Private ruling: Settlement payment
Date of advice: 2 September 2016
Published: February 2017
Ruling period: Year ended 30 June 2015
Date scheme commenced: 1 July 2014

Ruling: Q1: Is the compensation received from the out-of-court settlement assessable as ordinary income? | A1: No. | Q2: Is the relevant asset for capital gains tax purposes your right to seek compensation? | A2: No. | Q3: Is the compensation payment treated as a capital payment in its entirety? | A3: No. | Q4: Does the compensation payment constitute capital proceeds for your investments? | A4: Yes. | Q5: Does the cost base include the losses suffered for the loan repayment? | A5: No. | Q6: Does the unrecouped legal fees incurred in relation to the compensation form part of the cost base for your investments? | A6: Yes. | Q7: Can the 50% discount apply to reduce the capital gain from the disposal of the right to seek compensation? | A7: Not applicable.

Relevant facts and circumstances: You sought advice from a financial advisory firm. You were advised, and proceeded to invest in a number of investments. A number of the projects you invested in went into liquidation and you lost your investments. You suffered a loss. You initiated legal action against the financial advisors on their negligent conduct in providing misleading and deceptive advice and filed a claim to the Relevant Court. An out-of-court settlement agreement was reached for an amount in full and final settlement of the Proceeding.

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 104-25(3) | Income Tax Assessment Act 1997 section 108-5 | Income Tax Assessment Act 1997 section 110-25 | Income Tax Assessment Act 1997 Division 115

Reasons for decision: Summary: Ordinary income Subsection 6-5(2) of the Income Tax Assessment Act 1997 provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources 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 your case, you have received a lump sum compensation payment. This payment does not meet the characteristics of ordinary income. Therefore your payment will not be assessable as ordinary income under section 6-5 of the ITAA 1997. Capital gains Capital gains tax (CGT) is the tax you pay on certain gains you make. Section 102-20 of the ITAA 1997 states that a capital gain or capital loss is made only if a CGT event happens. For most CGT events, your capital gain is the difference between your capital proceeds and the cost base of your CGT asset. 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. Paragraph 70 of 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. The 'look-through' approach is defined in paragraph 3 of TR 95/35 to be 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 as the underlying asset approach. 'Underlying asset' is also defined in paragraph 3 of TR 95/35 as: 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 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. In your case, you suffered losses on your investments. The losses referred to in your statement of claims and used to calculate your loss is based on the losses on your investments. That is, the losses arose from the liquidation of your investments and shares sold at a loss. It is acknowledged that a margin loan was used for some of your investments, however, it remains that the funds from the loan were used to purchase the investments. Furthermore, although there may have been a breach of duty of care, under the settlement deed, the parties agreed to settle without any admission of liability. Considering the full circumstances of your case it is considered that the compensation amount is being paid to you because the financial performance of your investments were worse than it would have been had you received appropriate advice. Applying the 'look through' approach, the most relevant asset to which your compensation most directly relates are your investments. Paragraph 4 of TR 95/35 states that: If an amount of compensation is received by a taxpayer wholly in respect of the disposal of an underlying asset, or part of an underlying asset, of the taxpayer the compensation represents consideration received on the disposal of that asset. In these circumstances, we consider that the amount is not consideration received for the disposal of any other asset, such as the right to seek compensation. Treatment of compensation if a CGT event previously occurred In your case, your investments have made capital losses and you received the compensation after the relevant CGT event. As your compensation for losses arose from your former investments, your compensation payment is treated as additional 'capital proceeds' for the previous redemption or ending of your investments. This means that the capital loss made for the previous CGT events need to be recalculated. The calculation will be for the CGT event that occurred in that tax year and not the year of income the proceeds were obtained in. As you had more than one CGT event in relation to your investments, it will be necessary to apportion the additional capital proceeds on a pro-rata basis to each investment. This is confirmed by section 116-40 of the ITAA 1997 which states where a payment relates to more than one CGT event, the capital proceeds from each event are so much of the payment as is reasonably attributable to that event. As you have advised that a net capital loss resulted from your investments, you will need to adjust the amount of any capital losses you have available to carry forward for future years. You don't need to inform the Tax Office about an adjustment to net capital losses carried forward unless it results in changes to a net capital gain in a return you have lodged. This is because the calculation of a net capital loss does not form part of the making of an assessment. Therefore any potential change to a capital loss in a particular income year does not involve the amendment of an assessment. This means that a taxpayer who has a net capital loss in an income year and wishes to recalculate the quantum of the loss to correct an error, or change in circumstances, can do so without requiring an amendment of an assessment. You should keep a record of the reduction in the capital loss (as a result of the compensation received) to ensure that the correct amount of capital losses are carried forward to any future years. Cost base The cost base of a CGT asset is determined in accordance with the provisions of section 110-25 of the ITAA 1997. The cost base of a CGT asset consists of the cost of acquiring the asset, and other costs associated with acquiring, holding and disposing of the asset. The second element of a CGT assets cost base includes incidental costs of acquiring the CGT asset or that relate to the CGT event. Your share of the legal costs will be included in the second element of the cost base of the original investment as they were incurred in relation to the expenses arising from your court claim. Subsection 110-45(3) of the ITAA 1997 states that expenditure does not form part of any element of the cost base to the extent of any amount you have received as recoupment of it, except so far as the amount is included in your assessable income. Therefore the portion of your legal fees that were recouped are not included as part of the cost base. Subsection 110-45(1B) of the ITAA 1997 excludes such expenditure from the cost base to the extent that it has been claimed or can be claimed as a tax deduction. Therefore the interest expenses on your loan are not included as part of the cost base as they can be claimed as a tax deduction. Additionally, the funds representing the loan principal were used to purchase the investments and therefore form part of the first element of the cost base of the investments. The subsequent repayment of the loan therefore does not increase or form part of the cost base of the investments or any other CGT asset.