Edited version of private advice

Authorisation Number: 1051602458407

Date of advice: 30 October 2019

Ruling

Subject: Assessability of compensation payments

Question 1

Do compensation receipts received under an agreement constitute ordinary income in accordance with section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Do compensation receipts received under an agreement constitute capital proceeds in accordance with Division 116 of the ITAA 1997 in respect of a Capital Gains Tax (CGT) event happening?

Answer

No

Question 3

Do compensation receipts received under an agreement reduce the cost base of the property under subsection 110-40(3) of the ITAA 1997?

Answer

Yes

Question 4

To the extent that compensation receipts received under an agreement exceed the cost base of the property, will there be any CGT consequences?

Answer

No

This ruling applies for the following period(s):

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

Year ending 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

You are the Landholder of a farming property purchased in 19XX.

A company holds a tenement over part of the property. The company made plans to commence mining activities on the property.

It is estimated that there will be a significant reduction in the area of land available for farming as a result of the mining activities. The estimated reduction in carrying capacity of the land will be approximately 30%.

You and the company have entered into an agreement under the Petroleum and Gas (Production and Safety) Act 2004 (PGPS Act) and Mineral and Energy Resources (Common Provisions) Act 2014 (MERCP Act). The agreement sets out the compensation to be paid by the company to you, in relation to the proposed mining activities.

The relevant clauses of the CCA are included below:

1 Definitions and interpretation

1.1 In this agreement:

Activities means those activities which the Tenement Holder is authorised to carry out pursuant to the terms of the Tenement and as described in Schedule 1 and located on the map in Schedule 3.

Compensation means compensation to be provided to the Landholder under this agreement and calculated in accordance with Schedule 4[sic][1].

Compensatable Effect means the heads of compensation outlined in Section 81(4) of the MERCP Act.

Conduct and Compensation Agreement is an agreement for compensation for the purposes of Chapter 3, Part 7 of the MERCP Act.

Petroleum Legislation means the Petroleum and Gas (Production and Safety) Act 2004 (Qld) and the MERCP Act, as applicable.

2 Agreement

2.1 This agreement is an Access Agreement and Conduct and Compensation Agreement for the purposes of the MERCP Act.

3 Term

3.1 Subject to the Petroleum Legislation, this agreement commences on the Agreement Date and continues until the Tenement Holder provides notice that its Activities have been completed and the Land has been rehabilitated in accordance with Relevant Laws and the terms of this Agreement.

5 Compensation

5.1 The Tenement Holder shall provide the Compensation to the Landholder in accordance with Schedule 2.

5.2 The Compensation:

(a) compensates the Landholder for the Compensatable Effects of the Activities; and

(b) is in full and final satisfaction of the Tenement Holder's Compensation Liability to compensate the Landholder for the Activities;

The amounts of compensation to be paid are set out in Schedule 2 of the agreement and include an upfront compensation payment and annual compensation payments payable until the expiry of the term.

Relevant legislative provisions

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 section 6-5

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

Income Tax Assessment Act 1997 subsection 104-10(1)

Income Tax Assessment Act 1997 paragraph 104-25(1)(b)

Income Tax Assessment Act 1997 section 110-40

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

Income Tax Assessment Act 1997 Division 116

Income Tax Assessment Act 1997 section 116-1

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

Mineral and Energy Resources (Common Provisions) Act 2014 subsection 81(4)

Reasons for decision

Question 1

Summary

The upfront payment and the annual payments to be paid under the agreement will not constitute ordinary income under section 6-5 of the ITAA 1997.

Detailed reasoning

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that an Australian resident's assessable income includes the ordinary income they derive directly or indirectly from all sources, whether in or out of Australia, during the income year.

Ordinary income generally falls into one of the following three sources:

·         income from rendering personal services;

·         income from property; or

·         income from carrying on a business.

The following factors have been developed by the courts to help determine whether a receipt has the characteristics of income:

·         The receipt is earned;

·         The receipt is expected;

·         The receipt is relied upon;

·         The receipt has an element of periodicity, recurrence or regularity; or

·         The receipt is for the replacement of income.

As highlighted by the High Court in Federal Commissioner of Taxation v. Montgomery (1999) 198 CLR 639, no single factor is determinative of the receipt's character but some factors may be more relevant than others in light of the circumstances of the case.

Where an amount is paid to compensate for a loss, that payment generally acquires the character of that for which it is substituted, pursuant to Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 AITR 443; 10 ATD 82.

As a result, compensation payments that intend to substitute income have been regarded by the courts as having the characteristic of income: Federal Commissioner of Taxation v. Darcy Peter Smith (1981) 147 CLR 578; (1981) 11 ATR 538; 81 ATC 4114; Federal Commissioner of Taxation v. Inkster (1989) 24 FCR 53; (1989) 20 ATR 1516; 89 ATC 5142; and, Case Y47 (1991) 22 ATR 3422; 91 ATC 433.

The company holds a tenement over a part of your property. The company is planning to undertake mining activities.

