Edited version of private advice

Authorisation Number: 1051516598723

Date of advice: 30 May 2019

Ruling

Subject: Income/capital - taxation consequences for the receipt of compensation for damage to crops

Question 1

Is the rehabilitation/mitigation payment received assessable as ordinary income?

Answer

Yes

Question 2

Is the loss of sales payment for the previous seasons assessable as ordinary income?

Answer

Yes

Question 3

Is the loss of future sales payment received assessable as ordinary income?

Answer

Yes

Question 4

Is the payment for the cost of re-establishing the crops assessable as ordinary income to the extent of the capital expenditure incurred?

Answer

No, the amounts are not ordinary income to the extent of the capital expenditure incurred.

Question 5

Should the amount of the compensation payment that is greater than the capital expenditure be included as assessable as ordinary income?

Answer

No, but the full amount of the re-establishment payment you received for the cost of re-establishing the vineyard is assessable under CGT event C2 when the right to seek compensation came to an end (section 104-25 of the ITAA 1997).

Question 6

Are the interest payments received assessable as ordinary income?

Answer

Yes

Question 7

Should each component of the compensation payment be declared in the income year when it was received?

Answer

No, the amount that was received for the cost of re-establishing the crops is assessable when the right to seek compensation came to an end.

Question 8

Answer

This question has been withdrawn.

Question 9

Would the asset, 'right to seek compensation', be considered inherently connected to the business of the taxpayer to qualify as an active asset of the business?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 2016

Year ended 30 June 2017

Year ended 30 June 2018

The scheme commences on:

1 July 2015

Relevant facts and circumstances

The entity carries on a primary production business on land owned by related entities. The horticultural plants on the land were affected by an event due to actions originating from a neighbouring property. The effect of the incident caused significant damages to the plants with the quality deteriorated. It is considered viable to continue to run the plants as is with the decrease in yield and quality due to an increase in the price of the produce. The value of the land has also decreased due to this event.

Following a claim for compensation of losses and damages; the entity received an award for damages which comprised the following components:

The calculation of the rehabilitation and mitigation costs was based on actual costs. These costs were deducted in a prior income year. The components are:

·  nutrients

·  chemicals

·  contractors.

The re-establishment components are:

·   re-establish the crop

·   labour

·   fuel

·   equipment hire

·   chemicals.

Whilst the award judgement was handed down in one financial year, settlement did not occur until the following financial year. That is when the payment was made in one lump sum. Interest was also paid on the sum up until the date of judgement.

The entity does not intend to re-establish the plants. The crops will continue to be run in their condition.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 6

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 subsection 6-5(1)

Income Tax Assessment Act 1997 subsection 6-5(4)

Income Tax Assessment Act 1997 section 15-30

Income Tax Assessment Act 1997 Subdivision 20-A

Income Tax Assessment Act 1997 subsection 20-20(2)

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Section 40-30

Income Tax Assessment Act 1997 Section 40-295

Income Tax Assessment Act 1997 subsection 40-515(1)

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 Division 110

Income Tax Assessment Act 1997 Division 116

Income Tax Assessment Act 1997 section 118-24

Income Tax Assessment Act 1997 Division 152

Income Tax Assessment Act 1997 Subdivision 152-A

Reasons for decision

Division 6 of the Income Tax Assessment Act 1997 (ITAA 1997) discusses assessable income and exempt income. Your assessable income includes ordinary income and statutory income. Section 6-5 of the ITAA 1997 refers to income according to ordinary concepts (ordinary income). If there is a more specific provision of the Act it would be applied.

If you are an Australian resident, your assessable income includes the ordinary income you derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

A compensation amount generally bears the character of that which it is designed to replace. 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.

Rehabilitation/mitigation payment

If a taxpayer receives an amount as a 'recoupment of a loss' from an indemnity and the amount can be claimed as a deduction in the current or a past income year it is an assessable recoupment (subsection 20-20(2) of the ITAA 1997). It is not an assessable recoupment if it is ordinary income or statutory income.

