Private ruling: Compensation and other payments
Date of advice: 20 April 2016
Published: June 2016
Ruling period: Year ended 30 June 2015 | Year ending 30 June 2016 | Year ending 30 June 2017 | Year ending 30 June 2018 | Year ending 30 June 2019 | Year ending 30 June 2020 | Year ending 30 June 2021 | Year ending 30 June 2022 | Year ending 30 June 2023 | Year ending 30 June 2024
Date scheme commenced: 1 July 2014

Ruling: Q1: Will the compensation payments for access, damage and activities performed on your land form part of your assessable income? | A1: No. | Q2: Will the compensation payments for access, damage and mining activities performed on your land reduced the cost base of the land for any future capital gain under section 110-40 or section 110-45 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A2: Yes. | Q3: Will the compensation payments for the use of gravel and water extracted from your land form part of your assessable income? | A3: Yes.

Relevant facts and circumstances: You are the registered owner of land. You have entered into a Conduct and Compensation Agreement and Variation Agreement ('the Agreements') with the Tenement Holder. Under the Agreements, the Tenement Holder will carry out activities on your land and you will receive compensation for the compensatable effects of these activities. You will receive the following compensation under the Agreements: • an upfront payment within 30 days of the date of the Agreement, which includes your legal, valuation and accounting costs incurred in the negotiation or preparation of the Agreements • an annual payment to be paid on or before 30 July XX, and • subsequent annual payments to be paid within 30 days of each 30 June occurring after the first annual payment for the term of the Agreements. The Agreements were negotiated in accordance with the Petroleum and Gas (Production and Safety) Act 2004 ('the petroleum legislation'). You have entered into separate agreements with Entity X for the extraction of water and gravel from your land. Under these agreements Entity X will pay you a set rate per mega litre of water or cubic metre of gravel extracted from your land. You have not disposed of the land.

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 15-20 | Income Tax Assessment Act 1997 Section 110-40 | Income Tax Assessment Act 1997 Section 110-45

