A payment of compensation includes any amount (either money or other property) paid to a taxpayer in respect of a right to seek compensation or any proceeding instituted by the taxpayer in respect of that right . The right to seek compensation may arise in relation to any underlying asset.
Typical compensation payments may be made for:
- An administrative error on behalf of a fund manager resulting in a loss to an investor
- The settlement of Class Action proceedings, either in court or out of court
- A missed opportunity of gain as a result of a delay in processing a buy or sell order
- An incorrect calculation of an interest rate that requires rectification.
A right to seek compensation is a capital gains tax (CGT) asset for tax purposes. The right to seek compensation is acquired at the time of the compensable wrong, 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.
Generally, a compensation payment is treated in the same way for tax purposes as the asset or type of income that the compensation seeks to replace.
For example, a compensation payment for interest that had previously been underpaid will be treated as assessable income. Where damage has been suffered to a capital asset owned by a taxpayer, the compensation will generally be capital in nature.
Therefore, for tax purposes, compensation can be divided into four broad categories:
- Payment for compensation in respect of the disposal of an underlying asset
- Payment for permanent damage to, or permanent reduction in, the value of an underlying asset
- Payment in respect of excessive consideration
- Payment for disposal of a right to seek compensation
- Payment for the replacement of an income stream.
Where an amount of compensation is received by a taxpayer in respect of the disposal of an asset, this represents additional consideration for the disposal of the asset.
A capital gain or capital loss may arise in respect of post CGT asset.
Example – Emma disposes of her shares in a listed security. She receives an amount of money in her nominated account a couple of days after the sale has been completed. Upon further investigations, it is discovered that there has been an error with the amount of money transferred to Emma and she receives an additional transfer of $3,500 in her nominated account. How should this amount be treated for taxation purposes?
The additional $3,500 represents additional capital proceeds received in respect of the sale of her listed securities on the date the amount is received.
Where an investor receives an amount of compensation in respect of permanent damage or reduction in the value of an asset, and there is no disposal of that asset at the time the compensation is paid, the amount will represent a recoupment of all or some of the total acquisition cost of the asset.
The cost base of the asset should be reduced by the amount of the compensation paid. No capital gain or capital loss will arise in respect of the asset, until the asset is disposed of.
An example of this type of compensation might be where a taxpayer has suffered damage to a capital asset such as a building due to the negligence of another person.
Where an investor receives compensation for paying too much to acquire an asset, the amount of the compensation (being the excessive amount paid) represents a recoupment of all or some of the acquisition cost of the asset.
Example – Tim bought 2,000 units in an unlisted managed fund for $2,300 on 1 January 2013. The unlisted managed fund later disclosed to investors that there was a unit pricing error. Tim received a cheque for $200. How should Tim reflect this amount for taxation purposes?
When Tim bought the units on 1 January 2013, his acquisition cost was $2,300 or $1.15 per unit. Tim needs to reduce his cost base by the $200 received so that his acquisition cost will be reduced to $2,100 or $1.05 per unit. The cost base reduction will occur on the date that the compensation is received. Tim does not have to realise any capital gain as a result of the compensation.
Where an amount is received and it does not relate to the disposal of any particular asset, the amount is deemed to be treated as compensation received as a result of a disposal of the right to seek compensation. As the right being disposed of is a capital asset, a capital gain will arise to the extent the capital proceeds (e.g. the settlement amount) exceeds the cost base of the asset (e.g. legal expenses incurred in pursuing compensation). A capital loss will arise to the extent the reduced cost base of the asset exceeds the capital proceeds.
Example – Ann acquired shares in Company X in August 2007. A class action was subsequently brought against Company X, in August 2012 on behalf of investors who purchased or acquired an interest in Company X during the relevant period, which was 7 August 2007 to 15 February 2008. It was alleged Company X breached its obligations of continuous disclosure under the ASX Listing Rules and the Corporations Act and engaged in misleading and deceptive conduct regarding the financial position of the company. Anne incurred $2,000 in legal fees to participate in the class action.
On 19 June 2013, a settlement was agreed to by all parties. Ann’s share of the settlement was $50,000. On this date, Ann disposed of a CGT asset (being the right to seek compensation). The asset was acquired at the time of the compensable wrong, being when Ann acquired the shares in August 2007. The cost base of the asset will be $2,000 and the proceeds received will be $50,000. Ann’s capital gain therefore is $48,000, which will be able to be discounted as she held the asset for longer than 12 months.
A compensation payment will typically follow the characteristics of the thing that the payment seeks to replace. Compensation for damage to a capital asset will generally be a capital payment and compensation for the replacement of an amount that would have otherwise been assessable income will also be assessable income.
For example, compensation for loss of profits that would have ordinarily been assessable will generally be assessable income. An amount paid to compensate an investor for additional interest where the original interest rate was misquoted will also be assessable income.
Sometimes a compensation amount will include payments for more than one component. For example, where parties reach a settlement about the damage to a capital asset, the payer may also receive an amount in respect of interest due to a drawn out settlement.
Where the components are detailed as part of a settlement, or are able to be reliably determined, different tax treatments may apply to the different components.
In the example above, the payment for damage to a capital asset will be a capital payment and the payment for interest will be assessable income to the taxpayer.
We will endeavour to report compensation payments received by investors in the most accurate way possible for tax purposes, based on information available.
Where a component of the compensation received is in the nature of interest, the amount will be reported in our reports as assessable interest income on the date the interest was paid.
Where the compensation received is in the nature of income (and replaces lost income), the amount will be reported in our reports as unfranked dividend income and will be reported as assessable on the date the unfranked dividend was paid.
Where the compensation relates to a CGT event, the amount of the compensation may be reported in one of the following ways:
- a cost base adjustment in the form of a return of capital
- in the case of an asset realisation, an adjustment to the capital proceeds
- a distributed realised capital gain (reported as either discounted, indexed or other depending on the circumstances of the individual investor).
Where the nature of compensation cannot be determined or has not been disclosed to us, the payment will be treated as a disposal of a right to seek compensation on the date the compensation amount is received.