Penalty interest - assessable?

Has anyone considered if 'penalty interest' that a party (say the buyer) becomes entitled to if the other party delays settlement of a property is assessable income? Where the buyer is the party entitled to the 'penalty interest' it wouldn't appear to satisfy the typical legal definition of interest (broadly, a payment from the borrower of money to the lender for compensation for the use of money). The question is, is it still assessable income or is it a capital receipt (possibly an adjustment to the purchase price/cost base of the property)?

 

Depends upon the substance of the arrangement, considering the terms of the contract and the implied intention from your actions.

However, compensation for provision of financial accommodation is often income even where it relates to capital asset transactions.

If it is intended to be an adjustment to the purchase price then this is unusual. It is more usual to be a liquidated damages clause.

Again, it depends upon specific circumstances.

 

Ordinarily on a delayed settlement by an Australian tax resident it is assessable whether its a main residence or a investment property. Ditto interest shared / paid on held deposits on trust etc. As Rob points out there can also be other ways such an adjustment is made and this may have different outcomes.

I had a curly one where the parties needed to extend settlement due to delay and to avoid default the vendor agreed to extend the contract based on an increased purchase price of a fixed sum of $10,000. In that instance it was a capital price adjustment and ATO agreed it was not paid in the nature of interest based upon a financial arrangement.

 

The position under the WA Joint Form of General Conditions for the Sale of Land is pretty clear - it's an adjustment to the purchase price:

4.2 Seller delay
If for any reason attributable to the Seller, Settlement is not completed within 3 Business Days after the Settlement Date the Seller must allow to the Buyer at Settlement, as a deduction from the Purchase Price, compensation on:
(a) the balance of the Purchase Price; and
(b) any other money payable at Settlement.

4.3 Interest or compensation
Interest payable under clause 4.1 and compensation allowable under clause 4.2 is to be calculated:
(a) at the Prescribed Rate; and
(b) from and including the Settlement Date to but excluding the date on
which Settlement occurs,
and will be treated as being in full satisfaction of any claim the Party claiming interest or compensation has against the other Party as a result of the delay in Settlement.​

 

You are referring to a reduction in the consideration payable. That is a total sum that could be a composite of amounts for a different nature.

I have not read the relevant legislation and any legal definition of "purchase price" for this purpose if it is defined.

For example, the total consideration could include adjustments for the rates paid up to settlement. That amount would not form part of the purchase price, it is merely compensating the vendor for having prepaid the rates on the property. Rates do not form part of the price of the property.

Whether the substance under tax law amounts to a provision of financial accommodation then it could be treated as a finance charge.

If, on the other hand, the "deduction from the purchase price" is taken to mean a recoupment of the capital outlay relating to the underlying property then it would not usually be assessable.

All the interest clause suggests is a liquidated damages claim for a delay in settlement.

It is intended to compensate the purchaser for costs incurred by the delay.

It does not seem clear at all, in fact from a tax law point of view the use of the word "interest" implies income whilst "compensation" will take on the form of the underlying transaction.

 

Purchase Price is defined as "the price payable for Property stipulated in the Contract". In this instance, a "deduction from the purchase price" is entirely different to the adjustment that is made on settlement for outgoings.

I struggle to see how a payment from a Seller to a Buyer could be financial accommodation. The Buyer is the party which has the funds and is the one who is receiving the interest. Very simplistically, interest flows from the entity which holds the funds (i.e. borrower) to the entity where the funds came from (i.e lender).

However, even if the payment is not 'interest' this doesn't mean it can't still be assessable income...

 

I have seen settlement sheets where it clearly defines penalty interest at a rate of 10% x number of days. IMO that is interest especially where the word interest is used. Maybe a NSW thing ? I would imagine rules vary by state with standard contract wording or perhaps even by law firm. One for lawyers here ?

There is also a possibility an adjustment to the price could be a separate CGT event. Haven't seen it however. My learned colleague Rob may have encountered such a issue where a contract is resettled.

