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Edited version of private ruling

Authorisation Number: 1011534383219

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Ruling

Subject: Assessability of a receipt

Will a payment to compensate for the cessation of current business activities be assessable as income under section 6-5 or any other section of the Income Tax Assessment Act 1997 (ITAA 1997)?

No. The payment is being made to compensate for loss of goodwill not loss of income and is therefore capital in nature and subject to the capital gains tax provisions.

This ruling applies for the following period

1 July 2010 to 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts

You have been operating a small business for a number of years. Over time, the business has acquired a number of clients. One of those clients has made an offer to you to manage their Australian operations. The proposed contract would be for a period of years. The workload involved would prevent you from servicing the other clients of the business and you would have to cease your business relationship with them.

As compensation for the loss of years of business development, the company is proposing to pay your company a certain sum. The shares will be paid to your company and not to you personally. You estimate that you will suffer a loss of a certain amount of income per month as a consequence of losing your other clients. The employing firm is compensating for that loss of income by ensuring that you will receive at least the equivalent amount in additional income from them. That amount is independent of and entirely separate to the payment in question.

Relevant legislative provisions

Section 6-5 Income Tax Assessment Act 1997

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA of the ITAA 1936 to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part. If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA of the ITAA 1936, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

Unless otherwise stated, all legislative references in the following Reasons for Decision are to the Income Tax Assessment Act 1997.

Summary

A compensation amount generally bears the character of that which it is designed to replace. The compensation is a capital receipt and is not ordinary income. Therefore, the compensation is not assessable as income but is subject to the capital gains tax (CGT) provisions.

Detailed reasoning

Subsection 6-5(1) provides that the assessable income of a resident taxpayer includes ordinary income which is 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.

Characteristics of income that have evolved from case law include receipts that:

In the present case, the payment received will not be income from rendering personal services nor income from property. Whilst the sum was related to a business it could not be said to be income in respect of the carrying on a business. The payment is also a one off payment and thus it does not have an element of recurrence or regularity.

A compensation amount generally bears the character of that which it is designed to replace. 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.

An amount received in connection with a contract or agreement made in the course of carrying on a business is usually of an income nature if the amount which it replaces would have been income. On the other hand, if the transaction in respect of which the payment is being received affects the framework of the business or causes a substantial part of the business to be lost then the amount received will be of a capital nature.

When the right to service other clients ceases you will effectively ceased to carry on that business. The amount received is to compensate for the loss of the relationships with other clients, on which the goodwill of the business was founded, and the loss of the means of making profits from undertaking business with those clients after the exclusive contract ceases.

Your company will receive compensation for the loss of a capital asset, that is, the goodwill which had been created since the establishment of the business and the capacity to earn income from it in the future. The compensation is a capital receipt and is not ordinary income. Therefore, the compensation is not assessable as income but is subject to the CGT provisions.

Please note that it will be likely that a C2 CGT event will occur under section 104-25 when the shares are paid, as the payment will relate to the destruction or loss of an asset.

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