Private ruling: Compensation Payment
Date of advice: 21 December 2017
Published: June 2018
Ruling period: Income year ended 30 June 2015 | Income year ended 30 June 2016 | Income year ended 30 June 2017 | Income year ended 30 June 2018
Date scheme commenced: 4 September 2007

Ruling: Q1: Does the Compensation Payment form part of the cost base or reduced cost of the Taxpayer’s Partnership Agreement CGT Asset (right to exclusive use) that was the subject of CGT event C2 when this CGT asset ended? | A1: No | Q2: Is the Compensation Payment deductible under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A2: No | Q3: Is the Compensation Payment deductible under section 25-15 of the ITAA 1997? | A3: No

Relevant facts and circumstances: The Taxpayer was incorporated on 4 September 2007 to undertake farming operations to grow and sell its own produce. It was intended that The Taxpayer would contract with related parties that were to acquire agricultural land. The related parties would agree to exclusively allow The Taxpayer to grow and own the produce cultivated on the land. To that end, a Partnership of entities was created on 1 October 2007. The partners in the Partnership were associates of the shareholders in The Taxpayer. The Taxpayer wanted a separation between the sale of produce and the land acquired by the associates. The Taxpayer entered into an oral lease agreement (Lease Agreement) with the Partnership whereby all outgoings incurred by the Partnership were covered by The Taxpayer. In addition to the Lease Agreement, The Taxpayer and the Partnership also agreed that as The Taxpayer had a right to exclusively use of the land, The Taxpayer would compensate the Partnership for any loss in value of the land realised (the Compensation Clause) as The Taxpayer was aware of the inherent risks in farmland. For the purposes of this Ruling, this additional agreement is referred to as the Partnership Agreement CGT Asset (right to exclusive use). The Partnership acquired land at the end of 2007 and The Taxpayer commenced farming operations on the land. The Taxpayer grew produce on the Partnership land from 2008 to 2014. During this time, The Taxpayer made lease payments to the Partnership equivalent to all outgoings incurred by the Partnership. In 2014, The Taxpayer determined that the farming land was unsuitable to grow the desired produce and in December 2014, the partnership disposed of the land to an unrelated party. The Partnership made a loss (the difference between the land purchase and sale price) on the disposal of the land and also incurred other costs that were payable under the Compensation Clause. It is noted that for the purposes of this ruling, the amounts to be made under the Compensation Clause are collectively referred to as the Compensation Payment.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 25-15 | Income Tax Assessment Act 1997 Section 40-880 | Income Tax Assessment Act 1997 Section 104-25 | Income Tax Assessment Act 1997 Section 110-25 | Income Tax Assessment Act 1997 Section 110-35 | Income Tax Assessment Act 1997 Section 110-55

Reasons for decision: Summary: The Compensation Payment does not form part of the cost base or reduced cost base of the Taxpayer’s Partnership Agreement CGT Asset (right to exclusive use) that was the subject of CGT event C2 when this CGT Asset ended. | Detailed Reasoning - Detailed reasoning: CGT event C2 In accordance with subsection 104-25(1) of the ITAA 1997, CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset: (a) being redeemed or cancelled; or (b) being released, discharged or satisfied; or (c) expiring; or (d) being abandoned, surrendered or forfeited; or (e) if the asset is an option - being exercised; or (f) if the asset is a *convertible interest - being converted. Subsection 108-5(1) of the ITAA 1997 defines a CGT asset as: (a) any kind of property; or (b) a legal or equitable right that is not property. Note 1 to section 108-5 of the ITAA 1997 relevantly provides the following examples of CGT assets: ● land and buildings; ● shares in a company and units in a unit trust; ● options; ● debts owed to you; ● a right to enforce a contractual obligation; ● foreign currency. The Taxpayer’s Partnership Agreement CGT Asset (right to exclusive use) is an intangible CGT asset. It is noted that this CGT asset is separate from the oral Lease Agreement with the Partnership whereby all outgoings incurred by the partnership were covered by The Taxpayer. Based on the information provided, it is considered that the Partnership Agreement CGT Asset (right to exclusive use) ended when the land was disposed of by the Partnership to an unrelated party in December 2014. CGT event C2 therefore occurred at this time. The Taxpayer will make a capital gain from CGT event C2 happening if the capital proceeds from the ending are more than the asset's cost base. The Taxpayer will make a capital loss if those capital proceeds are less than the asset's *reduced cost base (see subsection 104-25(3) of the ITAA 1997). Capital proceeds The Taxpayer did not receive any capital proceeds from the ending of the Partnership Agreement CGT Asset (right to exclusive use) but in contrast is required to pay the Compensation Payment. Cost base and reduced cost base The cost base and reduced cost base of a CGT asset each consist of five elements (subsection 110-25(1) of the ITAA 1997 and subsection 110-55(1) of the ITAA 1997 respectively). Relevantly, the first of these elements (as per subsection 110-25(2) of the ITAA 1997) is the total of: (a) the money you paid, or are required to pay, in respect of *acquiring it; and (b) the *market value of any other property you gave, or are required to give, in respect of acquiring it (worked out as at the time of the acquisition). It is necessary to consider whether the Compensation Payment may constitute