Edited version of your written advice

Authorisation Number: 1013093492857

Date of advice: 19 September 2016

Ruling

Subject: CGT - compensation

Question 1

Is the compensation for all of the impacts of the activities Entity X listed under the Compensation and Conduct Agreement ('CCA') be assessable as ordinary income under subsection 6-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Will the compensation receipt reduce the cost base of the Land for any future capital gain under section 110-40 or section 110-45 of the ITAA 1997?

Answer

Yes.

Question 3

Is the one-off Commercial Agreement Payment ('CAP') assessable as ordinary income under subsection 6-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 4

Will the CAP reduce the cost base of the Land for any future capital gain under section 110-40 or section 110-45 of the ITAA 1997?

Answer

Yes.

Question 5

Is the compensation received for accounting fees relating to the CCA which have, or can be, deducted assessable?

Answer

Yes.

Question 6

Is the compensation received for non-deductible accounting fees, legal and valuation costs relating to the CCA assessable?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 2016

Year ending 30 June 2017

Year ending 30 June 2018

Year ending 30 June 2019

Year ending 30 June 2010

The scheme commences on

1 July 2015

Relevant facts and circumstances

You own Land which was acquired after 20 September 1985.

You have entered into a CCA with Entity X.

Under the CCA, Entity X and related parties will carry out activities on your land and you will be compensated effects of these activities.

By signing the CCA, you have acknowledged that the compensation:

• compensates for all of the activities including the loss of use of part of the land, all impacts of noise, light, dust, odour, vibration, vehicular movements and loss of amenity generally, and

• is in full and final satisfaction of the liability to pay compensation.

You will receive the following compensation under the CCA:

• an upfront payment

• annual payments on the anniversaries of the agreement date

• reimbursement for legal and accounting costs reasonably and necessarily incurred by you in respect of the negotiation of the CCA.

The CCA was negotiated in accordance with the relevant legislation.

You also received a one-off commercial agreement payment (CAP) which recognises the efforts spent by landowners in negotiating a CCA in an efficient and timely manner. The CAP is separate from and in addition to your compensation payment. A letter from Entity X, states the CAP payment is not compensation and Entity X is not obligated to make the CAP offer to you.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Paragraph 20-20(3)

Income Tax Assessment Act 1997 Section 20-30

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Subsection 110-55(6)

Reasons for decision

Summary

The compensation payments you have received and will continue to receive under the CCA, as well as the CAP, are considered to be compensation for the permanent damage to, or reduction in value of, the Land. The total acquisition costs of the property are to be reduced by the value of the compensation received.

Compensation received for that portion of the accounting fees for which you deducted, or could claim a deduction for, in the current or earlier income year will be an assessable recoupment and is required to be included in your assessable income in the year in which it is received.

Detailed reasoning

Compensation payments under the CCA

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 petroleum authority undertaking petroleum activities on a taxpayer's land 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 applies in your situation. The compensation payments were made in accordance to the legislative provisions of the petroleum legislation.

Accordingly, the compensation payments paid under the CCA 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

Under section 6-10 of the ITAA 1997 some amounts that are not 'ordinary income' are included in a taxpayer's assessable income due to another provision of the tax law. These amounts are 'statutory income'. Statutory income may arise from CGT events as consequence of an eligible claimant being entitled to receive compensation and the loss and destruction of a CGT asset.

Taxation Ruling TR 95/35 provides the Commissioner's view as to the CGT consequences of receiving a compensation payment. The ruling states that it is necessary to identify the underlying asset to which the payment relates and what has occurred to that asset.

The underlying asset is 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 leads directly to the payment of the amount of compensation. For example, if a taxpayer receives an amount of compensation for the destruction of his or her truck, the truck is the underlying asset.

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

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 that 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 of the compensation. No capital gain or loss arises in respect of that asset until the taxpayer actually disposes of the underlying asset. If 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.

In this case you have received, and will continue to receive, compensation payments as a result of activities being carried out on your property. These activities have resulted in the permanent damage to, or permanent reduction in the value of, the property.

As you did not dispose of all or part of the affected property there are no CGT consequences at the time of entering the CCA or receiving the compensation payments.

However, the property's acquisition cost will be reduced by the compensation payments received in relation to that property. That is, the cost base of the property will be reduced by the value of the payments and any gain or loss will crystallise at a later time when each property is sold.

Treatment of CAP

Payment as ordinary income

As stated above, a payment will be assessable where it is considered to be ordinary income. Ordinary income has generally been held to include three categories, namely income from rendering personal services, income from property and income from carrying on a business.

