Private ruling: Capital gains tax (CGT) asset – transfer of water access licence (wal) – consideration received - capital or revenue
Date of advice: 20 April 2018
Published: July 2018
Ruling period: Year ending 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: Will a payment made under an agreement to transfer your water access licence for a period of five years with an option to extend for a further five years be taxed on capital account and trigger the CGT event F1 for the purpose of section 104-110 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes. | Q2: When does CGT event F1 for the grant of the lease happen under paragraph 104-110(2)(a) of the ITAA 1997? | A2: CGT event F1 happens when the contract for the grant of the transfer (the First Term Transfer) is entered into. | Q3: When does a CGT event F1 happen for the option to take up the Second Term Transfer under paragraph 104-110(2)(b) of the ITAA 1997? | A3: CGT event F1 happens at the time the option to take up the Second Term Transfer is exercised.

Relevant facts and circumstances: Entity X acquired a Water Access Licence 1 (WAL 1) as part of a land purchase before 1985 to provide water for a farming operation. The share component under WAL 1 is several units in a Zone. A ‘Deed’ (the Deed) is signed between Entity X (the Grantor) and Entity Y (the Grantee) on 1 July 20XX. The Deed requires you to: ● subdivide existing WAL 1 and create two new water access licences with A and B units each; ● transfer A units (the Property) for a period of several years (the First Term Transfer); ● provide an option to extend the transfer of the Property for a further several years (the Second Term Transfer); ● retain B units; The Deed provides that: ● the Grantor is the registered proprietor of the Property; ● the Grantor has agreed to grant and the Grantee has agreed to accept or to nominate another person or entity to accept the First Term transfer of the Property; ● the Grantor has agreed to grant to the Grantee an option for the Grantee or its nominee to take up the Second Term Transfer of the Property; The Deed also provides: ● the definition of the Term Transfer means pursuant to section 71N of Water Management Act 2000 (WMA); ● term commencement and termination dates; ● consideration for Term Transfers; ● the Deed is subject to approval being granted by Department of Primary Industry (DPI) to change the new water access licence with the share components of A units (the Property) to remove the nominated water supply work(s) on the Property and add the nominated water supply work(s) of the Grantee or it’s nominee; ● The consideration for First Term Transfer will not be refundable to the grantee or its nominee if the Grantee’s or nominee’s application per section 71W of WMA is rejected or not approved by DPI; Provision is made for a document ‘Assignment and Assumption Agreement (the Assignment)’ between Entity X, the Assignor (the Grantor in the Deed), Entity Y, the Term Transferee (the Grantee in the Deed) and a third party purchase, the Assignee, to cater for a sale of their WAL in future or in circumstances of a death. The parties to the Deed and the Assignment and Assumption Agreement are not related.

Relevant legislative provisions: Income Tax Assessment Act 1997 subsection 6-5(2) | Income Tax Assessment Act 1997 section 6-10 | Income Tax Assessment Act 1997 subsection 104-110(1) | Income Tax Assessment Act 1997 subsection 104-110(2) | Income Tax Assessment Act 1997 paragraph 104-110(2)(a) | Income Tax Assessment Act 1997 paragraph 104-110(2)(b) | Income Tax Assessment Act 1997 subsection 104-110(3) | Income Tax Assessment Act 1997 subsection 108-5(1) | Income Tax Assessment Act 1997 paragraph 115-25(3)(e) | Income Tax Assessment Act 1997 subsection 116-20(2)

