Edited version of private advice

Authorisation Number: 1051539063390

Date of advice: 2 August 2019

Ruling

Subject: Income tax - compensation payments

Question 1

Will the one off agreement completion payment received from a mining entity be characterised as compensation under the conduct and compensation agreements (CCA)?

Answer

Yes

Question 2

Will the compensation received from a mining entity under the CCA for permanent damage to the land be treated as assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 3

Will the compensation received from a mining entity under the CCA for permanent damage to the Land be treated as capital proceeds from any capital gains tax event under Part 3-1 of the ITAA 1997?

Answer

No

Question 4

Will the compensation received under the CCA for permanent damage to the Land reduce the cost base of the relevant property for any future capital gain under section 110-40 or section 110-45 of the ITAA 1997?

Answer

Yes

Question 5

Will the payments for the sale of gravel form part of Landholder's assessable income under section 6-5 of the ITAA 1997?

Answer:

Yes

Question 6

Will payments received by Landholder for water taken from the Land be assessable as ordinary income as defined by section 6-5 of the ITAA 1997?

Answer

No as the payments are assessable as a royalty under section 15-20 of the ITAA 1997.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

A number of years ago Persons A and B purchased Land.

The Land has a number of water bores, dams and a gravel resource located on the property.

Persons A and B are partners in the partnership.

The partnership was formed a number of years ago.

The Partnership receives income from leasing the property to Entity A.

Entity A carries on a primary production business on the property.

Persons A and B hold shares in Entity A.

Recently, a letter of offer was received from a mining entity in respect of negotiation undertaken in respect to a CCA.

Persons A and B were offered a one off payment in respect of negotiation undertaken in respect to a CCA.

Persons A and B are intending to enter into CCA with a mining entity.

The scope of the CCA consists of the following agreements:

·         The CCA

·         Terms and Conditions

·         the Rules and Conduct

The CCA relevantly provides the following:

·         Persons A and B are the Landholder.

·         The mining entity holds a resource authority in the form of lease which covers the property.

·         The CCA is a conduct and compensation agreement made under a number of State mining provisions. The CCA stipulates compensation amounts to the Landholder for the impact of all continuing activities and proposed impacts which include the proposed placement of XX individual CSG wells and XX, XX well pads on the property.

·         The construction and maintaining of access roads.

·         The maintenance and upgrade of existing access roads.

·         The construction of an infrastructure right of way XX to XX metre wide to a distance of XX kilometres.

·         Construction of underground linear infrastructure buried at a depth on XXXmm within XX to XX meter right of way area.

·         Construction of XX vents and low drains where required.

·         The compensation amounts to be paid are set out in the CCA. These compensation amounts relate to the impacts of the mining entity constructing infrastructure, testing, operating, maintenance ongoing operations, noise, decommissioning and rehabilitation on the property. The CCA provides that the mining entity will pay the following compensation to the landholders:

·         The mining entity proposes to make resource payments to the Landholders for water sourced at a number of locations on the property at a rate of X.XX per litre.

·         The mining entity proposes to make resource payments to the Landholder for gravel sourced from the property at a rate of $X per cubic metre.

Extraction of Gravel

During the negotiation with the mining entity the Landholder saw a commercial opportunity to extract the gravel from the property as the Landholder believed there was a bio-security risk with the introduction of unwanted weeds on the property as a result of the mining entity supplying gravel from an outside source.

The gravel resource on the property will be extracted and stockpiled and prepared for sale by the Landholder using equipment owned by Person C. It is expected that the mining entity or one of its contractors will then take away the prepared gravel to use in constructing the tracks and roads on the property.

The extract process of removing and selling the gravel to the mining entity will be undertaken over a number of years or longer depending of further mining activities on the property.

The Landholder did not grant the mining entity access to the property to remove the gravel resource.

Your agent has provided a summary of the different categories of land that may be identified as resulting from mining activity owned by Landholder.

The following is a summary of the different categories of land that may be identified as resulting from CSG activity on the improved farmland/pasturage owned by the Landholder.

Other factors

The CCAs negotiations took into account the negative stigma of having mining activity on the land which includes the concept of blight on the land where the land has an unwelcome attribute and depresses the overall value of the property. The impact of the blight on the land will include the diminution in the long-term market value of the land as a result of having industrial activities on the land. This negative stigma is particularly concerning in the context of potential consumers of the high quality beef produced by the farm, where such consumers may have diminished demand for beef produced in an industrial environment.

