Edited version of your private ruling

Authorisation Number: 1011953757642

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Ruling

Subject: Capital gains tax on compensation received

Question 1

Will compensation received for deprivation of possession and diminution of use of the land severance and loss of profits for a post-CGT property be assessable as a D1 CGT event under section 104-35 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Is compensation received for deprivation of possession and diminution of use of the land severance and loss of profits for a pre-CGT property assessable as a capital gain?

Answer

No.

Question 3

Will compensation received for deprivation of possession and diminution of use of the land severance and loss of profits for a post-CGT property be assessable in the year that the surface rights are granted and the funds released, as opposed to when the contract is entered into?

Answer

No.

Question 4

Will compensation received for deprivation of possession and diminution of use of the land severance and loss of profits for a pre-CGT property be assessable in the year that the surface rights are granted and the funds released, as opposed to when the contract is entered into?

Answer

No.

Question 5

Will compensation received for reinstatement costs for damage to depreciable fixed improvements on the land, including dwelling, buildings, fences and yards for a post-CGT property be assessable under section 40-285 of the ITAA 1997?

Answer

Decline to rule. The Commissioner considers that correctly making a private ruling would depend on making an assumption about a future event.

Question 6

Will compensation received for reinstatement costs for damage to depreciable fixed improvements on the land, including dwelling, buildings, fences and yards for a pre-CGT property be assessable under section 40-285 of the ITAA 1997?

Answer

Decline to rule. The Commissioner considers that correctly making a private ruling would depend on making an assumption about a future event.

Question 7

Will compensation received for reinstatement costs for damage to depreciable fixed improvements on the land, including dwelling, buildings, fences and yards for a post-CGT property be assessable in the year that the surface rights are granted and the funds released, as opposed to when the contract is entered into?

Answer

No.

Question 8

Will compensation received for reinstatement costs for damage to depreciable fixed improvements on the land, including dwelling, buildings, fences and yards for a pre-CGT property be assessable in the year that the surface rights are granted and the funds released, as opposed to when the contract is entered into?

Answer

No.

Question 9

Will the compensation that was received for reinstatement costs for damage to fixed improvements on land, being dams and other water facilities for the post-CGT property be applied against the cost base of the land? Will the cost bases be reduced and any excess ignored for post-CGT assets?

Answer

Yes.

Question 10

For the compensation received for reinstatement costs for damage to fixed improvements on land, being dams and other water facilities for the pre-CGT property, will the claim under Subdivision 40F of the ITAA 1997 (an adjustment against the cost base of the underlying asset), be ignored for pre-CGT assets?

Answer

Amount is not assessable.

Question 11

For the compensation received for reinstatement costs for damage to fixed improvements on land, being dams and other water facilities for the post-CGT property be assessable in the year that the surface rights are granted and the funds released, as opposed to when the contract is entered into?

Answer

No.

Question 12

For the compensation received for reinstatement costs for damage to fixed improvements on land, being dams and other water facilities for the pre-CGT property be assessable in the year that the surface rights are granted and the funds released, as opposed to when the contract is entered into?

Answer

Amount is not assessable.

Question 13

Is the compensation received for diminution in the underlying value of the land for the post-CGT property treated as a reduction in the cost base of the property with the excess over the cost base being ignored as tax free?

Answer

Yes.

Question 14

For the compensation received for diminution in the underlying value of the land for the pre-CGT property ignored as it is merely a cost base adjustment to a pre-CGT asset?

Answer

Amount is not assessable.

This ruling applies for the following period:

The 2011-12 income year

The scheme commences on:

1 July 2011

Relevant facts and circumstances

The taxpayer owns two parcels of land.

The land is used for grazing.

One property is a leasehold parcel of land acquired pre-CGT. It is highly improved pastoral land suitable for grazing.

The other property is a freehold parcel of land. It is highly improved pastoral land suitable for grazing.

Both properties have fencing and dams. The land is cleared and well grassed and suitable for running breeders as well as fattening cattle. The improvements on the post-CGT property are in poor condition.

You are also a partner with your spouse in the family partnership. The partnership has operated a grazing business on these lands for many years and runs cattle across both properties. You do not charge the partnership for the use of your land in its business.

The partnership is registered for GST. You carry on an enterprise in the provision of the properties to the partnership, but, as no consideration is charged for the supply and it is to an associate that is registered for GST, you have not registered for GST.

