Edited version of private advice

Authorisation Number: 1051641949998

Date of advice: 23 June 2020

Ruling

Subject: Taxation treatment of compensation

Question 1

Is the one-off commercial payment characterised as compensation under the relevant agreements?

Answer

Yes.

Question 2

Are the compensation amounts received for the Alternative Arrangement and Additional Disturbance included in your assessable income?

Answer

No.

Question 3

Is the compensation received under the conduct and compensation agreement (CCA) for permanent damage to the Land assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 4

Is the compensation received under the CCA for permanent damage to the Land treated as capital proceeds under Division 116 of the ITAA 1997 from any capital gains tax (CGT) event in Division 104 of the ITAA 1997?

Answer

No.

Question 5

Does the compensation received under the CCA for permanent damage to the Land 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 6

Are you entitled to a deduction for the accounting fees?

Answer

Yes.

Question 7

Are you entitled to a deduction for legal, valuation and similar professional fees?

Answer

No.

Question 8

Are the amounts received as reimbursement of deductible accounting fees included in your assessable income?

Answer

Yes.

Question 9

Are the amounts received as reimbursement of non-deductible accounting, legal, valuation and similar professional fees included in your assessable income?

Answer

No.

Question 10

Are the amounts received for the sale of water and gravel included in your assessable income?

Answer

Yes.

Question 11

Does GST apply to the compensation receipts?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 20XX to 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

You purchased a property (Land).

You reside on the Land.

You entered into a Conduct and Compensation Agreement (CCA) with ABC for the construction of coal seam gas wells on your Land.

The petroleum activities to be undertaken by ABC outlined in the CCA include the following:

Construction:

·         Pre-construction preparation and investigation activities

·         Preparation of construction sites

·         Preparation of well pad areas

·         Drilling of wells identified as production wells

·         An agreement not to move a well from the current location to be within a closer proximity to the Landholder's primary residence on the Land

·         Installation of associated well infrastructure within the well pad area

·         Construction of underground linear infrastructure

·         Construction of incidental infrastructure

·         Construction of access roads including the installation of gates or grids as required

·         Upgrade of access roads, construction of access roads including the installation of gates or grids as required.

Ongoing Operations:

·         Operating, monitoring and maintaining the Wells within a fenced well pad area

·         Operation and use of associated well infrastructure within the well pad area

·         Use of maintenance rigs as required

·         Monitoring Wells, underground linear infrastructure and associated infrastructure such as high point vents and low point drains with unmanned aerial vehicles (UAVs)

·         Surface activities and disturbance associated with any workover rig if there is a requirement to improve the productivity of a Well

·         Surface activities and disturbance associated with any fracture stimulation of the Wells

·         Operating, monitoring and maintaining the underground linear infrastructure and associated infrastructure limited to low point drains and high point vents

·         Use and maintenance of roads and tracks and associated infrastructure such as gates on the Land, as reasonably necessary

·         Access for operation, monitoring and maintenance of any reasonably necessary or incidental activity not specifically listed in the Petroleum Activities

·         Installing, using, accessing, relocating and maintaining the Infrastructure

·         Rehabilitation activities required post construction of the Infrastructure

·         Rehabilitation activities associated with the decommissioning of the Infrastructure.

You will receive the following payments to compensate you for the compensatable effects of having the coal seam gas wells constructed on your land.

Type Amount

Pre-construction compensation: $X Payable within XX business days of agreement execution date.

Construction compensation: $X One off payment, payable within XX business days of issuing a construction notice or construction compensation payment.

Annual compensation: $X Payable each year after the construction period until the Petroleum Activities have ceased and the land has been rehabilitated.

Other compensation: $X for the legal, accounting, valuation and agronomist costs incurred in relation to the negotiation and preparation costs of the agreement.

In addition, ABC agreed to pay you a one-off commercial payment if you signed the CCA on or before a certain date.

The CCA provides that water is available to be used by ABC. All water used will be compensated at a rate of $X per litre. You are to be contacted prior to accessing water. Water availability is dependent on weather conditions at the time and may only be sourced from the land for the purpose of carrying out the Petroleum Activities on the land. Water may be sourced from the Land for use on other properties, subject to the availability and suitability for use having regards to water quality and your consent.

