Edited version of private advice

Authorisation Number: 1051677948985

Date of advice: 12 May 2020

Ruling

Subject: Income tax - transfer of accrued leave entitlements

Question 1

Does section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to the amount paid by Entity B under the contract, to include the amount in Entity A's assessable income as ordinary income?

Answer

Yes

Question 2

Does section 15-5 of the ITAA 1997 apply to the amount paid by Entity B under the contract, to include the amount in Entity A's assessable income as an accrued leave transfer payment?

Answer

Yes

Question 3

Does CGT event C2 in section 104-25 of the ITAA 1997 occur in respect of the payment made by Entity B to Entity A under the contract, such that no capital gain arises?

Answer

Yes

This ruling applies for the following period(s)

Year end 30 June 20XX

The scheme commences on

XX/XX/20XX

Relevant facts and circumstances

Entity A won the tender to acquire a bus service from Entity B.

Under the contract certain employees would be transferred to Entity A and Entity A would offer these employees the equivalent terms and conditions that existed previously.

As part of the assignment of these employees, Entity A would assume liability for and recognise various existing accrued leave benefits.

Entity B paid Entity A, $XXXX for assuming the accrued leave benefits. This payment was reduced by the corporate tax rate based on the assumption that the payment would not be considered assessable to Entity A.

Relevant legislative provisions

Income Tax Assessment Act 1997, Section 6-5.

Income Tax Assessment Act 1997, Section 6-10.

Income Tax Assessment Act 1997, Section 6-25.

Income Tax Assessment Act 1997, Section 15-5.

Income Tax Assessment Act 1997, Subsection 26-10(2).

Income Tax Assessment Act 1997, Paragraph 26-10(2)(a).

Income Tax Assessment Act 1997, Paragraph 26-10(2)(b).

Income Tax Assessment Act 1997, Paragraph 26-10(2)(c).

Income Tax Assessment Act 1997, Paragraph 26-10(2)(d).

Income Tax Assessment Act 1997, Section 104-25.

Income Tax Assessment Act 1997, Subsection 104-25(2).

Income Tax Assessment Act 1997, Subsection 104-25(3).

Income Tax Assessment Act 1997, Subsection 108-5(1).

Income Tax Assessment Act 1997, Section 110-25.

Income Tax Assessment Act 1997, Subsection 110-25(1).

Income Tax Assessment Act 1997, Subsection 110-25(2).

Income Tax Assessment Act 1997, Section 110-45.

Income Tax Assessment Act 1997, Subsection 110-45(2).

Income Tax Assessment Act 1997, Division 112.

Income Tax Assessment Act 1997, Section 112-35.

Income Tax Assessment Act 1997, Section 116-20.

Income Tax Assessment Act 1997, Paragraph 116-20(1)(a).

Income Tax Assessment Act 1997, Subsection 118-20(4).

Income Tax Assessment Act 1997, Subsection 995-1(1).

Reasons for decision

Question 1

Does section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to the amount paid by Entity B under the contract, to include the amount in Entity A's assessable income as ordinary income?

Summary

Section 6-5 applies to the amount paid by Entity B under the contact, to include the amount in Entity A's assessable income as ordinary income.

Detailed reasoning

Under section 6-5, assessable income includes income according to ordinary concepts, otherwise known as ordinary income.

There is no specific guidance on what is meant by 'ordinary concepts' and therefore it is necessary to refer to various factors that have been identified by case law which require consideration in determining whether an amount is income according to ordinary concepts.

The Full High Court in GP International Pipecoaters Pty Ltd v FC of T 90 ATC 4413 identified the following factors as relevant at paragraph 4420:

·                     character of receipts and their periodicity, regularity or recurrence;

·                     character of a right or thing disposed of in exchange for the receipt;

·                     scope of the transaction, venture or business in or by reason of which money is received and by the recipient's purpose in engaging in the transaction, venture or business may reveal the character of the receipt.

It is well established that profits derived in the ordinary course of a taxpayer's business are income and not capital in nature. Accordingly, to determine the nature of a receipt, it is necessary to identify the nature and scope of the taxpayer's business.