A company has underground mining rights granted on the majority of the properties and have now negotiated compensation under the Mineral Resources Act 1989 to enable it to apply for the granting of surface rights on the properties prior to the commencement of underground mining on the properties.

You and your advisors have been in negotiation with the company for some time with regards to appropriate compensation. You have reached an agreement on the compensation to be paid, but require confirmation from the ATO on the expected taxation treatment. Paragraph 1(i) of the offer of compensation states that the agreement is subject to you obtaining a ruling, with the expected outcomes. You agreed to apply for both CGT and GST rulings without delay.

You and your spouse have kept your business operations at a level you are both comfortable that you can manage. As a result of this, you are hopeful that as the mining is underground, you will be able to limit the impact of the mine to your business operation by moving cattle to areas not affected by the mining. Similarly, you are hopeful that the damage to improvements can be limited by the nature of the improvements and their construction.

The main detriment that will result from the mining operation is from the damage to the underlying land asset that will result from the long wall underground mining. The land is currently prime grazing land and would fetch top dollar because it is cleared, flat, well watered land that lends itself to an efficient grazing operation. It is expected that as a result of the mining operation, the land will suffer significant subsiding, cracking and sink holes across the affected area. The general natural water courses will also be affected which will have a negative impact on the ability to continue to run cattle on the property, as it is critical that the various paddocks have access to reliable water. History has shown that soil fertility is also affected, erosion can be expected and also water courses, both above and below ground can often be contaminated, making the water unusable for beef cattle. The underlying land asset will therefore suffer significant loss of value due to the impact of the mining operation. The company has conceded this and agreed to compensation. You have accepted these amounts of compensation.

The agreed compensation is to be paid to your solicitor's trust account within 60 days of signing the compensation agreement. You will be entitled to the interest from these funds until the surface rights are granted, at which time you will become entitled to the full amount of compensation. You will not be entitled to the principal if surface rights are not granted. The timing of the surface rights being granted is out of your control and will be when the company lodge their application and it is heard by the government.

The terms of the offer of compensation include:

· The compensation will be paid by the company to your solicitors on or before the date which is 60 days from the date of the signing of the Compensation agreement

· The sum will be invested by your solicitors in a trading bank, carrying on business in Australia, in the name of 'your solicitors as Trustee for you'

· All interest earned on the investment of the sum will be paid by your solicitors to you, as and when the interest is payable

· On the date on which the rights to the surface area are granted to the company, your solicitors will redeem the investment and pay the full amount (plus any accrued interest) to you for your own use and benefit absolutely

· The release of the sum by your solicitors to you is only to be made upon the grant of rights to the surface area to the company and upon receipt of written instructions from the company

· The company is to have the right to conduct mining operations on restricted areas

· The compensation amount is to be exclusive of GST. GST has not been charged on this payment as you are currently not registered for GST and it is believed that the consideration is not in respect of the provision of a 'taxable supply'. It is the intention that your clients accountants will apply for a private ruling on this issue from the Australian Taxation Office. If the transaction is subsequently considered to be a taxable supply by the ATO, then the company must pay to you an additional amount which is equal to the GST payable by you (the GST amount) in respect of the compensation (including any interest or penalties thereon). The payment is to be made within 10 business days of the earlier of:

o The receipt of the ruling advising that GST is payable; or

o The receipt of an amended assessment

· To avoid any misunderstanding, is it intended that as the additional payment will leave you with the full agreed amount of compensation clear of any GST liabilities (including interest and penalties) assessed

· The parties have negotiated compensation for the granting of surface rights in accordance with the Mineral Resources Act 1989, and have agreed upon the amounts:

· The agreement is subject to you obtaining a ruling in your favour from the ATO as to the expected taxation outcomes from the receipt of the above funds for compensation from the company. You agree to apply for both the GST and CGT ruling without delay and will notify the company immediately you have received confirmation form the ATO of the outcome of the rulings

· You means you, your personal representatives, trustees and beneficiaries pursuant to your Will.

The agreement also contains the details for an agistment licence.

Relevant legislative provisions

Section 6-5 of the Income Tax Assessment Act 1997

Subsection 6-5(2) of the Income Tax Assessment Act 1997

Subsection 6-5(4) of the Income Tax Assessment Act 1997

Subdivision 40-D of the Income Tax Assessment Act 1997

Subdivision 40F of the Income Tax Assessment Act 1997

Section 40-285 of the Income Tax Assessment Act 1997

Subsection 40-295(1) of the Income Tax Assessment Act 1997

Section 104-5 of the Income Tax Assessment Act 1997

Subsection 104-10(5) of the Income Tax Assessment Act 1997

Section 104-35 of the Income Tax Assessment Act 1997

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 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 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 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, 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

Question 1 and question 2

Summary

The amounts paid to you for deprivation of possession and diminution of the use of the land, severance and loss of profits for the two properties are not capital amounts. The amounts are assessable to you as income under section 6-5 of the ITAA 1997.

