Edited version of private ruling

Authorisation Number: 1011824939867

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Ruling

Subject: income or capital

Question 1

Is the payment, received by way of cash and shares, income and taxed as income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

Yes

Question 2

Is the payment, received by way of cash and shares, a capital receipt and included under Part 3-1 of the ITAA 1997?

Answer:

No, as it will be assessed as income.

Income

Assessable income includes the ordinary income derived directly or indirectly from all sources during the financial year under section 6-5 of the ITAA 1997.

Although the tax legislation does not provide specific guidance on what is meant by 'income according to ordinary concepts', a substantial body of case law has evolved to identify various factors that indicate whether an amount is income according to ordinary concepts.

The principle has been established in the High Court in FCT v Myer Emporium Ltd 87 ATC 4363; 1987 163 CLR 199; 18 ATR 693 (Myer Emporium) that profit arising from an isolated business or commercial transaction will be ordinary income if the taxpayer's purpose or intention in entering into the transaction is to make a profit, even though the transaction may not be part of the ordinary activities of the taxpayer's business.

The ATO view on application of the principles outlined in the decision of the Full High Court of Australia in Myer Emporium is set out in Taxation Ruling TR 92/3. This ruling states the ATO view that profits on an isolated transaction may be income. Isolated transactions are those activities that are outside the ordinary course of business of the taxpayer. Profit from an isolated transaction will be ordinary income when:

· the intention or purpose of a taxpayer in entering into the transaction was to make a profit or gain; and

· the transaction was entered into, and the profit was made in the course of carrying on a business operation or commercial transaction.

Mason J stated in FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355 at 378 - 379; 82 ATC 4031 at 4044; 12 ATR 692 at 707; and 39 ALR 521 at 537 (Whitfords Beach):

Unfortunately there is an element of ambiguity in the expressions "business deal" and "operation of business" as there is in the adjectives "business", "commercial" and "trading" which have about them a chameleon-like hue, readily adapting themselves to their surroundings, different though they may be. In some context "business deal" and "operation of business" may signify a transaction entered into by a person in the course of carrying on a business; in other context they denote a transaction which is business or commercial in character.

These comments by Mason J were accepted by and elaborated on by the Full High Court in Myer Emporium at 87 ATC 4363 at 4367; 1987 163 CLR 199 at 199 210; 18 ATR 693 at 697:

Generally speaking, however, it may be said that if the circumstances are such as to give rise to the inference that the taxpayer's intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer's business. Nor does the fact that a profit or gain is made as the result of an isolated venture or a "one-off" transaction precludes it from being properly characterised as income (Whitfords Beach 150 CLR at 366-367; 82 ATC at 4036-4037; 12 ATR at 695-696). The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit.

Taking the comments from the High Court in Myer Emporium and Whitfords Beach into account it can be ascertained that for a transaction to be characterised as a business operation or a commercial transaction it is sufficient that the transaction is business or commercial in nature. Some of the factors to consider when looking at whether an isolated transaction amounts to a business operation or commercial transaction are listed at paragraph 13 of TR 92/3:

(a) the nature of the entity undertaking the operation or transaction;

(b) the nature and scale of other activities undertaken by the taxpayer;

(c) the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained;

(d) the nature, scale and complexity of the operation or transaction;

(e) the manner in which the operation or transaction was entered into or carried out;

(f) the nature of any connection between the relevant taxpayer and any other party to the operation or transaction;

(g) if the transaction involves the acquisition and disposal of property, the nature of that property; and

(h) the timing of the transaction or the various steps in the transaction.

Paragraph 17 of Taxation Ruling TR 92/3 states that where an amount is received for an income stream it will be regarded as ordinary income, the future income becomes present income. This is so even if the income is from a contractual right.

In deciding this case, it is useful to look at some of the court decisions in similar cases. Myer Emporium demonstrates that in circumstances where there is an isolated transaction the profit can be treated as ordinary income. The company carried on a business of retail trading and property development. In order to expand further funds were required. Myer Emporium Ltd loaned money to Myer Finance Ltd at a commercial rate for over seven years. Myer entered into a deed of assignment with Citicorp for the right and interest on the loan for the rest of the period of the loan for a consideration of $45.3 million. This lump sum was held by the High Court to be income even though it arose from an isolated commercial transaction as the taxpayer entered into it with the intention of making a profit. Another part of the decision was that as the lump sum was received for future interest it still held the character of income.

In SP Investments Pty Ltd as trustee for the LM Brennan Trust v. FC of T (1993) 41 FCR 282; 93 ATC 4170; 25 ATR 165 the Full Federal Court examined whether a payment of a lump sum was income. The trustee had acquired an interest in an iron ore venture for which it was entitled to royalties. It assigned these royalty rights to National Mutual Life Association for over seven years for a lump sum of $4 million. As the lump sum was paid in substitution for an income stream it was considered to be revenue in nature, even though the taxpayer was not carrying on a business.