As your submission highlights, the Full High Court, in a joint judgment in FC of T v The Myer Emporium Ltd 87 ATC 4363 at pages 4366 to 4367 (Myer Emporium) made the following comments regarding the relevance of a taxpayers business:

Because a business is carried on with a view to profit, a gain made in the ordinary course of carrying on the business is invested with the profit-making purpose, thereby stamping the profit with the character of income. But a gain made otherwise than in the ordinary course of carrying on the business which nevertheless arises from a transaction entered into by the taxpayer with the intention or purpose of making a profit or gain may well constitute income. Whether it does depends very much on the circumstances of the case. Generally speaking, however, it may be said that if the circumstances are such as to give rise to the inference that the taxpayer's intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer's business. Nor does the fact that a profit or gain is made as a result of an isolated or a 'one-off'' transaction preclude it from being properly characterized as income (FC of T v Whitfords Beach Pty Ltd 82 ATC 4031 at pp 4036-4037, 4042...). The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit.

Whilst periodicity, recurrence and regularity are influential factors in concluding that a receipt is ordinary income, these factors are not determinative and often appear in conjunction with other indicia of ordinary income. For example, the High Court in Myer Emporium stated that, valuable though they may be in conventional situations, the significance of these considerations is diminished when the receipt in question is generated in the course of carrying on a business.

In Myer Emporium, the taxpayer assigned its right to receive interest from a subsidiary to a finance company for a lump sum of $45 million. The High Court held that the lump sum was assessable as ordinary income and was not a capital receipt and found that the transaction was in the ordinary course of the taxpayer's business. This was despite the fact that it was the first time the taxpayer had entered into such an arrangement.

In FC of T v Cooling 90 ATC 4472 (Cooling) the Full Federal Court held that a lump sum lease incentive paid to the partners of a firm of solicitors, in respect of a lease of premises, was income according to ordinary concepts, as the transaction was commercial and formed part of the business of the firm. Hill J stated at page 4484:

Where a taxpayer operates from leased premises, the move from one premises to another and the leasing of the premises occupied are acts of the taxpayer in the course of its business activity just as much as the trading activities that gave rise more directly to the taxpayer's assessable income. Once this is accepted, the evidence established that in Queensland in 1985 it was an ordinary incident of leasing premises in a new building, at least where the premises occupied were of substantial size, to receive incentive payments of the kind in question. Why then should a profit received during the course of business where the making of such a profit was an ordinary incident of part of the business activity of the firm not be seen to be income in ordinary concepts?

Relevantly, Gummow J in Cooling endorsed the above judgement of Hill J when he stated at page 4474:

I agree with the conclusions reached on this appeal by Hill J that the appeal should be allowed on the footing that the payment in question is assessable income of the taxpayer within the meaning of s25 of the ITAA 1936. I reach that conclusion for the reasons advanced by his Honour, whose judgment I have had the advantage of reading.

Lockhart J also made a similar endorsement of Hill J judgement on the assessable income argument.

It is agreed that there is a difference between income arising in the 'ordinary course of business' and income arising in the 'course' of business. The latter requiring a profit making intention or purpose.

The question that arises is whether the amount paid by Entity B under the contract is considered to have been received in the ordinary course of Entity A's business, such that the amount is assessable under section 6-5 as ordinary income.

Entity A is in the business of acquiring and operating bus services.

Entity A won the tender to acquire the bus service under the relevant contract. As part of the process of acquiring that service Entity A entered into numerous agreements with Entity B including one which affected the transfer of a number employees along with the payment in question.

Based on the facts provided, the payment was received by Entity A as an incidental component to the main services agreement which was pursued, won, and entered into in the ordinary course of Entity A's business. The payment reflected 'the usual way' in which Entity A obtains its bus services and was an ordinary incident of Entity A conducting its business. Consequently, the payment is considered income according to ordinary concepts and assessable to Entity A under section 6-5.

Alternatively, the payment received by Entity A from Entity B is considered to be assessable income under section 6-5, as a gain from property.