The CCA also provides that where lawful to do so, gravel is available under the following arrangements:

·         Stockpile gravel is available and will be compensated at a rate of $X per cubic metre

·         Un-stockpiled gravel is available and will be compensated at a rate of $X per cubic meter.

·         You are to be contacted prior to accessing gravel.

·         Gravel to be used on the land must be sourced from the Land subject to quality and availability. No external gravel is permitted to be used on the land, unless otherwise agreed in writing.

·         Gravel may be sourced from the land for use on other properties.

You have received tax advice from accountants in relation to the CCA including:

·         Review of terms of the CCA

·         Give consideration to all other compensable effects of the agreement and any Capital Gains Tax, GST or income tax obligations

·         Preparation and provision of written advice

You incurred legal fees, valuations and similar professional fees. The fees were incurred for the purpose of negotiating the agreement, not ensuring that the current income structure of the business was not diminished.

With regards to GST, the CCA provides the following:

GST

Amounts shown in this agreement do not include GST.

If a supplier is or becomes liable to pay GST in connection with a taxable supply made under this agreement, then the recipient must pay an additional amount to the supplier equal to the GST payable within 14 days of the recipient receiving a tax invoice from the supplier for that supply.

If the GST payable in relation to the supply made under or in connection with this agreement varies from the additional amount paid or payable by the recipient under clause XX or as part of GST inclusive consideration, whether as a result of an adjustment event or otherwise, the supplier must provide a corresponding refund or credit to, or will be entitled to receive the amount of that variation from, the recipient.

If an adjustment event occurs in relation to a supply, the supplier must issue an adjustment note to the recipient in relation to that supply within 14 days after becoming aware of the adjustment.

Where a party reimburses the other party for an expense or other amount incurred in connection with any wholly or partly creditable acquisition or any wholly or partly creditable importation made by the other party, the amount reimbursed shall be net of any input tax credit claimable in respect of that acquisition or importation (as the case may be).

Your personal residence is located on the land in a location which will be affected by the noise and traffic of the CSG activities and for these reasons you negotiated an Alternative Arrangement and Additional Disturbance compensation with ABC. The Alternative Arrangement and Additional Disturbance compensation was to compensate for the impacts on the personal use and enjoyment of the principle place of residence and personal displacement generally.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 104

Income Tax Assessment Act 1997 Division 116

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 15-20

Income Tax Assessment Act 1997 section 25-5

Income Tax Assessment Act 1997 section 20-30

Income Tax Assessment Act 1997 section 110-40

Income Tax Assessment Act 1997 paragraph 118-37(1)(b)

A New Tax System (Goods and Services Tax) Act 1999 section 9-5

A New Tax System (Goods and Services Tax) Act 1999 section 9-10

A New Tax System (Goods and Services Tax) Act 1999 subsection 9-10(1)

A New Tax System (Goods and Services Tax) Act 1999 section 9-15

Reasons for decision

Question 1

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts (TR 95/35) contains a broad definition of compensation receipt:

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.

Notwithstanding the one-off commercial payment is paid separately from the CCA and is not described by ABC as compensation, it can still meet this definition of a compensation receipt. Looked at from the totality of the relationship between the parties, the one-off commercial payment is part of the overall deal that you agree to. The one-off commercial payment along with the amounts payable under the CCA all form part of the compensation received by you. The one-off commercial payment is part of what results or 'moves' you to agree to the CCA.

There will be circumstances when an inducement payment is paid because something is provided by the recipient that is additional to agreeing to the offer of compensation. For instance, Example 21 in TR 95/35 involves a situation where an inducement payment is made to expedite the process following the conclusion of an agreement relating to the amount of compensation payable. The inducement payment is treated separately to the compensation. The compensation is treated as relating to the underlying land, while the inducement payment is treated as the right to enter on the land at an earlier time than previously agreed.

Your case is however distinguishable. There is only one agreement between the parties, that being the CCA. The situation would be different if the compensation amount was determined and then during subsequent dealings the parties agreed to expedite the timing of the original agreement (as is the case with Example 21 in TR 95/35).

