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Ruling

Subject: Capital Gains Tax - treatment of goodwill

Question 1

Does the receipt of an amount by the taxpayer from the purchaser in respect of goodwill constitute a derivation of income under ordinary principles under section 6-5 or any other provision of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Does the payment, or any part thereof, received by the taxpayer represent capital proceeds in respect of CGT event D1 under section 104-35 of the ITAA 1997?

Answer

No. It is an A1 event.

Question 3

Is the receipt of the payment, or any part thereof, disregarded under section 104-10(5) of the ITAA 1997?

Answer

Yes.

Question 4

Does all or part of the receipt otherwise comprise assessable income under any other provision of the ITAA 1997?

Answer

No.

Question 5

Are the basic conditions to qualify for the small business CGT concessions in Division 152 of the ITAA 1997 satisfied?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 2011

The scheme commences on:

1 July 2010

Relevant facts and circumstances

The taxpayer was approached by representatives from a company wishing to acquire his business. After negotiations, the taxpayer entered into a sale. The only significant asset of the business was goodwill.

The contract included the provision of services by the taxpayer to the purchaser. The taxpayer will render services from the new premises of the purchaser for several years. For some years thereafter, the taxpayer must not render services or conduct business at any place within a set radius of the business premises of the purchaser. The purchaser will supply services to the taxpayer at the new premises.

The taxpayer is a small business entity.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 104 -35

Income Tax Assessment Act 1997 Section 108-5

Reasons for decision

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

Question 1

Detailed reasoning

Assessable income is made up of ordinary income under section 6-5 and statutory income under section 6-10. Subsection 6-5(1) defines ordinary income as income 'according to ordinary concepts.' Ordinary income can include profits on isolated transactions.

Taxation Ruling TR 92/3 discusses whether profits on isolated transactions are income. TR 92/3 provides the following guidelines which can be applied to your circumstances:

§ If a transaction or operation is outside the ordinary course of a taxpayer's business, the intention or purpose of profit-making must exist in relation to the transaction or operation in question (paragraph 10).

§ It is not necessary that the profit be obtained by a means specifically contemplated (either on its own or as one of several possible means) when the taxpayer enters into the transaction (paragraph 14).

§ The intention or purpose of the taxpayer (of making a profit or gain) is not the subjective intention or purpose of the taxpayer. Rather, it is the taxpayer's intention or purpose discerned from an objective consideration of the facts and circumstances of the case (paragraph 38).

§ It is not necessary that the intention or purpose of profit-making be the sole or dominant intention or purpose for entering into the transaction. It is sufficient if profit-making is a significant purpose (paragraph 40).

§ The taxpayer must have the prerequisite purpose at the time of entering into the relevant transaction or operation (paragraph 41).

§ It is not our view, nor has it ever been, that all receipts or profits of a business are income. For example, when a taxpayer derives a profit from a transaction outside the ordinary course of carrying on its business and the taxpayer did not enter that transaction with the purpose of making a profit, the profit is not assessable income (paragraph 44).

In the present case, the transaction is clearly outside your ordinary course of carrying on a business. Your intention or purpose in entering into the transaction must be discerned from an objective consideration of the facts and circumstances.

The main elements of your agreement that in return for the payment and the services to be provided by the purchaser, you were to sell the business including the goodwill and provide exclusive services using the premises of the purchaser for a certain period of time. It cannot be said that you are entering into this transaction with a significant intention or purpose of making a profit as required in paragraphs 40 and 44 of Taxation Ruling TR 92/3.

The payment made to you could constitute income as an inducement or reward as considered in FC of T v. Montgomery (1999) 164 CLR 435; (1999) 198 CLR 639; (1999) 42 ATR 475; 99 ATC 4749. In Montgomery's case, the firm in question was able to use its capital to obtain a good inducement offer to take premises. The use of its capital was considered to be in the course of carrying on its business, although in a transaction which was regarded as singular or extraordinary. In your case, the information supplied does not indicate that such occurred in your dealings. Consequently, the definition of ordinary income would not extend to the payment received and it would not constitute ordinary income for the purposes of section 6-5.

Ordinary income has also been held to not include capital receipts. However, some amounts not assessable as ordinary income under section 6-5 may be specifically made assessable under particular provisions by virtue of the operation of section 6-10.

