Edited version of private advice

Authorisation Number: 1051808312857

Date of advice: 20 April 2021

Ruling

Subject: CGT - small business concessions - goodwill and earnout rights

Question 1

Will the Commissioner accept your proposed method of valuing goodwill?

Answer

Yes

Question 2

Do you pass the basic conditions in Subdivision 152-A of the ITAA 1997 to access the small business CGT concessions on the sale of goodwill to the Purchaser under Contract 1?

Answer

Yes

Question 3

Do you pass all of the conditions in Subdivision 152-B to access the 15-year exemption on the sale of goodwill in relation to Contract 1?

Answer

Yes

Question 4

If the answer to question 3 is "Yes", does the Commissioner accept your method of calculating the CGT exempt amount that can be paid out to the CGT concession stakeholders under the 15-year exemption?

Answer

Yes

Question 5

Will your sale of a specific parcel of clients of the business to one of your principals under Contract 2 qualify for the retirement exemption under Subdivision 152-D?

Answer

Yes

Question 6

If the answer to question 5 is "Yes", does the Commissioner accept your method of calculating the capital gain from the disposal of assets under Contract 2?

Answer

Yes

Question 7

Does the earnout right in Contract 1 qualify as a look-through earnout right under section 118-565 of the ITAA 1997?

Answer

Yes

Question 8

If the answer to question 7 is "Yes", can you make tax-free payments to the CGT concession stakeholders under the 15-year exemption when you receive additional payments under the earnout right?

Answer

Yes

This ruling applies for the following period:

Income year ended 30 June 20ZZ

The scheme commences on:

DDMMYY

Relevant facts and circumstances

You are a private company which was incorporated prior to September 1985 to carry on a business.

Prior to incorporation, the business was operated by a sole practitioner, who decided to operate the business in a company structure.

You recorded a goodwill value of $XXX when you acquired the sole trader's business.

Since inception, you have been operating the same business.

There were two ordinary shares on issue on your incorporation, one to Person 1 and one to Person 2.

On DDMMYY, there was a share split whereby each ordinary share was split into AA ordinary shares. After the share split, you had BBB shares on issue, equally owned by Person 1 and Person 2 with CC shares each.

On DDMMYY, a new shareholder, Person 3 joined the practice as an equity partner. Person 3 acquired all but 1 ordinary shares from Person 2.

On DDMMYY, Person 4 joined the firm as an equity partner and acquired all of the ordinary shares from Person 1. The arms-length purchase price paid for the share acquisition was $ZZZ,000.00 for a 50% equity interest. This valuation was based on the gross fees of the practice of $YYY,000.00 @0.90 x 50% (Rounded down to nearest thousand).

The entire market value of your shares on issue was $XXX,000.00.

On the same day, Person 3 also acquired 1 ordinary share from Person 2 on the same arms-length terms.

After these share transactions occurred on DDMMYY, Person 3 and Person 4 each owned DD ordinary shares in you.

On DDMMYY you then issued BBB new ordinary shares. Person 3 and Person 4 each were issued half of these new ordinary shares.

After this share issue, you had CCC ordinary shares on issue, with Person 4 and Person 3 each owning half of these ordinary shares.

On DDMMYY you also issued redeemable preferences shares as follows:

•                     1 "A" Class to Person 1

•                     1 "B" Class to Person 3

•                     1 "C" Class to Person 4

All were redeemed on DDMMYY.

On DDMMYY you issued redeemable preference shares as follows:

•                     1 "D" Class to Person 3

•                     1 "E" Class to Person 4

All were redeemed on DDMMYY.

On DDMMYY, Person 3 and Person 4 transferred their shares to their respective family trusts based on an arms-length market valuation.

On DDMMYY, Person 3 and Person 4 repurchased EE% of the shares from their respective family trusts due to certain professional regulation requirements.

On DDMMYY, Person 5 joined the firm as the third equity partner. Person 5 sold his business to you in an arm's length transaction for cash consideration of $AAA. Person 5 together with his trust acquired 1/3 of the shares from each of the existing shareholders. Person 5 personally owned BB% of the shares and his trust owned CC% of the shares, which mirrored the existing shareholding structure for each existing equity partner.

