Edited version of private advice

Authorisation Number: 1052366754830

Date of advice: 28 February 2025

Ruling

Subject: Tax treatment of settlement adjustment amount

Question 1

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the settlement adjustment amount of $X?

Answer 1

No.

Question 2

If the answer to question 1 is no, pursuant to subsection 116-20(1) of the ITAA 1997, is the amount of the capital proceeds from the sale of the Property $X?

Answer 2

Yes.

Question 3

If the answer to question 2 is yes, are the capital proceeds from the sale of the Property replaced with the market value of the Property under subsection 116-30(2) of the ITAA 1997?

Answer 3

No.

This ruling applies for the following period:

Income year ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You owned a rental property at X Street, State (Property).

The Property was held by you as a long-term investment to derive rent.

The Property was sold on in the relevant year, subject to an existing lease.

The Purchaser is an unrelated third-party that is not associated or connected with you.

The existing lease included monthly rent abatements payments by the Landlord to the Tenant of $X plus GST for the seven-year term of the initial lease, for as long as the Tenant satisfied certain conditions. Provided the conditions were met, the total amount of rent abatement to the Tenant would be $X.

The purchase price listed in the contract of sale was $X, which included a deposit of $X.

After the contract was signed but before settlement, both parties to the contract agreed to insert a special condition into the contract that required an adjustment amount at settlement in relation to the rent abatement.

The parties had agreed as part of the original sale negotiations that the Purchaser would not be responsible for any loss arising from the rent abatement. As the signed contract of sale had not included a clause detailing this agreement, you agreed to the special condition so that the sale would proceed to completion despite the fact that you would receive less than the contract price for the sale.

Settlement of the sale was completed in the relevant year.

You paid rent abatement to the Tenant totalling $X, being the amounts owed up to the day of settlement.

At settlement an adjustment was made to the purchase price in favour of the Purchaser in the amount of $X.

Other adjustments were also made to the purchase price.

In respect of the sale of the Property, you received the deposit of $X prior to settlement and $X at settlement.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 8-1(1)

Income Tax Assessment Act 1997 subsection 8-1(2)

Income Tax Assessment Act 1997 subsection 104-10(3)

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

Income Tax Assessment Act 1997 subsection 116-30(2)

Reasons for decision

Question 1

The general deduction provisions are set out in section 8-1 of the ITAA 1997, as follows:

8-1(1)

You can deduct from your assessable income any loss or outgoing to the extent that:

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

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

8-1(2)

However, you cannot deduct a loss or outgoing under this section to the extent that:

(a)           it is a loss or outgoing of capital, or of a capital nature; or

(b)           it is a loss or outgoing of a private or domestic nature; or

(c)           it is incurred in relation to gaining or producing your ^*exempt income or your ^*non-assessable non-exempt income; or

(d)           a provision of this Act prevents you from deducting it.

The general principles and approaches that may be taken into consideration to determine whether a loss or outgoing is of a capital nature have been developed in decisions of the courts over many years.

In Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers), Dixon J adopted a 'profit-yielding structure' approach. His Honour said (at 359-360):

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay ... In the same way expenditure and outlay upon establishing, replacing and enlarging the profit-yielding subject may in a general way appear to be of a nature entirely different from the continual flow of working expenses which are or ought to be supplied continually out of the returns or revenue.

As stated by Fullagar J in Colonial Mutual Life Assurance Society Ltd v Federal Commissioner of Taxation (1953) 89 CLR 428 at p 454, the following questions commonly arise when considering whether an expense is of a capital nature:

•                     What is the expenditure or loss really incurred for?

•                     Is what the expenditure or loss is really incurred for, in truth and in substance, a capital asset?

The following principles have also emerged from Australian and UK cases and may be taken into consideration in determining the nature of a loss or outgoing:

•                     the 'once and for all' test - that capital expenditure is made once and for all, whereas revenue expenditure is made to meet a continuous demand (Vallambrosa Rubber Co Ltd v Farmer (1910) 5 TC 529 at 536)

•                     the 'enduring benefit test' - that outgoings incurred once and for all to bring an asset or advantage of an enduring nature are capital (British Insulated & Helsby Cables Ltd v Atherton (1926) AC 205; 10 TC 15)

•                     the nature of a payment/receipt in the hands of one party to a transaction is not determinative of the nature of the receipt/payment in the hands of the other party (Colonial Mutual Life Assurance Society Ltd v FCT (1953) 89 CLR 428; GP International Pipecoaters Pty Ltd v FCT 170 CLR 124 at 136)

•                     what the parties call a payment may have some relevance but is not determinative (Jupiters Ltd v FCT (2002) 50 ATR 236; FCT v BHP Co Ltd (2000) 45 ATR 507); and

•                     expenditure can be capital even though no asset or advantage of an enduring nature is obtained (John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30; Pine Creek Goldfields Ltd v FCT (1999) 42 ATR 758).

