Edited version of private advice

Authorisation Number: 1052271985865

Date of advice: 2 August 2024

Ruling

Subject: Capital vs revenue income and expenditure

Question 1

Will the compensation payments be assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Are you entitled to claim a deduction for legal expenses incurred under section 8-1 of the ITAA 1997?

Answer

Yes.

Question 3

Are you entitled to claim a deduction for the special levy expenses incurred under section 8-1 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances:

You purchased the property on XX/XX/19XX.

The property is part of a body corporate strata plan.

The property has been rented out until XX/XX/20XX.

On XX/XX/20XX, the unit directly underneath the property was found to have significant termite damage, and this compromised the whole buildings structural integrity.

You do not own the unit underneath your property.

On XX/XX/20XX, all the units were deemed uninhabitable, and the tenants were forced to vacate.

The work done to the unit underneath your property was approximately $XXX,XXX.

The property remained vacant for the 20XX financial year.

In XX/20XX, the building was made habitable, and the units were able to be rented out.

All the renovations were signed off as completed on XX/XX/20XX.

In 20XX, you received $XX,XXX as a compensation payout reimbursement of lost rent from an Insurance company.

You received $XX,XXX as reimbursement for legal fees. This was an expense in obtaining the payout for the lost rent. The legal costs did not relate to anything else.

In 20XX the body corporate raised a special levy, and you incurred $XX,XXX in addition to your regular $XX,XXX body corporate levy charge.

All the collected special levy funds were spent on the above works before settlement date.

The property was sold on XX/XX/20XX for $XXX,XXX.

The property settled on XX/XX/20XX.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Ordinary Income - Compensation payments

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources, whether on or out of Australia during an income year.

Rental income received by a taxpayer is ordinary income for the purposes of subsection 6-5(2) of the ITAA 1997. Any amounts received in lieu of rental income would therefore also be considered as ordinary income.

Taxation Determination TD 93/58 Income tax: under what circumstances is the receipt of a lumpsum compensation /settlement payment assessable? outlines the treatment of a compensation receipt. This is an amount received as compensation for lost income. The compensation is revenue in nature being for the lost rent.

In determining whether the income is revenue or capital, the compensation payment may be apportioned. The replacement principle is used, the amount paid as compensation for an item that would have had the character of ordinary income had it been earned by the taxpayer, is itself ordinary income. Is the compensation for the loss of capital or for the loss of revenue income?

In your case, the reason for compensation was entirely for lost rental income that is revenue income. The compensation receipt should be declared as revenue income.

Deductions

Section 8-1 of the ITAA 1997 states that a loss or outgoing may be deducted from assessable income to the extent that:

a) it is incurred in gaining or producing assessable income; or

b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

However, under subsection 8-1(2) of the ITAA 1997, a loss or outgoing is not deductible to the extent that it is a loss or outgoing of capital or of a capital nature, private or domestic in nature.

Legal costs

In determining whether a deduction for legal expenses is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered. Legal costs will be characterised as an outgoing of capital or revenue in nature from the advantage sought in incurring the expenditure. Legal expenses take the character of the advantage sought due to incurring them.

Your legal expenses in enforcing payment of your contractual entitlement to payment in lieu of notice are outgoings with nexus to assessable income and where the character of the advantage sought is on revenue account.

In case law, a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenses must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634).

In your case, the legal expenses spent and reimbursed, was in order to enforce your payment in lieu of rental income are sufficiently connected to your assessable income. The character of each loss or outgoing is on revenue account. As such, the taxpayers' legal expenses are deductible under section 8-1 of the ITAA 1997 in the income year incurred.

Strata Special Levies

The contributions to the fund are only deductible if the amounts have been spent by the strata and it is incurred in the income year the strata paid the costs.

Paragraph 41 of Taxation Ruling TR 2015/3 Income tax: matters relating to strata title bodies constituted under strata title legislation outlines the principle of mutuality. This applies to a proprietor's levy to a special purpose fund. The lot owners are entitled to the deductions when the body corporate uses those funds to pay deductible outgoings.

Another consideration is the type of material use to distinguish if this a revenue or capital cost. If expenditure is incurred in replacing or renewing a part of property with a material of a different type from the original, the work done may either repair the property, or be an improvement to it. An improvement is capital in nature and a repair is revenue in nature.

Application to your circumstances

In your case, all the unit holders were asked to contribute towards a Special Levy for works to rectify the damage. The funds collected were wholly spent on the repairs to the building which includes the Property and other units. The materials used were the modern equivalent of the replaced materials. This was not an improvement. The strata spent all the funds contributed before the settlement date on disposal of the property.

You paid your contribution to the special levy and work was undertaken over both income years that this ruling applies. Therefore, you are entitled to claim a deduction for the special levy expenses in the respective financial year that the strata paid the cost.