Private ruling: Compensation payments
Date of advice: 18 November 2020
Published: January 2021
Ruling period: Income year ended 30 June 2020 | Income year ended 30 June 2021 | Income year ended 30 June 2022
Date scheme commenced: 1 July 2019

Ruling: Q1: Will the compensation received under the Agreement be treated as assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No | Q2: Will the compensation received under the Agreement be treated as capital proceeds under Division 116 of the ITAA 1997 from any capital gains tax event in Division 104 of the ITAA 1997? | A2: No | Q3: Will the compensation received under the Agreement reduce the cost base of the relevant property for any future capital gain under section 110-40 of the ITAA 1997? | A3: Yes | Q4: Will the Landholders incur a goods and services tax (GST) liability on the receipt of compensation amounts from under the Agreement? | A4: No

Relevant facts and circumstances: The Land was acquired by the Landholders several years ago. The Landholders are not registered for GST as individuals. The Landholders occupy the Land to run a business as partners in a partnership. The partnership is registered for GST. There is no Lease or agreement in place between the Landholders and the Landholders as occupiers in partnership. Entity B is to carry out activities on all or part of the Land. You, as Landholders have entered into an Agreement with Entity B for the use of the Land. Under the Agreement you will receive compensation. The Agreement was negotiated in accordance with the relevant legislation. The prime objective of the Agreement is to ensure the Landholders are properly compensated as required under the relevant Legislation. The compensation is payable in respect of the impacts of the activities. The Agreement provides compensation amounts payable to the individuals only in their capacity as the 'Landholders'. Accordingly, no monetary compensation is being made relating to the business operation by the partnership. The compensation as outlined in the Agreement includes several different payments which are payable during different phases. Reimbursements are being received for legal, accounting and valuation costs reasonably and necessarily incurred by you negotiating this agreement. The compensation in the Agreement is to compensate you for the impact of the activity on the land. The compensation is being paid in accordance with the relevant Legislation. Under the relevant Legislation, written consent for the right to access restricted land must be granted by the Landowner. This right is provided by the Agreement and there is no separate payment for this right. Subject to the terms of the Agreement, the Landholders acknowledge that the compensation compensates for all of the impacts of the activities, including the loss of use of part of the Land, all impacts and loss of amenity generally as the activities will cause permanent damage to, or permanent reduction in the value of, the Land.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 6-5 | Income Tax Assessment Act 1997 subsection 6-5(2) | Income Tax Assessment Act 1997 section 6-10 | Income Tax Assessment Act 1997 Division 104 | Income Tax Assessment Act 1997 section 110-40 | Income Tax Assessment Act 1997 subsection 110-40(3) | Income Tax Assessment Act 1997 subsection 110-45(3) | Income Tax Assessment Act 1997 Division 116 | Income Tax Assessment Act 1997 paragraph 118-37(1)(b) | A New Tax System (Goods and Services Tax) Act 1999 section 9-5 | A New Tax System (Goods and Services Tax) Act 1999 section 9-10 | A New Tax System (Goods and Services Tax) Act 1999 subsection 9-10(1) | A New Tax System (Goods and Services Tax) Act 1999 section 9-15

Reasons for decision: Summary: The compensation received by the Landholders under the terms of the Agreement will not be treated as assessable income under section 6-5 of the ITAA 1997. | Detailed Reasoning - Ordinary income: Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident includes the ordinary income derived directly or indirectly from all sources, whether in or out of Australia, during the income year. 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. For income tax purposes, an amount paid to compensate for a loss generally acquires the character of that for which it is substituted ( Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 AITR 443; 10 ATD 82). Compensation payments which substitute income have been held by the courts to be income under ordinary concepts ( Federal Commissioner of Taxation v. Inkster (1989) 24 FCR 53; (1989) 20 ATR 1516; 89 ATC 5142, Tinkler v. FC of T (1979) 10 ATR 411; 79 ATC 4641, and Case Y47 (1991) 22 ATR 3422; 91 ATC 433). On the other hand, if the compensation is paid for the loss of a capital asset or amount then it will be regarded as a capital receipt and not ordinary income. The compensation payment you will receive is not earned by you as it does not relate to services performed or from carrying on a business. Although the compensation relates to your property, the payment is not akin to rent. Rather the compensation is being received for the impact of the activity on your land. Although the payment can be said to be expected, and perhaps relied upon, this expectation does not arise from any personal services performed or business activity. Accordingly, the compensation payments paid under the terms of the Agreement do not give rise to income according to ordinary concepts, or to a profit arising from a profit-making undertaking or plan pursuant to section 6-5 of the ITAA 1997. As such, these payments are not assessable income under section 6-5 of