Edited version of your private ruling

Authorisation Number: 1012466378603

Ruling

Subject: Treatment of compensation receipts

Question 1

Is the proposed receipt for the loss of store space assessable income under Part 3-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Is the proposed receipt for the loss of store space assessable income as ordinary income under section 6-5 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

1 July 2012 - 30 June 2013

1 July 2013 - 30 June 2014

The scheme commences on:

The date the ruling is made.

Relevant facts and circumstances

X Pty Ltd (you) have leasehold agreements (current lease agreements) for the lease of your business premises.

The termination date of your current lease agreements is 30 June 2013.

Your business premises are being relocated.

You will be entering into a new lease agreement for your allocation of space at the new premises.

If the termination date of your current lease agreements does not coincide with the relocation of the current premises to the new premises, your current leases will be varied to extend their term to that time.

The relocation to the new premises will occur after the termination date of your current lease agreements.

You will be allocated less space at the new premises than you are allocated in accordance with your current lease agreements.

There has been no breach of your current lease agreements.

Correspondence to you from the lessor states that:

· you are entitled to a payment (the proposed receipt) for a loss of store space in relation to your leaseholds

· the payment for reduced space will only be made if you agree to the terms of the deed poll

Your commitments under the deed poll include:

· Withdrawal of any caveat you have lodged over the existing premises

· Non-participation in legal proceedings or lodging of future caveat

· Release and covenant not to sue the lessor in respect of all claims directly or indirectly related to:

o The space allocated to you at the new premises

o The withdrawal of any interest claimed in the caveat lodged over the existing premises

o The legal proceedings

You are not a party to the proceedings identified in the Deed Poll.

Your business's sales are generated as a result of customers seeing and inspecting displayed stock.

The reduction in floor space will result in your business being commercially disadvantaged.

The reduction in floor space will require you incur additional costs to your business

Relevant legislative provisions

Subsection 4-15(1) of the Income Tax Assessment Act 1997

Section 6-5 of the Income Tax Assessment Act 1997

Part 3-1 of the Income Tax Assessment Act 1997

Subsection 102-1(1) of Part 3-1 of the Income Tax Assessment Act 1997

Subsection 104-10(2) of the Income Tax Assessment Act 1997

Subparagraph 104-25(1)(c) of the Income Tax Assessment Act 1997

Section 108-5 of the Income Tax Assessment Act 1997

Subsection 108-5(1) of the Income Tax Assessment Act 1997

Paragraph 108-5(2)(b) of the Income Tax Assessment Act 1997

Further issues for you to consider

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'.

Issue 1

Question 1

Summary

No. The proposed receipt is not assessable income under Part 3-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

Detailed reasoning

The Law

Subsection 102-5(1) of Part 3-1 of the ITAA 1997 states that 'Your assessable income includes your net capital gain (if any) for the income year'.

Subsection 108-5(1) defines a CGT asset as:

(a) any kind of property; or

(b) a legal or equitable right that is not property.

Therefore, a lease is a CGT asset.

The right to seek compensation or the right to give up the right to receive compensation are also CGT assets which can be disposed of by obtaining an award for damages or by accepting a settlement.

Under paragraph 108-5(2)(b) goodwill is also a CGT asset. When determining whether an award for damages is assessable as ordinary income (revenue) or statutory income (capital), the Full Federal Court in Commissioner of Taxation v Sydney Refractive Surgery Centre Pty Ltd {2008} FCAFC 190; 2008 ATC 20-081; (2008) 73 ATR 28 confirmed that the proper test is to look at the character of the payment in the hands of the taxpayer. For an award of damages, that test requires an examination of the nature of the claim or cause of action for the payment and not how the payment was formulated.

In Case Z21 92 ATC 218; Case 7870 (1992) 23 ATR 1162, the Administrative Appeals Tribunal (P W Johnston, Deputy President) accepted that $165,000, received on the termination of a management agreement, was compensation for loss of future earnings, and therefore assessable income. The amount was received as compensation for the repudiation of the agreement, and was paid to avoid paying damages arising as a result of the termination of the agreement. The Tribunal found that the receipt stood in the place of damages to compensate for the loss of future profits, and not for the loss or destruction of the facility or business asset which the company would have exploited to earn those management fees.

You can only make a capital gain or loss from a CGT asset if a CGT event happens.

CGT event A1 occurs when you dispose of a CGT asset.

Subsection 104-10(2) states that you dispose of a CGT asset when a change of ownership occurs from you to another entity.

