Edited version of your written advice

Authorisation Number: 1013070620706

Date of advice: 14 September 2016

Ruling

Subject: Assessability of Lease Surrender Payments

Question 1

Will the Refunds be assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Are the Rental Reductions assessable under section 6-5 of the ITAA 1997?

Answer

No

Question 3

Will the Proposed Receipts be assessable as ordinary income under section 6-5 of the ITAA 1997?

Answer

Yes

Question 4

Are the Refunds and the Proposed Receipts assessable in the year in which they are earned in accordance with section 6-5 of the ITAA 1997?

Answer

Yes

Question 5

Will the Taxpayer be subject to tax as a result of a capital gain pursuant to Section 102-5 of the ITAA 1997, arising with respect to the Rental Reductions, Refunds or Proposed Receipts?

Answer

No

Question 6

Does Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the scheme or circumstance?

Answer

The Commissioner will not seek to apply Part IVA of the ITAA 1936 to the specific arrangement as described in the 'Relevant facts and circumstances' of this ruling.

This ruling applies for the following period(s)

1 July 20X to 30 June 20Y

The scheme commences on

1 July 20X

Relevant facts and circumstances

(a) The Taxpayer's business

• The Taxpayer is the service trust for a law firm (the Firm). The firm is a partnership currently carrying on business.

• The Taxpayer is currently the lessee under a lease with the Lessor covering a number of floors of the Premises, which will expire in 20XX (Lease).

• As part of the Lease, the Taxpayer and the Lessor also entered into an Incentive Agreement (Incentive Agreement) under which the Lessor makes incentive payments to the Taxpayer.

• The Taxpayer has supplied labour (in the form of the provision of legal professionals) and infrastructure (including a licence to use the Premises) to the Firm, from which the Taxpayer derives profits.

(b) Redevelopment of the Premises

• The Lessor wishes to obtain the Taxpayer's consent to terminate the Lease early, so that the Lessor can redevelop the Premises.

• As the lease agreement does not provide a mechanism for compensation and early termination, the Taxpayer views these circumstances as an opportunity to earn income.

• The Taxpayer has been able to negotiate compensation from the Lessor, which includes compensation for the incremental costs of finding, evaluating and leasing replacement premises, and an element of profit for the Taxpayer.

• The Taxpayer has negotiated the following benefits from the Lessor as identified in the Terms Letter:

(i) Refund of Costs and Expenses

• The Lessor will meet the Taxpayer's reasonable costs and bona fide expenses in relation to the arrangement as set out under the Terms Letter and the sourcing of alternative commercial premises (Refunds). The Lessor will pay the relevant invoices within 30 days of receipt.

(ii) Rental Reductions

• The Taxpayer will receive rental reductions rebated against each month for a set period and offset against the Taxpayer's monthly Lease rental payments (Rental Reductions).

(iii) Proposed Receipts

• The Lessor will also make certain payments to the Taxpayer in the form of Proposed Receipts.

• It is expected that the Taxpayer will incur a higher rental expense in the future for any new premise, although the quantum of this additional expense is not yet certain.

• It is likely that the Proposed Receipts will be used to pay the additional rent for any new premises, although the Proposed Receipts will not be calculated by direct reference to this outgoing (that is, in the unlikely event that the Taxpayer is able to obtain rent free premises, the amount from the Lessor would still be payable).

• The Taxpayer will be entitled to receive the benefit of the Remaining Incentive Payments set under the Incentive Agreement (Remaining Incentive Payments). The Remaining Incentive Payments are due and payable in 20XX, 20XY and 20XZ.

• The Taxpayer has the right to draw down the payment due in 20XZ up to two years early (i.e. from 20XX).

• The Taxpayer will be entitled to receive a stream of equal monthly payments over a set period (Monthly Payments), based on a notional sum attracting interest.

