Edited version of private ruling

Authorisation Number: 1011681009986

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Ruling

Subject: CGT - Sale of Management Contracts

Issue 1

Whether the restraint, endorsement and retention are separate assets from the management contracts

Question 1

Does the Commissioner consider that the sale of the management contracts is the sale of more than one asset?

Answer

Yes.

Question 2

If the answer to question 1 is yes, does the Commissioner consider that the restraint, the endorsement, and the retention are inextricably linked to the sale of the management contracts so that all disposal proceeds received are attributable to the management contracts rather than the management contracts, the restraint, the endorsement, and retention?

Answer

The restraint is inextricably linked to the sale of the management contracts. However, the endorsement and the retention are not inextricably linked to the sale of the management contracts.

Issue 2

Whether A Pty Ltd as trustee for the A Unit Trust (the Trust) will be required to reasonably estimate its turnover under subsection 328-120(5) of the Income Tax Assessment Act 1997 (ITAA 1997) for the year ended 30 June 2011

Question 1

Will the Trust be required to reasonably estimate its turnover under subsection 328-120(5) of the ITAA 1997 for the year ended 30 June 2011 where there has been a significant reduction in the scale of the business during the income year with a reduced number of management contracts being managed while the business is being wound up but with the wind up not being completed until 30 September 2011?

Answer

Yes.

Question 2

Will the Trust be required to reasonably estimate its turnover under subsection 328-120(5) of the ITAA 1997 for the year ended 30 June 2011 where the business is in the process of being wound up at the end of the year but the wind up is not complete at 30 June 2011?

Answer

Yes.

Question 3

Will the Trust be required to reasonably estimate its turnover under subsection 328-120(5) of the ITAA 1997 for the year ended 30 June 2011 where the business premises has been moved outside the 'restricted zone' (this simply means the geographic restraint zone in each sale contract) during the year and the business continues to be carried on outside the 'restricted zone'?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts

The Trust has carried on a property management business since 1998 when it acquired a small parcel of management contracts.

The business has grown both organically and through acquisition of further management contracts. During this time, the majority of the Trust's revenue has been derived from the management of residential rental properties. Property owners pay the Trust a percentage of the rental from each property to manage their property. The trust also derives ancillary fees as a result of managing these properties.

During the year ended 30 June 2011, the Trust has disposed of a number of residential property management contracts. The management contracts have been sold in a number of tranches and allocated to each tranche depending on the property type and geographic location. The Trust has confirmed that it was dealing at arm's length in all these sale transactions. The Trust has attached one of the sale contracts it has entered into. Each sale contract (the terms of which are the same in all material respects as the attached sale contract) imposes a number of obligations on the Buyer and the Seller (the Trust).

These obligations include:

§ Restraint on the Seller (restrictive covenant):

The restrictive covenant (the restraint) is contained in clause 11 of the contract and imposes restraints on the Seller including a restriction on the Seller to act as a manager or letting agent in certain capacities and for certain time periods.

§ Appointment of Buyer as managing Agent for the management contracts (endorsement):

The contract requires the Seller to take all reasonable steps to obtain in writing from the Property Owner's those forms of appointment for the engagement or appointment to act as Real Estate Agent or Assignment of the appointment to act as a Managing Agent for the purposes of property management in favour of the Buyer for each property subject of the contract. Furthermore, the clause imposes an obligation on the Buyer to introduce its principals to any of the Property Owners as the Seller may reasonably require.

§ Retention:

The contract provides for X% of the purchase price to be withheld and returned to the Buyer if certain conditions exist in the 90 days following settlement. Furthermore, the clause also provides for a refund by the Seller of part of the purchase price should the retention amount not be sufficient.