No single principle or approach is decisive. They are to be considered and weighed against each other to determine difficult cases.

You used the property at X Street, State (the Property) to produce rental income during the relevant income year. In the relevant year, you entered into a contract to sell the Property and the sale was settled in the relevant year.

At settlement, the purchase price of $X was adjusted by several amounts. Four adjustments are considered to be revenue in nature as they are sufficiently connected to the income you had produced from the Property prior to settlement.

It is considered that the adjustment of $X is not of a revenue nature. Although the adjustment was calculated based on the rent abatement terms of the lease, under the lease the rent abatement was only payable by the Landlord for as long as the Tenant remained the 'Tenant' and as long as the Tenant continued to meet its obligations under the lease.

You fully paid all rent abatement amount that were owed to the Tenant up to the day of settlement, so the Purchaser did not assume any outstanding liability in respect of the rent abatement. Further, you had no right to income from the Property or any obligation to pay rent abatement to the Tenant after settlement. As such, the $X adjustment was not incurred in connection with income you had earned or would earn from the Property in the future.

As the settlement adjustment of $X was not incurred in gaining or producing your assessable income it is not deductible under section 8-1 of the ITAA 1997.

Question 2

Capital proceeds - general rules

Under the general rules in subsection 116-20(1), the capital proceeds from a CGT event A1 happening on disposal of an asset are the total of:

(a)           the money you have received, or are entitled to receive, in respect of the event happening; and

(b)           the market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).

CGT event A1 happened when you entered into the disposal contract for the Property (subsection 104-10(3) of the ITAA 1997).

The agreed purchase price for the Property was $X, however, there were multiple adjustments required under the contract and by law that reduced the amount you received at settlement.

As discussed in question 1, the settlement adjustment of $X was not of a revenue nature and is not deductible against your assessable income. It is accepted that you agreed to the additional special condition in the sale contract so the sale would proceed to completion even though you would receive less than the agreed price for the sale. Even though you did not receive any tangible or intangible asset or any enduring benefit in respect of the adjustment, it was a 'once and for all' outgoing connected with the sale of the Property, which you held as a capital asset. For these reasons, it is considered that the adjustment was of a capital nature.

In respect of the CGT event A1, the disposal of the Property, you received the deposit of $X plus $X at settlement, totalling $X.

Consequently, pursuant to subsection 116-20(1) of the ITAA 1997, it is considered that the capital proceeds you received in respect of CGT event A1 happening was $X.

Question 3

The general rules about capital proceeds in section 116-20 of the ITAA 1997 may be modified by the market value substitution rule in section 116-30. Subsection 116-30(1) applies in circumstances where no capital proceeds are received, otherwise subsection 116-30(2) applies.

Under subsection 116-30(2) of the ITAA 1997, the capital proceeds from a CGT event are replaced with the market value of the CGT asset that is the subject of the event if:

(a)           some or all of those capital proceeds cannot be valued; or

(b)           those capital proceeds are more or less than the market value of the asset and:

(i)            you and the entity that *acquired the asset did not deal with each other at *arm's length in connection with the event, or

(ii)           the CGT event is CGT event C2 (about cancellation, surrender and similar endings).

The subsection also provides that the market value is worked out as at the time of the CGT event. As discussed in question 1, for CGT event A1, that time is when you enter into the contract for the disposal of the asset.

In relation to arm's length dealings, Dodds-Streeton J in ACI Operations Pty Ltd v Berri Ltd (2005) 15 VR 312 (at [223]) said the authorities establish that:

... an arm's length relationship is that of strangers, or parties who are unaffected by existing mutual duties, liabilities, obligations, cross-ownership of assets, or identity of interests which present a capacity in either party to influence or control the other, or an inducement to serve that common interest, which might operate to modify the terms on which strangers would deal.

As discussed above, the capital proceeds you received from the CGT event A1 that happened on disposal of the Property was $X. It is considered that the market value of the Property was the purchase price that was agreed by you and the unrelated Purchaser on the day the contract was signed, $X.

The Purchaser was not your associate or connected with you in any way. It is considered that you and the Purchaser were independent in your decision making and were not under any influence or control in negotiating the sale. It is considered that you dealt with each other at arm's length in connection with the disposal, including negotiating the additional special condition.

As such, the market value substitution rule in subsection 116-30(2) of the ITAA 1997 does not apply and your capital proceeds for the disposal of your Property was $X.