Edited version of private advice

Authorisation Number: 1051520296607

Date of advice: 31 May 2019

Ruling

Subject: Compensation

Question 1

Will the portion of the compensation received for the compulsory acquisition of part of your property be regarded as capital proceeds for your capital gains tax (CGT) event A1 under the CGT provisions?

Answer

Yes.

Question 2

Will the portion of the compensation received for permanent damage to the property reduce the cost base of the property for any future capital gain?

Answer

Yes.

Question 3

Will compensation received for temporary disturbances of the business carried out on the property be assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) or be an assessable recoupment under section 20-20 of the ITAA 1997?

Answer

Yes.

Question 4

In determining the portion of the compensation receipt that is the capital proceeds under section 116-20 of the ITAA 1997 for the compulsorily acquired land, is a value per hectare basis considered to be reasonable?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2018

Year ending 30 June 2019

Year ending 30 June 2020

The scheme commenced on

1 July 2017

Relevant facts

You have an interest in a large property.

You purchased the property several years ago.

You use the property to operate a business.

A portion of the property was resumed (resumed land).

The resumed land is a strip of land which divides the property into two sections.

You entered into agreements in relation to the resumption.

A valuation report assessed the market value of the property prior to the resumption.

According to the valuation report, the disturbance amount relates to potential additional business expenses that may be incurred during a period where construction is undertaken on the resumed land.

You have received compensation in the 2018-19 income year in relation to the above.

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 10-5

Income Tax Assessment Act 1997 Subdivision 20-A

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 110-40

Income Tax Assessment Act 1997 section 110-45

Income Tax Assessment Act 1997 subsection 116-20

Reasons for decision

Ordinary income

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes the ordinary income derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

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, are expected, are relied upon, and have an element of periodicity, recurrence or regularity.

For income tax purposes, an amount paid to compensate for a loss generally acquires the character of that for which it is substituted (Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 AITR 443; 10 ATD 82). Compensation payments which substitute income have been held by the courts to be income under ordinary concepts (Federal Commissioner of Taxation v. Inkster (1989) 24 FCR 53; (1989) 20 ATR 1516; 89 ATC 5142, Tinkler v. FC of T (1979) 10 ATR 411; 79 ATC 4641, and Case Y47 (1991) 22 ATR 3422; 91 ATC 433).

On the other hand, if the compensation is paid for the loss of a capital asset or amount then it will be regarded as a capital receipt and not ordinary income.

Statutory income

Statutory income is not ordinary income, but is included in assessable income by specific provisions of the income tax law (section 6-10 of the ITAA 1997).

These specific provisions are listed in section 10-5 of the ITAA 1997 and include capital gains, which are included in assessable income by virtue of the capital gains tax (CGT) provisions. These provisions also include Subdivision 20-A of the ITAA 1997 which deals with assessable recoupments.

Whether or not a particular receipt is ordinary income or statutory income depends on its character in the hands of the recipient. For income tax purposes, a compensation amount generally bears the character of that which it is paid to replace.

Compensation

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts considers the CGT consequences for compensation payments. Why the payment was made is an important factor in determining whether an asset has been disposed of for capital gains tax purposes.

TR 95/35 discusses the various scenarios, including:

·  disposal of the underlying asset,

·  compensation for permanent damage to, or permanent reduction in value of, the underlying asset, and

·  disposal of the right to seek compensation.

As outlined in the ruling, the Commissioner adopts an ''underlying asset'' approach to determine the asset to which the compensation amount is most directly related. In concluding that the underlying asset is the most relevant asset to which an amount of compensation relates, a person must be able to show that the compensation receipt has a direct and substantial link with the underlying asset. If an asset has not been disposed of and has not been permanently damaged or permanently reduced in value by the happening or event which generated the amount of compensation, the taxpayer is not able to demonstrate that link. It follows that the compensation cannot be directly related to that asset. In those cases, the most relevant asset may be the right to seek compensation, or the notional asset.

If the compensation receipt relates to more than one asset, the compensation needs to be apportioned between those assets. Similarly, if the amount is received for a number of heads of claim (for example, lost profits, interest and punitive damages), the amount also needs to be apportioned between the items.

In your case, the compensation payment has various components. It is not regarded as an undissected lump sum and therefore it is necessary to examine each component separately. Furthermore, the resumption amount covers various impacts and has more than one component.

Compensation for the disposal of an underlying asset

The compensation payment you received for the disposal of part of your property is not earned by you as it does not relate to services performed or from carrying on a business. Although the compensation relates to your property, the payment is not akin to rent. Rather the compensation is being received for the part disposal of your property.