The rehabilitation/mitigation payment was paid to assist with the cost of chemicals and nutrients, urea, fertiliser and contract work. It would be a revenue payment. The taxpayer claimed deductions for these amounts in previous income years, and it is not ordinary or statutory income. This payment would be included as an assessable recoupment at the time it was received.

Loss of past sales payment

Taxation Determination TD 93/58 gives the Commissioner's view on the circumstances when a lump sum compensation/settlement payment is assessable. If the amount is only for the loss of income it is assessable under subsection 6-5(1) of the ITAA 1997 (the subsection that replaced subsection 25(1) of the Income Tax Assessment Act 1936, paragraph 1 of TD 93/58). There is a more specific provision, section 15-30 of the ITAA 1997 which includes an indemnity for loss of assessable income if the amount would not have been included in your assessable income.

The payment for loss of past sales should be included as assessable income in the year when it was received.

Loss of future sales payment

There is a more specific provision, section 15-30 of the ITAA 1997 which includes an indemnity for loss of assessable income if the amount would not have been included in your assessable income.

The income from future grape sales would not have been included in your assessable income until a later date when it would have been received. It would not be assessable under section 6-5 of the ITAA 1997. The payment for future grape sales will be assessable under section 15-30 of the ITAA 1997 at the time it was received.

Cost of re-establishment of the crops payment

The definition of a depreciating asset

Section 40-30 of the ITAA 1997 defines a depreciating asset to mean an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used. The crops, irrigation, trellising and associated plant infrastructure in the block are considered depreciating assets under subsection 40-515(1) of the ITAA 1997 (and in this case they had been treated as such).

Where the rules in Division 40 of the ITAA 1997 apply, section 118-24 of the ITAA 1997 disregards most capital gains or capital losses made from CGT events involving depreciating assets. In such cases, any gain or loss resulting from a disposal of a depreciating asset will be treated as a balancing adjustment under the Uniform Capital Allowances (UCA) rules and either included in assessable income or allowed as a deduction. There are some exceptions to this rule and relevant to this case, where the CGT event is not a balancing adjustment event (which is the case here).

When a balancing adjustment occurs

Section 40-295 of the ITAA 1997 identifies when a balancing adjustment event occurs in respect to a depreciating asset. A balancing adjustment event occurs when the taxpayer:

·  ceases to hold the depreciating asset

·  ceases to use a depreciating asset and never expects to use it again

·  does not use the depreciating asset and decides never to use it

·  changes their holding or interests in the depreciating asset (only relevant to assets which are partnership assets).

None of these events apply to these circumstances as the entity is still using the plants and associated infrastructure. It has been decided to keep the existing damaged plants and accept the diminished crop that they yield. There has not been any balancing adjustment event and no amount of the re-establishment payment is assessable under Division 40 of the ITAA 1997.

Is this amount considered an 'assessable recoupment'?

Subdivision 20-A of the ITAA 1997 contains provisions that make your assessable income include amounts that you receive by way of recoupment if it is for a deductible expense and it is not otherwise assessable income.

You believe that the amount 'should be viewed as a recoupment of the initial acquisition costs, rather than a recoupment of rectification costs'.

In this case, a deduction has been claimed for decline in value of the horticultural plants (the plants and associated infrastructure). Subdivision 20-A of the ITAA 1997 does not apply to amounts that are ordinary income or otherwise assessable income under another provision. We consider that the re-establishment payment is assessable under section 104-25 of the ITAA 1997 that is, when the CGT event occurred. We do not consider any part of the re-establishment payment to be an assessable recoupment.

CGT event C2

Section 102-20 of the ITAA 1997 states that 'you can make a *capital gain or *capital loss if and only if a *CGT event happens. The gain or loss is made at the time of the event'.

Section 104-25 of the ITAA 1997 relates to CGT event C2 which concerns capital assets where there is a cancellation, surrender or similar endings. The time of the event is when the contract ending the asset is entered into or, if none, when the asset ends. A capital gain for this event is the capital proceeds from the ending less the asset's cost base.