Reasons for decision: Summary: The compensation payments you will receive under the Agreements do not form part of your assessable income. They are considered to be compensation received for the permanent reduction in value and damage relating to the land and will be treated as a reduction in the land's cost base. The payments you receive for the extraction of water and gravel are considered to be payments of royalties. These payments form part of your assessable income. | Detailed Reasoning - Compensation payments under the Agreements: Compensation payment as ordinary income Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year. Compensation paid due to loss and damage or a capital asset in the process of a petroleum authority undertaking petroleum activities on a taxpayer's land is an isolated transaction. Whether a profit from an isolated transaction is ordinary assessable income according to ordinary concepts depends 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 (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 Taxation Ruling TR 92/3). Neither of the above elements apply in your situation. The compensation payments were made in accordance to the legislative provisions of the petroleum legislation. Accordingly, the compensation payments paid under the Agreements 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 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 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 as consequence of an eligible claimant being entitled to receive compensation and the loss and destruction of a CGT asset. Taxation Ruling TR 95/35 provides the Commissioner's view as to the CGT consequences of receiving a compensation payment. The ruling states 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. If there is more than one underlying asset, the relevant asset is the asset which leads directly to the payment of the amount of compensation. For example, if a taxpayer receives an amount of compensation for the destruction of his or her truck, the truck is the underlying asset. If an amount of compensation is received by a taxpayer wholly in respect of the disposal of an underlying post-CGT asset, or part of an underlying post-CGT asset, of the taxpayer the compensation represents consideration received on the disposal of that asset. In these circumstances, the Commissioner considers that the amount is not consideration for the disposal of any other asset, such as the right to seek compensation. 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. Accordingly, the total acquisition costs of the post-CGT asset should be reduced by the amount of the compensation. 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 you will receive compensation for the compensatable effects of activities undertaken on your land. The term 'compensatable effects' is defined in section 532 of the petroleum legislation as meaning: • all or any of the following relating to the eligible claimant's land • deprivation of possession of its surface • diminution of its 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 petroleum authority on the land • accounting, legal or valuation costs the claimant necessarily and reasonably incurs to negotiate or prepare a conduct and compensation agreement, and • consequential damages the eligible claimant incurs because of a matter mentioned above. The activities have resulted in the permanent damage to, or permanent reduction in the value of, the land. As you did not dispose of all or part of the affected land there are no CGT consequences at the time of entering the Agreements or receiving the compensation payments. However, the land's acquisition cost will be reduced by the compensation payments received in relation to that land. That is, the cost base of the land will be reduced by the value of the payments and any gain or loss will crystallise at a later time when the land is sold. | Detailed Reasoning - Payments for water and gravel extraction: Payments for water and gravel as business income As stated above, the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year. Ordinary income includes payments for services provided, business income and income from property such as rental or dividend income. In your situation, the payments you receive for the extraction of water and gravel from your land are not payments for services provided or income from property. The payments will be considered business income if you are in the business of water and gravel extraction. Taxation Ruling TR 97/11 discusses the indicators to be considered in determining if a person is carrying on a business. These indicators include: • whether the activity has a significant commercial purpose or character • whether the taxpayer has more than just an intention to engage in business • whether there is regularity and repetition of the activity • whether the activity is of the same kind, and carried on in a similar manner, to that of ordinary trade in that line of business • whether the activity is planned, organised and carried on in a businesslike manner such that it is described as making a profit • the size, scale and permanency of the activity, and • whether the activity is better described as a hobby, a form of recreation or a sporting activity. Based on the information you have provided it is considered that you are not in the business of extracting and selling water or gravel as you have merely acquiesced to the extraction requests from Entity X. Therefore the payments for the gravel and water extracted are not assessable to you as business income. Payments for water and gravel as profits from an isolated transaction As discussed above, 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 Taxation Ruling TR 92/3). Neither of the above elements apply in your situation. The water and gravel extraction payments were not made in the course of carrying on a business, a business operation or commercial transaction. Accordingly, the water and gravel extraction payments paid do not give rise to a profit arising from a profit-making undertaking or plan pursuant to section 6-5 of the ITAA 1997. Payments for water and gravel as a royalty Section 15-20 of the ITAA 1997 states your assessable income includes an amount that you receive as or by way of royalty if the amount is not assessable as ordinary income under section 6-5 of the ITAA 1997. Royalties are statutory income. The Commissioner's view on the definition of a royalty is provided by Taxation Ruling IT 2660. The ordinary meaning of the term 'royalty' has been considered by the Courts on many occasions. In Stanton v. FC of T (1955) CLR 630, the High Court of Australia described the essence of a royalty and stated that: … the modern applications of the term seem to fall under two heads, namely the payments which the grantees of monopolies such as patents and copyrights receive under licences and payments which the owner of the soil obtains in respect of the taking of some special thing forming part of it or attached to it which he suffers to be taken. Paragraph 10 of IT 2660 provides that in the Commissioner's view there are four key characteristics of a common law royalty: • it is a payment made in return for the right to exercise a beneficial privilege or right, for example to remove minerals or natural resources such as timber (McCauley v. FC of T (1944) 69 CLR 235) • the payment is made to the person who owns the right to confer that beneficial privilege or right ( Barrett v. FC of T (1968) 11 CLR 666) • the consideration payable is determined on the basis of the amount of use made of the right required ( McCauley, Stanton) , and • the consideration will usually be paid as and when the right acquired is exercised. However, a lump sum payment will be a royalty where it is a pre-estimate or an after the event recognition of the amount of use made of the right acquired ( IR Commissioners v. Longmans Green & Co Ltd (1932) 17 TC 272). In your case you have entered into agreements with Entity X whereby you will receive a payments for the volume of water and gravel extracted from your property. Water and gravel are natural resources. It is considered that the payment for each cubic metre of gravel and mega litre of water extracted will be a payment by way of royalty and assessable under section 15-20 of the ITAA 1997.