Edited version of private advice

Authorisation Number: 1051627768553

Date of advice: 20 January 2020

Ruling

Subject: Pre CGT asset

Question

Will a capital gain made on the disposal of the Trust's business goodwill be disregarded pursuant to paragraph 104-10(5)(a) of the Income Tax Assessment Act 1997 (ITAA 1997) by reason of that goodwill having been acquired before 20 September 1985?

Answer

Yes, it is accepted that the goodwill was acquired before 20 September 1985 being a pre CGT asset. However, the calculation of the market value of the goodwill would need to be further considered.

This ruling applies for the following period:

1 July 20XX to 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Individual A worked as an employee and manager at a company.

Before 20 September 1985, Individual A believed they had enough relationships with customers to start his own business.

Before 20 September 1985, Company A was incorporated.

In the same year, the Trust was established.

Since being established, the Trust has at all times conducted its business that has been controlled by Individual A and there family.

Currently, Individual B and Individual C manage the business.

Only members of Individual A's family have been directors, secretaries and shareholders of the trustee company since the company has been established.

Individual A has always owned at least 80% of the issued shares in the trustee for the Trust, with Individual B and Individual C currently being minority shareholders.

The trustee has made distributions to members of Individual A's immediate family only.

Before 20 September 1985, the Trust has been administered for the benefit of Individual A's family.

There has been a family trust election in place.

The Trust operated a business assisting clients.

The Trust had 2 sources of income being commissions and fees.

The clients of the Trust were predominately located in a particular region of Australia.

The Trust operated its business from Individual A's home-office.

Individual A controlled the Trust. Individual A was responsible for sourcing and managing the Trust's clients. The trust employed Individual B who assisted Individual A with sales, marketing and client management.

After 20 September 1985, the Trust opened its first office as a result of the Trust's growing client base.

Individual B left the Trust and commenced working with an unrelated business. This resulted in a loss of clients who had a relationship with Individual B who continued to engage Individual B's services when they left and a loss to the Trust's revenue.

Individual C joined the Trust business who then began to assist Individual A with the activities of the business.

Individual B returned to the business at a later time. When Individual B returned to the Trust, the clients of Individual B returned as well who has previously left and engaged the services of the Trust as well as additional clients who Individual B had developed relationships with.

To service the Trust's increasing client based, the Trust hired an additional staff and moved to a larger office.

Individuals B and C took over control and management of the Trust as Individual A transitioned to retirement. Individual A has continued to be employed by the Trust in a reduced capacity.

Sale of the business of the Trust

The business of the Trust including its goodwill was sold during the 2019 income year to a third party.

The purchase price allocation regarding the various assets was negotiated between the Trust and the third party.

No valuations were performed on the Trust's assets.

This transaction of selling the business to the third party resulted in a capital gain for the Trust under subsection 104-10(1) of the ITAA 1997.

Relevant legislative provisions

Section 104-10 of the ITAA 1997

Section 108-5 of the ITAA 1997

Reasons for decision

CGT event A1 happens if you dispose of a CGT asset pursuant to subsection 104-10(1) of the ITAA 1997.

However, pursuant to paragraph 104-10(5)(a) of the ITAA 1997, any capital gain or capital loss you make on disposal of an asset acquired prior to 20 September 1985 (pre-CGT) is disregarded.

Goodwill

Goodwill, or an interest in it, is a CGT asset under paragraph 108-5(2)(b) of theITAA 1997.

Taxation Ruling TR 1999/16 Income tax: capital gains: goodwill of a business (TR 1999/16) provides guidance as to the taxation treatment of goodwill of a business.

Paragraphs 9 to 15 of TR 1999/16 provide the legal meaning of goodwill. Goodwill for the purposes of the definition of CGT asset in section 108-5 of the ITAA 1997 has the meaning it bears under the general law. It is the legal definition of goodwill as explained by the High Court in the Murry case, rather than its accounting and business definitions, which applies.

