Edited version of private advice

Authorisation Number: 1052276720122

Date of advice: 31 July 2024

Ruling

Subject: Payment - income or capital

Question 1

Does the payment of the Repayment Amount form part of assessable income in accordance with section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Does the payment of the Repayment Amount result in CGT Event C2 occurring as per section 104-25 of the ITAA 1997?

Answer

Yes.

Question 3

Is the capital gain arising from the payment of the Repayment Amount a discount capital gain in accordance with section 115-5 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ending 30 June 20XX

The scheme commenced on:

1 May 20XX

Relevant facts and circumstances

Person A and Person B were previously married, and divorced in December XXXX.

Consent orders were made in December XXXX in proceedings between Person A and Person B in the Family Court of Australia. The orders were complied with, and the party's financial relationship was completely severed. They lived independent lives both personally and financially.

Years later, Person A and Person B began living at the Property which was owned by Person A. Person A had purchased the Property with their own funds. Person B did not contribute to the purchase price.

Person B lent Person A approximately half the purchase price secured by a registered first mortgage over the Property approximately 18 months after it was purchased by Person A. A copy of the agreement under which that loan was made has not been provided.

Approximately 10 years later, Person A and Person B entered into a financial agreement ('The Agreement').

The Agreement sets out the following relevant key terms:

•         It was agreed that, upon the death of Person A, Person B may continue to reside in the Property during which time Person B would not need to pay rent.

•         During Person B's residence in the Property during Person A's lifetime, Person B was obliged to pay 50% of all outgoings.

•         During Person B's residence in the Property after the death of Person A, Person A's Executor would meet and bear all outgoings and all costs to maintain the Property from their estate.

•         Until the sale of the Property or during Person A's lifetime or whilst Person B continues to reside at the Property, Person B agreed not to seek to recover the loan.

•         Person B agreed that the loan is interest free.

•         At any time, Person A may give Person B a minimum of 8 weeks written notice to vacate the Property.

•         Person A may sell the Property at any time in which event Person B is to vacate but at a maximum period of 4 weeks after being given notice.

•         In the event of a sale, the Repayment Amount is to be paid to Person B upon completion of the sale.

•         Any sale of the Property by Person A's executor or trustee shall be at the best price reasonably achievable in the circumstances and in the then current market conditions.

•         On the occurrence of an event entitling Person B to have the Principal Sum repaid to them or to their estate, the parties shall agree on the Valuation Amount and Person A shall pay Person B the Repayment amount on the Repayment date.

•         "Repayment Amount" means the Principal Sum plus the Percentage Increase plus or minus Adjustments.

•         "Principal Sum" means the original loan amount

•         "Percentage Increase" means the amount equal to 40% of the difference between the Purchase Price and the Sale Price or Valuation Amount.

•         "Purchase Price" means the price Person A originally paid for the Property.

Person A died approximately three years after entering into the Agreement and, in their will, left their interest in the Property to their Executrix upon trust to permit and allow Person B to have the use, occupation and enjoyment of the Property so long as they lived there.

Until Person B's death approximately 6 years after Person A's, Person B continued to live at the Property.

Following Person B's death, the Property was sold by the executor of Person A's estate for more than the original purchase price.

Person B's estate is expected to receive the Repayment Amount from Person A's estate comprising repayment of the Principal Sum; and the Percentage Increase.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 subsection 6-5(2)

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 subsection 104-25(2)

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 108-25

Income Tax Assessment Act 1997 section 115-5

Income Tax Assessment Act 1997 section 115-10

Income Tax Assessment Act 1997 paragraph 115-10(c)

Income Tax Assessment Act 1997 section 115-15

Income Tax Assessment Act 1997 section 115-20

Income Tax Assessment Act 1997 section 115-25

Income Tax Assessment Act 1997 subsection 115-30(1)

Reasons for decision

Question 1

Does the payment of the Repayment Amount form part of assessable income in accordance with section 6-5 of the ITAA 1997?

Summary

The Repayment Amount is not assessable income under section 6-5 of the ITAA 1997 as it does not have the character of ordinary income.

Detailed reasoning

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

Ordinary income has generally been held to include three 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:

a)    are earned

b)    are expected

c)    are relied upon, and

d)    have an element of periodicity, recurrence or regularity.

