Edited version of private advice

Authorisation Number: 1052221481925

Date of advice: 28 May 2024

Ruling

Subject: Rental property - fire damage or destroyed

Question 1

Does section 124-70(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997) happen to the property located in Australia (Property) because part of it was lost or destroyed in a fire as per Taxation Determination TD 2000/38?

Answer

No.

Question 2

Does the receipt of money pursuant to section 124-75 of the ITAA 1997 mean that the rollover provisions apply to the proceeds received from the subsequent sale of the Property in an un-leasable condition because of the destruction of the fit out of the Property?

Answer

Not applicable; the sale of the Property does not meet the criteria in section 124-70 of the ITAA 1997, so section 124-75 of the ITAA 1997 does not apply.

Question 3

Can the capital gain which resulted from the subsequent sale of the Property after the tenant refused to re-occupy the Property as a result of the fire, be rolled over under Subdivision 124-B of the ITAA 1997?

Answer

No.

Question 4

Is the excess of the proceeds of $75,000 received in an out of court settlement included as capital proceeds of the building or included in a proportional manner to each individual asset of the fit out destroyed?

Answer

No.

This ruling applies for the following period:

30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

1.         The Taxpayer owned a commercial property in Australia (Property).

2.         The Taxpayer leased the Property to a tenant.

3.         Under the lease agreement the Taxpayer as landlord owned the fit out.

4.         The Taxpayer was claiming a deduction for the decline in value.

5.         A copy of the depreciation schedule was provided.

6.         The lease agreement states that the fit out must be maintained by the lessee during the lease and reinstated to a lettable condition on termination of the lease.

7.         There was a fire at the property on DDMMYYYY.

8.         The floors of the Property and the fit out of the Property were destroyed by the fire.

9.         The floors were replaced under an insurance claim.

10.      As the result of the fire the Property was no longer able to be leased, with the tenant refusing to reoccupy the property.

11.      A lengthy dispute arose over the tenant's obligations under the lease including to maintain and repair the fit out destroyed by the fire, their requirement to reinstate insurance, occupy the premises and continue payments under the lease.

12.      Litigation commenced on DDMMYYYY.

13.      There was an out of court settlement for the action brought by the Taxpayer as landlord.

14.      The litigation concluded with an out of court settlement on DDMMYYYY.

15.      The tenant paid the Taxpayer an amount of $XX,XXX in the out of court settlement as an undissected lump sum.

16.      The out of court settlement as described on the invoice dated DDMMYYYY was for the cancellation of the lease over the Property due to the partial destruction of the property.

17.      The Property was subsequently sold and settled on DDMMYYYY as a result of an unsolicited offer by the purchaser.

18.      At the time of the purchaser's offer the property had no fit out.

19.      When the property was sold it was in an unleasable condition because of the destruction of the fit out by the fire.

20.      The Taxpayer has a partnership interest in 2 properties that are leased and owns 1 commercial property in his own right.

21.      The Taxpayer is not in the business of property leasing.

22.      A new commercial property has been purchased in MMYYYY.

23.      Under the lease agreement in the new commercial property the landlord is responsible for the fit-out.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Subdivision 40-D

Income Tax Assessment Act 1997 section 40-285

Income Tax Assessment Act 1997 section 40-295

Income Tax Assessment Act 1997 section 40-300

Income Tax Assessment Act 1997 section 40-365

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 Division 104

Income Tax Assessment Act 1997 section 104-5

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 104-20

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 108-60

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 Division 124

Income Tax Assessment Act 1997 Subdivision 124-B

Income Tax Assessment Act 1997 subsection 124-70

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997 ('ITAA 1997') unless otherwise stated.

Question 1 and 3

Summary

As only part of the Property as the capital gains tax (CGT) asset, was destroyed, and as a whole the Property has been damaged and not destroyed, CGT event C1 does not occur, and therefore the rollover in Subdivision 124-B cannot be chosen.

