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Ruling

Subject: capital gains tax small business concessions

Question 1

Will the proceeds received from the sale of the business be assessable under the capital gains tax (CGT) provisions of the ITAA 1997?

Answer:

Yes

Question 2

Do you satisfy the basic conditions necessary to be eligible for the CGT small business concessions?

Answer:

Yes

This ruling applies for the following period

Year ended 30 June 2013

The scheme commenced on

1 July 2012

Relevant facts and circumstances

The taxpayer entered into an agreement to sell their business. The agreement entered into provides that 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.

You state that the company satisfies the small business entity test in relation to the turnover being under $2 million.

Relevant legislative provisions

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

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Paragraph 108-5(1)(a)

Income Tax Assessment Act 1997 Paragraph 108-5(1)(b)

Income Tax Assessment Act 1997 Subsection 104-35(1)

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Subsection 104-10(4)

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Section 110-35

Income Tax Assessment Act 1997 Section 152-10

Income Tax Assessment Act 1997 Section 152-15

Income Tax Assessment Act 1997 Subsection 152-10(1A)

Income Tax Assessment Act 1997 Section 152-35

Income Tax Assessment Act 1997 Section 152-40

Income Tax Assessment Act 1997 Subsection 152-35(1)

Income Tax Assessment Act 1997 Subsection 152-40(1)

Income Tax Assessment Act 1997 Section 152-205

Reasons for decision

Summary

The sale of the business constitutes the disposal of goodwill, a CGT asset, therefore the proceeds received from the sale will be assessable under the capital gains tax provisions.

As you meet all the necessary conditions to be eligible for the CGT concessions for small business you will be able to reduce your capital gain on the disposal of goodwill by utilising the 50% active asset reduction concession.

Detailed reasoning

Assessable as ordinary income

Subsection 6-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997) defines ordinary income as income 'according to ordinary concepts.' Ordinary income has generally been held to include 3 categories, namely income from rendering personal services, income from property and income from carrying on a business.

The proceeds received from the sale of the business, was not income from rendering personal services, income from property or, income from carrying on a business.

Importantly, ordinary income can also include profits on isolated transactions. The sale of a business may be considered an isolated transaction.

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 with the purchaser are 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 by the purchaser 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 it was in a transaction which was regarded as singular or extraordinary). In your case, the information supplied does not indicate that this has occurred in your dealings with the purchaser.

Accordingly, 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 of the ITAA 1997.

Assessable under the capital gains tax provisions

Section 6-10 of the ITAA 1997 provides that assessable income includes statutory income which constitutes amounts made assessable by specific statutory provisions. Such a provision is section 102-5 of the ITAA 1997 which states that capital gains are included in assessable income.

The agreement entered into contains a restrictive covenant in which it stipulates that you agree to provide your services at the new premises for a set period of time. It also specifies that during the period of the agreement and for a period of time 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 of the ITAA 1997, and is either a proprietary right (paragraph 108-5(1)(a) of the ITAA 1997) or a legal or equitable, non-proprietary right (paragraph 108-5(1)(b) of the ITAA 1997). The creation of such a right in favour of the purchaser is a CGT event D1 under subsection 104-35(1) of the ITAA 1997.

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 of the ITAA 1997. Section 104-10 of the ITAA 1997 provides that CGT event A1 occurs when your ownership in a CGT asset (eg. goodwill of a business) is transferred to another entity. The time of the event is when you enter into a contract for the disposal.

Taxation Ruling TR 1999/16 discusses capital gains and the goodwill of a business and explains that if a business owner disposes of their entire business or an interest in their business; goodwill may be transferred with that disposal.

Consequently, two events appear 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 TR 1999/16 is:

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.

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 CGT event A1.

Subsection 104-10(4) of the ITAA 1997 provides that you make a capital gain from an A1 event if the capital proceeds from the disposal are more than the asset's cost base. You make a capital loss if those capital proceeds are less than the asset's reduced cost base.

Cost base for a CGT asset

Section 110-25 of the ITAA 1997 provides that there are five elements of the cost base;

1) money paid, or market value of property given, to acquire the asset

2) incidental costs of acquiring the asset, or that relate to the CGT event that happens to the asset

3) certain non-capital costs of ownership

4) capital expenditure on improvements

5) capital expenditure in respect of title or right to the asset

Section 110-35 of the ITAA 1997 provides that incidental costs include remuneration for the services of a surveyor, valuer, auctioneer, accountant, broker, agent, consultant or legal adviser.

Small business CGT concession eligibility and the active asset test

Section 152-10 of the ITAA 1997 contains the basic conditions you must satisfy to be eligible for the small business capital gains tax (CGT) concessions. These conditions are:

(a) a CGT event happens in relation to a CGT asset in an income year.

(b) the event would have resulted in the gain

(c) 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 of the ITAA 1997

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

(iv) the conditions in subsection 152-10(1A) or (1B) of the ITAA 1997 are satisfied in relation to the CGT asset in the income year.

(a) the CGT asset satisfies the active asset test in section 152-35 of the ITAA 1997.

Section 152-40 of the ITAA 1997 provides the meaning of 'active asset'. A CGT asset will be an active asset at a time if, at that time, you own the asset and the asset was used or held ready for use by you, an affiliate of yours, or by another entity that is 'connected with' you, in the course of carrying on a business. However, an asset whose main use is to derive rent, can not be an active asset.

Sub-section 152-35(1) of the ITAA 1997 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.

Subsection 152-40(1) of the ITAA 1997 provides that an asset is an active asset if the asset is an intangible asset you own and is inherently connected with a business that is carried on (whether alone or in partnership) by you, your affiliate, or an entity connected with you. Goodwill is an asset that is considered to be inherently connected with a business. As goodwill is necessarily employed as an active asset throughout the period that it is held, the active asset test is satisfied.

Accordingly, based on the information provided, you satisfy all the necessary basic conditions to be eligible for the CGT concessions for small business.

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