Private ruling: Capital gains tax - compensation received - legal costs - interest expense - capital protected equity
Ruling period: Income year ended 30 June 2007 Income year ended 30 June 2008 Income year ended 30 June 2009 Income year ended 30 June 2010 Income year ended 30 June 2011 Income year ended 30 June 2012
Date scheme commenced: 1 July 2007

Ruling: Q1:  | A1:  | Q2:  | A2:  | Q3:  | A3:  | Q4:  | A4: 

Relevant facts and circumstances: You and your spouse are clients of a Banking organisation (the Bank). Relying on advice provided by a former employee of the Bank, you and your spouse applied for, and were granted a number of loans, some of which were used entirely for investment purposes, and others to fund the purchase of Put Options. You and your spouse incurred interest expenses in relation to the loans, which were jointly paid by you and your spouse. You and your spouse have calculated the capital protection amounts in relation to your loans. You and your spouse jointly incurred an amount in relation to the Termination Cost for your loans. You received advice that in addition to the Deed of Settlement, the Bank had also paid the Termination Costs of the loan. You and your spouse jointly paid legal costs incurred in obtaining the Settlement amount from Bank. You have provided a number of documents, and they form part of, and should be read in conjunction with this private ruling: You have given your authority for us to use information sourced from the following document while completing your private ruling: · Tax and Accounting Guide in relation to one of your loans, provided by the Bank.

Relevant legislative provisions: Income Tax Assessment Act 1997 - Section 8-1 Income Tax Assessment Act 1997 - Section 102-20 Income Tax Assessment Act 1997 - Section 104-10 Income Tax Assessment Act 1997 - Section 110-25 Income Tax Assessment Act 1997 - Section 116-20 Income Tax Assessment Act 1997 - Division 247 Income Tax Assessment Act 1997 - Section 247-10 Income Tax Assessment Act 1997 - Section 247-15 Income Tax (Transitional Provisions) Act 1997 - Division 247 Income Tax (Transitional Provisions) Act 1997 - Section 247-5

