Private ruling: Are compensation payments assessable as ordinary income
Published: August 2013
Ruling period: Year ended 30 June 2012
Date scheme commenced: 1 July 2011

Ruling: Q1: Are the payments received under the compensation agreement assessable as ordinary income under section 6-5 or section 15-15 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No | Q2: Are the payments received in the relevant financial year under the compensation agreement considered capital proceeds under Division 116 of the ITAA 1997? | A2: No | Q3: Are the payments received in the relevant financial year under the compensation agreement considered a recoupment of the cost base of the asset and therefore will have no capital gains tax (CGT) implications until the subsequent disposal of the asset? | A3: Yes

Relevant facts and circumstances: You own an asset. An agreement was entered into between you and another entity for the purpose of compensating you for the impact of an activity in relation to an asset owned by you. The market value of the asset will be used to calculate the compensation.

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 15-15 | Petroleum and Gas (Production and Safety) Act 2004

Reasons for decision: Summary: Compensation payments for certain things are not assessable as ordinary income. Where the compensation payment directly relates to the damage and loss of the underlying asset, the payment is treated as a reduction of the assets cost base and any statutory income arising from a CGT event will generally be deferred until the asset is disposed. | Detailed Reasoning - Detailed reasoning: An Act sets out the general compensation provisions. If the conditions are met this gives rise to a right to compensation. | Detailed Reasoning - Ordinary income sections 6-5 and 15-15 of the ITAA 1997: Taxation Ruling TR 95/35 considers the tax treatment of compensation receipts. A compensation receipt, or compensation, includes any amount (whether money or other property), received by a taxpayer in respect of a right to seek compensation or a cause of action, or any proceeding instituted by the taxpayer in respect of that right or cause of action, whether or not, in relation to any underlying asset; arising out of Court proceedings; or made up of dissected amounts (paragraph 3). Compensation paid due to loss and damage of a capital asset, or forgoing a right to sue, in the process of a mining authority entering and accessing minerals and resources, is an isolated transaction. Whether a profit from an isolated transaction is ordinary assessable income according to the ordinary concepts depends very much on the circumstances of the case. Profit from an isolated transaction is 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 the transaction was entered into, 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 Taxation Ruling TR 92/3). Neither elements (a) or (b) as noted above, apply in the circumstances of receiving compensation in this case. All compensation payments are made in accordance with the legislative criteria outlined in the Act . Accordingly, the compensation payments 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 and section 15-15 of the ITAA 1997. | Detailed Reasoning - Statutory income under section 6-10 of the ITAA 1997: Statutory income may arise from CGT events as a consequence of an eligible claimant being entitled to receive compensation, and the loss and destruction of a CGT asset. The CGT consequences of an award of damages depends on whether there is an underlying asset that damages have a direct and substantial link 'by looking through the transaction that gave rise to the compensation receipt to the most relevant asset relating to the receipt' (paragraph 76 of TR 95/35). In Carborundum Realty Pty Ltd v. RAIA Archicentre Pty Ltd and Graeme McDonald 93 ATC 4418; (1993) 25 ATR 192, Harper J suggested that the compensation receipt should be linked to the underlying asset in determining whether the plaintiff had received any capital gain. The ATO view is that where there is loss or destruction of the underlying asset that is why the compensation is received, rather than for the disposal of any rights arising from that loss or destruction. Only if the insurance or settlement proceeds do not relate to the disposal of part or all of any underlying asset is it necessary to consider the policy rights or the right to seek compensation as the relevant asset (paragraph 77 TR 95/35). The standard compensation agreements consist of an upfront payment and future ongoing payments reflective of the damages to underlying assets. Compensation payments paid to an eligible claimant under the Act in the forgoing circumstances are not assessable income under section 6-5 or section 15-15 of the ITAA 1997. Compensation received by the eligible claimant in relation to the damage and loss of value of an underlying asset will be treated as a reduction of the cost base. If the compensation amount exceeds the total acquisition costs of the property, there are no CGT consequences in respect of the excess compensation amount (paragraph 7 TR 95/35). The cost base of the land is reduced to the extent of the consideration and any gain or loss will crystallise at the later time when the asset is sold.