Edited version of your private ruling

Authorisation Number: 1012105509019

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Ruling

Subject: Cessation of business - sale of goodwill - tax consequences

Question 1:

Does the receipt of the amount under the agreement comprise a derivation of income under ordinary principles under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer: No.

Question 2:

Does the receipt of the amount received under the agreement result in a capital gain for the 30 June 2011 year of income for the purpose of Step 1 of subsection 102-5(1) of the ITAA 1997?

Answer: Yes.

Question 3:

If the answer to Question 2 is yes, will the basic conditions be satisfied for the application of the small business conditions for the application of the small business conditions under section 152-10 of the ITAA 1997?

Answer: Yes.

Question 4: If the answer to Question 3 is yes, provided the requirements in sections 152-315 and 152-325 of the ITAA 1997 are complied with, will X be entitled to make a choice under subsection 152-305(2) of the ITAA 1997 to disregard up to $1 million of the capital gain in relation to the two CGT concession stakeholders?

Answer: Yes.

Question 5: If the answer to Question 4 is yes, would the dividend streaming provisions, as contained in Subdivision 204-D of the ITAA 1997, apply where X makes a differential choice under 152-315 of the ITAA 1997 in relation to each of the payments made to the CGT concession shareholders?

Answer: No.

This ruling applies for the following periods:

1 July 2010 to 30 June 2011.

The scheme commences on:

1 July 2010.

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

X was incorporated several years ago.

Since that time it has carried on a business (the business) within Australia.

The company is owned in equal proportions by a number of entities. All entities are Australian tax residents.

During the 2010-11 financial year X entered into a agreement for the sale of its business.

Under the terms of the agreement, the purchaser agreed to make a payment to X for:

· X ceasing to operate the Business in accordance with the agreement

· the Principals and the Accepting Employees being released from their employment contracts with X in order to allow the Principals and the Accepting Employees to join the purchaser

The agreement provided that clients of X would be transferred to the purchaser under agreed arrangements.

On signing the agreement, restrictions have been placed on X in relation to its ability to trade.

No consideration was paid in relation to the restrictions placed on X under the agreement. All consideration has been paid by the purchaser to compensate X for agreeing to cease carrying out the Business.

The agreement provides that consideration for the transaction was payable as a lump sum upon signing the agreement, followed by potential annual payments based on certain sales revenue and gross margin targets being satisfied at a future point in time (the earn-out payments).

Based on the information contained in information provided:

· the market value of net assets owned by X and its connected entities just before the transaction date is less than $6 million

· the aggregated turnover of X for the current year is less than $2 million, and

· the aggregated turnover of X for the prior year is less than $2 million.

The individuals who directly (and indirectly) own the company are not considered to be 'affiliates' of the company under Division 328 of the ITAA 1997 as neither of them carried on a business in their own right at that time. There are no other individuals or trusts 'affiliated' with the company just before the transaction date.

The individuals have not previously accessed the Small Business Retirement Exemption in relation to a capital gain.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 subsection 6-5(1)

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 subsection 104-10(2)

Income Tax Assessment Act 1997 section 104-35

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 paragraph 108-5(1)(a)

Income Tax Assessment Act 1997 paragraph 108-5(1)(b)

Income Tax Assessment Act 1997 subsection 104-35(1)

Income Tax Assessment Act 1997 Division 152

Income Tax Assessment Act 1997 subsection 152-10(1)

Income Tax Assessment Act 1997 subsection 152-40(1)

Income Tax Assessment Act 1997 paragraph 152-40(1)(b)

Income Tax Assessment Act 1997 Subdivision 152-D

Income Tax Assessment Act 1997 section 152-300

Income Tax Assessment Act 1997 section 152-305

Income Tax Assessment Act 1997 Subdivision 152-A

Income Tax Assessment Act 1997 section 152-50

Income Tax Assessment Act 1997 section 152-325

Income Tax Assessment Act 1997 section 152-55

Income Tax Assessment Act 1997 section 152-65

Income Tax Assessment Act 1997 section 152-325

Income Tax Assessment Act 1997 section 152-315

Income Tax Assessment Act 1997 section 204-30

Income Tax Assessment Act 1997 subsection 152-315(5)

Income Tax Assessment Act 1997 Subdivision 204-D

Income Tax Assessment Act 1997 subsection 204-30(3)

Income Tax Assessment Act 1997 subsection 204-30(8)

Income Tax Assessment Act 1997 subsection 204-30(1)

Income Tax Assessment Act 1936 section 44

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: 'Part IVA: the general anti-avoidance rule for income tax'.

Reasons for decision

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Ordinary income

Section 6-5 of the ITAA 1997 provides that if you are an Australian resident, your assessable income includes the ordinary income you derived directly or indirectly from all sources, whether in or out of Australia, during the income year. In subsection 6-5(1) of the ITAA 1997, income according to ordinary concepts is called ordinary income.