The Landholders advise that the presence of the mining will affect travelling within the property and visit to neighbouring properties resulting in extended time frames to undertake common pastoral and farming activities including the management and movement of livestock and undertaking common farming tasks. Further, the presence of the mining will impact and will continue to impact the existing quality of life, lifestyle, quiet enjoyment or amenity for the human inhabitants on the property. The visual impact of viewing the wells and other infrastructure will be ever present.

Further the Landholder has advised that further restriction that the mining activity has on the land includes the potential limitations on the nature and range of agricultural enterprises that may be carried on the land. This may impact any potential future buyers of the property. In addition, bio-security control for the livestock maybe affected due to the high volume of traffic that comes and goes from the property.

Due to the demand from the mining industry for goods and services in the area this has resulted in an increase in costs associated with purchasing, maintaining and repairing equipment and engaging contractors which has an effect on the potential net income of the Landholder.

The noise during the construction of the wells and associated infrastructure is expected to be significant and there will be ongoing noise emitting from the individual wells during the extraction of water and gas and the subsequent compression of gas. The negotiations for the CCA included recognition of the significant construction and operational noise impact on the Landholder and their acquiescence of the higher levels of noise resulting in the diminution in the value of the land.

Further as part of the negotiations the Landholders engaged a land valuer who estimated there would be a reduction in the value of the property as a result of the placement of infrastructure on the land. The compensation that is likely to be paid in accordance with the CCA over the lifetime of the CCA is less than the current market value of the land.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 subsection 6-5(2)

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 section 15-20

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 104-25

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

Income Tax Assessment Act 1997 section 110-45

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

Reasons for decision

The compensation payments received by the Landholder

Section 6-5 of the ITAA 1997 provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year.

Compensation paid due to loss or damage to a capital asset, or forgoing a right to sue, in the process of a petroleum authority undertaking petroleum activities on a taxpayer's land is an isolated transaction. Whether a profit from an isolated transaction is ordinary assessable income according to ordinary concepts depends on the circumstances of the case. Profit from an isolated transaction is generally ordinary income when both of the following elements are present:

(a)  the intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain; and

(b)  the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction (paragraph 6 of Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income).

In this case, neither of the above elements applies to the Landholder as the owner of the property. The compensation payments are made in accordance with the legislative provisions of a State mining provision.

Accordingly, the compensation payments paid under the mining entity's CCA do not give rise to income according to ordinary concepts, or to a profit arising from a profit-making undertaking or plan pursuant to section 6-5 of the ITAA 1997. As such, these payments are not assessable income under section 6-5 of the ITAA 1997.

Capital proceeds in respect of a CGT event happening

Under subsection 116-20(1) of the ITAA 1997, money you have received (or are entitled to receive) and the market value of any property you have received (or are entitled to receive) are the capital proceeds from a CGT event.

For the compensation payments under an agreement to constitute capital proceeds, there must be a CGT event.

CGT events occur in respect of CGT assets. The definition of a CGT asset is contained in subsection 108-5(1) of the ITAA 1997. It provides that a CGT asset is any kind of property or a legal or equitable right that is not property. Not all things often referred to as 'rights' will be assets for CGT purposes. To be an asset, a right must be recognised and protected by law.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts provides the Commissioner's view as to the CGT consequences of receiving a compensation payment and relevantly, it states that a CGT event will occur (and any consideration form part of capital proceeds) where the amount of compensation is received by the taxpayer:

·         either wholly or partly in respect of the disposal of an underlying asset (CGT event A1); or

·         not in respect of any underlying asset but in relation to the disposal of the right to seek compensation (CGT event C2).

The above relate to CGT event A1 (section 104-10 of the ITAA 1997) and CGT event C2 (section 104-25 of the ITAA 1997) respectively.

TR 95/35 states that it is necessary to identify the underlying asset to which the payment relates and what has occurred to that asset.

The underlying asset is identified using the 'look-through approach' in order to determine the asset to which the compensation amount most directly relates. Paragraph 70 of TR 95/35 states the underlying asset is identified by looking through to the transaction which generates the compensation receipt.

Applying the look-through approach to the facts the property is the asset to which the compensation under the CCA most directly relates. The property is therefore, the underlying asset and the relevant CGT asset.

As there has been no disposal of the property, CGT event A1 does not occur.

Further, as the amounts are paid in respect of an underlying asset (being the property) CGT event C2 will not happen.

As such, the compensation amounts Persons A and B receive as the Landholder and owners of the Land under the CCA do not constitute capital proceeds in respect of a CGT event happening.