There have been no changes to the shareholders and shareholding structure since DDMMYY. You have CCC ordinary shares on issue which are currently held by:

•                     Person 4's trust - AAA ordinary shares (25%)

•                     Person 4 - BBB ordinary shares (8.3%)

•                     Person 3's trust - AAA ordinary shares (25%)

•                     Person 3 - BBB ordinary shares (8.3%)

•                     Person 5's trust) - AAA ordinary shares (25%)

•                     Person 5 - BBB ordinary shares (8.3%)

All shares are owned equally by three individual Principals together with their respective trusts.

Your directors are Person 3, Person 4 and Person 5.

Over the years you have purchased some fees/practices and also sold a small fee parcel as part of natural business development and growth. You recorded purchased goodwill of $ZZZ on your balance sheet on 30 June 20XX and also just before the CGT event.

You achieved an annual turnover of under $2million in the 20AA and 20BB income years respectively.

All of the three Principals are over 65 years of age. As part of the retirement plan, the directors engaged professional firms to assist with selling your business.

On DDMMYY, you entered into two simultaneous contracts to sell your business. One contract ("Contract 1") was entered into with an unrelated party - "the Purchaser" to sell your goodwill and plant & equipment for a total amount of $AAA, subject to earnout rights. Another contract ("Contract 2") was entered into with Person 5 to sell a particular parcel of clients of the business for $BBB. This parcel of clients is mainly related to the client base brought into you by Person 5 when he joined the firm. Both sale contracts were made on an arm's length basis. Settlement occurred on DDMMYY for both contracts. You continued operating the business until settlement.

Under Contract 1, the Purchase Price payable to you comprises of the following:

•                     Deposit of $AAA

•                     Completion Payment of $BBB plus $CCC for plant & equipment

•                     Transferring Working in Progress Consideration

•                     Holdback Sum - Retained by the Purchaser, payable subject to an earnout right.

The Holdback Sum consists of two payments, being $DDD for each tranche payable after the first year and second year, representing the final portion of the Purchase Price, subject to the following adjustments:

•                     If the turnover amount for the first year after the date of Completion is less than $EEE, there will be a reduction of the Purchase Price equal to 0.FF for each $1 for the amount of such shortfall, up to a maximum of $GGG.

•                     If the turnover amount for the second year after the date of Completion is less than $EEE, there will be a reduction of the Purchase Price equal to 0.FF for each $1 for the amount of such shortfall, up to a maximum of $GGG.

•                     If the turnover is not less than $EEE there will be no corresponding reduction of the Purchase Price, nor the first and second tranches.

•                     If the turnover for the first year after the date of Completion is greater than $EEE, there will be an increase of the Purchase Price equal to $0.HH for each $1 of such overage, up to a maximum of $JJJ.

•                     If the turnover for the first year after the date of Completion is greater than $EEE, there will be an increase of the Purchase Price equal to $0.HH for each $1 of such overage, up to a maximum of $JJJ.

All of your employees were offered employment by the Purchaser to continue working in the business following the completion of the sale of your business.

As per the contract for sale you were required by the Purchaser to change your name and it was changed.

As part of the conditions under Contract 1, you entered into two Consulting Service Agreements with the Purchaser on DDMMYY to provide consulting services via the services of Person 3 and Person 4 (the "Principals") for a period of 24 months after the completion of the sale:

•                     During the first 12 months of the consulting service term, the Principal is required to work a minimum of AA hours per week for the first 6 months but thereafter no minimum hours and a maximum of BB hours per week.

•                     During the second 12 months of the term, the Principal is required to work no minimum hours per week and a maximum period of CC hours per week.

The purpose of the Consulting Service Agreement is to assist the Purchaser in transitioning the business to them and retain the value of the business goodwill.

Both Person 3 and Person 4 will not engage in other employment other than performing limited consulting work for you for a maximum period of 2 years under the Consulting Service Agreements.

You incurred incidental costs (ie legal and brokerage fee) of $KKK in relation to Contract 1 and incurred legal costs of $LLL in relation to Contract 2.

There are no other related entities that carry on a business in relation to you.

It is intended that Person 3, Person 4 and Person 5 would each be made presently entitled to a trust distribution from their respective trusts in the 20ZZ income year such that they each will be a significant individual/CGT concession stakeholder in you just before the CGT event.

