Edited version of private advice

Authorisation Number: 1051606325421

Date of advice: 12 November 2019

Ruling

Subject: Capital gains tax - compensation - inappropriate advice

Question 1

Will the compensation amounts be assessable under sections 6-5 and/or 20-20 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Will the compensation amounts be assessable under the capital gains tax provisions contained in Parts 3-1 and 3-3 of the ITAA 1997?

Answer

Yes. However, section 118-20 of the ITAA 1997 will apply to reduce the capital gain to the extent that the compensation amount is otherwise included as assessable income under sections 6-5 and/or 20-20 of the ITAA 1997.

Relevant facts and circumstances

The Projects

For a number of years you obtained financial advice from a former authorised representative of Company A in relation to your investments.

You acted on the advice and invested in a number of managed investment schemes (MISs) either in your own right, or jointly, offered by Company XYZ over a number of years, collectively referred to as the Projects.

The investments involved you borrowing funds from Company XYZ (the loans) to invest in the MISs run by Company XYZ. The borrowed funds were used to pay for the initial cost of entering into the MISs as well as deductible expenses, such as annual management fees, rent and interest, which have been claimed as deductions in the relevant income years.

The Projects failed, with Company XYZ going into liquidation.

You received payments of net proceeds after Company XYZ went into liquidation in relation to some of the MIS's.

The liquidator issued a report in relation to the liquidation of Company XYZ which outlined that the liquidators had conducted sales and marketing campaigns for some assets, with the proceeds from the sales having been distributed to relevant stakeholders. Proceeds from the remaining asset realisations were distributed to relevant stakeholders.

Compensation offer

Company A sent you a letter in relation to their former financial advisor, Person A, and the Projects to which your spouse had responded.

Company A sent you a further letter which included the following information about their review on the advice you had been provided and a compensation offer:

·         for a number of years you had been provided with advice from a former Company A advisor and it had been concluded that they had provided you with inappropriate advice in relation to the Projects in regards to your long-term wealth creation and tax minimisation;

·         the advice to invest in the Projects was inappropriate, and you should have only have invested to a lesser extent;

·         the amount of compensation is being paid is to place in you the position you would have been in if you have received appropriate advice, including any earnings you would have made;

·         the amount of compensation was calculated using identified costs associated with investing in an appropriate manner in relation to the Projects, and compared the performance of your investments to reference portfolios aligned with your risk profile. Additionally, the offer includes compensation for the cost of finance for your investment in the Projects, adjusted for tax deductions and increased by its likely investment return;

·         the calculation was made using reasonable assumptions to determine amounts you could have recouped from the investment, mainly as tax deductions;

·         the compensation amount offered was $XXX,XXX made up of amounts relating to each MIS.

·         A deed of release (the Deed) was provided with the Company A letter which outlined that:

·         the Agreed Sum is to be paid, without any admissions, by Company A in full and final settlement of all present and future claims made by you in respect of this issue;

·         in consideration of the Agreed Sum of $XXX,XXX you would release and discharge Company A and its related associated bodies corporate, officer, employees and representatives from and against all claims, liability, costs and demands arising in relation to this issue and any taxation implications including goods and services tax of the Agreed Sum.

You accepted Company A's offer and have received the Agreed Sum.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Subdivision 20-A

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Part 3-3

Reasons for decision

Summary

The Commissioner considers that in view of the nature of the compensation amounts you received from Company A, the payment is assessable as either ordinary income and/or recoupments.

Detailed reasoning

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).

Interest

Interest income is regarded as ordinary income and therefore assessable under subsection 6-5(2) of the ITAA 1997.

Paragraph 26 of Taxation Ruling TR 95/35 deals with the treatment of interest awarded as a part of a compensation amount. It states:

Interest awarded as part of a compensation amount is assessable income of the taxpayer under the general income provisions. If the taxpayer receives an undissected lump sum compensation amount and the interest cannot be separately identified and segregated out of that receipt, no part of that receipt can be said to represent interest.

Recoupment

Subsection 20-20(2) of the ITAA 1997 provides that an amount you have received as a recoupment of a loss of outgoing is an assessable recoupment if:

·         you received the amount by way of insurance or indemnity, and

·         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 in an earlier income year, under any provision of this Act.

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 of the ITAA 1997 which deals with capital gains.

Capital gains

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.

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.

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.

If an amount of compensation is not received by a taxpayer in respect of any underlying asset, the amount relates to the disposal by the taxpayer of the right to seek compensation.

CGT event C2 happens when the ownership of an intangible CGT asset ends by the asset being satisfied or surrendered. A C2 event can apply where there is a release or discharge of a right to seek compensation.

Application to your circumstances

You acted on advice provided by a former employee of Company A and invested in the Projects operated by Company XYZ. You borrowed substantial funds which were used to pay for the initial investments and the ongoing expenses relating to the Projects.

The Projects failed and as a result of a review conducted by Company A you received the Agreed Sum because they determined that they had provided you with inappropriate financial planning advice for you to invest in the Projects, which had not performed as expected.

The Agreed Sum consists of an amount calculated for each MIS. The compensation amounts were calculated using identified costs associated with investing in the Projects and any earnings you would have received in relation to the funds if the Projects had performed appropriately. Additionally, the compensation amount was calculated to compensate you for the cost of financing the Projects, adjusted for tax deductions and increased by the likely investment return and taking into consideration amounts that your could have recouped from the Projects, such as tax deductions..

As noted above, an amount paid to compensate for loss generally acquires the character of that for which it is substituted.

You claimed deductions for the costs arising in relation to the Projects, such as interest expenses incurred on the loans to invest in the Projects. As such, the amounts relating to costs for which you have previously claimed deductions are assessable recoupments and are included in your assessable income in the income year the compensation was received.

When applying TR 95/35 to your situation, the most relevant CGT asset is either the Projects or your right to seek compensation in relation to the Projects. The Projects are the underlying asset.

There is no connection between the compensation payment made on behalf of the financial advisor and any reduction in value of, or permanent damage to the Projects. While the Projects had markedly reduced in value during your ownership period, the compensation payment was made as a result of you being provided with inappropriate advice by your former financial advisor in relation to the Projects.

Therefore, it is viewed that the compensation payment related to the disposal of your right to seek compensation in relation to that advice, and not to any permanent damage to or permanent reduction in value of the underlying asset, being the Projects.

While CGT event C2 occurred in relation to your right to seek compensation, it is viewed that the compensation amounts will be fully assessable under sections 6-5 and 20-20 of the ITAA 1997. Therefore, as these provisions take precedent over the CGT provisions all of the compensation amounts will be recorded as assessable income under those sections.