A proportion of the management contracts have been retained. The Trust will continue to manage these contracts while the Trust determines which of the following courses of action to pursue:

1. continue to carry on the business at its present location at a reduced scale while the business is being wound up;

2. terminate the remaining contracts and wind up the business; or

3. relocate the business outside the restricted zone and continue to carry on a property management business.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 section 104-5

Income Tax Assessment Act 1997 subsection 108-5(1)

Income Tax Assessment Act 1997 subsection 108-5(2)

Income Tax Assessment Act 1997 paragraph 152-10(1)(c)

Income Tax Assessment Act 1997 subparagraph 152-10(1)(c)(ii)

Income Tax Assessment Act 1997 subsection 328-110(5)

Income Tax Assessment Act 1997 paragraph 328-110(5)(a)

Income Tax Assessment Act 1997 paragraph 328-110(5)(b)

Income Tax Assessment Act 1997 subsection 328-120(5)

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997 unless otherwise stated.

Issue 1

Summary

The sale of the management contracts is the sale of more than one asset. Whereas the restraint can be taken as inextricably linked to the sale of the management contracts when the vendor and purchaser are dealing at arm's length and do not allocate a specific part of the sale proceeds to the covenant, the endorsement and the retention are not inextricably linked to the sale of the management contracts.

Detailed reasoning

Capital gains tax (CGT) is the tax you pay on any capital gain you make and include on your annual income tax return. Section 102-20 states that you make a capital gain or capital loss if and only if a CGT event happens. Section 104-5 gives a summary of the various CGT events, most of which include a CGT asset.

Subsection 108-5(1) defines a CGT asset as:

a) any kind of property, or

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

To avoid doubt, subsection 108-5(2) specifically states that CGT assets include:

a) part of, or an interest in, an asset referred to in subsection (1);

b) goodwill or an interest in it;

c) an interest in an asset of a partnership;

d) an interest in a partnership that is not covered by (c) above.

The Trust carries on a property management business and derives majority of its revenue from the management of residential rental properties in accordance with the management contracts. As such, when the Trust is disposing a number of its management contracts, it is in effect selling part of its business.

Taxation Ruling TR 1999/16 Income tax: capital gains: goodwill of a business establishes the ATO view on how the capital gains and losses provisions apply to a taxpayer who conducts a business with goodwill.

Paragraphs 75 to 77 of TR 1999/16 explain that where the part of the business sold constitutes a discrete business and it is sold as a business, the sale includes a disposal of goodwill. There must be a sale of sufficient assets including goodwill to enable a purchaser to carry on the business the vendor did previously without interruption. A disposal of business activities conducted at one geographical location separate from those conducted at other locations is a relevant factor in determining whether what was sold was a discrete business in its own right. As shown below, example 10 of TR 1999/16 further emphasises this point:

Example 10

Disposal of goodwill by partners

Facts

187. Rita and Daryl carry on a lawn mowing business in partnership. The partnership mows lawns in two suburbs of Perth, Leederville and Subiaco.

188. Rita and Daryl decide to reduce their workload and sell for $40,000 their lawn mowing round in Subiaco, including cylinder and rotary lawn mowers and customer records of cutting schedules and other requirements. They enter into a sale contract in which they undertake not to solicit the business of their Subiaco customers. The Subiaco round is capable of being conducted by a purchaser as a discrete - though small - business in its own right. An amount of $25,000 is allocated in the sale contract as capital proceeds for goodwill.

In this case, during the year ended 30 June 2011, management contracts have been sold in a number of tranches and allocated to each tranche depending on the property type and geographic location and management contracts have been retained and the Trust will continue to manage these contracts until the Trust determines which action to pursue. This is similar to the above example where the taxpayers carried on their businesses in different geographic locations and their Location A business is being sold off while they retain their business in Location B.

In addition, management contracts sold or being sold contain restrictive covenant clauses, which is similar to example 10 of TR 1999/16 in that the owners enter into a sale contract in which they agree to not solicit the business of their Location A customers.

