Edited version of your written advice

Authorisation Number: 1051230717375

Date of advice: 29 May 2017

Ruling

Subject: Goodwill of a business

Question

For the purpose of determining the application of subsections 104-230(2) and 104-230(6) of the ITAA 1997 to the disposal of shares by the Applicant, will the interest in the goodwill held by the Applicant arising from its business be considered to have been acquired before 20 September 1985?

Answer

Yes

This ruling applies for the following periods:

The year ended 30 June 2016.

The scheme commences on:

The year ended 30 June 2016.

Relevant facts and circumstances

The history of the business

In year 20, the Applicant sold shares in a company (Sold Co) that carried on a business.

Nature of the business

In year 1, the business involved the sale of goods.

The business’ customers were retailers of the goods and other suppliers of the goods.

The business also 'semi-manufactured’ all the products it sold. This involved the assembly of items that had been manufactured by other companies to form a final product for sale to its customers.

The business’ trading stock was kept in warehouses in premises it maintained prior to despatch to its customers.

Management of the business

From year 1 the management of the business was headed by Mr A and Mr B.

The business carried on by the business as at 20 September 1985

Sales for the business had grown. The increase in sales was mainly due to improvements in processes and from an improvement in marketing to customers.

Nature of the business

The business’ sole undertaking continued to be the wholesale distribution of goods.

The particular types of goods it sold reflected the needs of its clients at the time, as the business sales focus was on the provision of goods required by its customers rather than on the supply of any one particular product.

The business involved:

● the acquisition of trading stock from a number of suppliers;

● the forecasting and ordering of inventory;

● the semi manufacture of products;

● storage of the products in the company’s warehouse;

● marketing both through direct marketing and the production of catalogues of promoted product items;

● negotiations with key suppliers;

● negotiation with key customers; and

● despatch to customers as ordered.

All customers were retailers of the goods and other suppliers of the goods.

Bank A was used as the business’ main banking facility.

The business was operated through a warehouse in Australia.

Management of the business

The management group for the business expanded. The management was headed by XX and YY.

XX was responsible for:

● development of the annual business plan and budget;

● marketing and sales;

● all aspects of product purchase, costing and pricing;

● customer relationships;

● personnel;

● negotiations with key suppliers; and

● working capital management.

The business in year 6

In year 6, the business obtained the distributorship for another product in Australia. The expansion of the product range was considered important at the time as it allowed the business to provide more comprehensive supplies in the relevant segment within the industry.

Management of the business

XX and YY led the management team for the business.

The business in year 10 before the partnership

Nature of the business

The sales for the business grew to approximately $$ by year 10.

The nature of the business remained the exclusively wholesale distribution of the goods.

The business involved:

● the acquisition of trading stock from a number of suppliers;

● the forecasting and ordering of inventory;

● the semi-manufacture of products;

● storage of the products in the company’s warehouse;

● marketing both through direct marketing and the production of catalogues of promoted product items;

● negotiations with key suppliers;

● negotiation with key customers; and

● sale and despatch to customers as ordered.

Some of the acquisition of trading stock was of manufactured to the business’ specifications and under its brands.

The particular types of products sold reflected the needs of the business’ clients at the time, as the business sales focus was on the provision of products required by its customers rather than on the supply of any one particular product.

The business’ customers continued to be retailers of the goods and other suppliers of the goods.

The business’ customer base continued to increase. The business established a branch office overseas to facilitate the expansion and distribution of its products overseas, and the sale of products overseas continued in year 10.

Orders for products by customers were placed in writing by mail, over the phone, or by fax.

Bank A was the principal banking provider.

The business was operated from a warehouse in Australia.

Management of the business

The management team continued to expand. The management team was headed by XX and YY.

XX’s responsibilities included:

● development of the annual business plan and budget;

● marketing and sales;

● all aspects of product purchase, costing and pricing;

● customer relationships;

● personnel;

● negotiations with key suppliers; and

● working capital management.

The partnership

In year 10, Sold Co formed a partnership with Another Co pursuant to the terms of the partnership agreement.

The following facts pertain to the establishment of the partnership:

● In year 10 Sold Co sought to acquire assets held by Another Co, which owned and distributed a range of products that were complementary to the products distributed by Sold Co.

● Initial attempts to acquire these assets were rejected, but eventually an agreement was made for the formation of a partnership.

● A valuation was provided in respect of the assets contributed by Sold Co to the partnership. Based on the valuation, the market value of the implied goodwill contributed by Sold Co was $$$.

