Edited version of your written advice

Authorisation Number: 1051472559004

Date of advice: 11 January 2019

Ruling

Subject: Compensation payments and capital gains tax

Issue 1

Capital gains tax – compensation payments

Question 1

Will the first compensation payment described in compensation agreement be applied to reduce the cost base of the land on the basis it is compensation for the permanent damage and reduction in value of the land?

Answer

Yes

Question 2

Will the second compensation payment described in compensation agreement be applied to reduce the cost base of the land on the basis it is compensation for the permanent damage and reduction in value of the land?

Answer

Yes

Question 3

Will the taxpayers be taken to have recouped all or part of the acquisition cost of the land at the date of execution of the compensation agreement or at the time of receipt of the compensation payments in accordance with the compensation agreement?

Answer

The taxpayers will be taken to have recouped all of part of the acquisition cost of the land at the time of receipt of the compensation payment.

Question 4

Will the taxpayers be taken to have recouped all or part of the acquisition cost of the land if the taxpayers dispose of the land and assign the compensation agreement before the second compensation payment is paid?

Answer

No

Issue 2

Capital gains tax – capital proceeds

Question 1

Will the consideration under the deed of family agreement for the disposal of the land be treated as capital proceeds received in respect of the disposal of the property?

Answer

No. As the parties did not deal at arm’s length in connection with the CGT event, the capital proceeds will be substituted with the market value.

Question 2

What is the CGT event that will happen when the taxpayers assign the compensation agreement to their son and his wife?

Answer

CGT event A1 will happen when the taxpayers assign the compensation agreement to their son his wife.

Question 3

What are the capital proceeds in respect of the assignment of the compensation agreement?

Answer

The taxpayers will be taken to have received the market value of the of the rights under the compensation agreement

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Husband and wife (collectively referred to as ‘the taxpayers’) are owners of the land as tenants in common in equal shares.

The taxpayers became registered owners of the land prior to 20 September 1985.

The land was (and continues to be) used for primary production purposes.

In or about 20XX, the taxpayers were approached by representatives of a mining company with a view of reaching an agreement on compensation pursuant to the relevant mining Act and negotiations commenced.

The mining company has mining lease applications which take over a large portion of the taxpayers’ land.

The mining leases have not yet been granted.

The mining company acknowledges through its Environmental Impact Statement that there will be subsidence of the taxpayers’ land as a result of the mining activity.

The parties settled on the agreement compensation amount and executed the compensation agreement in the year ended 30 June 20XX.

The compensation agreement requires two payments (collectively, the compensation payments):

● The first payment is payable on execution of the compensation agreement, which has been received by the taxpayers

● The second payment is due within 60 days of the grant of the mining leases, which has not yet been received by the taxpayers.

The compensation agreement allows the taxpayers to assign their rights and obligations under the compensation agreement to any bona fide assignee/transferee of the land. If the taxpayers exercise this right, they must enter into a deed of assignment by which the assignee/transferee assumes the remaining obligations of the taxpayers.

Intention to dispose of the land

Due to the personal circumstances of the taxpayers, they intend on transferring the land to their son and his wife.

A deed of family agreement (Family Deed) has been prepared to give effect to the transfer. The Family Deed plans for the succession of the ownership of the land.

In accordance with the Family Deed:

● the son and his wife will carry on a primary production business from the land after completion of the transfer

● monetary consideration will be paid for the transfer

● an initial instalment will be paid 90 days from the date of the Family Deed

● the balance of the consideration will be vendor financed and will be payable upon the earlier of

● 90 days after the grant of the mining leases

● receipt of second compensation payment

● material breach of the Family Deed by the son or his wife

The consideration amount for the transfer of the land from the taxpayers to the son and his wife was arrived at by family agreement. It is an amount that the taxpayers would like to receive if their son and his wife can afford it. It will allow the taxpayers to plan for their succession and their own needs.

A market valuation has not been obtained.