the ITAA 1997. | Summary: The compensation payments received by the Landholders under the terms of the Agreement will not cause a capital gains tax event to happen. The compensation payments will reduce the cost base of the relevant property for any future capital gain in accordance with section 110-40 of the ITAA 1997. | Detailed Reasoning - Capital proceeds in respect of a CGT event happening: Under subsection 116-20(1) of the ITAA 1997, money you have received (or are entitled to receive) and the market value of any property you have received (or are entitled to receive) are the capital proceeds from a CGT event. For the compensation payments under an agreement to constitute capital proceeds, there must be a CGT event. CGT events occur in respect of CGT assets. The definition of a CGT asset is contained in subsection 108-5(1) of the ITAA 1997. It provides that a CGT asset is any kind of property or a legal or equitable right that is not property. Not all things often referred to as 'rights' will be assets for CGT purposes. To be an asset, a right must be recognised and protected by law. Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts provides the Commissioner's view as to the CGT consequences of receiving a compensation payment and relevantly, it states that a CGT event will occur (and any consideration form part of capital proceeds) where the amount of compensation is received by the taxpayer: • either wholly or partly in respect of the disposal of an underlying asset (CGT event A1); or • not in respect of any underlying asset but in relation to the disposal of the right to seek compensation (CGT event C2). The above relate to CGT event A1 (section 104-10 of the ITAA 1997) and CGT event C2 (section 104-25 of the ITAA 1997) respectively. TR 95/35 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 identified using the 'look-through approach' in order to determine the asset to which the compensation amount most directly relates. Paragraph 70 of TR 95/35 states that the underlying asset is identified by looking through to the transaction which generates the compensation receipt. Applying the look-through approach to the facts the Land is the asset to which the compensation under the Agreement most directly relates. The Land is therefore the underlying asset and the relevant CGT asset. As there has been no disposal of the Land, CGT event A1 does not occur. Further, as the amounts are paid in respect of an underlying asset (being the Land) CGT event C2 will not happen. As such, the compensation amounts the Landholders under the terms of the Agreement, do not constitute capital proceeds in respect of a CGT event happening. | Detailed Reasoning - Reduction in the cost base of the Land: 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 a consequence of an eligible claimant being entitled to receive compensation for the loss and destruction of a CGT asset. Paragraph 3 of TR 95/35 states that permanent damage or reduction in value does not mean everlasting damage or reduced value, but refers to damage or a reduction in value which will have permanent effect unless some action is taken by the taxpayer to put it right. Paragraphs 6 and 7 of TR 95/35 provide that compensation received wholly in respect of permanent damage or reduction in the value of a post-CGT underlying asset that is not disposed of represents a reduction in either the CGT cost base under either subsection 110-40(3) of the ITAA 1997 (for assets acquired before 7.30pm on 13 May 1997) or subsection 110-45(3) of the ITAA 1997 (for assets acquired after 7.30pm on 13 May 1997). In this case you have received, and will continue to receive, compensation payments as a result of activities being carried out on your property. These activities have resulted in the permanent damage to, or permanent reduction in the value of, the property. As stated above, for the purposes of TR 95/35, permanent damage or reduction in value does not mean everlasting damage or reduced value, but refers to damage or reduction in value that has permanent effect unless the taxpayer takes action to put it right. The activities permitted under the Agreement will cause such damage and reduction in value. Accordingly, pursuant to subsection 110-40(3) of the ITAA 1997, 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 Landholders actually dispose 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. Therefore, the Land's acquisition cost will be reduced by the compensation payments (excluding reimbursements) received in relation to that property. That is, the cost base of the property will be reduced by the value of the payments and any gain or loss will crystallise at a later time when the property is sold. | Summary: The receipt of the compensation amounts by the Landholders under the terms of the Agreement will not give rise to a GST liability. | Detailed Reasoning - Detailed reasoning: For the receipt of compensation amounts to give rise to a GST liability there has to be a taxable supply made. Section 9-5 of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act) provides that an entity makes a taxable supply if, amongst other requirements, the entity makes the supply for consideration. The existence of a 'supply' itself is an essential element in determining whether there is a taxable supply under section 9-5 of the GST Act. | Detailed Reasoning - Supply: 'Supply' is defined in subsection 9-10(1) of the GST Act as 'any form of supply whatsoever'. The statutory definition of 'supply' is very broad. Essentially, a supply is something which passes from one entity to another, and may be one of goods, services or