Edited version of private advice

Authorisation Number: 1052171522013

Date of advice: 21 September 2023

Ruling

Subject: Assessable income - rental property - insurance payment - recoupment

Question 1

Is Payment A for rectification of building defects assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No. It is a recoupment that will reduce the first element of the cost base of the Property.

Question 2

Is Payment B, being the XX% building contingency amount, assessable as ordinary income under section 6-5 of the ITAA 1997?

Answer

No. It is a recoupment that will reduce the first element of the cost base of the Property.

This ruling applies for the following period:

Income year ended XX/XX/20XX.

The scheme commenced on:

XX/XX/20XX.

Relevant facts and circumstances

You own an investment property (the Property) which have several units located on it.

One of the units experienced some fire damage and you made a claim with the insurance company that you held the landlord insurance policy for the Property (the Insurer).

The Insurer accepted liability to undertake the repairs arising in relation to the fire damage to the unit.

The Insurer engaged the services of a builder (the Builder) to undertake the works in relation to the claim (the Works).

The Builder provided most of the legal certificates of compliance, inspections, permits and the certificate of final inspection. However, you challenged their validity and the buildings compliance with the Australian construction code.

Issues arose during the Works, with the Insurer offering to settle the claim with a cash settlement, which you rejected as you maintained the Insurer should do the Works.

You lodged a complaint with the Authority who made a determination as summarised below:

• Prior to the hearing, the Insurer had issued it final decision offering to settle your complaint with the following amounts being part of the offer in addition to a rental loss amount:

-       Payment A for rectification of all building defects; and

-       Payment B, being a XX% building contingency

• It was accepted that it was fair in the circumstances for the Insurer to cash settle the complaint to resolve the dispute with the Insurer's cash settlement offer for the repairs being considered fair in the circumstances.

You received Payment A and Payment B (collectively referred to as the Payments) during the ruling period.

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 20-25

Income Tax Assessment Act 1997 Subsection 108-5(1)

Income Tax Assessment Act 1997 Subsection 110-45(3)

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

Income Tax Assessment Act 1997 Subsection 995-1(1)

Income Tax Assessment Act 1997 Division 104

Reasons for decision

Ordinary income

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

In determining whether an amount is ordinary income or capital in nature, the characteristics of ordinary 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. Compensation payments which substitute income have been held by the courts to be income under ordinary concepts. 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.

Application to your situation

One of the units had been fire damaged with further damage being sustained in relation to all of the units while the Works were being completed.

You lodged a claim with the Authority which made the decision for you to receive the Payments to settle your claim which included the following:

•         Payment A for rectification of building defects; and

•         Payment B for building contingency, which is XX% of the above amount paid in case any unforeseen or extra costs arise during the rectification of the building defects.

The Payments were paid to you in respect of the damage to the units which you continue to own. They do not have the characteristics of ordinary income and are viewed as being capital in nature.

Therefore, the Payments will not be assessable as ordinary income under section 6-5 of the ITAA 1997 but will be assessed under the capital gains tax provisions.

Capital gains tax

Under subsection 116-20(1) of the ITAA 1997, money you have received (or are entitled to receive) and the market value of any property you have received (or are entitled to receive) are the capital proceeds from a capital gains tax (CGT) event.

For compensation payments to constitute capital proceeds, there must be a CGT event.

CGT events occur in respect of CGT assets. Subsection 108-5(1) of the ITAA 1997 provides that a CGT asset is any kind of property or a legal or equitable right that is not property. Not all things often referred to as 'rights' will be assets for CGT purposes. To be an asset, a right must be recognised and protected by law.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts 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'.

Paragraph 3 of TR 95/35 states that permanent damage or reduction in value does not mean everlasting damage or reduced value but refers to damage or a reduction in value which will have permanent effect unless some action is taken by the taxpayer to put it right.

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.

Recoupment

Recoupment is defined in subsection 995-1(1) of the ITAA 1997 having the meaning given by section 20-25 of the ITAA 1997.

Subsection 20-25(1) of the ITAA 1997 states that a recoupment of a loss or outgoing includes:

a)    any kind of recoupment, reimbursement, refund, insurance, indemnity or recovery, however, described, and

b)    a grant in respect of the loss or outgoing.

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.

Application to your situation

In your situation, the Payments were received in respect of permanent damage to and/or the permanent reduction in the value of the Property, which is the relevant CGT asset.

You continue to own the Property after the receipt of the Payments and there was no CGT event occurring upon the receipt of the Payment. Therefore, the Payments are not capital proceeds received in respect of a CGT event/s occurring but are viewed as recoupments.

Therefore, as the Payments are not included in your assessable income, they cannot form any part of any element of the cost base of the Property. Accordingly, the first element of the cost base of the Property will be reduced by the amount of the Payments, being the total of Payment A and Payment B.