Assignment of the compensation agreement

A draft deed of assignment has been prepared in anticipation of the transfer of the land. The parties to the deed of assignment are the mining company, the taxpayers (as the owners of the land) and the son and his wife (as the proposed new owners).

The deed of assignment provides that:

● the mining company consents to the assignment of the compensation agreement to the son and his wife

● the son and his wife will assume the remaining obligations of the taxpayers under the compensation agreement

● the taxpayers will be released from the compensation agreement.

No consideration will be payable for the assignment of the compensation agreement.

Relevant legislative provisions

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 section 20-25

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 subsection 104-25(3)

Income Tax Assessment Act 1997 paragraph 104-10(5)(a)

Income Tax Assessment Act 1997 subsection 108-5(1)

Income Tax Assessment Act 1997 section 110-30

Income Tax Assessment Act 1997 section 110-30(1)

Income Tax Assessment Act 1997 section 110-30(2)

Income Tax Assessment Act 1997 subsection 110-40(3)

Income Tax Assessment Act 1997 subsection 110-45(3)

Income Tax Assessment Act 1997 subsection 116-20(1)

Income Tax Assessment Act 1997 subsection 116-30(1)

Income Tax Assessment Act 1997 subsection 116-30(2)

Reasons for decision

Issue 1

Capital gains tax – compensation payments

Questions 1 and 2

Summary

The compensation payments in relation to permanent damage to or permanent reduction in the value of the land will be treated as a recoupment of all or part of the acquisition cost of the land.

Detailed reasoning

The general CGT provisions are set out in Part 3-1. 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.

Taxation Ruling TR 95/35 Income Tax: capital gains: treatment of compensation receipts (TR 95/35) considers the treatment of compensation payments and the CGT consequences for the recipient. TR 95/35 states that compensation received may be attributed from:

● Disposal of an underlying asset

● Permanent damage to, or permanent reduction in the value of the underlying asset

● Excessive consideration to acquire an asset

● Right to seek compensation

● Disposal of a notional asset

TR 95/35 provides legislative references that relate to the Income Tax Assessment Act 1936 (ITAA 1936). The equivalent provisions in the ITAA 1997 are cited where appropriate.

Since there is no acquisition or disposal of asset, the only relevant factors would be whether such compensation payments are attributed from taxpayer’s right to seek compensation or permanent damage to / permanent reduction in the value of the underlying asset.

If the compensation payments relate to the former, it would represent capital proceeds. If it is the latter, it would be treated as a recoupment of all or part of the acquisition cost of the asset (that is, the cost base or reduced cost base would be reduced by the amount of the compensation).

Right to seek compensation

A right to seek compensation is defined in paragraph 3 of the TR 95/35 as:

● 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

● an asset for the purposes of Part IIIA

● being acquired at the time of the compensable wrong or injury, and includes all of the rights arising during the process of pursuing the compensation claim; and

● being disposed of when it is satisfied, surrendered, released or discharged.

For the disposal of the right to receive compensation, the relevant CGT event is CGT event C2 under section 104-25. It happens where a taxpayer’s ownership of an intangible CGT asset ends by the asset:

(a) being redeemed or cancelled

(b) being released, discharged or satisfied

(c) expiring

(d) being abandoned, surrendered or forfeited

(e) if the asset is an option being exercised

(f) if the asset is a convertible interest being converted

The right to be compensated for the specified activities is classified as an intangible CGT asset. A capital gain from CGT event C2 will arise if the capital proceeds from the ending are more than the right's cost base (subsection 104-25(3)).

Subsection 116-20(1) states that:

The capital proceeds from a * CGT event are the total of:

(a) the money you have received, or are entitled to receive, in respect of the event happening; and

(b) the * market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).

(Items marked with an asterisk (*) are defined in the dictionary at section 995-1).

If the compensation payments relate to the disposal by the taxpayer of the right to seek compensation, any capital gain arising on the disposal of that right is calculated using the cost base of that right (paragraph 11 of the TR 95/35).

