Edited version of your private ruling

Authorisation Number: 1012439869433

Ruling

Subject: Capital Gains Tax

Reasons for decision

Summary

The capital proceeds received for the proposed acquisition of an easement over your land would not be assessable as ordinary income; however, it would be assessable under the capital gains tax provisions (CGT).

Section 104-35 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that a CGT event D1 happens when you create a contractual right or other legal or equitable right in another entity. The time of the event is when you enter into the contract or create the right.

An easement is a right over someone else's land or property. If an easement is created as a result of the exercise of an option then this will trigger a CGT event D1.

Any annual easement payment that is received by the taxpayers is characterised as revenue rather than capital and assessable under section 6-5 of the Income Tax Assessment Act 1997 and must be included in your income tax return.

Detailed reasoning

Question 1

Is the proposed initial easement payment of $X for the voluntary grant of an easement over your land assessable under the capital gains tax (CGT) provisions of the Income Tax Assessment Act (ITAA 1997)?

Taxation Ruling IT 2561 Income Tax : Capital Gains : Grants of Easements, Profits a Prendre and Licences, (Taxation Ruling IT 2561) Taxation Ruling TR 97/3 Income tax: capital gains: compensation received by landowners from public authorities (Taxation Ruling 97/3) and Taxation Determination TD 93/235 Income tax: capital gains: how are grants of easements treated for the purposes of the capital gains tax (CGT) provisions of the Income Tax Assessment Act 1936 ? (TD 92/235) applies to assessments for the 1998-1999 and later income years. No change to the taxation treatment of easements occurred in the rewrite of the provisions from the ITAA 1936 to the ITAA 1997.

Easements in general

Taxation Ruling IT 2561 defines an easement as a right over someone else's land or property and provides that an easement is an asset created at the time it is granted. TD 93/235 states that the granting of an easement constitutes the disposal of an asset by the grantor.

Easements which can be created by compulsory acquisition

Easements which can be created by compulsory acquisition are considered differently to general easements.

Taxation Ruling TR 97/3 at paragraph 4 states:

Compensation in respect of an easement created by statute in favour of a public authority cannot be said to have been received for the grant of the easement. The Land Acquisition (Just Terms Compensation) Act 1991 (NSW) and similar Acts in other jurisdictions enable public authorities to take land or an interest in land (including an easement) for specified purposes and confer on the affected landowner a right to compensation. In these circumstances, the landowner cannot be said to have created an asset as required for subsection 160M(6) of the Act to apply. The easement is created by operation of the relevant statute and is vested in the public authority. This constitutes a compulsory acquisition of the easement.

TR 97/3 paragraph 8 states:

... compensation received by a landowner is accepted as consideration received for the part disposal of the underlying asset (the land). The amount is not consideration received for the disposal of any other asset, such as the right to seek compensation. TR 97/3 paragraph 8.

TR 97/3, at paragraphs 9 and 10, provides the Commissioners view on easements granted to a public authority, which has the statutory power to compulsorily acquire the easement, but acquires the easement by agreement with the landowner. As the public authority has the power to compulsorily acquire the easement, if it chooses, the amount received takes on the same character as compensation for a compulsorily acquired easement. It is payment for a part disposal of land.

Voluntary grant of an easement to someone without any statutory power to acquire the easement

Paragraph 11 of TR 97/3 provides the Commissioners view on granting an easement to an entity without any statutory power to acquire the easement. The grant of an easement in this case, where the grantee does not have any statutory power to acquire the easement, constitutes the creation and disposal of an asset to which subsection 160M(6) of the ITAA 1936 (now s104-35 of the ITAA 1997 ) would apply (CGT event D1 - creating contractual or other rights).

The potential voluntary grant of an easement would result in a D1 event creating a legal right by granting an easement rather than a part disposal of land. The landowners would be receiving payments for creating a right in favour of the power provider rather than a consequential loss of rights. While the payments may take into account the effect the voluntary grant would have on the land it does not mean that the payments are not paid to the power provider in respect of the creation of the easement and not in relation to a loss of rights. The initial easement payment would be taxable under the CGT provisions under subsection 104-35(2) of the ITAA 1997 at the time the legal right is created (when the option is executed).

