Private ruling: CGT - treatment of compensation payment
Date of advice: 19 September 2016
Published: November 2016
Ruling period: Year ended 30 June 2015
Date scheme commenced: 1 July 2014

Ruling: Q1: Are accounting fees to the extent that they relate to your tax affairs deductible under section 25-5 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes | Q2: Are the legal, valuation and similar professional fees deductible? | A2: No | Q3: Will the reimbursement of deductible accounting fees incurred be assessable? | A3: Yes | Q4: Will the reimbursement of non-deductible accounting, legal, valuation and similar professional fees be assessable? | A4: Yes | Q5: Does the payment under the Agreement for the decommissioning of the bore form part of your assessable income? | A5: No | Q6: Does the payment under the Agreement for the decommissioning of the bore reduce the cost base of the land for any future capital gain under section 110-40 or section 110-45 of the ITAA 1997? | A6: Yes. Issue 2 - Goods and Services Tax (GST) | Q8: Are you entitled to input tax credits for acquisitions you make that are related to the receipt of compensation amounts even if those acquisitions do not relate to making specific taxable supplies? Advice Yes, provided that the supplies made to you are subject to GST.

Relevant facts and circumstances: You own property ('the Land'). You operate a business on this property as a partnership and are registered for GST. You acquired the Land after 19 September 1985. The partnership owns a water bore on the land. Entity X is undertaking activities on part of the Land. The bore is located in the activity area The partnership entered into an Agreement in accordance with the Water Act 2000 (X) with Entity Z. Entity Z entered into the agreement as agent for Entity X. Under the Agreement: • the bore was assessed and is likely to have an impaired capacity as a result of Entity X undertaking its activities • it is preferred that the bore is decommissioned • Entity X will undertake the decommissioning • a compensation payment will be paid to the landowners • Entity X will compensate the landowners for reasonable costs associated with the negotiation of the Agreement

Relevant legislative provisions: A New Tax System (Goods and Services Tax) Act 1999 subsection 7-1(1) | A New Tax System (Goods and Services Tax) Act 1999 section 9-5 | A New Tax System (Goods and Services Tax) Act 1999 section 9-15 | A New Tax System (Goods and Services Tax) Act 1999 section 9-40 | A New Tax System (Goods and Services Tax) Act 1999 section 11-5 | A New Tax System (Goods and Services Tax) Act 1999 section 11-15 | A New Tax System (Goods and Services Tax) Act 1999 section 11-20 | Income Tax Assessment Act 1997 Section 8-1 | Income Tax Assessment Act 1997 Section 25-5 | Income Tax Assessment Act 1997 Paragraph 20-20(3) | Income Tax Assessment Act 1997 Section 20-30 | Income Tax Assessment Act 1997 Section 104-35 | Income Tax Assessment Act 1997 Section110-40 | Income Tax Assessment Act 1997 Section 110-45

Reasons for decision: Summary: The portion of the accounting fees which directly relate to managing your tax affairs are a deductible expense. The portion of accounting fees which are for services not directly related to managing your tax affairs, the valuation fees and the legal fees are not deductible expenses. | Detailed Reasoning - Detailed reasoning: Section 8-1 of the Income Tax Assessment Act 1997 (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). Accountancy fees 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 ( Bartlett v FC of T; Falcetta v FC of T 2003 ATC 4962; [2003] FCA 1125) 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 ( Hallstroms Pty Ltd v FC of T [1946] HCA 34; (1946) 72 CLR 634) ( Hallstroms ). Hallstroms case involved a company incurring legal expenses in opposing the extension of a patent for a particular type of refrigerator which the taxpayer wished to manufacture and sell once the patent expired. The High Court found that the expenses met the positive limbs of section 8-1 of the ITAA 1997 and were not of a capital nature. The majority found that the advantage sought by the legal expenditure was a company that already manufactures refrigerators was able to manufacture a new model of refrigerator and did not result in any alteration of the structure of its business. In your case, you have incurred legal and valuation expenses for the purpose of negotiating the Agreement. The expenditure was not incurred for the purpose of ensuring that your current income structure of the business was not diminished. But for the Agreement being negotiated, none of the expenses would have been incurred. The legal and valuation expenses are considered to be capital in nature and are not deductible expenses. | Detailed Reasoning - Questions 3 and 4 - Assessability of reimbursed fees: Subsection 20-20(3) of the ITAA 1997 provides that an amount you have received as a recoupment of a loss of outgoing is an assessable recoupment if: • you can deduct an amount for the loss or outgoing in the current