Edited version of private advice

Authorisation Number: 1051532595844

Date of advice: 2 August 2019

Ruling

Subject: Income tax - compensation payments

Question 1

Do the compensation amounts received by the Occupier of Property Two under the 'Conduct and Compensation Agreement' (Property A's CCA) for the placement of the mining infrastructure on the land leased from a local authority constitute assessable income in accordance with section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Will the one off agreement completion payment received from a mining entity be characterised as compensation under the conduct and compensation agreements (CCAs)?

Answer

Yes

Question 3

Will the compensation received under the CCA for permanent damage to Property One (P1) be treated as assessable income under section 6-5 of the ITAA 1997?

Answer

No

Question 4

Will the compensation received under the CCA for permanent damage to P1 be treated as capital proceeds from any capital gains tax event under Part 3-1 of the ITAA 1997?

Answer

No

Question 5

Will the compensation received under the conduct and compensation agreement for permanent damage to P1 reduce the cost base of the relevant property for any future capital gain under section 110-40 or section 110-45 of the ITAA 1997?

Answer

Yes

Question 6

Will the payments for the sale of gravel form part of your assessable income under section 6-5 of the ITAA 1997?

Answer

Not applicable as you are not the entity that owns Property 3 from where the gravel will be extracted.

Question 7

Will payments received by you for water taken from P1 be assessable as ordinary income under section 6-5 of the ITAA 1997?

Answer

No as the payments are assessable as a royalty under section 15-20 of the ITAA 1997.

This ruling applies for the following periods:

Year ended 30 June 2019

Year ending 30 June 2020

Year ending 30 June 2021

Year ending 30 June 2022

Year ending 30 June 2023

Year ending 30 June 2024

Year ending 30 June 2025

Year ending 30 June 2026

Year ending 30 June 2027

Year ending 30 June 2028

The scheme commences on:

1 July 2018

Relevant facts and circumstances

A few years ago you purchased P1.

P1 has a number of water bores and dams located on the property.

You carry on a primary production business.

Your shareholders are Persons A and B.

You carry on other business activities and employ Persons A and C.

A local authority owns Property Two (P2).

You and a local authority entered into a lease arrangement in respect of P2.

Under the lease arrangement you acquired the rights to use XX hectares of pasture land and a water reserve that adjoins P1.

You pay a lease payment to the local authority to lease P2.

You carry on a business of primary production on P1 and P2.

You also pay an amount of income for leasing Property 3 which is owned by Persons A and B.

Persons A and B are partners in a partnership.

Persons A and B were offered a one off payment in respect of negotiation undertaken in respect to the conduct and compensation agreements (CCAs).

You entered into CCAs with a mining entity.

P1 CAA

The scope of the P1 CCA consists of the following agreements:

·        The CAA

·        Terms and Conditions

·        The Rules and Conduct

The P1 CCA relevantly provides the following:

·        You are the Landholder.

·        The mining entity holds a resource authority in the form of Petroleum Lease which covers P1 and P2.

·        The CCA is a conduct and compensation agreement made under a number of State mining provisions. The CCA stipulates compensation amounts to the landholders for the impact of all continuing activities and proposed impacts which include the proposed placement of XX individual wells and only one well will be constructed on each pad located on the P1.

·        Construction of a number of temporary work areas.

·        The construction and maintaining of access roads.

·        The upgrade of existing access roads.

·        The construction of an infrastructure right of way XX to XX metre wide to a distance of XX.X kilometres

·        Construction of underground linear infrastructure buried at a depth on XXX mm within XX to XX meter right of way area.

·        The compensation amounts to be paid are set out in the P1 CCA. These compensation amounts relate to the impacts of constructing infrastructure, testing, operating, maintenance ongoing operations, noise, decommissioning and rehabilitation on the P1. The P1 CCA provides that mining entity will pay the following compensation to the landholder or P1:

·        The mining entity proposes to make resource payments to the Landholders for water sourced at a number of locations on the property at a rate of X.XX per litre.

·        The mining entity proposes to make resource payments to the Landholder for gravel sourced from the Property 3 at a rate of $X per cubic metre.

Extraction of Gravel

The gravel resource on Property 3 will be extracted and stockpiled and prepared for sale by the Persons A and B the owners of Property 3 using equipment owned by Person C or seek to hire equipment to extract the gravel. It is expected that the mining entity or one of its contractors will then take away the prepared gravel to use in constructing the tracks and roads on the Properties 1, 2 and 3.

The extract process of removing and selling the gravel may potentially take a number of years or r longer depending of further mining activities on the Properties 1 and 2.

P2 CCA

The scope of the P2 CCA consists of the following agreements:

·        The P2 CCA

·        The reference schedule Terms and Conditions

·        Annexure A and B

The P2 CCA relevantly provides the following:

·        You are the Occupier of the Land.