Any capital gain arising from the sale of the Property cannot be rolled over under Subdivision 124-B, as the Property was disposed of triggering CGT event A1 under section 104-10, rather than being lost or destroyed as required for CGT event C1. Since the proceeds are from the sale of the Property, and not compensation or an insurance payment for a CGT asset that is lost or destroyed, the section 124-70 rollover is not available on the sale of the Property.

Detailed reasoning

CGT

Capital gains tax applies where a CGT event happens to a CGT asset. Under section 102-20 you make a capital gain or loss if and only if a CGT event happens.

CGT Assets

Subsection 108-5(1) says a CGT asset includes any kind of property. The effect of paragraph 108-5(2)(a) is that part of, or an interest in, a CGT asset is itself a CGT asset. Note 1 to section 108-5 lists examples of CGT assets: the first bullet point reads 'land and buildings.'

At common law what is fixed to the land is presumed to become part of the land, so that both the land and what is attached is treated as the same CGT asset (Commissioner of Main Roads v North Shore Gas Co. Ltd [1967] HCA 41 (1967) 120 CLR 118 at 127 per Barwick CJ, McTiernan J, Kitto J and Taylor J). However, for CGT purposes, there are exceptions to this rule in Subdivision 108-D, which may treat the land and what is attached as separate assets. Where this is the case any capital gain or loss must be determined separately for each asset.

Section 108-60 provides that a depreciating asset that is part of a building or structure is taken to be a separate CGT asset from the building or structure. It provides the following example:

You own a factory from which you carry on a business. You install rest rooms for your employees. The plumbing fixtures and fittings are depreciating assets. These are taken to be a separate CGT asset from the factory.

Taxation Determination TD 98/24 Income tax: capital gains: what are the CGT consequences of a CGT event happening to post-CGT real property if the property comprises separate CGT assets under Subdivision 108-D in Part 3-1 of the Income Tax Assessment Act 1997 (the 1997 Act) or if the property is sold with depreciable assets?, states the Commissioners view. It says that a unit of plant, or chattels that are sold with the property, are separate CGT assets in their own right and are not part of the real property. This is the case whether the items were acquired with the property or afterwards.

CGT events

Section 104-5 lists the CGT events that can happen. Capital gains are triggered when a CGT event in Division 104 happens. Of relevance are CGT event A1, which happens if you dispose of a CGT asset (section 104-10), and CGT event C1, which happens if a CGT asset you own is lost or destroyed (section 104-20).

Where an asset has been acquired on or after 20 September 1985, if a CGT event happens, you may make a net capital gain or loss from the event. Generally, you make a capital gain when the capital proceeds exceed the cost base. You make a capital loss when the reduced cost base exceeds the capital proceeds (subsection 104-10(4)). Broadly, capital proceeds include the money and market value of property you receive (or are entitled to receive) when an event happens (section 116-20). The cost base includes the money and market value of property you provide (or are required to provide) to acquire a CGT asset, and some other costs (section 110-25).

Section 102-20 provides that CGT is incurred when a CGT event takes place, and you make a gain from the event.

Disposal of a CGT asset

A CGT event A1 happens if you dispose of a CGT asset. You dispose of a CGT asset if a change of ownership occurs from you to another entity, whether because of some act of event or by operation of law. The time of the event is when you enter into the contract for the disposal or if there is no contract, when the change of ownership occurs (section 104-10).

Loss or destruction of CGT assets

CGT event C1 in subsection 104-20(1) happens if a CGT asset you own is lost or destroyed. The time of the CGT event as determined by subsection 104-20(2) will be when you first become aware of the loss or destruction; or if you receive compensation, when you receive the compensation.

The words 'lost' and 'destroyed' in subsection 104-20(1) are not defined in the Act and they take their ordinary meaning.

