Edited version of your private ruling

Authorisation Number: 1012605180483

Ruling

Subject: Lump sum payment to medical officer for working in medical centre

Questions and Answers:

1. Does your receipt comprise a derivation of income under the ordinary concepts as outlined in section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes.

2. Does your receipt, or any part thereof, comprise a capital gain in respect of CGT event D1 under section 104-35 of the ITAA 1997?

No.

3. Are the small business CGT concessions under Division 152 of the ITAA 1997 available to you in relation to the transaction?

No.

This ruling applies for the following period

Year ending 30 June 2014

The scheme commenced on

1 July 2013

Relevant facts and circumstances

You received a lump sum payment (the "purchase price") from the purchasing company under a contract referred to as "Sale of Practice". You were approached by the company to relocate from one centre and to practice at the company's centre.

Under the contract, you must operate from the company's premises and engage the support services of the company at the exclusion of any others for a period of X years. However, there is scope for you to extend the contract for another X years. In the situation where you extend your contract, you will be paid a further separate lump sum payment.

Other relevant terms and assumptions of the contract include:

n The company must provide services to you, such as clerical staff, administrative services and facilities

n You must provide your own equipment

n You must attend the company's practice and provide a specified number of hours of service In a year, which includes weekends, evenings and public holidays;

n Upon entering into the Sale of Practice contract, you must also enter into an agreement and during the restraint period, which spans the term of the agreement, you must not provide services within a X kilometre radius of either the old premises or the new premises with penalties for failing to do so.

n You "owned" a practice at the Old Premises.

n You sold a practice conducted from the Old Premises, including the goodwill of the practice.

n Excluded from the sale of the practice conducted from the Old Premises are: (a) title, lease or other arrangements under which you occupied the old premises; (b) arrangements with suppliers of services used by you at the Old Premises; (c) any obligations you may have had in relation to employees at the Old Premises; and (d) any debts owed by you in relation to the Old Premises.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 104-35

Income Tax Assessment Act 1997 Section 118-20

Income Tax Assessment Act 1997 Section 995-1

Reasons for decision

Summary

Personal skills, knowledge and reputation are not capital in nature. As a practitioner, you are an independent contractor, earning income from the exercise of your personal skills, in your personal services business. You are not earning income through a business structure that you own. It follows the restrictive covenant you are subject to ties your provision of personal services (which is revenue in nature) rather than restrains a business structure (of a capital nature). Also, the courts have held payments similar to your $X payment are revenue in nature.

Detailed reasoning

No business structure

Section 995-1 of the ITAA 1997 states the term 'business' includes any profession, trade, employment, vocation or calling, but does not include occupation as an employee.

In ATO ID 2011/87, the Commissioner ruled sole medical practitioners are not employees. In the Commissioner's Decision Impact Statement on Primary Health Care Limited v Commissioner of Taxation [2010] FCA 419; 2010 ATC 20-181; 76 ATR 749, the Commissioner classified a medical practitioner that worked in a medical centre as an "independent contractor".

In paragraphs 103 and 104 of Taxation Ruling TR 2001/14 (about non-commercial business losses), the term 'business structure' is described as a structure that provides the framework of the business or their profit yielding subject; usually a collection of capital assets. It states:

For a business activity to commence, an appropriate business structure should also be in place. As to what this structure will consist of, and its size, this will be a question of fact and degree, and depend on the nature of the business activity. A suitable structure might even be established by the execution of certain documents, where independent contractors with the necessary capital assets are engaged. Even though the taxpayer may have no physical assets themselves, their rights as against the independent contractor secure use of such assets, and those rights can properly be said to be capital assets in the taxpayer's hands. However, each case will need to be determined on its own facts and having regard to industry norms.

Paragraphs 262 and 263 of Taxation Ruling TR 2001/8 (about a personal services business) make the following distinctions between a 'personal services business' and a business using 'business structure':

The question whether a particular situation is one where the income of an independent contractor, whether carried on as a sole trader or through an interposed entity, is in reality produced predominantly from the personal services of an individual or in reality from income producing assets of the entity or the entity's business structure is subject to the factual circumstances of the case. Taxation Ruling TR 2001/7 outlines the factors that are relevant.

Assessable income is generated from a very wide spectrum of activities, ranging from income derived solely as a result of the taxpayers personal skill and effort to income derived solely from the use or sale of assets, or from a business structure. The courts have not articulated a clear dividing line between personal service income and income from property (assets) or from a business structure, other than that the more substantial the assets (and investment) the more likely that they are to be the main generators of the income. Where only an asset exists (and there is no other indicator of a business structure), the contribution of the asset has to be balanced against the skills and effort of the relevant individual to determine the main source of the income.