As such, each purchaser of each tranche of management contract is capable of carrying on the business the Trust did previously, that is, generating revenue from managing residential rental properties in accordance with the management contracts, without interruption at their own geographic location. Furthermore, the Trust is able to continue to carry on the business (on a reduced scale) with the retained management contracts. Therefore, the sale of the management contracts is the sale of part of its business which constitutes a discrete business and thus, includes the disposal of goodwill in accordance with TR 1999/16.

Paragraphs 31 to 37 of TR 1999/16 provide the ATO view on the relationship between a restrictive covenant and goodwill. Paragraph 32 of TR 1999/16 specifically states that:

If on a sale of a business a restrictive covenant is entered into, the restrictive covenant is a CGT asset created and vested in the purchaser separate in its own right from the goodwill acquired by the purchaser.

It further states in paragraph 33 of the ruling that:

A restrictive covenant given by a vendor of a business or by an employee of the vendor is inextricably linked to the value of any goodwill disposed of. If a vendor and purchaser dealing at arm's length in a sale of a business (and its associated goodwill) do not allocate a specific part of the sale proceeds in the contract of sale to the covenant, for Part 3-1 purposes we will treat the giving of the covenant as being ancillary to the disposal of the goodwill of the business and no part of the proceeds will be attributed to the grant of the restrictive covenant.

Applying the above to this case, the restrictive covenant included in the sale contract is a separate CGT asset from the goodwill, which in turn means that it is a separate CGT asset from the management contract. However, the restrictive covenant is inextricably linked to the value of any goodwill disposed of and as no specific part of the sale proceeds in the contract of sale was allocated to the covenant and the Trust has confirmed that it was dealing at arm's length in all these sale transactions, we will treat the giving of the covenant as being ancillary to the disposal of the goodwill of the business and no part of the proceeds will be attributed to the grant of the restrictive covenant in accordance with TR 1999/16.

TR 1999/16 states at paragraph 37 that the above approach in relation to a restrictive covenant does not extend to the granting or creation of other contractual rights. In this case, these other contractual rights are the endorsement right and the retention right contained in the contract.

Although an additional obligation to endorse the Purchaser to the Property Owner is not explicitly expressed in the contract, the inclusion of Clause 4 has the effect of creating an endorsement right for the purchaser of the management contract to the property owners. In particular, the Trust is required to take all reasonable steps to obtain in writing from the Property Owner's those forms of appointment for the engagement or appointment to act as Real Estate Agent or Assignment of the appointment to act as a Managing Agent for the purposes of property management in favour of the Buyer for each property subject of the contract.

Although retentions do not exist independently of the management contracts, the retention is a right the Trust agreed at settlement to provide to the purchaser. The right provides the purchaser to retain X% of the purchase price and returned to the Buyer if certain conditions exist in the 90 days following settlement.

As mentioned above in subsection 108-5(1), a legal right or equitable right that is not property is a CGT asset. Both the endorsement and retention are legal rights created with the settlement of the contract and therefore are separate CGT assets.

Paragraphs 43 and 47 of TR 1999/16 state that these other contractual rights (in this case, the endorsement and the retention) should be valued before any value is attributable to goodwill.

In this case, the sale of the management contracts involves the disposal of more than one CGT asset, those being the goodwill (with the restraint inextricably linked to it), the endorsement right and the retention right. Therefore, the disposal proceeds received are separately attributable to the goodwill, the endorsement and retention.

Issue 2

Summary

The Trust will be required to reasonably estimate its turnover under subsection 328-120(5) for the year ended 30 June 2011 whether it will be carrying on the business on a reduced scale while winding up, or simply in the process of winding up or moving outside the restricted zone as it ceased carrying on part of its business during the 2010-11 income year.

Detailed reasoning

Under subsection 328-110(5), Subdivision 328-C applies to you as if you carried on a business in an income year if:

a) in that year you were winding up a business you previously carried on; and

b) you were a small business entity for the income year in which you stopped carrying on that business.

Note 1: Subsection 328-120(5) provides for how to work out your annual turnover (which is relevant to working out your aggregated turnover) if you do not carry on a business for the whole of an income year.