In FCT v Montgomery (1999) 198 CLR 639, the taxpayer received a lease incentive payment. It was held by the High Court that the payment received was assessable income as a gain from property (the property being the taxpayer's lease rights as a chose in action).

Further, in FCT v McNeil (2007) 229 CLR 656, Mrs McNeil as a shareholder in St George Bank, received put option rights. It was held by the High Court that the put option rights were a gain from property (the property being Mrs McNeil's shares) that was separate from that property and was not a dividend.

In Entity A's case, the rights under the contract it had with Entity B was a chose in action. Accordingly, section 6-5 could apply to include in Entity A's assessable income the payment received as a gain from property.

Implications of section 6-25

Section 6-25 has rules seeking to prevent double taxation of income, e.g. where the same amount is assessable income under more than one rule. Section 6-25 sets out that where an amount is considered ordinary income and also included as assessable income by one or more provisions about assessable income, that provision will prevail over the rules about ordinary income. Therefore, as you have asked whether the amount received is assessable under section 15-5 this is considered under Question 2.

Question 2

Does section 15-5 of the ITAA 1997 apply to the amount paid by Entity B under the contract; to include the amount in Entity A's assessable income as an accrued leave transfer payment?

Summary

Section 15-5 applies to the amount paid by Entity B to Entity A. Consequently, the amount of the payment will be included in Entity A's assessable income under section 6-10 as statuary income.

Detailed reasoning

Section 15-5 includes in assessable income an 'accrued leave transfer payment' received by a taxpayer.

The term 'accrued leave transfer payment' is defined in subsection 26-10(2) as:

An accrued leave transfer payment is a payment that an entity makes:

a)            in respect of an individual's leave (some or all of which accrued while the entity was required to make payments in respect of the individual's leave, or leave the individual might take); and

b)            when the entity is no longer required (or is about to stop being required) to make payments in respect of such leave; and

c)             to another entity when the other entity has begun (or is about to begin) to be required to make payments in respect of such leave; and

d)            under (or for the purposes of facilitating the provisions of) an *Australian law, or an award, order, determination or industrial agreement under an *Australian law.

It does not matter whether the leave accrues to the individual as an employee or for some other reason.

The first three requirements of this definition are satisfied. The last requirement in paragraph 26-10(2)(d) requires the payment made by Entity B to have been made under - or for the purposes of facilitating the provisions of - an *Australian law, or an award, order, determination or industrial agreement under an *Australian law.

Subsection 995-1(1) defines 'Australian law' to mean a *Commonwealth law, a *State law or a *Territory law.

The 'contract' is the agreement that affects the transfer of the relevant employees and the payment made by Entity B to Entity A. This contract provides a direct nexus linking Entity A with the relevant awards and Australian law governing the relevant leave arrangements.

These awards in turn provide a nexus linking the conditions with the relevant State Act which in turn links to the Industrial Relations Act 1996 (IRA).[1]

Part 8 Chapter 2 of the IRA deals specifically with protecting entitlements on the transfer of a business. Section 103 of the IRA makes clear that former employers are still liable for relevant entitlements to transferred employees of a new employer.

Relevant clauses under the contract obliged Entity A to meet all the Award and Industrial Relation conditions relating to the employees being transferred. In return for accepting these conditions Entity B was obliged to make the relevant payment based on the accrued leave entitlements that the transferred employees had accrued.

This establishes that the payment Entity A received from Entity B was a result of Entity B's obligations as a former employer under section 103 of the IRA and the payments being made 'under' an Australian law and an award.

Taking a broader view of the transaction would result in this same conclusion. A payment by the Entity B to Entity A in respect of the accrued leave entitlements of employees who transfer with the business will also qualify as an 'accrued leave transfer payment' where an Australian law, award, order, determination or industrial agreement provides for the employees to be entitled to a specified amount of leave. This is because a payment from one employer to a subsequent employer which supports the employee's continuing entitlement to the accrued leave would facilitate the provisions of that Australian law, award, order, determination or industrial agreement under an Australian law.

Therefore, all the requirements in subsection 26-10(2) are satisfied and section 15-5 will apply to the amount paid by Entity B to Entity A. Consequently, the payment amount will be included in Entity A's assessable income under section 6-10 as statuary income, and not under section 6-5.

