Edited version of your written advice

Authorisation Number: 1013111308218

Date of advice: 25 October 2016

Ruling

Subject: CGT on goodwill following the sale of a business

Question 1

Will any capital gain which would otherwise arise to the Company from the disposal of the goodwill on sale of its business be disregarded pursuant to subsection 104-10(5) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following periods:

01 July 20XX - 30 June 20XX

01 July 20XX - 30 June 20XX

01 July 20XX - 30 June 20XX

01 July 20XX - 30 June 20XX

The scheme commences on:

01 July 20XX

Relevant facts and circumstances

Business Structure

A discretionary trust (the Trust) established for the benefit of a family, was settled prior to September 1985 and commenced operating a business on or around the same time. Its trustee was Company 2 (Trustee Company).

In the late 19XX's the Trust decided to transfer its business to a wholly owned company (the Company) because its financier had become increasingly reluctant to lend to a discretionary trust and because a company would offer greater flexibility in attracting outside investment.

On incorporation of the Company in the late 19XX's:

● one $X A class share was issued to the Trustee Company as trustee for the Trust;

and

● one $X A class share was issued to a family member on trust for the Trustee Company as trustee for the Trust.

At the time of the Company's incorporation, the corporation's law required a private company to have X shareholders. Accordingly, a single $X A class share was issued to a family member to be held on trust for the Trustee Company as trustee for the Trust to give effect to the intention that the Company was to be a wholly owned subsidiary of the Trust.

The A class shares had all the rights to dividends, capital on windup, voting etc. which generally attach to ordinary shares.

The business was transferred from the Trust to the Company under a Sale Agreement dated in the late 19XX's and the Trustee Company as trustee for the Trust was issued with additional $X A class shares in the Company as consideration for the sale. All capital gains tax assets transferred to the Company, including the goodwill of the business, were acquired by the Trust prior to 20 September 1985.

Thereafter the Company continued to carry on the business in the same way that the business would have been carried on had it not been sold by the Trust.

Before the date of lodgment of the Trust's income tax return in that same year, the Trust, by written notice to the Commissioner, elected that former subsection 160ZZN(4) of the Income Tax Assessment Act 1396 (ITAA 1936) applied in respect of its disposal of the business and all other assets (including goodwill) with the effect that:

● the capital gains tax provisions at the time under former Part IIIA of the ITAA 1936 did not apply to the disposal;.

● the Company is deemed for the purposes of former Part IIIA of the ITAA 1936 and Parts 3-1 and 3-3 of the ITAA 1997 to have acquired the goodwill (and other assets) transferred to it under the Sale Agreement before 20 September 1985; and

● the Trustee Company is deemed for the purposes of former Part IIIA of the ITAA 1936 and Parts 3-1 and 3-3 of the ITAA 1997 to have acquired the A class shares in the Company that were issued to it as consideration for the sale before 20 September 1985.

Business Operations

In the late 19XX's, A family commenced business operations in the Trust servicing small commercial clients in an area. At inception, the Trust's business was operated from a premises. Together with the services provided, the Trust also sold amenities and consumables to its clients as part of its business model.

The Trust's contracts were won through participating in tender processes. Key contracts were secured during the business' start-up phase between the late 19XX's and the early 19XX's.

Staffing numbers grew quickly with the early expansion of the Trust's business, and included the appointment of the Trust's first non-family member general manager (individual 1) in the late 19XX's. The business also outgrew the families work premises, and was moved to an office and warehouse space in the late 19XX's.

From the early 19XX's, the strategic focus of the Trust's business expanded its target reach from the suburbs to include the CBD and surrounding areas. Opportunities also began to emerge in other markets around this time.

The continued expansion of the Trust's business in the early 19XX's led to the appointment of a non-family member as operation manager. Employee numbers had also grown to adequately cater for the Trust's labour intensive services. A small percentage of staff were employed on a full-time basis, while the remaining were employed on a permanent part-time basis.

Key new contracts were secured from the early 19XX's to the mid 19XX's through participating in tender processes in the CBD and surrounding areas.

Since inception, the Trust has always used plant and equipment procured under lease or hire-purchase arrangements to perform its services.

In the mid 19XX's, another non-family member (Individual 2) took over as general manager of the business, overseeing business services and financial matters. Individual 3 was appointed as a second operations/area manager in addition to Individual 1.

From the mid 19XX's, the Trust's business was extended geographically to include rural opportunities in response to the Trust's existing clients who also owned or operated commercial premises in that region and wanted to engage the Trust's services for those premises. A regional office was opened with an area manager overseeing the region to facilitate this expansion.

