The AAT has affirmed that a taxpayer was liable to CGT on a settlement payment of $350,000 made to her in respect of litigation she pursued for damages for breach of contract and negligence.
In particular, the AAT found that CGT event C2 applied to the payment, and that the CGT assets in question were the various claims made in her statement of claim (ie “choses in action”). It also found that she had failed to establish any relevant cost base for legal expenses (that would otherwise have substantially reduced the assessable capital gain), essentially on the basis there was no evidence she had incurred the expenses and that she failed to keep proper records, in any event.
In arriving at its conclusion, the AAT dismissed the taxpayer’s claim that the payment of damages per se could not give rise to a profit or gain. The AAT did so on the basis that it was clear law that damages received by way of settlement of a legal claim could be subject to CGT.
Finally, the AAT found that the 50% shortfall penalties imposed for “recklessness” were appropriate in the circumstances, particularly in view of the taxpayer taking no steps to seek independent legal advice in relation to whether tax may be payable on the amount and her failure to keep records as required by the tax law.
(AAT Case [2014] AATA 622, Re Coshott and FCT, AAT, Ref No 2013/3738, Deutsch, DP, 2 September 2014.)
[LTN 170, 2/9/14]
Extracts from [2014] AATA 622
5. Broadly, the Amended Statement of Claim alleged the following:
(a) that prior to 30 June 1991, the Applicant and Mr Coshott were profit sharing partners in Coshott Legal Practice, conducted at Double Bay;
(b) that in or around May 1991 Mr Coshott met with Mr Vardas, a solicitor trading as Gunn Hamilton & Blay, to discuss Mr Coshott’s proposed retirement and the future conduct by Mr Vardas of various matters on behalf of the Applicant and Mr Coshott;
(c) that in the period from on or about 30 June 1991, Mr Coshott and/or the Applicant entered into separate retainers (‘the Retainers’) with Mr Vardas regarding:
(i) the transfer of various client matters of the Coshott Legal Practice to Mr Vardas;
(ii) Mr Vardas acting, on a contingency basis or otherwise, in debt recovery matters against various former clients of the Coshott Legal Practice;
(iii) Mr Vardas acting for the Applicant and Mr Coshott in various personal matters.
(d) that, in relation to over 200 separate matters falling into one or more of the above categories, Mr Vardas breached duties owed under the Retainers, duties owed in tort and fiduciary duties;
(e) that Mr Vardas was liable to the Applicant and Mr Coshott to pay damages for negligence, damages for breach of contract and equitable compensation.
6. Mr Vardas was indemnified by LawCover in respect of the claims in the Supreme Court proceedings under a policy of professional indemnity insurance.
7. By deed dated 6 September 2007 the Supreme Court proceedings were settled (‘the Settlement Deed’).
8. The relevant material terms of the Settlement Deed were as follows:
(a) At clause 3.1, Mr Vardas agreed to pay the Applicant and Mr Coshott an amount of $700,000.
(b) The effect of clause 4 of the Settlement Deed was, inter alia, that in consideration for the payment of $700,000 under clause 3, the Applicant and Mr Coshott released Mr Vardas from all of the claims in the ASOC.
…
ISSUES
21. The issue in the proceedings is whether the Applicant can discharge her onus to show that the amended assessment was excessive. The questions that arise are:
(i) Whether, upon the execution of the Settlement Deed, CGT event C2 occurred in relation to each of the causes of action the subject of the ASOC?
(ii) If so, what capital proceeds were received by the Applicant in respect of each of those CGT events, (including whether the Applicant can establish how much of the $350,000 she received was reasonably attributable to each event for the purposes of subsections 116-40(1) or 116-40(2) of ITAA 1997)?
(iii) What, if anything, was the cost base of each of the CGT assets released upon execution of the Settlement Deed?
(iv) Whether, if the $350,000 is not assessable as a capital gain, it is assessable as ordinary income under s 6-5 of ITAA 1997?
(v) Whether the penalty imposed is correct or should be remitted either wholly or in part?
[Section 116-40 is a rule apportioning capital proceeds between CGT events and other transactions]
[FJM Note: This case may have just ‘slipped through the cracks’ in TR 95/35, which outlines the Commissioner’s approach to damages and compensation – see comments below about those ‘cracks’.]
TR 95/35 – CGT on damages etc.
The Commissioner said:
- CGT will be based on the underlying asset where there is one,
- otreating the damages as consideration for a CGT event happening to the underlying asset if applicable (eg. destruction of the underlying asset); and
- otreating the damages as recouping/reducing the cost base of the underlying asset, if it has sustained permanent damage (and any excess will not be subject to CGT).
- oThis ‘recoupment’ approach will also apply to damages for acquiring the underlying asset for too much.
- oThere will be no CGT if the underlying asset is not a CGT asset (eg cars); any gain or loss is disregarded (eg. a pre-CGT asset, or a main residence); where the capital gain is disregarded because other tax regimes apply to those assets (eg. trading stock, or depreciating assets); or where the damages are otherwise assessed as ordinary income (such that the capital gain is commensurately reduced).
- Where there is no underlying asset:
- oThere will be no CGT if the compensation is otherwise disregarded (eg. compensation under s118-37 of the ITAA97 – for civil wrongs, injury, illness suffered personally etc.); or
- oIn cases for compensation for pecuniary loss, the pecuniary loss can establish an adequate cost base.
- In all cases, the legal cost of pursuing the legal action will add to the cost base available in calculating any relevant gain.
- To the extent that none of the above apply or give an adequate cost base, there can be CGT on damages.
[The last dot point would be a bad result – because it contravenes the common sense principle that damages are compensatory in nature and inherently can’t lead to any gain. It could lead to the nonsense of having gross-up damages for tax.]