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Ruling

Subject: Restraint of trade amount

Question 1

Is the payment received considered to be ordinary income that is assessable under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)

Answer

No.

Question 2

Is the payment received considered to be capital proceeds that must be used to calculate a capital gain that is assessable as statutory income?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts

The entity operates a business that supplies products and services.

The entity entered into a Deed of Payment (payment deed) with the payer and received an amount of money.

Under the terms of the payment deed, the entity agreed to only promote and sell the payer's products.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 104-35

Reasons for decision

Ordinary Income

Summary

The payment amount received is not assessable as ordinary income under 6-5 of the ITAA 1997 as it is considered capital in nature

Detailed reasoning

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year.

Based on case law, it can be said that ordinary income generally includes receipts that:

· are earned;

· are expected;

· are relied upon; and

· have an element of periodicity, recurrence or regularity.

Characteristics of a capital receipt include:

· being paid in a lump sum, that is, not received periodically,

· being a one-off payment, that is a payment made once and for all; and

· being expected but not relied upon.

The lump sum payment received from the payer does not have an element of periodicity, recurrence or regularity as it is a one off payment. Also, it is not a normal receipt earned from the regular everyday operations of the business. Rather, it is a one-off payment made once and for all in exchange for entering into an exclusive dealing contract. The payment is considered to be capital in nature rather than ordinary income.

Capital Gain

Summary

By entering into the agreement the entity has created a right and CGT event D1 has occurred. The capital gain consists of the proceeds received less any associated incidental costs. The capital gain forms part of the entity's assessable income.

Detailed reasoning

Amounts that are not ordinary income can be included in assessable income by specific legislative provisions. These amounts are called statutory income.

Capital gains are statutory income.

You make a capital gain only if a CGT event happens.

CGT event D1 occurs when you create a legal, contractual or equitable right in another entity (section 104-35 of the ITAA 1997). The time of the event is when you enter into the contract or create the other right (Subsection 104-35(2) of the ITAA 1997).

CGT event D1 will occur where a taxpayer enters into a restrictive covenant.

For example:

You enter into a contract with the purchaser of your business not to operate a similar business in the same town. The contract states that $20,000 was paid for this. You have created a contractual right in favour of the purchaser. If you breach the contract, the purchaser can enforce that right.

You make a capital gain if the capital proceeds from creating the right are more than the incidental costs you incurred that relate to the event. You make a capital loss if those proceeds are less.

You paid a lawyer $1500 to draw up the contract. Therefore, you make a capital gain of: $20,000 - $1500 = $18,500

Taxation Ruling TR 95/3 states that restrictive covenants which would be subject to capital gains tax include exclusive dealing contracts tied to a product or to the supply of services.

In this case the payer has made a lump sum payment to the entity under an agreement tying the entity to selling and promoting only the payer's products to its customers. The agreement for the supply of only the payer's products to be sold by the entity is an exclusive dealing contract. Therefore, CGT event D1 occurred when the entity entered into the agreement.

The capital gain the entity must include in its assessable income consists of the capital proceeds less any incidental costs that relate to the event.

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