The relevant mining legislation, namely PGPS Act and the MERCP Act establishes a statutory scheme that requires the tenement holder to provide compensation to landowners for the impacts of mining activities on their land; and requires the relevant parties to enter into an agreement. This is to ensure that landowners are not financially disadvantaged by activities carried out on their property. Landowners are entitled to compensation for any compensatable effects related to the impact of the activities on their business operations and land use.

You entered into an agreement with the company as required under the PGPS Act and the MERCP Act. You have agreed to accept annual payments and an upfront lump sum as compensation from the company under the agreement. These amounts are to compensate you for the Compensatable Effects of the mining activities on your property.

The meaning of compensatable effect is defined in Clause 1 of the agreement to mean the heads of compensation outlined in subsection 81(4) of the MERCP Act:

"compensatable effect", suffered by an eligible claimant because of a resource authority holder, means-

(a)  any of the following caused by the holder, or a person authorised by the holder, carrying out authorised activities on the eligible claimant's land-

(i) deprivation of possession of the land's surface;

(ii) diminution of the land's value;

(iii) diminution of the use made, or that may be made, of the land or any improvement on it;

(iv) severance of any part of the land from other parts of the land or from other land that the eligible claimant owns;

(v) any cost, damage or loss arising from the carrying out of activities under the resource authority on the land; and

(b) consequential loss incurred by the eligible claimant arising out of a matter mentioned in paragraph (a) ...

Lump sum payment

Taxation Determination TD 93/58 Income tax: under what circumstances is the receipt of a lump sum compensation/settlement payment assessable? (TD 93/58), states that a lump sum compensation payment is assessable:

(a)  if the payment for compensation is for loss of income only; or

(b)  to the extent that a portion of the lump sum payment is identifiable and quantifiable as income.

The land in question is a capital asset as it is used by the you for farming activities. The mining activities carried out by the company significantly reduce the area of land available to be used in those farming activities.

The compensation paid under the agreement is for compensatable effects of the mining operation. Consequently you are being primarily compensated for the permanent damage to the land caused by the mining activities carried on by the company.

Furthermore, there is no indication in the agreement or subsection 81(4) of the MERCP Act that any identifiable part of the lump sum payment relates to loss of an income nature. In the absence of any portion being identifiable and quantifiable as being paid for a claim of an income nature, the whole lump sum payment will be considered capital.

Accordingly, lump sum compensation payable under the agreement is capital in nature and not ordinary income.

Annual payments

The fact that the annual payments are to be paid under the agreement on a regular or periodic basis for the term of the agreement does, in isolation, suggest that the amount is a replacement of income. However, as was the case in Barrett v Federal Commissioner of Taxation [1968] HCA 59; (1968) 118 CLR 666; 15 ATD 149; 10 AITR 685 (Barrett) and Nullaga Pastoral Company Pty Ltd v FC of T 78 ATC 4329; (1978) 8 ATR 757 (Nullaga), the fact that compensation payments are periodic and ongoing was not determinative in deciding the character of the payments.

Nullaga applied the earlier decision in Barrett and considered certain compensation payments made by mining joint venturers to a taxpayer company (the Nullaga Pastoral Company), whichowned and operated a successful farming property. While the land was privately owned by the taxpayer, the mineral rights in relation to the property belonged to the Crown.

A joint venture exploration and mining company was granted exploration rights for five years. As consideration for those rights, the taxpayer company was to receive $10,000 annually. If the joint venturers started mining, the annual payments were to be replaced by an amount based on each ton of ore removed. The joint venturers were interested in more than one-third of the area of the farm and their proposed mining activities would considerably interfere with farm planning, operation and development.

The first two payments of $10,000 were assessed by the Commissioner as income. The Commissioner did not argue that the payments were assessable as royalties, but that the periodic nature of the payments was enough to cause them to be analogous to payments for a lease or licence, and therefore income as rent.

However, Wickham J considered that the payments made once mining activities commenced were of a capital nature. It was held that these subsequent payments were not income because they were compensation for interference and damage to the land and diminution in its value resulting from the mining. In his opinion, the money was paid and received as consideration for the deprivation of part of a capital asset and in order to replace that capital.

The Nullaga and Barrett cases are analogous to your situation, in that payments were made as compensation for damage to property that forms part of your profit-yielding structure. As in your case, in both Nullaga and Barrett the taxpayers were conducting successful and ongoing farming operations, and the mining operations impacted on the use of the land that was being used for those farming operations. In Nullaga the mining venture affected more than one third of the farm, and it was acknowledged that this would considerably interfere with the planning, operation, and development of the farming business. Likewise, the mining activities carried out by the company significantly reduce the area of land on your property available for farming.

Additionally, in both Nullaga and Barrett, the taxpayers were not only owners of the businesses conducted on the land, they were the owners of the farming properties and had exclusive possession of the land. As owners, they were entitled to compensation for the damage and interference to their rights and interests. All of the circumstances in both cases supported the conclusion that the payments were compensation for the damage to the property belonging to the taxpayers.

