Edited version of private advice

Authorisation Number: 1051600914280

Date of advice: 5 November 2019

Ruling

Subject: Timber sale - royalties

Question

Are the proceeds you receive from the sales of timber cut and removed from your properties by timber companies assessable under the capital gains tax (CGT) provisions?

Answer

No

This ruling applies for the following period:

Year ended 30 June 2018

Year ended 30 June 2019

The scheme commences on:

1 July 2017

Relevant facts and circumstances

You and your spouse (you) are partners in a farming business in State A.

Over several years you have been planting improved pasture to assist your primary production activity.

In one year, you signed an agreement with Company A to grant them the right to enter your property A to cut and remove some timber. You agree on the volume of timber to be cut and removed and the payment. The contract had to be honoured the same year. You received the payment the same year. You provided a copy of the agreement.

In another year, you signed an agreement with Company B to grant them the right to cut and removed an agreed volume of timber from your property B for a specific lump sum. The job was completed by the same year. You provided a copy of the agreement.

Both timber companies contacted you to discuss the sale of your timber and sent a representative to inspect the paddocks considered ready for harvest.

Both companies organised the contracts.

For Property B you had to seek authorisation from the State A government to sell your timber. You provided a copy of the relevant regulatory forms.

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 15-20

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 118-20

Reasons for decision

'Ordinary income' is defined in section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) to mean income according to ordinary concepts. A substantial body of case law has evolved over time that identifies various factors that are taken into account in determining when an amount is 'income according to ordinary concepts'.

Ordinary income includes income that arises in the normal scope of a taxpayer's business. In addition, in limited circumstances, gains not within the ordinary scope of the taxpayer's business may form part of ordinary income.

Taxation Ruling TR 95/6 Income tax: primary production and forestry, deals with the extent to which receipts derived from the sale of timber constitute assessable income, whether or not the taxpayers are engaged in the forestry industry.

It is stated in TR 95/6 that the income from the sale of standing timber may be income from carrying on a business of forestry operations or income from a profit making undertaking or scheme under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997). It may also be assessable as a royalty under section 15-20 of the ITAA 1997 where it is not assessable as ordinary income under section 6-5 of the ITAA 1997.

Therefore, we need to consider if the proceeds you received from the sale of standing timber fall under any of the following categories:

● a business of forestry operations; or

● an isolated profit making undertaking or scheme; or

● a royalty

Carrying on a business

To be carrying on a business, you must intend to fell the trees in question for sale at a profit and your activities must be organised and run in a business-like way. This generally means that you actively tend and maintain the trees.

From the information you have provided you are not considered to be in the business of forestry.

Isolated profit making transaction

Receipts from the disposal of trees by a person who is not carrying on a primary production business of forestry operations may be assessable income under section 6-5 of the ITAA 1997 if the receipts are from an isolated profit making transaction.

A profit from an isolated transaction is generally assessable 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;

(b) The transaction was entered into, and the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction.

In very general terms, a transaction or operation has the character of a business operation or commercial transaction if the transaction or operation would constitute the carrying on of a business except that it does not occur as part of repetitious or recurring transactions or operations.

The intention or purpose of the taxpayer is discerned from an objective consideration of the facts and circumstances of the case. If the circumstances are such as to give rise to the inference that the taxpayer's intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income.

Paragraph 13 of Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income lists factors that the Commissioner will take into account in considering whether an isolated transaction amounts to a business operation or commercial transaction.

These factors are:

(a) The nature of the entity undertaking the operation or transaction;

(b) The nature and scale of other activities undertaken by the taxpayer;

(c) The amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained;

(d) The nature, scale and complexity of the operation or transaction;

(e) The manner in which the operation or transaction was entered into or carried out;

(f) The nature of any connection between the relevant taxpayer and any other party to the operation or transaction;

(g) If the transaction involves the acquisition and disposal of property, the nature of that property; and

(h) The timing of the transaction or the various steps in the transaction.

In your situation, after taking into consideration your facts and circumstances, your activity does not amount to a commercial transaction for which profits from an isolated transaction are brought to account as ordinary income.

Royalties

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: Income tax: definition of royalties.

The ordinary meaning of the term 'royalty' has been considered by the Courts on many occasions. In Stanton v. FC of T (1955) CLR 630, the High Court of Australia described the essence of a royalty and stated that:

... the modern applications of the term seem to fall under two heads, namely the payments which the grantees of monopolies such as patents and copyrights receive under licences and payments which the owner of the soil obtains in respect of the taking of some special thing forming part of it or attached to it which he suffers to be taken.

Paragraph 10 of IT 2660 provides that in the Commissioner's view there are four key characteristics of a common law royalty:

● it is a payment made in return for the right to exercise a beneficial privilege or right, for example to remove minerals or natural resources such as timber (McCauley v. FC of T (1944) 69 CLR 235)

● the payment is made to the person who owns the right to confer that beneficial privilege or right (Barrett v. FC of T (1968) 11 CLR 666)

● the consideration payable is determined on the basis of the amount of use made of the right required (McCauley, Stanton), and

● the consideration will usually be paid as and when the right acquired is exercised.

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 (IR Commissioners v. Longmans Green & Co Ltd (1932) 17 TC 272).

In your circumstances, you granted rights for the timber companies to enter your land and to cut and remove agreed volumes of timber. You conferred the right and received the payments. The payment was determined on the basis of timber to be removed from your property. The payment received is therefore assessable income as royalties.

Capital gains tax

Section 102-5 of the ITAA 1997 provides that a taxpayer's assessable income includes a net capital gain. The felling of timber or sale of standing timber on land acquired on or after 20 September 1985 results in the original asset (the land with the trees) being split into two post CGT assets.

Any net capital gain arising on the disposal of the materials is then assessable income in the year of income in which the disposal occurs.

This means that the income earned from the sale of your materials is assessable as both ordinary income as royalty, and as a capital gain.

However, section 118-20 of the ITAA 1997 prevents the amount from being taxed twice by reducing any capital gain from the disposal of the materials by any amount included in your assessable income. This will have the effect of avoiding double taxation.