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Ruling

Subject: Compensation payment

Question 1

Are the payments received under the compensation agreement (agreement) assessable as ordinary income under section 6-5 or section 15-15 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

No

Question 2

Are the payments received under the agreement assessable as statutory income under section 6-10 of the ITAA 1997?

Answer:

No

Question 3

Are the payments received under the agreement considered a recoupment of the cost base of the asset and therefore will have no capital gains tax implications until the subsequent disposal of the asset?

Answer:

Yes

This ruling applies for the following period

Year ended 30 June 2011

Year ended 30 June 2012

Year ending 30 June 2013

The scheme commenced on

1 July 2010

Relevant facts and circumstances

The arrangement that is the subject of the private ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description.

The relevant documents are:

· the application for private ruling

· letter from your tax agent

· copy of compensation agreement

You jointly purchased some land for recreational purposes.

X months after the land was purchased, a developer, and the Tenement Holder, began exploration activities on your land.

The developer has since found product and now has plans to develop the land.

You have entered into an agreement with the developer.

In the recitals of the agreement it is stated that the "document has been developed by the Government in consultation with landholder groups and groups representing explorers and producers. It is intended to represent a fair and balanced approach as between those parties to land access and compensation issues".

The agreement in this case is pursuant to the Petroleum and Gas (Production and Safety) Act 2004 (P & G Act).

A clause provides that the agreement is in full and final satisfaction of the Tenement Holder's Compensation Liability for the Compostable Effects of the Activities described within the document.

Relevant legislative provisions

Petroleum and Gas (Production and Safety) Act 2004 Subsection 532(1)

Petroleum and Gas (Production and Safety) Act 2004 Subsection 532(4)

Petroleum and Gas (Production and Safety) Act 2004 Section 534

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 15-15

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Paragraph 108-5(1)(b)

Income Tax Assessment Act 1997 Subsection 104-35(1)

Income Tax Assessment Act 1997 Paragraph 104-25(1)(b)

Reasons for decision

Summary

Compensation payments for damage and loss of assets, for example, deprivation of possession of its surface, diminution of its value, diminution as stated in the Petroleum and Gas (Production and Safety) Act 2004 (P & G Act) is not ordinary assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997).

Satisfying the conditions of the P & G Act gives rise to a capital gains tax (CGT) asset in the form of a right to receive compensation and statutory income pursuant to section 6-10 of the ITAA 1997. However, where the compensation payment directly relates to the damage and loss of the underlying asset, the payment is treated as a reduction of the asset's cost base and any statutory income arising from a CGT event will generally be deferred until the asset is disposed.

Detailed reasoning

Part 5 of the P & G Act sets out the general compensation provisions. The holder of each authority is liable to compensate each relevant owner or occupier of private or public land, known as the 'eligible claimant'. The eligible claimant owns private or public land included in the area of the authority; or access land for the petroleum authority. Subsection 532(1) of the P & G Act makes each authority liable to compensate for the effect the eligible claimant suffers caused by the authorised activities of an authority or the carrying out of an activity by a person authorised by the holder.

Compensatable effect, defined under subsection 532(4) of the P & G Act, means all or any of the following occurring to the claimants land; deprivation of possession of its surface, diminution of its value, diminution of the use made, or that may be made, of the land or improvement on it, severance of any part of the land from other parts, and any cost or loss arising from the carrying out of activities under the authority on the land. As such, the types of compensatable events are not exhaustive and this list is a reflection of the nature of events for which compensation is generally warranted.

The eligible claimant and authority holder may enter into an agreement (a 'compensation agreement') about the holder's compensation liability to the claimant or any future compensation that the holder may have to the claimant that relates to all or part of the liability or future liability.

Pursuant to section 534 of the P & G Act, a compensation agreement must be in writing and signed by, or for, the holder and the eligible claimant and state whether it is for all or part of the liability. Where the agreement is for only part of the liability the agreement must state, the details of each activity, or effects of it, and the period for which the agreement has effect.

It follows that where a landowner is an eligible claimant under subsection 532(1) of the P & G Act this gives rise to a right to compensation.

Ordinary income section 6-5 or 15-15 of the ITAA 1997

Taxation Ruling TR 95/35 discusses the treatment of compensation receipts. Paragraph 3 of TR 95/35 states that:

A compensation receipt, or compensation, includes any amount (whether money or other property), received by a taxpayer in respect of a right to seek compensation or a cause of action, or any proceeding instituted by the taxpayer in respect of that right or cause of action, whether or not:

· in relation to any underlying asset;

· arising out of Court proceedings; or

· made up of dissected amounts.

Compensation paid due to loss and damage of a capital asset, or forgoing a right to sue, in the process of a mining authority entering and accessing minerals and resources, is an isolated transaction.

