Edited version of your written advice

Authorisation Number: 1012779837624

Ruling

Subject: Taxation of commercial incentive payment

Question 1

Is the one-off "commercial incentive payment" (CIP) assessable as ordinary income under subsection 6-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No. The CIP is not assessable as ordinary income under subsection 6-5(1) of the ITAA 1997

Question 2

If the CIP is not assessable as ordinary income under subsection 6-5(1) of the ITAA 1997, what is the tax treatment of the payment?

Answer

The CIP is part of the compensation payable, and being in the nature of capital, it is dealt with under Part 3-1 of the ITAA 1997.

This ruling applies for the following period:

1 July 20XX to 30 June 20XX

Relevant facts and circumstances

The taxpayers own a rural property which is used for business purposes. A major coal seam gas company is looking to develop a well site on the property. The taxpayers have entered into negotiations with the company for suitable compensation. The agreement between the parties is called the Conduct and Compensation Agreement (CCA). The CCA will permit the company and its associates to enter the land for the purpose of conducting exploration activities.

The legislative provisions contained in the Petroleum and Gas (Production and Safety) Act 2004 (Qld) (PGPS Act) provide that before a coal seam gas company (or their authorised representative) can enter land to undertake any activities, they must enter into either a Conduct and Compensation Agreement (CCA), or a Deferral Agreement.

Section 531(2) of the PGPS Act provides that:

(2) The holder of each petroleum authority is liable to compensate each owner or occupier of private or public land that is in the area of, or is access and for, the petroleum authority (an eligible claimant) for:

(a) any compensatable effect the eligible claimant suffers that are caused by:

(i) authorised activities for the petroleum authority carried out by, or for, the authority holder; and

(ii) the carrying out of an activity by a person authorised by the holder if the holder has represented that the activity is an authorised activity for the authority; and

(b) consequential damages the eligible claimant incurs because of a compensatable effect caused by authorised activities for the authority.

In addition to the compensation payable under the PGPS Act, the company has offered the taxpayers a one-off payment, called a commercial incentive payment (CIP), as an incentive finalise negotiations in a timely manner. Acceptance of the CIP offer is voluntary. However if the taxpayers accept this payment, they forgo the possibility of negotiating a more attractive compensation payment under the CCA.

The payment of the CIP is meant to recognise the efforts spent by the taxpayers in negotiating a CCA with the company in a timely manner and also recognises that the company derives a commercial benefit from promptly entering into the CCA.

The offer of the CIP is at the discretion of the company and is not a requirement under the PGPS Act.

Relevant legislative provisions

Income Tax Assessment Act 1997

Section 6-1

Section 6-5

Section 6-10

Section 15-15

Part 3-1

Division 108

Division 110

Reasons for decision

Reasons for decision

Question 1

Section 6-1 of the ITAA 1997 identifies the two basic types of income - ordinary income and statutory income. To come within the classification of assessable income, an amount must be either ordinary income or statutory income.

Subsection 6-5(1) of the ITAA 1997 states that your income includes income according to ordinary concepts, which is called ordinary income. The legislation does not define what "income according to ordinary concepts" is. Instead it relies on the principles developed by the courts to determine what ordinary income is.

The expression "income according to ordinary concepts" was first used by the NSW Supreme Court in Scott v FC of T (NSW) (1935) 3 ATD 142. Since that decision the courts have applied the 'ordinary concept' test in determining whether or not a particular receipt is income or not.

The concept of ordinary income was considered by the Full Federal Court in FC of T v Cooke & Sherden 80 ATC 4140. In a joint decision, their Honours stated:

"Whether a receipt is to be treated as income or not is determined according to 'the ordinary concepts and usages of mankind'…except where statute sweeps in particular receipts or amounts which would not ordinarily be taken to fall within the concept."

Later, in FC of T v The Myer Emporium 87 ATC 4363, the Full High Court said (at p 4370):

"The periodicity, regularity and recurrence of a receipt has been considered to be a hallmark of its character as income in accordance with the ordinary concepts and usages of mankind."

The cases dealing with "income according to ordinary concepts" have identified the following (non-exhaustive) factors which may be relevant in determining whether an amount is ordinary income and therefore assessable under subsection 6-5(1) of the ITAA 1997:

• Whether the amount has the characteristics of periodicity, recurrence or regularity

• Whether it is convertible into money or money's worth

• Whether it is associated with business activities or services rendered, as distinct from the mere sale of property, and

• Whether it is solicited, as distinct from a windfall

Under section 6-10 of the ITAA 1997 certain receipts which could not be described as income according to ordinary concepts are included in a taxpayer's assessable income. These receipts are referred to as statutory income as they are treated as assessable income by statutory provision.

