Edited version of your written advice

Authorisation Number: 1051213641850

Date of advice: 27 April 2017

Ruling

Subject: Is the lump sum payment assessable as ordinary income under ITTAA 1997

Question 1

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

Answer

Yes

Question 2

If the lump sum payment received from the company is ordinary income can it be declared over the term of the deed?

Answer

No

This ruling applies for the following period

Year ended 30 June 2016

The scheme commenced on

1 July 2015

Relevant facts and circumstances

The company, Z and the doctor entered into a Provision of Services to Incorporated Medical Practitioner Deed (deed).

The company has a lease on premises which it has equipped for use as a medical practice.

Z is an incorporated medical practice. The doctor is a registered medical practitioner. Z wishes to conduct its incorporated medical practice from the premises and the company has agreed to make the premises available for this purpose and to supply extensive services to Z on the terms contained in the deed.

The deed will continue for a period of X years and after that until determined by either party giving to the other 30 days written notice.

The company is to provide such administrative services, clerical staff, facilities, plant and equipment which are necessary for Z to conduct its incorporated medical practice from the premises.

Z must conduct its incorporated medical practice and must procure that the doctor attends at the premises and renders medical services at the specified location within the premises specified by the company and during such hours that are mutually agreed upon by the company and Z at any time.

The company will charge, and Z agreed to pay to the company, X% of moneys banked for the use of the premises and the services provided by the company. After the X% has been deducted, the company will pay the rest (X%) to Z on a regular basis.

The company, Z and the doctor entered into a Further Provisions (practitioner contract). The practitioner contract states on the commencement date a lump sum of $X will be paid to Z. Also on the commencement date Z must commence its incorporated medical practice through the doctor at the premises. Z will conduct its incorporated medical practice and procure a doctor to render medical services from the premises for at least X years from the commencement date. The parties agreed that Z and the doctor must not during the restraint period render medical services at any place within a radius of X kilometres of the premises. The restraint period is the period from the commencement date until the later to occur of:

(a) The X^th anniversary of the commencement date; or

(b) The X^rd anniversary of the date on which the Practitioner Contract terminates for whatever reason.

The company and the doctor entered into a performance guarantee incorporated medical practitioner deed (performance guarantee). The doctor covenants with the company that he/she will procure that Z carries out the terms and obligations imposed on it under the practitioner contract.

Relevant legislative provisions

Income tax Assessment Act 1997 Subsection 6-5(1)

Income tax Assessment Act 1997 Subsection 102-5(1)

Income tax Assessment Act 1997 Section 104-35

Income tax Assessment Act 1997 Section 118-20

Reasons for decision

Question 1

Summary

The amount of $X is assessable as ordinary income under section 6-5 of the ITAA 1997 as an incentive/inducement for the doctor to work as a medical practitioner for a fixed period of X years from the commencement date. The amount is wholly assessable in the 2015-16 income year and no part of it can be amortised over subsequent income years.

Detailed reasoning

To determine the correct tax treatment of the lump sum payment, it must first be considered whether the payment is assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident includes the ordinary income (i.e. income according to ordinary concepts) the resident derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

The legislation does not define what is meant by income according to ordinary concepts, however there is a substantial body of case law that provides guidance on relevant factors to be considered.

In Scott v. Commissioner of Taxation (NSW) (1935) 3 ATD 142, Jordan CJ stated (at pages 144-145):

The word 'income' is not a term of art, and what forms of receipts are comprehended within it, and what principles are to be applied to ascertain how much of those receipts ought to be treated as income, must be determined in accordance with the ordinary concepts and usages of mankind, except in so far as the statute states or indicates an intention that receipts which are not income in ordinary parlance are to be treated as income, or that special rules are to be applied for arriving at the taxable amount of receipts.

