Private ruling: Compensation - incomplete advice - interest - taxation adjustment
Date of advice: 31 January 2020
Published: March 2020
Ruling period: Financial year ending 30 June 2020
Date scheme commenced: DD/MM/YYYY

Ruling: Q1: Will the amount you receive for missed earnings on your investment be included in your assessable income? | A1: Yes. | Q2: Will the amount you receive as compensation for the reduction in your age pension benefits due to the incomplete advice be treated as capital proceeds for the disposal of your right to seek compensation? | A2: Yes. | Q3: Will any additional amount of compensation you receive to cover any personal income tax liability (including capital gains tax (CGT)) that may arise in respect of the compensation amount be treated as additional capital proceeds for the disposal of your right to seek compensation? | A3: Yes.

Relevant facts and circumstances: You and your spouse obtained ongoing financial advice services from a financial adviser. You and your spouse attended a meeting with the adviser. At this meeting you expressed an intention to rollover your existing account-based pension account to a new provider. You rolled over your account-based pension to a new provider and notified Centrelink soon after. Due to legislative changes that were effective from DD/MM/YYYY you triggered an adverse change to Centrelink's assessment of your account-based pension, with your new account-based pension being subject to the deemed income rules for the purposes of the age pension income test (whereas your old account-based pension was exempt from the new arrangements and grandfathered under the existing rules). Your age pension entitlements were reduced due to the deeming of your account-based pension. You subsequently lodged a complaint with the Australian Financial Complaints Authority (AFCA) about the execution-only advice provided by the adviser following the meeting. In your complaint you claimed that: · you should have provided personal financial advice, not execution-only advice · the adviser failed to adequately explain the legislative changes to Centrelink's assessment of account-based income streams effective DD/MM/YYYY. AFCA concluded that, while execution-only advice may be provided, the adviser had to clearly offer personal advice to you and your spouse in the first instance and communicate the risks of declining personal advice in writing (incomplete advice). AFCA concluded that the adviser did not adequately inform you and your spouse of the risks and consequences of you proceeding to change pension providers without personal advice, and recommended that you should be compensated for the loss of your age pension benefits plus any taxation liability on the compensation amount. You are an Australian resident for tax purposes. You will enter into a deed of settlement and release (deed) with the adviser to resolve the claims set out in your complaint to AFCA in the financial year ended 30 June 2020.

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 104-10(1) | Income Tax Assessment Act 1997 Division 116

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 Income Tax Assessment Act 1997 (ITAA 1997)). 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. An amount paid to compensate for loss generally acquires the character of that for which it is substituted ( FC of T v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443; 10 ATD 82). Compensation payments which substitute income have been held by the courts to be income according to ordinary concepts ( FC of T v. Inkster 89 ATC 5142; (1989) 20 ATR 1516 and Tinkler v. FC of T 79 ATC 4641; (1979) 10 ATR 411). Any amount which is in the nature of interest, and which can be identified as interest, and whether paid as part of the compensation or separately, constitutes assessable income of the taxpayer under the general income provisions (paragraph 246 of Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts (TR 95/35)). | 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 is section 102-5 (capital gains). You make a capital gain or capital loss as a result of a CGT event happening (section 102-20 of the ITAA 1997). For most CGT events, your capital gain or loss is the difference between your capital proceeds and the cost base or reduced cost base of your CGT asset. CGT event C2 happens if your ownership of an intangible CGT asset ends in certain ways, including being redeemed, released, discharged or surrendered (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)). 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). We consider that the right to seek compensation is an asset for the purposes of the CGT provisions (paragraph 11 of TR 95/35). The asset, being the right to seek compensation, is acquired at the time a breach, damage or monetary loss occurs. The capital proceeds from a CGT event include the money you have received, or are entitled to receive, in respect of the event happening (subsection 116-20(1) of the ITAA 1997). The five elements of a CGT asset's cost base are acquisition costs, incidental costs, non-capital costs of ownership which are not deductible, capital expenditure to increase the value of the asset, and capital expenditure to establish, preserve or defend title to the asset or a right over the asset (section 110-25 of the ITAA 1997). Taxation Ruling TR 95/35 discusses the CGT implications for compensation receipts and provides (at paragraph 70) that in determining the most relevant asset in respect of which compensation has been received, it is often appropriate to adopt a 'look-through' approach to the transaction which generates the compensation receipt. The 'look-through' approach is defined in paragraph 3 of TR 95/35 as follows: The 'look-through' approach is the process of identifying the most relevant asset. It requires an analysis of all of the possible assets of the taxpayer in order to determine the asset to which the compensation amount is most directly related. It is also referred to in this Ruling as the underlying asset approach. 'Underlying asset' is also defined in paragraph 3 of TR 95/35 as follows: The underlying asset is 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 the amount of compensation is not received in respect of any underlying asset, the amount relates to the disposal by the taxpayer of the right to seek compensation (paragraph 11 of TR 95/35). Taxation adjustments A taxation adjustment is any additional amount of compensation (for example, a 'top-up') calculated to cover any income tax liability (including CGT) that may arise in respect of a compensation receipt. This amount may be determined and received at the time of the compensation receipt or at any other time (paragraph 3 of TR 95/35). Taxation adjustments are considered to be additional amounts received as a result of or in respect of the disposal of an asset (paragraph 27 of TR 95/35). | Detailed Reasoning - Application to your circumstances: Ordinary income - interest You will receive an amount for missed earnings on an investment that was not reinvested. Interest, or amounts received that are in the nature of interest, are ordinary income. As such, this amount will be included in your assessable income in the financial year ended 30 June 2020. Capital gains The compensation you will receive for the reduction in your age pension benefits due to the incomplete advice does not relate to any underlying asset. The relevant CGT asset in your case is your right to seek compensation. You acquired the right to seek compensation on DD/MM/YYYY when, as a result of the incomplete advice, your age pension benefits were reduced. Your right to seek compensation is an intangible CGT asset and your ownership of that asset will end when you enter into the deed. CGT event C2 will happen at that time. The amount you receive as compensation for the reduction in your age pension benefits, including any amount you receive to cover any income tax liability arising in respect of the compensation, will be capital proceeds received for the disposal of your right to seek compensation. It is unclear whether any amounts have been expended which would form part of the cost base of your right to seek compensation. Your capital gain is the difference between those capital proceeds and your cost base to the extent to which there are such amounts.