Taxation Determination TD 1999/79: Income Tax: capital gains: does the expression 'lost or destroyed' for the purposes of CGT event C1 in subsection 104-20(1) of the Income Tax Assessment Act 1997 apply to: (a) a voluntary 'loss' or 'destruction'? (b) intangible assets? (TD 104-20) relevantly states:

4. The word 'destroyed' in its context in subsection 104-20(1) contemplates both voluntary and involuntary actions. The Macquarie Dictionary, 3rd ed, defines 'destroyed' as '1. to reduce to pieces or to a useless form; ruin; spoil; demolish. 2. to put an end to; extinguish'. The word in its context in CGT event C1 applies if a CGT asset is destroyed in an involuntary occurrence, such as a natural disaster, or if it happens by the actions of others over which the taxpayer has no control. It also applies if a CGT asset is destroyed in a voluntary occurrence - if, for example, it happens due to a deliberate act of the taxpayer (e.g., a taxpayer might demolish a building in the course of redeveloping a property).

5...

6.Neither of the words 'lost' or 'destroyed', in the context of CGT event C1, contemplates damage to an asset that does not amount to the asset being lost or destroyed. A CGT asset must be wholly lost - not just damaged - or wholly destroyed - not just damaged - for the circumstances to be covered by CGT event C1. This is not to say, however, that CGT event C1 cannot happen to a discrete and identifiable part of a CGT asset - being a CGT asset in its own right - if the part is wholly lost or wholly destroyed and not just damaged.

Replacement asset roll-over

Subdivision 124-B allows taxpayers who have had a CGT asset lost, destroyed, or compulsorily acquired to choose roll-over relief from the CGT consequences that would normally flow from that event.

Subsection 124-70(1) says you may choose a roll-over if any of the listed events happens to a CGT asset you own (referred to as the original asset). Listed under paragraph 124-70(1)(b) is if 'it, or part of it is lost or destroyed'.

Subsection 124-70(2) says:

You must receive money or another *CGT asset (except a *car, motor cycle or similar vehicle), or both:

(a) as compensation for the event happening; or

(b) under an insurance policy against the risk of loss or destruction of the original asset.

The general effect of the replacement asset roll-over provisions is to defer or reduce the making of a capital gain or loss from one CGT event until a later CGT event happens. The provisions require the ownership of one CGT asset to end and another CGT asset to be acquired.

The roll-over under Subdivision 124-B is available where CGT event C1 occurs to a CGT asset owned by a taxpayer which is wholly or partially lost or destroyed, and the taxpayer receives compensation for the loss or destruction. Section 104-20 does not specifically refer to the possibility of partial loss or destruction. However, it is clear from the definition of a CGT asset in section 108-5 that this event can encompass a partial loss or destruction of an asset.

Loss or destruction of part of a CGT asset must be distinguished from mere damage to the asset, for the purposes of Subdivision 124-B. The importance of this distinction is that the destruction or loss of a CGT asset, in full or in part, is an eligible roll-over event whereas damage to the whole or part of a CGT asset is not.

It is possible that damage to an asset may, in some circumstances, amount to loss or destruction, but the question whether a CGT asset or part of it is damaged rather than destroyed is a question of fact that depends on the circumstances of each particular case.

Taxation Determination TD 2000/38 Income tax: capital gains: is roll-over available under Subdivision 124-B of the Income tax Assessment Act 1997 for the loss or destruction of a CGT asset if the asset is damaged? (TD 2000/38) provides the following examples of events that amount to loss or destruction and events that are merely damage:

• Example 1

The keel of a yacht was destroyed and the yacht is damaged. The keel is viewed as part of the yacht; however it is a separate CGT asset. To the extent that the roll-over is available, it would be available in respect of the destroyed keel and not the damaged yacht, if the other requirements in Subdivision 124-B of the ITAA 1997 are satisfied.

• Example 2

A holiday home is reduced to rubble by a cyclone. Roll-over is available for the destruction of the home as long as the requirements of Subdivision 124-B of the ITAA 1997 or met. However, if only part of the house is damaged, and not destroyed during the cyclone, then roll-over is not available. If part of the house is destroyed by the cyclone, and it can be identified as a separate CGT asset, the roll-over will be available for that separate CGT asset if the other requirements of Subdivision 124-B of the ITAA 1997 are satisfied.

