Edited version of private advice

Authorisation Number: 1051905524900

Date of advice: 15 October 2021

Ruling

Subject: Compensation payments

Question 1

Will the receipts under the Early Conduct and Compensation Agreement (ECCA) constitute assessable income in accordance with section 6-5 Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Will the receipts under the ECCA constitute capital proceeds under Division 116 of the ITAA 1997 in respect of any capital gains tax event in Division 104 of the ITAA 1997 happening?

Answer

No.

Question 3

Will the receipts under the ECCA reduce the cost base of the property under subsection 110-45(3) of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

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 part owner of a rural property.

You acquired the property several years ago.

The size of the property is approximately X ha.

You entered into an ECCA with Entity X.

You have provided a copy of the ECCA which forms part of the facts for the purposes of this private ruling.

The ECCA is a conduct and compensation agreement under a State government Act.

The ECCA states that Entity Y has appointed Entity X to carry out the authorised activities on the property under the ECCA on its behalf.

Broadly, the ECCA allows Entity X and its associates to enter the property to conduct exploration and production activities, and to compensate you for the resulting harm caused to the property and your use of it.

The area designated for activities under the ECCA is approximately Z ha.

You anticipate that the agreement may last for approximately XX years.

The activities under the ECCA will impact on the activities you carry out on the property during the construction and maintenance stages.

You were planning to build a house on the property in the future; however, the activities under the ECCA may deter this option.

The 'Background' included in the ECCA states that the agreement:

•                    is entered into before the particular timing, location on the land and activities are determined

•                    sets out how Entity X may carry out the activities on the land

•                    sets out a process for Entity X to carry out the activities anywhere on the land throughout the term provided the activities are not a scope change

•                    documents each party's rights and obligations regarding the activities

•                    aims to:

-                    foster a cooperative working relationship between the parties

-                    compensate the landholder for the impacts of the activities

-                    ensure the safety of the landholder, the landholder's associates, the landholder's property and animals, Entity X and the infrastructure, and

-                    find workable solutions to minimise adverse impacts of the activities.

A clause of the ECCA states that the agreement commences on the agreement date and ends when Entity X gives the landholder notice that it has completed all of the activities that Entity X proposes to carry out on the land or that it will not proceed with any activities.

Another clause of the ECCA states that monies paid under the agreement will compensate the landholder for all:

•                    'compensatable effects', disturbance impacts and noise impacts:

-                    of the activities (including any maintenance reopening the land's surface) and modifications

-                    resulting from any livestock management notice or livestock direction, and

-                    from authorised activities off the land, and

•                    other amounts payable by Entity X to the landholder under relevant laws for the activities (the compensation matters).

The ECCA also states that the compensation paid will be in full and final satisfaction of all of Entity X's and its associates' compensation liability to the landholder for the compensation matters.

'Compensatable effect' is defined in subsection of the State Act and means any of the following caused as a result of activities carried out under the ECCA:

•                    deprivation of possession of the land's surface

•                    diminution of the land's value

•                    diminution of the use made, or that may be made, of the land or any improvement on it

•                    severance of any part of the land from other parts of the land or from other land that the eligible claimant owns

•                    any cost, damage or loss arising from the carrying out of activities under the resource authority on the land, and

•                    consequential loss incurred by the eligible claimant arising out of any of the above.

The ECCA states that the landholder:

•                    consents to Entity X and its associates carrying out the activities (including where those activities are a prescribed activity in restricted land), and

•                    must not hinder or obstruct the activities without reasonable excuse, as provided under the relevant Act.

The ECCA also states that Entity X may carry out the activities anywhere on the land throughout the term provided that Entity X:

•                    does not:

-                    locate infrastructure in a sensitive area [as identified by the landholder]

-                    exceed the maximum well number

-                    exceed a maximum number of one camp at any one time

-                    exceed a maximum number of one laydown area at any one time, or

-                    carry out an activity that does not form part of the activities (such as a petroleum processing facility, power transmission line or a telecommunications tower)

•                    gives prior verbal or written notice to the landholder before carrying out scouting activities or water assessments, and

•                    follows the pre-construction steps before carrying out non-production activities or production activities (excluding preliminary activities and scouting activities).

Clauses of the ECCA relate to managing livestock and provide that:

•                    after each livestock management notice is given, the parties must promptly consult, act reasonably and work together with a view to: a) manage livestock on the land to allow certain activities to be carried out efficiently in the absence of livestock and in a manner that mitigates any loss or injury to the livestock, and b) minimise adverse impacts to the landholder's use of the land under future livestock directions

•                    the landholder acknowledges that it may need to relocate some of the livestock on the land to locations elsewhere on the land to comply with livestock directions

•                    the landholder must comply with each livestock direction given to the landholder by Entity X.

