Edited version of private ruling

Authorisation Number: 1011853164070

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Ruling

Subject: The timing of CGT event and determination of condition precedent

Issue 1

Question

What year are the capital gains on the sale of X Pty Ltd's rights to distribute Y products taxable - year ending 30 June 2011 or year ending 30 June 2012?

Answer

Year ending 30 June 2011

Issue 2

Question

Is there a condition precedent in the Transition and Release Agreement that means the contract does not come into force until 31 March 2012?

Answer

There is a condition precedent in the Transition and Release Agreement which was met on X Pty Ltd signing it in April 2011 and hence not prevented from coming into force until 31 March 2012.

Relevant facts

X Pty Ltd and Y (a foreign entity) entered into an agreement (the Distributor Agreement) whereby X Pty Ltd received the right to distribute Y's products in certain international territories (the Territory) as described in the Distributor Agreement.

With the purpose of ceasing the commercial relationship between X Pty Ltd and Y, a Transition and Release Agreement (Agreement) was drawn to be effective on X Pty Ltd signing the Agreement.

The Agreement states that provided X Pty Ltd properly execute and return this agreement to Y on or before mid April 2011, this Agreement will become effective immediately on the date X Pty Ltd executes this Agreement. That section further states that if X Pty Ltd fails to execute and return this Agreement by the deadline stated, this Agreement shall be deemed withdrawn and shall be null and void and of no further force or effect.

The recital of the Agreement defines X Pty Ltd as the Distributor.

X Pty Ltd informed ATO that it signed the Agreement before the deadline (early April 2011) given in the Agreement for execution.

The Recitals to the Agreement states the reason behind entering into the Agreement is to agree upon certain terms and conditions which will replace certain terms of the Distributor Agreement and govern the business relationship between the parties during the Transition Period in exchange for Y making a Transition Payment to X Pty Ltd. The Agreement further states the desire of the parties to release each other of all claims they may have against each other and agree, on these terms as well as other conditions contained in the Agreement.

The Agreement defines Transition Period as the period commencing on the Effective Date and continuing through and including the Transition Date. Transition Date is defined as 31 March, 2012.

The Agreement outlines the obligations of both parties during Transition Period. While the terms and conditions of the Distributor Agreement will continue to apply to both parties, the terms and conditions of the Agreement would also apply to the parties as if they are amendments to the Distributor Agreement. This section includes order deadline and shipment deadline. In addition, X Pty Ltd is required to transfer to Y all registration rights and URLs owned and used by X Pty Ltd in connection with the sale of Y products. A detailed procedure as to how inventory of the unsold Y products is to take place and how the compensation for the unsold products is to be paid are also included. Transition of any business relation with sub distributors engaged by X Pty Ltd in the sale of the Y products and disclosing of their details to Y is required of X Pty Ltd.

After the Effective Date, X Pty Ltd is required not to engage in any diversion activities of Y products or hold or sell any Y products. Both parties are to execute and deliver mutual releases in the form of Exhibit A, within 7 days from Transition Date and Exhibit B, just before the final instalment of the Transition Payment. A transition of Y's customers is to be undertaken by X Pty Ltd in a way that towards the end of 2011, Y would be able to contact these customers directly.

In addition, X Pty Ltd is also to provide Y on or before mid November 2011, a list of the customers who purchased any Y's products during 2010 and 2011. During the transition period, X Pty Ltd is required to maintain distribution of the Y products. If X Pty Ltd breaches any obligation of the Agreement or the Distributor Agreement, Y will have the right to sell, promote or market its products in the Territory in addition to similar rights under the Distributor Agreement.

The Agreement specifies the procedures of payment during and after the Transition Period. During the transition period, both the parties are to continue payment under the Distributor Agreement except the final payment which will be paid in nine monthly instalments. After the transition period, Y will make Transition Payment to X Pty Ltd for continued compliance with the Agreement and the Distributor Agreement, in three instalments, followed by satisfaction of certain conditions, namely inventory, release of customer list etc.

In the event that Y considers that X Pty Ltd is in breach or has not complied in full with any of its obligations, it shall give X Pty Ltd notice of such breach or non-compliance and X Pty Ltd is to have 14 days within which to remedy the breach or non-compliance.

Under the Agreement, X Pty Ltd acknowledges that as of certain date, Y is free to establish its own distribution operation in the Territory. Each party acknowledges that the Agreement is executed and delivered for adequate consideration and valid, binding and enforceable in accordance with its terms. Each party also acknowledges that they had enough time to consider the terms of the Agreement and discussion with legal counsel and that no duress has been used to execute the Agreement.

Under the Agreement, X Pty Ltd is to release Y of any claim relating to payment or other obligation under Distributor Agreement or forever refrain from instituting lawsuit against Y. However this does not apply to Y's obligation to make the transition payment. Upon discharge of X Pty Ltd's obligations in relation to inventory, it is released from all obligation under Distributor Agreement or the Agreement except for any continuing obligations under sections of the Agreement. Similar undertaking is also taken by Y releasing X Pty Ltd of any claims and covenanting not to sue X Pty Ltd.

