Taxation Law: Compensation Receipts and Capital Gains Tax Consequences

This article discusses the tax treatment of compensation receipts and the capital gains tax consequences in relation to taxation law. It covers various scenarios and provides insights into the applicable laws and exemptions.

Running head: TAXATION LAW
Taxation Law
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Table of Contents
Answer to question 1:.................................................................................................................2
Introduction:...........................................................................................................................2
Various Compensation Receipts:...........................................................................................2
Sophie Client:.........................................................................................................................2
2.1: Lump sum damages for potential loss of reputation.......................................................2
2.2: Compensation for the loss of income whilst the machine was being replaced:..............3
2.3: Reimbursement of Legal Fees:.......................................................................................4
3: Kate Client:............................................................................................................................5
3.1 A Lump sum payment for pain and suffering:.................................................................5
3.2 Payment of ongoing medical and cosmetic surgery costs................................................6
3.3 Interest on the lump sum payment...................................................................................7
Conclusion:............................................................................................................................8
Answer to question 2:.................................................................................................................8
Introduction:...........................................................................................................................8
Issues:.....................................................................................................................................8
Laws:......................................................................................................................................8
Application:..........................................................................................................................11
Conclusion:..........................................................................................................................13
References:...............................................................................................................................15

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Answer to question 1:
Introduction:
Issues:
1.1. The main issue to the question is whether the lump sum amount as damages,
compensation relating to the loss of income and reimbursement relating to legal fees
received by Sophie and Kate for damages will be treated as the taxable earnings under the
legislative provision of “sec 6-5, ITAA 1997”.
1.2. Is the capital gains arising from the damages payment is not regarded as taxable
under the “sec 118-37, ITAA 1997”?
Various Compensation Receipts:
Sophie Client:
2.1: Lump sum damages for potential loss of reputation
Laws:
As denoted under the “Taxation Ruling of TR 95/35” it is largely related with
providing guidelines regarding the tax liability of income earned from the compensation
receipts (Woellner et al., 2016). This rule is usually applied on those individual taxpayers that
gets any money as compensation. The ruling is useful in outlining the CGT outcomes that is
associated to the receipt of compensation payments and ascertain whether the amount
received should be taken into consideration as the taxable receipts for the recipient under
“Part IIIA of the ITAA 1936”.
Where a taxpayer receives any compensation which is completely associated to the
disposal of underlying asset or any part of the underlying asset of the individual taxpayer then
the compensation that is received amounts to a consideration received for the sale of asset

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(Coleman, 2015). The law court in the case of “FC of T v Spedley Securities Ltd (1988)”
stated that where any amount received as compensation for damage of business goodwill then
the amount will be considered as capital receipt.
Application:
As understood from the case facts of Sophie, she sued Fracpro for providing her
faulty calibration of laser machine. She received compensation from the Fracpro regarding
the loss of her income and reputation. The amount of $100,000 that is received by Sophie
should be viewed as the damage for the potential loss of business reputation. Apart from this
she also received a reimbursement of the legal fees that amounted to $7,000. Citing the
judgement made in “FCT v Spedley Securities Ltd (1988)” the sum of $100,000 that is
received by Sophie will be considered as the compensation for damage to business goodwill
and reputation (Braithwaite, 2017). The amount will be considered as capital receipt and non-
taxable as ordinary income under “sec 6-5, ITAA 1997”.
2.2: Compensation for the loss of income whilst the machine was being replaced:
Laws:
A compensation receipts generally carries the character which is aimed at substituting
for something. When a taxpayer receives any compensation amount for the loss of capital
asset then in such circumstances the receipt of such compensation amount relating to loss of
capital asset will be considered as capital receipt and will not be treated as ordinary income.
Similarly, under the “paragraph 118-37 (1)(a) of the ITAA 1997” capital gains are to be
disregarded when it is obtained as a result of “CGT event C2” (Kewley, 2014). Under this
provision, any amount that is received by the taxpayer in regard to any injuries that is
suffered while conducting any occupation should be simply disregarded.