Furthermore, Windeyer J in Scott v. Federal Commissioner of Taxation (1966) 117 CLR 514 noted that whether or not a particular receipt is income depends upon its quality in the hands of the recipient (at page 526). He further stated that whether a receipt is income must always depend on a consideration of the whole of the circumstances (at page 527).

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.

The profits of an isolated transaction, even if received as a lump sum, may be income (Federal Commissioner of Taxation v. Myer Emporium Ltd (1987) 163 CLR 199; [1987] HCA 18).

It is therefore necessary to consider whether the lump sum payment of $X made under the Further Provisions agreement (Practitioner Contract) Z and the doctor signed with the company has the character of income.

In Allied Mills Industries Pty Ltd v. Commissioner of Taxation (1989) 20 FCR 288; 89 ATC 4365, the taxpayer received a lump sum payment for giving up the right to manufacture and distribute certain biscuits. The Full Federal Court held that the lump sum payment was revenue - the taxpayer did not part with a substantial part of its business or cease to carry on business, nor did it dispose of the fixed framework of the business. The lump sum was found to be compensation for the termination of the arrangements between the parties, which was properly characterised as a payment for the loss of profits cause by the termination. The Court stated:

In characterising payments made under an agreement, the terms of the agreement must, of course, be examined; but so must the whole of the circumstances surrounding its execution, its operation and the receipt of the money in question: Federal Coke Co. Pty. Limited v. F.C. of T. 77 ATC 4255; (1977) 34 F.L.R. 375 per Bowen C.J. at ATC p. 4262; F.L.R. p. 385.

Contracts are made to be performed, not terminated … What is important in characterising the payment is … the nature of the contract which generated the payment, and the way in which that contract related to the structure and business of the taxpayer.

It may also be the case that the lump sum consists of elements of both capital and revenue nature. For example, in McLaurin v. Federal Commissioner of Taxation (1960-1961) 104 CLR 381 a farmer received an undissected lump sum payment in relation to damage caused to his grazing property. The High Court held, at page 391:

It is true that in a proper case a single payment or receipt of a mixed nature may be apportioned amongst its several heads to which it relates and an income or non-income nature attributed to portions of it accordingly … But while it may be appropriate to follow such a course where the payment or receipt is in settlement of distinct claims of which some at least are liquidated… or are otherwise ascertainable by calculation … it cannot be appropriate where the payment or receipt is in respect of a claim or claims for unliquidated damages only and is made or accepted under a compromise which treats it as a single, undissected amount of damages. In such a case the amount must be considered as a whole. (emphasis added)

Incentive/inducement payments

Courts have often held that incentive payments or inducements can be assessable income. For example, in McLean and Anor v. Federal Commissioner of Taxation 96 ATC 4443 the Federal Court held that lump sum payments made to a taxpayer to remain in the employment of their employer were held to be assessable income. Northrop J held, at page 4447:

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 left his employment, the amount of the payment was reduced but otherwise the payment was for the specified sum. The continual employment was at the very heart of the receipt of the payment. (emphasis added)

In Pickford v. Federal Commissioner of Taxation 98 ATC 2268, the taxpayer was an employee who had been granted options to purchase shares in his employer's parent company under an employee share scheme. However the options would lapse immediately if they ceased to be employed by the employer. Another company made an offer of employment to the taxpayer, which included a payment of $20,000 said to be compensation for the potential capital gain that may have been available to the taxpayer in relation to the shares they would have been entitled to if they had remained with the original employer. The AAT held the $20,000 lump sum payment was assessable income:

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.

ATO ID 2003/373 Retention bonus payments paid to Bougainville Peace Monitoring group also outlines the ATO view that lump sum retention bonuses paid by the Australian Defence Forces in order to encourage serving members to remain for a fixed period are assessable as ordinary income. In this ATO ID, where the 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.

Courts have also held, in a number of cases, that lease incentive payments received by the taxpayers were ordinary assessable income.

