It is becoming more common in Australia for class actions to proceed where aggrieved shareholders of listed companies sue in relation to the shares held due to perceived or real wrongdoings that led to them making a loss.
Where the class action succeeds (either via a decision or via a settlement), the shareholders who have joined the class action will often receive a payout of part of the damages/settlement sum. So what are the tax consequences of such a payout?
While there is little commentary from the ATO regarding the treatment of such payments, such a payout is definitely not a non-taxable windfall gain for the taxpayer (despite what many may think or hope).
Nor does it appear that the settlement proceeds are generally considered to be on income account. However, arguably this would be able to be determined by the nature of the relevant taxpayer’s other activities e.g. more broadly, are they an investor or a share trader?
Assuming that the taxpayer is an investor, settlement proceeds therefore can only be on capital account. However, there has historically been very little specific comment from the ATO to confirm this, or about the treatment of class action settlements generally.
There was a practice statement issued by the ATO back in 2004 in relation to a specific class action brought against GIO – this indicated that at the time the ATO were happy for taxpayers to choose either of the following approaches:
- Treat the amount received as part of the sale proceeds from the original shares. This would then require amendments to the prior year assessment to reflect the amended amount of the capital loss, with potential consequential amendments if the loss had since been partially or fully used; or
- Treat the proceeds as the disposal of the right to sue the company (which is a separate CGT asset). This right would have arisen when the events which gave rise to the class action occurred. Assuming this was in a prior income year the capital gain would arise in the current year and be discountable if the usual tests are passed.Any prior year capital loss would also be available (e.g. one incurred when the original shares had been sold).
The practice statement has since been withdrawn with no reason given for this. It is likely that it was withdrawn because after a few years all tax returns which needed to disclose the GIO matter would have been lodged.
Even if the practice statement could be applied to other class actions, the first option given by this practice statement assumes that the shares have been sold, and so will not be applicable to all. So where does this leave us? Should we be looking at a reduction in cost base instead of concentrating on any particular gain or loss?
A reduction in cost base seems in line with the approach taken by the ATO regarding compensation payments in general in TR 95/35, with this ruling taking the view that the actionable events had the result of reducing the value of the shares and thus that the compensation is an adjustment to the cost base of those shares. for situations where shares are sold, the consequence of a reduced cost base is the same as the same amount of increased proceeds (i.e. the original capital loss is reduced). Ultimately, adopting the treatment as outlined in the ruling gives the same practical outcome as the first of the above two approaches in the withdrawn practice statement, whilst also addressing the issue for continuing shareholders.
Based on several edited private rulings (which are not able to be relied upon by anyone other than the taxpayer to whom they relate), it appears that the ATO’s preferred option is to follow the same approach for class action payouts as other types of compensation payments.
Considering all the above approaches, I think that following TR 95/35 is more likely to be technically correct. However, guidance from the ATO specifically confirming this would be welcome. As a final note, affected taxpayers should ensure that they consider not only the immediate implications of the settlement payment, but also any follow-on effects for later capital gains where there is a change in the loss suffered.
This article provides a general summary of the subject covered and cannot be relied upon in relation to any specific instance. Webb Martin Consulting Pty Ltd and any person connected with its production disclaim any liability in connection with any use. It is not intended to be, nor should it be relied upon as, a substitute for professional advice.