Edited version of your written advice

Authorisation Number: 1013053189095

Date of advice: 15 July 2016

Ruling

Subject: A lump sum payment

Question 1

Is the lump sum payment received 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 included in your assessable income as a capital gain?

Answer

No.

This ruling applies for the following period

Year ended 30 June 2015

The scheme commenced on

1 July 2014

Relevant facts

You are a professional.

You entered into an agreement between you and entity A.

You received a payment from entity A.

Under the terms of the agreement you are to provide services for a specified period.

Under the agreement you and entity A are not partners and are not in an employer/employee relationship.

Relevant legislative provisions

Income tax Assessment Act 1997 Section 6-5

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

Goodwill

Goodwill is a capital gains tax (CGT) asset as defined in subsection 108-5(2) of the ITAA 1997. Taxation Ruling TR 1999/16 Income tax: capital gains: goodwill of a business explains the legal definition of goodwill as discussed by the High Court in FC of T v. Murry 98 ATC 4585; (1998) 39 ATR 129:

12. … goodwill is the product of combining and using the tangible, intangible and human assets of a business for such purposes and in such ways that custom is drawn to it. The attraction of custom is central to the legal concept of goodwill. Goodwill is a quality or attribute that derives among other things from using or applying other assets of a business. It may be site, personality, service, price or habit that obtains custom. It is more accurate to refer to goodwill as having sources than it is to refer to it as being composed of elements. 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.

Taxation Ruling TR 1999/16 also discusses the transferability of so-called 'personal goodwill':

127. What judicial decisions have referred to as 'personal goodwill' is the source of goodwill comprised of the particular personal skills and abilities, reputation, character and personality possessed by persons working in a business. These personal attributes are so intimately identified with, and inseparably attached to, the particular persons that if those persons withdraw from the business the value of its goodwill diminishes. They are inherently unique to the individual and they are not things that are capable of transfer or assignment.

128. Although the personal skills and attributes of a business owner or employees that have contributed to goodwill are not transferable, the fact remains a purchaser might be prepared to pay money for the goodwill built up from those attributes and other sources. Other sources of goodwill of a business, including the habit and inertia of customers, will continue to draw custom to the business: Murry case at paragraph [37] (98 ATC at 4593; 39 ATR at 141) and paragraph [52] (98 ATC at 4596; 39 ATR at 145). The goodwill of the business is transferable.

Application to your circumstances

In your case, the payment represented a payment to you for your "personal goodwill", which may be best described as your good reputation. In such circumstances, the key relevant aspects of the decision in Murry are:

• Goodwill is correctly identified as property because it is the legal right or privilege to conduct a business in substantially the same manner and by substantially the same means that have attracted custom to it (being a right or privilege that is inseparable from the conduct of the business).

• Goodwill is to be distinguished from its sources which are incapable of being disposed of as separate elements of goodwill (albeit that some may be disposed of in their own right to the extent that they are property).

That is, any goodwill in your case would have resulted from your personal skills and attributes, and therefore as discussed in paragraph 128 of TR 1999/16, this goodwill is not transferable. It would continue to attach to you during the relevant period.

It follows that there was no disposal of goodwill, being the right to conduct a business in substantially the same manner and by the same means conducted previously by you. The right to carry on business as a professional remained with you. Entity A acquired no right to carry on that business either at the old premises or at the new premises as a result of the contractual arrangements entered into with you. Those arrangements do not provide you to act as an employee in a business that has been acquired by entity A, nor do they otherwise indicate that the relevant business is to be carried on by entity A rather than by you.

Furthermore, based on the Murry case, your professional reputation ("personal goodwill") is not capable of disposition as an element of goodwill separately from the right to conduct the business. Professional reputation is also not property capable of disposition in its own right.

Accordingly, the payment is not considered to be for the disposal of goodwill.

It is therefore necessary to consider the nature of the payment.

Characterisation of the payment

The characterisation of the receipt in the hands of the recipient is necessary in order to determine the nature and character of the payment. Such characterisation is decided in light of the facts, the true nature of the transaction and the arrangement. Such a characterisation is not restricted solely to the documents executed. All relevant circumstances should be taken into account.

Hence, in examining the character of the obligations and relationship established under the legal documents, the true nature of the obligations and relationship are not determined by the labels given to them.

The main legal obligation imposed on you for entering into these agreements is that you provide l services for a period at entity A's premises.

Ordinary assessable income

Subsection 6-5(2) of the 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.

Earnings from the performance of services, whether as an employee or otherwise, are generally ordinary assessable income even if the services are performed, and/or the rewards received, irregularly. That is, a receipt will constitute income according to ordinary concepts if it is a receipt arising out of a taxpayer's employment or business activities. This will be so even if the receipt is not directly related to any service provided by the recipient to the donor - FC of T v. Dixon (1952) 86 CLR 540; 5 AITR 443; 10 ATD 82 (Dixon's case).

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 (Dixon's case 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 (1987) 163 CLR 199; [1987] HCA 18; 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.

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).

Whether a receipt is income must always depend on a consideration of the whole of the circumstances.

In Re Porter: re Transport Workers Union of Australia (1989) 34 IR 179, Gray J held at page 184:

Although the parties are free, as a matter of law, to choose the nature of the contract which they will make between themselves, their own characterisation of that contract will not be conclusive. A court will always look at all of the terms of the contract, to determine its true essence, and will not be bound by the express choice of the parties as to the label to be attached to it. As Mr Black put it in the present case, the parties cannot create something which has every feature of a rooster, but call it a duck and insist that everybody else recognise it as a duck.

