Private ruling: Capital gains tax - compensation - exemption
Date of advice: 8 November 2018
Published: January 2019
Ruling period: Year ended 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: Whether the payment received by Company A (the Receipt) from its insurance broker is a capital gain in the hands of Company A and not income in the ordinary sense? | A1: Yes. The Receipt is a capital payment and is not assessable as ordinary income under section 6-5 of the ITAA 1997 | Q2: Does the Receipt constitute ‘compensation or damages’ for the purposes of the CGT provisions in Part 3-1 of the ITAA 1997? | A2: Yes. The Receipt is considered to be a payment of compensation or damages arising from the Settlement Deed. | Q3: Does the Receipt constitute ‘compensation or damages’ for the purposes of the CGT provisions in Part 3-1 of the ITAA 1997? | A3: No. As the payment of the Receipt is not for physical or mental injury, subsection 118-37(1) of the ITAA 1997 will not apply to the Receipt.

Relevant facts and circumstances: Company B is a fully-owned subsidiary of Company A. Company B is the trustee for the Company B Trust (CBT), established by deed of trust. Since the date of establishment, 100% of the units in CBT have been owned by the Company A. Company A paid for the units in CBT. CBT used the proceeds from the subscribed capital to purchase a property on which a building was located. Company A retained an insurance broker to act as insurance consultants and insurance advisors in relation to the placement of insurance for itself and its subsidiaries, including CBT. Soon after, the insurance broker placed insurance cover with an insurance company for Company A “and its wholly or majority owned subsidiaries and any interest which may now exist…which are owned or operated by any one or more of those named insured” against loss or damage to a number of properties, including the property owned by CBT. Shortly after, the building located at the property sustained severe structural damage and destruction of contents as a result of a fire. Subsequently, Company A sought indemnity from the insurance company for the full loss sustained as a result of the fire. The insurance company informed Company A that the insurance company was entitled to value the property damage loss at nil under the insurance policy because the building located at the property was vacant and unoccupied at the time of the fire, but offered to settle the claim for a sum less than the amount claimed. Company A subsequently commenced legal proceedings against the insurance broker to recover the difference between the sum received from the insurance company and the full entitlement that Company A would have recovered but for the alleged breaches by the insurance broker. The action filed with the Supreme Court of relevant state identified the following grounds: ● Whether the defendant breached its retainer with the plaintiff and its duty of care to the plaintiff in relation to the insurance cover. ● Whether the defendant failed to warn the plaintiff about the existence and terms of a vacant or unoccupied land clause in the insurance policy. ● Whether the defendant failed to place effective insurance cover for the plaintiff. ● Whether the defendant failed to advise the plaintiff about steps the plaintiff should take in order to ensure that the defendant was able to obtain effective insurance cover for the plaintiff and the plaintiff was able to comply with the terms of cover or proposed cover. ● Whether the defendant has engaged in misleading or deceptive conduct in contravention of section 52 of the Trade Practices Act 1974 (Cth). Company A and the insurance broker executed a Deed of Release under which Company A would receive a payment (the Receipt) in full and final satisfaction of all its claims. Consent orders to this effect were filed with the Supreme Court. The receipt was accounted for as a capital receipt of Company A. Company A lodged its income tax return for the relevant income year including the amount of the receipt as a taxable capital gain rather than a disregarded capital gain pending resolution of this ruling request.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subsection 1-3(2) | Income Tax Assessment Act 1997 Section 4-5 | Income Tax Assessment Act 1997 Section 6-5 | Income Tax Assessment Act 1997 Section 118-37 | Income Tax Assessment Act 1997 Subsection 960-100 | Income Tax Assessment Act 1997 Subsection 995-1(1) | Income Tax Assessment Act 1936 Subsection 160ZB(1) (repealed)

