Edited version of private advice

Authorisation Number: 1052252007811

Date of advice: 22 May 2024

Ruling

Subject: Compensation

Question 1

Is the interest component of your compensation amount assessable as ordinary income?

Answer 1

Yes.

Question 2

Is the remainder component of your compensation amount assessable as ordinary income?

Answer 2

No.

Question 3

Is any capital gain or loss you made due to receiving the remainder component disregarded?

Answer 3

Yes.

This ruling applies for the following period:

For the year ending 30 June 2024

The scheme commenced on:

1 July 2023

Relevant facts and circumstances

From DDMMYYYY, you (X) were the director of the superannuation trustee proprietary company, Entity A Pty Ltd (ACN XXX XXX XXX) for your self-managed superannuation fund (SMSF).

You were the only member and had satisfied a condition of release to access the benefits, having reached 65 years of age so the fund was in full pension phase.

The SMSF was wound up on DDMMYYYY.

Entity A Pty Ltd was deregistered as a registered Australian company on DDMMYYYY.

However, in a letter dated DDMMYYYY from your financial institution, you were notified about a review (Reference X) of the financial advice provided by one of the former advisors between DDMMYYYY and DDMMYYYY.

The review was completed on DDMMYYYY.

It was determined that the advice provided was inappropriate and not considered suitable for investments at that time.

On DDMMYYYY you received total compensation offer of AU$X from the financial institution for the net financial loss that incurred as a result of the inappropriate financial advice consisting of an interest component and remainder component as follows:

AU$X Interest component

AU$X Remainder component

AU$X Total compensation amount (rounded up to the next AU$100).

The money was paid to you directly as an individual due to the SMSF and corporate trustee accounts already being closed.

The interest component of AU$X was calculated as of DDMMYYYY which was the expected payment date using the Consumer Price Index (CPI).

The remainder component of AU$X was based on the difference between the actual balance of your accounts at the end of the compensation period and what the balances would have been at that time if you had instead received appropriate advice.

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 102-5

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 118-305

Reasons for decision

Summary

The interest component of your compensation payment is assessable as ordinary income and must be reported on your individual tax return. The remainder component of your compensation payment is not assessable as ordinary income and the capital gain amount can be disregarded.

Interest component assessable

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

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts considered an argument raised that interest in relation to compensation is not interest that is ordinary income; rather the claim is that the interest represents a capital amount which is simply part of the compensation, and which effectively represents part of the consideration received on the disposal of either the underlying asset or the right to seek compensation, as the case may be.

However, TR 95/35 did not accept this view. It states:

237. Interest has been described as 'payment by time for the use of money' (Rowlatt J in Bennett v. Ogston (1930) 15 TC 374 at 379). In economic terms, interest is the return or compensation for the use or retention by one person of a sum of money belonging or owed to another. Court rules allow the Court to include in compensation interest on the whole or part of the amount for the whole or part of the period to which the judgment relates.

238. Any interest awarded as part of compensation is interest within the general meaning of that term. It represents assessable income of the taxpayer even when the judgment provides only for a single lump sum which would otherwise be a capital receipt (Federal Wharf Co Ltd v. DFC of T (1930) 44 CLR 24; 1 ATD 70 and Riches v. Westminster Bank Ltd [1947] AC 390).

246. It is a question of fact to be determined in each case whether any part of the compensation received by the taxpayer is in the nature of interest. We consider that any amount which is in the nature of interest, and which can be identified as interest, and whether paid as part of the compensation or separately, constitutes assessable income of the taxpayer under the general income provisions.

Consequently, the interest component of AU$X is assessable as ordinary income under section 6-5 of the ITAA 1997.

Remainder component

Ordinary income

Section 6-5 of the ITAA 1997 does not provide specific guidance on the meaning of income according to ordinary concepts (ordinary income), however likely characteristics of ordinary income that have evolved from case law include receipts that:

•         are periodical, regular or recurrent;

•         are relied upon by the recipient for their regular expenditure and paid to them for that purpose; and

•         are amounts that are the product in a real sense of any employment of, or services rendered by, the recipient.

Ultimately, whether or not a particular receipt is ordinary income depends on its character in the hands of the recipient.

In your case, the remainder component (apart from the interest component) was calculated based on the difference between the actual fund balance/s of your superannuation product/s at the end of the compensation period and what the balances would have been at that time if you had instead received appropriate advice.

The remainder component you received is not assessable as ordinary income for these reasons:

•         the amount is a one-off receipt and therefore does not have any elements of periodicity, regularity or recurrence.

•         the amount does not relate to your employment, or services rendered by you.

Consequently, the remainder component of AU$X is not assessable as ordinary income under section 6-5 of the ITAA 1997. The amount is considered to be capital in nature.

Statutory income - Capital gains

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 capital gains tax (CGT) asset. A taxpayer's right to seek compensation is therefore classified as an intangible CGT asset. The reasons for why the remainder component was paid is an important factor in determining whether an asset has been disposed of for CGT 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 receipt of the compensation payment was a result of the inappropriate advice provided to you which resulted in a financial loss in the SMSF. The relevant CGT asset in your case is the disposal of the right to seek compensation.

The right to seek compensation is an intangible CGT asset (acquired at the time the SMSF made a financial loss due to the superannuation fund providing the incorrect advice) and your ownership of that asset ended when you accepted the compensation payment to settle your claim. The right to compensation lay with the SMSF, however the amounts paid to you as the individual member are in satisfaction of its right to seek compensation given that the fund has now been changed.

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 remainder component are capital proceeds for your CGT C2 event.

Application to your circumstances

Capital gain disregarded

An exemption is provided under section 118-305 of the ITAA 1997 for any capital gain or loss made from a CGT event happening in relation to a right to an allowance, annuity or capital amount payable out of a superannuation fund or an asset of a superannuation fund.

In your case, the remainder component of AU$X is a considered to be a capital gain which may be disregarded due to section 118-305 of the ITAA 1997.

However, the interest component of AU$X is assessable as ordinary income under section 6-5 of the ITAA 1997.