Detailed reasoning

Taxation Ruling TR 95/35 considers the treatment of compensation receipts.

Paragraph 3 of TR 95/35 defines an undisected lump sum compensation receipt as any amount of compensation received where the components of the receipt have not been and cannot be determined or otherwise valued or reasonably estimated. You have negotiated a lump sum compensation amount. However, the components of this amount are identifiable, and have been valued. Therefore the nature of each component, and the taxation of each component, can be considered.

Paragraph 188 of TR 95/35 explains that whether a receipt constitutes income or capital in the hands of the taxpayer depends on the circumstances of the receipt, and the reasons why it was paid to the taxpayer (FC of T v. Slaven 84 ATC 4077; (1984) 15 ATR 242) (Slavens Case). In Slavens Case, the court (Bowen CJ, Lockhart and Sheppard JJ), stated that it is the character of the receipt in the hands of the taxpayer as recipient that must be determined.

In your situation, you have separately received compensation for damage to fixed improvements and diminution in the underlying value of the land. You have received the amounts of $A and $B for the deprivation of possession and diminution of use of the land, severance and loss of profits for the two properties. These amounts are compensation for the loss of profits due to the reduced access to part of your lands.

As the compensation is replacing an income stream, the payments will have the character and nature of income in the recipients' hands.

The compensation amounts are income and assessable to you under section 6-5 of the ITAA 1997.

Question 3 and question 4

Summary

The amounts received for deprivation of possession and diminution of use of the land severance and loss of profits for the two properties are assessable as income in the year when the contract was entered into.

Detailed reasoning

Section 6-5 of the ITAA addresses ordinary income. Subsection 6-5(2) of the ITAA 1997 explains that your assessable income includes the ordinary income you derived directly or indirectly from all sources. The term 'derived' is defined in subsection 6-5(4) of the ITAA 1997. In working out whether you have derived an amount of income, and if so, when, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct.

The special conditions in the Offer of Compensation explain that the compensation is to be paid to your solicitors, to be held in trust for you when the compensation agreement is signed. As these funds have been applied or dealt with on your behalf, then this is when you derived these amounts.

The amounts are assessable as income in the year that the agreement is signed.

Question 5 and question 6

Depreciating assets do not take on the CGT status of the property they may be attached to. For example, a barn affixed to pre-CGT land does not necessarily mean that the barn is a pre-CGT asset.

Balancing adjustments are covered in Subdivision 40-D of the ITAA 1997. Subsection 40-295(1) of the ITAA 1997 explains that a balancing adjustment occurs for a depreciating asset if:

· you stop holding the asset; or

· you stop using it, or having it installed ready for use, for any purpose and you expect never to use it, or have it installed ready for use, again; or

· you have not used it and

· if you have had it installed ready for use - you stop having it so installed; and

· you decide never to use it.

To determine if a balancing adjustment applies, it is necessary to know what happens to the particular depreciating asset. If an asset is completely destroyed, then a balancing adjustment under section 40-285 of the ITAA 1936 will apply. If an asset is only partially destroyed or damaged, or not damaged at all, then the balancing adjustment provisions will not apply.

The Commissioner is declining to rule as the level of damage to the dwellings, buildings, fences and yards is a future event which would require an assumption which the Commissioner is not prepared to make in issuing the ruling.

Question 7, question 8 and question 11

Summary

The compensation amounts received for the two properties will not be assessable in the year that the surface rights are granted and the funds released.

They will be assessable in the year that the contract was signed.

Detailed reasoning

Section 104-5 of the ITAA 1997 provides a summary of the CGT events. The timing for many of the CGT events is when a contract is entered into (For example CGT events A1, C2, D1, D3, D4, and so on).

The time when a contract is entered into is the time when it comes into existence for general law purposes.

If a contract is subject to a condition, an issue arises whether the condition is a condition precedent to its formation or whether it is a condition precedent to performance of the contract. In the first case, the contract does not come into existence until the condition is met. In the second case, the condition does not prevent the creation of the contract - non-fulfilment of the condition merely entitles a party to terminate the contract (see Perri v. Coolangatta Investments Pty Ltd (1982) 149 CLR 537).