Although the payment can be said to be expected, and perhaps relied upon, this expectation does not arise from any personal services performed or business activity. The compensation payment relates to the compulsory acquisition of part of your property and is capital in nature. Accordingly, it is not regarded as ordinary income and is therefore not assessable under subsection 6-5(2) of the ITAA 1997.

In your case, there has been a compulsory acquisition of part of your land. The transactions which generated your compensation payment are the actions of entity A. The underlying asset in your case is the property that has been partly resumed. Such compensation, received in respect of the part disposal, is capital in nature.

Section 102-20 of the ITAA 1997 states that a capital gain or capital loss is made only if a capital gains tax (CGT) event happens to a CGT asset. The property is a CGT asset (section 108-5 of the ITAA 1997).

The most common event is CGT event A1. Under section 104-10 of the ITAA 1997 CGT event A1 happens if you dispose of a CGT asset. You dispose of an asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law.

If an amount of compensation is received in respect of the disposal of an underlying asset, or part of an underlying asset, the compensation represents consideration received on the disposal of that asset. Where the underlying asset was acquired on or after 20 September 1985, a capital gain or loss may arise on the disposal (paragraphs 4 and 5 of TR 93/35).

Therefore the compensation received in relation to the disposal of part of your property is regarded as capital proceeds under the CGT provisions. That is the relevant portion of the amount is regarded as capital proceeds for your part disposal of land.

Where an asset was acquired from you by an entity under a power of compulsory acquisition conferred by an Australian law or foreign law, the time of the event is the earliest of:

·  when you received compensation from the entity; or

·  when the entity became the asset's owner; or

·  when the entity entered it under that power; or

·  when the entity took possession under that power (subsection 104-10(6) of the ITAA 1997).

Compensation for damage to property

Paragraph 3 of TR 95/35 states that permanent damage or reduction in value does not mean everlasting damage or reduced value, but refers to damage or a reduction in value which will have permanent effect unless some action is taken by the taxpayer to put it right.

If an amount of compensation is received wholly in respect of permanent damage suffered to a post-CGT underlying asset or for a permanent reduction in the value of a 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 (paragraph 6 of TR 95/35).

Accordingly, the total acquisition costs of the asset should be reduced by the amount of the compensation received for the damage to the property. No capital gain or loss arises in respect of that asset until you actually dispose 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 your case, the remaining portion of your property has not been disposed of, however the property will suffer permanent damage or permanent reduction in the value of the property. You will receive compensation in respect of the impact of the activities on your property. The relevant compensation amount to be paid is viewed as having a direct and substantial link or nexus with the property.

Such compensation relates to the damage to your property and is capital in nature. Accordingly, it is not regarded as ordinary income and is therefore not assessable under subsection 6-5(2) of the ITAA 1997.

As you have not disposed of the remainder of your property, there is no CGT event on receiving this portion of the associated compensation payment.

However, the property's acquisition cost will be reduced by the relevant compensation payment (excluding reimbursements) 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 the property is sold.

Subsections 110-40(3) and 110-45(3) of the ITAA 1997 provide that expenditure does not form part of any element of the cost base to the extent of any amount you have received as recoupment of it, except so far as the amount is included in your assessable income.

Compensation for disturbances

Compensation payments which are a substitute for income are themselves ordinary income. This is so even if the compensation is received as a lump sum.

Payments for loss of profits due to interruptions to business operations or other income support is regarded as ordinary income under section 6-5 of the ITAA 1997.

In your case you are receiving a disturbance amount. The disturbance allowance is provided for additional business expenses during the project.

As this compensation is paid to you for the temporary disturbances and consequential business losses, the amounts received are assessable under section 6-5 of the ITAA 1997.

Please note that where you have received an amount as recoupment of a deductible loss or outgoing, the amount is generally an assessable recoupment under subdivision 20-A of the ITAA 1997. Therefore, even if the compensation for disturbances was not assessable as ordinary income, when you incur the additional business expenditure, the compensation for this expenditure would become an assessable recoupment.

Apportionment

Under section 116-20 of the ITAA 1997, the capital proceeds from a CGT event includes the money you have received or are entitled to receive in respect of the event happening.

As your compensation relates partly for the part disposal and partly for the damage to the property, so much of the compensation that is reasonably attributed to the part disposal of the asset shall be taken to be capital proceeds for the CGT event A1. That is, you need to apportion the compensation using a reasonable basis.

Apportionment is a question of fact and involves a determination of the proportion of the compensation that is attributable to the part disposal and other components. The Commissioner believes that the method of apportionment must be fair and reasonable in all the circumstances.

In your case it is considered that a reasonable way to apportion your compensation for the disposal of part of your land is based on the value per hectare of land.

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