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

Incentive/ inducement payments

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

Lump sum payments made to two taxpayers to ensure they remained in employment was held to be ordinary assessable income in McLean & Anor v FC of T [1996] FCA 1459; (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 the present case, the Tribunal held that the retention payments received by the taxpayers constituted income derived by them within paragraph 25(1)(a) of the Assessment Act. In my opinion, the Tribunal was not in error in so concluding. In my opinion all the facts of this case point to the conclusion that the receipt of the retention payments by the taxpayers was related to their activities as employees and as continuing to be employees with the result that in substance and reality the amounts received were the product of the income-earning activity on the part of each taxpayer.

The nature of the payments is made clear by a reference to the contents of the letters written to them by Elders Resources. The payment was made as an inducement to each taxpayer to continue in his employment for a period of at least one year. If the taxpayer voluntarily left his employment, the amount of the payment was reduced but otherwise the payment was for the specified sum. The fact that this was not to be paid on a periodic basis does not detract from the true nature of the receipt of the payment. The continual employment was at the very heart of the receipt of the payment the amount of which was calculated having regard to the salary of the taxpayer. There is no similarity between the facts of this case and those discussed in Dickenson v. FC of T (1957) 11 ATD 157; (1958) 11 ATD 415; (1957-1958) 98 C.L.R. 460.

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 $xx,xxxx 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:

14. The facts of this matter, when viewed objectively, leave the Tribunal in no doubt that the agreement to pay the $20,000 was an integral part of the offer made by W Ltd and accepted by the applicant. To exclude the $20,000 is to omit one of the main attractions from the overall salary package which, in the Tribunal's opinion, should be regarded as a single bundle of entitlements attaching to the offer of employment with W Ltd.

15. A consideration of all the material including the letter containing the offer (T3) leads the Tribunal to the conclusion that, irrespective of the description furnished to the amount in contention, it represented a straightforward inducement for the applicant to enter the employment of W Ltd. Furthermore, the Tribunal is satisfied that the source of the payment is to be found in the service to be rendered by the applicant to W Ltd and that it was in the nature of a benefit for future service.

Lease inducements, received as part of a business enterprise, have been considered by the Courts on a number of occasions: Paul Montgomery v Commissioner of Taxation [1998] FCA 46, Commissioner of Taxation of the Commonwealth of Australia v the Myer Emporium Limited [1985] FCA 376 and Commissioner of Taxation v Cameron Richard Cooling [1990] FCA 204; 90 ATC 4472; 21 ATR 13, (1990) 22 FCR 42; (1990) 94 ALR 121 (Cooling). In Cooling, Hill J stated:

Where a taxpayer operates from leased premises, the move from one premises to another and 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.

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

In your case, it is considered that the character of the payment in your hands was an inducement for you to provide services at entity A's premises for a period.

As per the decision in Pickford, the payment was an 'integral part' of the Deed, 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 acknowledged that the payment was not made to you as an employee; however, it is considered that the principles established in these case law decisions in relation to such incentive/inducement payments are equally applicable to your 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.

It is noted that your Deed contains some restraints. We consider that the restraints are incidental to your activity of performing your services. Also, the Deed requires you to work a minimum number of hours per week. This would only allow a small opportunity, given the need for rest and recuperation, to take up other work in any event. As such, the clear implication from these circumstances is that the payment was made in relation to you satisfying your principal obligation of providing services at entity A's premises rather than any ancillary obligation to not provide services elsewhere. Furthermore, no amount of the payment is specifically allocated to any restraint.

Isolated transaction

The Commissioner's view on whether profits on isolated transactions are assessable income under ordinary concepts is contained in Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income. Paragraphs 6-8 of the Ruling state:

6. Whether a profit from an isolated transaction is income according to the ordinary concepts and usages of mankind depends very much on the circumstances of the case. However, a profit from an isolated transaction is generally income when both of the following elements are present:

(a) the intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain; and

(b) the transaction 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.

7. 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.

8. 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.

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.

In Commissioner of Taxation v Montgomery [1999] HCA 34, the majority judgement of the High Court held that inducement payments paid to a firm of solicitors to take up a lease were assessable income and not of a capital nature, Gaudron, Gummow, Kirby and Hayne JJ at [118]:

….. 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. And the sums it received from the transactions were not as growth or increment of value in its profit-yielding structure - the receipts came in or were derived for the separate use, benefit and disposal of the firm and its members as they saw fit.

In Cooling, a lump sum payment received by a firm of solicitors as an incentive to relocate to new premises was held by the Full Federal Court to be income according to ordinary concepts. As highlighted in paragraph 50 of TR 92/3:

At 90 ATC 4484; 21 ATR 27 Hill J concluded:

'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.'

Application to your circumstances

It is considered that the principles in the above cases apply to your circumstances as even though you have not entered into a lease for a fixed price, entity A is providing you a place to work.

By entering into the Agreement and receiving a lump sum which is directly related to you deriving income as a professional, it is considered that the transaction meets the requirements of paragraph 6 of TR 92/3 as a gain or profit arising from a commercial transaction. Therefore the payment is regarded as ordinary assessable income.

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 that CGT event D1 happens if you create a contractual right or other legal or equitable right or other legal or equitable right in another entity.

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. Please note that subsections 160M(6) and 160M(7) are now sections 104-35 and 104-155 of the ITAA 1997.

Application to your circumstances

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

The restraints follow as a natural consequence of the positive obligations of you to provide full-time services for entity A for a given 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 the period.

Even if part of the payment was considered to be in respect of the restraint after the Deed 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.

Finally, even if the lump sum 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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