Isolated transactions

As mentioned above, the profits of an isolated transaction, even if received as a lump sum, may still be income. Following on from the High Court decision in Federal Commissioner of Taxation v. Myer Emporium Ltd (1987) 163 CLR 199; [1987] HCA 18, Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income provides guidance in determining whether profits from isolated transactions are income. It states:

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.

In Commissioner of Taxation v. Cooling (1990) 22 FCR 42; (1990) 94 ALR 121, 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 described in paragraph 50 of TR 92/3:

At the relevant time in the city where the firm practised, it was an ordinary incident of leasing premises of the type in question to receive incentive payments. Hill J (with whom the other judges agreed on the subsection 25(1) issue) said that where a taxpayer operates from leased premises, the move from one premises to another and the leasing of premises occupied are acts of the taxpayer in the course of its business activity. 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.'

Restrictive covenants

A number of principles in relation to restrictive covenants have been highlighted through the cases below.

In Higgs v. Olivier [1952] 1 Ch 311 (Higgs), the taxpayer was contracted to perform services in relation to a movie. The taxpayer then entered into another agreement with the film company covenanting that for 18 months he would not appear in, produce or direct any film for any other company. It was held that this was a separate agreement that could not be read with the original service agreement and the lump sum was a capital receipt. Sir Raymond Evershed MR stated at page 318:

…if a trader, or professional man, for a money consideration covenanted to give up his trade or profession for the rest of his life, then it would be difficult to say that the money received was 'profits or gains accruing or arising from his trade or profession'. On the other hand it is not difficult to see that a restriction of a very limited or partial character might less easily be taken out of the ambit of the taxing provision. One example in the argument was that of an actor who covenanted for a limited period not to act for one particular company out of a large number. I myself gave the example of an actor who covenanted for a limited period not to act under his own or well-known stage name. But between the two extremes there is a large area, and for myself I am disposed to think that within that area it may well be a matter of degree. (emphasis added)

In Dickenson v. Federal Commissioner of Taxation (1958) 98 CLR 460; [1958] HCA 62 (Dickenson), the taxpayer was an owner of a garage and received two lump sum payments in entering into an exclusivity agreement with Shell for a period of 10 years. The High Court held that the two payments were capital receipts. Kitto J referred to the quote above from Higgs v. Olivier and went on to say (at 98 CLR 492):

Much the same may be said, I think, in relation to the Commonwealth Act, though its conceptions are by no means the same as those of the United Kingdom Act and it is possible that such a case as Higgs v Olivier might have to be decided against the taxpayer if it arose under the Commonwealth Act …. But a lump sum payment for a restriction of a garage and its proprietor to one brand of petroleum products for a period of ten years, effectuated by means of a lease and sublease of the premises as well as by personal covenants, seems in the nature of a sale price for a substantial and enduring detraction from pre-existing rights. The restriction does not strike my mind as an obligation undertaken incidentally to the carrying on of a business. Rather does it take a substantial piece out of the ordinary scope of the business activities to which otherwise the appellant might apply himself and for which he might use his premises. (emphasis added)

In Hepples v. Federal Commissioner of Taxation 91 ATC 4808 (Hepples) a taxpayer received a lump sum on termination of his employment in consideration for the taxpayer not divulging trade secrets or 'special processes' of the former employer, not competing with the former employer in Australia and assigning to the former employer any patent protection in any invention made by the taxpayer from the use of the 'special processes', for a period of two years. Deane J stated at page 4819:

Traditionally, a genuine payment to an individual employee as consideration for covenants in restraint of his or her freedom to compete or to use or divulge certain information during a specified number of years after the termination of employment has not been seen as income in the ordinary sense for the purposes of s. 25(1) of the Act …

Whilst Hepples is authority for the principle that restrictive covenants relating to the period after termination of a contract/employment are not generally seen as income, Taxation Ruling TR 95/3 Income tax and capital gains: application of subsections 160M(6) and 160M(7) to restrictive covenants and trade ties expresses the ATO view that restrictive covenants relating to the period of employment is assessable income.