Other provisions of the Agreement deal with mechanism to facilitate and to carry out the covenants between the two parties agreed under this Agreement.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 104-25(1)

Income Tax Assessment Act 1997 subsection 104-25(2)

Income Tax Assessment Act 1997 subsection 108-5(1)

Reasons for decision

Issue 1

Question 1

Summary

The capital gain on the sale of X Pty Ltd's right to distribute Y products is taxable in the year ending 30 June 2011.

Detailed reasoning

According to paragraph 104-25(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997), CGT event C2 happens if the ownership of an intangible CGT asset ends by the asset being released, discharged or satisfied.

Subsection 108-5(1) of the ITAA 1997 defines CGT asset as:

(a) any kind of property; or

(b) a legal or equitable right that is not property.

X Pty Ltd's right to distribute Y products in the Territory is a CGT asset under paragraph 108-5(1)(b) of the ITAA 1997.

Under subsection 104-25(2) of the ITAA 1997, the time of the CGT event C2 is:

(a) when you enter into the contract that results in the asset ending; or

(b) if there is no contract - when the asset ends.

In this case, the Agreement is the contract that was entered into between X Pty Ltd and Y to end their commercial relationship during the Transition Period and by the Transition Date.

The Agreement states that the Agreement is made effective as of the Effective Date. The Agreement defines the Effective Date as the date X Pty Ltd signs and executes the Agreement prior to mid April 2011. X Pty Ltd has informed ATO that the Agreement was signed by it in early April 2011. Therefore, the Agreement was effective in early April 2011.

Since the CGT event C2 happened in early April 2011, the CGT would be payable in the income year ending 30 June 2011.

Issue 2

Question 1

Summary

There is a condition precedent in the Agreement but that does not prevent the Agreement to come into force until 31 March 2012 as the condition has already been met in early April 2011.

Detailed reasoning

The difference between conditions precedent and subsequent was discussed in the case Perri v Coolangatta Investments Pty Ltd (1982) 149 CLR at 511 where Mason J observed that:

There is an obvious difference between the condition which is precedent to the formation or existence of a contract and the condition which is precedent to the obligation of a party to perform his part of the contract and is subsequent in the sense that it entitles the party to terminate the contract on non-fulfilment. In the first category the transaction creates no rights enforceable by the parties unless and until the condition is fulfilled. In the second category there is a binding contract which creates rights capable of enforcement, though the obligation of the party, or perhaps of both parties, to perform depends on fulfilment of the condition and non-fulfilment entitles him to terminate.

And later at 552:

Generally speaking the court will tend to favour that construction which leads to the conclusion that a particular stipulation is a condition precedent to performance as against that which leads to the conclusion that the stipulation is a condition precedent to the formation or existence of a contract. In most cases it is artificial to say, in the face of the details settled upon by the parties, that there is no binding contract unless the event in question happens. Instead, it is appropriate in conformity with the mutual intention of the parties to say that there is a binding contract which makes the stipulated event a condition precedent to the duty of one party, or perhaps of both parties, to perform. Furthermore, it gives the courts greater scope in determining and adjusting the rights of the parties. For these reasons the condition will not be construed as a condition precedent to the formation of a contract unless the contract read as a whole plainly compels this conclusion. (emphasis added).

In the present case, the Agreement states very clearly that if the Distributor, which is X Pty Ltd, fails to execute and return the Agreement by the stated deadline, namely mid April 2011, the Agreement shall be deemed withdrawn and shall be null and void and of no further effect. If X Pty Ltd had not executed the Agreement prior to the stated date, the contract would not have come into existence.

The High Court of Australia has considered the distinction between condition precedent to the formation of the contract and conditions to the performance of a contract in Meehan v Jones (1982) 149 CLR 571. The case involved a contract for the sale of land which contained a number of conditions including that the agreement was subject to the purchaser obtaining finance and that it was also subject to the purchaser entering into an agreement with a petrol supplier for crude oil.

In the case, Gibbs CJ states that every "such case must depend on the particular words of the contract in question, and that it is not profitable to compare with each other cases decided on different contractual provisions".

The legal issue revolved around the question of whether these conditions rendered the contract "illusory" so that a binding contract had or had not been created. In particular, the vendor argued that the condition left a discretion or option to the purchaser to decide whether he would carry out the contract. Gibbs CJ in rejecting this argument illustrated that, in his view, the characterisation of a conditional contract and an option arrangement were very closely related. At page 582, he stated as follows:

The submission on behalf of the [vendors]… was that the condition left discretion or option to the purchaser to decide whether he would carry out the contract and that the purported contract was therefore illusory. In my opinion, that principle does not apply where the discretion or option of the contracting party relates, not to the performance of the contractual obligations themselves, but only to the fulfilment of a condition upon which the contract depends. That this is so is illustrated by the case of an option to purchase which is, in many cases at least, a contract to sell the land upon condition that the grantee gives the notice and does the other things stipulated in the option …. Such an option gives the grantee a right, if he performs the stipulated conditions, to become the purchaser. However the fact that the grantee has discretion as to whether or not he performs those conditions does not render the option illusory. The case of a conditional agreement is analogous. The fact that the condition is one whose performance lies wholly or partly within the power of one of the parties to the contract does not mean that there is no binding contract once the condition is fulfilled.