In regards to subsection 328-110(5), paragraphs 1.19 and 1.20 of the Explanatory Memorandum to Tax Laws Amendment (Small Business) Bill 2007 states:

1.19 This rule ensures that a small business entity continues to be eligible for small business concessions while it is winding up a business it previously carried on.

1.20 An entity winding up a business will need to calculate what their turnover would have been had the entity carried on the business for the entire income year.

In this case, in the 2010-11 income year, the Trust is winding up their property management business that it has carried on since 1998 by disposing a number of their management contracts. Therefore, it satisfies the condition of paragraph 328-110(5)(a). Whether the Trust satisfies the condition of paragraph 328-110(5)(b) will depend on whether it was a small business entity for the 2010-11 income year, which in turn, depends on whether the Trust generated an aggregated turnover of not more than $2 million for that income year.

Under subsection 328-120(5), if an entity does not carry on a business for the whole of an income year, the entity's annual turnover for the income year must be worked out using a reasonable estimate of what the entity's annual turnover for the income year would be if the entity carried on a business for the whole of the income year.

Paragraph 2.29 of the Explanatory Memorandum to Tax Laws Amendment (Small Business) Bill 2007 states the intention underlying subsection 328-120(5):

2.29 The intent of the provision is to ensure that the eligibility test of turnover, as an indicator of the size of a business, is based on income for a full year. Without this rule, entities that carry on a business for part of the income year would have a lower turnover than is truly representative of the size of the business.

ATO Interpretative Decision ATO ID 2009/49 Income Tax Small Business Concessions: small business entity test - annual turnover - business carried on part year only provides an ATO view on subsection 328-120(5).

It is stated in the decision of ATO ID 2009/49 that:

If a taxpayer carries on one business for the whole of an income year and a second business for only part of that same income year, subsection 328-120(5) of the ITAA 1997 applies in working out the annual turnover of the taxpayer. The provision is not limited to applying only where a taxpayer has ceased to carry on all their business.

It is further explained in the reason for decision of ATO ID 2009/49 that:

Subsection 328-120(5) of the ITAA 1997 effectively provides for extrapolating the part year turnover of a business to a full year equivalent where that business is not carried on for the whole of an income year. The intent of the provision is to ensure the true size of a business is taken into account in determining whether the $2 million turnover requirement is satisfied.

It is clear from ATO ID 2009/49 that the aim of subsection 328-120(5) is to ensure that the turnover amount for determining whether the business is a small business is a true representation of the size of the business.

In this case, a property management business is carried on and part of this business has been disposed of during the 2010-11 income year while the Trust sold a number of residential property management contracts. As explained in issue 1 above, the sale of the management contracts is the sale of part of its business which constitutes a discrete business. The management contracts, which all contain restrictive covenant clauses, have been sold in a number of tranches and allocated to each tranche depending on the property type and geographic location. As such, each tranche enables its purchaser to carry on a discrete, though small, business in its own right at their own geographic location.

In this case, subsection 328-120(5) would apply to the circumstances to extrapolate the part year turnover of a business to a full year equivalent where that business is not carried on for the whole of an income year. This would ensure that the true size of the business is taken into account in determining whether the Trust satisfies $2 million turnover requirement. If subsection 328-120(5) does not apply, businesses which have partially wound down during the income year would have a lower turnover than is truly representative of the size of the business and contradicts with the objective of subsection 328-120(5).

Therefore, in order to obtain a true representation of the size of the business, the Trust will be required to reasonably estimate its turnover under subsection 328-120(5) regardless of the course of action the Trust decides to pursue:

§ continue carrying on the business at its present location at a reduced scale while the business is being wound up, or

§ terminate the remaining contracts and wind up the business, or

§ relocate the business outside the restricted zone and continue to carry on a property management business.

It should be noted that under subparagraph 152-10(1)(c)(ii), the Trust may still be able to satisfy paragraph 152-10(1)(c) if it passes the maximum net asset value test of section 152-15.