With respect to the DDMMYY share acquisitions by Person 4 and Person 3, you propose to value the goodwill of the business acquired at that time as the arm's length purchase price paid for those shares.

With respect to Contract 1, you propose to calculate the CGT exempt amount by applying indexation to the fee parcels acquired before 21 September 1999 and deducting the cost base of a small fee parcel sold in 20ZZ. The cost base of the original goodwill is included as is the incidental costs (legal expenses and brokerage) of selling the proportion of the business under Contract 1.

With respect to Contract 2, you propose to calculate the cost base by using the historical acquisition cost of those clients from Person 5 as he remained solely responsible for managing this client base and growing his client portfolio.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 116-30

Income Tax Assessment Act 1997 section 149-15

Income Tax Assessment Act 1997 section 149-30

Income Tax Assessment Act 1997 section 149-35

Income Tax Assessment Act 1997 section 152-10

Income Tax Assessment Act 1997 section 152-50

Income Tax Assessment Act 1997 section 152-110

Income Tax Assessment Act 1997 section 152-305

Income Tax Assessment Act 1997 section 118-565

Income Tax Assessment Act 1997 section 960-400

Reasons for decision

Summary

The Commissioner accepts your method for calculating the value of the goodwill of the business. With respect to Contract 1, you met the basic conditions for the small business CGT concessions and are also eligible for the 15-year exemption. The Commissioner accepts your method of calculating the CGT exempt amount that can be paid out to the CGT concession holders under the 15-year exemption.

With respect to Contract 2, you are eligible to apply the small business retirement exemption under subdivision 152-D of the ITAA 1997. The Commissioner accepts your method of calculating the capital gain associated with this contract.

The earnout right in Contract 1 is a look-through earnout right under section 118-565 of the ITAA 1997. Therefore, you can make tax-free payments to the CGT concession stakeholders under the 15-year exemption when you receive the additional payments under the earnout right.

Detailed reasoning

Question 1

Will the Commissioner accept your proposed method of valuing goodwill?

When you acquired the practice from Person 1 prior to September 1985, the business goodwill was a pre-CGT asset. Both Person 1 and Person 2 acquired their shares in you on that day.

The acquisition of AA% of the shares by Person 4 from Person 1 and the acquisition of

1% shares by Person 3 from Person 2 on DDMMYY triggered Division 149 of the ITAA 1997.

Under subsection 149-30(1) of the ITAA 1997, a pre-CGT asset of a non-public entity stops being a pre-CGT asset at the earliest time when the majority underlying interest in the asset were not had by the ultimate owners who had the majority underlying interests in the asset immediately before 20 September 1985.

Subsection 149-15(1) of the ITAA 1997 provides that majority underlying interests in a CGT asset consists of:

•                     more than 50% of the beneficial interests that ultimate owners have (whether directly or indirectly) in the asset; and

•                     more than 50% of the beneficial interests that ultimate owners have (whether directly or indirectly) in any ordinary income that may be derived from the asset.

The effect of these provisions is that the pre-CGT asset is taken to have been acquired at the time the disqualifying change occurs. Subsection 149-35(1) of the ITAA 1997 provides that the cost base of the asset will be its market value at that time.

Section 960-400 of the ITAA 1997 provides that the expression 'market value' is used in the income tax laws with its ordinary meaning. Further, section 960-400 states that the Commissioner may approve methods to use for working out the market value of assets or non-cash benefits.

The ATO market value guidelines state that the valuation of goodwill is generally based on the calculation of a residual value. In basic terms, this approach requires the valuation of the net identifiable assets of the business (market-adjusted) and the valuation (market value) of the equity of the business.

A residual value may be derived by subtracting the value of the net identifiable assets of the business from the value of equity of the business. As a general rule, the calculation of a residual value will be the most appropriate method for deriving goodwill. However, other methods may be accepted if they are appropriate to the circumstances.

In your case, the arm's length share price of $AAA was determined by adopting the 'cents in the dollar' valuation method which was widely used by the accounting profession as an industry valuation method to value business such as yours with revenue of less than $1 million. The value determined under this valuation method reflected the enterprise value of such businesses, which essentially reflected the goodwill value of the business.

