Edited version of private advice

Authorisation Number: 1052014929878

Date of advice: 9 August 2022

Ruling

Subject: Assessable income - compensation payment

Question 1

Will the payment be assessable as ordinary income under subsection 6-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Will the payment 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.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You operate a primary production business with a trust as part of a partnership.

The partnership purchased the land in the year ended 30 June 20XX and planned to expand their existing business by acquiring additional land nearby.

The property is just over XXX hectares of land.

Expanding operations on the property would have been cost-effective as the partnership would have been able to use an existing water licence to carry out cropping activities.

The solicitor acting for the partnership in relation to the purchase was specifically instructed to confirm that the land was able to be cleared.

In preparation of clearing the land, the partnership incurred costs during the years ended 30 June 20XX and 30 June 20XX to convert the land from leasehold to freehold.

During the year ended 30 June 20XX, your partnership commenced clearing operations but was advised on the same day by an officer from the Department of Environment and Heritage Protection (DEHP) that the clearing was unlawful.

The land clearing was not permitted upon notification of contravention of the Nature Conservation Act.

Upon subsequent investigation, it was revealed that there was a Flora Survey Trigger Map for the land, which shows that the property was encumbered as a high-risk area for protected plants and accordingly, clearing restrictions apply.

The partnership applied for a permit to clear the land but the DEHP refused the application, so you sought legal advice.

You lodged an application for a review of DEHP's decision but withdrew the application on advice regarding the likelihood of success to its application.

The partnership incurred legal and expert costs in relation to the DEHP decision.

You subsequently lodged a claim against the solicitor in relation to the purchase of the land. This claim encompassed various issues, including:

•         Overpayment for the land purchase.

•         Freehold costs incurred.

•         Legal and expert costs incurred.

•         Loss of future profits and capital growth in land.

•         You have been informed by your legal representative that an out of court settlement offer has been accepted by the insured's legal representatives.

This settlement agreement is for an undissected lump sum, covering the claim itself, along with costs, outlays and taxes (if any).

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 6-20

Income Tax Assessment Act 1997 Section 110-40

Income Tax Assessment Act 1997 Section 110-45

Reasons for decision

Nature of the compensation payment

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts applies to a person who receives an amount as compensation and considers the capital gains tax (CGT) consequences for the recipient of the amount.

Paragraph 3 of TR 95/35 defines 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.

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.

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.

Where an amount of compensation is received wholly in respect of the disposal of an underlying CGT asset, or part of an underlying CGT asset, 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.

Compensation for permanent damage to, or permanent reduction in the value of, the underlying asset

Paragraphs 6 to 10 of TR 95/35 provide:

6. 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.

7. Accordingly, the total acquisition costs of the post-CGT asset should be reduced in terms of subsection 160ZH(11) 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, in the case of a post-CGT underlying asset, 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.

8. The adjustment of the total acquisition costs effectively reduces those costs by the amount of the recoupment as if those costs had not been incurred. This means that indexation is not available in respect of the recouped amount.

9. Compensation received by a taxpayer has no CGT consequences if the underlying asset which has suffered permanent damage or a permanent reduction in value was acquired by the taxpayer before 20 September 1985 or is any other exempt CGT asset.

10. If a taxpayer is compensated for having paid excessive consideration to acquire an asset, the amount referable to the overpayment represents a recoupment of all or part of the total acquisition costs of the asset in terms of subsection 160ZH(11).

Compensation payment 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 government authority undertaking activities to relocate contaminated capital dredge 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.

Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income provides guidance in determining whether profits from isolated transactions are income and therefore assessable income under the ITAA 1997.

Paragraph 35 of TR 92/3 states that 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).

Neither of the above elements applies to your situation. Based on incorrect information received from the solicitor declaring that the land was able to be cleared, you are compensated for having excessive consideration to acquire the asset.

Accordingly, the compensation payments paid 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.

Reduction of cost base

Division 110 of the ITAA 1997 explains how to work out the cost base and reduced cost base of a CGT asset.

Subsection 110-15(3) of the ITAA 1997 states 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.

Recoupment is defined in subsection 995-1(1) of the ITAA 1997 having the meaning given by section 20-25.

Subsection 20-25(1) of the ITAA 1997 states that a recoupment of a loss or outgoing includes:

a)    any kind of recoupment, reimbursement, refund, insurance, indemnity or recovery, however, described, and

b)    a grant in respect of the loss or outgoing.

TR 95/35 sets out the capital gains tax consequences when a taxpayer receives a compensation payment. The payment is considered to be a compensation receipt in terms of paragraph 3 of TR 95/35.

TR 95/35 applies a look through approach to determine the underlying asset to which the payment relates. Applying the look-through approach it is considered that the underlying asset is the affected land itself.

Paragraph 6 of TR 95/35 states:

If an amount of compensation is received by a taxpayer wholly in respect of permanent damage 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.

Accordingly, 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.

As you have not disposed of the property or other CGT asset, there are no CGT consequences at the time of entering into the agreements or receiving the compensation payments. That is, no CGT event has occurred as a result of the agreements and the payments received are not regarded as capital proceeds under Division 116 of the ITAA 1997.

Therefore, the land's acquisition cost may be reduced by the compensation payments received in relation to that land. That is, the cost base of the land will be reduced by the value of the payments and any gain or loss will crystallise at a later time when the land is sold.

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).