Question 2

Will any capital gain or loss be disregarded?

Assessable under capital gains tax provisions

The CGT consequences will depend on the calculation of the cost base and the capital proceeds received. A capital gain would arise where the capital proceeds from creating the right are more than the incidental costs incurred in relation to the event. A capital loss would arise if the capital proceeds are less than the incidental costs.

Amounts received which are not direct compensation for loss of income, will usually be capital in nature and are potentially taxable as statutory income under the CGT provisions of the ITAA 1997.

Taxation Ruling TR 97/3 discusses the capital gains treatment of compensation receipts. TR 97/3 specifically deals with compensation received by landowners from public authorities. In your case, the power provider is not a public authority.

A CGT event D2 will not occur if the option is exercised: s 104-40(5) of the ITAA 1997. In this case, the option transaction will be "merged" with the grant of the easement to treat any exercise price, plus the amount given for granting the option, as the capital proceeds for CGT event D1: see Division 134 of the ITAA 1997 the cost base for the event will be the "incidental costs" incurred by the taxpayer in relation to the event: (s110-35 of the ITAA 1997).

The exercise of an option will trigger a CGT event D1 (the creating contractual or other rights). Section 104-35 of the ITAA 1997 provides that the time of the D1 event is taken to have occurred when you enter into the option agreement.

Accordingly, if the capital proceeds received in compensation exceed the cost base of the asset in question, you would be considered to have made a capital gain, and it will be assessable under the capital gains tax provisions.

Question 3

Can you apply the small business capital gains tax (CGT) concessions in Division 152 of the ITAA 1997 to any capital gain resulting from the voluntary grant of the easement if you satisfy the basic conditions in section 152-10 of the ITAA 1997 and any other relevant conditions?

CGT Small business concessions

Any capital gain that results from a CGT event may be reduced or disregarded under the small business CGT concessions provided certain conditions are satisfied.

To qualify for the small business CGT concessions, the basic conditions in section 152-10 of the ITAA 1997 must be satisfied for the gain. Some concessions also require other conditions to be satisfied.

In your case, if you make a capital gain as a result of CGT event D1 as discussed above, you may be able to apply the small business CGT concessions in Division 152 of the ITAA 1997 provided that you satisfy the basic conditions and any other relevant conditions.

Section 152-10 of the ITAA 1997 contains the basic conditions you must satisfy to be eligible for the small business capital gains tax (CGT) concessions. These conditions are:

(a) a CGT event happens in relation to a CGT asset in an income year.

(b) the event would have resulted in the gain

(c) at least one of the following applies:

(i) you are a small business entity for the income year

(ii) you satisfy the maximum net asset value test in section 152-15 of the ITAA 1997

(iii) you are a partner in a partnership that is a small business entity for the income year and the CGT asset is an asset of the partnership or

(iv) the conditions in subsection 152-10(1A) or (1B) of the ITAA 1997 are satisfied in relation to the CGT asset in the income year.

(a) the CGT asset satisfies the active asset test in section 152-35 of the ITAA 1997.

Section 152-40 of the ITAA 1997 provides the meaning of 'active asset'. A CGT asset will be an active asset at a time if, at that time, you own the asset and the asset was used or held ready for use by you, an affiliate of yours, or by another entity that is 'connected with' you, in the course of carrying on a business. However, an asset whose main use is to derive rent can not be an active asset.

Section 152-35 of the ITAA 1997 explains that an asset will be an active asset if you have owned the asset for more than 15 years and it was an active asset for a total of at least 7 ½ years from the time when you acquired the asset until the CGT event. Or, you have owned the asset for 15 years or less and the asset was an active asset of yours for a total of at least half of the time from when you acquired the asset until the CGT event.