The legal meaning of goodwill according to the majority justices of the High Court in the Murry case has three different aspects namely property, sources and value.

Paragraph 12 of TR 1999/16 further 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.

The goodwill of the business will be a CGT asset pursuant to paragraph 108-5(2)(b) of the ITAA 1997.

This goodwill will include customer relations as, in accordance with paragraph 101 of TR 1999/16, they can't be brought to account or realised separately from the Business itself.

When is the goodwill of a business acquired for CGT purposes?

Subsection 995-1(1) of the ITAA 1997 provides that you acquire a CGT asset in the circumstances and at the time worked out under Division 109 of the ITAA 1997.

Section 109-10 of the ITAA 1997 sets out specific rules for the circumstances in which, and the time at which, you acquire a CGT asset otherwise than as a result of a CGT event happening.

Item 1 of section 109-10 of the ITAA 1997 provides that if you create a CGT asset and you own it when the CGT asset is created, you acquire the CGT asset at the time the work that resulted in its creation started.

In respect of the acquisition of goodwill, this is further explained by paragraph 52 of TR 1999/16, which states:

If a taxpayer commences business and starts to create goodwill, the goodwill of the business is acquired when the taxpayer starts work that results in the creation of the goodwill (subsection 109-10, item 1). When a taxpayer starts the work resulting in the creation of goodwill of a business is a question of fact dependent on the circumstances of each particular case.

The Trust is taken to have acquired the goodwill associated with the business when the business commenced, which was prior to 20 September 1985.

Division 149 of the ITAA 1997 - majority underlying interest in a CGT asset

Division 149 of the ITAA 1997 determines when an asset acquired before 20 September 1985 stops being a pre-CGT asset.

In accordance with subsection 149-30(1) of the ITAA 1997, an asset will stop being a pre-CGT asset at the earliest time when majority underlying interests in the asset are not held by the same ultimate owners who had majority underlying interests before 20 September 1985.

Alternatively, if the Commissioner is satisfied or thinks it reasonable to assume that, at all times on and after 20 September 1985 and before a particular day, majority underlying interests in the asset were had by ultimate owners who had majority underlying interests in the asset immediately before that day, subsection 149-30(2) of the ITAA 1997 would apply as if that were in fact the case, so that the assets would retain their pre-CGT asset status.

Taxation Ruling IT 2340 (IT 2340) provides guidance on when an ultimate owners is considered to have majority underlying ownership of a discretion trust. It states:

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. That is consistent with the role of the section to close potential avenues for avoidance of tax in cases where there is a substantial change in underlying ownership of assets and the legislative guidance contained in Subdivision G of Division 3 of Part III of the Act. On that basis, trust assets acquired by the trustee before 20 September 1985 would remain outside the scope of the capital gains and losses provisions of the Act.

In this case, Individual has always owned at least 80% of the issued shares in the trustee for the Trust, with Individual B and Individual C being minority shareholders.

The trustee has only made distributions to members of Individual A's immediate family. Since before 20 September 1985, the Trust has been administered for the benefit of Individual A's family. There has been a family trust election in place.

For the purpose of section 149-30 of the ITAA 1997, it is concluded that the majority underlying interests in the pre-CGT assets of the Company were at all times held by ultimate owners who had majority underlying interests in the pre-CGT assets immediately before 20 September 1985.

Accordingly, Division 149 of the ITAA 1997 will not apply to stop the goodwill from being a pre-CGT asset.

Same business test for CGT goodwill purposes

Paragraph 25 of TR 1999/16 states that the goodwill of a particular business cannot be characterised as a partly pre-CGT goodwill and partly post-CGT goodwill.

Paragraph 17 of TR 1999/16 outlines a 'same business test' to determine whether goodwill will continue to be one asset throughout the life of the business where it was acquired prior to 20 September 1985. Paragraph 17 of TR 1999/16 states that:

The whole of the goodwill of a business that commenced before 20 September 1985 remains the same single pre-CGT asset (subject to Division 149 - about when an asset stops being a pre-CGT asset ...) provided the same business continues to be carried on. This is so 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.