Paragraphs 12 and 59 of Taxation Ruling TR 1999/16 (about the goodwill of a business) state:

Goodwill is a composite thing. It is one whole. It is an indivisible item of property that is legally distinct from the sources from which it emanates. It is something that attaches to a business and is inseparable from the conduct of a business. It cannot be dealt with separately from the business with which it is associated.

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. Similarly, if key employees of the sole practitioner are not employed by the purchaser on the disposal of the business, any part of the goodwill that emanates from their personality, reputation, skills or attributes is also 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.

Paragraphs 70 and 71 of Taxation Ruling TR 95/35 (about compensation receipts) state:

In determining which is the most relevant asset, it is often appropriate to adopt a 'look-through' approach to the transaction or arrangement which generates the compensation receipt. We regard this concept as the most appropriate basis on which to determine whether any capital gain arises on the disposal of any asset of the taxpayer.

Warner J in Zim Properties v. Procter (Inspector of Taxes) [1985] STC 90; 58 TC 371 applied this look-through approach in determining from which asset the settlement sum was derived. His Honour considered that the choice of which was the most relevant asset depended on the 'reality of the matter'.

In your case, we consider your old practice was not a business structure since it did not comprise of a collection of assets (per TR 2001/14) and was merely a kind of business that derived income solely as a result of your personal skill and effort (per TR 2001/8). Your equipment is not a CGT asset (since it is a depreciating asset). We believe our view that your old practice was not a business is supported by clause 3.1 in your Sale of Practice contract, which has 'exclusions from sale' assets that would ordinary comprise of a business structure (such as lease rights). Since goodwill is something that attaches to a business and since goodwill (that emanates from personal reputation and skills) cannot be dealt with or transferred separately from the business with which it is associated (per TR 1999/16), using a 'look-through approach' (per TR 95/35), we consider a bona fide sale of goodwill, as purported in your Sale of Practice contract, did not occur.

For the same reasons, we consider your new practice is not a business structure since it comprises of no assets (apart from your personal skill and reputation, which is not a CGT asset) that are saleable or transferable by you.

Not capital proceeds from entering into restrictive covenant

Section 104-35 of the ITAA 1997 states CGT event D1 happens if you create a contractual right or other legal or equitable right in another entity. It provides the following 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.

Taxation Ruling TR 95/3 states a restrictive covenant is an agreement between two or more parties to refrain from doing some act or thing (paragraph 6); that a restraint of trade implies that a person has contracted to give up some freedom which otherwise he would have had (paragraph 34); that a restraint of trade entitles the covenantee to protect an interest, which will usually be an interest in property, typically the goodwill of a business (paragraph 39).

In distinguishing the relevant tax treatments, paragraph 17 of TR 95/3 states:

…if a restrictive covenant relates both to a current period of employment…the portion of the consideration received that relates to the period of employment is assessable under [section 6-5]…

That portion also comes within…[section 104-35, CGT event D1]…if the restrictive covenant was entered into on or after 26 June 1992.

The portion of the consideration that relates to the period after the end of the employment is assessable under [section 104-35]….

[Section 118-20] applies to reduce any capital gain to the extent that the amount is assessable as ordinary income.

Paragraphs 128 to 136 of TR 95/3 provide the following two examples of restrictive covenants:

Penelope enters into an employment contract with her employer Tracey Bros. The terms of the contract require her to remain with her employer for three years to develop certain trade secrets and on termination of the contract, Penelope is prevented from entering into competition with Tracey Bros for a further two years. In consideration for entering into the contract, Penelope receives $500,000; the contract states that $200,000 relates to the current period of employment and $300,000 relates to the period after employment. That portion of the receipt which relates to employment is assessable under…[section 6-5] because that term of the contract comes into effect immediately. The portion relating to the period following the employment is assessable as a capital gain under…[section 104-35] (with… [section 104-155] as a backup).

Oil Co has made a lump sum payment to Pricecatch, the proprietor of XXON Service Station under an agreement tying Pricecatch to selling and promoting one brand of petrol to her customers. The agreement for the supply of only Oil Co's products to be sold at the service station is an exclusive trade tie. The payment is made as an inducement and Pricecatch has committed herself for the first time to the restriction of one brand trading. Under the agreement, Pricecatch covenants she will not conduct any service station business, other than at XXON; and she will not allow her land to be leased or sub-leased to any person. In consideration for accepting these restrictions, Oil Co pays the sum of $100,000 to Pricecatch. These receipts are of a capital nature as distinct from periodical payments which can be linked to the business operations. Since the payment is not assessable income by…[section 6-5] as a business receipt,…[section 104-35] applies.

