Edited version of your written advice

Authorisation Number: 1013060605337

Date of advice: 26 July 2016

Ruling

Subject: Assessability of Founders Retention Amount

Question

Is the retention payment, payable in accordance with a share purchase agreement, assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following periods:

Income years ended 30 June 2015

Income years ended 30 June 2016

Income years ended 30 June 2017

The scheme commences on

1 July 2014

Relevant facts and circumstances

You are a founder of a company.

Pursuant to a share purchase agreement (SPA) you sold your shares in the company to another company. The SPA defines the purchase price to include a retention payment, payable in three instalments provided that you remain employed within the group that purchased your shares.

Your employment agreement provided for the payment of an arm's length salary and bonuses conditional on certain performance targets being met. The relevant performance targets have been met for the period to date and bonuses paid accordingly.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Subsection 6-5(2)

Income Tax Assessment Act 1997 Section 118-20

Reasons for decision

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

A retention payment is considered ordinary income for the purposes of subsection 6-5(2) of the ITAA 1997. It is designed to reward and encourage employees to continue to work with the same employer.

In your case you entered into a SPA to sell your shares in your company. In addition to the purchase price of those shares the SPA stipulated that you would become entitled to receive a retention payment payable in three separate instalments, conditional upon you remaining employed within the group at the time each instalment was due to be paid.

A retention payment is an additional reward payment derived by a taxpayer in the capacity as an employee (Dean & Anor v. Federal Commissioner of Taxation (1997) 78 FCR 140; (1997) 37 ATR 52; 97 ATC 4762 (Dean's case)). In Dean's case a retention payment made by a parent company to senior managers of its subsidiary as an incentive to ensure they remained in the employ of the subsidiary after it was sold was found to be assessable as ordinary income.

In the decision of the Federal Court, Northrop J stated at p 4447:

"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 continual employment was at the very heart of the receipt of the payment...''

You have argued that, rather than being an additional reward payment derived in your capacity as an employee, the retention payments are capital proceeds from the sale of your shares and you subsequently separately agreed to continue on as an employee of the group who purchased them, thus distinguishing your case from the facts in Dean's case. Had the parties intended the retention payment to be a bonus or other reward for services, the retention payment could easily have been included in the employment agreement.  The retention payment wasn't included in the employment contract because the parties accepted that it related to the shares. As support for your contention, you have pointed out that the SPA makes clear that the retention payment is additional to and separate from the salary payable to you in respect of your employment within the group.

Further, you have pointed out that the SPA defines Purchase Price as including the retention payment.

In other words you are claiming that the characterisation of the retention payment as being of an income nature would be contrary to what is stated in the SPA.

The character of a payment cannot always be determined by reference to its description in a contract. It is clear that any retention payment under the SPA was dependent on you remaining in the employ of the group.

Characterising the payments as part of the sale consideration of the shares is not something the Commissioner will accept if the substance of the payment arrangement is clearly one of employment. The fact that one has to examine the substance of a legal arrangement to determine a matter, rather than the formal label the parties put to it in a contract, was clearly shown in the High Court case of Radaich v Smith (1959) 101 CLR 209 ('Radaich').

In Radaich, the High Court held that determining whether parties had a leasehold relationship or not had to be determined by the substance of the arrangement rather than the formal label the parties put to it.

In that case the respondents as "licensors" granted by deed to the appellant as "licensee" permission to operate a milk bar for 5 years. Similar to the facts in your case, the respondents in Radaich claimed that they did not have a leasehold or lessor/lessee relationship with the appellants, but merely a license agreement. However, the High Court unanimously rejected the respondent's argument stating that whether there was a leasehold agreement or not, had to be determined by the substance of the parties' relationship rather than its form. This was evident in McTiernan's J judgment at CLR 214 where he stated:

The words "lease", "lessor" and "lessee" however, are entirely excluded from the document, and the term "licence", and its appropriate mutations, are sedulously applied to the rights purported to be created. This fact is, of course, far from conclusive in favour of the respondents. It is the substance of the deed that matters. As Denning LJ said in Faccini v Bryson "…the parties cannot by mere words of their contract turn it into something else. Their relationship is determined by the law and not by the label they choose to put on it."

The above view was also supported by the judgment of Windeyer J in Radaich, where he stated at CLR 221-222:

Whether when one man is allowed to enter upon the land of another pursuant to a contract he does so as licensee or as tenant must, it has been said "be in the last resort a question of intention", per Lord Greene MR in Booker v Palmer. But intention to do what? Not to give a transaction one label rather than another. Not to escape the legal consequences of one relationship by professing that it is another.

While Radaich was in relation to whether a contract was a lease or license it is submitted the ratio in Radaich that a legal contract has to be determined by its substance - rather than the mere form of words used in it - has equal application in your case. As per Windeyer's J judgment, you cannot escape the legal consequences of a relationship by professing that it is another, when this is clearly contrary to the actual substance of the terms in the contract.

Following the principles from Radaich, although the terms of the payments are set out in the SPA and described as part of the purchase price, the substance of the three retention payment instalments is nonetheless retention payments and are paid as an incentive to continue your employment with the same employer. If you do not remain employed with the relevant entity at the relevant time, you are not entitled to receive an instalment. As such the payments are considered to be made principally for your services to your employer, to be provided over a period of time and bear the character of additional remuneration to you as an employee.

Consequently, as per the precedent in Dean's case, the retention payment is the product of your income-earning activity and must be included in your assessable income as ordinary income under section 6-5 of the ITAA 1997.

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