• Example 3

The iron roof of a factory is destroyed as a result of a hailstorm. Roll-over is available for the roof, the part of the factory that was destroyed and which is an identifiable CGT asset. However, if the roof was just damaged during the hailstorm, roll-over is not available because neither the factory nor the roof was lost or destroyed.

For roll-over relief to be available to an eligible CGT asset you must receive money (or other CGT assets) as compensation for the event happening, or under an insurance policy you hold covering the risk of loss or destruction to the asset (original asset) (paragraph 124-70(2)).

Depreciating assets

Subdivision 40-D provides that you may have to make an adjustment to your taxable income if you stop holding a depreciating asset.

When you stop holding a depreciating asset, such as when it is destroyed, a balancing adjustment event occurs under section 40-295.

If the termination value of the depreciating asset is more than its adjustable value, the difference is included in your assessable income in the income year in which the balancing adjustment event occurred (paragraph 40-285(1)(b)).

If the termination value of the depreciating asset is less than its adjustable value, the difference is deductible in the income year in which the balancing adjustment event occurred (paragraph 40-285(2)(b)).

However, under section 40-365, where you stop holding a depreciating asset because it is destroyed you may choose whether or not to include the balancing adjustment amount in your assessable income to the extent that you chose to treat it as a reduction in the cost and/or opening adjustable value of the replacement asset.

You can only make this choice for a replacement asset if:

•           you incur the expenditure on the replacement asset, or you start to hold it:

• no earlier than one year, or within a further period the Commissioner allows, before the balancing adjustment event occurred, and
• no later than one year, or within a further period the Commissioner allows, after the end of the income year in which the balancing adjustment event occurred (section 40-365), and

•           at the end of the income year in which you incurred the expenditure on the asset, or you started to hold it, you used it, or had it installed ready for use, wholly for a taxable purpose and you can deduct an amount for it (subsection 40-365(4)).

Application to your circumstances

CGT assets

Under section 108-5 the Property as a whole is a CGT asset as land and buildings are listed as CGT assets.

The exception in Subdivision 108-D to the common law principle of what is attached to the land is part of the land, applies, treating the land and what is attached to it as separate assets.

Each item that comprises the 'fit out' as a depreciating asset, is a separate CGT asset from the Property under section 108-60.

These items are subject to the balancing adjustment provisions in Subdivision 40-D. Under this Subdivision where you stop holding a depreciating asset because it was destroyed, you may offset an assessable balancing adjustment amount arising from the involuntary disposal against the cost of a replacement asset (section 40-365).

The floor as a discrete and identifiable part of the Property falls within the extended definition of a CGT asset under subsection 108-5(2). The floor was replaced under an insurance claim before the disposal of the property and is not the relevant CGT asset for the purpose of this ruling.

The CGT asset you are seeking Subdivision 124-B replacement asset rollover relief for, is the whole of the property located at Unit 2, 162 Ward Street North Adelaide SA 5006.

Loss or destruction of CGT assets

A CGT asset must be wholly destroyed not just damaged for CGT event C1 to happen and for rollover relief to be available under section 124-70.

CGT event C1 can happen to a discrete and identifiable part of a CGT asset - being a CGT asset in its own right - if the part is wholly lost or wholly destroyed and not just damaged.

The fire destroyed the individual assets that make up the 'fit out' and the floor. As a result, those discrete and identifiable parts of the CGT asset were destroyed, but the Property, which is the subject of the ruling, while badly damaged was not destroyed.

As the fire destroyed parts of the Property, but not the whole Property it is similar to Example 1 in TD 2000/38:

The keel of a yacht was destroyed, and the yacht is damaged. The keel is viewed as part of the yacht, however it is a separate CGT asset. To the extent that the roll-over is available, it would be available in respect of the destroyed keel and not the damaged yacht, if the other requirements in Subdivision 124-B of the ITAA 1997 are satisfied.