● A separate valuation was provided on the assets contributed by Another Co to the partnership. It determined that the value of the goodwill contributed by Another Co at that time was nil.

In the partnership:

● the profit and losses were split between the two partners. The sharing of profits was reflected in the financial accounts prepared for the partnership each year;

● the financial statements were prepared in the name of the 'partnership’ rather than in the name of each party. Such accounts were separate, distinct and in addition to the accounts prepared for each of the partners;

● the financial statements were audited each year since formation of the partnership;

● the audited financial accounts of the partnership provided that the net equity in the assets are held by the two venturers equally and distributed the net profit equally to the two partners;

● partnership income tax returns were lodged for the partnership since year 10 and the partners disclosed the profit share as provided in the partnership income tax return in their own separate company tax returns.

The partnership business

Nature of the partnership business

The partnership business was the exclusively wholesale distribution of the goods.

The partnership business involved:

● the acquisition of trading stock from a number of suppliers, including the purchase of supplies and stationery manufactured to the company’s specifications and under the company’s brands;

● forecasting and ordering of inventory;

● the semi-manufacture of products;

● storage of the products in the company’s warehouse;

● marketing both through direct marketing and the production of catalogues of promoted product items;

● negotiations with key suppliers;

● negotiation with key customers; and

● sale and despatch to customers as ordered.

The particular types of products sold by the partnership business reflected the needs of its clients at the time, as the business sales focus was on the provision of products required by its customers rather than on the supply of any one particular product.

The most significant expansion to the product range post the formation of the partnership was the addition of a product category. However, the entire product category represented a small percentage of the total sales of the business.

All of the partnership’s sales were to retailers of the goods and other suppliers of the goods. The customers of the partnership were largely the same as the customers of the business conducted by Sold Co.

The partnership business also distributed products overseas.

The main suppliers to the partnership business were the same as those in respect of the business prior to the formation of the partnership.

The main assets of the partnership business remained trading stock and debtors.

Bank A was the principal banking provider for the partnership business.

The administration of the partnership business was centred in the existing Sold Co warehouse in Australia, where products used in the partnership business were stored. Following the formation of the partnership, the administration and distribution facilities previously operated by Another Co were closed and all of Another Co’s trading stock was relocated to Sold Co’s warehouse in Australia.

Management of the partnership business

The management team for the partnership business was headed by XX and YY. No Another Co senior managers joined the management team following the formation of the partnership.

The day-to-day business of the partnership was managed by XX. Specifically:

● XX was appointed Chief Executive Officer of the partnership.

● XX (as CEO) was responsible for the preparation of the cash flow, profit and capital expenditure budgets for the business.

XX undertook responsibility for the following in respect of the partnership business:

● development of the annual business plan and budget;

● marketing and sales;

● all aspects of product purchase, costing and pricing;

● customer relationships;

● personnel;

● negotiations with key suppliers; and

● working capital management.

The employees of Sold Co maintained their roles in the partnership business following the formation of the partnership.

The majority of the former employees of Another Co left the partnership business soon after the formation.

The partnership business in year 20

Nature of the partnership business

As at year 20, the partnership business remained an exclusively wholesale distribution business of products to companies that resold products to the end consumer.

The partnership business involved:

● the purchase of products manufactured to the company’s specifications and under the company’s brands,

● forecasting and ordering of inventory;

● the semi-manufacture of products;

● marketing activities to promote the company’s key brands through primarily both direct marketing and the production of catalogues of promoted product items;

● negotiations with key suppliers;

● negotiation with key customers;

● storage of products in the company’s warehouse; and

● sale and despatch to the customers as ordered.

The particular types of products sold reflected the needs of the partnership business’ clients at the time, as its sales focus was on the provision of products required by its customers rather than on the supply of any one particular product.

This meant that certain products that were previously sold were phased out and no longer distributed by year 20. However, in their place other products were introduced to the products distributed.

The main customers of the partnership business were largely maintained.

The partnership business continued to distribute products overseas.

By year 20, registered commercial account holders could place orders with the business electronically through its website.

The main suppliers to the partnership business were manufacturers of products built to company specifications and labelled under the company’s brands. The suppliers were international.

Over the years the partnership business’ involvement in the semi-manufacture of its products decreased as more products were imported and sold directly. However it always maintained an involvement in semi-manufacture and continues to semi-manufacture its own products.