Question 3

Does CGT event C2 in section 104-25 of the ITAA 1997 occur in respect of the payment made by Entity B to Entity A under the contract, such that no capital gain arises?

Summary

CGT event C2 happens when the payment is made by Entity B to Entity A. However, subsection 110-45(2) applies to reduce the amount included in cost base by the operation of section 112-35 each time a deduction becomes available to Entity A when it makes a payment of the accrued leave entitlements to employees.

Detailed reasoning

A 'CGT asset' is defined in subsection 108-5(1) as:

a)            any kind of property; or

b)            a legal or equitable right that is not property.

...

Note 1: Examples of CGT assets are:

...

·                     debts owed to you;

·                     a right to enforce a contractual obligation;

...

Entity A's right to receive payment from Entity B under the contract falls within this definition. This is because Entity A holds a legal or equitable right that is not property, which Entity A has a right to enforce contractually.

CGT event C2

CGT event C2 in section 104-25 states:

(1)           CGT event C2 happens if your ownership of an intangible *CGT asset ends by the asset:

a)            being redeemed or cancelled; or

b)            being released, discharged or satisfied; or

....

(2)           The time of the event is:

a)            when you enter into the contract that results in the asset ending; or

b)            if there is no contract - when the asset ends.

(3)           You make a capital gain if the *capital proceeds from the ending are more than the asset's *cost base. You make a capital loss if those proceeds are less than the asset's *reduced cost base.

...

Entity A's right to receive payment from Entity B is an intangible asset. CGT event C2 happened when the right was discharged or satisfied. The time of the event was when the asset came to an end. This was on 31 July 20XX when Entity B made the payment. Entering into the agreement did not result in the right ending, but created the right. This is supported by the Full Federal Court in FCT v Dulux Holdings Pty Ltd & Orica [2001] FCA 1344. In this case there was an indemnity payment, where the Full Federal Court held that there was a chose in action created by the contract and that the due performance of that contract gave rise to a deemed disposal. Accordingly, the change in ownership occurred not under the contract but the time of the payments for the discharge of the chose in action.

Capital Proceeds

Section 116-20 provides the general rules about capital proceeds and states:

(1)           The capital proceeds from a *CGT event are the total of:

(a)          The money you have received, or are entitled to receive, in respect of the event happening; and

(b)          The *market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).

...

Entity A received $X million from Entity B under the contract, this amount is capital proceeds for the purposes of paragraph 116-20(1)(a). Entity A did not receive any other property in respect of its right to receive payment being discharged or satisfied.

There are six modifications to the general rules relating to capital proceeds that may be relevant to a CGT event. None of these modifications will apply, as the amount received from Entity B represents the market value of the right to receive payment.

Cost base

In determining whether a capital gain or loss arises under subsection 104-25(3) it is necessary to consider the asset's cost base rules. Section 110-25 sets out the general rules about cost base. Subsection 110-25(1) states the cost base of a CGT asset consists of five elements. On the basis there are no amounts relevant to the second, third, fourth and fifth elements - we will only be considering what will fall within the first element of the cost base.

First element

The first element of cost base is set out in subsection 110-25(2) and states:

The first element is the total of:

(a)          the money you paid, or are required to pay, in respect of *acquiring it; and

(b)          the *market value of any other property you gave, or are required to give, in respect of acquiring it (worked out as at the time of the acquisition).

...

Note 2: This element is replaced with another amount in many situations: see Division 112.

'Note 2' is relevant to this transaction. Division 112 contains rules that may modify the general rules about the cost base. Section 112-35 in Division 112 sets out the assumption of liability rule and may apply to determine the first element of cost base in the current situation.

Section 112-35 states:

If you *acquire a *CGT asset from another entity that is subject to a liability, the first element of your *cost base of the asset includes the amount of the liability you assume.

Entity A acquired a CGT asset, being the right to receive money from Entity B under the relevant clause of the contract. Entity A's right to receive money under that clause was subject to the liability assumed by Entity A under the contract.