Just like in the example, the keel of the yacht is destroyed, in Taxpayer's case the floor was destroyed. Like the yacht as a whole is only damaged, the Property as a whole is only damaged. The keel in the example is viewed as part of the yacht; however, it is a separate CGT asset. Similarly, the floor in the Taxpayer's Property is viewed as part of the Property, but a separate CGT asset. In the example to the extent that the roll-over is available, it would be available in respect of the destroyed keel and not the damaged yacht, if the other requirements in Subdivision 124-B are satisfied. Likewise in the Taxpayer's case the roll-over may be available for the destroyed floor, but not the damaged Property.

As the Property is the CGT asset being considered and as a whole it has only been damaged, CGT event C1 does not occur, and therefore a section 124-70 rollover cannot be chosen.

Under section 102-20 you only make a capital gain or loss if and only if a CGT event happens. As the damage to the Property was not a CGT C1 event at the time of the fire, and does not trigger any other CGT event, there are no capital gains consequences to the whole property at that time, and therefore there is no CGT to rollover.

Later, when the damaged Property was sold the change of ownership triggered a CGT A1 event. The time of the event was when the contract was entered into for the disposal or if there was no contract, when the change of ownership occurred (section 104-10). The proceeds were for the sale of the Property and not an insurance payment or compensation for the damaged Property. CGT C1 event did not happen at that time as the Property was disposed of and not destroyed.

The roll-over under Subdivision 124-B is not available for the proceeds from the subsequent sale of the Property as the proceeds are from the disposal of the Property which is an A1 event, not from compensation or insurance for the destruction of the Property which is a C1 event.

However, where a discrete and identifiable part of the Property, like the floor, is destroyed it is a separate CGT asset and may qualify for the rollover if all the other requirements are met.

Question 4

Summary

The $XX,XXX out of court settlement amount is a lease surrender receipt that is subject to the CGT provisions under Part 3-1. It is not included as capital proceeds of the Property or assigned in a proportionate manner to the individual assets of the fit out that were destroyed.

Detailed reasoning

Characterisation of the out of court settlement amount

The characterisation of a lump sum compensation payment is considered in Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts (TR 95/35).

Paragraph 3 of TR 95/35 takes a look-through approach where it seeks to connect the relevant compensation to the most relevant impacted asset. The ruling provides the following explanation of the look-through approach:

The look-through approach is the process of identifying the most relevant asset. It requires an analysis of all of the possible assets of the taxpayer in order to determine the asset to which the compensation amount is most directly related. It is also referred to in this Ruling as the underlying asset approach.

The ruling clarifies the concept of underlying asset as:

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 underlying 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.

In determining, which is the most relevant underlying asset, Taxation Ruling TR 95/35 at paragraph 70 provides:

...it is often appropriate to adopt a "look-though" approach to the transaction or arrangement which generates the compensation receipt. We regard this concept as the most appropriate basis on which to determine whether any capital gain arises on the disposal of any asset of the taxpayer.

The taxpayer must, as specified in paragraph 82 of Taxation Ruling TR 95/35, be able to 'show that the compensation receipt has a direct and substantial link with the underlying asset'.

Lease surrender receipt

Where the underlying asset is a commercial lease, an amount received to terminate the lease would come within the definition of a lease surrender amount.

Taxation Ruling TR 2005/6 Income Tax: lease surrender receipts and payments (TR 2005/5) addresses a number of situations involving lease surrender receipts and payments, and their treatment. It defines a lease surrender amount as the consideration given or received for surrendering a lease.

Paragraph 17 of TR 2005/6 introduces the Commissioner's position on the tax consequences for a lessor who derives a lease surrender receipt, it states:

A lease surrender receipt of a lessor would constitute assessable income under section 6-5 if received:

(a) in the ordinary course of carrying on a business of granting and surrendering leases;

(b) as an ordinary incident of business activity (even though it was unusual or extraordinary compared to the usual transactions of the business); or

(c) as a profit or gain from an isolated business operation or commercial transaction entered into by the lessor (otherwise than in the ordinary course of carrying on a business), with the intention or purpose of making the relevant profit or gain.

