Private ruling: Compensation payment
Date of advice: 16 June 2017
Published: October 2017
Ruling period: Year ending 30 June 2017 | This scheme commenced on: | 1 July 2016

Ruling: Q1: Is the compensation received from the out-of-court settlement assessable as ordinary income? | A1: No. | Q2: Is the compensation received from the out-of-court settlement assessable under the CGT provisions? | A2: Yes

Relevant facts and circumstances: You had a contract to supply goods to a company who then sourced the goods from elsewhere. You took legal action against company, which resulted in the agreed terms including: The company paid you an amount in full and final settlement, including your legal costs.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 6-5(2) | Income Tax Assessment Act 1997 section 6-10 | Income Tax Assessment Act 1997 section 10-5 | Income Tax Assessment Act 1997 section 102-5 | Income Tax Assessment Act 1997 section 102-20 | Income Tax Assessment Act 1997 subsection 104-25(1) | Income Tax Assessment Act 1997 section 108-5 | Income Tax Assessment Act 1997 subsection 110-25

Reasons for decision: Summary: While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision. Ordinary income Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes the ordinary income they derived directly or indirectly from all sources, whether in or out of Australia, during the income year. 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. 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. In Scott v. FC of T (1966) 14 ATD 286, Windeyer J expressed the view that whether or not a particular receipt is income depends upon its quality in the hands of the recipient. Regard must be given to the full circumstances in which the payment is received. The following guidelines for determining whether a loss or outgoing is of a capital nature have been set down by the High Court in Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 5 ATD 23; 5 ATD 87; 61 CLR 337: ● the expenditure is related to the business structure itself, that is, the establishment, replacement or enlargement of the profit yielding structure rather than the money earning process, or ● the nature of the advantage has lasting and enduring benefit, or ● the payment is 'once and for all' for the future use of the asset or advantage rather than being recurrent and ongoing. Although these guidelines relate to expenses, the principles are relevant for income receipts as well. In your case: ● the payment was not periodic, being paid once only, ● you agreed to settle the claim in return for the payment, ● the payment is income as compensation, ● the quantum of the payment is not merely a nominal amount, ● the payment is a once and for all payment, ● the payment provides an enduring benefit. Therefore the income is not assessable as ordinary income under subsection 6-5(2) of the ITAA 1997. 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 is capital gains, section 102-5 of the ITAA 1997. Capital gains tax provisions Your assessable income includes your net capital gain for the income year (section 102-5 of the ITAA 1997). Section 102-20 of the ITAA 1997 states that a capital gain or capital loss is made only if a CGT event happens. 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. Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts discusses the capital gains tax implications for compensation receipts. Why the payment was made is an important factor in determining whether an asset has been disposed of for capital gains tax purposes. TR 95/35 discusses the various scenarios, including: ● disposal of the underlying asset, ● compensation for permanent damage to, or permanent reduction in value of, the underlying asset, and ● disposal of the right to seek compensation. The transaction which generated your compensation receipt is your acceptance of the settlement payment by a third party. After considering your full circumstances, it is considered that the relevant CGT asset in your case is the right to seek compensation. The payment received was in full settlement of all claims made. Your right to seek compensation is an intangible CGT asset and your ownership of that asset ended when you accepted the compensation sum. At that time CGT event C2 happened. 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). In your case, the compensation lump sum payment represents capital proceeds for your CGT C2 event. The cost base will include your legal fees incurred. If you acquired the right to seek compensation more than 12 months before the CGT event, you are able to apply the 50% general discount to the capital gain.