year, or • you have deducted or can deduct an amount for the loss or outgoing for an earlier income year under a provision listed in section 20-30 of the ITAA 1997. Section 20-30 of the ITAA 1997 includes tax-related expenses deductible under section 25-5. A reimbursement of accounting fees for which you deducted, or could claim a deduction for, in the current or earlier income year, will be an assessable recoupment and is required to be included in your assessable income in the year in which it is received. A reimbursement of accounting, legal and valuation fees for which you could not claim a deduction for in the current or an earlier income year will not be an assessable recoupment or ordinary income. They are not required to be included in your assessable income in any year. | Summary: The payments received under the Agreement will not form part of your assessable income. They are considered to be compensation received for the permanent reduction in value of the Land and will be treated as a reduction to the Land's cost base. | Detailed Reasoning - Detailed reasoning: Compensation payment as ordinary income Section 6-5 of the 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 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 were made in accordance to the legislative provisions of the Water Act 2000 (X). Accordingly, the compensation payments paid under the Agreement do not give rise to income according to ordinary concepts or to a profit arising from an isolated transaction. They are not assessable under 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 the eligible claimant being entitled to receive compensation and the loss or 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 a '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 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 your case, you have received a payment for the decommissioning of a water bore on your Land to allow petroleum activities to be undertaken on the Land. The decommissioning of the water bore has resulted in the permanent damage to, or permanent reduction in the value of, the Land. You have not received compensation for loss of income or other economic benefits. As you did not dispose of all or part of the affected Land there are no CGT consequences at the time of entering the Agreement or receiving the compensation payments. However, the cost base of the Land will be reduced by the value of the payment received and any gain or loss will crystallise at a later time when the Land is sold. | Summary: The payment from Entity X to the Bore Owners is paid and received as compensation to the Bore Owners to discharge Entity X's statutory compensation liability for losses relating to the Bores resulting from Entity X's activities in exercising their relevant underground water rights. Any losses suffered by the Bore Owners is not a supply that the Bore Owner makes to Entity X and the compensation is not consideration for any supply that the Bore Owner makes to Entity X. Hence, there is no GST liability for the Bore Owners. | Detailed Reasoning - Detailed reasoning: Section 9-5 of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act) states: You make a taxable supply if: (a) you make the supply for *consideration; and (b) the supply is made in the course or furtherance of an *enterprise that you *carry on; and (c) the supply *is connected with Australia; and (d) you are *registered or *required to be registered. However, the supply is not a *taxable supply to the extent that it is *GST-free or *input taxed. A supply is broadly defined in section 9-10 of the GST Act to include the creation, grant, transfer, assignment or surrender of any right or an entry into, or release from an obligation to refrain from an act or to tolerate an act or situation. | Detailed Reasoning - Is there a supply from the Bore Owners to X of the right to exercise X's relevant underground water rights as a Business Holder?: Goods and Services Tax Ruling 2001/4 (GSTR 2001/4), sets out the Commissioner's views relating to GST consequences of court orders and out-of-court settlements. In relation to the meaning of supply, paragraphs 22 and 25 of GSTR 2001/4 state: 22. Essentially, a supply is something which passes from one entity to another. The supply may be one of particular goods, services or something else. 25. Subsection 9-10(2) refers to two aspects of a supply; the thing which passes, such as goods, services, a right or obligation; and the means by which it passes, such as its provision, creation, grant, assignment, surrender or release Goods and Services Tax Ruling 2006/9 (GSTR 2006/9), examines the meaning of "supply" in the GST Act. Proposition 5 in paragraph 71 of GSTR 2006/9 provides that to "make a supply" an entity must do something. The relevant paragraphs are paragraphs 74 and 78 (as follows): 74. However, Underwood J was of the view, with which the Commissioner also agrees, that an entity can still make a supply even if the supply is made under the compulsion of statute if the entity takes some action to cause a supply to