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It mainly comprises of the right of seeking compensation for the asset relating to CGT
purpose by taking into account for consideration the definition of asset. One of the
noteworthy case that is related to this issue is the “Happles v FCT (1991)” that considered
whether the right to work will be treated as the asset inside the sense of “part IIIA of the
paragraph 118-37(1)(a), ITAA 1997” (Barkoczy, 2016).
Application:
Sophie in the current instances received a sum of $20,000 as the compensation for the
loss of income. The sum of lump sum payment which is received as the compensation for the
loss of income will be treated as the capital receipt and it will not be held as the ordinary
earnings. Referring to the court’s judgement made in “Happles v FCT (1991)” the
compensation received by Sophie is associated to the loss of capital asset (Keyzer et al.,
2017). The lump sum amount that is received by Sophie has resulted in the capital gain and
under the “paragraph 118-37(1) (a), ITAA 1997” Sophie is required to simply disregard the
capital gains that is obtained from the “CGT event C2”. This is because the amount received
by Sophie is mainly to recompense the damage caused as injury to her business.
2.3: Reimbursement of Legal Fees:
Laws:
As explained under the “section 118-37 (2)” capital gains or loss should be simply
ignored when a person makes a receipt of payment or the property in the form of
reimbursement for the expenses occurred (Sadiq, 2019). When a taxpayer receives any
amount as the reimbursement of the legal expenditure it do not lead to any capital gains
because it is viewed as the capital asset.

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Application:
In the current situation it is noticed that Sophie received a reimbursement of the legal
expenses that was occurred in bringing a lawsuit against Fracpro. The legal expenditure that
is incurred by Sophie for her claims should be viewed as the part of cost base for her
business. Subsequently, there cannot be any CGT consequences for the reimbursement of
legal expenses received by her.
3: Kate Client:
3.1 A Lump sum payment for pain and suffering:
Laws:
As stated under the “paragraph 118-37 (1)(a), ITAA 1997” an individual taxpayer
should disregard the capital gains which is derived as the result of CGT event where the
amount is related with the compensation receipt, received for any form of wrong doings or
injury sustained (Morgan et al., 2018). Capital gains made under the right of seeking
compensation should simply be disregarded under “paragraph 118-37 (1)(a), ITAA 1997”
because the receipts are treated as having capital in nature.
Application:
As understood in the present state of Kate, she received a lump sum money for the
pain and sufferings together with the medical cost. The amount received by Kate should not
be viewed as income from providing any individual personal services, proceeds from
property or revenue earned from any business activities. The compensation received by Kate

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was not earned as the receipt of any performance of any services. Rather, the compensation
receipt amounted to a one-off payment which was received by Kate and do not comprise of
any element of repetition.
Despite the fact that the payment was expected and relied by Kate, the expected sum arose as
the outcome of pain and suffering from the alleged injuries and general damages instead of
any kind of relation to personal services rendered.
The compensation received by Kate for pain and suffering amounts to settlement for
damages. The sum of $120,000 will be treated as capital originating from the “CGT event
C2” based on the right of seeking compensation (Morgan & Castelyn, 2018). The capital
gains made as the outcome of CGT event by Kate is disregarded under “sec 118-37(1)(b),
ITAA 1997”.
3.2 Payment of ongoing medical and cosmetic surgery costs
Laws:
Where a taxpayer receives any lump sum then it may be held as capital gains. The net
amount of capital gains is included in the assessable income of the taxpayer under “section
102-5, ITAA 1997” except when any exemption is allowed to the taxpayer. Under the
“Division 118, ITAA 1997” an exemption is allowed to the taxpayer when they receive
compensation for any form of wrong or injuries suffered in regard to their occupation or
personal by the taxpayer (Murray et al., 2018). For example, compensation received by the
taxpayer for any kind of discrimination or harassment at the workplace then it is simply
disregarded under “section 118-37 (1) (a), ITAA 1997.” Furthermore, a taxpayer is also
allowed to obtain exemption under “sec 118-37 (1) (b), ITAA 1997” when they receive
compensation for any form of wrong, illness or the injuries suffered by the taxpayer
personally or their relatives.

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Application:
In the current situation the payment of $50,000 for medical cost and surgery should be
viewed as the single payment which does not contain any element of repetition. The
compensation payment should not be referred as income derived from providing any
individual services. Instead, the sum of $50,000 will be treated as the capital amount under
the “paragraph 118-37(1)(a), ITAA 1997” because the money received is related to her
personal injury (Trad & Freudenberg, 2018). The amount will be considered as the capital
receipt under “CGT event C2” as the right of seeking compensation.
3.3 Interest on the lump sum payment
Laws:
As explained in the “Taxation Ruling of TR 95/35” interest that is received by the
taxpayer on the lump sum payment in the form of award for compensation is treated as the
taxable income under the ordinary meaning of “sec 6-5, ITAA 1997”.
Application:
As evident Kate here received an interest on the lump sum amount awarded to her as
compensation. The amount will be considered as assessable income under the ordinary
concept of “sec 6-5, ITAA 1997”.
Receipts Tax Treatment Amount ($)
Lump sum payment for pain and suffering Non-Taxable (S118-38 (a)) 120000
Payment for medical and cosmetic surgery Exempted (S 118-37 (1) (b) 50000
Interest on lump sum payment Taxable (S 6-5, ITAA 1997) 7000