A schedule of the ECCA lists the specific amounts of compensation Entity X will pay to the landholder. These amounts include:

•                    reimbursement of the landholder's costs involved with negotiating the agreement

•                    a one-off payment on entering into the agreement

•                    annual payments during the pre-production period, and

•                    one-off and annual payments based on the number of wells and bores.

Another schedule of the ECCA details the specific activities that may be carried out on the land under the agreement. The activities include, broadly, the construction of wells, bores, access points, tracks, gates, grids, fences, vents, above ground piping skids, electrical substations, a camp site and laydown areas for construction related activities.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 Division 104

Income Tax Assessment Act 1997 subsection 110-45(3)

Income Tax Assessment Act 1997 Division 116

Reasons for decision

Compensation payments as ordinary income

Section 6-5 of the ITAA 1997 provides that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources during the income 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, or have an element of periodicity, recurrence or regularity.

Profits from isolated transactions may also be treated as ordinary income. The term 'isolated transactions' refers to:

a)            those transactions outside the ordinary course of business of a taxpayer carrying on a business, and

b)            those transactions entered into by non-business taxpayers (paragraph 1 of Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income (TR 92/3)).

Profits from an isolated transaction are 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 TR 92/3).

Whether a lump sum or other compensation payment constitutes assessable income in the hands of the recipient depends on whether it is a receipt of a capital or income nature which in turn depends upon a consideration of all the circumstances surrounding the payment. It is the character of the receipt in the hands of the recipient that must be determined. For income tax purposes, a compensation amount generally bears the character of that which it intends to replace.

In your case, you will receive a combination of one-off and annual payments to compensate you for the damage to your property, and limitations placed on its use by you, as a result of the activities carried out under the ECCA.

Based on the information provided, the payments you receive will not be considered income derived by you in providing services to another entity, or to the carrying on of a business on the property, or give rise to a profit made from an isolated transaction. Instead, you are entitled to receive the payments under the relevant state legislation and it is considered that you entered into the arrangement in order to receive compensation for damage that will be caused by the activities carried out under the ECCA.

Therefore, the compensation amounts are capital in nature and will not constitute ordinary income. The fact that some of the compensation payments are to be received annually rather than by means of a single lump sum does not disturb the capital nature of the receipts, because once the character of the payments is established, the manner in which the payments are received does not change the fundamental nature of the receipts.

The payments will not be included in your assessable income under section 6-5 of the ITAA 1997.

Compensation payments and the capital gains tax (CGT) provisions

Under section 6-10 of the ITAA 1997 some amounts that are not ordinary income are included in your assessable income due to another provision of the tax law. These amounts are statutory income. Statutory income may arise under the CGT provisions as a result of receiving a compensation payment.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts (TR 95/35) provides the Commissioner's view on the CGT consequences of receiving compensation payments. The ruling explains 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 the asset that, using the 'look-through' approach, is disposed of or has suffered permanent damage or has been permanently reduced in value because of some act, happening, transaction, occurrence or event which has resulted in a right to seek compensation from the person or entity causing that damage or loss in value or against any other person or entity (paragraph 3 of TR 95/35).

If an amount of compensation is received by a taxpayer wholly in respect of the disposal of an underlying CGT asset, or part of an underlying CGT asset, of the taxpayer the compensation represents consideration received on the disposal of that asset. In these circumstances, the Commissioner considers that the amounts are not consideration for the disposal of any other asset, such as the right to seek compensation (paragraph 4 of TR 95/35).

Alternatively, if an amount of compensation is received by a taxpayer wholly in respect of permanent damage suffered to an underlying asset of the taxpayer or for a permanent reduction in the value of an underlying asset of the taxpayer, and there is no disposal of that underlying asset at the time of the receipt, then the amount represents a recoupment of all or part of the total acquisition costs of the asset (paragraph 6 of TR 95/35).

'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 (paragraph 3 of TR 95/35).

Where there is a recoupment, the total acquisition costs of the CGT asset should be reduced by the amount of the compensation (subsection 110-45(3) of the ITAA 1997). 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 (paragraph 7 of TR 95/35).

In your case, from the scale of the activities and the 'compensatable effects' detailed in the ECCA and relevant legislation, it is considered that the amounts you will receive under the ECCA will be capital amounts to compensate you for permanent damage to, or a permanent reduction in the value of, your property.

Therefore, the amounts you receive under the ECCA will reduce the cost base of the property as per subsection 110-45(3) of the ITAA 1997

As you did not dispose of all or part of the affected land, there are no amounts assessable under the CGT provisions at the time of entering into the ECCA or on receipt of the compensation payments.