·        The mining entity holds a resource authority in the form of a lease which covers the P2.

·        The CCA is a conduct and compensation agreement made under a number of State mining provisions. The CCA stipulates compensation amounts to the landholders for the impact of all continuing activities and proposed impacts which include:

·        The upgrade of an access road.

·        Construction of underground linear infrastructure such as gas and water pipelines, electrical power lines and optic fibre cable buried at a depth on XXX mm within XX to XX meters right of way area up to X.X kilometres.

·        Construction of a number vents and drains

·        The compensation amounts to be paid are set out in the P2 CCA. These compensation amounts relate to the impacts of constructing infrastructure, testing, operating, maintenance ongoing operations, decommissioning and rehabilitation on P2. The P2 CCA provides that the mining entity will pay the following compensation to the Occupier of P2:

Your agent has provided a summary of the different categories of land that may be identified as resulting from CSG activity owned by Landholder.

The following is a summary of the different categories of land that may be identified as resulting from CSG activity on the improved farmland/pasturage owned by the landholders.

Other factors

The CCAs negotiations took into account the negative stigma of having mining activity on the land which includes the concept of blight on the land where the land has an unwelcome attribute and depresses the overall value of the property. The impact of the blight on the land will include the diminution in the long-term market value of the land as a result of having industrial activities on the land. This negative stigma is particularly concerning in the context of potential consumers of) the high quality beef produced by the farm, where such consumers may have diminished demand for product produced in an industrial environment.

The Landholder advise that the presence of the mining will affect travelling within the property and visit to neighbouring properties resulting in extended time frames to undertake common pastoral and farming activities including the management and movement of livestock and undertaking common farming tasks. Further, presence of the mining will impact and will continue to impact the existing quality of life, lifestyle, quiet enjoyment or amenity for the human inhabitants on the property. The visual impact of viewing the wells and other infrastructure will be ever present.

Further the Landholder has advised that further restriction that the activity has on the land includes the potential limitations on the nature and range of agricultural enterprises that may be carried on the land. This may impact any potential future buyers of the property. In addition, bio-security control for the livestock maybe affected due to the high volume of traffic that comes and goes from the property.

Due to the demand from the mining industry for goods and services in the area this has resulted in an increase in costs associated with purchasing, maintaining and repairing equipment, and engaging contractors which has an effect on the potential net income of the Landholder.

The noise during the construction of the wells and associated infrastructure is expected to be significant and there will be ongoing noise emitting from the individual wells during the extraction of water and gas and the subsequent compression of gas. The negotiations for the CCA included recognition of the significant construction and operational noise impact on the Landowners and their acquiescence of the higher levels of noise resulting in the diminution in the value of the land.

Further as part of the negotiations the Landholder engaged a land valuer who estimated there would be a reduction in the value of the property as a result of the placement of infrastructure on the land. The compensation that is likely to be paid in accordance with the CCA over the lifetime of the CCA is less than the current market value of the land.

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 15-20

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 subsection 108-5(1)

Income Tax Assessment Act 1997 section 110-45

Income Tax Assessment Act 1997 subsection 110-45(3)

Income Tax Assessment Act 1997 subsection 116-20(1)

Reasons for decision

P2 CCA

Subsection 6-5(2) of the 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.

The courts have identified a number of factors which indicate whether an amount has the character of income. A frequent characteristic of income receipts is an element of periodicity, recurrence or regularity. However, these characteristics are not always essential as in some circumstances proceeds from an isolated transaction received as a lump sum may also be income

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.

In this case, You, as the Occupier of the land have entered into an agreement or transaction that is not solely or directly in relation to diminution of the P2. Specifically, you entered into an agreement to allow the mining entity access to the use of part of the P2 land which is leased from a local authority to construct a right of way access through the land. The payments received are akin to rent or lease payments for the use of the part of the land and are ordinary income. Accordingly, the payments are assessable under subsection 6-5 of the ITAA 1997.

Further, as P2 is owned by a local authority the compensation payments made to you under the P2 CCA do not represent permanent damage to, or a permanent reduction in the value of, land leased by you. Therefore, the applications of the rules set out in TR 95/35 are not applicable.

P1 CCA

Section 6-5 of the 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 or damage to 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 Income tax: whether profits on isolated transactions are income).

In this case, neither of the above elements applies to You as the owner of the P1. The compensation payments are made in accordance with the legislative provisions of the Petroleum Legislation.

Accordingly, the compensation payments paid under the P1 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. As such, these payments are not assessable income under section 6-5 of the ITAA 1997.

Capital proceeds in respect of a CGT event happening.

Under subsection 116-20(1) of the ITAA 1997, money you have received (or are entitled to receive) and the market value of any property you have received (or are entitled to receive) are the capital proceeds from a CGT event.

