Edited version of private advice

Authorisation Number: 1051876537615

Date of advice: 28 July 2021

Ruling

Subject: Compensation payments

Question 1

Will the compensation received under the Agreements be treated as assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Will the compensation received be treated as capital proceeds under Division 116 of the ITAA 1997 from any capital gains tax event in Division 104 of the ITAA 1997?

Answer

No.

Question 3

Will the compensation received reduce the cost base of the relevant property for any future capital gain under section 110-40 and subdivision 110-A of the ITAA 1997?

Answer

Yes.

Question 4

Will the resource payments for the sale of gravel and water form part of your assessable income?

Answer

Yes.

Question 5

Does the inclusion of entity C (occupier of the land) as a party to the agreement mean that compensation needs to be apportioned between the land holder and the occupier?

Answer

No.

Question 6

Will the land holders incur a goods and services tax (GST) liability on the receipt of compensation amounts?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 20xx to year ending 30 June 20xx

The scheme commenced on

1 July 20xx

Relevant facts

Entity A acquired the majority of property A in xxxx. Entity A and entity B acquired a small lot of property A in xxxx which was and is their main residence. Entity A subsequently received additional lots which now forms the balance of property A.

Entity A and B jointly purchased property B in xxxx.

Entity A has been running a business for over xx years, and in partnership with entity B for more than xx years. Entity A and B have a policy to ensure the business longevity and success.

The combined properties in total is approximately xxxx hectares and is currently used to carry on a business which is undertaken by entity C. Entity A and B operate their business using a conservative management system.

Entity D have finalised negotiations on the Agreements with entity A and B to construct and operate items across their two properties. The Agreement dates were xxxx.

The activities in the agreement have been provided.

The Agreements set-out the relevant compensation details.

Under the terms and conditions signed on xxxx, the pre-construction compensation is only paid once.

The construction compensation will compensate you for part of the impact of the activities and the construction period and will only be paid once.

The annual compensation is calculated on a pro rata basis determined on the actual duration and quantity of the activities and/or timing of the construction compensation for the 12 months prior to the annual payment date as applicable.

The business will not need to reduce stock during the construction phase or post construction phase.

No improvements made by entity C will be permanently damaged by the activities carried out on the land as entity D are required to 'make good' on any damage.

The Rules of Conduct also specifically states that where practicable activities will be conducted with minimal disturbance to stock.

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 6-15

Income Tax Assessment Act 1997 section 10-5

Income Tax Assessment Act 1997 section 15-20

Income Tax Assessment Act 1997 Division 104

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 110-40

Income Tax Assessment Act 1997 section 110-45

Income Tax Assessment Act 1997 Subdivision 110-A

Income Tax Assessment Act 1997 Division 116

A New Tax System (Goods and Services Tax) Act 1999 section 9-5

A New Tax System (Goods and Services Tax) Act 1999 section 9-10

A New Tax System (Goods and Services Tax) Act 1999 section 9-15

A New Tax System (Goods and Services Tax) Act 1999 section 9-30

A New Tax System (Goods and Services Tax) Act 1999 section 38-285

Reasons for decision

Ordinary income

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

Ordinary income has generally been held to include three categories, namely, income form 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.

For income tax purposes, an amount paid to compensate for a loss generally acquires the character of that for which it is substituted (Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 AITR 443; 10 ATD 82). Compensation payments which substitute income have been held by the courts to be income under ordinary concepts (Federal Commissioner of Taxation v. Inkster (1989) 24 FCR 53; (1989) 20 ATR 1516; 89 ATC 5142, Tinkler v. FC of T (1979) 10 ATR 411; 79 ATC 4641, and Case Y47 (1991) 22 ATR 3422; 91 ATC 433).

On the other hand, 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.

Compensation paid due to loss and damage of a capital asset in the process of a petroleum authority undertaking petroleum activities on a person's land is regarded as an isolated transaction. Whether a profit from an isolated transaction is income according to ordinary concepts depends on the circumstances of the case.

As outlined in Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income, a profit from an isolated transaction will generally be income when:

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

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

After reviewing all the relevant facts in your circumstances, it is considered that you did not enter into the agreements to make a profit and the compensation payments do not form part of an isolated profit-making transaction.

Furthermore, the compensation payments are not earned by you as they do not relate to services performed or from carrying on a business. Although the compensation relates to your property, the payment is not akin to rent. Rather the compensation is being received for the impact of the activity on your land. Although the payment can be said to be expected, and perhaps relied upon, this expectation does not arise from any personal services performed or business activity. It is further noted that there is no amount of compensation specifically paid for any loss of income in relation to the business activities on the properties. The compensation payment relates to the damage to your property and is capital in nature.

Accordingly, the compensation payments paid 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. That is, the compensation amounts are not included in your assessable income under section 6-5 of the ITAA 1997.

Statutory income

Statutory income is not ordinary income, but is included in assessable income by specific provisions of the income tax law (section 6-10 of the ITAA 1997).