The liability assumed by Entity A under the contract forms part of Entity A's first element of cost base.

However, there are exclusions to the five elements of cost base that require consideration. Specifically section 110-45, which relevantly states:

(1)          This section prevents some expenditure from forming part of the *cost base, or of an element of the cost base, of a *CGT asset *acquired after 7.30pm, by legal time in the Australian Capital Territory, on 13 May 1997...

...

Deductible expenditure excluded from second and third elements

(1B) Expenditure does not form part of the second or third element of the cost base to the extent that you have deducted or can deduct it.

Other deductible expenditure

(2)          Expenditure (except expenditure excluded by subsection (1B)) does not form part of the cost base to the extent that you have deducted or can deduct it for an income year, except so far as:

(a)          the deduction has been reversed by an amount being included in your assessable income from an income year by a provision of this Act (outside this Part and Part 3-3 and Division 243); or

Note: Division 20 contains some of the provisions that reverse deductions. Section 20-5 lists some others.

....

We do not agree with your view that subsection 110-45(2) doesn't apply to exclude the liability assumed from Entity A's cost base on the basis that section applies to expenditure that would otherwise be included in cost base. The liability included in Entity A's cost base under section 112-35 is not expenditure; it is a liability for an expected amount of future expenditure and therefore as the liability assumed does not represent expenditure, it should not be excluded from the cost base of the right.

The reasons detailed below sets out why we do not agree with your view.

Taxation Determination TD 2019/D11 Income tax: where a liability is assumed on acquisition of a CGT asset, is the assumed liability excluded from the cost base of the asset if expenditure on discharge of the liability is deductible? states that if you acquire an asset with a liability, the first element of the cost base will include that liability under section 112-35.[2] However, that liability does not form part of the cost base of the asset to the extent that you 'have deducted or can deduct it' in discharging that liability in accordance with subsection 110-45(2).[3]

The meaning of the words 'have deducted or can deduct it' are explained in TD 2005/47 Taxation Determination Income tax: what do the words 'can deduct' mean in the context of those provisions in Division 110 of the Income Tax Assessment Act 1997 which reduce the cost base or reduced cost base of a CGT asset by amounts you 'have deducted or can deduct', and is there a fixed point in time when this must be determined?

Relevantly, paragraph 1 in TD 2005/47 states:

You 'can deduct' an amount for the purposes of a provision in Division 110 of the ITAA 1997 at a particular time if:

·                     the terms of the relevant deduction provision have been satisfied in respect of the amount; and

·                     the deduction is not prevented by the expiry of amendment periods prescribed by section 170 of the Income Tax Assessment Act 1936 (ITAA 1936).

The liability assumed by Entity A forms part of Entity A's first element of cost base. However, subsection 110-45(2) would apply to reduce the cost base of this CGT asset every time Entity A makes a deductible payment relating to the accrued leave liabilities attributed to those employees who have been transferred to Entity A from Entity B.

Paragraph 5 of TD 2019/D11 states an amount that is initially included in cost base can later be excluded due to the operation of a cost base modification provision. The assumption of liability rule under section 112-35[4] does not operate to necessarily fix the cost base upon acquisition of the relevant asset. The discharge of the liability mentioned in section 112-35 will change the constituent components of the first element of the cost base at the time the liability is discharged. That is, the cost base would reduce each time Entity A makes a deductible payment in relation to the accrued leave liabilities.

Therefore a capital loss (cost base minus capital proceeds) will arise when CGT event C2 happens. However, pursuant to the operation of subsection 110-45(2), each time Entity A makes a deductible payment relating to the accrued leave liabilities the cost base will need to be reduced by the amount of the payment. This will reduce the amount of capital loss, and eventually a capital gain is likely to arise. However, where a capital gain arises, subsection 118-20(4) will apply to reduce the amount of the capital gain by the amount that has already been included in Entity A's ordinary income or statutory income from the event.

[1] Specifically Part 8 Chapter 2.

[2] Paragraphs 47-49

[3] TD 2019/D11 paragraph 1.

[4] Refer paragraphs 46 to 49

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