• Alternatively, the Taxpayer has the absolute discretion to call on the Lessor with 12 months written notice to pay the cash balance (ie not Future Value) owing at this point in time. The interest outstanding at the date of payment will not be payable.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 21A

Income Tax Assessment Act 1936 Section 177C

Income Tax Assessment Act 1936 Section 177CB

Income Tax Assessment Act 1936 Section 177D

Income Tax Assessment Act 1936 Section 177F

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 102-25

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 118-20

Reasons for decision

Question 1

Will the Refunds be assessable as ordinary income under section 6-5 of the ITAA 1997?

Summary

The Refunds will be ordinary income and will be assessable under section 6-5 of the ITAA 1997.

Detailed reasoning

Australian Income Tax Liability

A resident's assessable income includes any ordinary income or statutory income derived directly or indirectly from all sources, during the income year (subsections 6-5(1) and (2) of the ITAA 1997).

Income according to ordinary concepts (ordinary income)

Subsection 6-5(1) of the ITAA 1997 provides that an amount is included as assessable income if it is income according to ordinary concepts (ordinary income).

In considering the assessability of lease surrender payments, Taxation Ruling TR 2005/6 Income Tax: Lease Surrender Receipts and Payments, explains the circumstances where it is considered a lease surrender receipt is assessable income under section 6-5 of the ITAA 1997.

The tax consequences for a lessee who derive a lease surrender receipt are set out in Paragraph 9:

A lease surrender receipt of a lessee would be of a capital nature when received for the surrender of a lease that formed part of the profit yielding structure of the business of the lessee. However, a lease surrender receipt of a lessee would constitute assessable income under section 6-5 if received:

(a) in the ordinary course of carrying on a business of trading in leases;

(b) as an ordinary incident of business activity (even though it was unusual or extraordinary compared to the usual transactions of the business); or

(c) as a profit or gain from an isolated business operation or commercial transaction entered into by the lessees (otherwise than in the ordinary course of carrying on a business), with the intention or purpose of making the relevant profit or gain.

Receipts as an incident of the Taxpayer's business

It is well established that profits derived in the ordinary course of a taxpayer's business are income and are not receipts of a capital nature (Californian Copper Syndicate v Harris (1904) 5 TC 159).

This is affirmed by the High Court in The Myer Emporium Ltd 87 ATC 4363 (Myer) at pp 4366 - 4367:

Because a business is carried on with a view to profit, a gain made in the ordinary course of carrying on the business is invested with the profit making purpose, thereby stamping the profit with the character of income.

Circumstances where incentive payments would be ordinary income:

In FCT v Cooling (1990) 22 FCR 42, a lease incentive payment made to a firm of solicitors to induce it to change premises was held to be assessable as ordinary income.

Hill J said at p4484:

Where a taxpayer operates from leased premises, the move from one premise 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 gives rise more directly to the taxpayer's assessable income.

The High Court stated its view on the application of the Myer principle to lease incentive payments in Federal Commissioner of Taxation v Montgomery (1999) 198 CLR 639 (Montgomery), where it was held that a lease incentive receipt was assessable income of the taxpayer (a law firm), albeit that the receipt was in respect of a transaction regarded as singular or extraordinary.

In Montgomery, the court made the following points in relation to the lessor paying the service company a lease incentive payment:

• The receipt of the inducement payments was an ordinary incident of the firm's business activity, even though it was an extraordinary and unusual part of that activity.

• Although, the lease interest was acquired as part of the profit yielding structure of the firm, the inducement amounts did not augment, and were not part of, that profit yielding structure.

• The partners of the firm used or exploited their capital in the course of carrying on their business to obtain the inducement payments.

• If a significant purpose of a transaction, even if not the only significant purpose, is profit making, then the receipt from it will be regarded as income.

In Rotherwood v FCT (1996), the recipient of payments was a service trust and it was held to be part of the business of the service trust to engage in the turnover of leases; in particular the payments were received as part of a wider transaction which exploited market conditions to obtain a profit. Accordingly, the payments were ordinary income.

