Private ruling: CGT - compensation payments
Date of advice: 15 March 2016
Published: May 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 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 by the company be assessable as capital gains under the capital gains tax (CGT) provisions of the ITAA 1997? | A2: No. | Q3: Will the compensation payments paid by the company reduce the cost base of the relevant property for any future capital gain under section 110-40 or section 110-45 of the ITAA 1997? | A3: Yes.

Relevant facts and circumstances: You operate a primary production business on the property. During the relevant financial year you executed a conduct and compensation agreement (CCA) with Entity X. Under the CCA, Entity X and related parties will undertake activities on your land and you will receive be compensated for the compensatable effects of carrying out the activities on your land. 'Compensatable Effects' is defined in subclause 24.1 of the CCA as having the meaning given to that term in the relevant legislation which includes: (a) deprivation of possession of the surface of the land (b) diminution in the value of the land (c) diminution of the use made, or that may be made, of the land or any improvement on it (d) severance of any part of the land from other parts of the land or from other land that you own (e) any cost or loss arising from the carrying out of the petroleum activities under the petroleum authority on the land (f) accounting, legal or valuation costs you necessarily incur to negotiate or prepare this agreement, other than costs of a person facilitating an alternative dispute resolution (ADR) process, and (g) consequential damages you incur because of a matter mentioned in (a) to (f). You will receive the following compensation under the CCA: • pre-construction compensation - this compensates you for the period between the agreement date and the start of the construction • construction compensation - this compensates you for the period of time from the start of the construction until the end of the annual payment period in which the construction notice is given to you • annual compensation - this is an annual compensation payment for the term of the agreement You also received an agreement completion compensation payment. This payment is not described or discussed in the CCA but appears on an invoice from Entity X. This was an incentive payment for you to enter the CCA without the commencement of an ADR process or involvement of the court system.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 6-5 | Income Tax Assessment Act 1997 Section 6-10 | Income Tax Assessment Act 1997 Part 3-1 | Income Tax Assessment Act 1997 Subsection 110-55(6)

Reasons for decision: Summary: The compensation payments you have received and will continue to receive are considered to be compensation for the permanent damage to, or reduction in value of, your property. The total acquisition costs of the property are to be reduced by the value of the compensation received. | Detailed Reasoning - Pre-construction, construction and annual compensation payments under the CCA: 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, 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 applies in your situation. The compensation payments were made in accordance to the relevant legislative provisions. Accordingly, the compensation payments paid under the CCA 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 have received, and will continue to receive, compensation payments as a result of petroleum activities being carried out on your property. These activities have resulted in the permanent damage to, or permanent reduction in the value of, the property. As you did not dispose of all or part of the affected property there are no CGT consequences at the time of entering the CCA 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 each property is sold. | Detailed Reasoning - Agreement Completion compensation payment: Payment as ordinary income As stated above, a payment will be assessable where it is considered to be ordinary income. 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, expected, relied upon and have an element of periodicity, recurrence or regularity. In your situation, you have received a one-off agreement completion compensation payment for entering into the CCA. This payment was in addition to the compensation payments described in the CCA. The payment does not have the characteristics of ordinary income as it has not been earned, could not be said to be relied upon and does not relate to your business activities. Any expectation of receiving the payment would be related to the CCA negotiation process. Accordingly, the agreement completion compensation payment is not assessable as ordinary income. Payment in relation to the CGT provisions The agreement completion payment is described as a compensation payment on Entity X's invoice. Considering the relationship between yourself and Entity X, it is considered that the agreement completion compensation payment is part of the overall deal that you agreed to. This payment, along with the amounts payable, under the CCA, all form part of the compensation received by you. In your hands, the agreement completion compensation and the compensation payable under the CCA comprise in essence one sum of money in return for agreeing to the conditions set out in the CCA. It is considered that the agreement completion compensation has been paid to compensate you for the permanent damage to, or permanent reduction in value of, your property. Accordingly, the amount of the payment reduces the cost base of the property and any gain or loss will crystallise at a later time when the property is sold or disposed of.