The cost base of the right to seek compensation is determined in accordance with the provisions of section 160ZH of ITAA 1936. The consideration in respect of the acquisition of the right to seek compensation, for the purposes of paragraph 160ZH(1)(a) of the ITAA 1936, includes the total acquisition costs incurred as a result of which the right to seek compensation arose (paragraph 12 of the TR 95/35).

Compensation for permanent damage to or permanent reduction in the value of the underlying asset

Paragraphs 6 to 9 of the TR 95/35 provide guidelines on the treatment of compensation for the permanent reduction in value of the underlying asset as a recoupment of some of the acquisition costs of the asset.

Paragraph 3 of TR 95/35 provides the following definitions:

Underlying asset

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.

If there is more than one underlying asset, the relevant underlying asset is the asset which leads directly to the payment of the amount of compensation.

Permanent damage or reduction in value

Permanent damage or reduction in value does not mean everlasting damage or reduced value, but refers to damage or a reduction in value which will have permanent effect unless some action is taken by the taxpayer to put it right.

Look-through approach

The look-through approach is the process of identifying the most relevant asset. It requires an analysis of all of the possible assets of the taxpayer in order to determine the asset to which the compensation amount is most directly related. It is also referred to in this Ruling as the underlying asset approach.

In determining which is the most relevant asset, it is often appropriate to adopt a 'look-through' approach to the transaction or arrangement which generates the compensation receipt.

Therefore, the CGT consequences of compensation payments depend on whether there is an underlying asset that payments have a direct and substantial link ‘by looking through the transaction that gave rise to the compensation receipt to the most relevant asset relating to the receipt’ (paragraph 76 of the TR 95/35).

If the compensation payments relate to permanent damage or reduction in the value of an underlying asset, the payments should be treated as a recoupment of all or part of the acquisition cost of the asset (paragraph 6 of TR 95/35).

Sections 110-40 and 110-45 exclude some expenditure from forming part of the cost base of an asset for the purpose of determining a CGT liability. Specifically, subsection 110-40(3) states that for assets acquired before 7.30pm on 13 May 1997:

Expenditure does not form part of any element of the cost base to the extent of any amount you have received as * recoupment of it, except so far as the amount is included in your assessable income.

(Items marked with an asterisk (*) are defined in the dictionary at section 995-1 of the ITAA 1997).

Subsection 110-45(3) is the equivalent provision for assets acquired after 7.30pm on 13 May 1997.

No capital gain or loss arises in respect of that asset until the taxpayer actually disposes of the underlying asset.

If, in the case of a post-CGT underlying asset, the compensation amount exceeds the total unindexed acquisition (including a deemed cost base) of the underlying asset, there are no CGT consequences in respect of the excess compensation amount (paragraph 7 of the TR 95/35).

Compensation received by a taxpayer has no CGT consequences if the underlying asset that has suffered permanent damage or reduction in value was acquired by the taxpayer before 20 September 1985 or is any other exempt CGT asset (paragraph 9 of the TR 95/35).

Application to your circumstances

In this case, the taxpayers have or will receive compensation payments for the permanent damage and reduction in the value of the land caused by the mining company as follows:

● deprivation of possession of the surface of the land

● diminution of the value of the land or any improvement to the land

● diminution of the use made or which may be made of the land or any improvements to the land

● severance of any part of the land from other parts of the land or from other land of the taxpayers

● any surface rights of access

● all loss or expense that arises

On the facts of this case, it is considered that the compensation payments have a direct and substantial link with the underlying asset, that is, the land. Accordingly, it is considered that the compensation payments will not be received for the disposal of any other asset, such as the right to seek compensation.

As the compensation payments have or will be received wholly in respect of permanent damage suffered to the land or permanent reduction in the value of the land, the Commissioner considers that the amount represents a recoupment of all or part of the total acquisition costs of the land. As such, the cost base or reduced cost base will be reduced by the amount of the compensation received.