Given that your main assets were represented by the business goodwill, the Commissioner accepts that it is reasonable to treat the arm's length value of your shares as the market value of the business goodwill for the purpose of determining the new cost base for CGT purposes.

Question 2

Do you pass the basic conditions in Subdivision 152-A of the ITAA 1997 to access the small business CGT concessions on the sale of goodwill to the Purchaser under Contract 1?

Division 152 of the ITAA 1997 provides for CGT small business concessions, including the 15-year exemption. To qualify for the small business CGT concessions, you must satisfy several conditions that are common to all the concessions being the basic conditions.

Under section 152-110 of the ITAA 1997, a company can disregard the capital gain made on the disposal of a CGT asset if the company:

a)            satisfies the basic conditions for the small business CGT concessions in Subdivision 152-A of the ITAA 1997 for the gain

b)            continuously owned the CGT asset for the 15-year period ending just before the CGT event

c)            had a significant individual for a total of at least 15 years (even if it was not the same significant individual during the whole period) during which the company owned the CGT asset; and

d)            an individual who was a significant individual of the company just before the CGT event was either:

o        55 or over at the time and the event happens in connection with the individual's retirement, or

o        permanently incapacitated at the time.

You satisfy paragraph (b) as you operated and owned the business for more than 15 years continuously.

Condition (a) - The basic conditions in Subdivision 152-A

The relevant basic conditions in section 152-10 of the ITAA 1997 that must be satisfied in relation to your sale of goodwill to the Purchaser are:

a)            a CGT event happens in relation to a CGT asset of yours in an income year;

b)            the event would have resulted in a capital gain;

c)            you are a CGT small business entity under subsection 152-10(1AA) for the income year or you satisfy the maximum net asset value test in section 152-15; and

d)            the CGT asset satisfies the active asset test in section 152-35.

In your case the sale of the business goodwill on DDMMYY triggered CGT event A1. Based on the sale proceeds and the cost base of the business goodwill, you made a capital gain.

Therefore, we need to consider whether you meet the CGT small business entity or the maximum net asset value test, and then the active asset test, for you to meet all of the basic conditions.

CGT Small business entity test

This test is passed if you are a CGT small business entity for the income year in which the relevant CGT event occurred. An entity is a CGT small business entity if it is carrying on a business in the income year and has an aggregated annual turnover of less than $2 million.

The aggregated annual turnover of an entity includes the annual turnover of the entity and that of its connected entities and affiliates. An entity's annual turnover for an income year is the total ordinary income that the entity derives in the income year in the ordinary course of carrying on a business. Capital gains from a sale of capital assets are excluded from the annual turnover.

Meaning of "affiliate" of an entity

Section 328-130(1) of ITAA 1997 provides that an individual or company is an affiliate of an entity if the individual or company acts, or could reasonably be expected to act in accordance with the entity's directions or wishes, or in concert with the entity in relation to the affairs of the business of the individual or company.

Only an individual or company is capable of being an affiliate of another entity. Further, the individual or company must carry on a business.

You have no affiliates.

Meaning of "connected with" an entity

Section 328-125 of ITAA 1997 provides that an entity is connected with another entity if:

•                     Either entity controls the other entity, or

•                     Both entities are controlled by the same third entity.

Control can exist through indirect control.

An entity controls a company if the entity, its affiliates or the entity together with its affiliates beneficially own, or have the right to acquire the beneficial ownership of, interests in the company that carry between them the right to receive at least 40% of any distribution of income or capital or the right to exercise, or control the exercise of at least 40% of the voting power in the company.

Based on your shareholding structure, no shareholder would've controlled you. Each director held A% shares directly and another BB% indirectly through a related trust.

You have no other related entities which carry on a business and so in calculating your aggregated turnover, only your own turnover is included.

The aggregated turnover can be determined by three ways:

•                     Aggregated turnover for the previous income year;

•                     Estimated aggregated turnover for the current year as at the beginning of the current year; or

•                     Actual aggregated turnover for the current year as at the end of the current year.

Based on your financial statements for 20ZZ, your annual turnover was less than the $2 million turnover threshold. You continued to carry on a business in 20YY until settlement of Contract 1. As such, you would be classified as a CGT small business entity for the 20YY income year.

As you passed the CGT small business entity test, there is no need to further consider the $6 million net asset value test.