occur. His Honour went on to compare a supply resulting from a positive act against a situation where there is no supply because nothing is done. It seems to me that different considerations arise when considering the meaning of 'supply' in the Act. Notwithstanding the statutory compulsion, the liquidator's disposition in St Hubert's Island Pty Ltd (in liq) was something that was 'made' by him and for that reason would be likely to be considered a supply within the meaning of the Act. This is quite a different situation from the matter at hand, for the release of the obligation to pay a judgment sum by the payment of that sum will occur regardless of whether the judgment creditor makes or does any act at all. It was held in Databank Systems Ltd v. Commissioner of Inland Revenue (NZ) (1987) 9 NZTC 6213 that 'supply' means 'to furnish or provide'. Application of that proposition to the word 'supply' as enacted in the Act, s9-10 reinforces the concept that there is a legislative intention not to include in the word 'supply' the release of an obligation that occurs independently of the act of the releasor. 78. The Court's wider comments about 'supply' and 'obligation' in paragraphs 16, 22 and 23 of its decision were expressed with some caution. With respect, the Commissioner does not consider the Court has stated a general principle, contrary to our proposition, that a supply can be brought about by operation of law in the absence of an entity taking any positive action. The Commissioner distinguishes something brought about solely by operation of law where there is no supply, from something done by an entity as a consequence of a legal requirement where there may be a supply, as was the situation noted by Underwood J in Shaw citing the example of the liquidator's actions in St Hubert's Island. The Commissioner also distinguishes an action that results in obligations arising by operation of law, as the Full Court found in Westley , where there may be a supply by the entity taking the action. The current case has a number of similarities to the decisions in Nullaga Pastoral Company Pty Ltd v FC of T 78 ATC 4329; (1978) 8 ATR 757; and Barrett v Federal Commissioner of Taxation 1968] HCA 59; (1968) 118 CLR 666; 15 ATD 149; 10 AITR 685. These cases involve 'compensation' payments relating to relevant activities conducted on farming properties; and consider whether the payments that were made to the farmers were licence fees. In Barrett's case , Owen J of the High Court held that the payments were not received (by the landholder) as income in return for the grant of a licence to use the land for the purpose of mining, as the mining company already had the right to take the minerals from the land and do all things necessary for that purpose pursuant to an agreement with another party. That is, the landowner taxpayer did not receive the payments for granting an authority to the mining company. Similarly, in Nullaga's case , the mining operators already had a permit to enter the land and could also apply for a mining tenement on the land pursuant to the Mining Act (X). Their exploration rights were therefore, not pursuant to any licence granted by the landowner. Wickham J of the Supreme Court of the relevant State thought that the agreement did embrace a kind of licence but it was held that the money was paid as consideration for the deprivation of a capital asset and in order to replace that capital asset. In the current case, Entity X has the rights to exercise Entity X's relevant underground water rights under legislation; however, Chapter 3 of the Water Act requires X to monitor and assess the impact of the exercise of underground water rights on water bores and to enter into make good agreements with the owners of the bores. Since Entity X's activities led to the impaired capacity of the bores which belong to the Bore Owners, Entity X has statutory obligations to enter into an Agreement with the Bore Owners as required under legislation. The Make Good Measures for the likely impaired capacity of the Relevant Bore consist of the payment of Compensation from Entity X to the Bore Owners and the decommissioning of the bores by Entity X in accordance with Best Industry Practice. In such circumstances, the right to exercise Entity X's relevant underground water rights is vested in Entity X under the legislation. The Bore Owners do not transfer or surrender their rights related to the water bores to Entity X. Hence there is no supply from the Bore Owners to Entity X of the right to exercise Entity X's relevant underground water rights. | Detailed Reasoning - Discontinuance supply:: Upon signing the Agreement, the Bore Owners accept that they give up their rights to pursue further compensation in relation to the relevant bores. However, we do not consider that the giving up of the rights is a separate supply from the Bore Owners to Entity X since it is not the reason for the decommissioning of the bores and for the compensation amount being paid to the Bore Owners. Paragraphs 106 to 109 of GSTR 2001/4 state: 106. Where the only supply in relation to an out-of-court settlement is a 'discontinuance' supply, it will typically be because the subject of the dispute is a damages claim. In such a case, the payment under the settlement would be in respect of that claim and not have a sufficient nexus with the discontinuance supply. 