The Full Federal Court also considered whether the taxpayer should be assessed on a lump sum in Henry Jones (IXL) Limited v. FC of T 91 ATC 4663; (1991) 31 FCR 64; 22 ATR 328 (IXL Case). In this case the taxpayer wished to exit the canned fruit industry. It made an agreement with Ardmona and SPC to grant them exclusive use of certain labels for a royalty of 5% of the net value of its sales of canned fruits worldwide for ten years. IXL then transferred the rights to the royalties under this agreement to Canberra Citicorp Pty Ltd for a lump sum of about $7.58 million. The court found that this payment was assessable as ordinary income, as it was an assignment of the right to the royalties converted to a lump sum.

The meaning of a royalty was said to mean a payment "in respect of a particular exercise of a right" when discussed in the IXL Case. A royalty is usually calculated with reference to a quantity when the right is exercised. It therefore has the character of income. Justice Hill in this case considered that Myer Emporium established the principle that a transfer of income from property without the underlying property would be on revenue account, a substitute for income that is to be derived.

An amount received for the cancellation of a contract was considered to be income in Heavy Minerals Pty Ltd v FCT (1996) 115 CLR 512; 40 ALJR 280. The company was involved in rutile mining. Contracts were made to supply overseas companies with the mineral. The following year the customers wished to be released from their agreements, paying a lump sum payment to do so. The High Court considered these payments to be income as the contracts that were cancelled were not part of the capital of the business. The taxpayer still owned the capital assets of the business such as the plant and the mine.

This was the same in Allied Mills Industries Pty Ltd v. FCT 89 ATC 4365; (1989) 20 ATR 457 (1989) 20 FCR 288 (1989) 93 ALR 157 where the company had an agreement with Peak Frean Australia to distribute one its products. This contract was later cancelled and a lump sum payment of $372,700 made to terminate the agreement. The Full Federal Court found this payment to be income as it was for giving up a right that was part of the normal course of its business. It was for the loss of profits that would have come from the previous agreement.

Another case where the characterisation of a receipt was considered was in Kosciusko Thredbo Pty Ltd v. FC of T 84 ATC 4043; 15 ATR 165. In this case the company was in the business of sub-letting apartments in a ski resort. A lease premium that it received was considered by the court to be income as it was just a different way of using the facilities that were the asset of the business.

TR 92/3 states at paragraph 61:

From the above passages, it is clear that if a stream of income can be regarded as flowing from property (rather than merely from a contractual right to that income) consideration received for the transfer of the right - without transfer of the property to which the contractual right relates - is income according to ordinary concepts.

TR 92/3 further states at paragraph 65:

Thus, an amount received for the transfer of a right to an income stream severed from the property to which it relates is income according to ordinary concepts. Future income is simply converted into present income. This is the case even if the income stream is produced by a contractual right rather than by the relevant property.

Access was granted for the other entity to collect plants from the property and use it for a commercial purpose. Payment was to be made quarterly to the taxpayer based on sales. A payment was made of cash and shares to cancel the agreement as well as discharge them from any further claim in relation to the previous agreement. It was a conversion of an income stream to a lump sum, similar to example 10 in paragraph 95 of TR 92/3. In that example the right to rental income was assigned to an unrelated party for a lump sum and regarded as income.

When the payment was received it did not mean the end of the taxpayer's business on the land. It still retained the land and the plants that the rights to income originated from. This transaction was another way of utilising the land from which the taxpayer runs its business. As well as using the land for farming it was also being used to profit from the plants found on the land.

On the basis of the above discussion, this profit is from a commercial transaction entered into to make a profit where a future stream of income was converted to present income without the disposal of the land and plants that the income stream related to. This income is ordinary income and therefore assessable under section 6-5 of the ITAA 1997.

Expenses incurred in earning this income are allowable under section 8-1 of the ITAA 1997 as a deduction.

Capital gains tax

A CGT asset is defined in section 108-5 of the ITAA 1997 and includes any kind of property. This is clarified in Note 1 to subsection 108-5 of the ITAA 1997 where it gives a right to enforce a contractual obligation as an example of a CGT asset.

A capital gain is reduced to zero under section 118-20 of the ITAA 1997 to the extent that it has been included as assessable income.

When you entered into the agreement to cancel your rights under the original agreement there was a CGT. However as the amount received is assessable as income it is not included under the capital gains tax provisions.

Therefore the payment from the entity is not subject to the capital gains tax provisions.

However shares have been acquired in the other company, which are CGT assets. If the shares are sold, CGT event A1 applies by virtue of section 104-10 of the ITAA 1997. Subsection 104-10(4) provides that a capital gain will arise if the capital proceeds from the disposal are more than the asset's cost base.

Summary

The profit received from this agreement is ordinary income and is assessable under section 6-5 of the ITAA 1997.

The cancellation of the agreement is a capital gains tax event but will not be subject to the capital gains tax provisions as the payment is to be treated as income.

CGT will apply, however, to the proceeds from the sale of the shares if they are sold under section 104-10(4) of the ITAA 1997.

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