Active asset test

Paragraph 152-40(1)(a) of the ITAA 1997 provides that a CGT asset is an active asset at a time, if at that time you own the asset (whether the asset is tangible or intangible) and it is used in the course of carrying on a business carried on by you (or an affiliate or a connected entity). Paragraph 152-40(1)(b) provides that an intangible asset will also be an active asset if you own it and it is inherently connected with a business that is carried on by you (or an affiliate or a connected entity). Note 3 to section 152-40 states that goodwill is an asset that is inherently connected with a business. Therefore, goodwill is an active asset.

The active asset test will be satisfied if an asset was an active asset for at least half of the period it was owned or for 7 and a half years if the asset was owned for more than 15 years. As you owned the goodwill for more than 15 years and operated the same business over the entire ownership period before September 1985, the goodwill is considered to pass the active asset test.

As all of the basic conditions are satisfied, you are eligible to access one or more of the small business CGT concessions.

Question 3

Do you pass all of the conditions in Subdivision 152-B to access the 15-year exemption on the sale of goodwill in relation to Contract 1?

As provided by subsection 152-110(1) of the ITAA 1997, in order for you to access the15 year exemption, you must satisfy the following conditions:

a)            The basic conditions for accessing the small business CGT concessions are satisfied;

b)            You continuously owned the goodwill for at least 15 years ending just before the CGT event;

c)            You had a significant individual for a total of at least 15 years (even if the 15 years was not continuous and it was not always the same significant individual) during which you owned the goodwill; and

d)            An individual who was a significant individual just before the CGT event either:

(i)                  was 55 or over at that time and the event happened in connection with the individual's retirement; or

(ii)                was permanently incapacitated at the time.

Condition (a) - Basic conditions

As discussed above under Question 2 the basic conditions are satisfied.

Condition (b) - You continuously owned the goodwill for the 15- year period ending just before the CGT event

Your original goodwill of $AAA was acquired upon your incorporation prior to September 1985 and so was a pre-CGT asset.

You acquired two small businesses in 19BB and 19CC respectively (goodwill of approximately $DDk and $EEk respectively).

Subsection 149-30(1) of the ITAA 1997 provides that an asset stops being a pre-CGT asset at the earliest time when majority underlying interests in the asset were not had by ultimate owners who had majority underlying interests in the asset immediately before 20 September 1985. Subsection 149-30(1A) deems the entity to have acquired the asset at the time of the change in majority underlying interests.

However, subsection 152-110(1A) of the ITAA 1997 provides that, for the purposes of paragraphs 152-110(1)(b) and (c), subsection 149-30(1A) is disregarded. Therefore, the two smaller parcels of goodwill you acquired in 1992 and 1997 are effectively subsumed into your original goodwill.

As you continuously owned the goodwill for a period of more than 15 years before the sale of the business, it is considered that you meet condition (b).

Condition (c) - You had a significant individual for a total of at least 15 years

Under section 152-55 of the ITAA 1997, an individual is a 'significant individual' in a company if the individual has a 'small business participation percentage' in the company of at least 20%. Section 152-65 provides that this percentage can be made up of direct and indirect percentages.

Subsection 152-70(1) of the ITAA 1997 explains that an entity's direct small business participation percentage in a company is the percentage of:

•                     voting power that the entity is entitled to exercise (except for jointly owned shares); or

•                     any dividend payment that the entity is entitled to receive; or

•                     any capital distribution that the entity is entitled to receive; or

•                     if they are different, the smallest of the three percentages above.

These percentages must arise because of legal and equitable interest the entity holds in shares in the company.

Subsection 152-70(2) of the ITAA 1997 provides, in relation to subsection 152-70(1) above, that redeemable shares are ignored. Therefore, the redeemable preference shares you issued on DDMMYY and DDMMYY (which were subsequently cancelled on DDMMYY and DDMMYY respectively) can be ignored.

From DDMMYY to DDMMYY, you always had an individual shareholder who had at least 20% of your shares which entitled the individual shareholder to at least 20% of your income and capital distribution and voting rights. As such you had a significant individual for a total of at least 15 years and therefore meet condition (c).

Condition (d) - An individual who was a significant individual just before the CGT event either:

(i)                  Was 55 or over at that time and the event happened in connection with the individual's retirement; or

(ii)                Was permanently incapacitated at the time.

