Capital Gains Tax: debt arising from the provision of services - whether same amount can be both ordinary income and a capital gain

Can subsection 118-20(1) of the Income Tax Assessment Act 1997 (ITAA 1997) apply to reduce any capital gain made when a debt that arises from the provision of services is discharged?

Yes. Subsection 118-20(1) of the ITAA 1997, as modified by subsection 118-20(1A) of the ITAA 1997, can apply to reduce any capital gain made from a CGT event that happens on discharge of the debt. Subsection 118-20(1) will apply to reduce the capital gain where an amount of the debt that was taken into account in working out the capital gain was included in assessable or exempt income under a provision of the ITAA 1997 (apart from Part 3-1).

A taxpayer carries on a business of providing services to clients.

The taxpayer's income is assessed on an accruals basis.

A debt arises in respect of the taxpayer's provision of services to a client which is discharged at a later time.

The taxpayer derives income according to ordinary concepts under section 6-5 of the ITAA 1997 when the debt arises in respect of the services provided.

The debt owed to the taxpayer is a CGT asset of the taxpayer under section 108-5 of the ITAA 1997 (refer Taxation Determination TD2).

In this case, the first element of the cost base and reduced cost base of the debt is nil as the provision of services is not money paid, or other property given, to acquire the debt under subsections 110-25(2) and 110-55(2) of the ITAA 1997. Further, the market value substitution rule in section 112-20 of the ITAA 1997 does not apply to treat the debt as having been acquired for its market value (refer to ATO ID 2005/211).

Under section 104-25 of the ITAA 1997, CGT event C2 happens when the taxpayer's ownership of an intangible CGT asset, which includes a debt, ends by the asset being discharged or satisfied. The taxpayer makes a capital gain under subsection 104-25(3) of the ITAA 1997 if the capital proceeds from the ending are more than the debt's cost base. The amount received by the taxpayer on discharge of the debt is included in the capital proceeds from CGT event C2 happening.

The anti-overlap provisions in section 118-20 of the ITAA 1997 apply to reduce a capital gain to the extent that because of a CGT event an amount is otherwise included in the taxpayer's assessable or exempt income.

With regard to the facts, if the amount received on discharge of the debt is taken into account in working out the capital gain the taxpayer made, subsection 118-20(1A) of the ITAA 1997 extends the application of subsection 118-20(1) of the ITAA 1997 to treat the amount that is included in assessable income under section 6-5 of the ITAA 1997 as if it were so included because of CGT event C2.

Accordingly, subsection 118-20(1) of the ITAA 1997 will apply to reduce the capital gain made when CGT event C2 happens on discharge of the taxpayer's debt thus preventing double taxation of the amount included in the taxpayer's assessable income under section 6-5 of the ITAA 1997.