In the late 19XX's, the Trust once again outgrew its premises and relocated its head office to a larger premises.

By the end of the 19XX's, the number of employees working in the business had grown, yet the business retained the proportions of staff on a full-time basis, and those on a permanent part-time basis.

New key contracts were acquired through participating in tender processes between the mid 19XX's and early 19XX's.

The Company's core business continued to grow in the early 19XX's, and its strategic focus continued to evolve with the demands of its clients. The Company implemented their first quality management system in the early 19XX's. By this time, the number of employees working in the business had also increased.

In the mid 19XX's, the Company was awarded a prominent contract. This was followed by another prominent CBD contract. Further key contracts were won under the tender process from the early to mid 19XX's.

During this period, the Company continued to improve its quality assurance systems in delivering its services to its clients, and officially obtained certification for its quality management system.

As a further illustration of the growth trend of integrating “soft services” with large scale tenders, in the late 19XX's the Company was requested by an existing client to provide additional services to their ordinary services.

No other clients requested the provision of these additional services and the Company did not actively advertise the provision of these additional services. The Company ceased providing these additional services to that client in the early X000's.

In the early X000's, the Company's business was boosted significantly by winning the contract for a very large client. As a consequence, the total contract represented approximately XX% of the Company's business turnover.

As the Company's business remained extremely labour intensive, the acquisition of the large contract led to a large increase in the number of staff. The Company also relocated its head office in response to growth in the business.

In the early X000's, the Company registered its name under the Business Names Act 1962 (Vic). On or around this time, the Company also changed its corporate logo to reflect its new business name.

In the early X000's, the Company's public liability insurance premiums experienced a marked increase, forcing the business to restrict growth in a certain sector for the short to medium term. Instead the Company began focusing on servicing more of the premium sectors.

Key contracts were won during the early to mid X000's.

Around the mid X000's, the Company ended its contract (refer paragraph 26) as public liability insurance risks and market premiums continued to escalate into the late X000's.

In the mid X000's, Individual 3 retired from the business after XX years of service.

In the mid X000's, the Company's head office moved to new premises, having outgrown its existing premises. By the late X000's, the number of the Company's employees grew, although it retained the same proportion of full-time/part-time employees since prior to 20 September 1985.

Meanwhile, the Company continued to improve the way in which it delivered its services and obtained formal certification for its safety systems in the late X000's. In line with its clients' increasing environmental and sustainability concerns, the Company also implemented a range of sustainable principles across its operations to maximise the protection of the natural environment. The Company obtained certification for its environment management system in the late X000's.

In the early 20XX's, the Company was awarded its first contract interstate and opened a new office in response to the needs of two existing clients which sought to use the Company's services at their interstate properties. Further, the Company commenced operations in another state, again in response to the needs of existing clients whose interstate properties had been impacted by the collapse of a competitor. Notwithstanding this, approximately XX% of the Company's business today remains from clients based in original locations, with the balance being made up from properties based interstate.

All of the Company's interstate offices operate as small spaces from which area managers operate to oversee their respective properties, and as a place for the business owners to use when they visit clients in that area. All support services and administrative functions are performed by the Company's head office.

In the early 20XX's, the Company's corporate logo was updated. Again, as with previous changes, the updates to the logo did not signal any shift in the strategy of the Company's business, but rather sought to emphasise the environmentally sustainable manner in which the Company's services were delivered.

In the mid 20XX's, the Company's head office was relocated to another premise (having outgrown its existing premises again) and Individual 1 retired after XX years of service.

The Company has used information technology improvements since its inception to deliver a premium service to its clients. This includes various IT platforms such as an internal intranet, quality control systems, and online training tools for its employees and contractors to ensure the efficient and effective delivery of the Company's services, as well as the implementation of client portals to provide its client's with a different way of interacting with the Company and accessing relevant information.

Notwithstanding its size, the Company is still a family business. Members have been heavily involved with the Company business since its inception in the late 19XX's. Their children also worked in the business.

In the mid X000's, the family relinquished day-to-day management and control of the business. They were succeeded by their child as managing director and co-managing director in the early 20XX's, but remained actively involved in the Company's business. All past and current directors of the Company are members of the family with the limited short-lived exceptions of Individuals 4 and 5 (see discussion below at paragraphs 48 and 49), and Individual 6 who was appointed a director in the mid X000's (see discussion below at paragraph 42) and resigned his position on the Board a few years ago.