There are two requirements under this condition. The first requirement is that an individual who is a significant individual was 55 or over at the time of the CGT event.

Each principal shareholder has an AA% direct shareholding interest in you with their family trust owning a BB% shareholding in you.

Contract 2 involves the sale of a parcel of clients back to one of the principal shareholders.

The family trusts of the other two principal shareholders are committed to making trust distributions of at least 50% to each of the two principal shareholders in the 20ZZ income year. This will result in both principal shareholders having a small business participation percentage in you of at least 20%. Based on those trust distributions, both of those two principal shareholders would be significant individuals in you just before the CGT event.

The second requirement is that the CGT event happens in connection with the significant individual's retirement. Whether a CGT event happens in connection with an individual's retirement depends on the particular circumstances of each case. There would need to be at least a significant reduction in the number of hours the individual works or a significant change in the nature of their present activities to be regarded as a retirement. However, it is not necessary for there to be a permanent and everlasting retirement from the workforce.

Both principal shareholders discussed in the preceding paragraphs were over 55 at the time of the CGT event. They actively sought potential buyers for their business as part of their retirement plan. While they are required to continue providing some consulting services to the purchaser for a fixed two-year period under consulting service agreements after the sale of the business, there will be a significant reduction in work hours. They would only be required to work for a maximum of AA hours per week in the first year and for a maximum of C hours per week in the second year. There will also be a change in the nature of their work. They will be working in a consultant capacity and be assisting with the transition of the business to the purchaser, which is a common practice for such businesses in managing client retention where there is a sale of business. On this basis, it is reasonable to conclude that the sale of the business occurred in connection with the significant individual's retirement. As such condition (d) is satisfied.

As all of the above conditions are met, you are able to access the 15-year exemption to disregard the entire capital gain arising from Contract 1.

Question 4

If the answer to question 3 is "Yes", does the Commissioner accept your method of calculating the CGT exempt amount that can be paid out to the CGT concession stakeholders under the 15-year exemption?

You intend that all of your principals and their spouses will be CGT concession stakeholders in you just before the CGT event in order for them to receive a CGT exempt amount from you under the 15-year exemption.

The CGT exempt amount is generally determined by reference to the capital gain that is disregarded under the 15-year exemption. Although Division 149 of the ITAA 1997 was triggered to deemed the pre-CGT goodwill to be a post-CGT asset acquired at market value at the time the triggering event happened, section 152-125(1)(a)(iv) operates to ensure the pre-CGT capital gain can be distributed tax-free to a CGT concessional stakeholder of you. In these circumstances, subsections 149-30(1) and 149-30(1A) together ensure the goodwill retains its original cost base and time of acquisition. As a result, the total capital gain, comprising the actual pre-CGT gain and actual post-CGT gain, is treated as a post-CGT gain for the purposes of allowing that capital gain to be an "exempt amount" under subsection 152-125(1).

You argue that given the policy intent of the amendments that produced the above provisions, that the cost base of the pre-CGT goodwill is not required to be indexed when calculating the CGT exempt amount which can be paid to the CGT concession stakeholders under section 152-125(1)(a)(iv). You request the Commissioner to confirm your position on this.

The Commissioner agrees that it is reasonable that the pre-CGT goodwill is not required to be indexed when calculating the CGT exempt amount which can be paid to the CGT concession stakeholders under section 152-125(1)(a)(iv) of the ITAA 1997.

Further, you acquired and disposed of some client base post-CGT as a result of business development and growth. These additions would generally form part of the cost base of the goodwill. However, you argue that the client base acquired by you from Person 5 when he joined the firm on DDMMYY should be excluded from the cost base calculation for the purpose of determining the capital gain on the sale of the business goodwill under Contract 1. This is because this particular client base was sold to Person 5 under Contract 2. See question 5 below for further discussion on Contract 2.

You acquired some fee parcels in 199A and 199B which were related to the goodwill disposed of under Contract 1. Indexation should be applied to the acquisition of these assets that occurred before 21 September 1999 when determining the cost base of the goodwill for the purpose of calculating the capital gain on the sale of the business goodwill under Contract 1. Further the disposal of a small fee parcel in 20XX was solely related to the goodwill acquired from Company A. Accordingly the cost base of this fee parcel is deducted from the indexed cost base of the goodwill acquired from Company A.

