ATO Interpretative Decision

ATO ID 2004/601 (Withdrawn)

Income Tax

• This ATO ID is withdrawn as a result of amendments to the Income Tax Assessment Act 1997 arising from Tax Laws Amendment (2006 Measures No. 1) Act 2006.
  This document incorporates revisions made since original publication. View its history and amending notices, if applicable.

Issue

Can costs incurred for the removal of a restrictive covenant form part of the fourth element of the cost base or reduced cost base of the taxpayer's contractual rights asset, under subsections 110-25(5) and 110-55(2) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision

Yes. Costs incurred to remove a restrictive covenant may form part of the fourth element of the cost base or reduced cost base of the taxpayer's contractual rights asset, under subsections 110-25(5) and 110-55(2) of the ITAA 1997.

Facts

The taxpayer, a subcontractor, entered into an agreement with a contractor for the provision of subcontract services to clients of the contractor.

The contract contained a restrictive covenant preventing the taxpayer from providing services to the contractor's clients for a period of 6 months from the date the contract ended.

One month before the ending of the contract, the taxpayer made a payment to the contractor for the removal of the restrictive covenant.

Consequently, the restrictive covenant was removed from the contract before the contract ended.

Reasons for Decision

Under section 108-5 of the ITAA 1997 a CGT asset is defined as any kind of property, or a legal or equitable right that is not property. When the taxpayer entered into the agreement with the contractor, the taxpayer acquired contractual rights under the agreement. The Explanatory Memorandum accompanying Taxation Laws Amendment Act (No 4) 1992 states that rights under a contract of personal services are CGT assets. Further, Taxation Determination TD 93/86 states that generally, the totality of rights under a contract is one asset, rather than separate assets. Therefore, in entering into the service contract, the taxpayer has acquired a CGT asset.

Under subsection 110-25(1) of the ITAA 1997 the cost base of a CGT asset has five elements. The fourth element of the cost base includes capital expenditure that is incurred to increase an asset's value, providing that the expenditure is reflected in the state or nature of the asset at the time a CGT event happens: subsection 110-25(5) of the ITAA 1997. The same test applies in respect of the asset's reduced cost base: subsection 110-55(2) of the ITAA 1997.

Therefore, the expenditure incurred to remove the restrictive covenant can only form part of the fourth element of the cost base of the taxpayer's contractual rights asset, if

•

the expenditure has increased the asset's value and

•

it is reflected in the state or nature of the asset when the contract ends

The taxpayer's contract is property and has value, even if the taxpayer is not able to assign it: O'Brien v. Benson's Hosiery (Holdings) Ltd [1980] AC 562; Federal Commissioner of Taxation v. Orica Ltd (1998) 194 CLR 500; 98 ATC 4494; (1998) 39 ATR 66; National Trustees Executors & Agency Co of Australasia Ltd v FCT (1954) 91 CLR 540 at 583. Property without restrictions on its use will inherently be of greater value than the same property which is subject to restrictions.

When the taxpayer removes the restrictive covenant, the value of the property increases. The costs incurred by the taxpayer to remove the restrictive covenant bring about an improvement to the taxpayer's contractual rights asset. The value of the asset increases, because a liability under the contract is released, and the contractor can no longer enforce the contract to restrain the taxpayer from providing services to the contractor's clients in his personal capacity.

In considering whether the expenditure to increase the value is reflected in the 'state' or 'nature' of the asset at the time of the CGT event, the ordinary meanings of these words need to be examined.

The Macquarie Dictionary, 2001, rev. 3rd edn, The Macquarie Library Pty Ltd, NSW, says that the word 'state' refers to the 'condition' of a thing 'as with respect to circumstances or attributes'. It can refer to a 'condition with respect to constitution, structure, form, phase or the like'. The word 'nature,' in relation to a thing, refers according to the Macquarie Dictionary to the 'particular combination of qualities belonging to a thing by birth or constitution; [its] native or inherent character;' or [its] 'character, kind or sort'.

The state of the taxpayer's asset (the attributes of the contract) has been changed by the removal of the restrictive covenant. Therefore not only has the value of the asset been increased, but there has been a change to the state or nature of the asset.

The increased value resulting from the expenditure must be reflected in the state or nature of the asset when the contract ends . The improvement brought about by the expenditure incurred by the taxpayer to remove the restrictive covenant is reflected in the state or nature of the contractual rights before those rights come to an end.

Accordingly, the costs incurred to remove the restrictive covenant can be included in the fourth element of the cost base of the taxpayer's contractual rights asset.

CGT event C2 happens to the taxpayer's contractual rights asset when the contract between the taxpayer and the contractor ends: section 104-25 of the ITAA 1997. The costs incurred to remove the restrictive covenant will be reflected in the state or nature of the contractual rights at the time of the CGT event.

Year of income:  Year ended 30 June 2004

Legislative References:
Income Tax Assessment Act 1997
   section 104-25
   section 108-5
   section 110-25
   subsection 110-55(2)

Case References:
O'Brien v. Benson's Hosiery (Holdings) Ltd
    [1980] AC 562

Related Public Rulings (including Determinations)
Taxation Determination TD 93/86

Other References:
Explanatory Memorandum accompanying Taxation Laws Amendment Act (No 4) 1992
The Macquarie Dictionary, 2001, rev. 3rd edn, The Macquarie Library Pty Ltd, NSW

Keywords
Capital gains tax
CGT cost base
Restrictive covenant

Business Line:  Losses and CGT Centre of Expertise

Date of publication:  23 July 2004

ISSN: 1445-2782