Edited version of your written advice

Authorisation Number: 1051323016207

Date of advice: 10 January 2018

Ruling

Subject: Compensation payment

Question 1

Will the one off compensation payments be assessable as ordinary income?

Answer

No.

Question 2

Will the first payment represent capital proceeds for a capital gains tax (CGT) event A1?

Answer

Yes.

Question 3

Will the other payment reduce the cost base of your property for any future CGT event?

Answer

Yes.

Question 4

Do the solicitor and valuer costs form part of the cost base of your CGT event A1?

Answer

Yes.

This ruling applies for the following periods

Income year ended 30 June 2017

Income year ended 30 June 2018

The scheme commences on

1 July 2016

Relevant facts and circumstances

You and your spouse purchased a house several years ago. The property was more than two hectares.

Recently you received a notice to resume part of your land from a State Department.

The portion of land resumed is not part of the main residence and the surrounding two hectares. There is no business activity on the property.

You have been offered an amount for the diminution in market value of the property as a result of the decrease in land size and other factors.

You are also being offered another amount for disturbance.

You have incurred costs for a solicitor and valuer so far. However the matter has not been finalised and more costs will be incurred.

You have not claimed a deduction for your costs.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 section 20-20

Income Tax Assessment Act 1997 section 20-25

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 110-25

Reasons for decision

Ordinary income

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (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 income 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.

For income tax purposes, an amount paid to compensate for a loss generally acquires the character of that for which it is substituted (Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 AITR 443; 10 ATD 82). Compensation payments which substitute income have been held by the courts to be income under ordinary concepts (Federal Commissioner of Taxation v. Inkster (1989) 24 FCR 53; (1989) 20 ATR 1516; 89 ATC 5142, Tinkler v. FC of T (1979) 10 ATR 411; 79 ATC 4641, and Case Y47 (1991) 22 ATR 3422; 91 ATC 433).

On the other hand, if the compensation is paid for the loss of a capital asset or amount then it will be regarded as a capital receipt and not ordinary income.

The compensation payments to be received are not earned by you as it does not relate to services performed or from carrying on a business. Although the compensation relates to your property, the payment is not akin to rent. Rather the compensation is being received in relation to the resumption of part of your land and the associated disturbance. Although the payment can be said to be expected, and perhaps relied upon, this expectation does not arise from any personal services performed. The compensation payment is capital in nature. Accordingly, it is not regarded as ordinary income and is therefore not assessable under subsection 6-5(2) of the ITAA 1997.

Statutory income

Statutory income is not ordinary income, but is included in assessable income by specific provisions of the income tax law (section 6-10 of the ITAA 1997).

These specific provisions are listed in section 10-5 of the ITAA 1997 and include recoupments and capital gains, which are included in assessable income by virtue of the relevant provisions.

Recoupment

Under section 20-20 of the ITAA 1997, an amount received as recoupment of a loss or outgoing may be an assessable recoupment if it is paid to cover the cost of a deductible expense and the deduction can be claimed in the current year or in an earlier income year.

Recoupment of a loss or outgoing includes any kind of recoupment, reimbursement, refund, insurance, indemnity or recovery (subsection 20-25(1) of the ITAA 1997).

The disturbance payment may be regarded as a recoupment. However, as the payment relates to your residential property, no deduction has been claimed. Such a payment is not regarded as an assessable recoupment under subdivision 20-A of the ITAA 1997.

Your first payment is also not an assessable recoupment under subdivision 20-A of the ITAA 1997.

Capital gains tax provisions

CGT is the tax you pay on certain gains you make. Section 102-20 of the ITAA 1997 states that a capital gain or capital loss is made only if a CGT event happens. For most CGT events, your capital gain is the difference between your capital proceeds and the cost base of your CGT asset.

Section 108-5 of the ITAA 1997 provides that a CGT asset is any kind of property, or a legal or equitable right that is not property.

Under section 104-10 of the ITAA 1997 CGT event A1 happens if you dispose of a CGT asset. You dispose of an asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts considers the CGT consequences for compensation payments. Why the payment was made is an important factor in determining whether an asset has been disposed of for capital gains tax purposes.

TR 95/35 discusses the various scenarios, including:

● disposal of the underlying asset,

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

● disposal of the right to seek compensation.

As outlined in the ruling, the Commissioner adopts an ‘’underlying asset'' approach to determine the asset to which the compensation amount is most directly related. In concluding that the underlying asset is the most relevant asset to which an amount of compensation relates, a person must be able to show that the compensation receipt has a direct and substantial link with the underlying asset. If an asset has not been disposed of and has not been permanently damaged or permanently reduced in value by the happening or event which generated the amount of compensation, the taxpayer is not able to demonstrate that link. It follows that the compensation cannot be directly related to that asset. In those cases, the most relevant asset may be the right to seek compensation.

If an amount of compensation is received by a taxpayer wholly in respect of the disposal of an underlying post-CGT asset, or part of an underlying post-CGT asset, of the taxpayer the compensation represents consideration received on the disposal of that asset. In these circumstances, the Commissioner considers that the amount is not consideration for the disposal of any other asset, such as the right to seek compensation.

In your case, the underlying asset is the land that has been resumed. You are now receiving compensation in respect of the land taken. This compensation amount being received is viewed as having a direct and substantial link or nexus with the land. The first payment is consideration in respect of the disposal of this portion of the land and is regarded as capital proceeds for a CGT A1 event.

Taxation Ruling TR 97/3 Income tax: capital gains: compensation received by landowners from public authorities confirms the above treatment with compensation payments that relate to a loss of some of the rights of ownership of the land. The compensation is treated as consideration in respect of the disposal of those rights, that is, in respect of a part disposal of the underlying land.

Where an amount of compensation is received by a taxpayer wholly in respect of permanent damage suffered to a post-CGT underlying asset of the taxpayer or for a permanent reduction in the value of a post-CGT underlying asset of the taxpayer, and there is no disposal of that underlying asset at the time of the receipt, we consider that the amount represents a recoupment of all or part of the total acquisition costs of the asset.

Accordingly, the total acquisition costs of the post-CGT asset should be reduced by the amount of the compensation. No capital gain or loss arises in respect of that asset until the taxpayer actually disposes of the underlying asset.

In this case you will receive compensation payment for disturbance. These activities have resulted in the permanent reduction in the value of your remaining property.

As this compensation does not relate directly to the disposal of the resumed portion of your land, rather to the disturbance suffered, there are no CGT consequences at the time of receiving this compensation payment.

However, the property’s acquisition cost will be reduced by the compensation payment received in relation to your remaining property. That is, the cost base of the property will be reduced by the value of the payment and any gain or loss will crystallise at a later time when the property is sold.

Cost base

Section 110-25 of the ITAA 1997 provides general rules about cost base.

Subsection 110-25(3) of the ITAA 1997 provides that the second element of a CGT asset’s cost base is the incidental costs you incurred. The solicitor and valuer costs you have incurred that relate to the resumption of part of your land and the CGT event A1 form part of your cost base when calculating your capital gain/loss.

As a CGT event has occurred in relation to your portion of land, you need to calculate your capital gain or loss. If you don’t have a valuation for the portion of land resumed, you can calculate the cost base using a reasonable basis.

Please note that as you have had your property for more than 12 months, you are generally entitled to the 50% CGT discount.

Any capital gain/loss is shared with your spouse according to your legal interest in the property.