In Case 57/94 (1994) the taxpayer firm first received notice that the landlord wanted vacant possession, and then exercised an existing option to extend the lease by three years. The AAT characterised this exercise as being motivated by the opportunity to derive profit from the landlords' desire for vacant possession. Accordingly the resulting payments were from a profit making scheme and therefore statutory income under the former subsection 25(1) of the ITAA 1936.

Further, the case of FCT v Dixon (1952) 86 CLR 540 (Dixon) takes into account characteristics such as periodicity and reliance whereby top up payments to a soldier from a former employer to make up the difference between former salary and salary as a soldier was held to be ordinary income.

Circumstances where incentive payments would not be ordinary income:

The case illustrating circumstances under which such payments would not be ordinary income is Westfair Foods Limited v The Queen (1991) 91 DTC 5073 (Westfair) in which there was no arrangement more elaborate than a simple surrender of the lease in exchange for a single lump sum payment.

Therefore, in considering the principles established, the simple surrender of a lease over business premises for a lump sum is capital would fall under CGT, while anything more elaborate would tend to be considered ordinary income.

Application to Taxpayer:

In applying the circumstances set out in Paragraph 9 of TR 2005/6, it is considered that the Refunds are assessable income on the basis that the amounts are received as an ordinary incident of business activity even though the payments are unusual or extraordinary compared to the usual transactions of the Taxpayer's business of supplying law firm labour and infrastructure to the legal industry at a profit.

The scheme is distinguishable from Westfair, and is not a simple lease surrender for the following reasons:

• The taxpayer is the service trust in the business of obtaining and on-letting premises and the proposed receipts will be in the course of this business; this is similar to Rotherwood (lease surrender) and Cooling (lease incentive).

• The proposal does not simply compensate the taxpayer for the incremental costs of obtaining replacement premises. In particular, the terms of the income payments will extend beyond the original term of the lease and is not capped by reference to the taxpayer's actual costs. This stamps the transaction as a profit making scheme which exploits the taxpayer's business situation to obtain profits, strongly indicating a conclusion that it is ordinary income.

Therefore, the refunds (properly characterised as compensation payments made by the Lessor in order to obtain the Taxpayer's consent to terminate the Lease Early) are revenue receipts that replaces deductible expenditure and are received as an ordinary incident of the Taxpayer's business activity.

Accordingly, the Refunds should constitute income according to ordinary concepts pursuant to section 6-5 of the ITAA 1997.

Question 2

Are the Rental Reductions assessable under section 6-5 of the ITAA 1997?

Summary

The Rental Reductions are not assessable to the Taxpayer and will be revenue neutral as the otherwise deductible rule in section 21A(3) of the Income Tax Assessment Act 1936 (ITAA 1936) will apply to reduce the taxable amount of the benefit to nil.

Detailed reasoning

Section 21A of the ITAA 1936 is the operative provision which provides that 'non-cash business benefits' not convertible to cash, shall be treated as if it were convertible to cash, and will have an income character.

In considering whether the Rental Reduction is a 'non-cash business benefit' for the purposes of Section 21A of the ITAA 1936 where subsection (5) defines a non-cash business benefit as:

"property or services provided after 31 August 1988:

(a) wholly or partly in respect of a business relationship; or

(b) wholly or partly for or in relation directly or indirectly to a business relationship."

Further, "services" in the context of subsection (5) is defined to include:

"any benefit, right (including a right in relation to, and an interest in, real or personal property), privilege or facility…"

Under the proposed arrangement, the taxpayer will not receive any monies from the Lessor, but rather the Lessor will reduce the remaining lease obligations.

In this case the non-cash business benefit is considered to be in relation to services provided after 31 August 1988, a business relationship established between the taxpayer and the Lessor (via the lease and terms letter). The benefit(s) are to be provided until 31 December 20XX. Each benefit will be satisfied as and when the Lessor meets those obligations.