An example is the inclusion of net capital gains in a taxpayer's assessable income by the operation of Parts 3-1 and 3-3 of the ITAA 1997.

Revenue or capital

An approach to distinguishing between revenue and capital receipts is to examine the character of the receipt from the point of view of the recipient. This approach has been utilised in a number of cases dealing with the revenue/capital distinction.

In McLaurin v FC of T (1961) 104 CLR 381 the High Court held (at p 391):

"…in point of law it would plainly be unsound to allow a determination of the character of a receipt in the hands of a recipient to be affected by a consideration of the uncommunicated reasoning which les the payer to agree to pay it."

In Scott v FC of T (1966) 117 CLR 514 Windeyer L held (at p526):

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

Again, in The Federal Coke Company Pty Ltd v FC of T 77 ATC 4255, Bowen CJ held (at p 4264):

"When one is considering the character of an amount received by a taxpayer, the enquiry must start with the question: what is the character of the receipt in the hands of the taxpayer?"

More recently, the High Court held in GP International Pipecoaters Pty Ltd (1990) 21 ATR 1:

"Sometimes, the character of the 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 of business in or by reason of which money is received and by the recipient's purpose in engaging in the transaction, venture or business. The factors relevant to the ascertainment of the character of a receipt of money are not necessarily the same as the factors relevant to the ascertainment of its payment."

Although the courts have referred to 'periodicity, regularity and recurrence' as 'hallmarks' of ordinary income, they are not necessarily decisive factors. Ordinary income can be received as a lump sum and capital amounts may be paid in instalments. Receipts from isolated transactions can be ordinary income if they are derived in the course of a business or under a profit making scheme or undertaking. As the High Court explained in FC of T v The Myer Emporium 87 ATC 4363:

"Valuable though these considerations may be in categorising receipts as income or capital in conventional situations, their significance is diminished when the receipt in question is generated in the course of carrying on a business, especially if it should transpire that the receipt is generated as a profit component of a profit-making scheme."

The nature of the CIP

The CIP offer recognises efforts spent by the taxpayers in negotiating a Conduct and Compensation Agreement (CCA) with the company in an efficient and timely manner and also recognises that the company derives a commercial benefit from promptly entering into a CCA. The CIP is in addition to and separate from the compensation package.

The payment of the CIP is a singular event and does not have the elements of 'periodicity, regularity and recurrence' which characterise ordinary income.

The profit or gain will not be made in the course of carrying on a business or in carrying out a business operation or commercial transaction. Nor have the partners provided any service to 'earn' the CIP.

The payment does not give rise to income according to ordinary concepts pursuant to section 6-5(1) of the ITAA 1997 or to a profit arising from a profit making undertaking or plan within the meaning of section 15-15 of the ITAA 1997.

In view of the above, the CIP received by the taxpayers is not considered to be ordinary income. Accordingly, the payment is not assessable as ordinary income under subsection 6-5(1) of the ITAA 1997.

Question 2

Compensation for permanent damage to, or permanent reduction in the value of the land

Taxation Ruling TR 95/35 contains a broad definition of compensation receipt:

A compensation receipt, or compensation, includes any amount (whether money or other property) 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, whether or not:

• in relation to any underlying asset;

• arising out of Court proceedings; or

• made up of dissected amounts.

Notwithstanding the CIP is paid separately from the CCA and is not described by the company as compensation, it can still meet this definition of a compensation receipt. Considering the totality of the relationship between the parties, the CIP is part of the overall deal that the landowner agrees to. The CIP, along with the amounts payable under the CCA, all form part of the compensation received by the landowner. The CIP is part of what results or "moves" the landowner to agree to the CCA.

In the hands of the landowner, the compensation under the CCA and the CIP comprise in essence one sum of money in return for agreeing to the conditions set out in the CCA.

According to TR95/35, if the compensation is received wholly for the permanent damage to, or permanent reduction in value of, the underlying asset, that receipt should be applied to reduce the total acquisition costs (cost base) of the asset. There is no disposal of the underlying asset at that time.

The cost base rules for CGT assets are contained in Division 110 of Part 3-1 of the ITAA 1997.