Edited version of your private ruling

Authorisation Number: 1012050133985

This edited version of your ruling will be published in the public register of private binding rulings after 28 days from the issue date of the ruling. The attached private rulings fact sheet has more information.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet.

Ruling

Subject: CGT - compensation payment

Question 1

Are the payments for compensation made in relation to the agreement assessable as income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Are the payments for compensation made in relation to the agreement assessable as capital gains under the CGT provisions in Part 3-1 and 3-3 of the ITAA 1997?

Answer

No. For the purposes of subsection 110-40(3) of the ITAA 1997, these compensation payments will normally constitute a recoupment of the underlying asset (the land) acquisition cost, thereby reducing its cost base.

Question 3

If subject to capital gains tax what is the type of capital gain and is any gain eligible for the small business CGT concessions?

Answer

Not applicable.

This ruling applies for the following periods:

1 July 2008 - 30 June 2009

1 July 2009 - 30 June 2010

1 July 2010 - 30 June 2011

1 July 2011 - 30 June 2012

The scheme commences on:

1 July 2000

Relevant facts and circumstances

You are the owner of a rural property. You inherited the property from your late father.

A primary production business is operated on the property by a related entity.

On the property there is a tenement holder which holds a petroleum authority in accordance with the relevant state legislation. Some years ago the tenement holder (the company) entered the property and drilled a gas well thereon. Your father prior to his passing, entered into a compensation agreement (the agreement) with the company in relation to the activity.

Under a succession clause in the agreement you continue to receive compensation in relation to the activity.

In accordance with the Agreement, the company continues to pay compensation amounts under various heads of claim. You have provided details of the payments you have received per year in relation to the gas well activity.

The Agreement provides that some amounts will be payable to you on an annual basis. Other amounts are payable as a result of maintenance activity and other testing of the wells and surrounding area.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 subsection 6-5(1)

Income Tax Assessment Act 1997 subsection 6-5(4)

Income Tax Assessment Act 1997 subsection 110-40(3)

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

Whether a lump sum or other compensation payment constitutes assessable income in the hands of the recipient depends on whether it is a receipt of capital or rather ordinary income which in turn depends upon a consideration of all the circumstances surrounding the payment.  A compensation amount generally bears the character of that which it intends to replace.

Under subsection 6-5(1) of the ITAA 1997 ordinary income means income 'according to ordinary concepts'.

Under subsection 6-5(4) of the ITAA 1997 in working out whether you have derived an amount of ordinary income, and (if so) when you derived it, 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 tax legislation does not provide specific guidance on the meaning of income according to ordinary concepts. However, a substantial body of case law exists which identifies likely characteristics. In determining whether an amount is ordinary income, the courts have established the following principles:

§ what receipts ought to be treated as income must be determined in accordance with ordinary concepts and usages, except in so far as a statute dictates otherwise;

§ whether the payment received is income depends upon a close examination of all relevant circumstances; and

§ whether the payment received is income is an objective test.

Relevant factors in determining whether an amount is ordinary income include:

§ whether the payment is the product of any employment, services rendered, or any business;

§ the quality or character of the payment in the hands of the recipient;

§ the form of the receipt, that is, whether it is received as a lump sum or periodically; and

§ the motive of the person making the payment, but noting that this latter factor is rarely decisive, as a mix of motives may exist.

In GP International Pipecoaters Pty Ltd v. Federal Commissioner of Taxation (1990) 170 CLR 124; 90 ATC 4413; (1990) 21 ATR 1, the Full High Court stated:

To determine whether a receipt is of an income or of a capital nature, various factors may be relevant. Sometimes the character of receipts will be revealed most clearly by their periodicity, regularity or recurrence; sometimes, by the character of a right or thing disposed of in exchange for the receipt; sometimes, by the scope of the transaction, venture or business in or by reason of which money is received and by the recipient's purpose in engaging in the transaction, venture or business.

Ultimately, whether or not a particular receipt is ordinary income depends on its character in the hands of the recipient. The whole of the circumstances must be considered. Amounts that are periodical, regular or recurrent, relied upon by the recipient for their regular expenditure and paid to them for that purpose are likely to be ordinary income.

However, payment for the loss of a capital asset or an enduring part of a taxpayer's profit-yielding structure will usually be capital in nature (Glenboig Union Fireclay Co Ltd v. IR Commrs (1922) 12 TC 427). In some cases compensation payments are assessable as ordinary income. These situations are outlined in Taxation Determination TD 93/58.

The payments you received to date have consisted partly of an annual payment in relation to the ongoing use of the wells. It could be said there are elements of ordinary income to these payments as they are periodic and may represent either rental income or replacement income (from loss of profits).

The agreement sets out that the receipt of the compensation payments from the company is to compensate you in full and final satisfaction of all obligations under the relevant state legislation for activities undertaken by the company in relation to the drilling and on going activity in relation to the gas wells. Under the agreement the company is and will remain the owner of infrastructure created. The land is not used by you as part of the profit yielding structure. (It is noted that primary production activity is carried on by a related entity).

The receipt of the compensation payments from the company are neither a normal incident of a business activity of yours nor are they paid for a purpose for which a business of yours was carried on.

