Edited version of your private ruling

Authorisation Number: 1012602592189

Ruling

Subject: Treatment of income

Question

Should an amount received on 1 July 2013 be declared as assessable income in the 2013-14 financial year?

Answer

No

This ruling applies for the following period

Year ending 30 June 2014

The scheme commenced on

1 July 2013

Relevant facts

You were a partner in a professional partnership.

The firm does not have a partnership agreement but is governed by another document.

By reason of your admission to the partnership, as a partner, you were subject to the requirements and conditions of that document.

A Deed of Release was entered into by the partnership and you on a date before 1 July 2013.

The partnership and you agreed that your retirement date would be on a date after 30 June 2013. After the signing of the Deed of Release you continued to work for the partnership until your retirement date which was after 30 June 2013.

The partnership will pay you, from its relevant financial year profit pool, a payment calculated as an estimate of the profit share at the operative date (being the date of execution of the deed i.e. before 1 July 2013).

The payment will be payable as a lump sum on the retirement date.

You were paid that lump sum on 1 July 2013 being an estimate of the profit share.

Relevant legislative provisions

Income Tax Assessment Act 1997 Paragraph 108-5(2)(d)

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Subsection 104-25(3)

Income Tax Assessment Act 1997 Paragraph 104-25(2)(a)

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)

Reasons for decision

Summary

The lump sum payment, paid by the Partnership, to you under a Deed of Release, is considered a receipt of capital and not ordinary income.

This is because you have surrendered a CGT asset (your partnership interest) and the amount received on the surrender represents a distribution of your share of the equity of the Partnership and not a distribution of the net income of the Partnership.

Detailed reasoning

The nature of a receipt, for the purposes of the Income Tax Assessment Act 1997 (ITAA 1997), is determined from the point of view of the recipient rather than that of the payer. Therefore, despite how your payment is described in the Partnership accounts or on your retirement statement, it is the nature of the receipt in your hands which determines how it is assessed.

The lump sum payment was not a distribution of the net income of the partnership, but a distribution of your share of the equity of the Partnership. Therefore, the receipt by you of the lump sum under the Deed of Release is not assessable as ordinary income and instead is considered a receipt of capital and will be assessable under the capital gains tax provisions.

Your retirement from the Partnership meant that you gave up your interest in the Partnership, and in any assets of the Partnership. Paragraph 108-5(2)(d) of the ITAA 1997 provides that a partner's interest in a partnership is a CGT asset. It is a chose in action.

Taxation Ruling IT 2540 examines the capital gains tax (CGT) implications of a disposal of a partnership interest. Though it is expressed in terms of the former CGT provisions (of the Income Tax Assessment Act 1936) the discussion is still relevant for the purposes of the ITAA 1997. At paragraphs 13 and 14 it states:

For large partnerships, which can have memberships numbering in the hundreds (for example, some major legal and accountancy partnerships) the situation is potentially complex. In some cases, the potential problems are overcome because the ownership of the assets used by the partnership is vested in a service company or trust. In other cases, it will generally be accepted, provided the evidence reasonably supports the conclusion that the partners are dealing with each other at arm's length. Any consideration paid or received on the acquisition or disposal of an interest in the partnership will be used for Part IIIA (CGT) purposes in determining the cost base or disposal proceeds of the interests in the partnership assets that the partnership interest represents. This will mean that if, for example, the partnership arrangement is such that no amount is payable for the acquisition or disposal of goodwill, it will be accepted for the purposes of Part IIIA (CGT) that the value of the goodwill is nil. This treatment will also apply to partners of smaller partnerships who deal with each other at arm's length, where those dealings take place in an ordinary commercial context.

In the case of large professional partnerships, where the partners' dealings with each other are at arm's length, it will only be where consideration is paid by a partner on entering the partnership or where a partner receives a payment on leaving the partnership that Part IIIA (CGT) will have any practical effect. Where consideration is neither paid by a person on entering the partnership, nor received on retirement from the partnership, the partner will not realise a capital gain or incur a capital loss on the disposal of particular assets. However, as noted above, the admission or retirement of a partner may affect the proportionate ownership of the partnership assets by the individual partners and therefore may affect the extent of a continuing partner's interest in the partnership. This would be relevant in the event of a subsequent disposal of the partnership assets for consideration, or where consideration is paid to a partner on retirement from the partnership.

Section 104-25 of the ITAA 1997 states that CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset:

a) being redeemed or cancelled; or

b) being released, discharged or satisfied; or

c) expiring; or

d) being abandoned, surrendered or forfeited; or

e) if the asset is an option - being excised; or

f) if the asset is a convertible interest - being converted

The time of the event 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.

An interest in a partnership is considered an intangible asset.

The capital gain the taxpayer makes from CGT event C2 is equal to the difference between the proceeds received from the event happening and the cost base of the asset (subsection 104-25(3) of the ITAA 1997).

In your case, your interest in the Partnership was a CGT asset. As a result of leaving the Partnership your interest in the Partnership has ended and CGT event C2 happened. The event happened before 1 July 2013 as this is when the agreement between the parties that resulted in the resignation was made (paragraph 104-25(2)(a) of the ITAA 1997). You made a capital gain equal to the difference between the payment you received from the Partnership and the cost base of your interest in the Partnership.

Restrictive covenant

The Deed of Release entered into contains a restrictive covenant in which it stipulates that you will, among other things not solicit or endeavour to solicit or entice away from the partnership any clients, partners or employees of the partnership.

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. 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 partnership is a CGT event D1 under subsection 104-35(1) of the ITAA 1997.

In your case, the Deed of Release contains exclusive dealing and restraint clauses. These clauses satisfy the definition of a restrictive covenant and CGT event D1 will happen at the time the contract is entered into.

However, as it is considered that you were dealing at arm's length in entering into the agreement and, no proceeds were specifically allocated to a restrictive covenant, we will treat the granting of the covenant as being ancillary to the surrender of your partnership interest.

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 surrender of your partnership interest and is attributable to CGT event C2.

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