Otherwise deductible rule

In respect of each benefit, the Taxpayer may be entitled to a 'once only deduction' determined in accordance subsection 21A(3) of the ITAA 1936. This is known as the 'otherwise deductible rule'.

Taxation Ruling IT 2631 Income Tax: lease incentives, provides guidance to the treatment of revenue expenses in accordance with the otherwise deductible rule.

According to paragraph 21:

Revenue expenses such as rent which would have been deductible in that year, if they had been incurred, would be able to be taken into account to reduce the assessable income.

Thus revenue expenses (only to the extent to which they are for the payment of rent, rates and other revenue type expenses payable under the lease) are considered to fall within the 'otherwise deductible rule' and therefore would be taken into account to reduce the taxpayer's assessable income.

Application to Taxpayer:

The Rental Reductions are non-cash business benefits that would ordinarily attract section 21A of the ITAA 1936 and the application of section 6-5(2) of the ITAA 1997.

However, if the taxpayer had, at the time the benefit was provided, incurred and paid unreimbursed expenditure in respect of the benefit equal to the amount of the arm's length value of the benefit, a once only deduction would have been allowable in the circumstances. Therefore the otherwise deductible rule in subsection 21A(3) of the ITAA 1936 applies and reduces the non-cash business benefits to be included in the taxpayer's assessable income to nil.

Accordingly, the Rental Reductions will not be assessable to the Taxpayer.

Question 3

Will the Proposed Receipts be assessable as ordinary income under section 6-5 of the ITAA 1997?

Summary

The Proposed Receipts are ordinary income and assessable income to the Taxpayer in accordance with section 6-5 of the ITAA 1997 on the basis that the receipts constitute income according to ordinary concepts.

Detailed reasoning

The reasoning in relation to determining the assessability of the Proposed Receipts is similar to that of Question 1.

The Proposed Receipts are covered in the Terms Letter which includes the Remaining Incentive Payments and Monthly Payments.

The Taxpayer will be entitled to receive the benefit of the remaining incentive payments set out under the Incentive Agreement.

The Taxpayer will be entitled to receive a stream of equal monthly payments over a period of X years.

Application to Taxpayer:

The Proposed Receipts constitute ordinary income in the hands of the Taxpayer and should be included in the Taxpayer's assessable income pursuant to subsection 6-5(2) of the ITAA 1997.

In circumstances where a business taxpayer is given a cash incentive to enter into a lease of business premises, Paragraph 8 of Taxation Ruling IT 2631 provides that the incentive is income of the taxpayer.

Remaining Incentive Payments

As set out in Cooling, the Remaining Incentive Payments obtained as a result of the surrendering of the lease, are acts of the taxpayer in the course of its business activity as the incentive payments are a product of a profit making scheme.

Similar to the Taxpayers in Montgomery, the Taxpayer is using its position as lessee of a large part of premises of the Lessor, to derive compensation in the form of the Proposed Receipts. The arrangement under which the Remaining Incentive Payments will be paid as set out in the Terms Letter is a commercial transaction which is being entered into by the Taxpayer for the purpose of making a profit. They are product of a profit making scheme and are received in the ordinary incident of the Taxpayer's business.

In relation to the Remaining Incentive Payments, these are lease incentive payments payable to the Taxpayer under the Incentive Agreement. Therefore, in accordance with the Commissioner's view in Paragraph 8 of IT 2631, these payments will form ordinary income of the Taxpayer.

Monthly Payments

Similarly, the arrangement for the Taxpayer to receive monthly payments will be considered ordinary income of the Taxpayer based on the application of Montgomery, whereby the arrangement under the Terms Letter, is a commercial transaction entered into for the purpose of making a profit.

Furthermore, the monthly payments the Taxpayer will be entitled to receive over a period of years will form ordinary income of the Taxpayer on the basis of the periodic nature of the payments. As set out in Dixon, payments will constitute ordinary income in circumstances where the payments are periodic.

Question 4

When will the Refunds and the Proposed Receipts be derived in accordance with section 6-5 of the ITAA 1997?

