Edited version of private advice

Authorisation Number: 1052034696007

Date of advice: 17 October 2022

Ruling

Subject: Compensation payments

Question 1

Will the receipt of the Access Fee be ordinary assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Is the Works Fee paid to the Landowners compensation for permanent damage to, or a permanent reduction in the value of an exempt underlying asset, being pre-CGT land, making the compensation exempt from CGT?

Answer

Yes.

Question 3

Is the Other Specified Fee paid to the landowner compensation for permanent damage to, or a permanent reduction in the value of value of an exempt underlying asset, being pre-CGT land, making the compensation exempt from CGT?

Answer

Yes.

Question 4

Will the receipt of the Easement Fee be capital proceeds in relation to a capital gains tax (CGT) event D1 happening due to the granting of the Easement?

Answer

Yes.

Question 5

Will the Reinstatement Licence Fee be capital proceeds in relation to CGT event D1 happening due to the granting of the AFL/Lease Reinstatement Licence?

Answer

Yes.

Question 6

Will the receipt of the Rent by the Landowners be ordinary assessable income under section 6-5 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Landowners own the land (Land) used for business activities.

The Landowners acquired the land prior to 20 September 1985.

On XX/XX/XXXX, the Landowners entered into an Agreement for Lease (AFL) with Entity A. The Landowners will also enter into a Lease with Entity A.

The Land will be impacted by the activities.

Pursuant to the AFL, Entity A is required to pay the Landowners the following:

a)    Works Fee;

b)    Other Specified Fee;

c)    Access Fee;

d)    Easement Fee; and

e)    Reinstatement Licence Fee.

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 10-5

Income Tax Assessment Act 1997 Subdivision 20-A

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 104-35

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 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 Scott v. FC of T (1966) 14 ATD 286, Windeyer J expressed the view that whether or not a particular receipt is income depends upon its quality in the hands of the recipient.

In the Landowners' circumstances, the Access Fee is payable annually for the relevant period. This periodic fee relates to the access and use of the Land and it is considered that the Access Fee payments are akin to rent. Therefore, the Access Fee is considered ordinary assessable income under section 6-5 of the ITAA 1997.

Similarly, the Rent payments received by the Landowners are also assessable 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.

Whether or not a particular receipt is ordinary income or statutory income depends on its character in the hands of the recipient. For income tax purposes, a compensation amount generally bears the character of that which it is paid to replace.

Compensation

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, or the notional asset.

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.

Paragraph 66 of TR 95/35 states that if the relevant asset is an exempt asset for the purposes of Part IIIA of the Income Tax Assessment 1936 an amount of compensation received for permanent damage to, or a permanent reduction in value of, an exempt underlying asset of the taxpayer, the compensation continues to be exempt from CGT. In adopting this view, the ATO has taken into account the general scheme and intent of Part IIIA, which dealt with capital gains and losses and has since been repealed and rewritten into the ITAA 1997. If the actual disposal of an asset would not give rise to a capital gain or loss, for example, where the relevant asset was acquired by the taxpayer before 20 September 1985, compensation in respect of a permanent decrease in value should also be exempt.

In the Landowners' case, the compensation payments are not earned by them as they do not relate to services performed or from carrying on a business. 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 undertaken. Furthermore, although the compensation relates to the Land, the payment is not akin to rent. The compensation payment relates to the damage to the Land and is capital in nature. Accordingly, it is not regarded as ordinary income and is therefore not assessable under subsection 6-5(2) of the ITAA 1997.

As the compensation payments, being the Works Fee and Monitoring Fee, are paid in respect to the impact of the Farm activities on the Land that will cause permanent damage to, or a permanent reduction in the value of the Land, the Land is an exempt asset (being acquired by the Landowners pre-CGT) and the Land has not been disposed of, the compensation payments will be exempt from CGT.

Easement

The granting of an easement creates a right over someone else's land or property. The taxation treatment of a payment for the granting of an easement depends on whether the easement has been created by compulsory acquisition or as a voluntary action.

CGT event D1 (section 104-35 of the ITAA 1997) happens when you create a contractual right or other legal or equitable right in another entity. The time of the CGT event D1 is when you enter into the contract or create the other right. A capital gain from CGT event D1 is not a discount capital gain, as the right is created at the time of the agreement.

Taxation Ruling IT 2561 Income tax: capital gains: grants of easements, profits a prendre and licences explains that an easement (or other comparable right) is an asset created at the time it is granted.

Taxation Determination TD 2018/15 Income tax: capital gains: does CGT event D1 happen if a taxpayer grants an easement, profit à prendre or licence over an asset? explains that CGT event D1 rather than CGT event A1 happens if a taxpayer grants an easement, profit à prendre or licence over an asset.

Under the AFL, the Landowners will grant an easement to the Tenant and receive an Easement Fee. The easement was not created by a compulsory acquisition, rather as a voluntary action. The easement is a separate CGT asset. CGT event D1 will happen at the time the easement is granted and the Easement Fee will be considered capital proceeds received as a result of CGT event D1 occurring.

AFL/Lease Reinstatement Licence Fee

As confirmed in TD 2018/15, CGT event D1 occurs if you grant a licence to another entity.

The Reinstatement Licence that will be granted to the Tenant at the expiration of the AFL or Lease will provide the Tenant with the right to access the Land for the purpose of removing infrastructure and restoring the land. It does not provide the Tenant with the right of exclusive access or occupation of the Land.

At the time the Landowners grant a Reinstatement Licence to the Tenant, CGT event D1 will happen. The Reinstatement Licence Fees are considered capital proceeds received as a result of CGT event D1 occurring.