Reasons for decision: Summary: Will your share of the compensation amount be treated as additional capital proceeds in respect of the disposal of your original investments? The general capital gains tax (CGT) provisions are set out in Part 3-1 of the Income Tax Assessment Act 1997 (ITAA 1997). Under the CGT provisions a taxpayer will make a capital gain or loss only if a CGT event happens. To determine if a CGT event happens in respect of a compensation payment it is necessary to consider the nature of the asset to which the compensation payment relates. The Commissioner's policy on the treatment of compensation payments is set out in Taxation Ruling TR 95/35 - Capital gains: treatment of compensation receipts (TR 95/35). TR 95/35 states that the particular asset for which compensation has been received by the taxpayer may be: · an underlying asset · a right to seek compensation; or · a notional asset in terms of subsection 160M(7) - (section 104-155 of the ITAA 1997). In determining the most relevant asset, it is often appropriate to adopt a 'look through' approach to the transaction or arrangement which generates the compensation receipt. In TR 95/35 the term 'underlying asset' is used. The underlying asset is defined in TR 95/35 as: "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 more than one underlying asset, the relevant underlying asset is the asset which leads directly to the payment of the amount of compensation. For example, if a taxpayer receives an amount of compensation for the destruction of his or her truck, the truck is the underlying asset." Paragraph 4 of TR 95/35 provides the following guidance on compensation received for the disposal of an underlying asset: "If an amount of compensation is received by a taxpayer wholly in respect of the disposal of an underlying asset, or part of an underlying asset of the taxpayer, the compensation represents consideration received on the disposal of that asset. In these circumstances, we consider that the amount is not consideration received for any other asset, such as the right to seek compensation." In your case, you and your spouse were clients of the Bank. Relying on the advice provided by a former employee of the Bank, you and your spouse applied for, and were granted a number of loans. Some of these loans were used entirely for investment purposes, while others were used to purchase Put Options. You and your spouse made a claim as a result of the advice and service you received from a former Bank employee and the Bank in relation to your loans, and the conduct of the former Bank employee and the Bank. Settlement was reached with the Deed of Settlement and Release being signed by the parties. Under the settlement the parties have agreed to you and your spouse's Investment Portfolio being sold down, with the proceeds used to pay out a prescribed number of you and your spouse's loans in full. The balance of the sale proceeds was paid into an account you and your spouse have. Another loan was broken and paid in full, with the Bank assuming all costs associated with the breaking of the loan. The Bank also agreed to pay you and your spouse a prescribed amount to compensate for some of the capital losses you had made on your investment portfolio, and not to replace lost income. On the facts of this case, it is considered that the compensation amount you and your spouse received had a direct and substantial link with the underlying asset (the investments). Accordingly, in line with the guidelines provided in paragraph 4 of TR 95/35, it is considered that the compensation amount was received as part of the underlying asset and it was not received for the disposal of any other asset, such as the right to seek compensation. The compensation amount is therefore accepted as consideration received for the disposal of the underlying assets, and CGT event A1 in section 104-10 of the ITAA 1997 occurred when you and your spouse's investments were sold. Your share of the compensation amount must be included in the capital proceeds for the disposal of your investments when determining whether you have made either a capital gain or a capital loss in relation to the disposal of your investments. | Detailed Reasoning - Can you claim a deduction for your share of the legal expenses incurred in relation to your legal claim?: Deductions can be claimed from assessable income for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income. Legal expenses will be allowable deductions if they arise out of the day to day activities of a taxpayers business or employment. Deductions are not allowed when they are of a capital, private or domestic nature, or relate to the earning of exempt income. When determining whether a deduction can be claimed for legal expenses, it is necessary to consider the reason for which the legal expenses were incurred. The character of legal expenses can be determined by examining the benefit to be gained from the legal action, or the purpose or motivation behind it. If the benefit or motive is to gain a capital benefit, then the expenses will take on the character of a capital nature. The cost base of a CGT asset consists of the cost of acquiring the asset, and other costs associated with acquiring, holding and disposing of the asset. The fifth element of a CGT assets cost base includes capital expenses incurred to preserve or defend your ownership of or rights to your asset. In your case, you and your spouse incurred legal expenses when you lodged a claim against the Bank. The settlement amount you received in relation to your claim was made in relation to capital losses you had made, and not lost income. Therefore it is viewed that the character of the benefit was of a capital nature, and will not be deductible. Your share of the legal costs will be included in the fifth element of the cost base of your original investment as they were incurred in relation to the capital expenses arising from your court claim. | Detailed Reasoning - Can you claim a deduction in respect of your share of the interest paid in relation to your loan?: The deductibility of interest on borrowed funds is determined by the use of the borrowed money. If the money is used to buy income producing assets, then the interest expense is an allowable deduction. In FC of T v. Brown 99 ATC 4600, (1999) 43 ATR 1 ( Browns case ) the Full Federal Court held that a taxpayer may still be entitled to a deduction for recurrent interest expenses incurred after an income producing activity has ceased provided the occasion of the interest expense arose out of the taxpayers previous income earning activities. In Browns case , the Full Federal Court stated that the occasion for the recurring payments of interest was to be found in the original loan agreement (carrying with it the obligation to pay interest over the term of the loan) entered into by the taxpayer. The Full Federal Court found that the ceasing of the income producing activity did not operate to break this nexus. However, the nexus between the interest expense and the relevant income earning activities will be broken where: · the taxpayer has the ability to repay the loan but chooses not to do so, or · the taxpayer makes a conscious decision to extend the loan in order to derive an ongoing commercial advantage unrelated to the prior income earning activities which resulted in the debt. In your situation, you and your spouse opened a loan account to be used entirely for the purchase investments. A nexus existed between the interest expense incurred in relation to the loan account and the assessable income earned. This nexus remains unbroken and therefore your share of the interest expense incurred in relation to the loan will be deductible in the income year in which the expense was incurred. | Detailed Reasoning - Will the interest amounts attributable to the cost of the capital protection be included in the cost base of the Put Options?: Division 247 of the ITAA 1997 outlines the taxation provisions applicable to capital protected borrowing and only applies to borrowers with respect to capital protected borrowings entered into on or after 9:30 am by legal time in the ACT, on 16 April 2003. The purpose of Division 247 of the ITAA 1997 is to separately identify an appropriate portion of the total consideration paid by a borrower as the premium paid for "capital protection". This premium is treated for CGT purposes as the price paid for a put option, whether or not a put option is actually granted to the borrower: If the financing agreement allows the borrower to invoke capital protection on more than one occasion, the borrower is taken to have acquired a put option for each relevant period for which capital protection may be invoked. In your case, you and your spouse have calculated the capital protection amounts for each income year in which you held your capital protection equity loan. As the outlined above, the amounts reasonably attributable to the cost of capital protection, calculated in accordance with Division 247 of the ITAA 1997 and Division 247 of the Income Tax (Transitional Provisions) Act 1997 for borrowings entered into on or after 9:30 am by legal time in the ACT on 16 April 2003 and before 1 July 2007, will be included in the cost base of the Put Options. Therefore, if the amounts of capital protection you have provided have been calculated in accordance with the relevant legislation, you will be entitled to include your share of the capital protection in the cost base of your Put Options.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. Contact us at the address given in the fact sheet if you have any concerns. | Question 3: Can you claim a deduction in respect of your share of interest incurred in relation to your investment loan?