Private ruling: Compensation payment
Published: June 2012
Ruling period: 1 July 2011 to 30 June 2012
Date scheme commenced: 19 October 2011

Ruling: Q1: Can the compensation payment received from a deed of settlement be treated as capital proceeds and access the small business capital gains tax (CGT) concessions under section 152 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No.

Relevant facts and circumstances: The rulee and another entity were parties to an agreement pursuant to which the rulee sold products and provided services to a third entity. The agreement was cancelled; the rulee was paid compensation for the termination of the contract.

Relevant legislative provisions: Subsection 6-5(1) of the Income Tax Assessment Act 1997 | Section 152 of the Income Tax Assessment Act 1997 | Subsection 116-20(1) of the Income Tax Assessment Act 1997

Reasons for decision: Summary: To help small business, if the basic conditions for relief are satisfied, capital gains can be reduced by various concessions in Division 152-A of the ITAA 1997. Pursuant to subsection 152-10(1) of the ITAA 1997, capital gain (except a capital gain from CGT event K7) you make may be reduced or disregarded under this division if the following basic conditions are satisfied for the gain: A CGT even happens in relation to a CGT asset of yours in an income year; The event would (apart from this division) have resulted in the gain; At least one of the following applies: · You are a small business entity for the income year; · You satisfy the maximum net asset value test · You are a partner in a partnership that is a small business entity for the income year and the CGT asset is an interest in an asset of the partnership; The conditions mentioned in subsection (1A) or (1B) are satisfied in relation to the CGT asset in the income year; The CGT asset satisfies the active asset test. Before assessing whether any of the small business CGT concessions apply, it is necessary to consider if the compensation payment is capital proceed. Capital proceeds under subsection 116-20(1) of the ITAA 1997 are the total of: · The money have received, or are entitled to receive, in respect of the event happening; and · The market value of any other property you have received, or are entitled to receive in respect of the event happening (worked out as at the time of the event). Broadly, amounts received as a result of carrying on a business, but not a pastime or hobby, are income. The proceeds arising from an isolated transaction outside the ordinary course of a business may also be income according to ordinary concepts if the purpose of the transaction is to make a profit. The ordinary income provisions will apply if the taxpayer was: · carrying on a business; · carrying out a business operation or commercial transaction; or · the profits resulted from isolated transactions. Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income (TR 92/3) explains that 'Isolated transactions' are those transactions that are outside the ordinary course of business of a taxpayer carrying on a business, or those transactions that are entered into by non-business taxpayers. Paragraph 35 of TR 92/3 confirms that a profit from an isolated transaction is generally assessable income when both of the following elements are present: · The intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain. · The transaction was entered into, and the profit was made, in the course of carrying a business or in carrying out a business operation or commercial transaction. For a transaction to be characterised as a business operation or a commercial transaction, it is sufficient if the transaction is business or commercial in character ( Federal Commissioner of Taxation v. Whitfords Beach Pty Ltd (1982) 150 CLR 355, 82 ATC 4031, 12 ATR 692). Whether a particular transaction has a business or commercial character depends on the circumstances of the transaction. In determining whether an isolated transaction amounts to a business operation or commercial transaction, paragraph 13 of TR 92/3 outlines a number of factors that must be considered, as follows: · the nature of the entity undertaking the operation or transaction. For example, if the taxpayer is a corporation with substantial assets rather than an individual, that may be an indication that the operation or transaction was commercial in nature · the nature and scale of other activities undertaken by the taxpayer · the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained · the manner in which the operation or transaction was entered into or carried out · the nature of any connection between the relevant taxpayer and any other party to the operation or transaction · if the transaction involves the acquisition and disposal of property, the nature of that property · the timing of the transaction or the various steps in the transaction. For example, if the relevant transaction consists of the acquisition and disposal of property, the holding of the property for many years may indicate that the transaction was not business or commercial in nature. | Detailed Reasoning - In the rulee's case,: · the rulee entered into a contract to supply products and provide services to another entity · the rulee's intention in entering the transaction was for profit making purposes. The contract was entered in the course of the rulee's ordinary business operations. · When the contract was cancelled, the rulee received compensation. · the rulee is still operating in the same industry Whether the compensation payment is income or capital in character may be determined by the character of the right, thing or transaction that gave rise to the compensation receipt. A compensation receipt takes on the character of the item it replaces. If an amount replaces what would have been income it will be assessable as income. Likewise, if an amount capital, the compensation receipt will be assessable under the CGT regime. Ordinarily, amounts received in connection with the variation, cancellation or breach or ordinary commercial contracts are income in nature. Conversely, where the breach of contract affects the capital structure of a taxpayer's assets any compensation received will be regarded as consideration on disposal of part of the entire asset. The distinction between income and capital compensation receipts were also raised in the case of Toyota Manufacturing Australia Ltd v. FC of T (1993) 26 ATR 495; (1993) 93 ATC 4820 ( Toyota Manufacturing ) and Heavy Minerals Pty Ltd v. FC of T (1966) 115 CLR 512 ( Heavy Minerals ). Heavy Minerals assessed whether the compensation payments that resulted from cancellation of contracts to purchase rutile from the taxpayer constituted capital receipts. The High Court affirmed the decision of the Taxation Board of Review that such receipts were not capital, but are part of its assessable income. In delivering the High Court decision on Heavy Minerals , Windeyer J made the following comments: The taxpayer's business was mining rutile and dealing in rutile. Its capital assets were the mining lease and the plant. After the contracts were cancelled it still had these. It was free to mine its rutile and to sell it if it could find buyers: and it tried to do so. The taxpayer was not put out of business by the cancellation of its overseas contracts. It did not go out of business when they were cancelled. Similarly, Toyota Manufacturing received compensation payments for cancellation of a trade contract. Toyota in its application to the High Court submitted that the compensation payment was interest on the money expended on the building and plant and equipment dedicated to the abandoned project. The submission by Toyota Manufacturing was that the contract was not an ordinary commercial contract for the supply of goods to be manufactured in the course of carrying on its trade, rather, the congeries of rights conferred by the contract constituted part of the whole structure of the applicant's profit making apparatus therefore constituted a capital asset, for the surrender of which the payment was to be recognised on capital account. | Detailed Reasoning - In dismissing the appeal of Toyota Manufacturing in the High Court, Jenkinson J observed:: But the applicant was engaged in the business of manufacturing and selling motor vehicle engine components, and this was a contract for the manufacture and sale of such goods in the ordinary way. By its performance the applicant expected to make profits. The consideration paid to the applicant for giving up the rights the contract conferred on it, or alternatively the rights which commercial honour binding great international corporations conferred on it, was income in the applicant's hands. In carrying out the contract, the rulee received income according to ordinary concepts. When the contract was cancelled, the rulee received compensation. Although an isolated transaction, the payment was received in the course of carrying on, or in connection with, the rulee's business. The cancelled contract was not a capital asset as the profit making structure is not permanently impaired. The compensation paid to the rulee for the cancelation of the contract constitutes recoupment for the loss of profits or income and can be described as a normal incident of business. It is therefore income according to ordinary concepts under section 6-5 of the ITAA 1997. As such, the CGT provisions and the small business CGT concessions do not apply.

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