Private ruling: Compensation - income or CGT
Date of advice: 25 July 2016
Published: September 2016
Ruling period: 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
Date scheme commenced: 1 July 2016

Ruling: Q1: Will the proposed compensation payments be assessable as ordinary income? | A1: No. | Q2: Will the proposed compensation payments be assessable as capital gains under the capital gains tax (CGT) provisions of the Income Tax Assessment Act 1997 (ITAA 1997)? | A2: Yes.

Relevant facts and circumstances: You and your spouse own a property. You do not use the property for income producing purposes. You commenced preparations to build a house on the property to use as your primary residence. You were approached by, and have entered into an agreement with, Entity X. Under the agreement, you agreed • not to build or reside on the property yourself, to let anyone else reside on the property, • not to build or permit construction of any other 'noise sensitive premises' as described in Schedule 1 Part C item 3 of the Environmental Protection (Noise) Regulations 1997 (WA) on the property during the term of the agreement • not object to an absolute caveat being lodged over the property if Entity X decides to lodge the caveat • give Entity X first right of refusal to the purchase of the property if, during the term of the agreement, you propose to sell, lease or otherwise deal with the property, and • if Entity X decline to purchase the property, you must ensure the new owner, lessee or other party agrees to comply with the agreement. In exchange for entering into the agreement, Entity X has agreed to pay you: • a weekly payment for the duration of the agreement term, and • a one-off compensation payment on execution of the agreement.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 6-5 | Income Tax Assessment Act 1997 Section 104-155 | Income Tax Assessment Act 1997 Section 110-25 | Income Tax Assessment Act 1997 Section 110-55

Reasons for decision: Summary: The compensation payments you will receive are considered to be compensation for the permanent damage to, or reduction in value of, your property. The compensation payments are not assessable as either ordinary income or under the capital gains tax (CGT) provisions of the Income Tax Assessment Act 1997 (ITAA 1997). However, the total acquisition costs of the property will be reduced by the value of the compensation received. | Detailed Reasoning - Are the payments assessable as ordinary income?: Your assessable income includes income according to ordinary concepts. 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 • are expected • are relied upon, and • have an element of periodicity, recurrence or regularity. The payments you will receive are not considered to be payments for rendering personal services, carrying on a business or replacement for income which might have been derived from the property. Whilst you will receive regular payments over the term of the agreement, the payments are considered to be capital in nature (see discussion below) and are not assessable as ordinary income. | Detailed Reasoning - Are the payments assessable under the CGT provisions?: You will receive a one-off and weekly payments for entering into an agreement not to build or reside in a residence or other 'noise sensitive premises' on your property. It is considered that you will receive the payments as compensation for the inconvenience of not being able to use your property as your or any other persons, residence. Additionally, the agreement prevents the potential income earning activities which could be carried out on your property. Payments for inconvenience or restriction in the use of property are considered to be capital in nature. As the compensation payment from Entity X will be capital in nature it is necessary to consider the CGT implications. You make a capital gain or capital loss if a CGT event happens to a CGT asset. To determine any CGT implications you must establish the nature of the asset to which the compensation payment relates. Taxation Ruling TR 95/35 provides guidance as to the treatment of compensation payments. TR 95/35 states that the particular asset for which the compensation has been received may be: • an underlying asset • a right to seek compensation; or • a notional asset In determining the most relevant asset, it is appropriate to adopt a look through approach to the transaction or arrangement which generates the compensation payment. In this case, using the look through approach, the compensation payments made by Entity X relate to permanent damage and reduction in value of the underlying asset (the property) by placing restrictions on its use. Permanent damage or reduction in value does not mean everlasting damage or reduced value, but refers to damage or reduction in value which will have a permanent effect unless some action is taken by the taxpayer to put it right. Where an amount of compensation is received in respect of permanent damage or reduction in value of an underlying asset acquired after 20 September 1985 and there is no disposal of that underlying asset at the time of the receipt, the payment will not be taxable under the CGT provisions.