Taxation Ruling No 2307 deals with the decision of Taxation Board of Review No. 3 reported as Case R123, 84 ATC 791; Case 4 28 CTBR 13, where It was held that a payment to a VHL footballer did not constitute assessable income because the contract was construed to restrain the taxpayer earning income from a former sporting profession. The judgment said:

It may be that the payment of $11,000 did incorporate some factor relating to a signing-on fee which, in itself, may have been assessable income, but there is not the slightest evidence on which a separate and distinct signing-on fee may be quantified. Accordingly, we find that the lump sum of $11,000 represented a payment for the sterilization of the taxpayer's professional foot-running career and would reduce the assessment by excising that amount from the assessable income.

In FC of T v Cooling 90 ATC 4472 (Cooling), it was held where a business taxpayer is given a cash incentive to enter into a lease of business premises, the incentive is income of the taxpayer because: (i) the leasing of the premises occupied are acts of the taxpayer in the course of its business activity, just as much as the trading activities that give rise more directly to the taxpayer's assessable income; and (ii) the transaction entered into by the firm was a commercial transaction; the purpose of it was to obtain a commercial profit by way of the incentive payment.

In FC of T v Montgomery 99 ATC 4749; 42 ATR 475 (Montgomery), the inducement received by the taxpayer for executing an agreement to lease business premises was held by the majority to be ordinary income. The majority said:

The inducement amounts received by the firm did not augment the profit-yielding structure of the firm. The lease was acquired as part of that structure; the inducement amounts were not.

…the firm used or exploited its capital (whether its capital is treated for this purpose as being the agreement to take premises or its goodwill) to obtain the inducement amounts…the firm was then "of a size which makes it a particularly attractive tenancy target''…The firm used or exploited its capital in the course of carrying on its business, albeit in a transaction properly regarded as singular or extraordinary...

In McLean v FCT; Dean v FCT (1996) 32 ATR 647 (McLean), retention payments made by a parent company to the senior managers of a subsidiary, as an incentive to ensure they remained in the employ of the subsidiary after it was sold, were assessable as ordinary income. Northrop J found that, in substance and reality, the payments were the product of the managers' income-earning activities and that the "continual employment was at the very heart of the receipt".

In your case, we consider your payment was not for a restrictive covenant of a capital nature (per the example of Oil Co in TR 95/3) that restricted a business structure (you owned) and tied it to exclusively operate from a new premise. We previously explained our view why we consider you did not operate under a business structure but, instead, provided personal services as an independent contractor.

Also, we consider your payment was not for a restrictive covenant of a capital nature (per the examples in section 104-35 and Case R123) that sterilized you from conducting a certain business or profession. If that was the case you would not have had to work at the new practice but, instead, merely had to cease working at the old practice.

Since the restrictive covenant in your contract tied you to providing your personal services (as an independent contractor) for a period of X years in the new practice, despite not being an employee, we consider your restrictive covenant is revenue in nature (per the example of Penelope in TR 95/3).

Since the restrictive covenant in your contract tied you to using the premises and services provide by the new centre, which are revenue expenses connected to the day-to-day earning of your assessable income, we consider your contract was similar to the kind of lease inducement in the case Cooling, which was revenue in nature.

Since the restrictive covenant in your contract and the payment you received was connected to the quality of your personal reputation and skills, which made you an "attractive target", we consider your payment is revenue in nature (per the examples of Montgomery and McLean). As previously stated (per TR 1999/16) your reputation and skills are not, in themselves, capital in nature.

Isolated commercial transaction

Taxation Ruling TR 92/3 is about whether profits on isolated transactions are income, i.e., whether an isolated transaction is a 'commercial' (rather than capital) transaction. Paragraphs 7 and 9 state:

The relevant 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.

The taxpayer must have the requisite purpose at the time of entering into the relevant transaction or operation. If a transaction or operation involves the sale of property, it is usually, but not always, necessary that the taxpayer has the purpose of profit-making at the time of acquiring the property.

Paragraph 40 of TR 92/3 includes the case of Cooling as an example of an isolated commercial transaction, where Hill J said:

In my view the transaction entered into by the firm was a commercial transaction; it formed part of the business activity of the firm and a not insignificant purpose of it was the obtaining of a commercial profit by way of the incentive payment. This result accords with common sense. The firm had the alternative of paying less rent and therefore obtaining a smaller tax deduction for its outgoings or paying a higher rent …and therefore obtaining a larger tax deduction but receiving an amount in the form of assessable income.

In your case, we consider your payment was a commercial transaction, with the purpose of obtaining a commercial profit (per TR 92/3 and Cooling).

Anti-overlap provisions

Should the Commissioner have erred in concluding your payment was not related to the disposal and/or acquisition of CGT assets, such payments are considered to be receipts from an isolated commercial transaction.

It follows the anti-overlap provisions in section 118-20 of the ITAA 1997 would operate to reduce any capital gain arising as a result of relevant CGT events by the amount of income assessed under section 6-5 of the ITAA 1997.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).