Tax implications on the compensation received
Scenario:
We (Australian Oil Distributors, AOD) supply petrol and oil products to a few independent service stations. We receive bulk petrol and oil products under an agreement with Mid-Eastern Oil (MEO) for which we pay MEO $1m annually.
MEO advised us that it was terminating the agreement. We sought compensation of $2m from MEO for the impact on its business arising from breach of the agreement.
It was subsequently settled with MEO agreeing to pay us a lump sum of $1.5m on the condition that we would not enter into any contract or agreement with any other oil producer for two years. The payment included compensation for any damage to our reputation in the industry.
Would you be able to advise us on the tax consequences of receiving the payment of $1.5m from MEO?
Explanation:
The first issue is to determine whether the $1.5m received by you (AOD) is of an income or capital nature and assessable as ordinary income under ITAA97 s 6-5 or assessable as a capital gain under ITAA97 s 104-25. If ITAA97 s 6-5 is held not to apply, it may be necessary to consider whether the compensation is assessable as recoupment under ITAA97 s 20-25.
It is also necessary to consider the substance of the $1.5m payment, i.e. whether it comprises of liquidated or unliquidated damages and whether the sum can be dissected into income and/or capital components. Where the relevant payment can be dissected into income and capital components, the income components will be assessable income, under ITAA97 s 6-5(1). Capital components may attract capital gains tax. Finally, the impact of the restrictive covenant condition in the settlement needs to be considered in addition to the allowance for damage to AOD's reputation in the industry.
If AOD argues that the $1.5m is unliquidated damages and cannot be dissected into income and capital components, then the entire amount will be assessable income under the capital gains tax provisions. However, if the $1.5m can be dissected into component elements then:
The amount attributable to loss of sales revenue will be treated as ordinary income and assessable under s 6-5.
Any amount that is an indemnity or recoupment of a deductible expense, which is not otherwise assessable income under s 6-5, will be assessable recoupment under ITAA97 20-20.
Amounts attributable to damage to or sterilisation of AOD’s profit-making structure (Van den Berghs Ltd v Clark [1935] AC 431) or damage to business reputation will be treated as an assessable capital gain.
The amount received in relation to agreeing to the restrictive covenant will be a capital gain, namely CGT event DI (ITAA97 104-35(1)).
The amount assessed as compensation for damage to business reputation will be of a capital nature and taxed as a capital gain. The underlying asset being business goodwill (FC of T v Murry 98 ATC 4585).