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This edited version has been archived due to the length of time since original publication. It should not be regarded as indicative of the ATO's current views. The law may have changed since original publication, and views in the edited version may also be affected by subsequent precedents and new approaches to the application of the law.

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Edited version of your written advice

Authorisation Number: 1012767755764

Ruling

Subject: Lump sum payment

Question 1

Is the lump sum payment received from entity A assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Is the lump sum payment received from entity A included in your assessable income as a capital gain from CGT event D1?

Answer

No.

Question 3

If the answer to question 2 is yes, will you be able to access the small business concessions under Division 152 of the ITAA 1997?

Answer

Not applicable as the answer to question 2 is no.

This ruling applies for the following period

Year ended 30 June 2014

The scheme commenced on

1 July 2013

Relevant facts

You are a professional.

You commenced working in your field several years ago.

Over the next several years you built up your business.

In 20XX you commenced discussions with entity A.

Entity A offered you the opportunity to move to centre C in city B.

The offer with entity A included several significant commercial and personal benefits for you.

You commenced working with entity A.

The next month you entered into an Agreement with entity A to work for a X year period.

Pursuant to the Agreement and in return for a % payment of your gross fees, you were relieved of the significant commercial and personal burden associated with the substantial administrative work at your previous work place.

As a result you had the opportunity to concentrate on your professional work.

In consideration for you entering into the Agreement for a fixed term and for agreement to certain restraints, entity A agreed to make a lump sum payment.

Under the agreement if you breach the conditions of the agreement you must pay entity A a payment for each whole month remaining until the term of the expiry of the agreement at the time of the breach.

Relevant legislative provisions

Income tax Assessment Act 1997 Section 6-5

Income tax Assessment Act 1997 Section 17-5

Income tax Assessment Act 1997 Section 102-5

Income tax Assessment Act 1997 Section 104-35

Income tax Assessment Act 1997 Section 118-20

Reasons for decision

Ordinary assessable income

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes the ordinary income they derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

The legislation does not provide any specific guidance on what is meant by 'income according to ordinary concepts'. However, a substantial body of case law has evolved to identify various factors that indicate whether an amount is income according to ordinary concepts.

In Scott v Commissioner of Taxation (NSW) (1935) 35 SR (NSW) 215; 3 ATD, Jordan CJ stated:

A frequent characteristic of income receipts is an element of periodicity, recurrence or regularity, even if the receipts are not directly attributable to employment or services rendered (FC of T v Dixon (1952) 86 CLR 540 and FC of T v Blake 84 ATC 4661).

However, periodicity, recurrence or regularity is not always essential for an amount to be income. For example, the proceeds of an isolated transaction, even if received as a lump sum, may be income (FC of T v Myer Emporium Ltd 87 ATC 4363), while instalments of a capital sum, even though received regularly from one source, are not income. Equally, an unsolicited lump sum payment which is unlikely to be repeated is generally not income according to ordinary concepts (FC of T v Harris 80 ATC 4238), while lump sum damages will nevertheless be assessable where they are compensation for losses of an income nature only.

Further, personal earnings from the performance of services, whether as an employee or otherwise, are clearly income even if the services are performed, and/or the rewards received, irregularly.

It is also important to determine the character of the payment in the recipient's hands (Scott v FC of T (1966) 117 CLR 514 at p. 526; Hayes v FC of T (1956) 96 CLR 47 at p. 55; Federal Coke Co. Pty. Ltd. v FC of T (1977) 34 FLR 375 at p. 402 per Brennan J. That does not mean that the motive of the person in making the payment will be irrelevant but it will not be determinative. The test to be applied will be objective rather than subjective (Hayes at p. 55).

Based on the Agreement, the payment made to you appears to have been a one-off lump sum payment by entity A to you. Thus, it is necessary to consider whether the payment has the character of income.

Incentive/ inducement payments

Based on case law precedents, incentive/inducement payments paid to taxpayers as lump sums can be assessable income.