You intend to calculate the CGT exempt amount by deducting the cost base as outlined in the preceding paragraph from the upfront amount received under Contract 1.

The Commissioner considers your method of calculating the CGT exempt amount to be paid to the CGT concession stakeholders under the 15-year exemption to be reasonable.

Question 5

Will your sale of a specific parcel of clients of the business to Person 5 under Contract 2 qualify for the retirement exemption under Subdivision 152-D?

You acquired a small business from Person 5 when he joined the firm on DDMMYY. While his practice was merged with your existing practice, Person 5 remained solely responsible for managing this client base and growing his client portfolio.

As part of the business sale, Person 5 wished to continue servicing his clients and therefore entered into a separate contract to acquire this specific parcel of client base from you under Contract 2.

The Commissioner agrees that this is a sale of an asset (i.e. client base) by you. While there may be a change in the composition of the client base due to natural growth and development of the business, the Commissioner accepts that this parcel of client base essentially represents the asset acquired by you on DDMMYY. On this basis you would make a capital gain of approximately $FFF on the sale of this client base. As the asset had not been owned by you for a continuous period of 15 years, the 15-year exemption is not be available to you.

To access the retirement exemption under Subdivision 125-D of the ITAA 1997, the following conditions need to be met:

(a)               The basic conditions under subdivision 152-A;

(b)               The significant individual test;

(c)                The CGT exempt amount is specified in writing;

(d)               You must make a payment to at least one of its 'CGT concession stakeholders' by the later of:

a.            7 days after the choice is made to apply the retirement exemption, or

b.            7 days after the capital proceeds are received;

(e)               The payment to the 'CGT concession stakeholder' must not cause them to exceed their individual lifetime limit of $500,000; and

(f)                 Where the CGT concession stakeholder is under the age of 55, the payment must be made to their complying superannuation fund

Condition (a) - Basic conditions

As discussed previously under question 2, you would be considered a CGT small business entity for the 20ZZ income year.

The client base is an active asset inherently connected with the business carried on by you. As it was an active asset since it was acquired by you in 200T, the active asset test is passed.

As such, the basic conditions are met.

Condition (b) - Significant individual test

As discussed at Question 3, two of the three principals' trusts are committed to make a proper trust distribution to them in the 20ZZ income year to ensure that those two principals are significant individuals of you just before the CGT event. On this basis, you are considered to have had a significant individual just before the CGT event.

Condition (c) - CGT exempt amount specified in writing

You will make a written choice and specify the percentage of the CGT exempt amount paid to each CGT concession stakeholder by the time you lodge your 20ZZ tax return.

On this basis, this condition will be met.

Condition (d) - Payment condition

You will make a payment to one of the CGT concession stakeholders by the later of:

•                     7 days after the choice is made to apply the retirement exemption; or

•                     7 days after the capital proceeds are received.

As long as you make a payment of the CGT exempt amount to at least one CGT

concession stakeholder within the required time frame, this condition will be met.

Condition (e) - Lifetime limit of $500,000

Two of the principals have used some of their lifetime limit (under $100,000 each). A payment made by you to the CGT concession stakeholders should not cause them to exceed their individual lifetime limit of $500,000. This condition should be met.

Condition (f) - Super contribution for CGT concession stakeholder under 55

This does not apply as the intended CGT concession stakeholders who will receive a payment are over 55.

Based on the above, it is reasonable to conclude you can utilise the retirement exemption under Subdivision 152-D of the ITAA 1997.

Question 6

If the answer to question 5 is "Yes", does the Commissioner accept your method of calculating the capital gain from the disposal of assets under Contract 2?

As discussed above, the disposal of the specific parcel of the client base should be considered as being related to the acquisition of the business by you from Person 5 on DDMMYY. On this basis, the cost base of this asset would be the acquisition cost of $AAA incurred by you for the purpose of calculating the capital gain under Contract 2.

The Commissioner accepts your method of calculating the capital gain from the disposal of assets under Contract 2.

Question 7

Does the earnout right in Contract 1 qualify as a look-through earnout right under section 118-565 of the ITAA 1997?

