Scholarship - deductibility of damages for breach of contract

Is the taxpayer entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for damages payable for breach of a scholarship contract?

No. The taxpayer is not entitled to a deduction under section 8-1 of the ITAA 1997 for damages payable for breach of a scholarship contract as the deduction is precluded under section 26-5 of the ITAA 1997.

The taxpayer entered into a scholarship contract made under the provisions of State legislation (the State Act). The scholarship contract provided that it was governed by the provisions of the State Act. It also provided that the contract together with the provisions of the State Act constituted the entire terms agreed between the parties.

The State Act provided that should the scholarship recipient default upon the terms of any service provision in their contract they will be subject to a sum payable as stipulated in that contract. The State Act provides that the sum payable would be paid as damages for a breach of that condition.

The scholarship contract entered into by the taxpayer contained a provision which required the taxpayer to work for a particular employer for a certain period after completion of their university course.

The contract provided that should the taxpayer fail to complete the required period of service they were liable, in addition to repaying a portion of the scholarship payments received, to pay an additional amount, pursuant to the State Act, as damages.

The taxpayer received payments under the scholarship contract whilst they were completing a degree at an Australian university.

The taxpayer failed to complete their period of service and were required to pay the additional amount, pursuant to the State Act, as damages.

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income. A deduction will not be allowed however where another provision of the Income Tax Assessment Act 1936 (ITAA 1936) or the ITAA 1997 prevents it.

Paragraph 26-5(1)(a) of the ITAA 1997 provides that a taxpayer cannot deduct an amount (however described) payable, by way of penalty, under an Australian law.

An Australian law means a Commonwealth, State or Territory law (section 995-1 of the ITAA 1997).

Taxation Determination TD 94/84 deals with the application of paragraph 51(4)(a) of the ITAA 1936 (the predecessor of section 26-5 of the ITAA 1997). While it deals with certain penalties under the corporations law it provides a useful discussion of the meaning of 'penalty' and the application of this provision. Paragraph 3 of TD 94/84 states that:

'The word 'penalty' is not defined in the ITAA and, in its context in paragraph 51(4)(a), bears its ordinary meaning. According to dictionary meanings, a 'penalty' is a punishment (which may be pecuniary) for a breach of the law. What is necessary for paragraph 51(4)(a) to apply is that the amount be one payable 'by way of' penalty. It is not essential that an amount actually be a penalty for it to come within paragraph 51(4)(a), but an actual penalty would satisfy the description 'an amount ... payable ... by way of penalty'.

It is not necessary therefore that an amount actually be a penalty for it to be covered by the section.

The taxpayer has breached the terms of their scholarship contract and as a result has been penalised in that they are required to pay an amount as damages for that breach. The amount of damages would probably fit within the ordinary meaning of 'penalty' but in any event would be an amount 'by way of ' penalty.

The exclusion under section 26-5 of the ITAA 1997 applies where the penalty is payable under an Australian law. The State Act provides that should a scholarship recipient breach the service provision in the scholarship contract they will be liable for the additional amount, as stipulated in the contract, payable as damages. The amount payable as damages (that is the penalty) is payable pursuant to the State Act. Therefore the amount is payable under State law for the purposes of section 26-5 of the ITAA 1997.

The amount payable by the taxpayer is therefore an amount by way of penalty payable under an Australian law. Consequently, pursuant to section 26-5 of the ITAA 1997, the taxpayer is not entitled to a deduction for the amount payable as damages. It is not necessary therefore to consider whether the amount would have been otherwise deductible under section 8-1 of the ITAA 1997.