The judgement from Mason J considers the following:

· a condition in a contract will not be considered as a condition precedent to the formation of a contract unless the contract, read as a whole, plainly compels this conclusion

· in most cases, it is artificial to say, in the face of details settled upon by the parties, there is no binding contract unless the event in question happens. Instead, it is appropriate in conformity with the mutual intention of the parties to say that there is a binding contract which makes the stipulated event a condition precedent to the duty of one party, or perhaps both parties, to perform

· if a contract does not fix a time for completion, it would accord with general principle to say that completion must take place within a reasonable time

· the expression of a provision in the form of a condition precedent endows it with the character of essentiality. However, when the condition looks to the happening of an event within a reasonable time, it leaves open the question whether this character of essentiality attaches to the time within which the condition is to be fulfilled. Provisions requiring something to be done within a reasonable time are not considered to be essential unless expressly or impliedly made so

In your situation it is noted:

· the full amount of the compensation benefit is to be paid to your benefit within 60 days of signing the contract, irrespective of the status of the grant of surface rights

· the contract does not expressly provide for you to cancel the contract if the grant of surface rights is not made

· the contract does not address the issue of what happens if the grant of surface rights is not made. The assumption is that the grant will happen

· there is no due date for the grant of rights to the surface area

The contract as a whole reads as if the grant of rights to the surface area will happen and this occurrence merely provides a time for the release of the funds from being held in trust for you by your solicitor, into your possession.

It is considered that the grant of rights to the surface area is a condition precedent to the performance of the contract, rather than a condition precedent to the formation of the contract.

It is clear that a binding contract came into existence immediately upon signature, and that the parties to it were from that moment forward subject to certain obligations. For example, the company became liable to invest an amount with your solicitor in trust for you and to seek the grant of rights to the surface area. You were obliged to apply for ATO rulings on the GST and CGT issues.

Question 9 and question 13

Summary

The compensation amounts received for diminution in the underlying value of the land for the post-CGT property and for reinstatement costs for damage to fixed improvements on land, being dams and other water facilities for the post-CGT property, will be treated as a reduction in the cost base of the property with the excess over the cost base having no CGT consequences.

Detailed reasoning

Paragraphs 6 to 9 of TR 95/35 discuss compensation for permanent damage to, or permanent reduction in the value of, the underlying asset. Where an amount of compensation is received wholly in respect of permanent damage suffered to a post-CGT underlying asset, or a permanent reduction in value of that asset, and there is no disposal of that asset at the time of receipt of the compensation, the amount represents a recoupment of all or part of the total acquisition costs of the asset.

Paragraph 7 of TR 95/35 further explains:

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, in the case of a post-CGT underlying asst, 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.

In your situation you have received amounts of compensation for the post-CGT property:

o $C being for the diminution in the underlying value of the land

o $D being for reinstatement costs for damage to fixed improvements on land, being dams and other water facilities

These amounts will be applied to reduce the cost base for the property, and, any excess compensation over the cost base will have no CGT consequences.

Question 10 and question 14

Summary

As this property is a pre-CGT asset that you own, any capital gain or capital loss you may make is disregarded.

Detailed reasoning

Paragraph 9 of TR 95/35 explains that 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.

This is reinforced in subsection 104-10(5) of the ITAA 1997 which states that a capital gain or capital loss is disregarded if you acquired the asset before 20 September 1985.

The pre-CGT property is leased to you under a perpetual lease that commenced before 20 September 1985. The Explanatory Memorandum to the First Home Saver Accounts Act 2008 discusses legal ownership.

An individual holds an interest if they are the legal owner; that is, if their name is recorded on the title register as the owner of the property. This is commonly referred to as freehold ownership.

Persons can also hold such an interest if they have a perpetual lease of the land granted by the Commonwealth or the State.

As you are the registered lessee for the property and the lease is a lease in perpetuity, you are therefore the legal owner of the property.

The lease commenced before the introduction of capital gains tax. This property is therefore a pre-CGT asset.

So, any capital gain or capital loss you may make is disregarded under subsection 104-10(5) of the ITAA 1997 as you acquired the asset before 20 September 1985.

Question 12

The compensation amount received for the pre-CGT property has been determined to be not assessable under the CGT provisions as it relates to a pre-CGT asset.

The amount is therefore not assessable in either the year that the surface rights are granted and the funds released or when the contract was entered into.