CGT event C2 occurs when your ownership of an intangible CGT asset ends by cancellation, surrender or similar endings.

The word 'expiring' in subparagraph 104-25(1)(c) of the ITAA 1997 is limited to a lapse of time in accordance with Taxation Determination 1999/76 Income tax: does the word 'expiring in paragraph 104-25(1)(c) and the expression 'expiry of a CGT asset' in subparagraph 116-30(3)(a)(i) of the Income Tax Assessment Act 1997 include voluntary terminations?

CGT event D1 occurs when you create a contractual or other right.

CGT event F4 occurs when a lessee receives payment for changing a lease.

If the proposed payment does not relate to either an underlying asset or a right to seek compensation, CGT event H2 must be considered.

CGT even H2 is a catch-all residual event that occurs when an act, transaction or even happens to a CGT asset that you own and the act, transaction or even does not result in an adjustment being made to the asset's cost base or reduced cost base.

Application of your circumstances to the law

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts (TR 95/35) considers the capital gains tax consequences of compensation receipts and whether the amount should be included in assessable income under Part 3-1 of the ITAA 1997.

Paragraph 3 of TR 95/35 defines relevant terms including:

· Compensation receipt

· Look-through approach

· Permanent damage or reduction in value

· Right to seek compensation

· Underlying asset

· Undissected lump sum compensation receipt

A compensation receipt includes any amount received by a taxpayer in respect of a right to seek compensation or a cause of action, or any proceeding instituted by the taxpayer in respect of that right or cause of action.

The right to seek compensation is the right of action arising at law or in equity and vesting in the taxpayer on the occurrence of any breach of contract, personal injury or other compensable damage or injury.

From the facts you have provided:

· the proposed receipt is for compensation for the reduction in store space.

· the reduction in floor space will not occur until the expiration of your current lease agreements

· your current lease agreements contain no clauses which grant you a right to a specified or minimum amount of floor space at the new premises

· clause 31 of your current lease agreements anticipates a possible extension to the term of your current lease agreements

Therefore, the proposed receipt will not be received as satisfaction for a right of action arising at law or in equity due to any breach or contract or other compensable damage.

What is the underlying asset?

TR 95/35 defines underlying asset as 'the asset that, using the 'look-through' approach is disposed of or has suffered permanent damage or has been permanently reduced in value … which has resulted in a right to seek compensation from the person or entity causing that damage or loss in value … .'

Your current lease agreements

From the facts you have provided:

· you are not aware that any variations will be made to your current lease agreements and the amount of stores and/or store space that you have rights to under your current lease agreements will not vary

· the current lease agreements will expire at the end of their current term, or if that date does not coincide with the relocation, the leases will be varied to extend the term of the current lease agreements to that time

· the amount of floor space will vary only when you enter into a new lease agreement/s

· your current lease agreements contain no clauses which grant you a right to a specified or minimum amount of floor space at the new premises

As the amount of floor space under your current lease agreements will not be reduced, the term of your current lease agreements may not be extended and there will not be a cancellation of your current lease agreements, the proposed receipt cannot be for a variation of any terms of the current lease agreements.

Therefore, the current lease agreements are not the underlying asset that has suffered permanent damage or has been permanently reduced in value, nor will there be a disposal of your current lease agreements.

Goodwill

Goodwill is a CGT asset in accordance with section 108-5 of the ITAA 1997. Therefore it is necessary to consider whether there has been a disposal or permanent damage to the goodwill of your business.

From the facts you have provided:

· the proposed receipt will be paid to you by the lessor for the reduction in floor space under the new lease agreement, not for a reduction in floor space under your current lease agreements

· any damage to your business will not be incurred until after you enter into the new lease and will only be caused by you entering into a new lease agreement for reduced floor area

· your current lease agreements will expire and contain no clauses which grant you a right to a specified or minimum amount of floor space at the new premises

· there has not been any reputational affect on your business

· your business will continue to operate when you enter into a new lease agreement, that is, the reduction in floor space will not cause your business to cease

· you do not have a right of action arising at law or in equity for the breach of any contract or other compensable damage or injury.

Therefore, the proposed payment cannot be connected to a permanent reduction in the value of your goodwill.

As explained at paragraph 11 of TR 95/35 the Commissioner considers that if the payment is not received in respect of any underlying asset, the amount relates to the disposal of your right to seek compensation. However in your case there will not be a breach of any terms of your current lease agreements and you will not have a right to seek compensation in respect of your current lease agreements.

