Edited version of private advice

Authorisation Number: 1052273902511

Date of advice: 18 February 2025

Ruling

Subject: Capital gains tax - settlement agreement

Question 1

Was the capital gains tax (CGT) event that happened on entering into the settlement agreement a CGT event in respect of an active asset for the purpose of paragraph 152-10(1)(a) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer 1

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You are a company incorporated in and resident of Australia.

From your incorporation in 20XX, you were in the business of investigating, researching, and investing in disruptive and innovative technologies.

You carried on your business initially using the 'studio lab' model, drawing on the entrepreneurial abilities of approximately X individuals who had agreed to provide their services to support the business. Those individuals were together responsible for the identification, development, design, marketing and sales of disruptive and innovative technologies.

Those activities occurred both prior to and after you were incorporated, and shortly after your incorporation, you had identified approximately XX diverse products upon which you would focus your business efforts in bringing those products to market.

With a large portfolio of products to develop, you sought external funding in order to properly fund each project.

One such product you were developing was specific technology owned by another entity.

During the course of 20XX, you undertook due diligence and feasibility studies in respect of the Technology and entered into a non-binding Licence Term Sheet (the Term Sheet) with a view to negotiating an exclusive licence in relation to the Technology.

During the course of 20XX, you then carried on your business operations of developing plans for the commercialisation of the Technology.

Shortly after the term sheet had been entered into, you had decided to focus your entire business on the technology.

In 20XX, you engaged an accounting firm (the Firm) to assist with identifying potential investors.

The Firm then offered to introduce you to an investor.

On the basis of representations made by the Firm that the investor was interested in making an investment, you consented to the Firm providing the investor with your confidential information.

After the investor obtained your confidential information, it then proceeded to commence negotiations directly for the purpose of assigning the intellectual property rights (the IP) to the Technology.

An assignment of the IP to the investor actually occurred in 20XX (the Assignment).

Once you discovered the Assignment in 20XX, you obtained legal advice to consider your options given the Assignment's impact on your business.

You obtained litigation funding which allowed you to undertake without prejudice settlement negotiations with the Firm in 20XX.

By 20XX, you had secured full litigation funding for the Claims, and in 20XX, you commenced proceedings in Court against the Firm and investor parties alleging misleading and deceptive conduct and seeking damages for losses suffered. A further amended pleading was filed in 20XX.

The particulars of the claimed loss were:

•                     loss of valuable property

•                     loss of the opportunity to obtain profits from the commercialisation of the Technology

In 20XX, the parties conducted a mediation with the result that in the 20XX financial year the parties entered into a comprehensive settlement agreement pursuant to which you were paid an amount of approximately $X million by the Firm in satisfaction of all your claims against the Firm.

Following the satisfaction of legal and other expenses relating to the settlement agreement, you anticipate that you will be wound-up.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 102-20

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

Income Tax Assessment Act 1997 section 118-20

Income Tax Assessment Act 1997 section 152-10

Income Tax Assessment Act 1997 paragraph 152-10(1)(a)

Reasons for decision

Summary

The nature of the compensation payment received is for the loss of future anticipated profits and is assessable under section 6-5 of the ITAA 1997.

We consider that CGT event C2 also occurred when the settlement was reached. At this time you disposed of your right to seek compensation. However, any capital gain arising will be reduced by the anti-overlap provision in section 118-20 of the ITAA 1997 to the extent that it has already been included in your assessable income.

Detailed reasoning

Ordinary income

Section 6-5 of the ITAA 1997 provides that the assessable income of a taxpayer includes income according to ordinary concepts (ordinary income).

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 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.

A compensation amount generally bears the character of that which it is designed to replace. If the compensation is paid for the loss of a capital asset or amount then it will be regarded as a capital receipt and not ordinary income. Compensation, damages and insurance payments which are a substitute for income are themselves ordinary income.

Generally, payments for loss of profits due to interruptions to business operations or in connection with compensation or damages for the loss of anticipated profits, are likely to be of an income nature. (Commissioner of Taxation (NSW) v Meeks (1915) 19 CLR 568)(Meeks).

In Meeks, the taxpayer conducted mining operations and entered into an agreement with a company. Under the agreement, the taxpayer was to sell to the company a large quantity of materials, delivery of which was to be made over a period of years. The company paid the taxpayer £pound;63,000 but, before any deliveries were made, defaulted on the agreement. The agreement was cancelled and the taxpayer was entitled to retain a substantial portion of the £pound;63,000. It was held by the High Court that the amount retained was assessable as profits from the taxpayer's business.

Griffith CJ stated (at p 580):

In my opinion, damages received as compensation for non-performance of a business contract stand on the same footing as the profits for the loss of which the damages are paid. It cannot, therefore, make any difference in principle whether the money is actually earned as profit, ascertained by deducting expenses from receipts, or paid as compensation for the loss of the opportunity of earning that profit, or, in the latter case, whether the amount of compensation is assessed by jury or by mutual agreement.

