Private ruling: Compensation
Date of advice: 7 December 2018
Published: April 2019
Ruling period: Year ended 30 June 2019
Date scheme commenced: 1 July 2018

Ruling: Q1: Will the compensation payments paid by the company be assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No. | Q2: Will the compensation payments paid reduce the cost base of the property for any future capital gain? | A2: Yes | Q3: Will the payments received for legal, accounting and valuation costs be assessable income or an assessable reimbursement? | A3: No


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

Reasons for decision: Detailed Reasoning - Compensation payments: 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 of a capital asset, or forgoing a right to sue, 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 will be made in accordance to the legislative provisions of the petroleum legislation. Accordingly, the compensation payments paid under the agreement 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. | Detailed Reasoning - 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 compensation payments will be made as a result of activities being carried out on your property. These activities will result in the permanent damage to, or permanent reduction in the value of, the property. As you do not intend to dispose of all or part of the affected property, there are no CGT consequences at the time of entering the agreement or receiving the compensation payments. However, the property’s acquisition cost will be reduced by the compensation payments received in relation to that property. That is, the cost base of the property will be reduced by the value of the payments and any gain or loss will crystallise at a later time when the property is sold. | Detailed Reasoning - Amounts received in respect of fees and costs in negotiating the agreement: To determine if the compensation for the accounting, legal and valuation costs are an assessable recoupment, it must first be determined if those costs are deductible and under what provisions. Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income or a provision of the taxation legislation excludes it. Section 25-5 of the ITAA 1997 allows a deduction for expenditure you incur to the extent that it is for: ● managing your tax affairs ● complying with an obligation imposed on you by a Commonwealth law, insofar as that obligation relates to the tax affairs of an entity ● the general interest charge or shortfall interest charge ● a penalty under Subdivision 162-D of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act) which relates to situations where a taxpayer varies their instalment rate too low, or ● obtaining a valuation in accordance with section 30-212 (gifts of properties to deductible gift recipients) or 31-15 (entering into conservation covenants). Costs which relate to your tax affairs are an allowable deduction. Where the services to which the fees relate go beyond managing your tax affairs, you must apportion the fees between the various purposes and only those services that directly relate to your tax affairs are deductible. Legal fees will be deductible where the nature or character of the legal expenses follows the advantage which is sought to be gained by incurring the expenses. Where accounting, legal and valuation costs are not incurred in the management of your tax affairs they are capital in nature and not deductible. A reimbursement of accounting, legal and valuation costs which are deductible will be an assessable recoupment and are required to be included in your assessable income in the year in which they are reimbursed. A reimbursement of accounting, legal and valuation fees for which you cannot claim a deduction are neither an assessable recoupment nor ordinary income.

Relevant facts: The individuals in the partnership entered into a compensation agreement (agreement) in 2018 for activities to be carried out on the property. | The compensation deed was made pursuant to a relevant Act. | Under the agreement, the parties will carry out activities on your land and you will be compensated for the effects of these activities. | By signing the agreement, you will acknowledge that the compensation compensates for all of the activities including the loss of use of part of the land, all impacts of noise, light, dust, odour, vibration, vehicular movements and loss of amenity generally. | You will receive the following compensation under the agreement: | ● an upfront payment as a one off within 30 days of the agreement date; | ● a lump sum amount within 30 business days after receipt of a commencement notice from, and | ● compensation for legal, valuation and accounting costs reasonably and necessarily incurred by you in respect of the negotiation of the agreement. | The property was purchased after the introduction of the capital gains tax regime.