Summary

The refunds and proposed receipts will be assessable in the year in which the income is earned.

Detailed reasoning

Section 6-5 of the ITAA 1997 requires an amount of ordinary income to be brought to account as assessable income when it is derived.

Under subsection 6-5(2) of the ITAA 97, as an Australian resident, assessable income includes the ordinary income you derive directly or indirectly from all sources whether in or out of Australia for the income year.

Subsection 6-5(4) of the ITAA 1997 provides:

In working out whether you have derived an amount of ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it applied or dealt with in any on your behalf or as you direct.

Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings sets out the Commissioner's opinion on the derivation of income, with particular reference to the receipts and earnings reporting methods in paragraphs 8 to 11.

Receipts method

The 'receipts' method is sometimes called the 'cash received' basis or the 'cash' basis. Under the receipts method, income is derived when it is received, either actually or constructively, under subsection 6-5(4). The effect of the subsection is that income is taken to have been derived by a person although it is not actually paid over, but is dealt with on his/her behalf or as he/she directs.

Earnings method

The 'earnings' method is often referred to as the 'accruals' method or the 'cash and credit' method. Under the earnings method, income is derived when it is earned. The point of derivation occurs when a 'recoverable debt' is created.

The term 'recoverable debt' is used to describe the point of time at which a taxpayer is legally entitled to recover an ascertainable amount as the result of having performed an agreed task. Henderson v. FCT (1970) 119 CLR 612; 70 ATC 4016; (1970) 1 ATR 596 (Henderson's case); Henderson v. FCT 69 ATC 4049; (1969) 1 ATR 133.

A taxpayer may have a recoverable debt even though, at the time, they cannot legally enforce recovery of the debt. Barratt & Ors v. FC of T 92 ATC 4275; (1992) 23 ATR 339 (Barratt's case).

Circumstances where a particular method is appropriate

Paragraph 17 of TR 98/1 provides that when accounting for income in respect of a year of income, a taxpayer must adopt the method that, in the circumstances of the case is most appropriate.

Paragraphs 18 to 20 of the TR set out the circumstances where it would generally be appropriate to apply the receipts or earnings method.

As a general rule, the receipts method is appropriate to determine income derived from investments, while the earnings method, in most cases, is appropriate to determine business income derived from a trading or manufacturing business.

In cases which are not clearly within the descriptions at paragraphs 18 to 20, the factors that may assist to determine the correct method of accounting for income are set out in paragraphs 52 to 59.

Paragraphs 53 to 56 of the TR consider the following factors:

Size of business:

The larger the business structure, the more likely is the reliance on employees and capital equipment to generate income and the more likely the earnings method of accounting is appropriate (Barratt).

Circulating capital:

Where a taxpayer relies, to a significant extent, on circulating capital or consumables to produce income it is likely that the appropriate method for determining income is the earnings method (Barratt).

Similarly, where a taxpayer's employees directly generate significant income, the earnings method is likely to be appropriate to account for that income in the relevant year (Henderson and Barratt).

Consumables and capital items:

The reliance placed by the taxpayer on the use of capital items, such as plant and machinery, to produce income is relevant. The greater the reliance, the greater the likelihood is that the earnings method is the appropriate accounting method (Barratt).

Application to Taxpayer:

It is considered that the Refunds and Proposed Receipts will be assessable under section 6-5 of the ITAA 1997 when the amounts are legally entitled to be recovered, in accordance with the accruals method, or the income is derived when it is earned.

The taxpayer is a service trust in the business of supplying labour and infrastructure to the legal industry. This means that the Taxpayer places a great reliance on its employees and assets to generate income.

Therefore, in applying the principles set out under TR 98/1 and as found in Henderson and Barratt respectively, the earnings method is the more appropriate method to be applied in this circumstances.

When will the Refunds and Proposed Receipts be "earned"?

The Refunds and Proposed Receipts will be assessable in accordance with the earnings method and will not be derived until it is legally enforceable.