Capital gains tax

You make a capital gain or capital loss as a result of a capital gains tax (CGT) event happening (section 102-20 of the ITAA 1997). For most CGT events, your capital gain or loss is the difference between your capital proceeds and the cost base or reduced cost base of your CGT asset.

The capital proceeds from a CGT event include the money you have received, or are entitled to receive, in respect of the event happening (subsection 116-20(1) of the ITAA 1997).

CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset:

(a)           being redeemed or cancelled; or

(b)           being released, discharged or satisfied; or

(c)           expiring; or

(d)           being abandoned, surrendered or forfeited; or

(e)           if the asset is an option - being exercised; or

(f)            if the asset is a convertible interest - being converted.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts (TR 95/35) provides the Commissioner's view on the CGT consequences for recipients of compensation amounts received. Paragraph 70 of TR 95/35 provides that 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 defined in paragraph 3 of TR 95/35 as follows:

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.

'Underlying asset' is also defined in paragraph 3 of TR 95/35 as follows:

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 no underlying asset to which the compensation receipt directly relates, the receipt will be capital proceeds for CGT event C2, the ending of the right to seek compensation.

Goodwill

In relation to goodwill, TR 95/35 states:

231.        In certain limited circumstances a taxpayer may be able to demonstrate that he or she has suffered some permanent damage to his or her goodwill, or that it has been permanently reduced in value by some act or event which has generated the right to seek compensation. In these circumstances the taxpayer is entitled to reduce the total acquisition costs of his or her goodwill by so much of the compensation that relates to the permanent damage or permanent reduction in value.

232.        It is generally very difficult, however, for the taxpayer to demonstrate that there has been some permanent damage to, or permanent reduction in value of, the goodwill, rather than an actual disposal of that goodwill, or a temporary fluctuation in the value of the goodwill.

233.        It should also be noted that receipts are often attributed to 'goodwill' or to the disposal of goodwill, when in fact they represent a receipt in respect of loss of profits. The actual characterisation of a receipt is, of course, always a question to be determined in each case.

Taxation Ruling 1999/16 Income tax: capital gains: goodwill of a business (TR 1999/16) provides the following in relation to the meaning of goodwill:

9.             'Goodwill' for the purposes of the definition of 'CGT asset' in section 108-5 has the meaning it bears under the general law. It is the legal definition of goodwill as explained by the High Court in the Murry case, rather than its accounting and business definitions, which applies.

10.          The legal meaning of 'goodwill', according to the majority justices of the High Court in the Murry case, has three different aspects namely property, sources and value.

11.          In this Ruling 'goodwill' is the legal concept described by the High Court majority in paragraphs [4] and [12] to [52] of their judgment (98 ATC at 4587 and 4589-4596; 39 ATR at 132 and 134 - 145). It is not appropriate to single out only one of the aspects of goodwill and to regard that aspect as being 'goodwill' for legal purposes. Rather, it is the overall concept described by the High Court majority which constitutes the legal meaning of 'goodwill'.

TR 1999/16 considers whether a CGT event happens to goodwill when a business ceases:

68.          The most specific CGT event when a business permanently ceases is CGT event C1 (about loss or destruction of a CGT asset) in section 104-20.

Anti-overlap provisions

The anti-double taxation provisions contained in section 118-20 of the ITAA 1997 apply to prevent double taxation. The provision reduces a capital gain arising from a CGT event to the extent that an amount has already been included in the assessable income of a taxpayer. For example, being included as assessable income under section 6-5 of the ITAA 1997.

Application to your circumstances

In your case you commenced legal action claiming a loss of property and the loss of the opportunity to obtain profits from the commercialisation of that technology. Using the look-through approach in relation to your situation, as you were yet to acquire any rights in relation to the Technology, we do not consider the Technology itself to be the relevant underlying asset.

Rather, as per the decision in Meeks, the nature of the compensation payment received is for the loss of future anticipated profits and is assessable under section 6-5 of the ITAA 1997.

We consider that CGT event C2 also occurred when the settlement was reached. At this time, you disposed of your right to seek compensation. However, any capital gain arising will be reduced by the anti-overlap provision in section 118-20 of the ITAA 1997 to the extent that it has already been included in your assessable income.

The basic eligibility conditions for the small business concessions under section 152-10 of the ITAA 1997 state under paragraph (b) that the CGT event would (apart from this Division) have resulted in the gain.

In this case, we consider the compensation payment is assessable as ordinary income and the anti-lap overlap provisions will reduce any capital gain to nil. Consequently, the basic conditions for the small business concessions won't be satisfied and therefore you cannot apply the small business CGT concessions.