As such the one-off commercial payment represents compensation received.

Questions 2, 3, 4 and 5

Compensation payments as ordinary income

Section 6-5 of the ITAA 1997 provides that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources during the income year.

Compensation paid due to loss and damage of a capital asset 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

(c)   TR 92/3).

Neither of the above elements apply in your situation. You did not enter into the CCA to make a profit. Rather, you entered into the CCA in order to receive compensation for damage that will be caused by the CSG activities.

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 CGT provisions

Under section 6-10 of the ITAA 1997 some amounts that are not 'ordinary income' are included in your 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 for the loss and destruction of a CGT asset.

TR 95/35 provides 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 CGT asset, or part of an underlying 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 CGT underlying asset of the taxpayer or for a permanent reduction in the value of a 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 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.

Amounts received for the Alternative Arrangement and Additional Disturbance

The amounts received for the Alternative Arrangement and Additional Disturbance have been paid to you to compensate you for the impacts of the CSG activities on your personal use and enjoyment of the principle place of residence and your personal displacement generally.

Adopting the 'look through' approach the relevant asset to which these compensation amounts relate is your right to seek compensation and not any other underlying asset, such as the Land.

Normally, a payment for surrendering the right to seek compensation would be assessable as a capital gain; however, in this instance, the right relates to a wrong which you have suffered personally and will therefore be disregarded under paragraph 118-37(1)(b) of the ITAA 1997.

The on-off commercial payment, pre-construction, construction (excluding the Alternative Arrangement and Additional Disturbance amounts) and annual compensation

The relevant asset to which these compensation amounts relate is the Land. The CSG activities will result in permanent damage to, or a permanent reduction in the value of the Land.

As you did not dispose of all or part of the (affected) Land there are no CGT consequences at the time of entering the CCA or receiving these compensation amounts. The Land's acquisition cost will be reduced by the compensation payments received in relation to the Land. That is, the cost base of the Land will be reduced by these compensation amounts and any gain or loss will crystallise at a later time when the Land is disposed of.

Questions 6, 7, 8 and 9

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 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 accounting fees relating to the tax consequences of entering the CCA. These fees are deductible under section 25-5 of the ITAA 1997.

Additionally, 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.

Assessability of reimbursements for accounting, legal and valuation fees

As discussed above, only those accounting fees which relate to managing your tax affairs are deductible under section 25-5 of the ITAA 1997. Section 20-30 of the ITAA 1997 includes tax-related expenses deductible under section 25-5 of the ITAA 1997 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 are included in your assessable income in the year in which the reimbursement is received.

As the legal and valuation fees you incurred are not deductible, the reimbursement of these fees will not be an assessable recoupment or ordinary income. As such, their reimbursement is not included in your assessable income.

Question 10

You may receive payments for the volume of water and gravel taken from the Land. It is considered that any amounts you receive from the sale of gravel and water is ordinary income under section 6-5 of the ITAA 1997. If the amounts are not ordinary income, they are assessable as royalties under section 15-20 of the ITAA 1997 as the gravel and water are natural resources that will be from the Land.

Question 11

GST is payable on taxable supplies and the supplier must pay the GST payable on any taxable supplies that it makes. For the receipt of compensation amounts to give rise to a GST liability there has to be a taxable supply made.

Section 9-5 of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act) provides that an entity makes a taxable supply if, amongst other requirements, the entity makes the supply for consideration.

The existence of a 'supply' itself is an essential element in determining whether there is a taxable supply under section 9-5 of the GST Act.

Supply

'Supply' is defined in subsection 9-10(1) of the GST Act as 'any form of supply whatsoever'. The statutory definition of 'supply' is very broad. Essentially, a supply is something which passes from one entity to another, and may be one of goods, services or something else.

Consideration

Section 9-15 of the GST Act provides that a payment will be consideration for a supply if the payment is 'in connection with' a supply and 'in response to' or 'for the inducement' of a supply. Thus, there must be a sufficient nexus between a particular supply and a particular payment, which is provided for that supply, for there to be a supply for consideration.

