Edited version of private ruling

Authorisation Number: 1011839120172

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Ruling

Subject: Treatment of a compensation receipt

Question 1

Given that the lump sum compensation amount paid to you by the state government makes reference to the existence of an amount relating to a loss of profits but there is no documentation quantifying it, will the whole undissected amount constitute a capital payment in respect of the taking of the two easements?

Answer

Yes.

Question 2

Did the grant of the easement result in a part disposal of the underlying asset (the land)?

Answer

Yes.

Question 3

Did an A1 capital gains tax (CGT) event happen under section 104-10 of the Income Tax Assessment Act 1997 (ITAA 1997) in relation to the lump sum compensation payment received by you in respect of the part disposal of the underlying asset (the land)?

Answer

Yes.

Question 4

Given that the land to which the A1 CGT event happens is a pre CGT asset, will any capital gain derived in relation to the taking of the two easements be disregarded under subsection 104-10(5) of the ITAA 1997?

Answer

Yes.

Question 5

Are you entitled to the CGT 50% discount under Division 115 of the ITAA 1997?

Answer

Not applicable. The relevant underlying asset (the land) is a pre CGT asset and any capital gain in relation to it is already disregarded under subsection 104-10(5) of the ITAA 1997.

Question 6

Are you entitled to the CGT small business active asset 50% reduction under Subdivision 152-C of the ITAA 1997?

Answer

Not applicable. The relevant underlying asset (the land) is a pre CGT asset and any capital gain in relation to it is already disregarded under subsection 104-10(5) of the ITAA 1997.

Question 7

Are costs incurred in acquiring the lump sum compensation payment included in its cost base under Division 110 of the ITAA 1997?

Answer

Not applicable. The relevant underlying asset (the land) is a pre CGT asset and any capital gain in relation to it is already disregarded under subsection 104-10(5) of the ITAA 1997.

This ruling applies for the following period;

Year ended 30 June 2010

Relevant facts and circumstances

You own and operate a primary production business and land.

You carry the business on in partnership. Each of you have a 50% interest.

The land on which the farm operates was acquired by the partnership prior to 20 September 1985.

A portion of the farm land was identified by the state government as land they would need to utilise for certain purposes. A Taking of Land Notice was issued which compulsory registered easements over lots on your property. No sale of land has occurred.

With reference to a formal valuation you lodged a formal claim for compensation with the state government under the 'Compensation Claim Acquisition of Land Act 1967'. This claim consisted of components for diminution in land value, disturbance to and replacement costs for stock, and other heads of claim.

As experienced farmers, your claim was lodged on the basis that the work undertaken on the easement areas will permanently hinder your ability to undertake your primary production activities.

You reference the formal valuation which states that as a result of the work undertaken within the easement area the land is now not suitable for farming purposes.

A letter from your solicitor to your tax agent states that your solicitor has not been advised in relation to the break up of the compensation payment received.

In a letter from the state government to your solicitors an offer of compensation was made 'in full and final settlement of all claims arising out of the Taking of Land Notice'. It states that the offer is made in relation to the easements but also includes an amount reasonably attributed to the loss in profits. The break up of the payment between these two components is not quantified in the offer. There are no other components present. This payment was subsequently received in the year ended 30 June 2010.

A copy of a valuation report was provided and forms part of the facts of the ruling.

This report states that where the work has been undertaken throughout the easement areas the land has been adversely impacted upon and is now not suitable for farming purposes. It states that the increased difficulty and costs associated with reforming these areas around the easements has resulted in a diminution in the value of the land. Disruption to roads, accesses and drainage has also occurred throughout.

A copy of the formal compensation claim was provided and forms part of the facts of the ruling.

A copy of a Title Search was provided and forms part of the facts of the ruling.

A copy of the letter from the state government to your solicitor was provided and forms part of the facts of the ruling.

A copy of the letter from your solicitor to your tax agent was provided and forms part of the facts of the ruling.

A copy of the relevant easement plans has been provided and forms part of the facts of the ruling.