Reasons for decision: Detailed Reasoning - Revenue or capital: An approach to distinguishing between revenue and capital receipts is to examine the character of the receipt from the point of view of the recipient. This approach has been utilised in a number of cases dealing with the revenue/capital distinction. In McLaurin v FC of T (1961) 104 CLR 381 the High Court held (at p 391): “…in point of law it would plainly be unsound to allow a determination of the character of a receipt in the hands of a recipient to be affected by a consideration of the uncommunicated reasoning which led the payer to agree to pay it.” In Scott v FC of T (1966) 117 CLR 514 Windeyer L held (at p526): “Whether or not a particular receipt is income depends upon its quality in the hands of the recipient.” Again, in The Federal Coke Company Pty Ltd v FC of T 77 ATC 4255, Bowen CJ held (at p 4264): “When one is considering the character of an amount received by a taxpayer, the enquiry must start with the question: what is the character of the receipt in the hands of the taxpayer?” More recently, the High Court held in GP International Pipecoaters Pty Ltd (1990) 21 ATR 1 (at p7): “Sometimes, the character of the receipts will be revealed most clearly by their periodicity, regularity or recurrence; sometimes by the character of a right or thing disposed of in exchange for the receipt; sometimes by the scope of the transaction, venture of business in or by reason of which money is received and by the recipient’s purpose in engaging in the transaction, venture or business. The factors relevant to the ascertainment of the character of a receipt of money are not necessarily the same as the factors relevant to the ascertainment of its payment.” Although the courts have referred to ‘periodicity, regularity and recurrence’ as ‘hallmarks’ of ordinary income, they are not necessarily decisive factors. Ordinary income can be received as a lump sum and capital amounts may be paid in instalments. Receipts from isolated transactions can be ordinary income if they are derived in the course of a business or under a profit making scheme or undertaking. As the High Court explained in FC of T v The Myer Emporium 87 ATC 4363: “Valuable though these considerations may be in categorising receipts as income or capital in conventional situations, their significance is diminished when the receipt in question is generated in the course of carrying on a business, especially if it should transpire that the receipt is generated as a profit component of a profit-making scheme.” Paragraph 108-5(1)(b) of the ITAA 1997 specifically includes a legal or equitable right within the definition of a CGT asset. A taxpayer’s right to seek compensation is therefore classified as an intangible CGT asset. 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 right to seek compensation is an intangible CGT asset and the ownership of that asset ends when you accept the lump sum to settle your claim. 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 lump sum payment represents capital proceeds for your CGT C2 event. Therefore the Receipt is not assessable as ordinary income under section 6-5 of the ITAA 1997. | Detailed Reasoning - Question 2: Although “compensation” is not defined in the ITAA 1997, Taxation Ruling TR 95/35 contains a definition of compensation receipt: A compensation receipt, or compensation, includes any amount (whether money or other property) received by a taxpayer in respect of a right to seek compensation or a cause of action, or any proceeding instituted by the taxpayer in respect of that right or cause of action, whether or not: ● in relation to any underlying asset; ● arising out of Court proceedings; or ● made up of dissected amounts. For income tax purposes, a compensation amount generally bears the character of that which it is designed to replace. Taxation Ruling TR 95/35, Income tax: capital gains: treatment of compensation receipts, in dealing with the taxation treatment of compensation receipts, suggests the assessability of a lump sum in the hands of the recipient depends on whether it is a receipt of capital or income nature. It is the character of the receipt in the hands of the recipient that must be determined: FCT v. Slaven (1984) 52 ALR 81; 15 ATR 242; 84 ATC 4077 ( Slaven’s Case ). Generally, the material factor in determining whether compensation is of an income or capital nature is not the measure of the compensation, but what it is truly paid for: Glenboig Union Fireclay Co Ltd v. IR Commrs (1921) 12 TC 427. 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. 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 Part 3-1 of the ITAA 1997. 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. In this instance the Receipt has been paid as a settlement in full for a breach of contract. The amount paid bears no relationship to the income earning activities of the company, nor is it intended to replace any past or future income that may have been forgone. The payment of the receipt is for the disposal of the right to seek compensation. | Detailed Reasoning - Question 3: Under paragraph 118-37(1)(a) of the ITAA 1997 a capital gain is disregarded if it is compensation or damages you receive for: (i) any wrong or injury you suffer in your occupation; or (ii) any wrong, injury or illness you or your relative suffers personally. Subsection 160ZB(1) of the Income Tax Assessment Act 1936 (ITAA 1936) which was re-written as paragraph 118-37(1)(a) of the ITAA 1997 sheds light on what is meant by a wrong you suffer personally. Subsection 160ZB(1) of the ITAA 1936 stated: A capital gain shall not be taken to have accrued to a taxpayer by reason of the taxpayer having obtained a sum by way of compensation or damages for any wrong or injury suffered by the taxpayer to his or her person or in his or her