Edited version of private advice

Authorisation Number: 1051948102142

Date of advice: 11 May 2022

Ruling

Subject: Compensation payment

Question 1

Are the insurance proceeds received assessable to the Trust?

Answer

No.

Question 2

Are Individual 1 and Individual 2 liable for any tax payable in relation to the insurance proceeds?

Answer

Yes.

Question 3

Is there a capital gains tax (CGT) event at the time the insurance payout is received as compensation for the assets that were destroyed?

Answer

Yes.

Question 4

Is there a capital gains tax (CGT) event at the time the insurance payout is received as compensation for the assets that were damaged?

Answer

No, but the cost base of those assets is reduced.

Question 5

In relation to assets that were damaged but not destroyed, is the portion of the insurance received, in relation to the cost of repairs to assets, equivalent to the amount of deductible expenditure incurred in a year of income for those repairs included in assessable income?

Answer

Yes, and also added back to the cost base of those assets.

Question 6

Is there a capital gain when you replace damaged assets that were temporarily repaired but eventually removed and replaced?

Answer

Yes, however, the cost of replacing the assets can be rolled over, reducing any resulting capital gain.

Question 7

Does Individual 1 meet the basic conditions under section 152-10 of the Income Tax Assessment Act 1997 (ITAA 1997) to apply the small business capital gains tax (CGT) concessions?

Answer

No.

Question 8

Does Individual 2 meet the basic conditions under section 152-10 of the ITAA 1997 to apply the small business capital gains tax (CGT) concessions?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Individual 1 owns two properties, Property 1 and Property 2.

Property 1 was acquired after 19 September 1985.

Property 2 was purchased before 20 September 1985.

Individual 2 owns two properties, Property 3 and Property 4.

Property 3 was acquired after 19 September 1985.

Property 4 was purchased after 19 September 1985.

A Trust, through its corporate trustee, Company A carries on a business on all four of these properties.

The shareholders and directors of Company A are Individual 1 and Individual 2.

The primary beneficiaries of the trust are Individual 2 and their spouse.

Assets were partly destroyed by a natural disaster over the four properties.

An asset on Property 1 was destroyed completely by the natural disaster.

You received a compensation payment from your insurance company.

You have temporarily repaired assets over the four properties.

Individual 1 has no intention to replace the destroyed asset on Property 1.

Individual 1 does not receive any distributions from the trust and does not have any input on how the business is operated. All day-to-day decisions and how the business is operated is made by Individual 2 and their spouse.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 20-20

Income Tax Assessment Act 1997 section 20-35

Income Tax Assessment Act 1997 section 104-20

Income Tax Assessment Act 1997 section 110-45

Income Tax Assessment Act 1997 section 124-70

Income Tax Assessment Act 1997 section 124-75

Income Tax Assessment Act 1997 section 124-85

Income Tax Assessment Act 1997 section 152-10

Income Tax Assessment Act 1997 section 152-35

Income Tax Assessment Act 1997 section 152-40

Income Tax Assessment Act 1997 section 328-125

Income Tax Assessment Act 1997 section 328-130

Reasons for decision

Who is assessed?

It is considered that the individuals, are liable for any amounts of the insurance that are considered assessable income as they are the owners of the damaged assets, they own the land upon which the assets were, they are beneficiaries of the trust and so amounts are ultimately distributed to them and the assertion that the individuals were insured in respect to legal liability and respect to contents and residences on the farmland owned by them so it appears the failure of the insurance policy to mention the farm buildings and infrastructure is an oversight by the insurance company.

Ordinary income or capital?

An amount received as an insurance payment for damages to properties has to be considered under both the concepts of ordinary income (section 6-5) and statutory income (capital gains tax [Part 3] or assessable recoupment [section 20-20] of the ITAA 1997).

Ordinary income

Section 6-5 of the ITAA 1997 provides that your assessable income includes income according to ordinary concepts, which is called ordinary income.

Ordinary income has generally been held to include three categories:

•         income from rendering personal services

•         income from property, and

•         income from carrying on a business.

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

•         are earned

•         are expected

•         are relied upon, and

•         have an element of periodicity, recurrence or regularity.

For income tax purposes, an amount paid to compensate for a loss generally acquires the character of that for which it is substituted (Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540). Compensation payments which substitute income have been held by the courts to be income under ordinary concepts (Federal Commissioner of Taxation v. Inkster (1989) 24 FCR 53). Where compensation is paid for the loss of a capital asset or capital amount then it will be regarded as a capital receipt and not ordinary income.

Here amounts were received as compensation for destructions of capital assets. These amounts are clearly capital in nature as they are to replace destroyed capital assets.

