Edited version of private advice

Authorisation Number: 1052006636942

Date of advice: 26 July 2022

Ruling

Subject: Compensation payments

Question 1

Do the receipts under the Agreement constitute assessable income in accordance with section 6-5 of the Income Tax Assessment Act 1997 (ITAA97)?

Answer

No.

Question 2

To the extent that the receipts under the Agreement do not constitute assessable income in accordance with section 6-5 of the ITAA 97, will the receipt of these amounts constitute capital proceeds under Division 116 of the ITAA 97 in respect of a capital gains tax (CGT) event happening?

Answer

No

Question 3

To the extent that the receipts under the Agreement do not constitute assessable income in accordance with section 6-5 of the ITAA 97 and do not constitute capital proceeds under Division 116 of the ITAA 97 in respect of a CGT event happening, does any compensation received reduce the cost base of the property under Subdivision 110-A of the ITAA 97?

Answer

Yes.

Question 4

To the extent that the receipts under the Agreement do not constitute assessable income in accordance with section 6-5 of the ITAA 97 and do not constitute capital proceeds under Division 116 of the ITAA 97 in respect of a CGT event happening, does any compensation received reduce the cost base of the right to receive the compensation under Subdivision 110-A of the ITAA 97?

Answer

Not applicable

This ruling applies for the following period:

1 July 20xx - 30 June 20xx

The scheme commences on:

1 July 20xx

Relevant facts and circumstances

You are the registered proprietor of a block of land (Property).

The Property is used for agricultural purposes.

Company A is an entity holding a licence to enter the Property for exploration purposes.

Prior to accessing the Property to carry out certain activities Company A is required by the relevant legislation to enter into a compensation agreement with the landowner.

The previous owner of the Property had entered into negotiations with Company A with respect to compensation for damages caused by the activities of Company A on the Property.

At the time you purchased the Property the previous owner had not signed a compensation agreement with Company A.

Following the purchase of the Property, you and Company A entered into an agreement whereby you will receive compensation payments from Company A (Agreement).

The compensation payments are compensation for damages caused to the Property.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Division 110

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

Income Tax Assessment Act 1997 Division 116

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

Reasons for decision

Question 1

Section 6-5 of the ITAA 1997 provides that the assessable income of a resident taxpayer includes income according to ordinary concepts, derived directly or indirectly from all sources during the income year.

There is no definition of 'ordinary income' in the tax law. In order to determine whether the compensation payments constitute ordinary income it is necessary to consider how the courts have determined when a receipt is ordinary 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).

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.

Company A holds a licence which confers the right to enter the Property for the purpose of exploration. The payments made to you under the Agreement are made as compensation for damages to the Property as a result of the activities carried out by Company A.

Therefore, the payments are not a replacement of income.

The payments are not the result of you entering into the Agreement with the intention to make a profit or gain in the course of carrying on a business. There was no profit-making purpose.

Accordingly, the compensation amounts you receive from Company A do not give rise to income according to ordinary concepts pursuant to section 6-5 of the ITAA 1997.

Questions 2, 3 and 4

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 to constitute capital proceeds, there must be a CGT event.

CGT events occur in respect of CGT assets. Subsection 108-5(1) of the ITAA 1997 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 (TR 95/35) considers the tax treatment of compensation receipts. TR 95/35 provides the Commissioner's view on the CGT consequences for the recipient of compensation receipts 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 (paragraph 4); or

•         not in respect of any underlying asset but in relation to the disposal of the right to seek compensation (paragraph 11).

The above relate to CGT event A1 (section 104-10 of the ITAA 1997) and CGT event C2 (section 104-25 of the ITAA 1997) respectively.

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 that the underlying asset is identified by looking through to the transaction which generates the compensation receipt.

Applying the look-through approach to the facts of this case, the Property is the asset to which the compensation directly relates. The Property is therefore, the underlying asset and the relevant CGT asset for the purposes of this ruling.

As the compensation payments are received in respect of permanent damage to, or permanent reduction in the value of, an underlying asset, the payments do not relate to the right to seek compensation (paragraphs 6 and 11 of TR 95/35)

CGT event A1 does not occur because there has not been a disposal of the Property. Further, as the amount is paid in respect of an underlying asset (being the Property), CGT event C2 is not relevant.

There is no CGT event occurring upon receipts of the compensation payments, therefore, the payments do not constitute capital proceeds.

As the compensation payments are received in respect of an underlying asset the payments do not relate to the disposal of the right to seek compensation (paragraph 11 of TR 95/35).

Paragraph 6 of TR 95/35 provides that 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.

As you acquired the Property was acquired after 13 May 1997, subsection 110-45(3) of the ITAA 1997 is relevant, which states:

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.

The compensation amounts under the Agreement are paid to you in respect of permanent damage to the Property and, therefore, reduce the cost base of the Property pursuant to subsection 110-45(3) of the ITAA 1997.

Therefore, the compensation amounts received by the Partnership under the CCA do not constitute capital proceeds in respect of a CGT event happening, nor do they relate to the right to seek compensation. They will reduce the cost base of the Property pursuant to subsection 110-45(3) of the ITAA 1997.

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