profession or vocation and no such wrong or injury, or proceeding instituted or other act done or transaction entered into by the taxpayer in respect of such a wrong or injury, shall be taken to have resulted in the taxpayer having incurred a capital loss. (emphasis added) Subsection 1-3(2) of the ITAA 1997 states that where the 1936 Act expressed an idea in a particular form of words and the 1997 Act appears to have expressed the same idea in a different form of words in order to use a clearer or simpler style, the ideas are not be taken to be different just because different forms of words were used. There is nothing in the Explanatory Memorandum to the Tax Law Improvement Act (No.1) 1998 or any other extrinsic material in relation to the remaking of subsection 160ZB(1) of the ITAA 1936 into paragraph 118-37(1)(a) of the ITAA 1997 that indicates that the meaning or effect of the new provision was to be any different to the old provision. Paragraphs 49 to 51 of Taxation Ruling TR 2006/10 Public Rulings (TR 2006/10) discusses the status of public rulings following a rewrite of the law, which is relevant in this case as TR95/35 was issued prior to the rewrite of subsection 160ZB(1) of the ITAA 1936. Paragraph 49 states that where a relevant provision is re-enacted, and the new law expresses the same ideas as the old law, it is considered that the issued public ruling is taken to be about the re-enacted provision. Paragraph 51 discusses how to determine if the new law expresses the same ideas as the old law, and states that entities can assume that there has been no change in those ideas, unless it is announced otherwise. We do not accept that there is a material change in the language of paragraph 118-37(1)(b) of the ITAA 1997 compared to its predecessor, subsection 160ZB(1) of the ITAA 1936, being that “you” has replaced “his or her”. Therefore, it is considered that a wrong suffered personally by a taxpayer means a wrong suffered ‘to his or her person’. It could be argued that the negligence by the insurance broker in providing incorrect information was a wrong that you suffered personally. However, the meaning of ‘wrong’ must be considered in the context of the words around it which are ‘injury’ and ‘illness’ in relation to paragraph 118-37(1)(a) of the ITAA 1997 and ‘injury suffered by the taxpayer to his or her person’ in relation to subsection 160ZB(1) of the ITAA 1936. In Dibb v. Commissioner of Taxation (2003) 53 ATR 290 Justice Heerey stated that personal injury encompasses injury or disease of a physical or psychological nature. However it would not extend to anguish, distress or embarrassment of the kind traditionally taken into account in assessing damages for defamation. Taking into account this context, it is considered a wrong suffered personally for the purposes of paragraph 118-37(1)(a) of the ITAA 1997 would not include negligence that causes financial loss, as unlike injury or illness, it is not a wrong suffered by a taxpayer to his or her person. This interpretation is supported by TR 95/35 which contains two examples that deal with compensation for negligence that resulted in financial loss (examples 8 and 28). In example 8, the taxpayer was assessed on the compensation as a capital gain on the disposal of their right to seek compensation and no CGT exemptions (including subsection 160ZB(1) of the ITAA 1936 (paragraph 118-37(1)(a) of the ITAA 1997) were considered to apply. In example 28, the end result was that there was no capital gain but this was because of reasons other than the exemption provided for by subsection 160ZB(1) of the ITAA 1936 (paragraph 118-37(1)(a) of the ITAA 1997). In the discussion of the CGT consequences in this example there is no mention of that exemption. If that exemption applied to compensation for negligence that resulted in financial loss, then it is considered that the exemption would have been made clear. We do not accept the proposition that a company, which is an incorporeal and inanimate entity, is capable of suffering a wrong which is a physical injury or illness. | Detailed Reasoning - Conclusion: We have fully considered your submission on whether or not section 118-37 would apply so as to allow CTUC to disregard the capital gain made on receipt of the payment from Willis. It is the Commissioner’s view that section 118-37 of the ITAA 1997 cannot apply to CTUC as that provision does not extend to a company. We can find no evidence to support a conclusion that there was an intended change in policy when paragraph 118-37(1)(b) of the ITAA 1997 replaced subsection 160ZB(1) of the ITAA 1936. This being the case, and noting that TR 95/35 has not been withdrawn, we are unable to reach a favourable view on this point. Therefore, it is not considered that the negligence by the insurance broker that caused your financial loss is a wrong that was suffered personally by a natural person for the purposes of exemption under paragraph 118-37(1)(a) of the ITAA 1997, and any capital gain made cannot be disregarded.

Reasons for decision: These reasons for decision accompany the Notice of private ruling for Company A. | While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.