These specific provisions are listed in section 10-5 of the ITAA 1997 and include capital gains, which are included in assessable income by virtue of the capital gains tax (CGT) provisions and royalties, assessable under section 15-20 of the ITAA 1997.

Property A and property B are CGT assets under section 108-5 of the ITAA 1997.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts considers the CGT consequences for compensation payments. Why the payment was made is an important factor in determining whether an asset has been disposed of for capital gains tax purposes.

TR 95/35 discusses the various scenarios, including:

•        disposal of the underlying asset,

•        compensation for permanent damage to, or permanent reduction in value of, the underlying asset, and

•        disposal of the right to seek compensation.

As outlined in the ruling, the Commissioner adopts an ''underlying asset'' approach to determine the asset to which the compensation amount is most directly related. In concluding that the underlying asset is the most relevant asset to which an amount of compensation relates, a person must be able to show that the compensation receipt has a direct and substantial link with the underlying asset. If an asset has not been disposed of and has not been permanently damaged or permanently reduced in value by the happening or event which generated the amount of compensation, the taxpayer is not able to demonstrate that link. It follows that the compensation cannot be directly related to that asset. In those cases, the most relevant asset may be the right to seek compensation.

Paragraph 3 of TR 95/35 states that 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.

Where an amount of compensation is received wholly in respect of the disposal of an underlying CGT asset, or part of an underlying CGT asset, the compensation represents consideration received on the disposal of that asset. In these circumstances, the Commissioner considers that the amount is not consideration for the disposal of any other asset, such as the right to seek compensation.

If an amount of compensation is received 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, and there is no disposal of that underlying asset at the time of the receipt, we consider that the amount 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 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.

The transaction which generated your compensation payments is the actions of entity D. The underlying asset in your case is the land that has been used for the activities. You have not disposed of the land, however the land will suffer permanent damage. You will receive compensation in respect of the impact of the activities on the land. The compensation amounts to be paid are viewed as having a direct and substantial link or nexus with the land.

As you have not disposed of the property or other CGT asset, there are no CGT consequences at the time of entering into the agreements or receiving the compensation payments. That is, no CGT event has occurred as a result of the agreements and the payments received are not regarded as capital proceeds under Division 116 of the ITAA 1997.

However, the property's acquisition cost will be reduced by the compensation payments (excluding any reimbursements) received in relation to your property (subdivision 110-A of the ITAA 1997). 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.

Please note, that although entity C operates the business, no part of the compensation specifically relates to the business. Therefore, it is considered that no part of the compensation belongs to entity C, as occupiers of the land. The compensation belongs to the land holder.

Royalties

Under section 15-20 of the ITAA 1997 your assessable income includes an amount that you receive as or by way of royalty within the ordinary meaning of "royalty" (disregarding the definition of royalty in section 995-1) if the amount is not assessable as ordinary income under section 6-5 of the ITAA 1997.

The Commissioner's view on the definition of a royalty is set out in 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 meaning of 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; 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 case, the agreements included payments to you for the volume of gravel extracted from your property. Gravel is a natural resource. It is considered that the payment for each cubic metre of gravel extracted will be a payment by way of royalty and assessable under section 15-20 of the ITAA 1997.

You also receive payments for the volume of water taken from your property. The amount of water taken is dependent on the available level of water which is governed by weather conditions. It is considered that any proceeds you receive from the sale of the water is assessable as a royalty given that the water is a natural resource that is removed from the land.

GST

Supply

'Supply' is defined in subsection 9-10(1) of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act) as 'any form of supply whatsoever'. The statutory definition of 'supply' is very broad. Essentially, a supply is something which passes from one entity to another, and may be one of goods, services or something else.

Consideration

Section 9-15 of the GST Act provides that a payment will be consideration for a supply if the payment is 'in connection with' a supply and 'in response to' or 'for the inducement' of a supply. Thus, there must be a sufficient nexus between a particular supply and a particular payment, which is provided for that supply, for there to be a supply for consideration.

Sufficient nexus

A sufficient nexus between the compensation amounts and a supply must exist to create the 'supply for consideration' relationship.

In the present case, the issue is whether the landholders have provided something to entity D, in return for the compensation amounts that are paid to them.

The landholders giving up their rights for further compensation upon commencing the agreement, clause 5 of the agreement, raises the issue of whether giving up of a landholder's rights would be a separate supply or as termed in Goods and Services Tax Ruling 2001/4: Goods and Services Tax: GST consequences of court orders and out-of-court settlements (GSTR 2001/4) a 'discontinuance supply'.

Paragraphs 106 to 109 in GSTR 2001/4 discuss discontinuance supplies as follows:

106. Where the only supply in relation to an out-of-court settlement is a 'discontinuance' supply, it will typically be because the subject of the dispute is a damages claim. In such a case, the payment under the settlement would be in respect of that claim and not have a sufficient nexus with the discontinuance supply.

107. In most instances, a 'discontinuance' supply will not have a separately ascribed value and will merely be an inherent part of the legal machinery to add finality to a dispute which does not give rise to additional payment in its own right. They are in the nature of a term or condition of the settlement, rather than being the subject of the settlement.