Capital Gains Tax

Taxation Ruling TR 95/35 sets out the capital gains tax consequences when a taxpayer receives a compensation payment. One of the receipt types it addresses is 'compensation for permanent damage to, or permanent reduction in the value of, the underlying asset'.

TR 95/35 advocates a 'look through' approach to determine the underlying asset to which the payment relates.

When applying the 'look through' approach provided for in TR 95/35 it becomes apparent that the underlying asset in your case are the assets that were damaged and destroyed.

Paragraph 6 of TR 95/35 states:

6. If an amount of compensation is received by a taxpayer wholly in respect of permanent damage suffered to a post-CGT underlying asset of the taxpayer or for a permanent reduction in the value of a post CGT underlying asset of the taxpayer, and there is no disposal of that underlying asset at the time of the receipt, we consider that the amount represents a recoupment of all or part of the total acquisition costs of the asset.

Paragraphs 7 and 8 discuss the consequences of the recoupment and have direct application to the calculation of the cost base of the asset. These paragraphs state:

7. Accordingly, the total acquisition costs of the post-CGT asset should be reduced ... by the amount of the compensation. No capital gain or loss arises in respect of that asset until the taxpayer actually disposes of the underlying asset. If, in the case of a post-CGT underlying asset, the compensation amount exceeds the total unindexed acquisition costs (including a deemed cost base) of the underlying asset, there are no CGT consequences in respect of the excess compensation amount.

8. The adjustment of the total acquisition costs effectively reduces those costs by the amount of the recoupment as if those costs had not been incurred ...

A compensation payment in these circumstances is considered a recoupment which directly reduces the cost base of the underlying asset. It is not a receipt in relation to the disposal of a separate CGT asset. It follows that a CGT event has not happened and there is no assessable capital gain in terms of Division 104 of the ITAA 1997.

Under subsection 110-45(3) of the ITAA 1997 expenditure does not form any part of any element of the cost base to the extent of any amount you have received as recoupment of it, except so far as the amount is included in your assessable income.

If you acquire a CGT asset a deceased had owned and the CGT assets passes to you after 20 August 1996, the first element of the cost base of the asset is its market value at the date the deceased passed away.

Assets destroyed

In terms of section 104-20 of the ITAA 1997, CGT event C1 happens if a CGT asset you own is lost or destroyed. The timing of the event is when you first receive compensation for the loss or destruction. An insurance payout would constitute compensation. You make a capital gain if the compensation is more than the asset's cost base.

In Individual 1's case, a C1 CGT event happened when the insurance payout was received in relation to the destruction of property. This is because those assets were completely destroyed.

Individual 1 will make a capital gain if the capital proceeds received are more than the asset's cost base. Individual 1 will make a capital loss if those capital proceeds are less than the asset's reduced cost base.

Where destroyed assets are replaced, subdivision 124-B of the ITAA 1997 allows taxpayers to choose roll-over relief from the CGT consequences that would normally flow from that event.

Subsection 124-70(2) of the ITAA 1997 says:

You must receive money or another *CGT asset (except a *car, motor cycle or similar vehicle), or both:

(a)  as compensation for the event happening; or

(b)  under an insurance policy against the risk of loss or destruction of the original asset.

Section 124-75 of the ITAA 1997 allows you to choose to obtain a roll-over if you receive money for the event occurring and you satisfy the following requirement.

You must incur expenditure:

(a)  acquiring a replacement asset, or

(b)  if only part of the asset is lost or destroyed, you incur expenditure of a capital nature repairing or restoring it.

To qualify for the roll-over at least some of the expenditure must be incurred:

(a)  no earlier than one year before the event happens: or

(b)  no later than one year after the end of the income year in which the event happens;

(c)   or within such further time as the Commissioner allows in special circumstances.

If you receive money as a result of the destruction, you can only choose a rollover if you incur expenditure in acquiring another CGT asset. Under subsection 124-75(3) of the ITAA 1997, you must incur at least some of the expenditure no earlier than one year before the event happens or, within one year after the end of the income year in which the event happens.

Section 124-85 of the ITAA 1997 provides the consequences if you receive money and choose to obtain a roll-over. If the money received does not exceed the expenditure to acquire another CGT asset or to repair or restore the original asset; the gain is disregarded.

The gain is disregarded in working out your net capital gain or net capital loss for the income year. The amount of expenditure that you can include in the cost base of the replacement asset is reduced by the amount of the capital gain.

Therefore, where insurance was received in relation to destroyed assets, CGT event C1 occurred upon the receipt of the insurance proceeds. When the assets are repaired, the portion of the capital proceeds relating to those assets reduces the cost base of those assets.

