Background

The recognition of water as a precious resource in Australia has led to a proliferation of statutory licensing schemes throughout our various states and territories. In many cases, a water license will feature as a significant asset of a typical primary production business. Moreover, primary producers are increasingly becoming involved in transactions and dealings involving water rights. These include, for example, the sale of water licenses as part of an overarching land and business sale, the trading of water rights or the transfer of water rights between related entities in the course of restructuring private groups.

It is therefore critical for advisers acting for primary producers to have an understanding of the broader legislative regime governing water rights, as well as the particular taxation treatment afforded to water rights under the income tax legislation.

Legal framework

Common law

Historically, landowners have had common law rights to use the water flowing on to their land, to extract water from underground sources and from rivers or streams flowing through or adjacent to their land (known as "riparian water rights").2 These rights were inseparable from the land and were necessarily transferred upon the conveyance of the land. The only limitation on the amount of water that could be extracted was not to interfere with the reasonable usage of other landowners possessing such rights. Moreover, a landowner could have no greater right to water than their interest in the land allowed.

Water rights did not exist as a distinct legal concept and were instead part of the bundle of rights associated with land ownership.3

Statutory licenses

The common law has been largely replaced by legislation in all states and territories4 that provide comprehensive statutory schemes for the regulation of water resources by the issuing of water licenses. This includes water resources in major river systems such as the Murray–Darling Basin and more localized water resources such as aquifers and lakes.

In general terms, the holder of a water license has the right to extract a certain volume of water from a specified water resource for a prescribed use on the terms and conditions of the license. These water resources might include a water course, ground water, springs, dams and other water works.

Relevant state and territory government departments maintain water registers that record and maintain information about water rights and their ownership. However, unlike property registers, there is no overarching concept of infeasibility of title applied to water rights registered on a water register.

Water trading

The volume of water that can be extracted from a specific water source is an important term of the license. This volume is expressed as the water entitlement, being the permanent entitlement to a certain volume of water. The proportion of the entitlement that the license holder may use in a water year is referred to as the allocation. The allocation is subject to change, depending on water availability, environmental flow requirements and relevant state and federal laws. The allocation, entitlement and/or water license are all trade able. In New South Wales, Victoria and South Australia, water rights can be purchased and sold on a permanent or temporary basis by both landowners and non-landowners.

Water trading is most notable within the Murray–Darling Basin, which is Australia’s most active water market. A number of water exchanges have now emerged providing a platform upon which water rights can be traded within the basin with ease.

Water rights as legal property

The separation of water rights from real property provides a basis for water rights to be regarded as legal property.5 Indeed, the legislation in some jurisdictions is highly instructive on this issue. For example, in South Australia, both water licenses and water allocations are deemed to be:

"personal property and may pass to another in accordance with the provisions of the [Natural Resources Management Act 2004] or, subject to this Act, in accordance with any other law for the passing or property."6

The New South Wales legislation, although not specifically stating that water rights are property, provides for a system that treats water rights in a manner similar to real property. For instance, the New South Wales legislation allows for mortgages and caveats to be registered against water licenses.7 Similar provisions exist in both South Australia and Victoria, but the relevant provisions in South Australia are, as at the date of writing, yet to commence.

The recognition of water rights as having a separate legal existence from the land to which those rights relate is fundamental to the taxation treatment of water rights under the income tax legislation, which is explored below.

Taxation implications

Revenue or capital account

The ability for license holders to engage in water trading activities necessitates an assessment of whether gains made from the sale or transfer of water rights may give rise to revenue gains rather than capital gains.

Revenue gains are potentially assessable as ordinary income under s 6-5 of the Income Tax Assessment Act 1997 (Th) (IT AA 1997) and naturally would not qualify for any of the present concessions applicable to capital gains, including the general 50% discount.8

There also remains the possibility that licenses and allocations could be treated as trading stock if transactions were particularly frequent. It is not inconceivable that a taxpayer involved in regular and systematic water trading activities could be regarded as conducting a business of dealing in water entitlements. There has been considerable growth in the marketplace of public companies, fund managers and other large organizations buying and selling water rights. Although a significant proportion of those assets may be leased, some are turned over in the course of trading.

It may also be possible for an isolated transaction involving the acquisition of a water entitlement with an intention to profit on its sale to give rise to ordinary income.9

For the most part, however, water rights owned by primary producers are likely to be regarded as held on capital account and should therefore only give rise to taxation under the capital gains tax (CT) regime.