107. In most instances, a 'discontinuance' supply will not have a separately ascribed value and will merely be an inherent part of the legal machinery to add finality to a dispute which does not give rise to additional payment in its own right. They are in the nature of a term or condition of the settlement, rather than being the subject of the settlement. 108. We do not consider that the inclusion of a 'no liability' clause in a settlement deed alters this position. 'No liability' clauses are commonly included in settlement agreements and we do not consider their inclusion to alter the substance of the original dispute, or the reason payment is made. 109. We consider that a payment made under a settlement deed may have a nexus with a discontinuance supply only if there is overwhelming evidence that the claim which is the subject of the dispute is so lacking in substance that the payment could only have been made for the discontinuance supply. | Detailed Reasoning - Damage: The Make Good Measures under the Agreement is compensation in respect of any damage caused or likely to be caused to the Bores and any inconvenience suffered by the Bore Owners as a consequence of Entity X's activities in exercising their relevant underground water rights. In paragraph 71 of GSTR 2001/4, the Commissioner identifies situations where the subject matter of a claim for damages or compensation cannot be regarded as a 'supply'. Examples of such claims include property damage, negligence causing loss of profits, wrongful use of trade name, breach of copyright, termination or breach of contract or personal injury. The payment under the Agreement is not consideration for a supply from the Bore Owners to Entity X, but is solely compensation for damage. In summary, when the Bore Owners receive the payment from Entity X, there is no supply from the Bore Owners to X and no consideration. Hence there is no GST liability arising for the Bore Owners. | Summary: The expenses in question are business expenses and these expenses do not relate to making input taxed supplies. Therefore, you acquire the associated goods and services for a creditable purpose. Your acquisitions of these items are creditable acquisitions under section 11-5 of the GST Act where the supplies made to you are subject to GST. | Detailed Reasoning - Detailed reasoning: You are entitled to input tax credits on your creditable acquisitions. Section 11-5 of the GST Act states: You make a creditable acquisition if: (a) you acquire anything solely or partly for a *creditable purpose (b) the supply of the thing to you is a *taxable supply; and (c) you provide, or are liable to provide, *consideration for the supply; and (d) you are *registered, or *required to be registered. Creditable purpose Subsection 11-15(1) of the GST Act states: You acquire a thing for a creditable purpose to the extent that you acquire it in *carrying on your *enterprise. Subsection 11-15(2) of the GST Act states; However, you do not acquire the thing for a creditable purpose to the extent that: (a) the acquisition relates to making supplies that would be *input taxed; or (b) the acquisition is of a private or domestic nature. Section 11-5 of the GST Act does not require that an acquisition made by a taxpayer relates to particular taxable supplies that the taxpayer makes in order for the taxpayer to be entitled to an input tax credit on its acquisition. The compensation relates to damage to your farming property on which you carry on your farming enterprise. Therefore, the acquisitions you make that are related to the receipt of compensation amounts are acquisitions made in carrying on your farming enterprise. The acquisitions do not relate to making input taxed supplies. The acquisitions are not of a private or domestic nature. Therefore, you make the acquisitions for a creditable purpose. Hence, you meet the requirement of paragraph 11-5(a) of the GST Act. Where the supplies made to you of the goods and services you acquire are subject to GST, you will meet the requirement of paragraph 11-5(b) of the GST Act. Where you pay for the acquisitions in question, you meet the requirement of paragraph 11-5(c) of the GST Act. You are registered for GST. Therefore, you meet the requirement of paragraph 11-5(d) of the GST Act. Hence, you are entitled to input tax credits for purchases you make that are related to the receipt of compensation amounts, provided that the supplies of the goods and services to you are subject to GST. This is the case even for an acquisition that does not relate to making specific taxable supplies.

Question 1: Is there a GST liability for the partnership when Entity X pays it compensation under the Agreement for the effects caused by Entity X's activities to the water bore?