Around the time that the child took over as managing director, the Company's business was perceived as “under-utilised”, being under-capitalised with sub-optimum financial controls, and with financial performance being measured based on cash flow rather than operating profit. To address these issues, a Board of Directors was established in the mid X000's with an independent external Chair, Individual 6, and policies were put in place to ensure better governance and to more efficiently align the Company's operations. The Company's business benefited greatly from the implementation of better controls and corporate governance around this time, such that the performance of the business began to show marked improvement after approximately X years.

Notwithstanding the changes in management polices noted above, the Company continued to service its clients in the same manner as it had since inception, with all new work being won as a result of tender processes, or through the Company's existing relationships with various property managers which had been built over the years.

XX% of the Company's business now stems from large contracts.

The Company's business remains extremely labour intensive, utilising a large number of employees in the same proportions as prior to 20 September 1985. All substantial plant and equipment currently in use to provide the Company's services continue to be procured under lease or hire-purchase arrangements. The Company also continues to sell associated amenities and consumables to its clients, albeit at larger volumes and higher margins, which has contributed to the growth of the business as a result of the increased scale of contracts being secured.

The Company treats provision of its services as a single business for which it prepares a single set of accounts and files its statutory returns (including BAS, income tax and GST returns) as a single business.

Changes to the shareholding structure of the Company

In the late 19XX's, B class participating, but non-voting shares in the Company were issued to Individual 2, who held the position of general manager at that time. The rights attached to the B class shares are the same as those attaching to the A class shares save for any voting rights. In the early X000's, the Company dismissed Individual 2 and all of their B class shares were transferred to a family member.

In the late 19XX's, Individuals 4 and 5 joined the Company and were appointed to positions in the management team. In the early X000's, they were issued with A class shares in the Company for a consideration. The total shares issued represented XX% of the total A class shares on issue immediately after this transaction. They were also appointed as directors of the Company.

The relationship between the family members and Individuals 4 and 5 deteriorated subsequent to their investment in the Company. In the early X000's, Individuals 4 and 5 resigned as directors of the Company and the Company conducted a buy-back of the shares for a consideration equal to the initial investment of Individuals 4 and 5. Following this, all the A class shares issued to Individuals 4 and 5 were cancelled.

As at the date of this ruling, the shareholding of the Company is as follows:

The beneficiaries of the Trust continue to be members of the family. No variation or amendments have been made to the trust deed of the Trust to add, alter or substitute any member of the class of general beneficiaries of the trust since its settlement in the mid 19XX's.

Relevant legislative provisions

Income Tax Assessment Act 1936 former Part IIIA

Income Tax Assessment Act 1936 former subsection 160ZZN(4)

Income Tax Assessment Act 1936 former section 160ZZS

Income Tax Assessment Act 1936 former subsection 160ZZS(1)

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 subsection 104-10(5)

Income Tax Assessment Act 1997 paragraph 104-10(5)(a)

Income Tax Assessment Act 1997 paragraph 108-5(2)(b)

Income Tax Assessment Act 1997 Part 3-3

Income Tax Assessment Act 1997 Division 149

Income Tax Assessment Act 1997 section 149-10

Income Tax Assessment Act 1997 paragraph 149-10(1)(a)

Income Tax Assessment Act 1997 paragraph 149-10(1)(b)

Income Tax Assessment Act 1997 paragraph 149-10(1)(c)

Income Tax Assessment Act 1997 subsection 149-15(1)

Income Tax Assessment Act 1997 subsection 149-15(2)

Income Tax Assessment Act 1997 subsection 149-15(3)

Income Tax Assessment Act 1997 subsection 149-30(1)

Reasons for decision

Summary

The goodwill of the business operated by the Company is a pre-CGT asset. Therefore any capital gain which would otherwise arise to the Company from the disposal of its goodwill on sale of its business will be disregarded pursuant to paragraph 104-10(5)(a) of the ITAA 1997.

Detailed reasoning

Goodwill, or an interest in goodwill, is a CGT asset (paragraph 108-5(2)(b) of the ITAA 1997).

CGT event A1 happens under section 104-10 of the ITAA 1997 if you dispose of a CGT asset, but any capital gain or capital loss made from that disposal is disregarded pursuant to paragraph 104-10(5)(a) of the ITAA 1997 if you acquired the asset before 20 September 1985.

The meaning of goodwill

Taxation Ruling TR 1999/16 deals with CGT issues relating to the goodwill of a business. TR 1999/16 reflects the decision of the High Court of Australia in FC of T v Murry 98 ATC 4585; (1998) 39 ATR 129 (the Murry case).

