Private ruling: Capital Gains Tax: Treatment of compensation receipt
Published: December 2013
Ruling period: 1 July 2012 to 30 June 2013
Date scheme commenced: 19 April 2013

Ruling: Q1: Are the payments for compensation paid by the company assessable as income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No. | Q2: Are the payments for compensation paid by the company assessable as capital gains under the CGT provisions in Part 3-1 and 3-3 of the ITAA 1997? | A2: No.

Relevant facts and circumstances: You and your spouse are the joint tenants of the property. The company is conducting mining operations within a permitted area close to your property. The company has agreed to compensate you and your spouse in exchange for allowing the company to conduct mining operations within a permitted area which will restrict your use of the land and also permanently reduce the value of your land.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 6-5 | Income Tax Assessment Act 1997 Part 3-1 and 3-3 | Income Tax Assessment Act 1997 section 108-5 | Income Tax Assessment Act 1997 section 110-25

Reasons for decision: Summary: The amount of lump sum compensation received is not assessable as ordinary income as it takes the characteristic of a capital receipt that replaces the amount lost in the value of the underlying asset which in this instance is the value of the land. The amount received will reduce the cost base of the land. | Detailed Reasoning - Detailed reasoning: Whether a lump sum or other compensation payment constitutes assessable income in the hands of the recipient depends on whether it is a receipt of capital or rather ordinary income which depends upon a consideration of all the circumstances surrounding the payment. A compensation amount generally bears the character of that which it intends to replace. Under subsection 6-5(1) of the ITAA 1997 ordinary income means income 'according to ordinary concepts'. Under subsection 6-5(4) of the ITAA 1997 in working out whether you have derived an amount of ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct. Relevant factors in determining whether an amount is ordinary income include: · whether the payment is the product of any employment, services rendered, or any business; · the quality or character of the payment in the hands of the recipient; · the form of the receipt, that is, whether it is received as a lump sum or periodically; and · the motive of the person making the payment, but noting that this latter factor is rarely decisive, as a mix of motives may exist. In your case it is considered the compensation payment received from the company as per the compensation agreement is a capital receipt intended to recoup the loss of value of your land, and is not assessable income under section 6-5 of the ITAA 1997. | Summary: In accordance with TR 95/35, these compensation payments will normally constitute a recoupment of the underlying asset (the value of the land) acquisition cost, thereby reducing its cost base. A capital gain or loss under the CGT provisions will only arise if a CGT event happens. | Detailed Reasoning - Detailed reasoning: As it has been determined that the compensation payment received is not assessable income it must be considered under the general CGT provisions which are set out in Part 3-1 of the ITAA 1997. Under the CGT provisions, you will make a capital gain or loss only if a CGT event happens. To determine if a CGT event happens in respect of a compensation payment it is necessary to consider the nature of the asset to which the compensation payment relates with reference to the Income Tax legislation and the Commissioner's guidelines on the treatment of compensation payments. The guidelines are set out in TR 95/35 which states that the particular asset for which compensation has been received by the taxpayer may be: · an underlying asset; · a right to seek compensation; or · a notional asset in terms of section 104-155 of the ITAA 1997 (in relation to trusts) Paragraph 3 of TR 95/35 provides helpful definitions for some of the key terms used in the ruling. In determining the most relevant asset for which the compensation was paid, the 'look-through' approach requires an analysis of all of the possible assets of the taxpayer in order to determine the asset to which the compensation amount is most directly related. Another key term defined is 'underlying asset' as 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. Paragraphs 6 to 9 of TR 95/35 provide the following guidelines on the treatment of compensation for permanent damage to or permanent reduction in the value of the underlying asset: · If an amount of compensation is received by the 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 the underlying asset at the time of the receipt it is considered 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 in terms of section 110-25 of the ITAA 1997 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. · The adjustment of the total acquisition costs effectively reduces those costs by the amount of the recoupment as if those costs had not been incurred. · Compensation received by a taxpayer has no CGT consequences if the underlying asset which has suffered permanent damage or a permanent reduction in value was acquired before 20 September 1985 or is any other exempt CGT asset. The portion of the compensation receipt allocated to the damage to the land which is a pre-CGT asset will have no effect on the value of that land for CGT purposes. As discussed in TR 95/35 the compensation payment received for the 'permanent' damage and reduction to the value of the property is treated as a 'recoupment' therefore the legislation applies to reduce the cost base of the land by the amount of that payment. The 'underlying asset' the payment of compensation is replacing is the value of the land.