Taxation Ruling TR 95/35 gives the Commissioner's view on the treatment of compensation receipts. 'If the taxpayer chooses not to incur the expenditure on the underlying asset for which they have been compensated, there is no recoupment'. 'The right to seek compensation is the most relevant asset in respect of which the compensation has been received' (paragraph 135 of TR 95/35). Any capital gain or capital loss needs to be determined then and brought to account when the settlement proceeds were received (paragraphs 136 and 137 of TR 95/35).

The relevant asset in this instance is the right to seek compensation for the damage to the crops. The right to pursue compensation is taken to be acquired at the time of the damage to the crops. It includes all of the rights which arise during the course of pursuing the damages claim.

In this situation compensation was awarded for the damage caused to the crops. The compensation awarded by the court was made with reference to the cost of rehabilitating the damaged crops. There was no legal requirement that any of the amount awarded had to be used to re-establish the crops. Instead a choice was made to accept the damage to the crops and accept a lower quality crop yield.

Originally, when the damage occurred to the crops, a legal right was exercised to sue for damages. That right was surrendered and cancelled when the judgement of the court that awarded compensation for the damage sustained was accepted. This is when the capital asset being the right to sue for damages was disposed of.

After the judgement there was a legally enforceable right to the amount that was awarded to the entity. The re-establishment payment that was calculated as the cost to re-establish the damaged crops is related to a CGT event C2 (section 104-25 of the ITAA 1997). The CGT event arose when the court granted a judgement debt in the favour of the entity.

The cost base of a right to seek compensation is determined in accordance with Division 110 of the ITAA 1997. The consideration or capital proceeds in respect of the disposal is the amount of compensation in accordance with Division 116 of the ITAA 1997. The date of the C2 event is the judgement date where the entity effectively surrendered it's right to further compensation for the damage that was incurred to the crops.

Prejudgement interest payment

Interest payments are included as assessable income. It is assessable under subsection 6-5(1) of the ITAA 1997. Interest awarded as part of a compensation payment is included as ordinary assessable income (paragraph 26 of TR 95/35).

The compensation payment included an amount paid for damages in the nature of interest to the day of judgement. This amount is included as assessable income in the financial year when it was paid.

The financial year the income should be declared

In working out whether you have derived an amount of ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct (subsection 6-5(4) of the ITAA 1997).

The compensation payments that are on revenue are included as assessable income to the taxpayer in the financial year when it was received. As the payment for the re-establishment of the crops is on capital account, it is assessable at the time that the right ended, when the court granted the judgement debt.

Small business CGT concessions - active asset

To qualify for the small business CGT concessions, you must satisfy several conditions that are common to all the concessions. These are called the 'basic conditions'.

The basic conditions in Subdivision 152-A of the ITAA 1997 (as relevant to this case) are:

·         the CGT small business entity test for the income year and

·         the active asset test.

For a CGT asset of a business to be an active asset for the purposes of Division 152 of the ITAA 1997 it must firstly satisfy one of the 'positive tests' in subsection 152-40(1) of the ITAA 1997 and then also not be excluded by one of the exceptions in subsection 152-40(4) of the ITAA 1997.

An intangible CGT asset is an active asset if it is owned by you and it is inherently connected with a business that is carried on by you, your affiliate, or an entity connected with you in the course of carrying on a business for at least seven and a half years or half of the time period it was owned (subsections 152-35(1) and 152-40(1) of the ITAA 1997).

A right to seek compensation is an intangible asset. The Advanced Guide to Capital Gains Tax Concessions for Small Business provides guidance. It says a thing might be regarded as 'inherently connected to a business when it is a permanent or characteristic attribute of the business - for example, goodwill, or trade debtors'.

Class Ruling CR 2009/68 paragraph 97 confirms that a capital gain from the disposal of a right to seek compensation is an active asset and the small business CGT concessions can be applied to it.

The right to seek compensation is an active asset under section 152-40 of the ITAA 1997. The right to seek compensation was held for more than 12 months.

The entity was entitled to apply the small business 50% active asset reduction to the capital gain on the right to seek compensation.

Conclusion

The re-establishment costs are capital and CGT event C2 applies. This amount is eligible for the small business 50% active asset reduction as it was inherently connected to the business of the entity.