Private ruling: Taxation treatment of compensation
Published: May 2015
Ruling period: Year ended 30 June 2015
Date scheme commenced: 1 July 2014

Ruling: Q1: Is any part of the compensation payment you received assessable as ordinary income? | A1: No. | Q2: Did CGT event C2 happen when you accepted the recommendation of the Financial Ombudsman Service (FOS) to receive the compensation payment? | A2: Yes. | Q3: Is the compensation amount you received for distress and inconvenience exempt? | A3: Yes. | Q4: Is the compensation amount you received for deductible expenses an assessable recoupment? | A4: Yes. | Q5: Can you apply the 50% discount to the capital gain? | A5: Yes.

Relevant facts and circumstances: You and your spouse acquired a rental property which was financed by way of an investment loan from financial institution A. The investment loan was refinanced through financial institution B. You sold your main residence and financial institution B incorrectly applied the proceeds from this sale against your investment loan. When you discovered the error you notified financial institution B but they refused to rectify it. After you contacted the FOS financial institution B reversed the transactions in an attempt to reinstate the investment loan. You applied for a private ruling on the deductibility of the interest on the investment loan and the Commissioner ruled that you were not entitled to deductions for your share of the interest incurred on the reinstated amount. You incurred deductible fees in applying for the private ruling. The FOS made a Recommendation to resolve the dispute between you and financial institution B. The FOS recommended that financial institution B pay you and your spouse compensation for additional tax payable, capital expenses you would need to incur to return yourselves to the position you were in before the error was made and for distress and inconvenience. You accepted the Recommendation in full and final settlement of all matters between you and financial institution B arising out of the dispute. You claimed a deduction for your share of the deductible expense paid in relation to applying for the private ruling on the deductibility of the interest on the investment loan. You also incurred deductible expenses in relation to the CGT event.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 6-5 | Income Tax Assessment Act 1997 section 6-10 | Income Tax Assessment Act 1997 section 10-5 | Income Tax Assessment Act 1997 Subdivision 20-A | Income Tax Assessment Act 1997 subsection 20-25(1) | Income Tax Assessment Act 1997 subsection 20-20(3) | Income Tax Assessment Act 1997 section 20-30 | Income Tax Assessment Act 1997 subsection 20-30(1) | Income Tax Assessment Act 1997 section 25-5 | Income Tax Assessment Act 1997 section 102-5 | Income Tax Assessment Act 1997 subsection 102-5(1) | Income Tax Assessment Act 1997 section 102-20 | Income Tax Assessment Act 1997 subsection 104-25(1) | Income Tax Assessment Act 1997 subsection 104-25(2) | Income Tax Assessment Act 1997 section 108-5 | Income Tax Assessment Act 1997 section 110-25 | Income Tax Assessment Act 1997 subsection 110-25(1) | Income Tax Assessment Act 1997 subsection 110-25(2) | Income Tax Assessment Act 1997 subsection 110-25(3) | Income Tax Assessment Act 1997 subsection 110-35(2) | Income Tax Assessment Act 1997 subsection 110-45(1B) | Income Tax Assessment Act 1997 Subdivision 115-A | Income Tax Assessment Act 1997 section 116-20 | Income Tax Assessment Act 1997 subsection 116-40(2) | Income Tax Assessment Act 1997 paragraph 118-37(1)(b)