Reasons for decision: Summary: While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision. Unless otherwise stated, all legislative references are to the Income Tax Assessment Act 1997 . | Summary: The lump sum payment that you will receive from the lessee/Grantee has the character of a lease premium as opposed to prepaid rent. Accordingly, the payment will represent capital proceeds in relation to the granting of the lease. This payment must be taken into account in accordance with the CGT provisions. The time of the CGT event for the First Term Transfer is 1 July 20XX and for the Second Term Transfer on 1 July 20XX. | Detailed Reasoning - Detailed reasoning: Subsection 6-5(2) provides that the assessable income of an Australian resident includes income according to ordinary concepts (ordinary income) derived directly or indirectly from all sources, whether in or out of Australia, during the income year. Under section 6-10 assessable income also includes statutory income. Statutory income is amounts that are not ordinary income but are included as assessable income by provisions of the tax law. | Detailed Reasoning - Rent vs premium: The terms of lease agreements entered into by a lessor and lessee are important, although not necessarily decisive, in determining the proper characterisation of an amount received by a lessor The courts will look to the true nature of the transactions between the lessor and the lessee, and are not bound by the label which the lessor and lessee attribute to the transactions (Taxation Ruling TR 96/24 : Income tax: capital gains: guidelines to determine whether an amount described in a sale of business agreement as consideration for goodwill is properly characterised as a lease premium (TR 96/24). A lease premium is not defined in Australian tax law. It is therefore necessary to consider its meaning from an ordinary or legal perspective. Paragraph 7 of TR 96/24 provides that a lease premium is consideration paid to the lessor for the leasehold interest over the asset, that is, the grant of a lease. This is distinguishable from rent which is the remuneration for the use and enjoyment of the leased property. Factors to be considered when determining whether a payment is prepaid rent or a lease premium are: ● the provision for a refund – if the lessee is entitled to receive a pro-rata refund of the payment on termination of the lease it may indicate the payment is of the nature of prepaid rent (Taxation Ruling TR 2002/14 - Income tax: taxation of retirement village operators (TR 2002/14)); ● the advantage sought by the lessee – where a payment is made by a lessee to secure an enduring advantage, such as the future use and advantage of an asset, it will be in the nature of a lease premium (as per the concept explained under paragraph 106 of TR 2002/14); and ● the calculation of the payment – where a prepayment of rent has been made, it should be a capitalised amount that reflects a periodic outlay for the use of property for periods commensurate with the payment ( FCT v. Creer 86 ATC 4318); In this case, it is considered that the entitlement to a refund of the lease payment is very limited (as per the Deed). The lessee/Grantee will only be entitled to a refund if you, as the lessor/Grantor, breach the lease agreement. This can be contrasted to a retirement village lease (as described in TR 2002/14) which will generally allow for a refund in a wide variety of circumstances. The Grantee paid an amount to secure the WAL with no right to refund. The lease is for an initial period of several years, with options to extend for further several years. The advantage provided to the Grantee was of an enduring kind that points towards the payment being capital or of a capital nature. You received a single lump sum payment in relation to the lease (and an additional lump sum if the option is exercised); the amount you will receive is not subject to review. Consequently, on the basis of all of the factors identified above it is considered, in substance, that the Initial Payment will not be in the nature of rent but will rather be full market value consideration for the granting of the lease for a certain period of time. The true nature of the Initial Payment is best described as a lease premium and is capital in nature. A capital receipt is not ordinary income; however it may be assessable as statutory income under the CGT provisions. | Detailed Reasoning - Capital gains tax (CGT): The CGT provisions in Parts 3-1 and 3-3 apply to CGT assets. Water rights, such as licences and water allocations are CGT assets as defined in section 108-5. Subsection 108-5(1) defines a CGT asset as: a. any kind of property; or b. a legal or equitable right that is not property They are legal rights existing by the terms of the prevailing State Legislation. Under subsection 56(1) of the WMA 2000, an access licence entitles its holder to take water subject to the specifications applicable to that licence. This entitlement is a statutory right. Therefore the licence falls within the definition of 'CGT asset' in subsection 108-5(1). Where a water right has been acquired after 19 September 1985 any disposal of that right will have CGT consequences. The capital gain on each disposal will equal the excess of the consideration over the cost base. The Commissioner takes the view, on the basis of the information provided, that the grant of the transfer of the water licence constitutes a lease. In that case, CGT event F1 in subsection 104-110(1) happens when a taxpayer grants, renews or extends a lease. A capital gain or capital loss may arise from the CGT event happening. The CGT discount does not apply to CGT event F1 (paragraph 115-25(3)(e)). The lessor makes a capital gain if the capital proceeds from the grant, renewal or extension are more than the expenditure it incurred on the grant, renewal or extension; conversely a capital loss occurs if the capital proceeds are less (subsection 104-110(3)). The capital proceeds are any premium paid or payable for the grant of the lease (subsection 116-20(2)). Expenditure incurred on the grant of the lease does not include any part of the cost of the underlying asset. CGT event F1 occurs: ● at the time the contract for the lease is entered into, or if there is no contract, at the start of the lease (paragraph 104-110(2)(a)); and ● for a renewal or extension – at the start of the renewal or extension (paragraph 104-110(2)(b)) You have granted a lease and received a lump sum lease payment. CGT event F1 will occur at the time the lease contract is entered into and the lease premium will form part of the capital proceeds of the event. The capital gain or loss that occurs following CGT event F1 will be included in your assessable income in the year the event occurs. In your case it is 1 July 20XX and therefore the payment that you received for granting the lease will form part of the income for the year ending 30 June 20XX.

Reasons for decision: These reasons for decision accompany the Notice of private ruling for Entity X.