Paragraph 6 of Taxation Ruling TR 92/3 explains that whether a profit from an isolated transaction is ordinary assessable income according to ordinary concepts depends very much on the circumstances of the case. Profit from an isolated transaction is generally ordinary income when both of the following elements are present:

· the intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain; and

· the transaction was entered into, and the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction.

Neither elements (a) nor (b), as noted above, apply in the circumstances of receiving compensation where a holder exercises its powers to access and use a claimants land for prosecting and mining under the P & G Act.

The compensation payments are made in accordance with the legislative criteria outlined in the P & G Act. Standard compensation agreements state that payments may be dissected into events, for example, damages from drilling and clearing land where payments are received by the claimant over a number of years. A receipt received this way this does not disturb the nature of the compensation payment in the hands of the claimant.

As the payments were clearly paid as compensation for damage to and interference with your land, these payments are considered capital amounts and not ordinary assessable income.

Accordingly, the compensation payments do not give rise to income according to ordinary concepts pursuant to section 6-5 of the ITAA 1997 or to a profit arising from a profit-making undertaking or plan within the meaning of section 15-15 of the ITAA1997.

Statutory income under section 6-10 of the ITAA 1997

Statutory income may arise from CGT events as a consequence of an eligible claimant being entitled to receive compensation for the loss and destruction of a CGT asset.

Compensation for loss and destruction of underlying assets

The CGT consequences of an award of damages depend on whether there is an underlying asset that damages have a direct and substantial link to 'by looking through the transaction that gave rise to the compensation receipt to the most relevant asset relating to the receipt'. In Carborundum Realty Pty Ltd v. RAIA Archicentre Pty Ltd and Graeme McDonald 93 ATC 4418; (1993) 25 ATR 192, Harper J suggested that the compensation receipt should be linked to the underlying asset in determining whether the plaintiff had received any capital gain.

The ATO view, in paragraphs 76 to 77 of TR 95/35, is that the loss or destruction of the asset which generates the right to seek compensation is the most relevant transaction or event producing the right to receive compensation. Accordingly, we consider that it is for the loss or destruction of the underlying asset that compensation is received, rather than the disposal of any rights arising from that loss or destruction.

The standard compensation agreements consist of an upfront payment and future ongoing payments reflective of the damages to underlying assets.

If the payment relates to permanent damage to, or permanent reduction in the value of, an underlying asset, the compensation is treated as a recoupment of all or part of the acquisition cost of the asset (that is, you reduce the cost base and reduced cost base by the amount of the compensation). The total acquisition costs of the post-CGT asset should be reduced by the amount of the compensation. No capital gain or loss arises in respect of that asset until the taxpayer actually disposes of the underlying asset. If, in the case of a post-CGT underlying asset, the compensation amount exceeds the total unindexed acquisition costs (including a deemed cost base) of the underlying asset, there are no CGT consequences in respect of the excess compensation amount.

For example, where there is an upfront lump sum payment paid by the statutory authority party to the claimant in relation to clearing land and the constructing of a dam, the consideration received is treated as being in respect of the underlying asset, the land. The cost base of the land is reduced to the extent of the consideration and any gain or loss will crystallise at the later time when the land is sold.

Compensation received by a taxpayer has no CGT consequences, if the underlying asset that has suffered permanent damage or a permanent reduction in value was acquired by the taxpayer before 20 September 1985, or is any other exempt CGT asset.

Right to seek compensation

TR 95/35, at paragraph 2, provides that the right to seek compensation is the right of action arising at law or in equity and vesting in the taxpayer on the occurrence of any breach of contract, personal injury or other compensable damage or injury. The right to seek compensation, is acquired at the time of the compensable wrong or injury, and includes all of the rights arising during the process of pursuing the compensation claim. The right to seek compensation is disposed of when it is satisfied, surrendered, released or discharged.

The legal right to compensation satisfies the definition of a capital asset for capital gains tax purposes under section 108-5(1)(b) of the ITAA 1997. The creation of the right is a D1 event under 104-35(1) and arises when the conditions of the P & G Act were met. The compensation payment made to the eligible claimant discharges the taxpayer's right to compensation and triggers a C2 CGT event under subsection 104-25(1)(b) of the ITAA 1997. The timing of the event is where the claimant first enters into the contract that results in the asset ending.

Where the payment is not for an underlying asset, it relates to the disposal of the right to seek compensation. The capital gain or capital loss will be the difference between the incidental costs and the compensation received. If the compensation amount relates to a number of heads of claim and cannot be allocated on any reasonable basis between those heads of claim, the whole amount is taken to be the claimants right to seek compensation.

Conclusion

Compensation payments paid to an eligible claimant under the P & G Act in the forgoing circumstances are not ordinary assessable income under section 6-5 of the ITAA 1997. Compensation received directly by the eligible claimant in relation to the damage and loss of value of an underlying asset will be treated as a reduction of the cost base. Only on occasions where no underlying asset can be found via a look through approach should statutory income arise from the disposal of the right to compensation.

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