For the purposes of the definition of 'CGT asset' in section 108-5, goodwill has the meaning it bears under general law (as explained in the Murry case). Paragraph 12 of TR 1999/16 states:

… 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.

Goodwill acquired by the Company before 20 September 1985

Since the rollover made in the late 19XX's satisfied all the requirements of former subsection 160ZZN(4) of the ITAA 1936, the Company is deemed for the purposes of former Part IIIA of the ITAA 1936 and Parts 3-1 and 3-3 of the ITAA 1997 to have acquired the goodwill transferred to it upon the disposal of the Trust's business when that goodwill was first acquired by the Trust, i.e. before 20 September 1985.

Has the business of the Trust continued to be carried on?

For the purposes of Part 3-1 of the ITAA 1997, the goodwill of a business that commenced before 20 September 1985 remains a pre-CGT asset (subject to the operation of Division 149 of the ITAA 1997) provided the same business continues to be carried on. As stated at paragraph 17 of TR 1999/16, this principle holds even though:

(a) the sources of the goodwill of a business may vary during the life of the business; or

(b) there are fluctuations in goodwill during the life of the business.

A business or the sources of its goodwill may change to such an extent that it is no longer the same business, resulting in the goodwill of the old business ceasing when the goodwill of the new business is established. Paragraph 21 of TR 1999/16 provides guidance on the growth of a business:

The business does not need to be identical from its acquisition to its disposal. If the essential nature or character of the business is not changed, the business remains the same business for the CGT goodwill provisions. A business owner may expand or contract activities, or change the way in which a business is carried on, without ceasing to carry on the same business provided the business retains its essential nature or character. Organic growth, expansion or diversification of a business by, for example:

(a) adopting new compatible operations,

(b) servicing different clients, or

(c) offering improved products or services

does not of itself cause it to be a new business provided the business retains its essential nature or character.

In accordance with paragraph 24 of TR 1999/16, the same business is not carried on if:

(a) through a planned or systematic process of change within a reasonable period of time, a business changes its essential nature or character, or

(b) there is a sudden and dramatic change in the business brought about by either the acquisition or the shedding of activities on a considerable scale.

Whether the same business is being carried on is a question of fact and degree that ultimately depends on the circumstances of each particular case. Paragraph 91 of TR 1999/16 provides various factors to consider in determining whether the same business is being carried on. These include:

● the nature or character of the business;

● its location and size;

● the extent of changes in the assets and resources of the business;

● the activities of the business - whether the activities constitute, or are treated by the business owner as constituting separate or distinct activities, enterprises, divisions or undertakings; and

● the way in which the business is structured, carried on, managed and controlled.

In applying these factors to the circumstances of the Company, it is considered that the business being carried on now is essentially the same as the business being carried on by the Trust prior to 20 September 1985 for the following reasons:

● Prior to 20 September 1985 and until its transfer in the late 19XX's, the Trust carried on a business. As part of that business, the Trust also provided “soft services” and sold amenities and consumables to its clients. The business conducted by the Company since the transfer, though substantially larger than that carried on by the Trust, has continued to be the provision of services and the provision of “soft services” and amenity and consumable supplies. The essential nature and character of the business has therefore remained the same since inception.

● Since its inception, the core activities of the business have remained unchanged, none of which constitute, or are treated by the business owners as constituting separate or distinct activities, enterprises, divisions or undertakings.

● Despite certain temporary changes in the ownership structure, the management and control of the business has always rested with the family.

● The expansion of the business and the growth in terms of revenue, client base, employee numbers, resources and other business attributes can be attributed to organic growth of the business and relates predominantly to the core business operations.

As the business being carried on now by the Company is essentially the same as the business being carried on by the Trust prior to 20 September 1985, the goodwill of the business is the same asset and, subject to the operation of Division 149 of the ITAA 1997, retains its status as a pre-CGT asset.

Division 149 of the ITAA 1997

Division 149 of the ITAA 1997 contains rules which govern when an asset acquired before 20 September 1985 stops being a 'pre-CGT asset'. Section 149-10 of the ITAA 1997 provides:

A CGT asset that an entity owns is a pre-CGT asset if, and only if:

(a) the entity last acquired the asset before 20 September 1985; and

(b) the entity was not, immediately before the start of the 1998-99 income year, taken under:

(i) former subsection 160ZZS(1) of the Income Tax Assessment Act 1936; or

(ii) Subdivision C of Division 20 of former Part IIIA of that Act;

to have acquired the asset on or after 20 September 1985; and

the asset has not stopped being a pre-CGT asset of the entity because of this Division.