 

Provision of financial accommodation is probably not an appropriate term. Unfortunately the term "interest" is ambiguous in the clause, it seems to be a generic compensation for waiving of rights to recover costs.

Does the purchaser by waiving their right to recover costs due to the delay, provide a benefit to the vendor?

If it is, then a setoff against the purchase price in lieu of payment of interest or compensation is still a benefit received for waiving that right.

A right has been surrendered in lieu of the right to recover costs. A type of compensation - this is the key issue.

The fact that the amount of compensation accrues daily has some characteristics of income from delaying their taking possession of the property.

However, the fact that the underlying transaction is overwhelmingly related to a transaction on the capital account is significant for compensation issues.

An analogy would be where you owned a call option and then received payments by the grantee to delay exercise of the option. If instead you agreed to set off the payments by a reduction in exercise price, this would not change the nature of those payments.

It is a restrictive covenant, which if in the form once-off payment relating to compromising an underlying capital asset then it would most likely be a capital receipt.

The fact that it accrues daily is unsettling just as much as the fact that it is labelled "interest". However, the method of working out the amount of compensation should not be confused with the reason why it is paid.

Don't forget that post judgement interest in a damages case has been held to be ordinary income even where the underlying damages are merely capital and even CGT exempt. I would wonder about a case of specific performance where the courts also ordered a similar compensation for delayed settlement to the purchaser. It might be analogous to interest or even rent or compensation for income foregone.

Compensation takes on the form of what it is intended to replace.

 

The compensation analysis is persuasive. Would the receipt of the compensation would be a separate CGT event or an adjustment to the cost base of the property? In TR 95/35 the ATO considers that where the compensation is for permanent damage to, or permanent reduction in the value of, the underlying asset, there is an adjustment to the cost base of the asset. Arguably there's been no permanent damage or reduction here...

The alternative view to the compensation analysis is that cl 4.2 is merely an adjustment to the price of the property. If you settle on X date the price is $Y, but if you settle on a later date the price is $Y + $Z. The courts have considered this issue on a number of occasions. See for example, FCT v Broken Hill Pty Company Ltd [2000] FCA 1431 where the Court found that "interest" the taxpayer was obligated to pay was not interest in the real sense of the word but really was just an adjustment to the price under the contract.

Practically, I see lots of examples in commercial contracts where the parties will agree that certain amounts will merely be adjustments to the price under the contract and everyone proceeds on the basis that this is effective.

The other side to this question is whether the seller would get a revenue deduction for the payment?

 

Proceeding on the basis that the adjustment is not assessable income under any other provision ... this is a separate issue.

CGT event C2 occurs when you waive your right to recover damages.

The Commissioner takes a pragmatic view with compensation cases and generally adopts the "look through approach" to the underlying asset transaction as opposed to compensation for the waiving of rights.

See for example TR 1999/19 involving a forfeited deposit on a prospective sale for an example of the look through approach.

The facts in this case are in reverse to the ruling, we are looking at a prospective purchase and no underlying CGT event is occurring for the purchaser in relation to the property. However, they do have an interest in the property prior to settlement.

Alternatively, you could argue that the rights were waived at the time the contract was entered into because it is a clause. CGT event C2 either did not occur or had zero capital proceeds and value at the time the contract was signed

A reasonable view would be that if the purchase actually proceeds then the compensation is an adjustment to the purchase price if it is not assessable income.

Similarly, if a taxpayer receives a partial refund after purchase that is not included in their assessable income then it is an adjustment to the asset cost base, see s.110-45(3) ITAA97.

So the first step is to determine if this is a non-assessable amount.

On the facts discussed previously, we were assuming an investor is acquiring a capital asset. If the adjustment does not amount to interest or rent (depends on detailed analysis) then is unlikely to be assessable income.

If the taxpayer was a developer acquiring trading stock then the amount might be assessable because the asset is on the revenue account. Although it is still possible that the specifics of the contract may make it an adjustment to the purchase price. However, here the result is the same because there is a reduced deduction for a stock purchase.