Bank A was the main banking service provider for the partnership.

The operations of the partnership business were centred in the head office and main warehouse facility in Australia. The partnership business also utilised satellite warehouses in various locations throughout Australia.

Management of the partnership business

The management team for the partnership business continued to be headed by XX and YY.

In year 20, X remained the Chief Executive Officer of the partnership, which continued to conduct the partnership business. XX continued to be responsible for the management of the partnership business on a day-to-day basis and remained responsible for:

● the development of the annual business plan and budget;

● marketing and sales;

● all aspects of product purchase, costing and pricing;

● customer relationships;

● personnel;

● negotiations with key suppliers; and

● working capital management.

Relevant legislative provisions

Section 104-230 of the Income Tax Assessment Act 1997 (ITAA 1997)

Section 109-10 of the ITAA 1997

Reasons for decision

Introduction

The application of subsection 104-230(2) and subsection 104-230(6) depends on the determination and calculation of the market value of property of the company or trust, or the market value of interests the company or trust owned though interposed companies or trusts, in property that was acquired on or after 20 September 1985. Under subsection 104-230(2) the market value of such property or interests must be at least 75% of the net value of the company or trust in order that CGT event K6 happens.

The broader question that arises in this case is whether, at the time the Applicant entered into the share sale (that is, the time 'just before the other event happened’ under the terms of subsection 104-230(2)), the interests the Applicant held through interposed companies in property acquired on or after 20 September 1985 was 75% of the net value of the company.

However, the specific question for which the present ruling is sought is whether the interest in goodwill of the business owned by Sold Co through the various interposed companies at the time of the share sale was acquired prior to 20 September 1985.

Determination

The business as it was established in year 1, and the partnership business at the time of the share sale, are one and the same. Specifically, the goodwill of the business held by Sold Co at the time of the share sale was one and the same as that which was acquired by Sold Co in respect of the same business prior to 20 September 1985. This view takes into account the following events in the evolution of the business:

● the establishment of the business in year 1;

● the business as at 20 September 1985;

● the formation of the partnership in year 10 with Another Co; and

● the business in year 20.

The reasons for the Commissioner’s view are expressed in detail below and have been structured into 3 parts:

1) The first part considers goodwill in general and the authority governing the tax treatment of goodwill of a business.

2) The second part focusses on the formation of the partnership and its impact on the business and goodwill. This issue was flagged as a significant event in the existence of the business and it is appropriate that it be specifically considered.

3) The third part contains the collective, broader reasons for the determination of the issue. It contains an analysis from an overarching perspective of the business as it existed between its establishment in year 1 and the share sale in year 20 and in doing so examines the character of, and management of, the business during this period.

Part 1: Goodwill - general

The general meaning of 'goodwill’ as used in the context of the CGT provisions is explained in Taxation Ruling TR 1999/16 Income tax: capital gains: goodwill of a business (TR 1999/16). It is derived from general law. Under the decision of the High Court in FCT v Murry 98 ATC 4585, it has 3 aspects: property, sources and value.

Paragraph 12 of TR 1999/16 provides as follows:

'….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….’

The business was established in year 1. The goodwill attached to it is also taken to have commenced at that time, being the time at which 'work that resulted in the creation started’: item 1, section 109-10 of the ITAA 1997.

Paragraph 7 of TR 1999/16 provides that the word 'business’ refers to:

'….a course of conduct carried on for the purpose of profit and also involves notions of continuity and repetition of actions. It is an undertaking or going concern in which an entity or entities use assets, knowledge, skills, human resources and other things as required in continuing activities or transactions for commercial purposes…’

The business conducted by Sold Co in year 1, being its sole commercial undertaking and the course of conduct in which it was engaged, was the sale of goods to retailers and suppliers for the purpose of profit.

Goodwill is a single CGT asset for the purposes of Part 3-1 of the ITAA 1997: paragraph 16 of TR 1999/16. The whole of the goodwill of a business that commenced before 20 September 1985 remains the same single pre-CGT asset provided that the same business continues to be carried on. The goodwill of a business ceases if the business changes to the extent that it can no longer be regarded as the same business. In such a case, the old business (and its associated goodwill) ceases and a new business commences: paragraphs 17 and 18 of TR 1999/16.

Part 2: Was a separate business created by the formation of the partnership?

The most significant change in the life of the business is the formation of the partnership in year 10 with Another Co.