108. We do not consider that the inclusion of a 'no liability' clause in a settlement deed alters this position. 'No liability' clauses are commonly included in settlement agreements and we do not consider their inclusion to alter the substance of the original dispute, or the reason payment is made.

109. We consider that a payment made under a settlement deed may have a nexus with a discontinuance supply only if there is overwhelming evidence that the claim which is the subject of the dispute is so lacking in substance that the payment could only have been made for the discontinuance supply.

In the process of entity D carrying out its activities on the Land, significant damage and adverse effects will impact the landholders, for which entity D must compensate the landholders under the law. Upon receipt of the compensation amounts under the agreement, the landholders accept that they give up their right to pursue further compensation in relation to the Authorised Activities.

Applying the principle in paragraphs 106 to 109 in GSTR 2001/4, it is considered the landholders giving up their right for further compensation is not a separate supply for GST purposes. It is rather considered an inherent part of the legal machinery to bring finality to the amount of compensation that will ultimately be sought by the landholders. We do not consider that the giving up of the landholders' rights for further compensation is a separate supply from the landholders to the company since it is not the reason for which the compensation amount is paid to the landholders.

Damages

GSTR 2001/4 states the following in relation to damages, at paragraph 73:

The most common form of remedy is a claim for damages arising out of the termination or breach of a contract or for some wrong or injury suffered. This damage, loss or injury, being the substance of the dispute, cannot in itself be characterised as a supply made by the aggrieved party. This is because the damage, loss or injury in itself does not constitute a supply under section 9-10 of the GST Act.

Paragraphs 110 and 111 of GSTR 2001/4 further explain:

110. With a dispute over a damages claim, the subject of the dispute does not constitute a supply made by the aggrieved party...

111. If a payment is made under an out-of-court settlement to resolve a damages claim and there is no earlier or current supply, the payment will be treated as payment of the damages claim and will not be consideration for a supply at all, regardless of whether there is an identifiable discontinuance supply under the settlement.

Although the above explanation in GSTR 2001/4 is made in respect of court orders and out-of-court settlements, the underlying principles are equally relevant in this case.

The landholders received the amounts as a landholder under state legislation, as compensation for any economic loss, hardship and inconvenience as a result of activities carried out on their Land by entity D.

The payment by entity D to the landholders is compensation in respect of any damage caused or likely to be caused to the Land and any inconvenience suffered by the landholders as a consequence of the Authorised Activities carried out on the Land.

In applying the above principles in GSTR 2001/4 to the present circumstances, we consider that, the compensation amounts are paid to the landholders to resolve a damages claim. A claim for damages (or payment that the landholders receive as a consequence of such claim) due to activities conducted by entity D on the landholders' Land, does not constitute a supply under section 9-10 of the GST Act.

The landholders do not provide entity D with any supply in return for the compensation amounts. As such, the compensation payments made by entity D is not consideration for a supply from the landholders to entity D, and accordingly no taxable supply will be made by the landholders.

Therefore, the receipt of the compensation amounts by the landholders from entity D will not give rise to a GST liability.

Supply of water

Subsection 9-30(1) of the GST Act states that a supply is GST-free if:

a) it is GST-free under Division 38 or under a provision of another Act, or

b) it is a supply of a right to receive a supply that would be GST-free under paragraph (a).

A supply of water in section 38-285 of the GST Act refers to the delivery or the making available of water, as goods. A supply of water is GST-free under subsection 38-285(1) of the GST Act.

However, a supply of water is not GST-free under subsection 38-285(2) of the GST Act where it is 'supplied in a container', or 'transferred into a container, that has a capacity of less than 100 litres'.

Goods and Services Tax Ruling GSTR 2000/25 Goods and service tax: GST-free supplies of water, sewerage and sewerage-like services, storm water draining services and emptying of a septic tank explains the Commissioner's view of what activities are covered by Subdivision 38-I of the GST Act.

Paragraphs 25 and 26 of GSTR 2000/25 deal with the application of paragraph 9-30(1)(b) of the GST Act to the supply of water rights and discuss trading 'water rights.

Paragraph 25 provides that a supply of a right to receive a supply of water includes:

•        a right to receive a supply of a quantity of water; or

•        a right to receive a supply of water for a specified period; or

•        a tradeable right to receive a supply of water.

As stated above the supply of water is GST-free under subsection 38-285(1) and section 9-30 of the GST Act.

Accordingly, the supply of water is GST-free and the consideration for this supply will not be subject to GST.

Supply of gravel

The property is currently used to carry on a business which is undertaken by entity C.

In this case, you have agreed to receive payments from entity D for the volume of gravel extracted based on a rate per cubic metre. It is considered that the gravel is a natural resource that will removed from the land.

This is not a supply that is made by the enterprise. Rather, it is a supply made by the landowners as a result of entering into the agreements with entity D. Therefore, it is a supply outside the scope of the GST Act and any amounts received form part of the compensation amounts payable as damages.