The sale of a portion of your business in Contract 1 includes a Holdback Sum, which is payable subject to the business meeting certain revenue targets in the following 2 years after the sale of the business. To qualify as a look-through earnout right under section 118-565 of the ITAA 1997, you must satisfy all of the following:

(a) the right is a right to future financial benefits that are not reasonably ascertainable at the time the right is created;

(b) the right is created under an arrangement that involves a disposal of a CGT asset;

(c) the disposal causes CGT event A1 to happen;

(d) just before the CGT event, the CGT asset was an active asset of the entity who disposed of the asset;

(e) all of the financial benefits that can be provided under the right are to be provided within a period ending no later than five years after the end of the income year in which the CGT event happens;

(f) those financial benefits are contingent on the economic performance of the CGT asset or a business for which it is reasonably expected that the CGT asset will be an active asset for the period to which those financial benefits relate;

(g) the value of those financial benefits reasonably relates to that economic performance, and

(h) the parties to the arrangement deal with each other at arm's length in making the arrangement.

We will address each of these conditions below:

(a) The right is a right to future financial benefits that are not reasonably ascertainable at the time the right is created.

At the time the earnout right was created (i.e. at the time of the CGT event), it was not possible to ascertain that the business would achieve the revenue targets in order to receive future payments. The right to the Holdback Sum is contingent on the future financial performance of the business. This condition is satisfied.

(b) The right is created under an arrangement that involves the disposal of a CGT asset.

This condition is met as the right was created under Contract 1 for the disposal of the business goodwill which, as discussed previously, is a CGT asset.

(c) The disposal causes CGT event A1 to happen.

The sale of the business goodwill under Contract 1 triggered CGT event A1. This condition is met.

(d) Just before the CGT event, the asset was an active asset of the entity that disposed of the asset.

The business goodwill was an active asset of yours just before the CGT event. This condition is met.

(e) All of the financial benefits that can be provided under the earnout right are to be provided over a period ending no later than 5 years after the end of the income year in which the CGT e vent happens.

The earnout right requires financial benefits to be provided within 2 years after the sale of the business. This condition is met.

(f) The financial benefits are contingent on the economic performance of the asset or business.

The financial benefits to be provided are contingent on the future economic performance of the business as they are directly measured by the revenue to be achieved by the business in the next two years. This condition is met.

(g) The value of those financial benefits reasonably relates to that economic performance.

The Holdback Sum is linked to the financial performance of the business and is measured by the revenue targets of the business. This condition is satisfied.

(h) The parties to the arrangement deal with each other at arm's length in making the arrangement.

You and the Purchaser are unrelated parties and entered into Contract 1 on an arm's length basis. The earnout right arrangement was part of the arm's length sale transaction. As such, this condition has been met.

Based on the above, the earnout right qualifies as a look-through earnout right. The tax effect of creating a look-through earnout right for you is as follows:

•                     The value of the right is ignored for CGT purposes in determining capital proceeds and any CGT event that occurs when the right comes to an end will be disregarded. You are only required to include the upfront payment you received (or entitled to receive) in the year in which the sale of the asset occurred.

•                     The value of any financial benefits received under the right is taken into account in determining the capital proceeds from your original CGT event. This would require you to amend your 20ZZ tax return to include any additional payments received.

Question 8

If the answer to question 7 is "Yes", can you make tax-free payments to the CGT concession stakeholders under the 15-year exemption when you receive additional payments under the earnout right?

Section 152-125 of the ITAA 1997 sets out the rules on making payments of the CGT exempt amount by a company to the CGT concession stakeholders under the 15-year exemption. It requires you to make one or more payments relating to the exempt amount to a CGT concession stakeholder before the later of:

(i)                  2 years after the relevant CGT event; and

(ii)                if the relevant CGT event happened because the Taxpayer disposed of the relevant CGT asset - 6 months after the latest time a possible financial benefit becomes or could become due under a look-through earnout right relating to that CGT asset and the disposal.

Based on the above, if you receive further payments in year 1 and year 2 after the sale of the business under the look-through earnout right, you are able to pay these additional amounts to the CGT concession stakeholders as long as the payments are made within the required time period.

These additional amounts received by the CGT concession stakeholders will be tax-free in their hands.

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