Reduction in the cost base of the Land

Under section 6-10 of the ITAA 1997 some amounts that are not 'ordinary income' are included in a taxpayer's assessable income due to another provision of the tax law. These amounts are 'statutory income'. Statutory income may arise from CGT events as a consequence of an eligible claimant being entitled to receive compensation for the loss and destruction of a CGT asset.

Paragraphs 6 and 7 of TR 95/35 provide that compensation received wholly in respect of permanent damage or reduction in the value of a post-CGT underlying asset that is not disposed of represents a reduction in either the CGT cost base under either subsection 110-40(3) of the ITAA 1997 (for assets acquired before 7.30pm on 13 May 1997) or subsection 110-45(3) of the ITAA 1997 (for assets acquired after 7.30pm on 13 May 1997).

Further, compensation received by a taxpayer for the disposal or permanent damage or reduction in value of an asset has no CGT consequences if the underlying asset to which it relates was acquired by the taxpayer before 20 September 1985.

For the purposes of TR 95/35, permanent damage or reduction in value does not mean everlasting damage or reduced value, but refers to damage or reduction in value that has permanent effect unless the taxpayer takes action to put it right. The activities permitted under the CCA will cause such damage and reduction in value.

Accordingly, pursuant to subsection 110-45(3) of the ITAA 1997, 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. If the compensation amount exceeds the total unindexed acquisition costs (including a deemed cost base) of the underlying asset, there are no CGT consequences in respect of the excess compensation amount.

In this case, Persons A and B as the owners of the property have received, and will continue to receive, compensation payments as a result of mining activities being carried out on the property. These activities have resulted in permanent damage to, or a permanent reduction in the value of, the property.

As Persons A and B as the owners did not dispose of all or part of the affected property there are no CGT consequences at the time of entering the CCA on receiving the compensation payments.

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

Payments for gravel extraction

Subsection 6-5(2) of the 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 financial 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.

It was noted in Federal Commissioner of Taxation v McNeil [2007] HCA 5 (McNeil's case) at paragraphs 20 and 21, that:

... whether a particular receipt has the character of the derivation of income depends upon its quality in the hands of the recipient, not the character of the expenditure by the other party. ...

... as a general proposition, a gain derived from property has the character of income and this includes a gain to an owner who has waited passively for that return from property.

Further, a principle has been established in the High Court in FCT v Myer Emporium Ltd 87ATC 4363; 1987 163 CLR 199; 18 ATR 693 (Myer Emporium) that profit arising from an isolated business or commercial transaction will be ordinary income if the taxpayer's purpose or intention in entering into the transaction is to make a profit, even though the transaction may not be part of the ordinary activities of the taxpayer's business.

The Commissioner's view on whether profits on isolated transactions are assessable income under ordinary concepts is contained in Taxation Ruling TR 92/3. Profit from an isolated transaction is ordinary income when:

·         the intention or purpose of a taxpayer in entering into the transaction was to make a profit or gain; and

·         the transaction was entered into, and the profit was made in the course of carrying on a business operation or commercial Isolated transaction.

The relevant intention or purpose of the taxpayer (of making a profit or gain) is not the subjective intention or purpose of the taxpayer. Rather, it is the taxpayer's intention or purpose discerned from an objective consideration of the facts and circumstances of each case (paragraph 38 of TR 92/3). Further, it is not necessary that the intention or purpose of profit-making be the sole or dominant intention or purpose for entering into the transaction. It is sufficient if profit-making is a significant purpose (paragraph 40 of TR 92/3).

Mason J stated in FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355 at 378 - 379; 82 ATC 4031 at 4044; 12 ATR 692 at 707; and 39 ALR 521 at 537 (Whitfords Beach):

Unfortunately there is an element of ambiguity in the expressions "business deal" and "operation of business" as there is in the adjectives "business", "commercial" and "trading" which have about them a chameleon-like hue, readily adapting themselves to their surroundings, different though they may be. In some context "business deal" and "operation of business" may signify a transaction entered into by a person in the course of carrying on a business; in other context they denote a transaction which is business or commercial in character.

These comments by Mason J were accepted by and elaborated on by the Full High Court in Myer Emporium at 87 ATC 4363 at 4367; 1987 163 CLR 199 at 199 210; 18 ATR 693 at 697:

Generally speaking, however, it may be said that if the circumstances are such as to give rise to the inference that the taxpayer's intention or purpose in entering into the isolated transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer's business. Nor does the fact that a profit or gain is made as the result of an isolated venture or a "one-off" transaction precludes it from being properly characterised as income (Whitfords Beach 150 CLR at 366-367; 82 ATC at 4036-4037; 12 ATR at 695-696). The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit.

