Edited version of your written advice

Authorisation Number: 1051214196581

Date of advice: 27 April 2017

Ruling

Subject: Sale of materials

Question 1

Will the income from the sale of the road building material be assessable as a royalty under section 15-20 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Can the sale of road building material be treated as subject to capital gains tax, rather than under section 15-20 of the ITAA 1997?

Answer

No

This ruling applies for the following period(s)

Year ending 30 June 2017

Year ending 30 June 2018

The scheme commences on

1 July 2016

Relevant facts and circumstances

The farmland was inherited pre September 1985.

The portion of the land where the gravel is located was never cleared as it was too rocky to be cleared for farmland.

A government body approached you as they wanted the road building material for the bypass road.

You entered into a contract with the buyer. You will receive a lump sum payment once the extraction is completed and the quantities determined. The rate of payment will be $X.XX per cubic metre(m3), in the ground, for all materials extracted from the site.

You will not be involved in the extraction process in any way.

The purchaser has cleared the area to extract the material and will rehabilitate the land once they have finished.

There is no entitlement to any minimum payment from the purchaser. You are yet to receive any payment.

You did not buy the land to extract material for sale.

You will relinquish all rights to the material.

You have provided a copy of the agreement.

Relevant legislative provisions

Income Tax assessment Act 1997 Section 6-5

Income Tax assessment Act 1997 Section 15-20

Reasons for decision

Ordinary income

Income is generally assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997).

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

There is no definition of ordinary income under the income tax law. To determine whether an amount is ordinary income, the courts have established the following principles:

● the receipts that should be treated as income must be determined in accordance with ordinary concepts and usages, except where legislation requires otherwise

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

● it is an objective test.

The disposal of the road building material is not part of a business, nor did you have an intention or purpose at the time of acquiring the property to make a profit on the sale of the road building material which is located on the land. This is supported by the fact that the land was acquired by way of inheritance and you were approached by the purchaser to extract an amount of road building material for a payment based on per cubic metre, in the ground, for all materials extracted from the site.

By entering into the contract, you have realised a natural resource on the inherited property in an enterprising way. You were approached by the purchaser, thereby supporting a mere realisation of one of the property's natural resources.

Because you are not in the course of carrying on a business of quarrying, and:-

1. the intention in entering into the operation was to realise an asset; and

2. the transaction entered into was not a commercial transaction (paragraph 15 of TR 92/3), then,

 the profit is not ordinary income and not assessable under subsection 6-5 of the ITAA 1997.

We now need to consider if the payment is a capital payment in terms of a profit a prendre or a royalty payment.

Profit a prendre

A profit a prendre is a right to enter and remove some product or part of the soil from someone else's land. It applies to such things as stone, sand, gravel, standing timber and minerals which are part of the land. A profit a prendre is an interest in land and is a CGT asset separate from the land. It is created at the time it is granted. The circumstances in which a profit a prendre may arise are summarised in paragraph 70 of TR 95/6, which deals with timber but the principle can also apply to other materials. Where, at the time of the contract, it is contemplated that the purchaser will derive a benefit from the further growth of the thing sold, then the purchaser will acquire an interest in the land, that is a profit a prendre: Ashgrove Pty Ltd and Ors v. FC of T (1994) 124 ALR 315; (1994) 28 ATR 512; (1994) 53 FCR 452; 94 ATC 4549.

The terms of each individual agreement must be examined to determine the intent of the parties regarding the benefit of any future growth, whether it is an agreement for the sale of goods to which the right to enter and sever the timber is ancillary, or whether it is an agreement for the sale or creation of an interest in the land (a profit a prendre).

For example, in the case of timber, when predominantly mature timber is sold, it is likely that a purchaser desires to acquire only the timber rather than a benefit from the land itself. This type of arrangement is not a profit a prendre. It is an agreement for the sale of goods to which the right to enter and sever the timber is ancillary.

In your case, the purchaser simply acquired the right to remove the material from the land. There will be no ongoing interest in the land. Therefore, the payment you received was not for the granting of a profit a prendre. There was no separate payment for this right, a CGT asset. The amount you are paid is dependent on the amount of material removed (per cubic metre). There is no minimal payment, even if no material is removed. There is no payment for the right to enter the property and remove the road building material; the payment is for the material itself.

The agreement for the sale of road building material does not constitute a profit a prendre. Rather the receipts from the agreement are considered to be royalties (see below).

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 and Co Ltd (1932) 17 TC 272; Mills v. Jones (1929) 14 TC 769; Constantinesco v. R (1927) 11 TC 730.

The ordinary meaning of a royalty has been considered by the Courts on various occasions.

In Stanton v. F.C. of T. (1955) 92 CLR 630; (1955) 11 ATD 1(Stanton's case), a grazier who owned land on which stood a quantity of timber entered into an agreement with a sawmiller to sell a specified quantity of timber to a sawmiller. The agreement provided that the latter had the right to enter the land and cut the timber and that payment was to be made by way of a deposit and then equal quarterly instalments. The agreement made it clear that the instalments were payable irrespective of the amount of timber cut. However, the agreement also provided that should the specified quantity of timber not be found then the purchaser was entitled to a proportionate rebate of the price. The Commissioner claimed that the amounts paid to the taxpayer were by way of royalty and therefore were assessable. He relied on the decision in McCauley v. F.C.T. (1944) 69 CLR 235 (McCauley's case), a case in which the taxpayer had agreed to sell the right to cut and remove timber at a price of 3 shillings per hundred superfeet of timber.

The full High Court distinguished between these two cases on the basis that, in McCauley's case, payment was contingent on the amount of timber whereas, in Stanton's case, payment was made in instalments without reference to the amount of timber taken. Because payment in McCauley's case related to the amount of timber taken it was a royalty and because this essential feature was lacking in Stanton's case the payment did not amount to a royalty.

Another leading Australian case, Earle v FCT (1986) 17 ATR 766; 86 ATC 4441 (Earle's case) further illustrates the essential characteristic of a royalty by its decision that an amount can only be a 'royalty' payment if it is proportionate to the quantity of material taken. In Earle's case, a partnership agreed to sell specified quantities of rock and granted the purchaser the right to remove the rock from the land. Monthly instalments were payable irrespective of the amount of rock removed from the land at the time of payment. The Court held that the payment received was not a royalty as the obligation of the purchaser of the rock to make payment was not attached to the removal of the rock, for the payment was due whether or not the purchaser exercised its right to take the rock.

Conversely, we consider that the arrangement between the parties in your case does constitute a royalty because the payment arrangement agreed upon relates to the amount of road building material taken by the purchaser.

The amount is in return for the right of the purchaser to exercise a beneficial privilege, eg. to remove road building material. A royalty means a payment for the use made of the right and not a payment on a purchase or sale.

Royalties are assessable under section 6-5 of the ITAA 1997 if they are ordinary income or section 15-20 of the ITAA 1997 if they are not assessable as 'ordinary income'. Your payment will be assessable under section 15-20 of the ITAA 1997.

Conclusion

You have agreed to allow the purchaser to enter the property and remove road building material at a fixed rate per cubic metre. The agreement you have entered into is not a profit a prendre, there is no payment for the granting of the right. The payment you will receive is in the nature of a royalty.

The royalty payment will be determined on a quantitative basis by reference to the amount of product removed. The fact that it is paid as a lump sum at the end does not change the nature of the payment. The payment will be assessable under section 15-20 of the ITAA 1997.  

Although there is no profit a prendre, there is a part disposal of the land (being the road building material), so CGT event A1 applies. However, section 118-20 of the ITAA 1997 operates to reduce the capital gain to nil.