Private ruling: Capital gains tax
Date of advice: 1 June 2017
Published: September 2017
Ruling period: Year ended 30 June 2016
Date scheme commenced: 1 July 2015

Ruling: Q1: Will the compensation amount received in accordance with the Deed of Settlement be included in your assessable income? | A1: No.

Relevant facts and circumstances: You were a director and owned a class of shares in a company which was incorporated prior to 1985. You were allotted your shares when the company was incorporated. Prior to 1985 the company purchased several properties to operate the business. Several meetings took place without your knowledge and decisions were made in respect of the company without your involvement including the issuing of a new class of shares, the sale of the properties and the buy back of another shareholder's shares for a large sum. In XXXX you commenced legal proceedings against the company and the other directors as their actions resulted in the devaluation of your shares. You sought relief given the alleged oppressive and prejudicial conduct of the defendants. In XXXX you attended mediation and entered into a heads of agreement with the defendants to resolve the matter before proceeding to trial. Under the agreement you were to be paid an amount of compensation and a liquidator was to be appointed to the company. You received the compensation. The liquidation of the company was completed and the company deregistered. The only assets ever acquired by the company were the pre-CGT properties.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 6-5 | Income Tax Assessment Act 1997 section 102-20 | 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, expected, relied upon and have an element of periodicity, recurrence or regularity. A compensation amount generally bears the character of that which it is designed to replace. If the compensation is paid for the loss of a capital asset or amount then it will be regarded as a capital receipt and not ordinary income. You received compensation for the reduction in value of your shares. Accordingly, as the compensation was paid in relation to your capital asset it is regarded as a capital receipt and not ordinary income. Therefore, the compensation payment is not assessable ordinary income under section 6-5 of the ITAA 1997. Capital gains tax (CGT) 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. Taxation Ruling TR 95/35 discusses the CGT implications for compensation receipts. TR 95/35 provides that in determining the most relevant asset in respect of which the compensation has been received, it is often appropriate to adopt a 'look-through' approach to the transaction which generates the compensation receipt. Paragraph 3 of TR 95/35 defines some key terms: | Detailed Reasoning - Look through approach: 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. | Detailed Reasoning - Underlying asset: 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. It is noted that permanent damage or reduction in value does not mean everlasting damage or reduced value, but refers to damage or a reduction in value which will have permanent effect unless some action is taken by the taxpayer to put it right. Paragraph 9 of TR 95/35 goes on to explain that compensation received by a taxpayer has no CGT consequences if the underlying asset which has suffered the permanent damage or a permanent reduction in value was acquired by the taxpayer before 20 September 1985. | Detailed Reasoning - Application to your circumstances: In this case, you acquired your shares in the company prior to the 20 September 1985. You commenced legal proceedings against the company and other shareholders. As part of the Deed of Settlement your shares were cancelled. The matters which generated the compensation receipt were the alleged oppressive and prejudicial conduct of the defendants. Using the look-through approach we consider the compensation amount, that is the settlement sum, was directly related to your shares. As these shares were acquired prior to 20 September 1985 the settlement sum will not be assessable to you as a capital gain.