Private ruling: Capital proceeds from a CGT event - modification rule 4
Date of advice: 21 September 2017
Published: February 2018
Ruling period: 1 July 2012 to 30 June 2018
Date scheme commenced: 1 July 2012

Ruling: Q1: Does the payment made by the Trustee of the ABC Trust represent a repayment that causes a reduction in capital proceeds pursuant to section 116-50(1) of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes | Q2: If the answer to Question 1 is no, does the payment qualify as black hole expenditure in accordance with section 40-880 of the ITAA 1997? | A2: Not applicable

Relevant facts and circumstances: 1. In 1980, the trustee of the ABC Trust, purchased 50% of the Business, which included the leasehold and business asset. In 1990, it purchased 50% of the business premises. 2. In 2010, the trustee of the XYZ Trust, purchased the remaining 50% of the business and premises of the Business. 3. In 2012, the trustees of the ABC and XYZ Trusts (as vendors) entered in an agreement to sell the business and the premises of the Business for consideration of $x million to a third party purchaser. 4. Subsequent to settlement, the purchaser commenced legal action against the trustees. The purchaser made claims that the market value of the business had been overstated and made an application for damages. 5. In 2015, the purchaser and vendors came to a settlement where, without admission of misrepresentation, the vendors agreed to pay the purchaser $y of the settlement sum plus x% of the Applicant’s costs to settle the dispute.

Relevant legislative provisions: Section 102-5 of the Income Tax Assessment Act 1997 | Section 102-20 of the Income Tax Assessment Act 1997 | Section 104-10 of the Income Tax Assessment Act 1997 | Division 116 of the Income Tax Assessment Act 1997 | Subsection 116-20(1) of the Income Tax Assessment Act 1997 | Section 116-50 of the Income Tax Assessment Act 1997

Reasons for decision: Summary: Does the payment made by the trustee of the XYZ Trust represent a repayment that causes a reduction in capital proceeds pursuant to section 116-50(1) of the ITAA 1997? | Detailed Reasoning - CAPITAL GAINS TAX PROVISIONS: 6. Subsection 102-5(1) of the ITAA 1997 provides that the assessable income of a taxpayer includes any net capital gain made during the income year. 7. Section 102-20 provides that a taxpayer may make a capital gain or loss when a capital gains tax (CGT) event occurs to a CGT asset. | Detailed Reasoning - CGT Event A1: 8. Section 104-5 sets out a list of CGT events. CGT event A1 is the disposal of a CGT asset pursuant to subsection 104-10(1). 9. Subsection 104-10(5) provides that a capital gain or loss is disregarded if a taxpayer acquired an asset before 20 September 1985. | Detailed Reasoning - CALCULATING CAPITAL GAINS OR LOSS ARISING FROM A CGT EVENT: 10. Under subsection 104-10(4), a taxpayer will make a capital gain if the capital proceeds from the disposal are more than the asset’s cost base. The capital gain is calculated by determining the capital proceeds from the disposal, less the asset’s cost base. 11. The capital proceeds from a disposal are calculated in accordance with the rules set out in Division 116. 12. The general rule regarding capital proceeds is outlined in subsection 116-20(1) which provides that capital proceeds are equal to the total of the money a taxpayer received, or is entitled to receive, in respect of the event happening and the market value of any other property the taxpayer has received or is entitled to receive in respect of the event happening. | Detailed Reasoning - Modification 4 – Repaid rule: 13. There are six modifications to the general rule. Relevant to the current case is modification rule 4 – the repaid rule, contained in section 116-50. The repaid rule provides that the capital proceeds will be reduced by any amount that is repaid, or any compensation paid that can be reasonably regarded as repayment of the capital proceeds. However, where a part of the repaid amount can also be deducted, section 116-50 provides that this amount cannot reduce the capital proceeds. 14. An example is provided in section 116-50 to help illustrate how the provision operates. This example states: You sell a block of land for $50,000 (the capital proceeds). The purchaser later finds out that you misrepresented a term in the contract. The purchaser sues you and the court orders you to pay $10,000 in damages. The capital proceeds are reduced by $10,000. 15. The terms ‘repaid’ and ‘repayment’ are not defined in the legislation and consequently take on their ordinary meaning. The Macquarie Dictionary defines the term ‘repay’ as ‘to pay back or refund (money, etc)’. 16. Although focussing on capital receipts rather than payments, Taxation Ruling TR 95/35 Income Tax: capital receipts: treatment of compensation receipts (TR 95/35) provides some guidance of the CGT consequences for the payer of compensation payments associated with the disposal of an asset. Specifically, paragraph 10 states that: If a taxpayer is compensated for having paid excessive consideration to acquire an asset, the amount referrable to the overpayment represents a recoupment of all or part of the total acquisition costs of the asset in terms of [former] subsection 160ZH(11) [of the Income Tax Assessment Act 1936 ]. 17. Although former section 160ZH of the Income Tax Assessment Act 1936 has been repealed, the principles of TR 95/35 can be broadly applied to the current provisions. TR 95/35 illustrates that where an amount that represents repayment of excess consideration it will not be included in the calculation of the capital gain or loss. | Detailed Reasoning - Application to your circumstances: 18. Together with the ABC Trust, you entered into an agreement to sell the business and premises of the Business for consideration of $x million to a third party purchaser. As this represents the disposal of a CGT asset, pursuant to subsection 104-10(1), CGT event A1 occurred. 19. In order to calculate the capital gain you made from the sale pursuant to subsection 104-10(4), it is necessary to establish the capital proceeds from the sale. 20. In your case, you received a share of the $x million from the proceeds of the sale of the business and premises. Ordinarily, this would represent the capital proceeds from the sale. However, subsequent to the settlement of the sale of the property, the purchaser commenced legal action. The purchaser contended that you had misrepresented the financial position of the business. 21. In 2016, you entered into a settlement agreement to resolve the dispute with the purchaser such that you, and the ABC Trust, agreed to pay $y to the purchaser. Although this agreement was reached without judgement of a court, it is similar to the example provided in section 116-50 and that explained in paragraph 10 of TR 95/35. That is, the $y represents a repayment of the original settlement sum. 22. The $y repayment of the original consideration cannot otherwise be deducted. Consequently, pursuant to modification rule 4 contained in section 116-50, you are entitled to reduce your proportion of the capital proceeds from the sale of the business, being the 50% share of the business and premises, by your share of the $y that you paid to the purchaser as repayment of the consideration that represents repayment of your share of the proceeds. | Detailed Reasoning - Question 2: If the answer to Question 1 is no, does the payment qualify as black hole expenditure in accordance with section 40-880 of the ITAA 1997? | Detailed Reasoning - Application to your circumstances: 23. The answer to Question 1 is yes and therefore consideration of the black hole expenditure provisions in section 40-880 of the ITAA 1997 is not necessary.

Does the payment made by the Trustee of the XYZ Trust represent a repayment that causes a reduction in capital proceeds pursuant to section 116-50(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?