Question 2

Detailed reasoning

Section 6-10 provides that assessable income includes statutory income which constitutes amounts made assessable by specific statutory provisions. Such a provision is section 102-5 which states that capital gains are included in assessable income.

The agreement entered into stipulates that you agree to provide your services for a period of several years. It also specifies that during the period of agreement and for some years thereafter restrictions apply as to where you can provide your services.

The Commissioner's definition of a restrictive covenant in subparagraph 6(a) of Taxation Ruling TR 95/3 is 'an agreement between two or more parties to refrain from doing some act or thing'. Examples of restrictive covenants are provided in paragraph 35 of TR 95/3 and include:

§ a covenant by an employee to an employer in which the employee promises to refrain from doing some act (e.g. not to disclose special processes, trade connections and trade secrets of the employer);

§ a restrictive (negative) covenant preventing an employee from competing in another business or opening a new business;

§ a restriction on competition, enforced by an agreement separate from an employment agreement, which comes into effect after employment ceases;

§ a contract of employment stipulating exclusive service by the employee during its term

A right created under a restrictive covenant is a CGT asset which is separate from the goodwill of a business. Such a right constitutes a CGT asset as defined in section 108-5, and is either a proprietary right (paragraph 108-5(1)(a)) or a legal or equitable, non-proprietary right (paragraph 108-5(1)(b)). The creation of such a right in favour of the purchaser is a CGT event D1 under subsection 104-35(1).

In your case, the contracts contain exclusive dealing and restraint clauses. These clauses satisfy the definition of a restrictive covenant and CGT event D1 will happen at the time the contracts are entered into.

Goodwill is also listed as a CGT asset under section 108-5, and the sale of goodwill is a CGT event A1 under section 104-10. Such an event took place when the business, including the goodwill of the business and all other developed goodwill, was sold.

Consequently, two events seem to have occurred at the time of the contract: a right created under a restrictive covenant and the sale of goodwill. The Commissioner's view on the relationship between a restrictive covenant and goodwill in Taxation Ruling TR 1999/16 is:

105. The value of goodwill and the granting of a restrictive covenant on the sale of a business are inextricably linked. The absence of a covenant may be reflected in a lower price being paid for goodwill. The presence of a restrictive covenant tends to indicate the parties really do transfer some goodwill, though this is by no means conclusive. As the High Court majority justices said in the Murry case, the lack of competition from an enforceable restrictive covenant may enhance the goodwill of a business: 98 ATC at 4591; 39 ATR at 138.

106. If a vendor and a purchaser of a business, dealing at arm's length and having given proper thought to the appropriate value of a restrictive covenant, do not separately allocate any part of the capital proceeds to a restrictive covenant, we will treat the granting of the covenant as being ancillary to the disposal of the goodwill of the business. We will accept that no part of the capital proceeds is attributable to the restrictive covenant.

We consider that as you were dealing at arm's length in transacting the sale and in allocating the capital proceeds and, as no proceeds were specifically allocated to a restrictive covenant, we will treat the granting of the covenant as being ancillary to the disposal of the goodwill of the business in accordance with the views expressed in TR 1999/16.

We therefore accept that no part of the capital proceeds is attributable to the restrictive covenant CGT event D1. The total of the capital proceeds is for the goodwill as per the Commissioner's stated position in TR 1999/16 and is attributable to the CGT A1 event.

Question 3

Detailed reasoning

The contract which you have entered into includes a payment in respect of goodwill. The transferability of goodwill is discussed in Taxation Ruling TR 1999/16 at paragraph 59 which states:

If a sole practitioner disposes of their business, the part of the goodwill of the business that emanates from their personality, reputation, skills or attributes is not transferable. … However, other sources of goodwill continue to draw custom to the business even though the owner or employee has no further connection with the business and, in that respect, the goodwill can be sold.

That goodwill is a CGT asset is confirmed in paragraph 108-5(2)(a). The disposal of the goodwill in the present case will constitute an A1 event.

Capital gains events A1 which predate 20 September 1985 are disregarded under paragraph 104-10(5)(a). In order to determine the appropriate treatment of the payment in this case, it is necessary to determine the extent to which the payment received represents pre and post CGT components.