Relevant legislative provisions

Income Tax Assessment Act 1997, section 104-10

Income Tax Assessment Act 1997, subsection 104-10(5)

Income Tax Assessment Act 1997, Division 110

Income Tax Assessment Act 1997, Division 115

Income Tax Assessment Act 1997, Subdivision 152-C

Income Tax Assessment Act 1997, section 104-155

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA of the ITAA 1936 to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA of the ITAA 1936 applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA of the ITAA 1936, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

Note, all subsequent legislative references are to the ITAA 1997 unless otherwise stated.

Question 1

According to Taxation Determination TD 93/58 lump sum damages or a lump sum out-of-court settlement, representing compensation for losses of an income nature will usually be regarded as assessable income.

However, in some instances a claim for compensation may include both capital and revenue components. Where the income component can be identified and quantified it will be assessable as ordinary income under section 6-5. Paragraph 1(b) of TD 93/58 states:

1. It is assessable income under subsection 25(1) of the Income Tax Assessment Act 1936 (ITAA 1936):

(b) to the extent that a portion of the lump sum payment is identifiable and quantifiable as income. This will be possible where the parties either expressly or impliedly agree that a certain portion of the payment relates to a loss of an income nature [cf. Mc Laurin v. FC of T (1961) 104 CLR 381; (1961) 8 AITR 180 and Allsop v. FC of T (1965) 113 CLR 341; (1965) 9 AITR 724].

(Note that the reference in the above paragraph to subsection 25(1) is to the Income Tax Assessment Act 1936 (ITAA 1936). However the comments are equally applicable to section 6-5 contained within the ITAA 1997.)

In some instances lump sum damages or out-of-court settlements will be paid in satisfaction of claims which contain both income and capital components but the amount apportioned to each component is not specified or cannot be quantified.

These payments for composite claims are termed 'undissected lump sum payments' and as a general rule where there is no basis for calculating otherwise the Courts have treated these payments as being entirely of a capital nature.

Application to your circumstances

In the year ended 30 June 2010 the state government issued you with a formal letter outlining an offer of compensation in relation to which you have since accepted and received a lump sum payment.

The letter stated that the offer was made for the taking of the easements and also included an amount reasonably attributed to the loss in profits. This letter did not quantify either of these amounts or provide any basis upon which the lump sum was calculated.

If there is no other documentation satisfactorily quantifying the split between these two components and you are unable to reasonably apportion it yourself the guidance provided by TD 93/58 and the relevant court cases is that there will be no apportionment of the settlement sum. The whole payment will be considered a capital receipt.

Question 2 & 3

If the compensation is a capital receipt it is necessary to consider the CGT implications. The general CGT provisions are set out in Part 3-1 of the ITAA 1997. Under the CGT provisions you will make a capital gain or loss only if a CGT event happens. 

To determine if a CGT event happens in respect of a compensation payment it is necessary to consider the nature of the asset to which the compensation payment relates. 

The Commissioners policy on the treatment of compensation payments is set out in Taxation Ruling TR 95/35 (capital gains: treatment of compensation receipts). TR 95/35 states that the particular asset for which compensation has been received by the taxpayer may be: 

· an underlying asset;

· a right to seek compensation; or

· a notional asset in terms of subsection 160M(7) (section 104-155 of the ITAA 1997).  

(TR 95/35 provides only legislative references that relate to the ITAA 1936. Therefore the equivalent provisions in the ITAA 1997 are cited where appropriate.) 

In determining which asset is most relevant, it is often appropriate to adopt a look through approach to the transaction or arrangement which generates the compensation receipt. In TR 95/35 the term underlying asset is defined in paragraph 3 as: 

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. 

TR 95/35 provides the following guidelines on the treatment of compensation for the disposal of an underlying asset: 

If an amount of compensation is received by a taxpayer wholly in respect of the disposal of an underlying asset, or part of an underlying asset, of the taxpayer the compensation represents consideration received on the disposal of that asset. In these circumstances, we consider that the amount is not consideration received for the disposal of any other asset, such as the right to seek compensation.  

82. In concluding that the underlying asset is the most relevant asset to which an amount of compensation relates, the taxpayer must be able to show that the compensation receipt has a direct and substantial link with the underlying asset. If the 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, or the notional asset.