money paid ‘in respect of’ the acquisition of the Partnership Agreement CGT Asset (right to exclusive use). Paragraphs 101 and 102 of Taxation Ruling TR 95/35 (which considers the treatment of compensation receipts) provide guidance of the meaning of the phrase ‘in respect of’ the acquisition of the asset as it applied to subsection 160ZH(4) of the Income Tax Assessment Act 1936 (which was the predecessor to subsection 110-25(2) of the ITAA 1997). These paragraphs specifically state: 101. Broadly speaking, money, property, or money and property come within the cost base and are regarded as paid or given in respect of the acquisition of the asset in terms of paragraph 160ZH(4)(a), (b) or (c) if there is some direct and substantial link between the money or property and the acquisition of the asset. In determining whether there is a direct and substantial link, we believe it is appropriate to consider the following indicators: * the necessity for the payment of money or the giving of property; * the degree of temporal relationship between the payment of money or the giving of property and the acquisition of the asset; * the purpose (objective and subjective) of the payment of money or the giving of property; * the nature of the asset; * the circumstances of the acquisition of the asset including: - parties (e.g., whether money paid or property given to a third party); - terms of the contract or agreement; and - arising from a wrong or by a lack of consent; * the extent of causation; * whether money paid or property given is in proportion to the value of the asset; and * whether the degree of connection is diminished if money is paid or property is given for multiple benefits rather than solely to acquire the asset (e.g., for services). 102. The question whether a connection or link exists is a question of fact and degree. In the current circumstances, although there is an over-arching connection between the Partnership Agreement CGT Asset (right to exclusive use) and the Compensation Payment, this payment is not money paid by the Taxpayer ‘in respect of’ the acquisition of the Partnership Agreement CGT Asset (right to exclusive use)’ as it is money paid to compensate for a separate and independent liability. It is considered that the Taxpayer and the Partnership have effectively entered into a financial arrangement that is largely independent of the Partnership Agreement CGT Asset (right to exclusive use). The arrangement in this instance is focussed on the outcome of the disposal of the land. Accordingly although the payment is generally linked to the Partnership Agreement CGT Asset (right to exclusive use), this link is not sufficient to treat this payment as money paid ‘in respect of’ the acquisition of the Partnership Agreement CGT Asset (right to exclusive use). It is also noted that the Compensation Payment will not come within the other cost base elements because: ● for the purposes of the second element, the Compensation Payment does not fall within the category of 'incidental costs', which is the subject of a strict definition in subsection 110-35(1) of the ITAA 1997; In this regard, it is relevant to note that the Compensation Payment would not fall within subsection 110-35(11) of the ITAA 1997. Subsection 110-35(11) of the ITAA 1997 is applicable to CGT events happening on or after 1 July 2008 and allows ‘ termination or other similar fees incurred as a direct result of your ownership of a CGT asset ending ’ to be included in the cost base of an asset as an incidental cost. Paragraphs 2.84 to 2.86 of the Explanatory Memorandum to the Tax Laws Amendment (2010 Measures No. 4) Bill 2010, which enacted subsection 110-35(11) of the ITAA 1997, provides the following further guidance on the operation of this provision: 2.84 Typically, termination fees (and exit fees) are contractual fees imposed by one party on the other as a result of the second party breaking the contract. 2.85 An asset's cost base and reduced cost base consist of five elements. The second element consists of specific incidental costs that a taxpayer incurs in relation to the asset. These incidental costs are set out in section 110-35. 2.86 A taxpayer that incurs a termination or a similar fee (such as an exit fee) as a direct result of their ownership of an asset ending includes that fee in the second element of the asset's cost base and reduced cost base as an incidental cost. In the current circumstances, it is considered that the Compensation Payment does not fall within the cost base of the Partnership Agreement CGT Asset (right to exclusive use) under subsection 104-35(11) of the ITAA 1997. This is because the Compensation Payment is not incurred as direct result of the Taxpayer’s ownership of a CGT asset ending i.e. the Partnership Agreement CGT Asset (right to exclusive use) . In contrast, it is considered that the Compensation Payment is incurred as a result of the Partnership’s ownership of the Land ending. ● The Compensation Payment is not considered to be a cost of owning the asset for the purposes of the third element (subsection 110-25(4) of the ITAA 1997); ● for the purposes of the fourth element, the Compensation Payment is not incurred for the purpose or expected effect of increasing or preserving the original asset's value, and nor does it relate to installing or moving the original asset (subsection 110-25(5) of the ITAA 1997); and ● the Compensation Payment cannot be considered to have been incurred to 'establish, preserve or defend' the taxpayer's title to, or a right over, the asset for the purposes of the fifth element (subsection 110-25(6) of the ITAA 1997). | Detailed Reasoning - Question 2: Is the Compensation Payment deductible under section 40-880 of the ITAA 1997? | Summary: The Compensation Payment is not deductible under section 40-880 of the ITAA 1997 as paragraphs 