TR 1999/16 makes clear that the whole of the goodwill of a business is either pre-CGT goodwill or post-CGT goodwill. The goodwill of a particular business cannot be characterised as partly pre-CGT goodwill and partly post-CGT goodwill. Goodwill is a composite asset. The ruling states at paragraph 89:

The goodwill of a business that commenced before 20 September 1985 remains a pre-CGT asset provided the same business continues to be carried on. As the majority justices of the High Court said in the Murry case (98 ATC at 4594; 39 ATR at 143), 'as long as the business remains the "same business" (cf Avondale Motors (Parts) Pty Ltd v. FC of T (1971) 124 CLR 97), the goodwill acquired or created by a taxpayer is the same asset as that which is disposed of when the goodwill of the business is sold or otherwise transferred'. For a business that commenced before 20 September 1985, any accretion to its goodwill since 20 September 1985 is not a post-CGT asset.

Consequently, where goodwill exists in a business that commenced prior to 20 September 1985, that goodwill will be an exempt pre CGT asset. The ruling notes that a business or the sources of its goodwill may conceivably change so much that it can no longer be said to be the same business as that previously conducted i.e. the old business and its goodwill effectively ceases and a new business commences. That is, pre-CGT goodwill can become post-CGT goodwill.

In the present case, discussions with your tax agent have established that the goodwill is entirely post-CGT. As a result, the provisions of paragraph 104-10(5)(a) do not apply and any capital gain in respect of the goodwill will not be disregarded.

Question 4

Detailed reasoning

The receipt is not assessable as ordinary income under section 6-5. There is no provision by which it otherwise becomes assessable income.

Question 5

Detailed reasoning

In order to gain access to the small business concessions, the basic conditions in section 152-10 must be met. The basic conditions are:

a) that a CGT event happens to the asset;

b) the event would have resulted in the gain in question;

c) that at least one of the following applies:

(i) you are a small business entity for the income year;

(ii) you satisfy the maximum net asset value test in section 152-15;

(iii) you are a partner in a partnership that is a small business entity for the income year and the CGT asset is an interest in an asset of the partnership;

(iv) the conditions mentioned in subsection (1A) or (1B) are satisfied in relation to the CGT asset in the income year;

d) that the relevant CGT asset satisfies the active asset test in section 152-35.

Both a) and b) are satisfied and the information supplied indicates that the requirements of c) are satisfied by virtue of being a small business entity.

On that basis, the basic conditions will be met if the requirements of paragraph 152-10(1)(d) are satisfied. That means that the active asset test in section 152-35 must be passed.

Sub-section 152-35(1) states that a CGT asset satisfies the active asset test if:

§ you have owned the asset for 15 years or less and the asset was an active asset of yours for a total of at least half of the period of ownership, or

§ you have owned the asset for more than 15 years and the asset was an active asset of yours for a total of at least 7 and a half years.

Therefore, there are effectively two conditions required to pass the test. Firstly, the asset must be an active asset and secondly it must have been used as such for at least half of the period that it has been held or seven and a half years if held for more than fifteen.

The meaning of an active asset is provided in section 152-40. Sub-section 152-40(1) states:

(1) 'A CGT asset is an active asset at a time if, at that time:

(a) you own the asset (whether the asset is tangible or intangible) and it is used, or held ready for use, in the course of carrying on a business that is carried on (whether alone or in partnership) by:

(i) you; or

(ii) your affiliate; or

(iii) another entity that is connected with you; or

(b) if the asset is an intangible asset - you own it and it is inherently connected with a business that is carried on (whether alone or in partnership) by you, your affiliate, or another entity that is connected with you.

Note 3 to sub-section 152-40(1) expressly includes goodwill as example of an asset that is inherently connected with a business.

Paragraph 152-40(4)(e) qualifies the definition by listing classes of assets which would not constitute active assets. However, none of those exclusions are applicable in the present case. As a result, the goodwill would fall within the definition of an active asset in subsection 152-40(1).

As goodwill is necessarily employed as an active asset throughout the period that it is held, the active asset test is satisfied and the conditions of section 152-35 are met. Consequently, all of the basic conditions in section 152-10 to qualify for the small business concessions have been met.

As qualification for the small business fifty per cent reduction in section 152-205 requires only satisfaction of the basic conditions, it will therefore become available at that point. Some of the other concessions require further conditions to be fulfilled as detailed in the relevant sections.

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