Edited version of private advice

Authorisation Number: 1051785192779

Date of advice: 27 November 2020

Ruling

Subject: Income v capital - royalty income

Question 1

Do the compensation receipts, under the Land Administration Act 1997, constitute assessable income in accordance with section 15-20 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

To the extent that the compensation receipts do not constitute income in accordance with section 6-5 of the ITAA 1997, will the receipt of these amounts be characterised as capital proceeds under Division 116 of the ITAA 1997 in respect of a CGT event happening?

Answer

Yes, but the compensation payment is assessable under section 15-20 of the ITAA 1997 so there are no amounts that are characterised as capital proceeds.

Question 3

Do the compensation receipts, under the Land Administration Act 1997, that relate to permanent damage to land and improvements constitute assessable income in accordance with section 6-5 of the ITAA 1997?

Answer

No

Question 4

To the extent that the compensation receipts do not constitute assessable income in accordance with section 6-5 of the ITAA 1997 and do not constitute capital proceeds under Division 116 of the ITAA 1997 in respect of a CGT event happening, does the compensation, to the extent that it represents compensation for permanent damage to the land and improvements on the land, reduce the cost base of the property under section 110-40 and section 110-45 of the ITAA 1997?

Answer

Yes, but none of the compensation payment is for the permanent damage to the land and improvements on the land.

This ruling applies for the following periods:

Income year ending 30 June 20ZZ

Income year ending 30 June 20ZZ

The scheme commences on:

1 July 20ZZ

Relevant facts and circumstances

You hold the land as a passive investment - you do not carry on any business.

You have an arrangement whereby:

•         XXX wishes to stockpile gravel excavated from land owned by you. Gravel stockpiling is estimated for commencement on approximately the 00/00/0000.

•         Entry to the land an removal of the materials is in accordance with the relevant Act and provides for compensation for damages to be made.

•         XXX will obtain necessary environmental and other clearances for their work and will manage the operations in accordance with relevant Acts and Regulations.

•         XXX will pay compensation for inconvenience and damage to your land based on the volume of materials removed. Payment will be $0.00 c/m3.

•         A survey of stockpile volumes will be undertaken at the completion of stockpiling operations and you will be asked to submit a tax invoice for the actual volume of material stockpiled.

•         XXX will rehabilitate the area back to pasture as agreed.

On 00/00/0000 you issued an invoice for the volume of gravel removed and you have received the payment.

Reasons for decision

Summary

The payment is assessable income under section 15-20 of the ITAA 1997. In the alternative, CGT event D1 happens in relation to the agreement for the taking of the gravel,

Detailed reasoning

Profit à prendre

The profits or gains made from the granting a right can be assessed for income tax purposes in a number ways, including:

•         as statutory income under section 6-10 of the ITAA 1997 including pursuant to the capital gains tax (CGT) provisions in Part 3-1 and 3-3 of the ITAA 1997 and section 15-20 of the ITAA 1997; or

•         as ordinary income under section 6-5 of the ITAA 1997, resulting from:

-        carrying on a business; or

-        an isolated or commercial transaction that was entered into with a profit-making intention.

Creating contractual or other rights: Capital Gains Tax (CGT) event D1

CGT event D1 (section 104-35 of the ITAA 1997) happens 'if you create a contractual right or other legal or equitable right in another entity'. The time of the CGT event D1 will be when the right is created.

You will make a capital gain if the capital proceeds from creating the right are more than the incidental costs you incurred that relate to the event. You will make a capital loss if those capital proceeds are less than those costs.

Taxation Determination TD 2018/15 Income tax: capital gains: does CGT event CGT event D1 happen if a taxpayer grants an easement, profit à prendre or licence over an asset? provides the Commissioner's view on the application of section 104-35 of the ITAA 1997 in instances where a right is granted.

The rights contemplated by CGT event D1 include a profit à prendre, which is a right to enter and remove some product or part of the soil from someone else's land.

The Commissioner has, since 21 September 1989, relied on comments made by the Full Federal Court in Gray & Anor v. FC of T (1989) 24 FCR 37; 89 ATC 4640; 20 ATR 649 to support the view that the grant of an easement or profit à prendre involves the creation of rights in another entity and does not involve the part disposal of land (see TD 2018/15 and Taxation Determination TD 96/35 Income tax: capital gains: when does a person, who on or after 21 September 1989 grants to another a right to cut and remove timber from the grantor's land, dispose of the right? Is it when the right is granted or when the trees are felled?).

Characterisation of agreement

Whether an arrangement is properly characterised as a sale of goods or the grant of a profit à prendre has been the subject of judicial consideration in a number of cases. Hill J in Ashgrove Pty Ltd and Ors v. Federal Commissioner of Taxation (1994) 53 FCR 452 conducted a review of the authorities and texts. In deciding that both types of arrangements fell into the category of agreements for the sale of goods (to which the right to enter and sever the timber was ancillary), Hill J focused on the fact that the purchaser derived no benefit from further growth and as such did not obtain a benefit from the land itself.

In your case, it is arguable that there is a granting of a profit à prendre over the gravel in favour of the XXXX - the transaction is the granting of a right and CGT event D1 happened at the time you entered into the agreement with XXXX.

