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Ruling

Subject: Taxation implications of compensation payments on the surrender of commissions

Question 1

Are the payments received in compensation for the surrender of your rights to receive future trail commissions considered ordinary income and assessable under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer: Yes

Question 2

Are the payments received in compensation for the surrender of your rights to receive future trail commissions assessable under the capital gains tax provisions?

Answer: No

This ruling applies for the following period

Year ended 30 June 2008

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commenced on

1 July 2007

Relevant facts and circumstances

The arrangement that is the subject of the private ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are:

· your application for a private ruling.

· letter to the trustee from the purchasing company (Attachment A)

· a further letter to the trustee from the purchasing company (Attachment B)

You run a business as a franchisee.

The business receives income from the franchisor in the form of trail commissions.

The trail commission is paid monthly and varies depending on a variety of factors.

The purchasing company signalled their interest in purchasing the franchise network.

You received a letter from the purchasing company proposing that you surrender your right to future trail commission payments in return for compensation payments based on a specifically calculated value as at particular date in time, with payment to be made monthly over the next X years (the New Payment Regime).

The New Payment Regime proposed only affects products prior to a particular date (the closed book)

Products after this date (the new book), are not affected by the arrangement.

The value was calculated on your circumstances including your personal trail commission rate, the value of your products to a particular date and the average run-off percentage rate.

A deed was executed with the purchasing company confirming the agreement to the New Payment Regime proposed by the purchasing company.

The sale of products to the purchasing company became effective and on that date the purchasing company cemented the new payment regime and gave franchisees seven days notice to have a Deed signed formalising the surrender of their rights to the trail commission established from date of commencement of their franchise to a particular date.

Pursuant to execution of this Deed, you are entitled to receive monthly payments for the next X years.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Subsection 6-5(1)

Income Tax Assessment Act 1997 Subsection 6-5(2)

Reasons for decision

Summary

The payments received in compensation for the surrender of your rights to receive future trail commissions are considered ordinary income. This is because compensation amounts follow the nature of the item that the payment seeks to compensate and in this situation, the amounts received are in replacement for what would otherwise be ordinary income from business.

Detailed reasoning

Are the payments in compensation for future ordinary income?

Subsection 6-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997) defines ordinary income as income 'according to ordinary concepts'. Under subsection 6-5(2) of the ITAA 1997, the assessable income of an Australian resident includes the ordinary income derived directly or indirectly from all sources during the income year.

The tax legislation does not provide specific guidance on the meaning of income according to ordinary concepts. However, a substantial body of case law exists which identifies likely characteristics. Relevant factors in determining whether an amount is ordinary income include:

· It is received periodically

· It is earned as a result of work performed

· It is expected

· It is relied upon; and/or

· It replaces income.

The characterisation of a compensation amount follows the nature of the item that payment seeks to compensate. Thus a compensation payment which replaces an amount that would have been ordinary income, but for the circumstances giving rise to the payment, is itself assessable as ordinary income. The replacement principle is further strengthened where payments are periodic and regular however, a lump sum payment may nevertheless constitute ordinary income.

The purchasing company sent a letter to the Trustee outlining the proposed changes to trail commission payments resulting from the sale of products to the purchasing company. The letter states:

We will not have guaranteed access to the entirety of the value remaining with the selling company to calculate your trail commission payments.

Therefore, we are asking you to surrender your right to trail commission payments in return for which you will receive compensation payments at the value and timing set out below.

The document provides that, in return for compensation, the franchisee is surrendering its right to the trail commissions in respect of the closed book only. That is, the payment is made as compensation for the franchisee giving up the income to which it would have been entitled to receive in the future, if the purchasing company had not acquired the selling company's origination business. Put another way, the franchisee is receiving its income at an earlier date and in a different manner to what it would have received in the future.

When viewed in the context of the purchasing company's acquisition of the selling company's origination business, the compensation payment is made only because the purchasing company could not be guaranteed access to the closed book to calculate the exact amount of the franchisee's trail commissions on dates they would have fallen for payment in the future. Accordingly, the New Payment Regime seeks to ensure the franchisee is paid the trail commissions that are due to the franchisee and would have been paid in the future, but for the inability to access the closed book.

The compensation amount represents a substitution for future trail commissions in relation to the closed book and simply reflects a variation to how the franchisee would otherwise have been paid by the franchisor in respect of the closed book. As the amount is paid in compensation for what would otherwise be ordinary income from business, the compensation amount is similarly characterized, - that is, it is income pursuant to section 6-5 of the ITAA 1997.

Are the payments in compensation for surrendering a franchisee's right to earn trail commissions?

It cannot be said that the payment is in compensation for the franchisee giving up any of its rights as a franchisee (including its right to earn trail commissions). The rights of the franchisee under a franchise agreement constitute a legal chose in action and the right to earn trail commissions is part of the legal chose in action. All that the franchisee has given up is the income it would have received in respect of the closed book only, not the right to earn trail commissions itself. The fact that trail commissions on products other than the closed book are not affected by the New Payment Regime further supports this conclusion.

The source of the trail commissions under the franchise agreement is the services that the franchisee has rendered in selling the approved products. The trail commission is designed to reward a franchisee in circumstances where a customer stays and regarded as flowing from the personal exertion on the part of the franchisee in carrying on the franchisee's business.

Thus the trail commission is paid as remuneration for the services that the franchisee has actually performed in operating the franchisee's business. It is not the produce of the mere contractual right to the trail commissions severed from the bundled rights that comprise the legal chose in action under a franchise agreement. In this sense the reasoning in Federal Commissioner of Taxation v. The Myer Emporium Ltd (1987) 163 CLR 199 applies to hold that the compensation is being received in exchange for, and as the expected present value of, the future trail commissions the franchisee would have received in relation to the closed book. It is a mere conversion of a stream of future income into another stream of future income over a shorter period of time. This is evident from the purchasing company's letter where it was stated that the calculated amount "seeks to give franchisees the same value over five years as the trail payments they would have received over the next 20 years if the closed book were to run-off according to the average performance of the selling company's book".

Furthermore, the periodic, recurring and regular nature of the compensation payments will give the franchisee certainty in cash flow over time (regardless of closed-book performance). This further supports the conclusion that the compensation is in substitution for trail commission payments that would have been income had they been received in the usual manner.

Surrendering the right to the trail commissions with respect to the closed book does not cause a substantial part of the business to be lost nor materially cripple the structure of the business. The franchisee continues to carry on the franchisee's business with all its rights including the right to trail commissions in relation to products other than the closed book.

In this context, you are not considered to have disposed of an intangible capital gains tax (CGT) asset (i.e. the surrender of the right to receive future trail commissions), as the right to earn trail commissions itself, still exists. The compensation payments are considered to be a replacement of ordinary income from business. Accordingly, CGT event C2 (section 104-25 of the ITAA 1997) has not occurred.

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