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Conclusion:
The lump sum amount received by Kate and Sophie as compensation is mainly for the
personal injury and damages suffered in her business. The amount will be considered as
capital receipt and it will be exempt “sec 118-38 (a)” and “sec 118-37 (1) (b), ITAA 1997”.
Answer to question 2:
Introduction:
Issues:
The central issue to the problem is associated with the determination of the capital gains
tax consequences to Joe and Amy, the taxpayers, regarding the sale of the property provided
that the;
1.1. The property was the pre-CGT asset of deceased
1.2. Before the death, the property was regarded as the main residence of the deceased
1.3. The taxpayer here acquired the property as the beneficiary under the deceased estate
1.4. The taxpayer lived in that property commencing from the day of death till the day
when the property was sold.
Laws:
As it has been explained in the “sec 118-110, ITAA 1997” the main residence of the
taxpayer is usually considered tax exempt from the provision of capital gains tax. Main
residence is better known as the dwelling along with the plus 2 hectares of land which
surrounds the dwelling (Main, 2019). Partial main residence exemption is available to the
taxpayer that subdivides or sells the land of their main residence or if the property has been
used by the taxpayer for generating taxable earnings. Where any capital gains or capital loss

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arises from the dwelling that is the main place of residence for the taxpayer, then it is
exempted from tax given that;
a. The taxpayer is an individual
b. The house was the main residence of the taxpayer for the whole period of ownership
c. The ownership of the main residence was not given or passed to the taxpayer as the
beneficiary of deceased estate.
As stated in the “Division 128, ITAA 1997” it is largely related with CGT
consequences when the taxpayer dies (Payne, 2018). Denoting the explanation in “sec 128-
10” when the taxpayer dies, then their death should be regarded as the sale of asset by
deceased. Subsequently, no CGT event takes in this regard. Importantly “sec 128-10, ITAA
1997” is concerned with the CGT and consequences of death (Pert et al., 2018). The general
rule of the “sec 128-10” explains that when the taxpayer passes away, a CGT event that is
associated to the CGT asset is simply disregarded under this provision. When the taxpayer
passes away, the beneficiary or their legal heirs is deemed to have obtain the ownership of the
CGT asset starting from the day when the taxpayer died.
Additionally, when it is noticed that the a pre-CGT asset of the deceased is inherited
by a beneficiary, then in such situation the new beneficiary is assumed to have acquired the
asset based on the current market value on the day of death. While “sec 128-15, ITAA 1997”
provides explanation regarding the inheritance of the post-CGT assets (Liu, 2018). As per the
“sec 128-15, ITAA 1997” when it is noticed that the asset forms the part of post-CGT asset
of the deceased, the beneficiary is assumed to have acquired the asset on the day of death of
deceased based on the present case base.
While “sec 118-195” provides explanation regarding the inherited main residence
(Lieuallen & Shurtz, 2018). Under this provision, when it is noticed that the asses forms the

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main residence of the deceased and it not used for generating assessable income such as
renting out or performing any business activities, the cost base to the beneficiary represents
the market value on the day of demise (Trad & Freudenberg, 2018). Furthermore, where the
asset is regarded as the main residence of the decease and not used for producing assessable
income, the beneficiary in this can inherit the exemption on main residence when some
specific conditions listed under “sec 118-195, ITAA 1997” are met.
As explained in the “sec 118-195, ITAA 1997”, a taxpayer is permitted to ignore any
kind of capital gains or loss that they make from the sale of dwelling that is passed to them as
the trustee or the beneficiary of the deceased estate on meeting some specific criteria (Minas
et al., 2018). In the meantime, “sec 118-195, ITAA 1997” provides the permission to the
taxpayer, as a legal heir, to ignore any form of capital gains or loss in respect of the previous
residence of the deceased person if any one of the below listed criteria is satisfied;
(1). The taxpayer has sold their interest of ownership in the asset inside the time span
of two years following the demise of the deceased or inside the longer time span as
permitted by the taxation commissioner (Siebert, 2019); or
(2). The taxpayer has not sold their ownership interest inside the timespan of two
years, the house was, from the day of the demise until the ownership of the taxpayer
ended; the main house was;
(a). The spouse of the deceased was alive during the time of the demise
(b). an individual that had the right of occupying the dwelling under the will of
the deceased or as the beneficiary of the estate.
The sale of the CGT assets results in the CGT event A1 under “sec 104-10, ITAA
1997”. An asset is usually described as the pre-CGT asset if the asset has been acquired by
the taxpayer before 20th September 1985 (Krever & Sadiq, 2019). Any asset that are acquired