Lump sum payments made to two taxpayers to ensure they remained in employment was held to be assessable income in McLean & Anor v FC of T (1996) 32 ATR 647; 96 ATC 4443 (McLean) and Dean & Anor v FC of T (1997) 37 ATR 52; 97 ATC. In the Federal Court decision in McLean, Northrop J stated the following at 96 ATC 4447:

In Pickford v FC of T 98 ATC 2268; 40 ATR 1078 (Pickford), the taxpayer was an employee of E Ltd who had been granted options to purchase ordinary shares in his employer's parent company pursuant to an employee share scheme. However, the options would lapse immediately if the taxpayer ceased to be an employee of E Ltd.

W Ltd made an offer of employment to the taxpayer which included a payment of $20,000 as compensation for the potential capital gain that may have been available to the taxpayer in respect of the shares to which he would have been entitled had he remained an employee of E Ltd.

The Commissioner ruled that the payment was assessable as ordinary income, and affirmed this decision at the objection stage.

At the Administrative Appeals Tribunal, DJ Trowse (Member) upheld the Commissioner's decision, stating at page 2271 that:

It is also the Australian Taxation Office (ATO) view that the lump sum retention bonuses paid by the Australian Defence Forces (ADF) in order to encourage serving members to remain within the ADF for a fixed period are assessable as ordinary income (see ATO Interpretative Decision ID 2003/373). Notably, where these ADF members failed to complete the required period of service, they were contractually obliged to repay part of the retention bonus based on the incomplete part of the service.

Application to your circumstances

As stated in the Agreement, the amount paid to you was paid, prime facie in consideration for you entering into the Agreement for a fixed term. Indeed, where you breached the terms of the Agreement, or entity A terminated it, you were required to pay back an amount of the lump sum payment for each whole month remaining until the term of the Agreement expired. It can thus be concluded that the character of the payment in your hands was an inducement for you to provide your services to entity A for the duration of the Agreement (in association with an agreement to abide by the 'restraint' provisions of the Agreement both for the term of the service and for six months afterward). As per the decision in Pickford, the payment was thus an 'integral part' of the Agreement, being part of '…a single bundle of entitlements…', and a 'straightforward inducement' to secure your future services for entity A over the period of the Agreement. It is also analogous to the retention bonus payments made to ADF members, which required a repayment of the lump sum to the extent the taxpayer did not complete the contracted period of service.

It is acknowledged that the payment made to you was in the context of a business rather than employment relationship. However, it is considered that the principles established in these case law decisions in relation to such incentive/inducement payments are equally applicable to a business service contract.

On that basis, the amount received by you is considered to be assessable as ordinary income under section 6-5 of the ITAA 1997.

Isolated transaction

It is also arguable that the payment made to you is assessable as a business profit or gain, including a gain made as part of an isolated transaction.

Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income provides guidance for determining whether profits from isolated transactions are assessable as ordinary income under section 6-5 of the ITAA 1997. Paragraphs 6-8 of the Ruling state:

Thus, in order to determine whether your motive for entering into the transaction was to make a profit it is necessary to consider your intention or purpose from an objective consideration of the facts and circumstances rather than your subjective intention or purpose.

Discussing the decision in FC of T v. Cooling [1990] FCA 204; 90 ATC 4472; 21 ATR 13, paragraph 50 of TR 92/3 states that:

Application to your circumstances

In your ruling application, it is contended that you entered into the Agreement for commercial and personal reasons and that profit-making by reason of receiving the lump sum payment was not a significant purpose.

In the ruling application, it is further contended that the payment was not a reward for services.

However, your statements are not consistent with the full terms of the Agreement accepted by you. According to the Agreement, the payment was clearly made to you by entity A for only two stated purposes being:

Thus, based on the 'facts and circumstances of the case…', we cannot accept that the objective purposes of the payment was limited to those contended in the ruling application. Rather, viewed objectively, the significant purpose of the payment is directly stated in the Agreement to be you entering into an agreement to provide services, and for your agreeing to abide by restraints placed on you by entity A during the course of this service and for a period afterward.