Taking the comments from the High Court in Myer Emporium and Whitfords Beach into account it can be ascertained that for a transaction to be characterised as a business operation or a commercial transaction it is sufficient that the transaction is business or commercial in nature. Some of the factors to consider when looking at whether an isolatedtransaction amounts to a business operation or commercial transaction are listed at paragraph 13 of TR 92/3:

·         the nature of the entity undertaking the operation or transaction;

·         the nature and scale of other activities undertaken by the taxpayer;

·         the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained;

·         the nature, scale and complexity of the operation or transaction;

·         the manner in which the operation or transaction was entered into or carried out;

·         the nature of any connection between the relevant taxpayer and any other party to the operation or transaction;

·         if the transaction involves the acquisition and disposal of property, the nature of that property; and

·         the timing of the transaction or the various steps in the transaction

In determining whether activities relating to isolated transactions are a profit making undertaking or are the realisation of a capital asset, it is necessary to examine the facts and circumstances of each particular case. This may require a consideration of the factors outlined above; however there may also be other relevant factors that need to be weighed up as part of the process of reaching an overall conclusion. No single factor will be determinative; rather it will be a combination of factors that will lead to a conclusion as to the character of the activities.

Royalties

Subsection 15-20(1) of the ITAA 1997 explains that your assessable income includes an amount received as or by way of a royalty. However, a royalty is only assessable as income under this section if, among other conditions:

·         the royalty falls within the ordinary meaning of the term 'royalty', and

·         the royalty is not assessable as ordinary income under section 6-5 of the ITAA 1997.

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

In Case H9 76 ATC 39 (Case H9), the taxpayer company, which owned a grazing property, granted a sand company the exclusive right to excavate and carry away such sand and gravel on and beneath specified parts of the land in return for monthly 'royalty' payments calculated by reference to the quantity of sand removed. The sand company was obliged to make minimum monthly payments irrespective of the quantity of sand removed. The payments were assessable as a royalty, or by way of a royalty.

In this case, the Landholder purchased an asset being the land. The land was purchased for purpose of conducting primary production activity. Currently, the Landholder leased the property to the Entity A to carry out its business activities of primary production. There is no information that indicates the Landholder has carrying on a business of extracting and selling gravel or any other business activity on the property.

The Landholder entered into a commercial agreement or transaction that was not solely or directly in relation to the diminution of the land in respect of the mining activities to be carried out on the land.

The Landholder's case can be distinguished from Case H9 as under the agreement the Landholder did not grant Mining entity access to the property to extract the gravel as the Landholder saw a commercial to opportunity to extract the gravel from the land and to sell it to the mining entity and its contractors.

The Landholder voluntary entered the agreement and accepted the risk of further diminution of the land in exchange for a greater rate of return from the land. This is supported by the fact that Landholder refers to gravel as the sale of goods as noted in the private ruling application. The Landholder will receive a payment per cubic metre of gravel sold to the mining entity and their contractors. There is no payment for the permanent reduction in the value of the land or the impact on an underlying asset. Therefore, there is no application of the rules set out in TR 95/35.

Further, while there may have been no intention to make a profit or gain from entering into the transaction based on the information provided the Landholder will use their labour, and equipment to extract the gravel from the land to stockpile it for sale. Further, given the extensive network of roads and tracks to be established on the property this indicates the scale of the activity is significant as the extracting and supplying of the gravel is expected to occur over a number of years on a repetitive basis or for a longer period of time depending on future mining activities to be carried out on the property.

After objectively considering the Landholder's agreement with the mining entity and the principles from TR 92/3, the Landholder intention or purpose in entering the commercial agreement with the mining entity for the extraction and sale of gravel was to derive ordinary income from a commercial transaction. This means the payments to the Landholder under the agreement for the extraction and sale of the gravel are assessable as ordinary income under section 6-5 of the ITAA 1997.

Water resource payments

Section 15-20 of the ITAA 1997 states your assessable income includes an amount that you receive as or by way of royalty if the amount is not assessable as ordinary income under section 6-5 of the ITAA 1997. Royalties are statutory income.

The Commissioner's view on the definition of a royalty is provided by Taxation Ruling IT 2660 as outlined above.

In this case, the Landholder has agreed to receive payments from the mining entity for the volume of water extracted from a number of dams located on the property. The amount of water taken is dependent on the available level of water in the dam which is governed by seasonal conditions. It is considered that any proceeds the Landholder receives from the sale of the water is assessable as a royalty given that the water is a natural resource that was removed from the Landholder's Land.