something else. | Detailed Reasoning - Consideration: Section 9-15 of the GST Act provides that a payment will be consideration for a supply if the payment is 'in connection with' a supply and 'in response to' or 'for the inducement' of a supply. Thus, there must be a sufficient nexus between a particular supply and a particular payment, which is provided for that supply, for there to be a supply for consideration. | Detailed Reasoning - Sufficient nexus: A sufficient nexus between the compensation amounts and a supply must exist to create the 'supply for consideration' relationship. The issue is whether the Landholders have provided something to Entity B, in return for the compensation amounts that are paid to them. In regards to the Landholders giving up their rights for further compensation upon commencement of the Agreement, this raises the issue of whether giving up of a landholder's rights would be a separate supply or as termed in Goods and Services Tax Ruling 2001/4: Goods and Services Tax: GST consequences of court orders and out-of-court settlements (GSTR 2001/4) a 'discontinuance supply'. Paragraphs 106 to 109 in GSTR 2001/4 discuss discontinuance supplies as follows: GSTR 2001/4 sets out the Commissioner's view relating to GST consequences of court orders and out-of-court settlements. The following is stated in relation to discontinuance supplies at paragraphs 106 to 109: 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. In the process of Entity B carrying out its activities on the Land, significant damage and adverse effects will impact the Land, for which the Entity B must compensate the Landholders under the law. Upon receipt of the compensation amounts under the Agreement, the Landholders accept that they give up their right to pursue further compensation in relation to the activities. The Landholders giving up their right for further compensation is not a separate supply for GST purposes. Rather, it is considered an inherent part of the legal machinery to bring finality to the amount of compensation that will ultimately be sought by the Landholders. | Detailed Reasoning - Damages: Paragraph 73 of GSTR 2001/4 states the following in relation to damages: 73. The most common form of remedy is a claim for damages arising out of the termination or breach of a contract or for some wrong or injury suffered. This damage, loss or injury, being the substance of the dispute, cannot in itself be characterised as a supply made by the aggrieved party. This is because the damage, loss, or injury, in itself does not constitute a supply under section 9-10 of the GST Act. Paragraphs 110 and 111 of GSTR 2001/4 further explain: 110. With a dispute over a damages claim, the subject of the dispute does not constitute a supply made by the aggrieved party. If a payment made under a court order is wholly in respect of such a claim, the payment will not be consideration for a supply. 111. If a payment is made under an out-of-court settlement to resolve a damages claim and there is no earlier or current supply, the payment will be treated as payment of the damages claim and will not be consideration for a supply at all, regardless of whether there is an identifiable discontinuance supply under the settlement. Although the above explanation in GSTR 2001/4 is made in respect of court orders and out-of-court settlements, the underlying principles are equally relevant in this case. The Landholders received the amounts under relevant legislation, as compensation for any economic loss, hardship and inconvenience as a result of activities carried out on their land by the Entity B. The payment by Entity B to the Landholders is compensation in respect of any damage caused or likely to be caused to the land and any inconvenience suffered by the Landholders as a consequence of the authorised activities carried out on the Land. In applying the above principles in GSTR 2001/4 to the present circumstances, the compensation amounts are paid to the Landholders to resolve a potential damages claim. A claim for damages (or payment that the landholders receive as a consequence of such claim) due to activities conducted by Entity B on the Landholders' land, does not constitute a supply under section 9-10 of the GST Act. Under terms of the Agreement, when the Landowners provide the right to Entity B to carry out activities on restricted land, you make a supply. In this case, as there is no separately identifiable amount (consideration) paid for that supply and as you are not individually registered or required to be registered for GST, it is not a taxable supply. Accordingly, you do not incur a GST liability. You do not create, transfer or surrender any rights related to these activities on the Land to Entity B (apart from the right to access restricted land detailed above). Hence, there is no further supply made by you as Landholders to Entity B, instead the payments in the Agreement are compensation in respect of any damage caused or likely to be caused to the Land, for example the diminution of the value of the Land, as a consequence of activities being carried out. The Landholder does not provide Entity B with any supply in return for the compensation amounts. As such, the compensation payments made by the company are not consideration for a supply from the Landholder to Entity B, and accordingly no taxable supply will be made by the Landholder. Therefore, the receipt of the compensation amounts by the Landholder from Entity B will not give rise to a GST liability. Further, the Landholders are not registered nor required to be registered for GST as a result of this Agreement.