In addition, under the assessable recoupment rules (see below) a portion of the insurance payment equivalent to the repair deduction will be assessable in that year. Because this amount is included in your assessable income it will now be included in the capital gains tax (CGT) cost base.

When the assets are replaced, CGT event C1 occurs but the cost of replacing the assets can be rolled over, reducing any resulting capital gain.

If the money you received exceeds the cost you have incurred to repair or replace the original asset, you may have a CGT liability.

The capital gain you include on your tax return depends on whether your capital gain from the compensation is more or less than the amount by which the compensation exceeds the cost of repair or replacement.

If the capital gain is more than the excess, you reduce the capital gain you report to the amount of the excess. Include this amount on your tax return in the year the event happens.

Assessable recoupments

An amount received by way of insurance is an assessable recoupment if it is paid to cover the cost of a deductible expense and the deduction can be claimed in the current year or in an earlier income year (subsection 20-20(2) of the ITAA 1997). [Current year means the income year for which you are working out your assessable income and deductions].

If you receive an insurance payout during a year and you do not incur any deductible expenditure in that year of income, there is no assessable recoupment in that income year, under this division.

Where an expense is deductible in a single income year and the insurance or recoupment has been received in an income year prior to the income year that the deductible expenditure was incurred, subsection 20-35(3) of the ITAA 1997 applies to determine how much of the assessable recoupment is included in your assessable income. When this amount is included in your assessable income the reduced CGT cost base will be increased by this amount, in accordance with subsection 110-45(3) of the ITAA 1997.

Therefore, an insurance payout will be an assessable recoupment when both the insurance payout has been received and deductible expenditure has been incurred. Any excess amount above what is incurred on deductible expenses will not be assessable income.

The total of all amounts that subsection 20-35(1) of the ITAA 1997 includes in your assessable income for one or more income years in respect of a loss or outgoing cannot exceed the amount of the loss or outgoing (subsection 20-35(2) of the ITAA 1997).

Therefore, in relation to assets that have been repaired, the deductible cost of those repairs is an assessable recoupment in the year the repairs are made (and claimed). This amount is also added into the cost base of the assets under subdivision 110-A as outlined above.

An amount is not an assessable recoupment to the extent that it is ordinary income, or it is statutory income because of a provision outside of Subdivision 20-A of the ITAA 1997.

Small Business CGT Concessions - Basic conditions

The basic conditions for the small business CGT concessions are contained in section 152-10 of the ITAA 1997. To qualify for the small business CGT concessions, you must satisfy several conditions that are common to all the concessions. The following are the basic conditions:

(a) a CGT event happens in relation to a CGT asset of yours in an income year;

(b) the event would have resulted in the gain;

(c) at least one of the following applies:

(i) you are a small business entity for the income year;

(ii) you satisfy the maximum net asset value test;

(iii) you are a partner in a partnership that is a small business entity for the income year and the CGT asset is an interest in an asset of the partnership;

(iv) the conditions mentioned in subsection (1A) or (1B) are satisfied in relation to the CGT asset in the income year;

(d) the CGT asset satisfies the active asset test (see section 152-35).

As explained previously, where an asset, or part of an asset is destroyed, CGT event C1 occurs at the time the payment is received with the portion of the insurance proceeds relating to that asset being the capital proceeds. As Individual 1 has advised that there is no intention to replace that asset a CGT event C1 has occurred and the condition in paragraph 152-10(1)(a) is satisfied.

The second condition paragraph 152-10(1)(b) is satisfied, as a capital gain on the destroyed assets will arise where they have not been replaced or when replaced but the portion of the insurance proceeds relating to that asset exceeds the cost of replacement.

In relation to the third condition in paragraph 152-10(1)(c), Individual 1 does not satisfy this condition but Individual 2 does as explained below.

Neither Individual 1 nor Individual 2 carry on a business in their own right so they do not pass the first requirement in subparagraph 152-10(1)(c)(i) of the ITAA 1997.

For the purpose of this ruling, it is assumed both Individual 1 and Individual 2 do not pass the maximum net asset value test (MNAV) in subparagraph 152-10(1)(c)(ii) of the ITAA 1997. As you will see below, it does not make a difference either way.

Subparagraph 152-10(1)(c)(iii) of the ITAA 1997 does not apply as neither Individual 1 nor Individual 2 are partners in a partnership that is a small business entity.

This leaves subparagraph 152-10(1)(c)(iv) of the ITAA 1997 to be considered. Subsection 152-10(1B) of the ITAA 1997 refers to partnerships and is not applicable here which leaves subsection 152-10(1A) of the ITAA 1997.