In the context of conditional takeover offers, the Commissioner has stated in Taxation Determination TD 2002/4 (TD) that it is important to clearly understand the nature and effect of particular conditions of a contract. The TD also draws a clear distinction between a condition precedent to the formation of the contract and a condition precedent subsequent to the formation of the contract.

The TD states that, where the condition is a conditional contract is a condition precedent to the formation or existence of the contract, effectively no contract is formed until the condition is complied with.

Paragraph 5 of the TD states that:

5. It is important to clearly understand the nature and effect of particular conditions of a contract. There is a clear difference between a condition which is precedent to the formation or existence of a contract (referred to in this Taxation Determination as a 'condition precedent to the formation of a contract') and a condition which is precedent to the obligation of a party to perform their part of the contract (referred to in this Taxation Determination as a 'condition precedent to performance of a contract'). In the former case, non-fulfilment of the condition prevents a binding contract from coming into existence. No contractual rights enforceable by the parties are created unless and until the condition is fulfilled. In the latter case, a binding contract exists which creates rights capable of enforcement, though the obligation of a party to the contract (or perhaps of both parties) to perform their part of the contract depends on fulfilment of the condition. Non-fulfilment of the conditions entitles one or both parties to terminate the contract.

Paragraph 8 of the TD states some examples to explain the difference between condition precedent and subsequent as follows:

8. The status of a particular condition depends on the intention of the parties to the contract as expresses in their contract but will usually be described in the offer documents issued by a 'bidder company'. For example, the takeover offer that SingTel Australia Investment Ltd made in respect of C&W Optus Limited shares (see Class Ruling CR 2001/17) was subject to a condition precedent to formation of the contract that the Treasurer raises no objections to the takeover under foreign investment policy. The offer that Wesfarmers Retail Pty Ltd (Wesfarmers) made to Howard Smith Limited (Howard Smith) shareholders (see Class Ruling CR 2001/51) was subject to a condition precedent to performance of the contract that Wesfarmers acquire ownership of 90% of the shares in Howard Smith.

Where there is a condition subsequent, it is accepted generally that a contract has been made. Condition subsequent is a contract with condition precedent to the performance of a contract. It does not prevent the contract coming into existence. If a condition subsequent is not satisfied, then the aggrieved party may have a number of remedies including specific performance, damages or a rescission of the contract.

In the present case, the main purpose of the Agreement is to wind up the commercial relationship between X Pty Ltd and Y, which they entered into under the Distributor Agreement. Once X Pty Ltd signs the Agreement within the specified deadline, the Agreement becomes effective immediately.

From the Effective Date till the Transition Date, which is the Transition Period, X Pty Ltd has to undertake various actions, namely carry out the inventory, releasing the customer list to Y, transiting customers to Y, winding up X Pty Ltd's business relationship with any other sub distributors engaged by it to sell and distribute Y products in the Territory and so on. On fulfilment of certain conditions, namely release of customer list and inventory of the Y products, Y undertakes to pay X Pty Ltd Transition Payment in various stages. Both parties covenant to release each other of any legal actions and execute release forms once the required conditions of the Agreement are satisfied. Other obligations and conditions in the Agreement are inserted to facilitate the carrying out of the main obligation of the Agreement, namely ceasing of the commercial relationship between X Pty Ltd and Y.

Therefore, once the Agreement is signed and becomes effective, there is no condition precedent to the formation of the contract, rather condition precedent to the performance of the contract. Breaches or non-performance of any provision of the Agreement does not make the entire Agreement null and void as the Agreement allows X Pty Ltd certain days to remedy the breach or non-compliance. Also the Agreement gives both parties right to enforce specific performance of the Agreement and seek injunctive relief.

However, if the Agreement is not executed by X Pty Ltd prior to mid April, 2011, there would be no contract at all.

In the example given in the TD at paragraph 8, the takeover contract between SingTel Australia Investment Ltd and C&W Optus Limited would take effect only if the Treasurer raises no objection under foreign investment policy. In the present case, the contract will come only into existence once it is signed and executed by X Pty Ltd. The rest of the conditions in the Agreement relates to the performance of the contract, non-compliance of which would give the parties certain rights to enforce the non-compliance.

Therefore, signing and executing the Agreement before mid April 2011 is the condition precedent to the formation of the contract rather than conditions precedent to the performance of the contract. However, since the condition is satisfied when it was signed and executed by X Pty Ltd in early April 2011, it will not prevent the contract to come into force until 31 March 2012.

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