Edited version of private advice

Authorisation Number: 1052004605594

Date of advice: 11 July 2022

Ruling

Subject: Conduct and compensation agreement payments

Question 1

Are the annual payments for compensation made in relation to the agreement assessable as income under Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Are the annual payments for compensation made in relation to the agreement assessable as capital gains under the CGT provisions in Part 3-1 and 3-3 of the ITAA 1997?

Answer

No.

Question 3

Will payments made under the agreement reduce the cost base of the underlying asset ("the land") pursuant to Section 110-40(3) of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

Income year ending 30 June 20XX

Income year ending 30 June 20XX

Income year ending 30 June 20XX

Income year ending 30 June 20XX

Income year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

1. The XXXX is the owner of a XXXX property.
2. A company controlled by the XXXX manages an XXXX operation on the land.
3. The XXXX acquired the land as a post-CGT asset acquired after 7.30pm on XX XXX XXXX.
4. A company not associated with the XXXX, is the holder of a XXXX XXXX which covers all or part of the land and has been appointed to carry out XXXX activities on the land.
5. A compensation agreement ("the Agreement") with the XXXX in respect of their activities on the XXXX land has been entered. A copy of the Agreement has been provided.
6. Under the Agreement, the XXXX will receive compensation in respect of the impact of the activities on the XXXX land.
7. The agreed compensation amount during the term of the Agreement consists of a one-off lump sum and annual payments.
8. The XXXX has previously obtained a private ruling which expires on XX XXXX XXXX.
9. There are no updated versions of the Conduct and Compensation Agreement (CCA).
10. No Early Termination Notices have been provided under the CCA.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 section 110-40

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

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

Reasons for decision

Question 1

Summary

The compensation payments received by you under the CCA will not be treated as assessable income under section 6-5 of the ITAA 1997.

Detailed reasoning

Subsection 6-5(2) of the 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 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, 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.

In this case, the compensation payment XXX will receive is not earned by XXX, 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 activities on XXXX 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.

The payments paid under the terms of the CCA do not give rise to income according to ordinary concepts or to a profit-making undertaking pursuant to section 6-5 of the ITAA 1997. Therefore, these payments are not assessable income under section 6-5 of the ITAA 1997.

Question 2

Summary

The compensation relates to the permanent damage or reduction in the value of land and as there is no disposal of the land, therefore the compensation under the CCA does not constitute capital proceeds in respect of a CGT event.

Detailed reasoning

Under section 6-10 of the ITAA 1997 some amounts that are not 'ordinary income' are included in a taxpayer's assessable income due to another provision of the tax law. These amounts are 'statutory income'. Statutory income may arise from CGT events occurring in connection with a taxpayer receiving an amount as compensation.

For the compensation payments under an agreement to constitute capital proceeds, there must be a CGT event. CGT events occur in respect of CGT assets. The definition of a CGT asset is contained in subsection 108-5(1) of the ITAA 1997. It provides that a CGT asset is any kind of property or a legal or equitable right that is not property. Not all things often referred to as 'rights' will be assets for CGT purposes. To be an asset, a right must be recognised and protected by law.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts (TR 95/35) provides the Commissioner's view as to the CGT consequences of receiving a compensation payment. Relevantly, it states that a CGT event will occur (and any consideration from part of capital proceeds) where the amount of compensation is received by the taxpayer:

(a)  either wholly or partly in respect of the disposal of an underlying asset (CGT event A1); or

(b)  not in respect of any underlying asset but in relation to the disposal of the right to seek compensation (CGT event C2).

TR 95/35 states that it is necessary to identify the particular asset to which the payment relates (Paragraph 69 of TR 95/35), which may be an underlying asset or the right to seek compensation, and what has occurred in relation to that asset.

Paragraph 70 of TR 95/35 provides that in determining what is the relevant asset, it is often appropriate to use the 'look through' approach to the transaction or arrangement which generates the compensation receipt. An underlying asset is an 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.

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

If an amount of compensation is received by a taxpayer wholly in respect of permanent damage suffered to a post-CGT underlying asset of the taxpayer or for a permanent reduction in the value of a post-CGT underlying asset of the taxpayer, 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 (paragraph 6 of TR 95/35).

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. Accordingly, any capital gain arising on the disposal of that right is calculated using the cost base of that right (TR 95/35).

Applying the look-through approach to the facts in relation to compensation payments outlined in the CCA, the land/property is the asset to which the compensation under these agreements most directly relates. As discussed in Question 1, it is considered that the relevant payments under the CCA most directly relate to the permanent damage suffered and diminution in value of the property.

There has been no disposal of the land, and we will accept that the compensation payments under the CCA are not for part disposal of the property. Therefore, CGT event A1 does not occur. Further, as the amounts are paid in respect of an underlying asset (the land) CGT event C2 will not happen.

As such, the compensation amounts the taxpayer receives as the landowner under the CCA do not constitute capital proceeds in respect of a CGT event happening.

Question 3

Summary

The compensation relates to permanent damage or a reduction in value of the land, as per subsection 110-45(3) of the ITAA 1997, the total acquisition costs of the post-CGT asset should be reduced by the amount of the compensation received. No capital gain or loss arises in respect of that asset until the taxpayer actually disposes of the underlying asset.

Detailed reasoning

Paragraphs 6 and 7 of TR 95/35 provide that compensation received wholly in respect of permanent damage or reduction in the value of a post-CGT underlying asset that is not disposed of represents a recoupment of all or part of the total acquisition costs of the asset.

For the purposes of TR 95/35, permanent damage or reduction in value does not mean everlasting damage or reduced value but refers to damage or reduction in value that has permanent effect unless the taxpayer takes action to put it right. The activities permitted under the CCA will cause such damage and a reduction in value.

Accordingly, pursuant to subsection 110-45(3) of the ITAA 1997, the total acquisition costs of the post-CGT asset should be reduced by the amount of the compensation received. 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.

In this case, the landowner will receive, and continue to receive, compensation payments as a result of XXXX activities being carried out on the land. These activities will result in permanent damage to, or a permanent reduction in the value of, the land. The compensation as outlined in the CCA for the permanent damage to the property will reduce the cost base of the property and any gain or loss will crystallise at a later time when the land is disposed of.