Where a landowner agrees to a restrictive covenant of any kind, extreme care is needed to consider any potential capital gains tax liability and ensure it is properly built into relevant contract documents.
The ATO is vigilant regarding covenants of all kinds, including settlement agreements involving covenants that restrict or restrain future activity. Examples include:
- a sale of business contract in which covenants restrict the operation of a similar business,
- an employment contract that restricts a period of employment.
Payments in return for the compulsory acquisition of an easement may be treated as capital proceeds on the part disposal of land. The grant of a right to take timber may be a CGT event at the contract date incurring immediate liability, rather than at the date when the trees are ultimately felled.
In respect of a restrictive covenant burdening land, the ATO may treat the restriction as the disposal of an underlying asset, despite the burden registered onto the land. The ATO regards a restrictive covenant as a distinct equitable interest in land[1] and, therefore, an asset for CGT purposes.
The grant of a restrictive covenant is also a taxable supply of a real property interest or right for GST purposes if the grantor is registered (or required to be registered) and the grant is in the course of carrying on an enterprise. The grantee, if registered (or required to be registered) having paid consideration for the covenant in the course of carrying on an enterprise, is entitled to an input tax credit.
Where the grant of a restrictive covenant forms part of an overall agreement involving multiple compromise strands, the ATO will require the covenant portion of the settlement to be apportioned on some reasonable basis. It has no clear guidelines as to what will be deemed ‘reasonable’. On audit, the ATO will focus on what is the underlying asset to which the agreed payment relates.
Extreme care is needed to anticipate CGT in any settlement and ensure any written agreement correctly addresses a potential future ATO inquiry.
KA has experience in complex cases involving land agreements where taxation issues arise.
We are happy to address such complex issues.
Contact Dr Leonie Kelleher OAM
22 August 2023
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This fact sheet is intended only to provide a summary and general overview on matters of interest. It does not constitute legal advice. You should always seek legal and other professional advice which takes account of your individual circumstances.
[1] Newton Abbot Co-operative Society Ltd v Williamson & Treadgold Ltd (1952) Ch 286.