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following that date is termed as the post-CGT asset. Where the proceeds of the sale of asset
goes past the cost base then the capital gains is triggered. The cost base of the CGT asset is
usually ascertained under the “Division 110” (Miller, 2018). While “sec 128-15 of the ITAA
1997” explains that where the asset is passed to the taxpayer in the form of deceased personal
legal representative and the property was used by the deceased as his main residence
immediately prior to the death and was not employed for generating any business income, the
cost of the asset would reflect the market of the CGT asset.
On the other hand, if the asset is the post-CGT asset in the hands of deceased taxpayer
the similar conditions relating to the pre-CGT asset must be met and along with this the
dwelling must also be the main residence of the deceased just prior to the demise (Steyn et
al., 2018). The property should also not been used for generating assessable income during
that time. Where under “sec 118-95” a full main residence exemption is not applicable then a
partial main residence exemption might be available under the “sec 118-200, ITAA 1997”.
The taxpayer can apportion the capital gain or loss by computing the number of days spent as
the non-main residence in comparison to the ownership days which is pertinent for the main
dwelling exemption (Bentley, 2019). While “division 115, ITAA 1997” explains that where a
capital gains is not applicable and the asset has been under the ownership of taxpayer for
twelve months or more then CGT discount is available under this provision.
Application:
The current case of Bob explains that he was an Australian inhabitant before passing
away on 23rd May 2015. He was survived by his two children named Joe and Amy. A family
home was owned by the deceased that he had bought in 1982 January for a cost of $110,000
with his late wife. On the day when Bob passed away the market value of the property stood
$560,000.

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The case facts suggest that the property was never used for producing any business
income and Bob used it completely for residence purpose from the first day of his ownership
interest to the last day of his demise. Joe being the son of Bob was living in the house from
2006 onwards as the caretaker of Bob. On one occasion the solicitor stated that the Bob has
equally divided the share of property in his will among his two children. The evidences from
the case obtained suggest that Amy decides to sell her portion of shares in the dwelling and
Joe did not had sufficient amount of money to buy Amy’s share. As a result, left with no
other options Joe also decided to sell his part of shares in the property and received an offer
of $680,000 for the property.
As evident from the case, it should be noted that the house was bought by Bob in
January 1982. Therefore, the house will be classified as the pre-CGT asset because the asset
was purchase prior to the introduction of the CGT regime on 19th September 1985. The
dwelling right from the day of Bob’s ownership till the final day of this demise was the main
residence and he did used the house for generating assessable income. Additionally, after his
passing away the property was exclusively used by Joe and Amy for residential purpose only
and did not used the house for generating business income.
Referring to “sec 128-15, ITAA 1997” legal heirs Joe and Amy under the will of
deceased is presumed to have inherited the property on the day when Bob passed away in
relation to the cost base of the deceased (He et al., 2016). Furthermore, as the property was
not utilised by both the deceased as well as the beneficiary for income producing purpose and
was exclusively used for residential purpose, the cost base of the property is passed on to the
natural heirs in respect of their current market value. As a result both Joe and Amy can be
entitled to the full main residence exemption under “sec 118-195, ITAA 1997”.

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As apparent from the case facts that that dwelling was acquired by Mr Bob before 19th
September 1985 and the property constitute the pre-CGT asset to him. The house was
regarded as the main home that was used for dwelling purpose by Mr Bob before his death
and did used for making income (Bankman et al., 2018). On the basis of the law explained
above, a full main residence exemption is applicable under the “sec 118-195”, the taxpayer
here Joe and Amy would have to either;
a. Have to sell the property of the dwelling inside the time of 2 years of Mr Bob’s death
or any long period if the discretion of the commissioner is sought, or
b. The dwelling from day of death to the day of the sale should have to be the main
residence of either the spouse of deceased or the individuals that has the right of
occupying the dwelling as stated in the will of deceased or provided that the CGT
event was bought by the individual to whom the interest of ownership has been passed
as the beneficiary.
As evident from the case of Joe and Amy it is understood that the property was
equally divided among the taxpayer in equal shares as stated in the will of the deceased.
Furthermore, the dwelling was not sold by the legal heirs inside the span of two year of death,
hence option (a) cannot be applied in this case.
As understood from the case fact that the dwelling formed the main place of dwelling
for Joe and Amy starting from the day of demise of Bob till the day of sale. Furtherer, both
being the individual to whom the ownership of the property has been passed as the
beneficiary and the CGT event was also bought by them. Therefore, option (b) is applicable
in this case. Both Joe and Amy can obtain the full main residence exemption under the “sec
118-195, ITAA 1997”.
Conclusion:

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On the basis of the facts and applying the necessary laws the main residence
exemption is available to Joe and Amy in regard to the asset that is acquired from the estate
of deceased. Conclusively, Joe and Amy would be entitled to complete exemption from the
CGT under “sec 118-195, ITAA 1997”.

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