As the business commenced before 20 September 1985, it will remain a pre-CGT asset where the same business test is satisfied

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 21 of TR 1999/16 provides the following guidance on establishing whether the same business is carried on:

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.

Paragraph 22 of TR 1999/16 states that the essential nature or character of the business would remain the same:

... if all that happens is that portions of the operations of a business are discarded in an ordinary commercial way but the business retains its essential nature or character.

Paragraph 23 of TR 1999/16 further states that if the types of customers a business attracts change as the business evolves over the years, this does not necessarily mean the business is no longer the same business as was originally carried on.

When deciding whether a business has the same essential nature or character, a similar kind of business being carried on would be insufficient. The same business would not be carried on according to TR 1999/16 paragraph 24 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.

Paragraph 91 of TR 1999/16 also provides important factors to consider when establishing the essential nature or character of the business. It states that consideration should be given, among others, to the following:

·         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

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

Accordingly, it is necessary to consider whether the 'same business' is being carried on such that the goodwill of the business retains its pre-CGT status. Consideration must be given to the essential nature or character of the business as well as some of the factors stated above.

Nature and/or character of the business

Paragraph 93 of TR 1999/16 states in part that for CGT goodwill provisions, the same business is carried on and new goodwill asset is created if the business retains its same essential nature or character.

The nature of the Trust's business is providing services. The nature of the Trust's business activities remain the same as they were as at 20 September 1985.

Changes in the assets and resources of the business

The business name of the Trust changed for commercial reasons. The Trust's key assets had not changed between 1985 and 2019.

When Individual B left the business, there was no change to business operations other than sole control of the Trust to Individual A. The subsequent reduction in the revenue of the Trust was a natural contraction of the Trust's business activities which held no bearing on the essential nature or character of the business.

Following Individual B's return to the business, the Trust leveraged Individual B's relationships to grow its client base and revenues. The Trust moving to a larger office and hiring additional staff help to service and grow its client base. The nature of the business of the Trust had not changed.

Location and size

The Trust has always operated in a particular region. The Trust's offices have been located in this region to service its client base. The Trust has not made a significant change in business location. The Trust's relocation from Individual A's home office to the region office was a result of the expansion of its operations.

Activities of the business

The Trust's sources of income remain identical pre and post 20 September 1985 being commissions and the Trust charging fees to their customers for their services.

There have been no major changes to the structure of the business. It has always operated via the Trust and key family members and associates.

The way in which the business is carried on, managed and controlled

The Trust is a family business that has been controlled by Individual A prior to 20 September 1985. Individual A trained Individuals B and C to manage the Trust once Individual A transitioned towards retirement allowing Individuals B and C to manage the Trust. Individual A remains involved with the Trust in a client management capacity.

Individuals A, B and C have been responsible for growing the Trust's client list. All other staff employed by the Trust have assisted in servicing the Trust's client list, being administrative assistants.

There have been no periods of discontinuance or temporary cessation of the business since its inception. No part of the business or any of its business assets have been disposed of since commencement of the business.

Conclusion

Based on the above information, the essential nature of the Trust's business has remained unchanged since its establishment. The Trust's business has been providing services and has continued to do so before and after 20 September 1985. Individual A has held majority underlying interest in the business at the beginning and continued to hold the same interest before the sale. The business has grown organically with the expansion of the customer base.

As a consequence, the goodwill attached to the business carried on by the Trust is a pre-CGT asset of the Trust and any capital gain made on the disposal of the business will be disregarded pursuant to paragraph 104-10(5)(a) of the ITAA 1997 by reason of that goodwill having been acquired before 20 September 1985.

The Commissioner notes that an appropriate market value of goodwill be determined to ensure it accurately reflects its value at the time of the sale.

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