Paragraph 104-10(5)(a) provides that a capital gain or capital loss you make is disregarded if you acquired the asset before 20 September 1985. Accordingly, as the taxpayers acquired the land before 20 September 1985, there will be no CGT consequences in relation to the compensation payments and any capital gain or capital loss on the subsequent disposal of the land will be disregarded.

Question 3

Summary

The taxpayers are taken to have recouped all or part of the acquisition cost of the land at the time of receipt of the compensation payments.

Detailed reasoning

Recoupment of a loss or outgoing is defined in subsection 20-25(1) as:

(a) any kind of recoupment, reimbursement, refund, insurance, indemnity or recovery, however described; and

(b) a grant in respect of the loss or outgoing.

The Macquarie Dictionary, [Online], viewed 18 October 2018, www.macquariedictionary.com.au, defines ‘recoup’ as:

1. to obtain an equivalent for; compensate for

2. to regain or recover

3. to yield in return; return an amount equal to

4. to reimburse or indemnify

Based on the ordinary meaning of ‘recoup’, the Commissioner considers that recoupment occurs when expenditure is actually recovered, regained or reimbursed.

Accordingly, the taxpayers will be taken to have recouped all or part of the acquisition cost of the land at the time they receive the compensation payment as this is when the taxpayers have or will actually recover the relevant expenditure, being the acquisition cost.

Question 4

Summary

The taxpayers will not be taken to have recouped all or part of the acquisition cost of the land if they dispose of the land and assign the compensation agreement before the second compensation payment is paid.

Detailed reasoning

The compensation agreement stipulates that if the taxpayers transfer the land, they must assign the rights and obligations under the compensation agreement to the transferee. The assignment of the compensation agreement will result in the disposal of the rights under the contract by the taxpayers. If this disposal occurs prior to the second compensation payment being made to the taxpayers, the taxpayers will no longer have a right to receive the compensation payment and it is the new owner of the land that will ultimately receive the compensation payment.

As outlined in the detailed reasoning to question 3 above, the Commissioner considers that recoupment occurs when expenditure is actually recovered, regained or reimbursed. As such, if the taxpayers transfer the land and assign the rights and obligations under the compensation agreement to their son and his wife prior to the second compensation payment being made, the taxpayers will not be taken to have recouped all or part of the acquisition cost of the land.

Issue 2

Capital gains tax – CGT events and capital proceeds

Question 1

Summary

The capital proceeds, being the consideration under the Family Deed for the disposal of the land, will be replaced by the market value of the land.

Detailed reasoning

A CGT asset is defined to include land (Note 1 of section 108-5).

When the taxpayers enter into the Family Deed for the disposal of the land, CGT event A1 will occur as they will have disposed of a CGT asset.

The time of CGT event A1 is when you enter into the contract for the disposal (paragraph 104-10(3)(a)).

Subsection 116-20(1) states that:

The capital proceeds from a * CGT event are the total of:

(a) the money you have received, or are entitled to receive, in respect of the event happening; and

(b) the * market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).

(Items marked with an asterisk (*) are defined in the dictionary at section 995-1).

However, there are six modifications to the general rules about capital proceeds that may be relevant to a CGT event.

The relevant rule in this case is the market value substitution rule.

Where you have received, or are entitled to receive, money in respect of an event happening, subsection 116-30(2) states that:

The * capital proceeds from a * CGT event are replaced with the * market value of the * CGT asset that is the subject of the event if:

(a) some or all of those proceeds cannot be valued; or

(b) those capital proceeds are more or less than the market value of the asset and:

(i) you and the entity that acquired the asset from you did not deal with each other at * arm’s length in connection with the event; or

(ii) the CGT event is CGT event C2 (amount cancellation, surrender and similar endings).

(The market value is worked out as at the time of the event.)