Under the earnings basis, income is not derived as per subsection 6-5(4) of the ITAA 1997, until it has been earned, where a recoverable debt has been created.

A recoverable debt only comes into existence when income is earned, not contingent, indefeasible, and quantifiable. In the present case, the payments are clearly set out under the contract and are not contingent. Therefore, the Refunds and Proposed Receipts are a recoverable debt which arises for the Taxpayer in each of the income years.

The Taxpayer will be legally entitled to an ascertainable amount on the dates specified in the Terms Letter, as the result of having performed an agreed task, which, in this instance, is the arrangement to surrender the lease as well as execution of the Terms Letter.

Accordingly, no payments are derived by and assessable to the Taxpayer under section 6-5 of the ITAA 1997 until the amounts are legally entitled to be recovered as a recoverable debt.

The timing of when the Refunds and Proposed Receipts will be earned can be set out as follows:

Refunds

The refunds will be earned when they are legally entitled to be recovered by the taxpayer.

Each respective refund should be included in the taxpayer's assessable income in the year in which the amount is earned.

Proposed Receipts - Remaining Incentive Payments

The remaining incentive payments will be "earned" when the amounts are legally entitled to be recovered.

Therefore, the payments will be earned in 20XX, 20XY and 20XZ respectively.

In the event the Taxpayer exercises its right under the Terms Letter to draw down the payment due in 20XZ up to two years early (i.e. from 20XX), the payments will be earned on that particular date.

Each respective remaining incentive payment should be included in the taxpayer's assessable income in the year in which the amount is earned.

Proposed Receipts - Monthly Payments

The Monthly Payments will be "earned" when the amounts are legally entitled to be recovered (being the first day of every month from the set period).

The Taxpayer also has the option to call on the cash balance at that point in time with 12 months written notice. After 12 months, the Taxpayer will be legally entitled to that balance. The payment will be earned on that date should the taxpayer exercise this option.

Each respective monthly payment should be included in the taxpayer's assessable income in the year in which the amount is earned.

Question 5

Will the Taxpayer be subject to tax as a result of a capital gain pursuant to section 102-5 of the ITAA 1997, arising with respect to the Rental Reductions, Refunds or Proposed Receipts?

Summary

The taxpayer will not be subject to tax as a result of a capital gain under section 102-5, on the basis that the operation of section 118-20 of the ITAA 1997 will reduce the resulting capital gain to nil.

Detailed reasoning

Subsection 102-5(1) of the ITAA 1997 provides that a taxpayer's assessable income includes any net capital gain for the income year. The subsection goes on to set out a five step process to work out a taxpayer's net capital gain.

CGT event

A taxpayer can only make a capital gain or loss if a capital gains tax (CGT) event happens to a CGT asset. The following CGT events may apply to the payments:

• CGT event A1 (disposal of a CGT asset).

• CGT event C2 (cancellation, surrender and similar endings).

• CGT event D1 (creating contractual or other rights).

• CGT event F4 (lessee receives payment for changing a term of the lease).

• CGT event H2 (receipt for event relating to a CGT event).

Section 102-25 of the ITAA 1997 sets out which CGT event rules are to be applied if more than one CGT event is applicable to the circumstances. Subsection 102-25(1) states that if more than one event applies, the taxpayer should use the most specific event (subject to the application of additional ordering rules).

The Rental Reductions, refunds and proposed receipts are compensation payments made by the lessor in order to obtain the taxpayer's consent to terminate the lease on 31 December 20XX.

Paragraph 10 of Taxation Ruling TR 2005/6 Income Tax: Lease Surrender Receipts and Payments, provides that a lessee makes a capital gain from surrendering a lease acquired after 19 September 1985 (CGT event A1 - disposal of a CGT asset pursuant to section 104-10 of the ITAA 1997), to the extent that the surrender receipt exceeds the cost base of the lease (including any non-deductible premium paid by the lessee for the grant of the lease).