In that case:

•         no part of the cost base of the asset (the land) can be taken into account in working out the amount of any capital gain or capital loss that arises from the grant (section 110-10 of the ITAA 1997 provides that the rules about cost base are not relevant for CGT event D1);

•         any capital gain or capital loss from the grant cannot be disregarded merely because the asset (the land) was acquired prior to 20 September 1985;

•         any capital gain from the grant is not a discount capital gain (Subsection 115-25(3) of the ITAA 1997); and

•         no exemption is available under Division 118 if the grant relates to a main residence because CGT event D1 is not one of the events listed in subsection 118-110(2) of the ITAA 1997 that is relevant to that exemption.

The calculation of the capital gains is by deducting from your capital proceeds any incidental costs incurred in respect of the grant of the profit à prendre.

Profits or gains made in the ordinary course of business

Whether a gain on the granting of a profit à prendre a is included in your assessable income as a capital gain or as ordinary income depends on all the facts and circumstances of the case. In the case of an isolated transaction that is not carried out as part of a business operation, the Commissioner considers that a gain will generally be ordinary income where the intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain, and the transaction was entered into in carrying out a commercial transaction (see paragraph 6 of Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income ('TR 92/3')).

TR 92/3 sets out the Commissioner's view on the application of the principles established in Federal Commissioner of Taxation v The Myer Emporium Ltd (1987) 163 CLR 199. Paragraph 32 of TR 92/3 sets out instances when the Commissioner considers that a profit or gain is made in the ordinary course of a business. However, in this case there is no business being carried on by you.

Isolated transaction with a profit making intention

In some instances, a profit or gain made from an isolated or commercial transaction could constitute ordinary income if the taxpayer's purpose or intention in entering into the transaction was to make a profit, notwithstanding that the transaction was not part of its daily business activities.

Factors considered relevant to determining whether an isolated transaction amounts to a commercial transaction are listed at paragraph 49 of TR 92/3.

TR 92/3 provides that profits from an isolated transaction will be income when:

•         the intention or purpose in entering into the transaction was to make a profit or gain, and

•         the transaction was entered into, and the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction.

The relevant intention or purpose of the taxpayer (of making a profit or gain) is the taxpayer's intention or purpose discerned from an objective consideration of the facts and circumstances of the case. Generally, in cases where a person's subjective purpose or intention is a relevant issue, the person's evidence as to their subjective purpose or intention can be considered but it must be tested closely and received with the greatest caution.

In this case you were approached by XXX and required, pursuant to the relevant Act to grant XXX the right to take the gravel from your property. The requisite profit making intention is not present on those facts.

Royalties

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.

The Commissioner's view on the definition of a royalty is set out in Taxation Ruling IT 2660: Income tax: definition of royalties. 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 meaning of 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 your case it is arguable that you have entered into an agreement with a XXX whereby XXX will extract gravel from your property for their purposes. You will receive a payment for the volume of gravel taken.

In that case, the payment for the cubic meterage of gravel will be a payment by way of royalty and assessable under section 15-20 of the ITAA 1997.

Method of payment

Notwithstanding that a recurrent payment is more likely to be of an income nature and a one-off payment is more likely to be capital in nature, the manner of payment will not negate the character of the payment with reference to the purpose for which the payment is made: see e.g. ESSO Australia Resources Ltd (formerly ESSO Exploration and Production Australia Incorporated) v FC of T 98 ATC 4768, where the court observed:

The so called "one-off" nature of the payment did not alter the revenue character of the receipt as stamped by the circumstances described. (See GP International Pipecoaters (1990) 170 CLR 124 at 137; Allied Mills Industries Pty Ltd v Federal Commissioner of Taxation (1989) 20 FCR 288, 300-301).

Compensation payments

The Commissioner's view in relation to the treatment of compensation payments is set out in Taxation Ruling TR 95/35 Income Tax: capital gains: treatment of compensation receipts.

However, the Commissioner's view is that while the payment is described as a compensation payment is better characterised for taxation purposes as the grant of a profit à prendre or a royalty as there is no permanent damage or reduction in value. This is because XXX will rehabilitate the area back to pasture.

Summary

The agreement involves a a profit à prendre and a sale of goods.

The transactions together can be taken to constitute the granting of a profit à prendre - the payment comprises the capital proceeds for the purposes of working out your capital gain for the granting of the profit à prendre.

The Commissioner considers that in your circumstances the right to enter and remove gravel is merely incidental to sale of the gravel, and for this reason the better view is that the amount is assessable pursuant to section 15-20 of the ITAA 1997. In the alternative, the payment is for the granting of a profit à prendre for the purposes of CGT event D1 and the payment is taken into account in determining the net capital gain to be included in your assessable income.

To the extent CGT event D1 and section 15-20 of the ITAA 1997 could apply to this transaction, the anti-overlap provisions in section 118-20 of the ITAA 1997 would reduce any capital gain by amounts otherwise included in your assessable income. Consequently, where proceeds are included in your assessable income as a royalty under section 15-20 of the ITAA 1997, practically there would be no CGT consequences.

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