Private ruling: Income Tax and Capital gains tax - Compensation - Bank loan
Date of advice: 18 March 2016
Published: May 2016
Ruling period: 20XX-YY income year | 20YY-ZZ income year
Date scheme commenced: 1 July 20VV

Ruling: Q1: Is any part of your share of the loan shortfall component compensation payment assessable as ordinary income? | A1: No. | Q2: Is any part of your share of costs compensation payment assessable as ordinary income? | A2: No. | Q3: Is your share of the loan shortfall component compensation payment considered to be additional capital proceeds in respect of the sale of the house? | A3: Yes. | Q4: Is your share of the costs compensation payment an assessable recoupment to the extent it relates to your deductible expenditure? | A4: Yes. | Q5: Does your share of costs compensation payment reduce the cost base of the house to the extent it relates to expenses that were previously included in its cost base? | A5: Yes. | Q6: Is your share of the compensation amount for distress and inconvenience exempt? | A6: Yes. | Q7: Is your share of the loan shortfall component compensation interest payment assessable as ordinary income? | A7: Yes. | Q8: Is your share of the costs compensation interest payment assessable as ordinary income? | A8: Yes.

Relevant facts and circumstances: You jointly purchased a house. This house then became your main residence. To finance the purchase of the house, you borrowed money from a bank. This amount was also used to re-finance an existing loan over another property and to pay certain fees incurred at that time. Late in 20WW, one of you lost your employment making it more difficult to keep up with the epayments. You moved interstate for work reasons and let the house shortly afterwards. You have included the rental income and expenses in with your income tax returns for the relevant income years. You sought financial difficulty assistance twice. The bank allowed a repayment free period after the first time, but declined your second request. During this period, there were also some issues related to receiving rental payments from the tenants occupying the house. You sold the house during 20XX and used the net proceeds to reduce the balance of the loan with the bank. You re-financed the other property a few months later and paid out the remaining balance of the loan with the bank. You subsequently lodged a complaint with the Financial Ombudsman Service in relation to your dealings with the bank in relation to this now repaid loan. The Financial Ombudsman Service provided its Determination to you which you accepted. This Determination found against the bank with section 1.3 of the Determination stating that they were obligated to pay you the following: • compensation for the Applicants' non-financial loss associated with the stress you suffered as a result of the FSP's maladministration in lending in respect to the loan, plus • compensation to the Applicants plus interest on that amount until the payment required by this Determination is made in full, plus • The Total Amount of the Applicants' costs, calculated in accordance with the Costs Formula set out at section 3.3 of this Determination plus interest on that amount until the payment required by this Determination is made in full. The Determination provided you with a lengthy document outlining their findings and the basis of their calculations. In section 2.1, they outlined the rationale behind their method of determining your compensation entitlement under the heading 'The Applicants incurred loss on the additional Loan funds'. The Determination states under this heading: 'The applicant would be required to account for any benefit they obtained while owning the property, for example, not having to pay rent, or in the case of an investment property, any rent received from leasing the property and any claimed tax deduction. … If the sale proceeds are insufficient to repay the loan and the costs, then the financial services provider must waive the balance of the loan (if any) and also pay the applicant an amount of compensation equivalent to the costs incurred.' This amount is described as the loan shortfall component and is calculated in section 3.4. The other amount is described as your purchase, holding and sale costs and they are calculated in accordance with the Costs Formula set out in section 3.3. The Financial Ombudsman Service was unaware of the amounts of some of your expenses at the time of the Determination. You subsequently submitted the following figures which were accepted: Purchase costs Stamp Duty $ Registration on Transfer $ Copying Costs $ Conveyancing Fee $ Application Fee $ Registration Fee $ Lender's Mortgage Insurance $ Sub Total $ Ownership or Holding Costs Insurance $ Emergency Repairs $ Rates $ Agents Fees - Rent $ Interest Charges $ Travel for Repairs and Sale $ Variation and Discharge Fees $ Valuation $ Sub Total $ Less Rental Income or Rental Benefit $ Sub Total $ Selling Costs Water and Sewerage Charge $ Water Meter Reading $ LTO Fee $ Conveyance Fee $ Search Fees $ Agent's Fees Sale (Advertising) $ Sub Total $ Total $ The costs were reduced by an amount as an extrapolation from the rental income that you declared in your 20AA-XX income tax returns. The bank paid the total amount into your bank account before the end of the 20YY-ZZ income year as a single lump sum. You also sold the other property during the 20YY-ZZ income for a capital gain. You bought this property some ten years ago. The Financial Ombudsman Service Determination is to be read with and forms part of the description of the scheme for the purpose of this ruling.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 6-5, | Income Tax Assessment Act 1997 Subdivision 20-A and | Income Tax Assessment Act 1997 Part 3-1.