Therefore, CGT event A1 is likely to be the most specific event to apply to Rental Deductions, Refunds and Proposed Receipts which are characterised as payments made by the lessor in order to obtain the taxpayer's consent to terminate the lease. The time for the event would be when the agreement is entered into.

Circumstances disregarding capital gains or losses

In determining a taxpayer's assessable income under subsection 102-5(1), a taxpayer should consider the application of any provisions which permit or require a taxpayer to disregard certain capital gains or losses when working out the taxpayer's net capital gain under subsection 102-5(1).

This is specified at Note 2 under Step 1 of subsection 102-5(1) which provides:

Some provisions of this Act (such as Divisions 104 and 118) permit or require you to disregard certain capital gains or losses when working out your net capital gain.

Specifically, in these circumstances, the taxpayer must consider the application of section 118-20 of the ITAA 1997.

Section 118-20 of the ITAA 1997 prevents double taxation by reducing a capital gain arising from a CGT event to the extent that an amount has already been included in the assessable income of the taxpayer in any income year under a provision outside Part 3-1 of the ITAA 1997 (such as section 6-5 of the ITAA 1997). Section 118-20 applies to reduce a capital gain prior to the five step net capital gain calculation process set out at section 102-5(1) of the ITAA 1997.

Application to Taxpayer:

It is considered that the Taxpayer will not be liable to tax as a result of a capital gain assessable under Section 102-5 of the ITAA 1997, where a capital gain arises with respect to the rental deductions, refunds or proposed receipts.

The Rental Reductions, Refunds and Proposed Receipts received by the taxpayer constitute income according to ordinary concepts pursuant to section 6-5 of the ITAA 1997.

Section 118-20 of the ITAA 1997 reduces the capital gain where an amount is otherwise assessable under a provision outside of Part 3-1 of the Act.

On this basis, the capital gain resulting from CGT event A1 will be reduced to nil as a result of the operation of section 118-20 of the Act.

Question 6

Does Part IVA of the ITAA 1936 apply to the scheme or circumstance?

Summary

The Commissioner will not seek to apply Part IVA of the ITAA 1936 to the specific arrangement as described in this ruling.

Detailed reasoning

Part IVA of the ITAA 1936 is the general anti-avoidance provision that may apply in certain circumstances. Part IVA gives the Commissioner the power to cancel a tax benefit, or part of a tax benefit, that has been obtained, or would, but for section 177F of the ITAA 1936, be obtained, by a taxpayer in connection with a scheme to which Part IVA applies.

Under section 177D, Part IVA can only apply to a scheme where there is a sole or dominant purpose of obtaining a tax benefit in entering the scheme.

The general anti avoidance provision set out at section 177D applies if:

• There is a scheme;

• A taxpayer has obtained (or would, but for Part IVA, obtain) a tax benefit in connection with that scheme; and

• Having regard to a number of objective factors or matters, it would be concluded that the scheme was entered into or carried out for the sole or dominant purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme.

A scheme

Based on the facts of this private binding ruling application, the relevant scheme is able to be identified as the entering into the terms as set out in the Terms Letter.

Tax Benefit in connection with the scheme

A "tax benefit" is defined under section 177C of the ITAA 1936. Determining whether a tax benefit exists is a two-step enquiry. Along with recognising whether a tax benefit exists, it also needs to be considered whether the beneficial tax outcome would not have arisen (or it is reasonable to expect that the beneficial tax outcome would not have arisen) if the scheme had not been entered into or carried out (the alternative postulate or counterfactual). This requires an objective prediction or a reasonable counterfactual, against which the actual scheme is compared.