Otherwise the lease surrender receipt is of a capital nature.

CGT

Where a lease surrender receipt is of a capital nature the CGT provisions in Part 3-1 apply.

The entry into a lease by a lessor and lessee constitutes the acquisition of an asset by the lessor. The asset comprises the contractual rights vested in the lessor under the lease agreement, including the right to receive the nominated rent, but subject to possession.

The rights of the taxpayer under the lease are legally enforceable rights and therefore, in their totality, a CGT asset according to the definition in subsection 108-5(1).

On the surrender or termination of the lease, the Taxpayer's ownership of the contractual rights under the lease are discharged or satisfied, and this is a mere realisation of a capital asset.

This discharge or satisfaction of the contractual rights gives rise to CGT Event C2 from the cancellation of a CGT asset pursuant to paragraph 104-25(1)(b).

Section 104-25 provides that CGT event C2 happens if the ownership of an intangible CGT asset ends by the asset:

a) being redeemed or cancelled

b) being released, discharged or satisfied

c) expiring; or

d) being abandoned, surrendered or forfeited

The time of the event is when the contract that results in the asset ending is entered into or if there is no contract, when the asset ends.

A lessor makes a capital gain from surrendering a lease acquired after 19 September 1985 triggering CGT event C2, to the extent that the surrender receipt exceeds the cost base of the lease.

The lessor will make a capital gain if the capital proceeds from the surrender of its rights are more than the asset's cost base.

The lessor makes a capital loss if those capital proceeds are less than the assets reduced cost base.

Application to your circumstances

An undissected lump sum was received in the out of court settlement. Using the look through approach described in TR 95/35 it is possible to show that the proceeds received in the out of court settlement directly relate to the underlying CGT asset of the lease. The invoice dated DDMMYYYY describes the payment of $XX,XXX for the 'cancellation of the lease over the Property due to the partial destruction of the property.'

In relation to the other assets identified, no evidence was proffered to show a direct and substantial link between the damage to the Property or the fit out, and the compensation payment. As such, the lease is the relevant underlying CGT asset and there is no basis on which to consider apportioning the compensation receipt.

As the receipt is for the cancellation of the lease, it would be considered a lease surrender receipt for the purposes of TR 2005/6, as it is consideration received by the lessor on the surrender of the lease by the lessee.

The principle in TR 2005/6 provides that where the lessor is in the business of leasing, the receipt is an ordinary incident of a business activity or is received as a profit or gain from a profit-making undertaking or scheme, the lease surrender receipt constitutes assessable income under section 6-5. Otherwise, the lease surrender receipt is of a capital nature.

The Taxpayer's leasing activities undertaken in partnership for 2 commercial properties and individually for one property, does not constitute a business activity or meet the other criteria listed at paragraph 17 of TR 2005/6. Consequently, under TR 2005/6, the lease surrender receipt is not assessable income under 6-5 but is of a capital nature.

As a capital receipt, the settlement amount of $XX,XXX is assessable under the CGT provisions in Part 3-1. On the surrender of the lease by the lessee in the out of court settlement, CGT event C2 under section 104-25 happens to the lessor in relation to the discharge of his rights under the lease agreement. The lease surrender receipt is the capital proceeds for the event happening to the asset.

The Taxpayer will make a capital gain if the capital proceeds from the surrender of his rights are more than the asset's cost base. The Taxpayer makes a capital loss if those capital proceeds are less than the assets reduced cost base.

Conclusion

Using the look through approach, the $XX,XXX settlement amount directly relates to the underlying asset of the lease. As the amount is for the cancellation of the lease and qualifies as a lease surrender receipt that is subject to the CGT provisions under Part 3-1, it is not included as capital proceeds of the building or included in a proportionate manner to each individual asset of the fit out that was destroyed.

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