If the income has characteristics of the four listed above, then it can be considered as ordinary income under section 6-5 of the ITAA 1997.

It is well settled that interest is ordinary income regardless of how it might be described by the contracting parties.

In FC of T v Broken Hill Pty Ltd [2000] FCA 1431 (BHP), the Full Federal Court considered the characterisation of the payment (referred to as 'interest') under a contract for the completion of sale of shares. Hill J noted that the label used by the parties to describe the payment is not determinative of its character.

Further, it is well settled that a profit derived from an isolated transaction may be ordinary income. In FC of T v The Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; 18 ATR 693 (Myer Emporium) the Court said:

Although it is well settled that a profit or gain made in the ordinary course of carrying on a business constitutes income, it does not follow that a profit or gain made in a transaction entered into otherwise than in the ordinary course of carrying on the taxpayer's business is not income. Because a business is carried on with a view to profit, a gain made in the ordinary course of carrying on the business is invested with the profit- making purpose, thereby stamping the profit with the character of income. But a gain made otherwise than in the ordinary course of carrying on the business which nevertheless arises from a transaction entered into by the taxpayer with the intention or purpose of making a profit or gain may well constitute income. Whether it does depends very much on the circumstances of the case. Generally speaking, however, it may be said that if the circumstances are such as to give rise to the inference that the taxpayer's intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer's business. Nor does the fact that a profit or gain is made as the result of an isolated venture or a 'one-off' transaction preclude it from being properly characterised as income ( FC of T v Whitfords Beach Pty Ltd). The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit.

Where money is lent without interest, or at a low rate of interest, a premium accompanying repayment would usually be in the nature of, or in substitution for, interest and would be an income receipt (refer for example, R Commrs v Thomas Nelson & Sons Ltd (1939) 22 TC 175).

Interest is a sum payable for the use of another sum (the principal) and is expressed as a percentage of the principal (The CCH Macquarie Dictionary of Accounting). Interest accrues from day to day even if payable only at intervals and is, therefore, apportionable in respect of time between persons entitled in succession to the principal (Halsbury 4th ed, vol 32 p 53).

In Myer Emporium, the Full High Court described interest as "compensation to the lender for being kept out of the use and enjoyment of the principal sum''. As such, interest which becomes due is not the product of the mere contractual right to interest severed from the debt for the money lent, but flows from the principal sum.

Application

On the facts here, it is clear that the loan made by Person B was not done so as a commercial transaction or with a profit making purpose. Person B had a domestic purpose in making the loan. It was undertaken with the sole purpose of securing enduring private accommodation occupancy rights.

There is also no sum payable expressed as a percentage of the principal sum that accrues on a day-to-day basis as compensation for being kept out of the use and enjoyment of the principal sum.

The contractual right is to share in the gain or loss on disposal of the Property where the gain or loss is the difference between the sales price and purchase price.

Nothing accrues on a day-to-day basis on the facts here.

It is not in the nature of interest that a lender stands to suffer a financial detriment as compensation for the lending of the principal sum yet that would be the outcome here were the Property sold during the holding period for a loss.

Despite how the contractual terms were framed which sought to give Person B no freehold estate in the Property, in substance Person B gained occupancy rights and a companion right to share in the profit or loss on sale of the Property akin to the holder of a freehold estate.

Further the contract expressly provides that no interest is payable although contractual doctrine is well settled in that it matters not how something is badged, it is what it is (as noted by Hill J in the BHP case above).

What is clear from the contractual terms is that they provide for no amount to accrue on a day-to-day basis in compensation for the lending of the principal sum.

For these reasons and on these particular facts and circumstances, Person B's contractual right to any positive amount over and above the purchase price that may be (and was) payable as part of the Repayment Amount is not considered interest or in the nature of interest.

The Repayment Amount includes a sharing in the profit or loss on the sale of the Property and has a character of capital.

Question 2

Does the payment of the Repayment Amount result in CGT Event C2 occurring as per section 104-25 of the ITAA 1997?

Summary

Yes, the relevant CGT asset is the contractual right to the Repayment Amount. CGT event C2 occurs at the time Person B or their Estate receive this payment from Person A or their Estate.