Other characteristics of income that have evolved from case law include receipts that are earned, expected, relied upon and have an element of periodicity, recurrence or regularity.

In your situation, you have received a one-off CAP for entering into the CCA. This payment was in addition to the compensation payments described in the CCA.

The payment does not have the characteristics of ordinary income as it has not been earned, could not be said to be relied upon and does not relate to your business activities. Any expectation of receiving the payment would be related to the CCA negotiation process.

Accordingly, the agreement completion compensation payment is not assessable as ordinary income.

Payment in relation to the CGT provisions

Notwithstanding the CAP is paid separately from the CCA and is not described by Entity X as compensation, it can still meet this definition of a compensation receipt. Considering the totality of the relationship between the parties, the CAP is part of the overall deal that the landowner agrees to. The CAP, along with the amounts payable under the CCA, all form part of the compensation received by the landowner. The CAP is part of what results or "moves" the landowner to agree to the CCA.

In your hands, the agreement completion compensation and the compensation payable under the CCA comprise in essence one sum of money in return for agreeing to the conditions set out in the CCA.

It is considered that the agreement completion compensation has been paid to compensate you for the permanent damage to, or permanent reduction in value of, your property. Accordingly, the amount of the payment reduces the cost base of the property and any gain or loss will crystallise at a later time when the property is sold or disposed of.

Compensation for accounting, legal and valuation fees relating to the CCA

Subsection 20-20(3) of the ITAA 1997 provides that an amount you have received as a recoupment of a loss of outgoing is an assessable recoupment if:

• you can deduct an amount for the loss or outgoing in the current year, or

• you have deducted or can deduct an amount for the loss or outgoing for an earlier income year

under a provision listed in section 20-30 of the ITAA 1997.

To determine if the compensation for the accounting, legal and valuation fees is an assessable recoupment, we must first determine if those fees are deductible and under what provisions.

Deductibility of accounting, legal and valuation fees

Section 8-1 of the Income Tax Assessment Act 1997 (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 or a provision of the taxation legislation excludes it.

Section 25-5 of the ITAA 1997 allows a deduction for expenditure you incur to the extent that it is for:

• managing your tax affairs

• complying with an obligation imposed on you by a Commonwealth law, insofar as that obligation relates to the tax affairs of an entity

• the general interest charge or shortfall interest charge

• a penalty under Subdivision 162-D of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act) which relates to situations where a taxpayer varies their instalment rate too low, or

• obtaining a valuation in accordance with section 30-212 (gifts of properties to deductible gift recipients) or 31-15 (entering into conservation covenants).

Accountancy fees which relate to your tax affairs are an allowable deduction. Where the services to which the fees relate go beyond managing your tax affairs, you must apportion the fees between the various purposes and only those services that directly relate to your tax affairs are deductible (Bartlett v FC of T; Falcetta v FC of T 2003 ATC 4962; [2003] FCA 1125)

Legal fees will be deductible where the nature or character of the legal expenses follows the advantage which is sought to be gained by incurring the expenses (Hallstroms Pty Ltd v FC of T [1946] HCA 34; (1946) 72 CLR 634) (Hallstroms).

Hallstroms case involved a company incurring legal expenses in opposing the extension of a patent for a particular type of refrigerator which the taxpayer wished to manufacture and sell once the patent expired. The High Court found that the expenses met the positive limbs of section 8-1 of the ITAA 1997 and were not of a capital nature. The majority found that the advantage sought by the legal expenditure was a company that already manufactures refrigerators was able to manufacture a new model of refrigerator and did not result in any alteration of the structure of its business.

In your case, you have incurred legal and valuation expenses for the purpose of negotiating the CCA. The expenditure was not incurred for the purpose of ensuring that your current income earning activities were not diminished. But for the CCA being negotiated, none of the expenses would have been incurred.

The legal and valuation expenses are considered to be capital in nature and are not deductible expenses.

Assessability of accounting, legal and valuation fees

As discussed above, only those accounting fees which relate to managing your tax affairs are deductible. Section 20-30 of the ITAA 1997 includes tax-related expenses deductible under section 25-5 as assessable recoupments.

A reimbursement of accounting fees for which you deducted, or could claim a deduction for, in the current or earlier income year, will be an assessable recoupment and is required to be included in your assessable income in the year in which it is received.

A reimbursement of accounting, legal and valuation fees for which you could not claim a deduction for in the current or an earlier income year will not be an assessable recoupment or ordinary income. They are not required to be included in your assessable income in any year.

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