For the compensation payments under an agreement to constitute capital proceeds, there must be a CGT event.

CGT events occur in respect of CGT assets. The definition of a CGT asset is contained in subsection 108-5(1) of the ITAA 1997. It provides that a CGT asset is any kind of property or a legal or equitable right that is not property. Not all things often referred to as 'rights' will be assets for CGT purposes. To be an asset, a right must be recognised and protected by law.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts provides the Commissioner's view as to the CGT consequences of receiving a compensation payment and relevantly, it states that a CGT event will occur (and any consideration form part of capital proceeds) where the amount of compensation is received by the taxpayer:

·        either wholly or partly in respect of the disposal of an underlying asset (CGT event A1); or

·        not in respect of any underlying asset but in relation to the disposal of the right to seek compensation (CGT event C2).

TR 95/35 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 identified using the 'look-through approach' in order to determine the asset to which the compensation amount most directly relates. Paragraph 70 of TR 95/35 states the underlying asset is identified by looking through to the transaction which generates the compensation receipt.

Applying the look-through approach to the facts and P1 is the asset to which the compensation under the P1 CCCA most directly relates. Therefore, P1 Land is therefore, the underlying assets and the relevant CGT assets.

As there has been no disposal of the P1 Land CGT event A1 does not occur.

Further, as the amounts are paid in respect of an underlying asset (being the P1) CGT event C2 will not happen.

As such, the compensation amounts You receive as the owner of the P1 under the P1 CCA do not constitute capital proceeds in respect of a CGT event happening.

Reduction in the cost base of the P1

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 a consequence of an eligible claimant being entitled to receive compensation for the loss and destruction of a CGT asset.

Paragraphs 6 and 7 of TR 95/35 provide that compensation received wholly in respect of permanent damage or reduction in the value of a post-CGT underlying asset that is not disposed of represents a reduction in either the CGT cost base under either subsection 110-40(3) of the ITAA 1997 (for assets acquired before 7.30pm on 13 May 1997) or subsection 110-45(3) of the ITAA 1997 (for assets acquired after 7.30pm on 13 May 1997).

Further, compensation received by a taxpayer for the disposal or permanent damage or reduction in value of an asset has no CGT consequences if the underlying asset to which it relates was acquired by the taxpayer before 20 September 1985.

For the purposes of TR 95/35, permanent damage or reduction in value does not mean everlasting damage or reduced value, but refers to damage or reduction in value that has permanent effect unless the taxpayer takes action to put it right. The activities permitted under the Santos CCA will cause such damage and a reduction in value.

Accordingly, pursuant to subsection 110-45(3) of the ITAA 1997, 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 as the land owner of P1 intends to received, and will continue to receive, compensation payments as a result of mining activities being carried out on P2. These activities have resulted in permanent damage to, or a permanent reduction in the value of, the P2.

As You did not dispose of all or part of the affected P2 there are no CGT consequences at the time of entering the P1 CCA on receiving the compensation payments.

However, the P2'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 P2 is sold.

Payments for the sale of water

Section 15-20 of the ITAA 1997 states your assessable income includes an amount that you receive as or by way of royalty if the amount is not assessable as ordinary income under section 6-5 of the ITAA 1997. Royalties are statutory income.

The Commissioner's view on the definition of a royalty is provided by Taxation Ruling IT 2660. The ordinary meaning of the term 'royalty' has been considered by the Courts on many occasions. In Stanton v. FC of T (1955) CLR 630, the High Court of Australia described the essence of a royalty and stated that:

... the modern applications of the term seem to fall under two heads, namely the payments which the grantees of monopolies such as patents and copyrights receive under licences and payments which the owner of the soil obtains in respect of the taking of some special thing forming part of it or attached to it which he suffers to be taken.

Paragraph 10 of IT 2660 provides that in the Commissioner's view there are four key characteristics of a common law royalty:

·        it is a payment made in return for the right to exercise a beneficial privilege or right, for example to remove minerals or natural resources such as timber (McCauley v. FC of T (1944) 69 CLR 235)

·        the payment is made to the person who owns the right to confer that beneficial privilege or right (Barrett v. FC of T (1968) 11 CLR 666)

·        the consideration payable is determined on the basis of the amount of use made of the right required (McCauley, Stanton), and

·        the consideration will usually be paid as and when the right acquired is exercised.

However, a lump sum payment will be a royalty where it is a pre-estimate or an after the event recognition of the amount of use made of the right acquired (IR Commissioners v. Longmans Green & Co Ltd (1932) 17 TC 272).

In this case, You have agreed to receive payments from a mining entity for the volume of water extracted from a number of dams located on P1. The amount of water taken is dependent on the available level of water in the dam which is governed by seasonal conditions. It is considered that any proceeds You receive from the sale of the water is assessable as a royalty given that the water is a natural resource that was removed from the land.

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).