Edited version of your private ruling

Authorisation Number: 1012580594358

Ruling

Subject: Assessability of compensation payments

Questions and answers

1. Is the lump sum compensation payment assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) or as capital gains under the CGT provisions in Part 3-1 and 3-3 of the ITAA 1997?

No.

2. Are the monthly compensation payments assessable as ordinary income under section 6-5 of the ITAA 1997?

Yes.

This ruling applies for the following periods:

Year ending 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

Year ending 30 June 2017

Year ending 30 June 2018

The scheme commenced on:

1 July 2013

Relevant facts and circumstances

You hold a perpetual lease on a farming property that is owned by the State Government.

The property is a pre-CGT asset.

There is a significant amount of natural resource on this property.

You entered into an agreement with Company X to allow them to use a natural resource from the property.

You received an amount as compensation for the decrease in value of the land.

You will also receive a monthly compensation payment of $x for every tonne of natural resource taken by Company X. The rate will be indexed according to CPI on 30 June each year.

Relevant legislative provisions:

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 15-20

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Part 3-3

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 110-25

Reasons for decision

Assessability of $250,000 lump sum payment

Ordinary income

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 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'.

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 your case, the compensation payment received from Company X as per the compensation agreement is a capital receipt intended to recoup the loss of value of your land, and is not assessable income under section 6-5 of the ITAA 1997.

Statutory income - capital gains

As it has been determined that the compensation payment received is not assessable income it must be considered under the general CGT provisions which 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 with reference to the income tax legislation and the Commissioner's view on the treatment of compensation payments.

The Commissioner's view is set out in Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts (TR 95/35), which 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 section 104-155 of the ITAA 1997 (in relation to trusts)

The term 'underlying asset; is defined in paragraph 3 of TR 95/35 as:

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.

In your case, the underlying asset is the farming property.

Paragraph 9 of TR 95/35 states:

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.

In your case, you received a lump sum compensation payment where the underlying asset, being the farming property, has suffered a permanent reduction in value, and this property was acquired by you before 20 September 1985.

Therefore, there are no CGT consequences for you in regards to this lump sum amount.

Assessability of monthly payments

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident includes the ordinary income they derived directly or indirectly from all sources, whether in or out of Australia, during the financial year.

Ordinary income has generally been held to include three categories, namely, income from rendering 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

· are relied upon, and

· have an element of periodicity, recurrence or regularity.

It was noted in Federal Commissioner of Taxation v McNeil [2007] HCA 5 (McNeil's case) at paragraphs 20 and 21, that:

… whether a particular receipt has the character of the derivation of income depends upon its quality in the hands of the recipient, not the character of the expenditure by the other party. …

… as a general proposition, a gain derived from property has the character of income and this includes a gain to an owner who has waited passively for that return from property.

Subsection 15-20(1) of the ITAA 1997 explains that your assessable income includes an amount received as or by way of a royalty. However, a royalty is only assessable as income under this section if, among other conditions:

· the royalty falls within the ordinary meaning of the term 'royalty', and

· the royalty is not assessable as ordinary income under section 6-5 of the ITAA 1997.

Royalties

Taxation Ruling IT 2660 Income Tax: Definition of Royalties (IT 2660) and its addendum explains the Commissioner's view on the ordinary and statutory definition of a royalty.

Paragraph 10 of IT 2660 identifies a common law royalty, or a royalty within the ordinary meaning of the term, as having all of the following key characteristics:

(a) It is a payment made in return for the right to exercise a beneficial privilege or right (e.g. to remove minerals or natural resources such as timber, to use a copyright, or to produce a play) - McCauley v. F.C. of T. (1944) 69 CLR 235; 7 ATD 427; F.C. of T. v. Sherritt Gordon Mines Ltd (1977) 137 CLR 612; 77 ATC 4365; 7 ATR 726. Amongst other things, copyright can cover music, literary and artistic works, various forms of mechanical, electronic and biological knowledge, equipment and processes. Where, for example, the copyright is licensed to someone to manufacture and sell records, compact discs, books, prints of art works, motor vehicle engines, packaged computer software etc., for an amount based on the number of units produced or sold, the amount paid would be a royalty.

(b) The payment is made to the person who owns the right to confer that beneficial privilege or right - Barrett v. F.C. of T. (1968) 118 CLR 666; Sherritt Gordon Mines Ltd; Case H9 76 ATC 39; 20 CTBR(NS) Case 64. However, the payment would still be a royalty if paid to another person or otherwise applied or dealt with at the direction of the owner. Moreover, payments for the use of the right that are made to a person who has been licensed or sub-licensed to deal with the right will also be regarded as royalty payments.

(c) The consideration payable is determined on the basis of the amount of use made of the right acquired - McCauley; Stanton; Sherritt Gordon Mines; Case H9.

(d) The consideration payable will usually be paid as and when the right acquired is exercised - McCauley; Stanton; Case H9. However, a lump sum payment will be a royalty where it is a pre-estimate or an after the event recognition of the amount of use made of the right acquired - I.R. Commissioners v. Longmans Green & Co Ltd (1932) 17 TC 272; Mills v. Jones (1929) 14 TC 769; Constantinesco v. R (1927) 11 TC 730.

In Case H9 76 ATC 39, the taxpayer company, which owned a grazing property, granted a sand company the exclusive right to excavate and carry away such sand and gravel on and beneath specified parts of the land in return for monthly 'royalty' payments calculated by reference to the quantity of sand removed. The sand company was obliged to make minimum monthly payments irrespective of the quantity of sand removed. The payments were assessable as a royalty, or by way of a royalty.

In your case, you entered into a commercial agreement with Company X, in which you agreed to allow Company X to excavate a natural resource from your property in return for $x per tonne of natural resource removed.

It is considered that you entered into a commercial agreement or transaction that is not solely or directly in relation to the diminution of your land.

Specifically, you entered the agreement and accepted risk of further diminution to your land, in exchange for a greater rate of return from the land. Paragraphs 6 to 14 of TR 92/3 confirm that, although you are not in the business of commercial mining, the payments you received under the agreement represent assessable income that you derived from a commercial transaction.

After objectively considering your agreement with Company X and the principles from TR 92/3, your significant intention or purpose in entering the commercial agreements with Company X was to derive ordinary income from a commercial transaction. This means the payments to you under the agreement are assessable as ordinary income under section 6-5 of the ITAA 1997.