Paragraphs 149-10(1)(a) and (b) of the ITAA 1997 apply in respect of the goodwill owned by the Company.

In relation to paragraph 149-10(1)(c) of the ITAA 1997, and pursuant to subsection 149-30(1) of the ITAA 1997, an asset of a non-public entity stops being a pre-CGT asset at the earliest time when majority underlying interests in the asset were not held by the ultimate owners who had majority underlying interests in the asset immediately before 20 September 1985. Where a change in the ultimate owners who had the majority underlying interests occurs, the CGT asset is deemed to be acquired after 19 September 1985.

'Majority underlying interests' in a CGT asset is defined in subsection 149-15(1) of the ITAA 1997 to consist of more than 50% of:

(a) the beneficial interests that ultimate owners have (whether directly or indirectly) in the asset; and

(b) the beneficial interests that ultimate owners have (whether directly or indirectly) in any ordinary income that may be derived from the asset.

An 'underlying interest' in a CGT asset is defined in subsection 149-15(2) of the ITAA 1997 as a beneficial interest that an ultimate owners has (whether directly or indirectly) in the asset or in any ordinary income that may be derived from the asset.

An 'ultimate owner' is defined in subsection 149-15(3) of the ITAA 1997 to include an individual. Taxation Ruling IT 2340 reflects on an approach of looking through interposed entities (including trusts) to determine which natural persons hold the beneficial interests for the purposes of former section 160ZZS of the ITAA 1936, which preceded Division 149 of the ITAA 1997.

Taxation Ruling IT 2340 reflects the position that former section 160ZZS of the ITAA 1936, by its terms, necessarily supplants normal legal concepts of interests in assets. Relevantly, for the purposes of former section 160ZZS, a beneficiary of a discretionary trust is treated as having a beneficial interest in the trust's assets.

Immediately prior to 20 September 1985, the goodwill of the business was held by the Trust, a discretionary trust. Subsequent to 20 September 1985:

● the business was transferred by the Trust to the Company in the late 19XX's, at which time the Company was a wholly-owned subsidiary of the Trust, in consideration for A class shares;

● B class shares in the Company were issued to Individual 2 in the early 19XX's, representing a total of X.XX% of the total shares on issue in the Company at that time;

● the B Class shares held by Individual 2 were transferred to a family member in the early X000's;

● A class shares in the Company were issued to Individuals 4 and 5 in the early X000's, representing a total of XX.XX% of the total shares on issue in the Company at that time;

● the A class shares held by Individuals 4 and 5 were cancelled a couple of years later pursuant to a share buy-back by the Company; and

● as at the date of this ruling, all issued shares in the Company are held by the Trust and a member of the family and a beneficiary of the Trust.

In considering whether majority underlying interests have been maintained in the assets of a trust, paragraphs 5 to 7 of IT 2340 are relevant and provide:

5. In relation to what are generally referred to as discretionary trusts, i.e., family trusts, the trustees of which have discretionary powers as to the distribution of trust income or property to beneficiaries, in considering the question of whether majority underlying interests have been maintained in the assets of the trust it will be relevant to take into account the way in which the discretionary powers of the trustees are in fact exercised.

6. Where a trustee continues to administer a trust for the benefit of members of a particular family, for example, it will not bring section 160ZZS into application merely because distributions to family members who are beneficiaries are made in such amounts and to such of those beneficiaries as the trustee determines in the exercise of his discretion.

7. In such a case the Commissioner would, in terms of sub-section 160ZZS(1), find it reasonable to assume that for all practical purposes the majority underlying interests in the trust assets have not changed…

Since the settlement of the Trust in the late 19XX's, there have been no changes to the class of beneficiaries, or otherwise, under the Trust's Deed such that the Trust has always been administered for the benefit of the family.

Based on the factors set out in paragraphs 71 and 73 above, there has been no change in the majority underlying interests in the goodwill of the business.

As the majority underlying interests in the goodwill of the business have been had at all times by the same ultimate owners who had such interests immediately before 20 September 1985, i.e. the beneficiaries of the Trust, Division 149 of the ITAA 1997 will not affect the pre-CGT status of the goodwill for the purposes of the ITAA 1997.

Conclusion

Any capital gain made by the Company under section 104-10 of the ITAA 1997 from the disposal of its goodwill will therefore be disregarded pursuant to paragraph 104-10(5)(a) of the ITAA 1997.

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