Private ruling: Settlement payment
Date of advice: 28 June 2016
Published: August 2016
Ruling period: Year ended 30 June 2016
Date scheme commenced: 1 July 2015

Ruling: Q1: Will CGT event C2 occur when you settle your legal action? | A1: Yes.

Relevant facts and circumstances: A financial planner advised you to buy and sell shares and other products that resulted in capital losses. You commenced proceedings against the financial planner. You agreed to a Deed of Settlement.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 6-5 | Income Tax Assessment Act 1997 section 102-20 | Income Tax Assessment Act 1997 subsection 104-25(3) | Income Tax Assessment Act 1997 section 108-5

Reasons for decision: Summary: Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a taxpayer includes income according to ordinary concepts (ordinary income). Ordinary income has generally been held to include 3 categories, namely income from rendering personal services, income from property and income from carrying on a business. Other characteristics of income that have evolved from case law include receipts that: • are earned; • are expected; • are relied upon; and • have an element of periodicity, recurrence or regularity. The settlement payment received was not income from rendering personal services, income from property or income from carrying on a business. The payment is also a one off payment and thus it does not have an element of recurrence or regularity. Accordingly, the compensation payment is not assessable ordinary income under section 6-5 of the ITAA 1997. Capital gains CGT is the tax you pay on certain gains you make. Section 102-20 of the ITAA 1997 provides that you make a capital gain or capital loss as a result of a CGT event happening to an asset in which you have an ownership interest. Section 108-5 of the ITAA 1997 provides that a CGT asset is any kind of property; or a legal or equitable right that is not property. 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 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 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. Right to seek compensation The right to seek compensation is the right of action arising at law or in equity and vesting in the taxpayer on the occurrence of any breach of contract, personal injury or other compensable damage or injury. A right to seek compensation is an asset for the purposes of capital gains tax. The right to seek compensation is acquired at the time of the compensable wrong or injury, and includes all of the rights arising during the process of pursuing the compensation claim. The right to seek compensation is disposed of when it is satisfied, surrendered, released or discharged. This disposal triggers a CGT event C2. Paragraphs 283 and 284 and 285 of TR 95/35 provide the following example: 283. On 4 July 1989 Marty acquired a rental property. In January 1990 Marty decided to sell the property. On 15 March 1990 Waldo indicated to Marty that he was willing to buy the property for $200,000. On 20 March 1990 Marty engaged his solicitors, Legal Eagles, to act for him in the sale. Legal Eagles had also acted for Marty when he purchased the property. On 10 July 1990 contracts were exchanged with a requirement that the sale be settled one year later on 10 July 1991. The sale was not finalised on 10 July 1991 because of a delay in receiving a clearance from one of the local authorities. Waldo later exercised his right under the contract to repudiate the contract and claimed a refund of his deposit. 284. On 24 October 1991 Marty commenced legal action against Legal Eagles seeking damages for their negligence in not ensuring that the certificate was received by the proposed settlement date. On 20 December 1991 Legal Eagles advised Marty they were willing to negotiate a settlement. On 17 January 1992 Marty accepted and received compensation of $95,000 in settlement of his claim against Legal Eagles. At this date Marty had not sold the property. Note: no part of the $95,000 represents a repayment of the deposit paid by Waldo. 285. | Detailed Reasoning - Relevant asset:: The right to seek compensation. The property is not the relevant asset as it was neither permanently damaged nor was its value permanently reduced by the actions of Legal Eagles. | Detailed Reasoning - Acquired:: July 1991 (when Legal Eagle's negligent action became apparent) | Detailed Reasoning - Cost base:: Nil acquisition cost plus legal costs | Detailed Reasoning - Disposed of:: January 1992 | Detailed Reasoning - Consideration:: $95,000 | Detailed Reasoning - CGT consequences:: Marty will be assessed in the 1992 income tax year on the net capital gain While it is acknowledged that your particular circumstances differ from those provided in the above example, the principles of identifying the underlying asset remain the same. Application to your circumstances In this case, you will receive a lump sum settlement payment in relation to the advice provided by a financial planner. As with the example, the relevant asset is not the investments. The lump sum payment was made to compensate you for the inappropriate advice. Therefore, we consider that you have disposed of your right to seek compensation. When you entered into the Deed of Settlement CGT event C2 occurred. You will make a capital gain if the proceeds from the ending of your right to seek compensation are more than the cost base of the asset under subsection 104-25(3) of the ITAA 1997.