Similarly, you are the owner of the property and circumstances support the conclusion that the annual payments are to compensate you for the damage and reduction in value of the property as a result of mining activities and not a replacement of lost income. Accordingly, the annual payments are not income according to ordinary concepts.

Consequently, both the lump sum and annual payments made by the company to you are capital in nature and will not be included in your assessable income as ordinary income pursuant to section 6-5 of the ITAA 1997.

Question 2

Summary

The upfront payment and the annual payments received under the agreement will not constitute capital proceeds under Division 116 of the ITAA 1997.

Detailed reasoning

Subsection 116-20(1) of the ITAA 1997 then defines capital proceeds from a CGT event to include the total of the money you have received, or are entitled to receive, in respect of the event happening.

Therefore, the compensation receipts paid to you will only constitute capital proceeds if those receipts are in respect of a CGT event.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts considers the CGT consequences for a taxpayer who receives an amount as compensation, and whether the amount should be included in the taxpayer's assessable income under Part 3-1 of the ITAA 1997.

There are two CGT events that are considered within TR 95/35. The first event is the disposal of the underlying asset ('CGT event A1') and the second event is the cancellation, surrender and similar endings of the right to seek compensation ('CGT event C2').

Paragraph 4 of TR 95/35 relevantly provides that CGT event A1 will occur if the amount of compensation is received by a taxpayer either wholly or partly in respect of the disposal of an underlying asset, as the compensation represents consideration received on the disposal of that asset.

Paragraph 11 of TR 95/35 relevantly provides that if the amount of compensation is not received in respect of any underlying asset, the amount relates to the disposal by the taxpayer of the right to seek compensation, meaning that CGT event C2 will occur.

It is evident that the term 'underlying asset' is central to determining whether either CGT events A1 or C2 will occur when you receive the compensation payments under the agreement. Paragraph 70 of TR 95/35 provides that the underlying asset is identified by adopting a 'look-through approach' to the transaction or arrangement which will generate the compensation receipt to determine the most relevant asset.

By adopting the look-through approach to the agreement, the Commissioner considers that the underlying asset is the property. The prime objective of the agreement is to ensure that you are properly compensated under the PGPS Act and MERCP Act for any compensatable effects suffered as a result of the mining activities carried on by the company. It is clear from the definition of compensatable effects (in subsection 81(4) of the MERCP Act) that the landholder is compensated primarily for the effects of the resource authority holder activities on the land.

It therefore follows that:

·         CGT event A1 did not happen, as the underlying asset - the property - has not been disposed of; and

·         CGT event C2 did not happen as the compensation receipts are wholly in respect of the underlying asset. They are not for the disposal of the right to seek compensation.

In conclusion, the Commissioner accepts that receipt of compensation does not constitute capital proceeds in respect of a CGT event happening.

Question 3

Summary

The compensation received will reduce the cost base of the property under subsection 110-40(3) of the ITAA 1997.

Detailed reasoning

Section 110-40 of the ITAA 1997 specifies what expenditure does not form part of the cost base of an asset for the purpose of determining a CGT liability. Subsection 110-40(3) of the ITAA 1997 specifies that the cost base of an asset will not include expenditure to the extent that expenditure has been recouped.

Although former section 160ZH of the Income Tax Assessment Act 1936 has been repealed, the principles in TR 95/35 can still be broadly applied to the current provisions.

Paragraph 6 of TR 95/35 states:

6. If an amount of compensation is received by a taxpayer wholly in respect of permanent damage suffered to a post-CGT underlying asset or for a permanent reduction in the value of a post-CGT underlying asset 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 are required to be reduced by the amount of the compensation.

In this instance, as there is no disposal of the underlying asset, the compensation payments are wholly in respect of permanent damage and reduction in value of your property. The compensation receipts represent the recoupment of expenditure on the acquisition of the property and reduce the cost base of the asset in accordance with subsection 110-40(3) of the ITAA 1997.

Question 4

Summary

There will be no CGT consequences where compensation receipts received under the agreement exceed the cost base of the property.

Detailed reasoning

Paragraph 133 of TR 95/35 states the following in respect of recouped amounts that exceed the acquisition costs of a property:

133. Accordingly, if the amount of recoupment exceeds the taxpayer's total acquisition costs at the time of the compensation, the effect of subsection 160ZH(11) is to reduce the costs to zero. The excess of the recoupment over the costs in these circumstances does not represent a taxable capital gain derived from the disposal of that asset. There are no CGT consequences in respect of any excess. It follows that the whole consideration received on a later actual disposal of that asset by the taxpayer will be a taxable capital gain (unless the taxpayer incurs additional expenditure which forms part of the cost base of that asset).

In addition, paragraph 7 states:

If, in the case of a post-CGT underlying asset, 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 short, where compensation amounts received under the CCA exceed the cost base of the property, the cost base of the property will be reduced to nil at the time the compensation is received. There will be no CGT consequences in respect of the excess compensation.

[1] The compensation to be provided to the Landholder is calculated in accordance with Schedule 2 to the CCA.