Thus, it is considered that objectively, your intention or purpose in entering into the transaction was to make a profit or gain from your agreement to provide services to entity A, including a profit or gain through the receipt of the lump sum payment.

Commercial transaction

You entered into the Agreement with entity A in the course of carrying on your business as a professional. Indeed, the Agreement and the payments made under it solely relate to you entering into the arrangement under which you would provide your services for a fixed period, and would agree to be bound in the undertaking of this business by certain restraints of trade.

As contended by you, it is considered that the payment was not received as part of a transaction which was outside the course of your normal business. Rather, it was directly related to the gaining of profit or gain from the undertaking of this business through the Agreement with entity A.

It is considered that the transaction represented by the Agreement '…was entered into, and the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction.'

Indeed, as per Cooling, it is considered that the:

By entering into the Agreement and receiving a lump sum which is directly related to your business of deriving personal services income, it is considered that the transaction meets the requirements of paragraph 6 of TR 92/3 as a gain or profit arising from an isolated transaction, and that this gain was not made outside the ordinary course of your business.

Capital gains

Under subsection 102-5(1) of the ITAA 1997, your assessable income includes your net capital gain (if any) for the income year. A net capital gain is worked out in accordance with the method statement set out in subsection 102-5(1) of the ITAA 1997.

A capital gain or loss arises when a CGT event occurs. A summary of CGT events is set out in section 104-5 of the ITAA 1997.

Section 104-35 of the ITAA 1997 deals with CGT event D1 and states the following:

Taxation Ruling TR 95/3 Income tax and capital gains: application of subsections 160M(6) and 160M(7) to restrictive covenants and trade ties sets out the ATO view on the taxation treatment of consideration received for granting restrictive covenants and trade ties. For the purposes of the Ruling, a restrictive covenant is an agreement between two or more parties to refrain from doing some act or thing.

The Ruling considers the taxation treatment of payments for restrictive covenants under former subsections 160M(6) (which has been replaced by section 104-35 of the ITAA 1997) and 160M(7) of the ITAA 1936 (which has been replaced by section 104-155 of the ITAA 1997) both before and after the 1992 amendments to those provisions. Despite the fact that the Ruling refers to former subsections 160M(6) and (7) of the ITAA 1936, which have now been repealed, it applies in the same way to the rewritten provisions.

Paragraphs 17-19 of TR 95/3 state the following:

The following example, which assists in explaining how this principle would work in practice, is set out at paragraphs 128 and 130 of TR 95/3, as follows:

Application to your circumstances

As the payment under the Agreement is not solely for the restraints you agreed to both during the period of the Agreement and for a short period after it ended, it is considered that the principles set out in TR 95/3 do not apply in this case.

The restraints follow as a natural consequence of the positive obligations of you to provide full-time services for entity A for a period and as such, it is considered that no part of the payment made relates specifically to the restraints. That is, the payment is prime facie an inducement paid to you in order to obtain your services for a period.

Even if part of the payment was considered to be in respect of the restraint after the Agreement ceased, it is not possible to apportion the amount attributable to that restraint as the payment under the Agreement is a lump sum and there is no evidence that there was any separate bargaining/negotiation regarding that restraint.

Furthermore, under the Agreement, you are required to repay an amount for each whole month remaining until the term of the expiry of the Agreement if entity A terminates the Agreement in accordance with its terms or you breach the Agreement. This means that if the Agreement was terminated in the first month, you would be required to pay back the whole of the payment. This further indicates that no amount paid under the Agreement is attributable to the restraint after the Agreement ends.

Finally, even if the lump payment was considered to be assessable as a capital gain arising from CGT event D1, the amount of that capital gain would be reduced to nil under section 118-20 of the ITAA 1997 as a result of the payment also being included in your assessable income under section 6-5 of the ITAA 1997.


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