Reasons for decision: Summary: Your share of the of the loan shortfall component and costs compensation payments you received are not assessable as ordinary income. | Detailed Reasoning - Detailed reasoning: There are a number of factors which can assist in determining whether a particular receipt is ordinary income. These include: • whether the payment is the product of any employment, services rendered, or any business • the quality or character of the payment in the hands of the recipient • the form of the receipt, that is, whether it is received as a lump sum or periodically, and • the motive of the person making the payment. Motive, however, is rarely decisive as in many cases a mixture of motives may exist. In looking at these four factors in the circumstances here it is considered that the payment is not ordinary income as: • it was paid as a lump sum and once and for all • there is no connection between any employment or services rendered by you and the payment made • you did not rely on the payment for their regular expenditure, and • the payment was not made to cover your regular expenses but to redress the situation which arose due to the actions of the bank. Accordingly, these payments are not assessable as ordinary income. Note: This is only one provision under which a receipt may be treated as assessable income. The following discussion considers the application of other provisions to your receipt of the compensation payments. | Summary: Your share of the loan shortfall component compensation payment is considered to be additional capital proceeds in respect of the sale of the house. | Detailed Reasoning - Detailed reasoning: The four factors mentioned above are also aids to determining whether a particular receipt is capital in nature. The reference above to 'the quality or character of the payment in the hands of the recipient' means we must consider what misdeed this component of the compensation payment was intended to redress. The Determination of the Financial Ombudsman Service is that the Loan Shortfall Component representing their calculation of the amount by which the loan balance should have been reduced by the bank when the house was sold. An adjustment of this type is capital in nature and, therefore, so is the compensation payment to remedy the failure to do so. The right to seek compensation from another person or entity can be an independent asset for capital gains purposes. However, where the cause giving rise to this right is related to your ownership of another asset, it is preferable to see the right as a constituent element emerging from the other asset and to treat the right as part of that other asset. In your case, the rights you asserted in the referral of this matter to the Financial Ombudsman Service relate to your loan with the bank and you used this portion of the loan to finance the purchase of the house. Therefore, the relevant asset is the house. The capital gains provisions define 'capital proceeds' from a CGT event in very broad terms as: • the money you have received, or are entitled to receive, in respect of the event happening, and • the market value of any property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event). An amount of money or other property is considered to be received by you if it has been applied for your benefit (including by discharging all or part of a debt you owe) or as you direct. It is important to note that the money or property need not be given to you by, or on behalf of the purchaser of the house. The Financial Ombudsman Service has concluded that the bank should have waived the remainder of the loan that related to the purchase of the house. Such a waiver would have been additional capital proceeds in respect of the sale of the house. As they didn't waive the remainder of the loan, they have now had to pay the loan shortfall component as compensation to you. This amount is likewise additional capital proceeds in respect of the sale of the house. | Summary: Your share of the costs compensation payment is an assessable recoupment to the extent it relates to your deductible expenditure. | Detailed Reasoning - Detailed reasoning: The costs compensation payment is the other element of the Determination by the Financial Ombudsman Service to put the two of you back into the financial position that you would have been in if you had not bought the house. The expenses that you incurred in relation to the house fall into three categories: • purchase costs • ownership or holding costs, and • selling costs. The Financial Ombudsman Service determination fully compensates you in relation to your purchase costs and selling costs, however, they have only provided a partial compensation for your ownership or holding costs. This compensation has been reduced by the rental income or rental benefit of ownership (as determined by them). You have only been compensated for a portion of your ownership or holding costs because of the rental income or rental benefit you have received. The compensation that you have received is defined as a 'recoupment' for tax purposes. There are additional requirements that must be met before any part of the compensation is considered to be an 'assessable recoupment' in respect of amounts that you have claimed as a deduction, being: • you received the amount by way of insurance or indemnity, or • be on a Table of deductions for which recoupments are assessable. An indemnity can be a payment that is made under a contract of indemnity. It can also include 'a receipt pursuant to an antecedent obligation (whether by virtue of a contract, statute or a breach of some common law duty of care) to make good or compensate for a loss which arises after the obligation comes into existence'. It is considered that the costs compensation would meet the definition of an 'indemnity' due to its relationship to the breach of the duty of care by the bank and the findings made by the Financial Ombudsman Service. Consequently, the costs compensation payment is an assessable recoupment, but only to the extent that it relates to your deductible expenditure. Note: the assessable recoupment is assessable when received. You do not go back and remove the deductions from the previously lodged income tax returns. | Summary: Your share of the costs compensation payment reduces the cost base of the house to the extent it relates to expenses that were previously included in its cost base. | Detailed Reasoning - Detailed reasoning: The capital gains provisions apply more generally to recoupments that would otherwise be included in the cost base and reduced cost base of the house. Therefore, the distinction noted above does not affect the extent to which recoupments of expenses are removed from the cost base of a CGT asset. The capital gains provisions explicitly provide that expenditure does not form part of any element of the cost base to the extent of any amount you have received as recoupment of it, except so far as the amount is included in your assessable income. Consequently, you must re-calculate the cost base of the house by excluding all of the expenses that have been returned to you in the costs compensation payment. | Summary: Your share of the compensation amount for distress and inconvenience is exempt. | Detailed Reasoning - Detailed reasoning: For the reasons outlined above, this payment is capital in nature and potentially subject to the capital gains provisions. However, the capital gains provisions provide an exemption in relation to compensation for any wrong or injury that you suffer personally. This exemption applies to the compensation payment as it was paid for distress and inconvenience. | Summary: Your share of the two interest payments is assessable as ordinary income. | Detailed Reasoning - Detailed reasoning: For the reasons outlined above, these payments are income in nature and are assessable as ordinary income when received. | Summary: You can include your share of the holding costs in the cost base of the other property which you sold during the 20YY-ZZ income year. | Detailed Reasoning - Detailed reasoning: The cost base of CGT asset includes five elements being: • direct acquisition costs • incidental costs related to the acquisition of the CGT asset or the CGT event • holding or ownership costs • capital expenditure that enhances or preserves the asset's value, and • capital expenditure to establish, preserve or defend your title to the asset. The Determination by the Financial Ombudsman Service has not seen any of your holding costs in relation to this property refunded. Therefore, you have not recouped any of this expenditure and they continue to be available to be included in the cost base of this property (unless there is another reason why they shouldn't be included in the cost base).

Question 1: Can you include your share of the holding costs in the cost base of the other property which you sold during the 20YY-ZZ income year?