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Ruling

Subject: Capital Gains Tax

Question 1

Does the payment, or any part thereof, made to you by the company constitute assessable income under section 6-5 or any other provision of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Does the payment, or any part thereof, made to you by the company represent a capital gain in respect of capital gains tax (CGT) event D1 of the CGT provisions of the ITAA 1997?

Answer

No. CGT event A1 will take place.

Question 3

Does the payment, or any part thereof, made to you by the company represent a capital gain in respect of capital gains tax (CGT) event A1 of the CGT provisions of the ITAA 1997?

Answer

Yes.

Question 4

Would the small business CGT concessions in Division 152 of the ITAA 1997 be available?

Answer

The capital gain which was made is one to which the Small Business CGT concessions could potentially apply if the relevant conditions are met.

This ruling applies for the following periods:

Year ended 30 June 2009

The scheme commences on:

1 July 2008

Relevant facts and circumstances

The taxpayer was approached by representatives from a company wishing to acquire his business. After negotiations, the taxpayer entered into a sale. The only significant asset of the business was goodwill.

The contract included the provision of services by the taxpayer to the purchaser. The taxpayer will render services from the new premises of the purchaser for several years. For some years thereafter, the taxpayer must not render services or conduct business at any place within a set radius of the business premises of the purchaser. The purchaser will supply services to the taxpayer at the new premises.

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 104-10

Income Tax Assessment Act 1997 Section 104 -35

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 118-20

Income Tax Assessment Act 1997 Division 152

Reasons for decision

Unless otherwise stated, all references in the following Reasons for Decision are to the Income Tax Assessment Act 1997 (ITAA 1997).

Question 1

Assessable income is made up of ordinary income under section 6-5 and statutory income under section 6-10. Subsection 6-5(1) defines ordinary income as income 'according to ordinary concepts.' Ordinary income can include profits on isolated transactions.

Taxation Ruling TR 92/3 discusses whether profits on isolated transactions are income. TR 92/3 provides the following guidelines which can be applied to your circumstances:

If a transaction or operation is outside the ordinary course of a taxpayer's business, the intention or purpose of profit-making must exist in relation to the transaction or operation in question (paragraph 10).

It is not necessary that the profit be obtained by a means specifically contemplated (either on its own or as one of several possible means) when the taxpayer enters into the transaction (paragraph 14).

The intention or purpose of the taxpayer (of making a profit or gain) is not the subjective intention or purpose of the taxpayer. Rather, it is the taxpayer's intention or purpose discerned from an objective consideration of the facts and circumstances of the case (paragraph 38).

It is not necessary that the intention or purpose of profit-making be the sole or dominant intention or purpose for entering into the transaction. It is sufficient if profit-making is a significant purpose (paragraph 40).

The taxpayer must have the prerequisite purpose at the time of entering into the relevant transaction or operation (paragraph 41).

It is not our view, nor has it ever been, that all receipts or profits of a business are income. For example, when a taxpayer derives a profit from a transaction outside the ordinary course of carrying on its business and the taxpayer did not enter that transaction with the purpose of making a profit, the profit is not assessable income (paragraph 44).

In the present case, the transaction is clearly outside your ordinary course of carrying on a business. Your intention or purpose in entering into the transaction must be discerned from an objective consideration of the facts and circumstances.

The main elements of your agreement with the purchaser are that in return for the payment and the services to be provided by them, you were to sell the asset and provide exclusive services for a certain period of time. It cannot be said that you are entering into this transaction with a significant intention or purpose of making a profit as required in paragraphs 40 and 44 of Taxation Ruling TR 92/3.

The payment made to you could constitute income as an inducement or reward as considered in FC of T v. Montgomery (1999) 164 CLR 435; (1999) 198 CLR 639; (1999) 42 ATR 475; 99 ATC 4749. In Montgomery's case, the firm in question was able to use its capital to obtain a good inducement offer to take premises. The use of its capital was considered to be in the course of carrying on its business, although in a transaction which was regarded as singular or extraordinary. In your case, the information supplied does not indicate that such occurred in your dealings. Consequently, the definition of ordinary income would not extend to the payment received and it would not constitute ordinary income for the purposes of section 6-5.