Passively held assets - affiliates and entities connected with you

The conditions in subsection 152-10(1A) of the ITAA 1997 are satisfied in relation to the CGT asset in the income year if:

(a) your affiliate, or an entity that is connected with you, is a small business entity for the income year; and

(b) you do not carry on a business in the income year (other than in partnership); and

(c) if you carry on a business in partnership - the CGT asset is not an interest in an asset of the partnership; and

(d) in any case - the small business entity referred to in paragraph (a) is the entity that, at a time in the income year, carries on the business (as referred to in subparagraph 152-40(1)(a)(ii) or (iii) or paragraph 152-40(1)(b) in relation to the CGT asset.

An affiliate can only be an individual or a company as per subsection 328-130(1) of the ITAA 1997 so is not applicable here since it is a trust which conducts the business.

Connected entities

Connected entity is defined under section 328-125 of the ITAA 1997 which states:

An entity is connected with another entity if:

(a) either entity controls the other entity in the way described in this section; or

(b) both entities are controlled in a way described in this section by the same third entity.

With respect to discretionary trusts, subsection 328-125(2) of the ITAA 1997 provides that, for the purposes of the small business capital gains tax concessions, a taxpayer will be taken to have control of a trust where the taxpayer and their affiliates own, or have the right to acquire ownership of, interests in the trust that gives them the right to receive at least 40% of the income or capital distributions of the trust.

Direct control of a discretionary trust may be established via either of two paths. Subsection 328-125(3) of the ITAA 1997 or subsection 328-125(4) of the ITAA 1997.

Subsection 328-125(3) of the ITAA 1997 provides that an individual controls a discretionary trust if the trustee of that trust acts, or could reasonably be expected to act, in accordance with the directions or wishes of the individual, his/her affiliates, or the individual together with his/her affiliates.

Subsection 328-125(4) of the ITAA 1997 provides, in part, that an individual directly controls a discretionary trust for an income year if, for any of the preceding four income years, the discretionary trust distributed at least 40% of any income or capital paid for that year to either the individual, the individual's affiliates, or to the individual together with any of his/her affiliates.

In this case, the Trust carried on a business on the properties. Individual 1 does not have any control over the Trust. Individual 1 does not share any of the distribution of income or capital from the Trust and does not share in any of the decision-making powers with the running of the business. Therefore, Individual 1 would not satisfy the meaning of 'connected with'. As the two properties Individual 1 owns are not being used, or held ready for use, in the course of carrying on a business that is carried on by Individual 1 or another entity that is connected with Individual 1, Individual 1 will not satisfy the conditions for the small business concessions.

As for Individual 2, as Individual 2 share at least 40% of the income or capital distribution of the trust and has the decision-making powers with the running of the business, Individual 2 would satisfy the meaning of 'connected with'. As the two properties Individual 2 owns are being used, or held ready for use, in the course of carrying on a business that is carried on by another entity that is connected with Individual 2, Individual 2 satisfies the third condition in paragraph 152-10(1)(c) of the ITAA 1997.

The final condition in paragraph 152-10(1)(d) of the ITAA 1997 requires the CGT asset to satisfy the active asset test in section 152-35 of the ITAA 1997.

Active asset test

The active asset test is contained in section 152-35 of the ITAA 1997. The active asset test is satisfied if:

•         you have owned the asset for 15 years or less and the asset was an active asset of yours for a total of at least half of the test period detailed below, or

•         you have owned the asset for more than 15 years and the asset was an active asset of yours for a total of at least 7.5 years during the test period.

The test period is from when the asset is acquired until the CGT event. If the business ceases within the 12 months before the CGT event (or such longer time as the Commissioner allows) the relevant period is from acquisition until the business ceases.

Under subsection 152-40(1) of the ITAA 1997, a CGT asset is an active asset if it is owned by you and is used or held ready for use in a business carried on (whether alone or in partnership) by you, your affiliate, your spouse or child, or an entity connected with you.

We have previously determined that the Trust conducting the business is not an entity connected to Individual 1, therefore Individual 1 does not meet the active asset test. Even if Individual 1 passed the MNAV test, since they do not meet the active asset test, they are not eligible for the CGT small business concessions.

As for Individual 2, the Trust is an entity connected with Individual 2 and it carries on a business with a turnover of less than $2 million. The active asset test has been satisfied as Property 3 has been owned for less than 15 years and has been used in the Trust for at least half of the test period and Property 4 has been owned for more than 15 years and has been used in the Trust for more than 7.5 years. As all four conditions have been met, Individual 2 satisfies the basic conditions to apply the CGT small business concessions.