Private ruling: Capital gains tax
Published: April 2014
Ruling period: 1 July 2013 to 30 June 2014.
Date scheme commenced: 1 July 2013.

Ruling: Question and answer: | Does subsection 118-37(1)(b) of the Income Tax Assessment Act 1997 apply to allow you to disregard a capital gain made from receipt of a compensation payment? | No.

Relevant facts and circumstances: In the years following 20 September 1985 you were given advice that resulted in financial losses. You took legal action against the entity providing the advice. You entered into an agreement to settle your legal action. As part of the agreement you agreed to accept an undissected lump sum payment as full and final settlement of your claims.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 102-5 | Income Tax Assessment Act 1997 Section 102-20 | Income Tax Assessment Act 1997 Section 104-25 | Income Tax Assessment Act 1997 Section 108-5 | Income Tax Assessment Act 1997 Section 118-37

Reasons for decision: Detailed Reasoning - Capital gains tax - general: You can only make a capital gain when a capital gains tax (CGT) event happens to a CGT asset that you own. The gain is made at the time of the CGT event. In most cases, you must have acquired the asset on or after 20 September 1985 for the CGT provisions to apply to it. An assessable gain you make from a CGT event is included in your assessable income by section 102-5 of the Income Tax Assessment Act 1997 (ITAA 1997), unless an exemption applies that allows you to disregard that gain. There are numerous CGT events that can happen to a CGT asset and these include what is known as CGT event C2 (section 104-25 of the ITAA 1997). CGT event C2 happens when your ownership of an intangible CGT asset (such as a right to seek compensation) ends. The time of a C2 event is generally the time the contract is entered into, that results in the asset ending. Any assessable gain from a CGT event is divided between joint owners of the asset according to their legal interest in the asset. | Detailed Reasoning - CGT and receipts of undissected lump sum compensation amounts: Guidance on the application of the CGT provisions to compensation receipts is provided by Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts . Taxation Ruling TR 95/35 specifies that: • when an undissected compensation amount is received, the whole amount is treated as being received for the disposal of a right to seek compensation, • a right to seek compensation is a 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 a CGT asset, • a right to seek compensation is acquired at the time of the compensable wrong to which it relates and is disposed of (thereby giving rise to CGT event C2) when the right is satisfied, surrendered, released or discharged (usually this is when an arrangement to settle the matter is entered into), • the normal cost base rules apply to determining the cost base of a right to seek compensation, and • generally, there will be no acquisition cost for a right to seek compensation; however, legal and similar costs that are incurred in reaching an agreement to end a right to seek compensation are included in the cost base of the asset. | Detailed Reasoning - Exemption under subsection 118-37(1)(b) of the ITAA 1997: Subsection 118-37(1)(b) of the ITAA 1997 provides that you can disregard (and therefore not include in your assessable income) any assessable gain that results from a compensation amount you receive for a wrong, illness or injury you suffer personally. The wording of the subsection suggests the exemption is only available if a compensation amount has been derived specifically from some sort of personal injury or illness claim. This position is supported by paragraph 20 of TR 95/35 which specifies (in relation to undissected lump sum compensation amounts) that the exemption under subsection 118-37(1)(b) of the ITAA 1997 is only available to taxpayers who receive an undissected lump sum compensation amount wholly because of a wrong or injury they have suffered personally. Paragraph 20 of TR 95/35 goes on to cite Example 17 in TR 95/35 as an example of when the exemption under subsection 118-37(1)(b) of the ITAA 1997 would apply. In the example referred to, the assessable gain made by a taxpayer from receipt of an undissected lump sum compensation amount is wholly exempt under the provisions of 118-37(1)(b) of the ITAA 1997 because the whole of the amount received can be shown to relate to the taxpayer's disposal (ending) of a right to seek compensation for personal injury arising from a motor vehicle accident. Considering the above, it is clear that for the exemption under subsection 118-37(1)(b) of the ITAA 1997 to apply to any gain made from an undissected lump sum compensation amount, that amount cannot have been received because of the ending of a taxpayer's right to seek compensation for a compensable wrong that has not resulted in personal injury to or illness of the taxpayer. | Detailed Reasoning - Conclusion and application to your facts: You agreed to accept an undissected lump sum amount as compensation for financial losses resulting from poor financial advice. Because the compensation amount was undissected, the whole of the amount is treated (for CGT purposes) as having being received for the disposal of your right to seek compensation. A right to seek compensation is a CGT asset. Because you received the advice that resulted in the financial losses after 20 September 1985, it follows that you acquired your right to seek compensation after 20 September 1985, thereby making the CGT provisions applicable to any assessable gain made from your disposal of that right. In this case, the right to seek compensation you acquired was not a right to seek compensation for personal injury or illness. Rather, it was as a right to seek compensation for financial losses resulting from poor advice. CGT event C2 happened to your right to seek compensation on the day you signed the agreement to settle your claim. This was the day your right to seek compensation ended. Because the CGT asset you disposed of was not a right to seek compensation for personal injury or illness, the exemption under subsection 118-37(1)(b) of the ITAA 1997 cannot be applied to any assessable gain you made from receipt of the compensation amounts. Any assessable gain made from the receipt of the compensation amounts will therefore be included in your assessable income under the provisions of section 102-5 of the ITAA 1997. Your assessable gain from the ending of your right to seek compensation will be your share (according to your legal interest in the right to seek compensation) of the assessable gain made from the disposal of the asset.