Edited version of your written advice

Authorisation Number: 1012983405996

Date of advice: 15 March 2016

Ruling

Subject: CGT: Treatment of compensation payment

Question 1

Will the Head One component of the Compensation Payment be treated as a reduction to the cost base of Lot 2?

Answer

Yes.

Question 2

Will the Head Two component of the Compensation Payment be included in calculating the capital proceeds from the sale of Lot 1?

Answer

Yes

Question 3

Will the Head Three component of the Compensation Payment be including in calculating the capital proceeds from the sale of Lot 1?

Answer

Yes

Question 4

Will the Head Four component of the Compensation Payment received be treated as the capital proceeds of capital gains tax (CGT) event C2?

Answer

No

Question 5

Should the Head Five part of the Compensation Payment received be apportioned between each CGT asset as a recoupment of the cost base of each asset?

Answer

Yes

Question 6

Can the CGT general discount be applied to reduce any capital gain that resulted from the Head One and Head Four components of the Compensation Payment?

Answer

No

Question 7

Can the CGT general discount be applied to reduce any capital gain that resulted from the Head Two and Head Three components of the Compensation Payment?

Answer

Yes

This ruling applies for the following period

Year ended 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

You own the property consisting of multiple lots on which you run a business.

Entity X operates a mine in the area and has applications for mining leases in the area:

Under section 279 of the Mineral Resources Act 1989 (Qld) ('MRA') Entity X is required to enter into a conduct and compensation agreement with you before their mining leases are granted.

You entered into two agreements with Entity X:

(a) a sale agreement ('Sale Agreement') for the sale of Lot 1, and

(b) a conduct and compensation agreement ('Compensation Agreement).

Each agreement states it was contingent on the other.

Under the Sale Agreement, you

(a) agreed to sell Lot 1

(b) were granted a license to use Lot 1 for a specified period, and

(c) were allowed to remove the dwelling houses from Lot 1.

Under the Compensation Agreement, you agreed to compensation ('Compensation Agreement') and agreed to apportion between the following heads of payment:

(a) severance and injurious affection loss in respect of Lot 2, including the blast exclusion zone, ('Head One')

(b) reinstatement of houses at approved locations ('Head Two')

(c) transfer duty and legal fees for replacement land ('Head Three')

(d) waiver of restricted land rights and not lodging objections to mining leases or development approvals ('Head Four'), and

(e) refund for legal, valuation and accounting fees ('Head Five').

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 20-20

Income Tax Assessment Act 1997 Section 104-5

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 104-35

Income Tax Assessment Act 1997 Section 112-30

Reasons for decision

Summary

Compensation received for the permanent reduction in value and damage relating to Lot 2 will be treated as a reduction to its' cost base.

Compensation for future costs associated with relocating the dwellings and purchasing replacement land are included in the capital proceeds from the sale of Lot 1 and can be discounted.

Compensation for agreeing not to lodge an objection to Entity X's mining leases or development approvals is a CGT event D1 as a contractual right has been created between yourself and Entity X. Any gain from this event cannot be discounted.

The compensation to refund legal, accounting and valuation fees is to be apportioned between the affected assets.

Detailed reasoning

Under Schedule 1 to the MRA the holder of a mining lease is required to compensate the relevant owners or occupiers of land subject to that lease for the effect the owners or occupiers suffer as a result of the activities undertaken by the mining lease holder on that land.

'Compensatable effect' is defined under the MRA as meaning all or any of the following:

(a) all or any of the following relating to the owner's or occupier's land

(i) deprivation of possession of its surface

(ii) diminution of its value

(iii) diminution of the use made or that may be made of the land or any improvement on it

(iv) severance of any part of the land from other parts of the land or from other land that the owner or occupier owns

(v) any cost, damage or loss arising from the carrying out of activities under the mining lease on the land, and

(b) accounting, legal or valuation costs the owner or occupier necessarily and reasonably incurred to negotiate or prepare a conduct and compensation agreement.

Compensation payment as ordinary income

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year.

Compensation paid due to loss and damage or 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. Whether a profit from an isolated transaction is ordinary assessable income according to ordinary concepts depends on the circumstances of the case. Profit from an isolated transaction is generally ordinary income when both of the following elements are present:

(a) the intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain, and

(b) the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction (paragraph 6 of Taxation Ruling TR 92/3).