Detailed reasoning

Section 108-5 of the ITAA 1997 states that a CGT asset can be any kind of property or a legal or equitable right that is not property.

Section 104-25 of the ITAA 1997 provides that CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset being redeemed or cancelled; or expiring; or being abandoned, surrendered, or forfeited.

The timing of the event is when you enter into the contract that results in the asset ending, or if there is no contract- when the asset ends as per subsection 104-25(2) of the ITAA 1997.

Application

Person B's contractual right to receive the Repayment Amount, is the relevant CGT asset within the meaning of section 108-5 of the ITAA 1997. The Agreement between Person A and Person B contains a contractual right for Person B or their Estate to share in the gain or loss on disposal of the Property where the gain or loss is the difference between the sale price and purchase price in companion with the right to receive repayment of the principal sum. In the event of a loss, the effect of the agreement is that the loss is indemnified out of the principal sum meaning the principal sum less the amount of the loss is returned to Person B or their Estate.

At the time Person B or their Estate receive the Repayment Amount from Person A (or their Estate), Person B's contractual right to receive the payment has been satisfied and CGT event C2 occurs.

The first element of the cost base of the CGT asset, being the contractual right held by Person B, will be the original loan amount and the capital proceeds will be the Repayment Amount.

Question 3

Is the capital gain arising from the payment of the Repayment Amount a discount capital gain in accordance with section 115-5 of the ITAA 1997?

Summary

Yes, the capital gain that will result from the CGT event is eligible for the CGT discount under section 115-5 of the ITAA 1997 as the capital gain meets the requirements in sections 115-10, 115-15, 115-20 and 115-25 of the ITAA 1997. Namely, the gain will be made by a trust, the CGT event that resulted in the gain happened after 11:45am on 21 September 1999, the capital gain will not have an indexed cost base, and the asset that the capital gain happened to was acquired by the entity at least 12 months before the CGT event.

Detailed reasoning

Subdivision 115-A of the ITAA 1997 outlines the meaning of discount capital gains. It states that a discount capital gain remaining after the application of any capital losses and net capital losses from previous income years is reduced by the discount percentage when working out the net capital gain.

Section 115-5 of the ITAA 1197 outlines that a discount capital gain is a capital gain that meets the requirements of sections 115-10, 115-15, 115-20 and 115-25 of the ITAA 1997.

Section 115-10 of the ITAA 1997 provides the types of entity that can make a discount capital gain and paragraph 115-10(c) of the ITAA 1997 includes a trust.

Section 115-15 of the ITAA 1997 states that to be a discount capital gain, the capital gain must result from a CGT event happening after 11:45 am on 21 September 1999.

Section 115-20 of the ITAA 1997 states that a discount capital gain must not have an indexed cost base.

Section 115-25 of the ITAA 1997 provides that the capital gain must result from a CGT event happening to a CGT asset that was acquired by the entity making the capital gain at least 12 months before the CGT event. Item 3 of the table in subsection 115-30(1) of the ITAA 1997 states that a CGT asset acquired by the legal personal representative of a deceased individual is taken to be acquired when the deceased acquired the asset.

Application

The entity that will make the capital gain is the Estate of Person B, satisfying paragraph 115-10(c) of the ITAA 1997.

The capital gain will result from a CGT event that happened after 11:45 am on 21 September 1999, satisfying section 115-15 of the ITAA 1997.

The capital gain is not calculated in reference to an indexed cost base, satisfying the requirement in section 115-20 of the ITAA 1997.

The capital gain in relation to the Repayment Amount will result from CGT event C2 happening to the CGT asset, being the contractual rights under the Agreement. As per item 3 of the table in subsection 115-30(1) of the ITAA 1997, the rights were acquired by the legal personal representative of the deceased individual when the deceased acquired the asset. In this case the contractual rights were created, and the CGT event will occur in the income year ending approximately 10 years later. Therefore, the entity making the capital gain, being the Estate of Person B, acquired the asset at least 12 months before the CGT event, satisfying section 115-25 of the ITAA 1997.

The capital gain arising from the Repayment Amount is a discount capital gain in accordance with section 115-5 of the ITAA 1997.