Since the Banking Royal Commission concluded in 2019, there has been a spike in compensation payments paid to investors by financial institutions writes Mark Chapman, director of tax communications at H&R Block. But did you know that these payments could be taxable?
The way tax law applies to such payments is complicated because different tax treatments apply to different types of compensation. It depends on the nature of the compensation, including what it is being paid for and how the investments are (or were) held and may include several different components, including:
- compensation for loss on an investment
- the refund or reimbursement of adviser fees
- an interest component.
The compensation may relate to multiple investments, with different amounts of compensation granted against each one. Each compensation amount is treated separately, and the various different components of the compensation need to be split up into their component parts.
Compensation that relates to the loss on an investment
Compensation is typically received because the value of the individual’s investments is lower than it would have been if they had received appropriate advice. The tax treatment depends on whether the investment has been disposed of or is still held:
- Compensation for an investment that has been disposed of - When the relevant investment is disposed of, a CGT event happens. Any compensation received is treated as additional capital proceeds relating to the disposal of those investments. If the individual had more than one investment, it is necessary to apportion the additional capital proceeds to each disposal. Where the capital gain or loss on the investment arose in a previous tax year, it will be necessary to amend the earlier year’s tax return to reflect the additional capital proceeds arising from the compensation.
- Compensation in relation to existing investments - Where compensation is received for investments that the individual still owns, the cost base of the investment is reduced, meaning that the individual will either increase any capital gain or reduce any capital loss which subsequently arises on that investment. Again, the compensation needs to be apportioned where the amount received relates to more than one investment. If the compensation received exceeds the cost base of the investment, there are no CGT consequences in respect of the excess compensation amount.
Refund or reimbursement of adviser fees
The tax treatment for such receipts depends on whether a deduction was claimed for the original adviser fees.
Where it was, the amount received as a refund or reimbursement will be assessable income in the year of receipt.
Where it was not, the refund or reimbursement of the fees is not assessable income but is instead treated as additional capital proceeds on the disposal of the investment (where the investment has been disposed of) or, alternatively, where the investment is still held, it reduces the cost base or reduced cost base of the investment, leading to a larger capital gain or a reduced capital loss on the ultimate disposal of the investment.
Interest component
This element of compensation (if any) will be treated as ordinary income in the year it is received.
Compensation that cannot be attributed to a particular investment
Where compensation cannot be attributed to a particular investment, it will be treated as a CGT event C2 arising on the ending of the right to seek compensation.
The capital gain/loss arises on the difference between the amount of compensation received (the capital proceeds) and the cost base or reduced cost base, which will typically be just the legal costs incurred to get the compensation.
Similarly, where the amounts of compensation cannot be split into their constituent parts (any of the categories above), it will be “undissected” and treated wholly as capital proceeds in relation to the ending of the right to seek compensation, as above.
Finally…
Don’t forget that if the payout you receive is taxable, you may be able to claim a deduction for any fees you incurred in getting it (such as lawyer fees).
Author Mark Chapman is director of tax communications at H&R Block.