Where the compensation is not for loss or destruction of the underlying asset but is for permanent damage to, or permanent reduction in the value of, the underlying asset, TR 95/35 states:

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.

Paragraph 3 of TR 95/35 defines permanent damage or reduction in value as follows:

Permanent damage or reduction in value does not mean everlasting damage or reduced value, but refers to damage or reduction in value which will have permanent effect unless some action is taken by the taxpayer to put it right.

Whilst paragraph 6 of TR 95/35 indicates that the compensation would generally represent a recoupment of the total acquisition costs, Taxation Ruling TR 97/3 provides a different interpretation for compensation received by landowners from public authorities in relation to easements.

Compensation for easement

Generally, the creation of a contractual right in the form of an easement would indicate that CGT event D1 has happened. In the case of a voluntary grant of an easement to an entity without any statutory power to acquire it, paragraph 11 of TR 97/3 confirms this approach.

However, the Commissioner's views contained in TR 97/3 give a different conclusion where compensation is received for the compulsory acquisition of an easement by a public authority, in which case the compensation cannot be said to be received for the grant of the easement. Rather, at paragraph 7 it references paragraph 4 (above) of TR 95/35 and concludes at paragraph 8 that 'an amount of compensation received by a landowner for the loss of part of the rights of ownership is accepted as being consideration received in respect of the part disposal of the underlying asset (the land)." This would constitute an A1 CGT event in respect of the land.

Paragraphs 9 and 10 of TR 97/3 provide that even where the easement is acquired by agreement with the landowner the Commissioner takes the view that the compensation received takes on the same character as an amount paid in relation to a compulsorily acquired easement. This is because the grantee of the easement (the public authority) has available, if it chooses to exercise it, the power to compulsorily acquire the easement.

Application to your circumstances

At question 1 we have concluded that there is a revenue component, however in the absence of any documentation actually quantifying that component the compensation will all be on capital account.

We must determine whether the most relevant CGT asset is (i) the right to seek compensation or (ii) adopting the look through approach, the land.

You have provided a valuation report and have referenced this document in citing the reasons why you consider there has been a permanent reduction in the value of the land which is the subject of the easement and compensation claim.

The report states that where the work has been undertaken throughout the easement areas the land has been adversely impacted upon and is now not suitable for farming purposes. It states that the increased difficulty and costs associated with reforming these areas around the easements has resulted in a diminution in the value of the land. Disruption to roads, accesses and drainage has also occurred.

From the information provided we are satisfied that the compensation receipt had a direct and substantial link with the underlying asset. The existence of the easement and works undertaken have resulted in the land suffering a permanent reduction in value. It follows that the appropriate CGT event is an A1 event happening in relation to the land.

TR 97/3 further supports this conclusion. In your case, the compensation was paid in relation to the compulsory acquisition of the easements by the state government which is a public authority. In accordance with TR 97/3, the compensation does not relate to the easement, it was paid to you for the loss of part of your rights of ownership of the land and is considered to be received in respect of the part disposal of that underlying asset.

In summary, we find that there has been a part disposal of the underlying asset, and that an A1 CGT event has happened under section 104-10 when you accepted the offer for the compensation in relation to the land.

Question 4

Subsection 104-10(5)(a) provides that an A1 capital gain you make is disregarded if you acquired the asset before 20 September 1985.

For compensation in relation to the disposal of, or permanent reduction in the value of an underlying asset TR 95/35 states the following:

5. It follows that if the underlying asset disposed of was acquired by the taxpayer before 20 September 1985, the receipt of the compensation has no CGT consequences for the taxpayer.

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.

Application to your circumstances

At question 2 we have confirmed that the CGT event happened in relation to the underlying asset ie. the land.

As the land was acquired prior to 20 September 1985 any capital gain made in relation to it is disregarded under subsection 104-10(5)(a).

Questions 5, 6 and 7

Not applicable. The relevant underlying asset (the land) is a pre CGT asset and any capital gain in relation to it is already disregarded under subsection 104-10(5) of the ITAA 1997.