Reasonable alternative postulate

For a counterfactual to be reasonable, the counterfactual must be sufficiently reliable (FC of T v Peabody (1994) 94 ATC 4663) and must be more than a mere possibility (Peabody at 385, Essenbourne Pty Ltd v FC of T (2002) 2002 ATC 5201). In determining whether a counterfactual is reasonable, particular regard must be had to (i) the substance of the scheme; and (ii) any result or consequence for the taxpayer that is or would be achieved by the scheme (other than a result in relation to the operation of the ITAA 1936) (subsection 177CB(4)). The counterfactual is objectively determined, but a taxpayer's subjective evidence of what it would have done otherwise is relevant for the objective determination of the counterfactual. Section 177CB restricts the ambit of counterfactuals that can be raised to compare the tax benefits obtained from the actual scheme. In particular, the counterfactual must be a counterfactual that:

• Section 177CB(2): disregards the "scheme" and relies on all other steps in the transaction actually carried out, without speculating the alternative steps (annihilation approach); or

• Section 177CB(3): is a reasonable alternative to the scheme (i.e. one that speculates the alternative steps that would have otherwise happened), having "particular regard" to the substance and results of the scheme, but disregarding any tax consequences (reconstruction approach).

Dominant purpose

The term "dominant purpose" is defined as "the ruling, prevailing or most influential purpose" (Taxation Laws Amendment Act (No.2) 1997). The purpose of the taxpayer or other persons is determined objectively and concluded by a "reasonable person".

The dominant purpose is objectively determined by applying a global balancing assessment of the eight listed factors under subsection 177D(2) of the ITAA 1936.

Application to Taxpayer:

One reasonable counterfactual to the scheme that could arise is that the Proposed Receipts are made as one lump sum in the one financial year. Objectively determined, it is possible that the Taxpayer and the Lessor would negotiate a lump sum to be paid in lieu of the compensation set out in the Terms Letter being the refunds, rental reductions and proposed receipts.

However, this counterfactual is not sufficiently reliable and a mere possibility in the circumstances. Each year, the firm has new partners as well as partners who may be retiring. Taking this into account, the Taxpayer entered into the arrangement to ensure the compensation package did not merely benefit current partners who may be retiring in the near future. Therefore, the Taxpayer requires the benefit of the compensation to be spread over a period of X years in order for existing and potential future partners to benefit from the opportunity.

Secondly, even if this counterfactual was a reasonable alternative to the scheme, a lesser tax benefit would result under the counterfactual. This is because the Lessor would not be willing to match the total value of the Proposed Receipts if the amount was paid as one lump sum in the one financial year. From a cash flow perspective, the Lessor would be better equipped to provide the funds for the Proposed Receipts over the course of a X year period as opposed to paying the amount as a lump sum.

In relation to the stream of lease surrender payments to the taxpayer, it is considered that there is no tax benefit in connection with the scheme.

Further, it is not considered that there is any sole or dominant purpose to obtain a tax benefit, based on a global assessment of the eight factors of the dominant purpose test set out under subsection 177D(2).

The scheme is consistent with normal commercial arm's length dealings, while the form and substance of the scheme is to receive compensation at a profit for the taxpayer. The purpose of the scheme as well as its form and substance and timing were driven by commercial purposes of the Lessor and the Taxpayer's exercising its bargaining power.

The financial position of the Taxpayer and beneficiaries will increase as a result of the scheme while the timing and length of duration is only related to the lease and commercial requirements.

In relation to the Australian tax outcome that would be achieved by the scheme, it is considered that the Refunds and Proposed Receipts will form the assessable income of the Taxpayer while the Rental Reductions will be revenue neutral.

In considering other relevant consequences for the Taxpayer entering into the scheme, the Terms Letter provides that should the ruling from the Commissioner assess the amounts detailed in the Terms Letter as something other than income resulting in the taxation up front, the Lessor will fund the payment of the taxation capped at a maximum of $X million and the Taxpayer will repay this amount to the Lessor over X years.

This highlights the fact that the Taxpayer agreed to enter into this arrangement with the Lessor, regardless of the taxation consequences as the Trust will receive the necessary funds to pay its tax liability.

Therefore, the Commissioner does not consider that there is a dominant purpose to obtain a tax benefit.

There is no scheme to which Part IVA applies under section 177D.

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