Subsection 152-40(1) of the ITAA 1997 provides that an asset is an active asset if the asset is an intangible asset you own and is inherently connected with a business that is carried on (whether alone or in partnership) by you, your affiliate, or an entity connected with you.

50% CGT discount

A 50% discount may be applied to a discount capital gain realised by an individual. In order to be considered a discount capital gain, the asset that gave rise to the capital gain must have been owned for a period of at least 12 months prior to the CGT event (section 115-25 of the ITAA 1997).

A capital gain from CGT event D1 is not a discount capital gain under subsection 115-25(3) of the ITAA 1997. This is because the CGT asset comes into existence at the time of the event, making it impossible to have acquired the asset at least 12 months before the event.

In your circumstances you will not be able to apply the 50% CGT discount.

Question 4

Assessable as ordinary income

Under section 6-5 of the ITAA 1997 your assessable income includes income according to ordinary concepts. This income is called 'ordinary income'.

There is no definition of 'ordinary income' in the tax law. The courts however have established the following principles to determine if an amount is ordinary income:

i) it must be determined in accordance with ordinary concepts and usages, except where statute provides otherwise;

ii) it depends on a close examination of all relevant circumstances; and

iii) it is an objective test

Ordinary income has generally been held to include three categories, namely, income from rendering personal services, income from property (rent) and income from carrying on a business.

Other characteristics of income that have evolved from case law include receipts that:

· are earned

· are expected

· are relied upon, and

· have an element of periodicity, recurrence or regularity.

No one factor is decisive and each situation must be examined to determine if the particular payment can be characterised as income according to ordinary concepts.

Periodicity or regularity of payment is a common characteristic of income receipts, even where the receipts are not directly referrable to employment or services rendered (Commissioner of Taxation v. Citibank (1993) 44 FCR 434; 93 ATC 4691;(1993) 26 ATR 557).

Characterising amounts as income or capital is important in determining the correct tax treatment. In Scott v FCT (1966) 117 CLR 514, Windeyer J stated:

Whether or not a particular receipt is income depends upon its quality in the hands of the recipient.

Therefore, whether amounts are income or capital will depend upon what it is that the amount is replacing in your hands. This necessitates consideration of all the circumstances surrounding the receipt. As the High Court stated in G P International Pipecoaters Pty Ltd v. Federal Commissioner of Taxation (1990) 170 CLR 124; 90 ATC 4413; (1990) 21 ATR 1 at CLR 138; ATR 7; ATC 4420:

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 the transaction, venture or business.

Capital gains are not ordinary income in the hands of the recipient however they may still be assessable statutory income under section 6-10 of the ITAA 1997.

The character of the receipt in the hands of the recipient must be determined. It is in this context that the character of the payment is determined. If the payments are periodical, the question becomes, are the payments instalments of the capital amount or really in the nature of income. 

In your case, the annual easement payment does have an element of recurrence or regularity. In addition, the payment is expected and relied upon.

To determine whether the annual payment is direct compensation for loss of income, or identifiable and quantifiable as income it is necessary to consider the activities for which the compensation is being paid.

Compensation receipts which substitute for income have been held by the courts to be income under ordinary concepts. The annual payment you will receive if the easement is granted is an annual easement payment. The payments the taxpayers will receive are considered to be an annual payment in relation to the ongoing use of the easement. 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). In respect of the annual easement payment is considered to be rental income or compensation for loss of primary production income.

Accordingly, the annual payment is considered ordinary income and is therefore assessable under section 6-5 of the ITAA 1997.

Conclusion

The voluntary grant of an easement by the taxpayers to a power provider will result in a CGT event D1. Under subsection 104-35(3), you will make a capital gain from CGT event D1 if the capital proceeds from creating the right are more than the incidental costs you incurred that relate to the event. You make a capital loss if those capital proceeds are less.

The taxpayers may be eligible for the small business concessions under Division 152 of the ITAA 1997 if they are able to satisfy the conditions.

The annual easement payment is characterised as income and is therefore assessable under section 6-5 of the ITAA 1997.