Therefore TR 95/35 cannot apply to the proposed receipt because it will not be received as:

· compensation for the disposal of an underlying asset

· compensation for permanent damage to, or permanent reduction in the value of the underlying asset or

· disposal of the right to seek compensation

Further explanation of why the payment is not assessable under Part 3-1 of the ITAA 1997 is provided by an analysis of the following CGT events:

CGT event A1:

Is the proposed receipt proceeds for a disposal of your current lease agreements?

No, the proposed receipt is not a disposal of your current lease agreements as your current lease agreements will expire and there will be no change of ownership of the current lease agreements from you to another entity.

Is the proposed receipt proceeds for the disposal of a right to seek compensation?

No. As the payment cannot be attributed to permanent damage or reduction in value of an underlying asset, and there has been no breach of an agreement that would create a right for you to seek compensation, the payment cannot be received for disposal of a right to seek compensation.

Is the proposed receipt proceeds for the disposal of the goodwill of your business?

No. Your current lease agreements will expire you will continue to operate your business under new lease agreement. There will be no transfer of your business's goodwill from you to another entity.

CGT event C2: Is the proposed receipt proceeds for the cancellation, surrender and similar ending of your current lease agreements?

When a lease expires it has no value and the word 'expiring' in paragraph 104-25(1)(c) of the ITAA 1997 is limited to an expiry by a lapse of time. This is confirmed in TD 1999/76

From the facts you have provided:

· your current lease agreements will expire at the end of their current or any extended term

· there will not be a cancellation or surrender of any of your current lease agreements

· the proposed receipt is for the reduction in floor space which will result in a commercial disadvantage to your business

While CGT event C2 will occur in relation to the expiration of your current lease agreements, this is not the cause of you receiving the proposed receipt. Therefore, the proposed receipt cannot be capital proceeds from CGT event C2.

CGT event D1: Is the proposed receipt proceeds for the creation of a contractual or other right?

From the facts you have provided:

· your current lease agreements will expire at the end of their current or any extended term

· your current lease agreements contain no clauses which grant you a right to a specified or minimum amount of floor space at the new premises

· there will not be a cancellation or surrender of any of your current lease agreements

· the proposed receipt is for reduction in store space and not for satisfaction for a right of action arising at law or in equity due to any breach of contract or other compensable damage or injury

· the proposed receipt for reduced space will only be made if you agree to the terms of the deed poll

Upon the expiration of your current lease agreements there cannot be a breach of these agreements by the lessor. Therefore, the proposed receipt cannot be for the creation of a contractual right between you and the lessor that you will not sue or seek compensation or damages for any claim you have arising out of the space allocated to you at the new premises or the current premises.

A condition of you receiving the proposed payment is that you sign the deed poll.

· Your commitments under the deed poll include:

· Withdrawal of any caveat you have lodged over the existing premises

· Non-participation in the legal proceedings or lodging of future caveat

· Release and covenant not to sue the lessor in respect of all claims directly or indirectly related to:

o The space allocated to you at the new premises (including the loss of space or the requirement to pay for the gain of space)

o The withdrawal of any interest claimed in the caveat lodged over the existing premises

o The legal proceedings

TR 95/35 adopts a 'look-through' approach, which identifies the most relevant to which the compensation amount is most directly related to. Further, Goods and Services Tax Ruling GSTR 2001/4 GST consequences of court orders and out of court settlements states that a discontinuance supply is 'in the nature of a term or condition of the settlement, rather than being the subject of the settlement.' Therefore, the proposed payment is not proceeds for the creation of a contractual right.

CGT event F4: Is the proposed receipt proceeds for payment for changing a lease?

From the facts you have provided and clause 26 of your current lease agreements:

· the current lease agreements expire at the end of their current term however, if the current termination date of the lease agreements does not coincide with the shift of the premises then the lease will be varied to the extend the term of the current lease to that time.

Therefore, the proposed receipt is not being paid to you for varying any terms of the lease agreements as the terms of the current lease agreements may not need to be changed.

CGT event H2:

For CGT even H2 to apply, the proposed receipt must:

· relate to a CGT asset that is owned by you and

· not result in an adjustment being made to the asset's cost base or reduced cost base.

From the facts you have provided:

· the proposed receipt will be paid to you by the lessor for the reduction in floor space under the new lease agreement, not for a reduction in floor space under your current lease agreements

Therefore, the payment relates to a potential future CGT asset - the new lease agreement. As you do not own this CGT asset until you enter into the new lease agreement, there is no CGT asset owned by you for CGT event H2 to apply.