Ordinary income has also been held to not include capital receipts. However, some amounts not assessable as ordinary income under section 6-5 may be made assessable by virtue of the operation of section 6-10.

Questions 2 and 3

Section 6-10 provides that assessable income includes statutory income which constitutes amounts made assessable by specific statutory provisions. Such a provision is section 102-5 which states that capital gains are included in assessable income.

The agreement entered into stipulates that you agree to provide services for a certain period. It also specifies that during the period of agreement and for a period thereafter certain restrictions apply.

The Commissioner's definition of a restrictive covenant in subparagraph 6(a) of Taxation Ruling TR 95/3 is 'an agreement between two or more parties to refrain from doing some act or thing'. Examples of restrictive covenants are provided in paragraph 35 of TR 95/3 and include:

1. a covenant by an employee to an employer in which the employee promises to refrain from doing some act (e.g. not to disclose special processes, trade connections and trade secrets of the employer);

2. a restrictive (negative) covenant preventing an employee from competing in another business or opening a new business;

3. a restriction on competition, enforced by an agreement separate from an employment agreement, which comes into effect after employment ceases;

4. a contract of employment stipulating exclusive service by the employee during its term

A right created under a restrictive covenant is a CGT asset which is separate from the goodwill of a business. Such a right constitutes a CGT asset as defined in section 108-5, and is either a proprietary right (paragraph 108-5(1)(a)) or a legal or equitable, non-proprietary right (paragraph 108-5(1)(b)). The creation of such a right in favour of the purchaser is a CGT event D1 under subsection 104-35(1).

In your case, the contracts contain exclusive dealing and restraint clauses. These clauses satisfy the definition of a restrictive covenant and CGT event D1 will happen at the time the contracts are entered into.

Goodwill is also listed as a CGT asset under section 108-5, and the sale of goodwill is a CGT event A1 under section 104-10. Such an event took place when the asset was sold.

Consequently, two events seem to have occurred at the time of the contract: a right created under a restrictive covenant and the sale of goodwill. The Commissioner's view on the relationship between a restrictive covenant and goodwill in Taxation Ruling TR 1999/16 is:

105. The value of goodwill and the granting of a restrictive covenant on the sale of a business are inextricably linked. The absence of a covenant may be reflected in a lower price being paid for goodwill. The presence of a restrictive covenant tends to indicate the parties really do transfer some goodwill, though this is by no means conclusive. As the High Court majority justices said in the Murry case, the lack of competition from an enforceable restrictive covenant may enhance the goodwill of a business: 98 ATC at 4591; 39 ATR at 138.

106. If a vendor and a purchaser of a business, dealing at arm's length and having given proper thought to the appropriate value of a restrictive covenant, do not separately allocate any part of the capital proceeds to a restrictive covenant, we will treat the granting of the covenant as being ancillary to the disposal of the goodwill of the business. We will accept that no part of the capital proceeds is attributable to the restrictive covenant.

We consider that as you were dealing at arm's length in transacting the sale and in allocating the capital proceeds and, as no proceeds were specifically allocated to a restrictive covenant, we will treat the granting of the covenant as being ancillary to the disposal of the goodwill of the business in accordance with the views expressed in TR 1999/16.

We therefore accept that no part of the capital proceeds is attributable to the restrictive covenant CGT event D1. The total of the capital proceeds is for the goodwill as per the Commissioner's stated position in TR 1999/16 and is attributable to the CGT A1 event.

Question 4

Any capital gain resulting from the sale of the goodwill may qualify for the small business CGT concessions under Division 152 provided that any relevant conditions for the particular concessions applied are satisfied.

Please note that we have not considered whether you do in fact satisfy the basic conditions for the concessions, which are set out in section 152-10. If required, you may seek another ruling in respect of those matters and the additional information necessary to answer those questions will be obtained at that time.