In Federal Commissioner of Taxation v. Woite 82 ATC 4578 a professional footballer received a lump sum payment from the North Melbourne Football Club for signing a 'Form 4', the effect of which meant he was not to play for any Victorian club other than North Melbourne. Although holding that the lump sum in that case was not income, Mitchell J noted at page 4582:

Had the signing of Form 4 by the respondent been followed by a contract with the North Melbourne Club to play football for that club it may well have been difficult, if not impossible, for the respondent to discharge the onus of establishing that the $10,000 was not income. In Case A14 69 ATC 80 the Board of Review considered a restrictive covenant under which the taxpayer, a footballer or international standard, entered into a contract with the Metropolitan Rugby League Football Club to play football for that club for three years and covenanted not to play football with any other club in the metropolitan area for a further period of three years. The majority of the Board held that the payment for the restrictive covenant represented the rewards of professional football as much as did the signing-on fee and match payments in that the amount was paid in consideration of his services as a footballer being available to the club and as such amounted to income.

His Honour then went on to refer to Dickenson as providing a useful analogy, citing with approval Kitto J's suggestion in that case that Higgs might have been decided against the taxpayer if it arose under the Australian provisions. He went on to say that in the present case 'the restriction was not an obligation undertaken incidentally to the playing of football for reward by the taxpayer'.

In Brent v. Federal Commissioner of Taxation (1971) 125 CLR 418; 71 ATC 4195 (Brent), the taxpayer sold the exclusive right to publish her life story throughout the world. As part of the agreement, the taxpayer agreed not to communicate about the subject matter to anyone else or give any press, radio or television interviews about any subject for a period of 60 days from the date of signing the manuscript for her life story. The taxpayer ultimately received two lump sum payments. The High Court held that the lump sums received by the taxpayer were for services rendered by the taxpayer to the company and were ordinary income. The Court noted, at 71 ATC 4198:

Clause 8 contained an undertaking by the appellant not to communicate with or make statements to others relative to the subject matter of the agreement and, in particular, not to give press, radio or television interviews on any subject within sixty days from the signing of the manuscript. This negative covenant was no doubt of real value to the company, but it was ancillary to the main purposes of the agreement [which was for the provision of services]. (emphasis added)

Application in your case

Incentive/inducement payments

Whilst clause X of the practitioner contract states that the lump sum 'payment' is in consideration for rendering medical services as well as specified restraints, as outlined above, consideration of the whole of the circumstance is required in order to determine the nature of the lump sum payment.

As there are no specific terms in any of the contracts entered into which state that an amount needs to be repaid if the contract is not fulfilled, it is assumed that the company could take legal action to recover amounts which would be in relation to services which will not be provided by the doctor if for some reason he/she does not fulfil the terms of the practitioner agreement.

No value can be attributed to the restrictive covenant of the Agreement from the terms of the contracts. The lump sum is clearly an inducement payment.

ATO enquiries have identified that medical centre owners make lump sum payments to new health care practitioners joining their medical centres, which indicates these lump sum payments are a prevalent industry practice.

As referred to above, the Full Federal Court in Allied Mills Industries Pty Ltd v. Commissioner of Taxation reinforced that contracts are to be performed, not terminated. The nature of the contract here is for the performance of medical services by the doctor at a clinic operated by the company for a fixed term period, and the lump sum payment clearly link to this income-generating purpose.

The above factors indicate that the true nature of the lump sum payment is that of an inducement for Z to provide the doctor's medical services at the company's medical centre for the X year fixed term period. As such, the whole of the lump sum payment is assessable as ordinary income under section 6-5 of the ITAA 1997.

Isolated transactions

It is also arguable that the lump sum payment is assessable as a profit or gain from an isolated transaction. As referred to above, TR 92/3 requires two elements to be satisfied:

(a) the intention or purpose of a 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.