Sufficient nexus

A sufficient nexus between the compensation amounts and a supply must exist to create the 'supply for consideration' relationship.

The issue is whether the landholders have provided something to ABC, in return for the compensation amounts that are paid to them.

In regards to the landholders giving up their rights for further compensation upon commencing the agreement (clause 13 of the CCA), this raises the issue of whether giving up of a landholder's rights would be a separate supply or as termed in Goods and Services Tax Ruling 2001/4: Goods and Services Tax: GST consequences of court orders and out-of-court settlements (GSTR 2001/4) a 'discontinuance supply'. Paragraphs 106 to 109 in GSTR 2001/4 discuss discontinuance supplies as follows:

106. Where the only supply in relation to an out-of-court settlement is a 'discontinuance' supply, it will typically be because the subject of the dispute is a damages claim. In such a case, the payment under the settlement would be in respect of that claim and not have a sufficient nexus with the discontinuance supply.

107. In most instances, a 'discontinuance' supply will not have a separately ascribed value and will merely be an inherent part of the legal machinery to add finality to a dispute which does not give rise to additional payment in its own right. They are in the nature of a term or condition of the settlement, rather than being the subject of the settlement.

108. We do not consider that the inclusion of a 'no liability' clause in a settlement deed alters this position. 'No liability' clauses are commonly included in settlement agreements and we do not consider their inclusion to alter the substance of the original dispute, or the reason payment is made.

109. We consider that a payment made under a settlement deed may have a nexus with a discontinuance supply only if there is overwhelming evidence that the claim which is the subject of the dispute is so lacking in substance that the payment could only have been made for the discontinuance supply.

In the process of ABC carrying out its Authorised Activities on the Land, significant damage and adverse effects will impact the landholders, for which ABC must compensate the landholders under the law. Upon receipt of the compensation amounts under the CCA, the landholders accept that they give up their right to pursue further compensation in relation to the Authorised Activities.

The landholders giving up their right for further compensation is not a separate supply for GST purposes. It is rather considered an inherent part of the legal machinery to bring finality to the amount of compensation that will ultimately be sought by the landholders. We do not consider that the giving up of the landholders' rights for further compensation is a separate supply from the landholders to the company since it is not the reason for which the compensation amount is paid to the landholders.

Damages

GSTR 2001/4 states the following in relation to damages, at paragraph 73:

The most common form of remedy is a claim for damages arising out of the termination or breach of a contract or for some wrong or injury suffered. This damage, loss or injury, being the substance of the dispute, cannot in itself be characterised as a supply made by the aggrieved party. This is because the damage, loss or injury in itself does not constitute a supply under section 9-10 of the GST Act.

Paragraphs 110 and 111 of GSTR 2001/4 further explain:

110. With a dispute over a damages claim, the subject of the dispute does not constitute a supply made by the aggrieved party...

111. If a payment is made under an out-of-court settlement to resolve a damages claim and there is no earlier or current supply, the payment will be treated as payment of the damages claim and will not be consideration for a supply at all, regardless of whether there is an identifiable discontinuance supply under the settlement.

Although the above explanation in GSTR 2001/4 is made in respect of court orders and out-of-court settlements, the underlying principles are equally relevant in this case.

The landholders received the amounts as a landholder under state mining legislation, as compensation for any economic loss, hardship and inconvenience as a result of Coal Seam Gas mining activities carried out on their Land by ABC.

The payment by ABC to the landholders is compensation in respect of any damage caused or likely to be caused to the Land and any inconvenience suffered by the landholders as a consequence of ABC Authorised Activities carried out on the Land.

In applying the above principles in GSTR 2001/4 to the present circumstances, we consider that, the compensation amounts are paid to the landholders to resolve a damages claim. A claim for damages (or payment that the landholders receive as a consequence of such claim) due to activities conducted by ABC on the landholders' Land, does not constitute a supply under section 9-10 of the GST Act.

The landholders do not provide ABC with any supply in return for the compensation amounts. As such, the compensation payments made by ABC is not consideration for a supply from the landholders to ABC, and accordingly no taxable supply will be made by the landholders.

Therefore, the receipt of the compensation amounts by the landholders from ABC will not give rise to a GST liability.

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