ITAA 1936/paragraph 118-37(1)(a) of the ITAA 1997. In that example it states that if any amount of the compensation had been for inconvenience or personal suffering then that amount would be exempt from CGT under the wrong suffered personally exemption. However, as the whole amount of the compensation was for a financial loss caused by negligence the wrong suffered personally exemption did not apply.

Therefore, it is not considered that the negligence by your solicitor that caused you financial loss is a wrong you suffered personally for the purposes of exemption under subparagraph 118-37(1)(a)(ii) of the ITAA 1997.

Wrong you suffer in your occupation

The Commissioner states in TR 95/35 that the exemption under subsection 160ZB(1) of the ITAA 1936 (paragraph 118-37(1)(a) of the ITAA 1997) will only apply where an individual receives compensation for a wrong or injury suffered to his or her person or in his or his occupation, profession or vocation.

While at paragraph 214 of TR 95/35 it states that the terms 'to his or her person' and 'in his or her vocation' should be read as widely as possible, the intention of the 'wide' interpretation was to cover the full range of employment and professional type claims; for example to include claims for discrimination, harassment, victimisation, wrongful dismissal, and defamation as well as personal injury or illness.

The negligent provision of incorrect information by your solicitor that you suffered is very different to wrongs such as discrimination, harassment, victimisation, wrongful dismissal and defamation which a person can suffer 'in' their occupation, profession or vocation.

In your circumstances you would not be eligible for an exemption under paragraph 118-37(1)(a) of the ITAA 1997.

Conclusion

The lump sum proceeds you received are from CGT event C2. The legal expenses incurred would form part of the cost base for the calculation.

You will only be eligible for the general CGT discount on the capital gain if you held the asset for more than 12 months.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 subsection 6-5(2)

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 section 104-25

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

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

Income Tax Assessment Act 1997 section 118-37

Income Tax Assessment Act 1997 paragraph 118-37(1)(a)

Income Tax Assessment Act 1997 section 118-305

Income Tax Assessment Act 1997 subparagraph 118-37(1)(a)(ii)

Income Tax Assessment Act 1936 subsection 160ZB(1)