An objective assessment of the taxpayer's intention is required, and the profit-making intention need not be the sole or dominant purpose for entering into the agreement, it need only be a significant purpose.

Consideration of all the circumstances indicates that an intention to make a profit from entering the agreement was a significant purpose. The Agreement directly states that the lump sum payment is for entering into the Agreement to provide the doctor's medical services as a general practitioner for a period.

It is also considered that the transaction was entered into, and the profit made, in the course of carrying on a business or in carrying out a business operation or commercial transaction. Although a general practitioner may not enter into many arrangements to provide their medical services, it is part of their business to provide such medical services. Furthermore, Z, the company and the doctor were clearly contracting on a commercial basis under a business relationship.

Incentive/inducement payments are also common in the health care industry.

As such, the lump sum payment could also be assessable under section 6-5 of the ITAA 1997 as a profit or gain made from an isolated transaction.

Restrictive covenants

Even if part of the payment was found to be legitimately referable to the restraints in the practitioner's contract, it is still considered that the entire lump sum payment is assessable as income under section 6-5 of the ITAA 1997:

● The restraints are ancillary in nature to the main purpose of the contract, which is to engage the doctor to work in the company's medical centre for a fixed period (following Brent).

● The restraints are of a 'very limited or partial character' and do not 'take a substantial piece out of the ordinary scope of the business activities' for the company, such that they are not taken out of section 6-5 of the ITAA 1997. The restraints relate to a very small area which can be distinguished from Higgs, Dickenson and Hepples. Those cases involved substantial giving up of rights and covered extensive geographical areas.

Furthermore, whilst McLaurin v. Federal Commissioner of Taxation is authority for the principle that an undissected lump sum must generally be considered as a whole, the High Court acknowledged that apportionment may be appropriate where at least some of the claims are 'liquidated … or are otherwise ascertainable by calculation' (emphasis added). There has been no provision made in the practitioner contract for the calculation of a portion for the restraint clause.

Under this view, there would be two elements to the payment:

● an inducement for entering into the X year fixed term agreement; and

● restraints during the fixed term period of the Agreement

The inducement for entering into the fixed term agreement would be assessable income. It is also considered that, following the principle in Dickenson, the restraints during the fixed term period would be 'an obligation undertaken incidentally to the carrying on of a business'. Under the terms of the Agreement, the doctor has positive obligations to:

● work no less than X hours per week at the company's medical centre for a minimum of X weeks per year

● use his/her best endeavours to ethically and professionally, expand the turnover, profitability, quality and image of the services provided at the premises

It therefore follows that the restraints relating to the period of the fixed term agreement are merely a natural consequence of, and an obligation incidental to, these positive obligations under the Agreement. As such, they are income in nature.

Accordingly, the entire lump sum amount is attributable to the two elements:

1. an inducement for entering into the X year fixed term agreement

2. restraints during the fixed term period of the Agreement

which are considered to be assessable income under section 6-5 of the ITAA 1997.

Based on the arrangement and the contractual documentation, there is no amount attributable to the restrictive covenant post the termination/expiration of the Agreement.

Question 2

As discussed above, the payment is assessable as ordinary income. It is assessable when it is derived. It is considered that the income was derived when it was received. Therefore, the payment is included in assessable income in the income year it was received, that is, the 2015/16 income year.

In similar cases, submissions have been to the Commissioner that the lump sum incentive/inducement payment should be assessed over the period of the agreement. These submissions have relied on the decision in Arthur Murray (NSW) PTY Ltd v. Federal Commissioner of Taxation (1965) 114 CLR 314 (Arthur Murray). However, unlike in Arthur Murray, the lump sum payment in this situation is not a pre-payment for services to be rendered, rather it is an inducement to enter into the agreement. Therefore, we consider that Arthur Murray is clearly distinguishable. As such, the lump sum payment is assessable as ordinary income when it is derived and it was derived when it was received. As the payment was received in the 2015-16 income year it is wholly assessable in that income year.

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