40-880(5)(d) or 40-880(5)(f) of the ITAA 1997 will prevent The Taxpayer from claiming a deduction. | Detailed Reasoning - Detailed reasoning: Section 40-880 of the ITAA 1997 is a provision of last resort which allows a deduction over five income years for certain business capital expenditure incurred after 30 June 2005 which is not otherwise taken into account or denied a deduction by some other provision. Subsection 40-880(2) of the ITAA 1997 specifically provides that you can deduct, in equal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur: (a) in relation to your business; or (b) in relation to a business that used to be carried on; or (c) in relation to a business proposed to be carried on; or (d) to liquidate or deregister a company of which you were a *member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business. Subsection 40-880(2) of the ITAA 1997 is however subject to various limitations and exceptions. Of these exceptions, it is considered necessary to examine those contained in paragraphs 40-880(5)(d) and 40-880(5)(f) of the ITAA 1997 based on the facts of this case. In this regard, paragraph 40-880(5)(d) of the ITAA 1997 states that you cannot deduct anything under this section for an expenditure incurred that is ‘ in relation to a lease or other equitable right ’. The Commissioner’s view on the application of section 40-880 of the ITAA 1997 is set out in Taxation Ruling TR 2011/6 : Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues (TR 2011/6). Paragraph 47 of TR 2011/6 elaborates on the application of this exception as it states: The existence of paragraphs 40-880(5)(a) and 40-880(5)(f) and section 25-110 mean that paragraph 40-880(5)(d) has limited practical application. It applies to expenditure incurred on or after 1 July 2005 that has a sufficient and relevant connection to a lease or right held by an entity other than the taxpayer. The 'rights' in question do not include all legal rights but only those similar to leases in that they give the taxpayer a right to exploit the asset with which the right is associated. In other words, the right is carved out of an asset but falls short of full ownership of the asset. Examples of such rights include profits à prendre, easements and other rights of access to land. The rights however are not limited to rights associated with land. In the current circumstances, based on the information provided, it would seem that the rights relating to Partnership Agreement CGT Asset (right to exclusive use) are of the nature of the rights referred to in paragraph 40-880(5)(d) of the ITAA 1997. Accordingly, it is considered the Compensation Payment would constitute expenditure that is ‘in relation to’ a lease or other equitable right and therefore paragraph 40-880(5)(d) of the ITAA 1997 would prevent The Taxpayer from claiming a deduction for the Compensation Payment under section 40-880 of the ITAA 1997. In addition, paragraph 40-880(5)(f) of the ITAA 1997 excludes from the operation of section 40-880 of the ITAA 1997 any expenditure that could be taken into account in working out the amount of a capital gain or a capital loss from a CGT event. Generally, two factors: capital proceeds and cost base (or reduced cost base) are taken into account in working out a capital gain or capital loss from a CGT event (section 100-40 of the ITAA 1997). As detailed above, the Compensation Payment will not form part of the capital proceeds or cost base of the Partnership Agreement CGT Asset (right to exclusive use) when working out the amount of the capital gain or capital loss from CGT event C2 happening when this CGT asset ended. It is however considered that the Compensation Payment may form part of the capital proceeds from CGT event A1 happening to the Partnership when it disposed of the land as it is money or property that the partners are entitled to receive in respect of this CGT event happening (subsection 116-20(1) of the ITAA 1997). While this CGT event happens to another entity (the partners in The Partnership) and not to The Taxpayer, we note that, unlike other provisions of section 40-880 of the ITAA 1997, paragraph 40-880(5)(f) only requires that the expenditure could be taken into account in working out a capital gain or a capital loss from a CGT event and not your capital gain or a capital loss from a CGT event. As such, it is consider that paragraph 40-880(5)(f) of the ITAA 1997 may also operate so as to exclude you from claiming a deduction under section 40-880 of the ITAA 1997 for the Compensation Payment. | Detailed Reasoning - Question 3: Is the Compensation Payment deductible under section 25-15 of the ITAA 1997? | Summary: No. The Compensation Payment in not deductible under section 25-15 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Section 25-15 of the ITAA 1997 states that ‘ you can deduct an amount that you pay for failing to comply with a lease obligation to make repairs to premises if you use or have used the premises for the * purpose of producing assessable income ’. In the current circumstances, based on the information provided, it is considered that the Compensation Payment is not an amount paid by The Taxpayer for ‘ failing to comply with a lease obligation to make repairs to premises ’ as it is money paid to compensate for a separate and independent liability. It is considered that The Taxpayer and the Partnership have effectively entered into a financial arrangement that is independent from the Lease. The arrangement in this instance is focussed on the outcome of the disposal of the land. Accordingly, this amount would not be deductible under section 25-15 of the ITAA 1997.

Question 1: Does the Compensation Payment form part of the cost base of the Taxpayer’s Partnership Agreement CGT Asset (right to exclusive use) that was the subject of CGT event C2 when this CGT Asset ended?