In Nullaga Pastoral Co Pty Ltd v FC of T 78 ATC 4329 (Nullaga's Case), the taxpayer owned a farming property which two other companies, as joint venturers, wished to explore for bauxite. An agreement was negotiated whereby the joint ventures were granted exploration rights for five years and, as consideration for those rights, the taxpayer was to receive $10,000 annually. Wickham J said that the agreement had hardly any of the characteristics of a lease and that in his opinion the amounts were paid and received as consideration for the deprivation of part of the capital asset and in order to replace that capital.

In Barrett v Federal Commissioner of Taxation (1968) 118 CLR 666; (1968) 15 ATD 149; (1968) 10 AITR 685 (Barrets Case), the right to mine soapstone was exercised on Barret's land. Barret received an amount of money to compensate for damage to and loss of value to the land and inconvenience to Barret. Mining operations were carried out on the land for a number of years and in each year the mining company paid the taxpayer by monthly instalments an amount calculated at the rate of five shillings per ton for every ton of soap stone removed from the land during the year.

In each year, the Commissioner had included the payments as assessable income, but the High Court ruled the payments were made and received for the purpose of making good the estimated diminution in value of the land and the amount of damage to it which might result from the carrying on of mining operations. They were not payment of royalties or payments received by the company as income in return for the grant of a licence to use the land for the purpose of mining. Further, in both cases the periodic nature of the payments did not convert them into revenue sums.

In this case it is considered the payments received from the company as per the compensation agreement are capital receipts, and are not assessable income under section 6-5 of the ITAA 1997.

Question 2

Taxation Ruling TR 95/35 deals with the CGT treatment of compensation receipts. TR 95/35 sets out the 'look-through' approach of identifying the most relevant asset. Paragraph 3 of TR 95/35 reads:

The look through approach is the process of identifying the most relevant asset. It requires an analysis of all 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.

Under TR 95/35 there are three main issues to contemplate:

§ an actual disposal of the underlying asset

§ no disposal of the underlying asset but compensation for permanent damage or reduction to that asset

§ no disposal of the underlying asset but compensation for giving up the right to seek compensation.

Paragraph 3 also discusses underlying assets, and states:

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.

Compensation for the disposal of an underlying asset

Paragraph 4 of TR 95/35 states that 'if an amount 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'.

Therefore, it is necessary to show that there is an actual disposal of the underlying asset (in this case the land subject to the agreement), and also that the receipt is wholly in respect of that disposal. The company has the right to enter and re-enter part of the land but there has not been an actual disposal of the land.

No disposal of the underlying asset, but permanent damage to, or permanent reduction in the value of, the underlying asset

The term 'permanent damage or reduction in value' is defined in paragraph 3 of TR 95/35 as not meaning an everlasting damage or reduced value, but damage or value reduction which will have permanent effect unless some action is taken by the taxpayer to put it right.

Where the compensation received relates to land acquired after 19 September 1985 (post CGT land) then using the look through approach, if the compensation relates to permanent damage to it, or a permanent reduction in its value, then the cost base of the asset is reduced accordingly. Specifically, under subsection 110-40(3) of the ITAA 1997, the payment is treated as a recoupment of the asset's acquisition cost.

Paragraphs 6 to 8 of TR 95/35 provide comment on this legislation confirming that the payment would not be considered an assessable capital gain. Rather, the compensation for reduced value or damage to the underlying asset would result in a recoupment of the acquisition cost of the asset, which in turn would reduce its cost base. There would be no capital gain until a disposal of the underlying asset occurs.

No disposal of the underlying asset, but disposal of the right to seek compensation

As per paragraph 11 of TR 95/35, if the amount of compensation is not received in respect of any underlying asset, the amount relates to the disposal by the taxpayer of the right to seek compensation.

Application to your situation

Annual payments

The details of this payment are that it will continue to be made until abandonment or transfer of the well to the landholder. The payment rate will be adjusted to reflect any changes to the unimproved value of the land in accordance with shire rate notices.

In Question 1 it was concluded the payment was not ordinary income in the form of rent or replacement income.

The payment could not be said to be for disposal of the right to seek compensation. The agreement outlines the landholder's rights for compensation in relation to future loss or damage to livestock or facilities on the land as a result of the company's activities.

In the circumstances outlined, payments received under this section relate to a permanent reduction in the value of the land and such compensation would be treated as a recoupment of the asset's acquisition cost under subsection 110-40(3) of the ITAA 1997.

Other non periodic payments

The details of these payments are that they will be paid in respect of certain development or other activity which the company may carry out on or in respect of the well after the execution of the agreement. The activities relate to testing, access and creation of supporting infrastructure.

The payment rate will be adjusted to reflect any changes to the unimproved value of the land in accordance with shire rate notices (section 1.4 of the agreement).

The payment could not be said to be for disposal of the right to seek compensation. The agreement outlines the landholder's rights for compensation in relation to future loss or damage to livestock or facilities on the land as a result of the company's activities.

In the circumstances outlined, any payments received under this section relate to a permanent reduction in the value of the land and such compensation would be treated as a recoupment of the asset's acquisition cost under subsection 110-40(3) of the ITAA 1997.

Question 3

The payments received under the agreement are treated as a recoupment of the acquisition cost of the CGT asset, therefore a capital gain will not arise. As a result, consideration of the small business CGT concessions is not required.