Paragraphs 63 and 64 in TR 1999/16 provide as follows:

63. If a taxpayer who founded or purchased a business adds to that business an additional business purchased as a going concern, it is a question of fact dependent on the circumstances of each particular case whether the additional business is subsumed into and forms part of the existing business or whether the two businesses remain as separate businesses. If two post-CGT businesses are subsumed in this way, the goodwill of the businesses coalesce and the cost base of the goodwill of the business purchased as a going concern becomes part of the cost base of the goodwill of the entire business.

64. If a pre-CGT business is combined with another business acquired post-CGT and they are conducted as one business without the pre-CGT business losing its essential nature or character, the goodwill of the post-CGT business is subsumed into the goodwill of the pre-CGT business and all of the goodwill of the business is taken to have been acquired before 20 September 1985. The goodwill of each of the businesses coalesce without any disposal of the goodwill of the post-CGT business. The pre-CGT business must not lose its essential nature or character in the sense that it must remain the same business and not be overwhelmed by the post-CGT business in such a way that it has become a different business. The purchase of the post-CGT business must involve merely organic growth of the pre-CGT business or an expansion or accretion to it in reasonable proportions or it gives rise to a new, different business and its goodwill is a new asset.

Our view is that despite the restructure effected by the formation of the partnership, no change was made to the essential nature of the business; that under the partnership arrangement the business conducted by Another Co was subsumed into, and became a part of, the pre-existing business conducted by Sold Co, which at its core remained fundamentally the same as that which was conducted prior to the restructure.

This view takes into consideration the following factors:

● The partnership arrangement was entered into primarily as a means by which products that were complementary to the goods distributed by Sold Co would be acquired; and in this respect was more in the nature of an expansion of the existing business rather than a cessation of the business followed by the emergence of a new, distinct business, or a coexistence of two separate businesses.

● The essential nature processes and activities of the business remained the same after the partnership. This included the character and range of products distributed by the business (albeit expanded by the products introduced by Another Co), and the main clients of the business.

● The nature and continuity of the business as it existed in the broader period between year 1 and year 20 is examined in further detail below.

● The management of the business remained the same. XX was appointed its Chief Executive Officer of the partnership and they were contractually bound to manage the business on a day-to-day basis. For practical purposes XX remained the manager of the business.

● The management of the business as it existed in the broader period between year 1 and year 20 is considered in further detail below.

● The employees of Sold Co maintained their roles in the business following the formation of the partnership, while the majority of the former employees of Another Co left the business within a short period of time following the formation.

● Sold Co contributed significantly more in assets to the partnership.

● The market value of the goodwill contributed by Sold Co to the partnership has been estimated to be $$$$ while the goodwill contribution by Another Co has been valued at nil.

● The administration and storage facilities for the business were centred in the existing Sold Co warehouse in Australia. Following the formation of the partnership, the administration and distribution facilities previously operated by Another Co were closed and all of its trading stock was relocated to Sold Co’s warehouse in Australia.

For the reasons above, it is our view that the business did not change in its essential character as a result of the partnership and that the commercial undertakings of Another Co (and any associated goodwill) were subsumed into the business conducted by Sold Co and its established goodwill.

For the purposes of applying the 75% test in section 104-230, the provisions in Division 149 are ignored: paragraphs 65 to 67 of TR 2004/18.

The goodwill associated with the partnership business was not, for the purposes of subsection 104-230(2), a new, separate interest acquired by Sold Co on or after 20 September 1985 solely by reason of the partnership arrangement. The goodwill was rather a continuation of that which existed prior to the partnership.

Part 3: The nature of the business from year 1 to year 20

To address the larger question of whether the goodwill that commenced from the inception of the business continued to exist until the date of the share sale, the following paragraphs examine in greater detail the nature of the business (including business processes and activities) and the management of the business in the broader period between the time of the business’ establishment in year 1 and the date of the share sale in year 20, drawing together the common elements that continued to exist as part of the business during the length of this period. Our view is that the continuity of these elements in the life of the business point towards the existence of a single uninterrupted business (and therefore to the existence of goodwill as a single asset attaching to that business). Reference has been made in this regard to the description of the business provided in the application to this Ruling at the following points in time:

● the establishment of the business in year 1;

● the business as at 20 September 1985;

● the formation of the partnership in year 10 with Another Co; and

● the business in year 20.

Between its establishment in year 1 and the share sale in year 20, the nature of the business remained the same. That is, the business during that period was a going concern with the following primary characteristics:

● The sale of goods

While the types of goods sold changed over time as part of the evolution of the business, some of the products that were distributed by the business in year 1 continued to be sold in year 20.