Reasons for decision: Detailed Reasoning - Ordinary income: Your assessable income includes income according to ordinary concepts, which is called ordinary income (section 6-5 of the ITAA 1997). 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. Compensation payments are considered to be ordinary income where the payments are compensation for the loss of income or where some portion of the payment is identifiable and quantifiable as income. As the payments you received are not for loss of income, nor are any part of them identifiable as income, the payments are not assessable as ordinary income under section 6-5 of the ITAA 1997. | Detailed Reasoning - Statutory income: Amounts that are not ordinary income, but are included in your assessable income by another provision are called statutory income (section 6-10 of the ITAA 1997). The provisions dealing with statutory income are listed in section 10-5 of the ITAA 1997. Included in this list are Subdivision 20-A of the ITAA 1997 (assessable recoupments) and section 102-5 of the ITAA 1997 (capital gains). | Detailed Reasoning - Assessable recoupment: An amount received (except by way of insurance or indemnity) as recoupment of a loss or outgoing is an assessable recoupment if it is paid to cover the cost of a deductible expense listed in section 20-30 of the ITAA 1997 and the deduction can be claimed in the current year or in an earlier income year (subsection 20-20(3) of the ITAA 1997). Section 25-5 of the ITAA 1997 is listed in section 20-30 which allows a deduction for tax-related expenses such as accountant's fees (item 1.3 in the table in subsection 20-30(1) of the ITAA 1997). Recoupment of a loss or outgoing includes any kind of recoupment, reimbursement or refund (subsection 20-25(1) of the ITAA 1997). You incurred deductible expenses and claimed a deduction for this expenditure. The compensation you received for this amount is an assessable recoupment. | Detailed Reasoning - Capital gains tax: Your assessable income includes your net capital gain for the income year (subsection 102-5(1) of the ITAA 1997). You make a capital gain (or loss) as a result of a CGT event happening (section 102-20 of the ITAA 1997). CGT event C2 happens if your ownership of an intangible CGT asset ends in certain ways, including being released or cancelled (subsection 104-25(1) of the ITAA 1997). The time 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 (subsection 104-25(2) of the ITAA 1997). A CGT asset is any kind of property or a legal or equitable right that is not property (section 108-5 of the ITAA 1997). In your case, your right to seek compensation was an intangible CGT asset (acquired at the time of the compensable wrong) and your ownership of that asset ended when you accepted the Recommendation of the FOS. At that time CGT event C2 happened. The capital proceeds from a CGT event are the total of the money you have received, or are entitled to receive, in respect of the event happening, and 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) (section 116-20 of the ITAA 1997). If you receive a payment in connection with a transaction that relates to one CGT event and something else, the capital proceeds from the event are so much as is reasonable attributable to the event (subsection 116-40(2) of the ITAA 1997). In your case, the capital proceeds will include the compensation amount you received for your share of additional tax paid as a result of the error, capital expenses you would need to incur to return yourselves to the position you were in before the error was made and for distress and inconvenience. You made a capital gain as those proceeds were more than the right's cost base. The cost base of the right to seek compensation is determined in accordance with the provisions of section 110-25 of the ITAA 1997. The cost base of a CGT asset consist of 5 elements (subsection 110-25(1) of the ITAA 1997). The first two elements are relevant to your particular circumstances. The first element includes in the cost base any consideration in respect of the acquisition of the right to seek compensation (subsection 110-25(2) of the ITAA 1997). If the right to seek compensation arises in respect of a monetary loss, the amount of that loss is included in the cost base of the right to seek compensation for that loss. As such, your cost base includes your share of the additional tax paid as a result of financial institution B's error. The second element is the incidental costs you incurred to acquire a CGT asset or that relate to a CGT event (subsection 110-25(3) of the ITAA 1997). Incidental costs include remuneration for the services of an accountant (subsection 110-35(2) of the ITAA 1997). However, expenditure does not form part of the second element of the cost base to the extent that you have deducted it or can deduct it (subsection 110-45(1B) of the ITAA 1997). As the amounts you paid in relation to the CGT event are deductible these expenses do not form part of the cost base of your right to seek compensation. A capital gain you make from a CGT event relating directly to compensation you receive for any wrong you or your relative suffers personally is disregarded (paragraph 118-37(1)(b) of the ITAA 1997). Therefore, that part of the capital gain you made that relates to the compensation you received for distress and inconvenience will be disregarded. To qualify for the 50% general discount a capital gain must be made by an individual, a complying superannuation entity, a trust or a life insurance company. The capital gain must result from a CGT event happening after 11.45am on 21 September 1999 and must not have an indexed cost base. Also, the gain must result from a CGT event happening to an asset that was acquired at least 12 months before the CGT event (Subdivision 115-A of the ITAA 1997). As you acquired your right to seek compensation more than 12 months before the CGT event, you are able to apply the 50% general discount to your share of the capital gain.