To be acting at arm’s length, each party must act in their own best interests. In Granby Pty Ltd v. Federal Commissioner of Taxation (1995) 129 ALR 503 at 506-507; (1995) 95 ATC 4240; (1995) 30 ATR 400 Lee J said that the term 'at arm's length' means at least that the parties to a transaction acted severally and independently in forming their bargain.

The mere fact that parties are not at arm's length is not determinative of the issue. The question is whether the parties dealt with each other at arm's length: The Trustee for the Estate of the late AW Furse No. 5 Will Trust v. FC of T 91 ATC 4007 at 4014-4015; (1990) 21 ATR 1123 at 1132.

The taxpayers have not obtained a market valuation for the land. The consideration amount of for the transfer of the land was arrived at by family agreement and is the amount that the taxpayers would like to receive if their son and his wife can afford it. Not only will the balance of the consideration will be vendor financed, but it will ultimately be paid from the proceeds of the compensation payment.

The Commissioner considers that the agreement to transfer the land was not entered into in a manner in which arm’s length parties would be expected to have dealt with each other. Accordingly, for the purposes of calculating the capital gain, the capital proceeds receivable under the Family Deed will be replaced by the market value of the land at the time of its disposal.

Question 2

Summary

CGT event A1 will happen when the taxpayers assign the compensation agreement to their son and his wife.

Detailed reasoning

CGT event A1 happens if the ownership of a CGT asset changes (section 104-10).

Pursuant to subsection 108-5(1):

A CGT asset is:

(a) any kind of property; or

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

Taxation Ruling TR 1999/19 Income Tax capital gains: treatment of forfeited deposits (TR 1999/19) provides guidance on the treatment of contractual rights for CGT purposes. Paragraphs 114 and 115 of TR 1999/19 state:

It seems clear that the purchaser’s bundle of contractual rights, e.g., the right to a transfer of the property, is an asset for CGT purposes. Being proprietary rights, they are an asset as defined both before and after 26 June 1992.

These rights are created by the vendor in the purchaser and are taken to have been acquired by the purchaser when the purchaser becomes the owner of the rights, that is, when the contract is entered into (subsection 109 5(1)).

As such, the rights under the compensation agreement are considered a CGT asset.

When the taxpayers enter into the deed of assignment, they will have disposed of their rights under the compensation agreement. Under the terms of the deed of assignment, the ownership of the CGT asset, being the rights under the compensation agreement, will change from the taxpayers to their son and his wife, such that CGT event A1 will happen.

Question 3

Summary

As no consideration will be paid to the taxpayers in respect of the assignment of the compensation agreement, the taxpayers will be taken to have received the market value of the rights under the compensation agreement.

Detailed reasoning

Subsection 116-20(1) states that:

The capital proceeds from a * CGT event are the total of:

(a) the money you have received, or are entitled to receive, in respect of the event happening; and

(b) the * market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).

(Items marked with an asterisk (*) are defined in the dictionary at section 995-1).

However, there are six modifications to the general rules about capital proceeds that may be relevant to a CGT event.

The relevant rule in this case is the market value substitution rule.

Section 116-30 states that:

No capital proceeds

(1) If you received no * capital proceeds from a * CGT event, you are taken to have received the * market value of the * CGT asset that is the subject of the event. (The market value is worked out as at the time of the event.)

Example: You give a CGT asset to another entity. You are taken to have received the market value of the CGT asset.

There are capital proceeds

(2) The * capital proceeds from a * CGT event are replaced with the * market value of the * CGT asset that is the subject of the event if:

(a) some or all of those proceeds cannot be valued; or

(b) those capital proceeds are more or less than the market value of the asset and:

(i) you and the entity that acquired the asset from you did not deal with each other at * arm’s length in connection with the event; or

(ii) the CGT event is CGT event C2 (amount cancellation, surrender and similar endings).

(The market value is worked out as at the time of the event.)

As no capital proceeds will be received by the taxpayers for the assignment of the compensation agreement, the taxpayers will be taken to have received the market value of the rights under the compensation agreement.