Question 2

Summary

Yes. The proposed receipt is assessable income as ordinary income under section 6-5 of the ITAA 1997.

Detailed reasoning

The Law

Income tax is imposed on 'taxable income'. Under subsection 4-15(1) of the ITAA 1997 taxable income = assessable income - deductions.

Division 6 of the ITAA 1997 explains 'assessable income' and 'exempt income'.

Assessable income includes 'ordinary income' and 'statutory income'.

Ordinary income is defined under section 6-5 of the ITAA 1997 as 'income according to ordinary concepts'. There is no specific guidance on what is meant by ordinary concepts however, there has been much case law on this definition.

Statutory income includes net capital gains. Part 3-1 of the ITAA 1997 explains how the capital gains tax (CGT) provisions apply to working out your taxable income.

Ordinary income has been held to include income from providing personal services, income from property and income from carrying on a business. Other characteristics of income that have evolved from case law include receipts that:

· are earned

· are expected or relied upon

· have an element of periodicity, recurrence or regularity

· replace income

An amount paid to compensate for loss generally acquires the character of that for which it is substituted (FC of T v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443; 10 ATD 82).

Taxation Determination TD 93/58 Income tax: under what circumstances in the receipt of a lump sum compensation/settlement payment assessable? outlines the circumstances under which the receipt of a lump sum compensation/settlement payment is assessable as ordinary income. The determination states that where the compensation payment is for loss of income, the amount is assessable as ordinary income. Where a portion of a lump sum payment is identifiable and quantifiable as income, that portion of the payment will be assessable.

Taxation Ruling No. IT 2631 Income Tax: Lease Incentives considers the taxation of cash and non-cash lease incentives in view of the following cases:

The Full Federal Court in F.C. of T. v. Cooling 90 ATC 4472 determined that an incentive to enter into a lease agreement had an income character.

The judgement in the Cooling case also cited the Full Court of the High Court case F.C. of T. v. Myer Emporium Ltd 87 ATC 4363 where Hill J determined that:

A receipt may constitute income, if it arises from an isolated business operation or commercial transaction entered into otherwise than in the ordinary course of the carrying on of the taxpayer's business, so long as the taxpayer entered into the transaction with the intention or purpose of making a relevant profit or gain from the transaction.

Application of your circumstances to the law

Is the proposed receipt assessable as ordinary income under section 6-5 of the ITAA 1997?

A lump sum compensation payment received for loss of income or profits is assessable as income according to ordinary concepts under section 6-5 or the ITAA 1997. That is, it is of the nature of the income that it is replacing.

The calculation of the compensation amount as detailed in the letter from the Department of Business and Innovation, indicates that the whole amount of the payment is in respect of the reduction in store space.

From the facts you have provided:

· the sales of your business are generated by customers seeing and inspecting displayed stock

· the reduction in floor space will result in a reduced floor display

· your business will be commercially disadvantaged

· you will not be able to mitigate the damage to your business

· you will be required to incur additional costs in your business to secure separate warehousing space

Therefore, the nature of the payment is for loss of future profits and assessable under section 6-5 of the ITAA 1997.

Alternatively, the payment may be a cash incentive to enter into a new lease agreement and provide consideration for you to move your business from the current premises to the new premises.

The letter from the Department of Business and Innovation states that the 'Minister has agreed to pay $3,000 per square metre from the Industry Assistance Package for loss of store space to assist in the relocation.'

The Full Federal Court in F.C. of T. v. Cooling 90 ATC 4472 determined that an incentive to enter into a lease agreement had an income character where Hill J. stated:

Where a taxpayer operates from leased premises, the move from one premises to another and the leasing of the premises occupied are acts of the taxpayer in the course of its business activity just as much as the trading activities that give rise more directly to the taxpayer's assessable income. Once this is accepted, the evidence established that in Queensland in 1985 it was an ordinary incident of leasing premises in a new city building, at least where the premises occupied were of substantial size, to receive incentive payments of the kind in question. Why then should a profit received during the course of business where the making of such a profit was an ordinary incident of part of the business activity of the firm not be seen to be income in ordinary concepts?

Therefore in accordance with IT 2631 and the decisions in Myer and Cooling 'where a business taxpayer is given a cash payment to enter into a lease of business premises, the incentive is income of the taxpayer.'