Neither of the above elements apply in your situation. The compensation payments were made in accordance to the legislative provisions of the MRA.

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

Compensation payments and the capital gains tax (CGT) provisions

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

Taxation Ruling TR 95/35 considers the tax treatment of compensation receipts. For the purposes of TR 95/35 a compensation receipt is defined as including:

… 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 undissected amounts.

TR 95/35 uses a 'look-through' approach to identify the most relevant asset. This approach requires an analysis of all the possible assets of the taxpayer in order to determine the asset to which the compensation amount is most directly related.

An underlying asset is defined in the Ruling as:

… the asset that, using the 'look-through' approach, is disposed of or has suffered permanent damage or has been permanently reduced in value because of some act, happening, transaction, occurrence or event which has resulted in a right to seek compensation from the person or entity causing that damage or loss in value or against any other person or entity.

If there is more than one underlying asset, the relevant asset is the asset which directly leads to the payment of the amount of compensation.

If an amount of compensation is received wholly in respect of the disposal of a post-CGT underlying asset, or part of an underlying asset, of the taxpayer the compensation represents consideration received on the disposal of the asset. In these circumstances, we consider that the amount is not consideration for the disposal of any other asset, such as the right to seek compensation.

Where the underlying asset is a pre-CGT asset, the receipt of the compensation on disposal has no CGT consequences for the taxpayer.

If an amount of compensation is received by a taxpayer wholly in respect of permanent damage suffered to a post-CGT underlying asset of the taxpayer or for a permanent reduction in the value of a post-CGT underlying asset of the taxpayer, and there is no disposal of that underlying asset at the time of the receipt, we consider the amount represents a recoupment of all or part of the total acquisition costs of the asset.

Accordingly, the total acquisition costs of the post-CGT asset should be reduced by the amount recoupment as if those costs had not been incurred. If the compensation amount exceeds the total acquisition costs of the underlying asset, there are no CGT consequences in respect of the excess compensation.

Compensation received by a taxpayer has no CGT consequences if the underlying asset to which has suffered permanent damage or a permanent reduction in value was acquired by the taxpayer before 20 September 1985.

Where the total compensation is paid in relation to multiple assets, pre-CGT and post-CGT assets or for multiple reasons, the total compensation is to be apportioned between the assets and each portion examined separately to determine its' appropriate treatment.

The Compensation Agreement has apportioned the total compensation payment between five heads of payment. Each head of payment will be examined separately to determine how it should be treated.

Head One component - compensation for severance and injurious affection loss in respect of Lot 2

As stated above, where you receive compensation wholly in respect of permanent damage to your post-CGT underlying asset or for a permanent reduction in the value of your post-CGT underlying asset and there is no disposal of that underlying asset at the time of the receipt, we consider that the amount represents a recoupment of all or part of the total acquisition costs of the asset. There are no CGT consequences for that portion of the compensation which relates to a pre-CGT asset.

In your situation, you have received compensation for severance and injurious affection loss in respect of Lot 2 ('the underlying asset'). Essentially, this payment is for permanent damage to, or reduction in the value of, Lot 2 as a result of the mining lease and associated activities. You have not disposed of Lot 2.

The Head One compensation which relates to your post-CGT interests in Lot 2 will be treated as an assessable recoupment. The effect is to reduce the total acquisition costs by the compensation payment. If this portion of the compensation payment is more than the total acquisition costs there are no CGT consequences in respect of the excess compensation.

Head Two component - compensation to reinstate houses at approved locations

You have received the Head Two component of compensation for costs associated with either relocating the dwellings situated on Lot 1 to another parcel of your existing land or to build replacement dwellings on that land.

As stated in TR 93/35 it is necessary to determine the underlying asset to which this compensation relates. There are two possible assets - Lot 3 or the land on which the dwellings will be relocated to or erected on.

In determining which asset is the most relevant asset, it is often appropriate to adopt a 'look-through' approach to the transaction or arrangement which generates the compensation receipt.

Using the 'look-through' approach, the transaction which has generated the compensation receipt is the sale of Lot 3. At the time of receiving the compensation amount you had not relocated the dwellings or erected new dwellings on other land.

Accordingly, the Head Two component of the compensation is considered to form part of the capital proceeds from the sale of Lot 1.

Head Three component - compensation for transfer duty and legal fees for replacement land

You have received the Head Three component of compensation for costs associated acquiring replacement land in the future.