The change in many of the other products offered for sale reflects the needs of its clients over the course of the business’ existence. The range of products sold by the business also expanded significantly in response to the needs of its clients.

Nevertheless, the essential character of the business remained the same, and the products it sold were bound together by the same common element, being 'x products’.

In this regard, paragraph 21 of TR1999/16 provides that:

A business owner may expand or contract business 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 itself cause it to be a new business provided the business retains its essential nature or character.

Notwithstanding the changes and expansion in the products distributed, the business remained of the same fundamental character at all times throughout the period between year 1 and the time of the share sale in year 20.

● Sale exclusively to retailers and suppliers

Another defining feature of the business is the nature of its clients. From the start of the business in year 1 to the share sale in year 20, the clients of the business have remained exclusively the retailers and suppliers of goods rather than an end consumer of the products. In other words the business commenced as, and continued to be, a wholesale distributor.

The establishment of the partnership in year 10 did not disturb this essential feature of the business.

The business’ customer base expanded gradually between the date of its establishment and year 20. Notably, a branch office was set up overseas to accommodate the distribution of goods by the business overseas, which continued in year 20. However, the expansion of the business and of its client base is a recognised element of its natural evolution given that the essential nature or character of the business is preserved: paragraph 21 of TR 1999/16.

It is also relevant in this case that, as mentioned above, the biggest clients of the business as it existed after the partnership were also clients that the business had acquired in the years prior to the establishment of the partnership.

● Business processes and activities

Many of the processes and activities undertaken in carrying out the business remained the same between year 1 and year 20. This, taken in the context of the other factors outlined in this document, reflects a continuity in the existence of the same business during that period.

In general, the activities conducted by the business included:

● the purchase of products from suppliers, including products manufactured to the company’s specifications and under the company’s brands,

● forecasting and ordering of inventory;

● the semi-manufacture of products;

● marketing activities to promote the company’s key brands,

● negotiations with key suppliers;

● negotiation with key customers,

● storage of products in the company’s warehouse and

● sale and despatch to the customers as ordered.

With regard to the activities listed above, we make the following observations:

● The semi-manufacture of products has always been part of the business activities. However the development of the business over the years has resulted in a decreased involvement in semi-manufacture. Certain products are no longer semi-manufactured and sold by the business.

While the business’ involvement in semi-manufacture decreased as more products were imported and sold directly, it has always maintained an involvement in the activity and continues to semi-manufacture its own products. A variation or reduction in the extent to which a particular aspect of a business’ operations is carried out does not itself cause it to be a new business provided that the business retains its essential nature: paragraphs 21 and 22 of TR 1999/16.

The continued involvement in the semi-manufacture of goods in this case is a factor that – taken together with other considerations – points to the continued existence of the business that was established in year 1, notwithstanding that this activity has slowly diminished over the course of the business’ existence. It is recognised in this case that the gradual decrease in the business’ involvement in semi-manufacture is the result of its organic development in response to the changing market environment.

The marketing activities undertaken by the business have always involved direct marketing and the production of catalogues of promoted product items, and this continued to the sale of the shares in year 20.

The head office of the business has always been based in Australia, and the business has always maintained its bank accounts with Bank A.

● Management of the business from year 1 to year 20

The management team for the business expanded since its inception but had at all times been led by XX and YY, the founders of the business. In particular XX had between year 1 and year 20 assumed the following responsibilities in respect of the management of the business:

● development of the annual business plan and budget;

● marketing and sales;

● all aspects of product purchase, costing and pricing;

● customer relationships;

● personnel;

● negotiations with key suppliers; and

● working capital management.

The skills of both individuals and their management contribution to the business formed a significant source of goodwill generated by the business. The 'personal goodwill’ that may be attributed to both individuals emanates from their management skills and reputation as founders of the business.

The continued involvement of XX in the assumption of management responsibilities as Chief Executive Officer of the partnership, and notably the specific responsibilities they undertook pursuant to the partnership Agreement for the day-to-day operation of the business, is both a reflection of the recognition of their management skills as instrumental to the success of the business; and indicative of a general continuity in the essential character of the business and of its associated goodwill between year 1 and year 20.

For the reasons mentioned above, the goodwill of the business held by Sold Co at the time of the share sale was the same as that which was created by Sold Co in respect of the same business prior to 20 September 1985.

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