Edited version of private advice

Authorisation Number: 1051882014221

Date of advice: 06 August 2021

Ruling

Subject: Compensation receipts

Question 1

Do the receipts under the Agreement signed on xxxx constitute assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

To the extent that the receipts under the Agreement signed on xxxx do not constitute assessable income under section 6-5 of the ITAA 1997, will the receipt of these amounts constitute capital proceeds under Division 116 of the ITAA 1997 in respect of a CGT event happening?

Answer

No.

Question 3

To the extent that the receipts under the Agreement signed on xxxx do not constitute assessable income under section 6-5 of the ITAA 1997 and do not constitute capital proceeds under Division 116 of the ITAA 1997 in respect of a CGT event happening, does any compensation received under the Agreement reduce the cost base of the property/land under subsection 110-45(3) and subdivision 110-A of the ITAA 1997?

Answer

Yes.

Question 4

Will you incur a goods and services tax (GST) liability on the receipt of compensation amounts from entity A?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2021

Year ending 30 June 2022

Year ending 30 June 2023

Year ending 30 June 2024

Year ending 30 June 2025

Year ending 30 June 2026

Year ending 30 June 2027

Year ending 30 June 2028

Year ending 30 June 2029

Year ending 30 June 2030

The scheme commenced on

1 July 2020

Relevant facts

Entity B and entity C (you), own land located at xxxx (the property).

Entity B purchased the property in xxxx, after 1985 and transferred a one-half interest in the property to entity C in xxxx while retaining the other one-half interest.

Entity C runs a business on the land. The property is xxxx acres in size and you lease xxxx acres of the land to entity D and entity E. Entity D and E pay entity A and B a lease payment of $xxxx per acre per year to lease the land.

Entity A and B do not live on the property and rent out the residential premises on the land to a tenant at an arm's length rate. They receive rent of approximately $xxxx per week from the tenant.

The part of the property not used by entity D and E is used for business activities by entity C.

You entered into an Agreement with entity A on xxxx.

A separate Agreement has been negotiated between entity D and E with entity A to compensate them for the impact of the activities on their activities.

The Agreement compensates the landholder (you) for the impact of all related activities on the property undertaken by entity A.

Entity A intends to construct infrastructure on the land.

You are currently developing another operation. You are concerned that the activities by entity A will impact the new venture.

Water is sourced for the property.

You manage the business under the specified accreditations and certifications/standards.

It is not expected that you will incur any additional costs for your business as a result of the activities by entity A

The Agreement provides that entity A is authorised to carry out the Authorised Activities. The Agreement acknowledges that you are the eligible claimants/landholders under the relevant authority.

The relevant legislation defines the general liability of entity A to compensate you for any compensatable effect you suffer as a result of authorised activities carried out.

The full agreement has been provided. The agreement includes the proposed activities to be carried out and the special and general conditions.

The duration of the agreement is at the sole discretion of entity A.

The actual amount of compensation that will be paid is $xxxx upfront and $xxxx annually.

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 Division 104

Income Tax Assessment Act 1997 Subdivision 110-A

Income Tax Assessment Act 1997 section 110-40

Income Tax Assessment Act 1997 section 110-45

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

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 an entity undertaking specified 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 relation to your circumstances, it is not considered that your compensation payments form part of an isolated profit-making undertaking.

Furthermore, the compensation payments you will receive is not earned by you as it does 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. The fact that amounts are received annually does not mean that such payments are ordinary income. 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. The compensation payment relates to the damage to your property and is capital in nature. Accordingly, the compensation payments paid under the Agreement are not regarded as ordinary income and are therefore not assessable under subsection 6-5(2) 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.

The property is a CGT asset 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 transactions which generated your compensation payments are the actions of entity A. The underlying asset in your case is the land that is being used for the activities. You have not disposed of the land, however the land will suffer permanent damage or permanent reduction in value. 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 Agreement or receiving the compensation payments. That is, no CGT event has occurred as a result of the Agreement 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 the 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.

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 current case, the issue is whether the landholders have provided something to entity A, 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 x 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 A carrying out its Activities on the land, significant damage and adverse effects will impact the landholders, for which entity A 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 that 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 entity 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 A.

The payment by entity A 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 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 A on the landholders' land, does not constitute a supply under section 9-10 of the GST Act.

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

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