As per the discussion regarding the Head Two component, above, using the 'look-through' the transaction which has generated the compensation receipt is the sale of Lot 1. You would not have received this compensation if Lot 1 had not been sold. You have not acquired replacement land at this point in time.

Accordingly, the Head Three component of the compensation is considered to form part of the capital proceeds from the sale of Lot 1.

Head Four component

The Head Four component of the compensation payment has been paid in exchange for a waiver of restricted land rights and you not objecting to the mining leases or development approvals.

Taxation Determination TD 1999/80 states that if money or property is received for withdrawing an objection against a proposed land development, and not for the permanent damage or reduction in value to the property by the development CGT event D1 happens. CGT event D1 happens where a contractual or other right is created.

We believe that the situation described in TD 1999/80 aligns to your situation. You have received money for agreeing not to object to the mining leases or development approvals. You have received a separate amount (the Head One component) for the permanent damage and reduction in value to the property resulting from the resulting mining activities.

Therefore, by entering the agreement not to lodge an objection, you have created a contractual right between yourself and Entity X. Thus, CGT event D1 has happened.

Head Five component

The Head Five component of the compensation payment will be paid as a refund of the legal, valuation and accounting fees incurred in entering the Sale Agreement and the Compensation Agreement.

Legal, valuation and accounting fees incurred are deductible where the expenses relate to the earning of assessable income.

Legal costs take their character as an outgoing of capital or revenue nature from the cause or purpose of incurring the expenditure. If the advantage to be gained is of a revenue nature, then the costs incurred in gaining the advantage will also be of a revenue nature. Similarly, if the advantage sought is capital in nature the expenses will be capital in nature. This principle can also be applied to the treatment of valuation and accounting fees.

Where a taxpayer receives a refund or compensation for an expense incurred, the amount received has the same nature as the original expense. Thus, if the expense was revenue in nature and deductible to the taxpayer, the refund will be revenue in nature and may be treated as an assessable recoupment under section 20-20 of the ITAA 1997.

In your situation, you incurred legal, valuation and accounting fees in relation to the Sale Agreement and Compensation Agreement. The amounts you received under the Agreements are capital in nature and therefore the fees incurred are also capital in nature.

The Head Five component represents a refund of the legal, accounting and valuation expenses incurred in negotiating the two Agreements. Therefore, as those expenses are capital in nature, the refund is also capital in nature.

Section 112-30 of the ITAA 1997 states that

If you acquire a CGT asset because of a transaction and only part of the expenditure you incurred under the transaction relates to the acquisition of the asset, the first element of your cost base and reduced cost base of the asset is that part of the expenditure that is reasonably attributable to the acquisition of the asset.

Similarly, where you incur expenditure and only part of it relates to another element of the cost base or reduced cost base of a CGT asset, that element includes that part of the expenditure that is reasonably attributable to that element.

In this case the legal, accounting and valuation expenses were incurred in relation to multiple assets. Therefore, the expenses should be apportioned between the assets on a reasonable basis. It follows that the Head Five component should be apportioned between the assets on a reasonable basis and treated accordingly.

CGT general discount

Under section 115-5 of the ITAA 1997 you make a discount capital gain if the following requirements are satisfied:

• you are an individual, a trust or a complying superannuation entity

• a CGT event happens to an asset you own

• the CGT event happened after 11.45am (by legal time in the ACT) on 21 September 1999

• you acquired the asset at least 12 months before the CGT event, and

• you did not choose to use the indexation method.

Under the discount method you reduce your capital gain by the discount percentage. For individuals, the discount percentage is 50%. However, you can reduce the capital gain only after you have applied all the capital losses for the year and any unapplied net capital losses from earlier years.

The discount capital gain is included in your assessable income and taxed at the marginal rate applicable to that income for that year.

However, the following CGT events do not qualify for the CGT discount: D1 to D3, E9, F1, F2, F5, H2, J2, J5, J6 and K10.

The compensation payment in relation to the Head One component will not directly result in a capital gain in the year it is received as it acts as a recoupment of Lot 2's acquisition cost.

The compensation payment in relation to the Head Two and Head Three components are included in the capital proceeds from the sale of Lot 1. If the disposal of post-CGT interests in Lot 3 results in a capital gain, this gain can be discounted as you owned Lot 1 for more than 12 months.

The Head Four component of the compensation payment may result in a capital gain however as it is a CGT event D1 the gain cannot be discounted.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).