The payment made to you by the purchaser could constitute income as an inducement or reward as considered in FC of T v. Montgomery (1999) 164 CLR 435; (1999) 42 ATR 475; 99 ATC 4749 (Montgomery). In Montgomery, the firm 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 this occurred in your dealings with the purchaser. Nor is there any indication that the payment of the amount is a normal incident of the signing of an exclusive trade tie by you. It is therefore considered that the payment to you by the purchaser would not be assessable income on this basis.

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 your case, the transaction is clearly outside your ordinary course of carrying on a business. To determine your intention or purpose in entering into the transaction, it has to be discerned from an objective consideration of the facts and circumstances of your case.

The main elements of your agreement with the purchaser is that in return for the payment and the services to be provided by the purchaser, you will cease the business and sell the goodwill and provide exclusive services to clients as employees of the purchaser for a certain period of time. In your case, it can not 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 will therefore also not be assessable income on this basis.

The payment will therefore not be included in your assessable income under section 6-5 of the ITAA 1997.

Has a CGT event occurred?

Section 102-20 of the ITAA 1997 states that a capital gain or capital loss can only be made as a result of a CGT event happening.

CGT events are the different types of transactions or happenings which may result in a capital gain or a capital loss. CGT events are not limited to the sale of assets. The CGT provisions apply to many transactions that do not involve the disposal of an asset.

Once it has been established that there is a CGT event, there can be exceptions or exemptions that apply to the resulting capital gain or capital loss.

By their very nature, capital proceeds as per section 116-20 of the ITAA 1997 must be amounts that are on capital account and not ordinary income under section 6-5 of the ITAA 1997. The payment received for entering into the agreement is capital in nature as you have effectively ceased the business and are now abiding by the terms of the agreement.

CGT event A1: disposal of a CGT asset

CGT event A1 happens when a taxpayer disposes of a CGT asset. A taxpayer disposes of a CGT asset when a change of ownership occurs from them to another entity, whether by some act or event or by operation of law subsection 104-10(2) of the ITAA 1997.

Generally, CGT event A1 happens when the contract for the disposal is entered into or, if there is no contract, when the change of ownership occurs.

CGT event D1: creation of contractual or other rights

CGT event D1 under section 104-35 of the ITAA 1997 occurs when you create a contractual or other legal or equitable right in another entity. CGT event D1 would happen, for example, if an agreement creating a restrictive covenant is entered into.

Goodwill

Goodwill is listed as a CGT asset under section 108-5 of the ITAA 1997, and the sale of goodwill is a CGT event A1 under section 104-10 of the ITAA 1997.

A right created under a restrictive covenant is also 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 of the ITAA 1997, and is either a proprietary right (paragraph 108-5(1)(a) of the ITAA 1997) or a legal or equitable, non-proprietary right (paragraph 108-5(1)(b) of the ITAA 1997). The creation of such a right in favour of the purchaser is a CGT event D1 under subsection 104-35(1) of the ITAA 1997.

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'.

In your case, the agreement contains certain restrictions and conditions. These restrictions and conditions satisfy the definition of a restrictive covenant and CGT event D1 potentially happened at the time the contract was entered into.

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 agreement and in allocating the capital proceeds, we will treat the granting of the covenant as being ancillary to the disposal of the goodwill of the business. We therefore accept that no part of the capital proceeds is attributable to the restrictive covenant and that the total of the capital proceeds is for the goodwill. Accordingly CGT event D1 did not happen.

CGT event A1 under section 104-10 of the ITAA 1997 therefore happened when you enter into the agreement.

Conclusion

The sale of your goodwill is a CGT event A1 under section 104-10 of the ITAA 1997. Any capital gain resulting from the sale of the goodwill may qualify for the small business CGT concessions under Division 152 of the ITAA 1997 provided that any relevant conditions for the particular concessions applied are satisfied.

Small business CGT concessions

For the capital gain to qualify for the small business concessions contained within Division 152 of the ITAA 1997, the four basic conditions in subsection 152-10(1) of the ITAA 1997 must generally be satisfied. Those conditions 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 gain;

(c) at least one of the following applies:

· you are a small business entity for the income year;

· you satisfy the maximum net asset value test;

· you are a partner in a partnership that is a small business entity for the income year and the CGT asset is an asset of the partnership;

(d) the CGT asset satisfies the active asset test.

Condition (a)

CGT event A1 will happen in relation to a CGT asset (goodwill) of yours and this condition is satisfied.

Condition (b)

There is no cost base in respect of the business goodwill. Therefore, there will be a capital gain and this condition is satisfied.

Condition (c)

You advised that X is both a small business entity and satisfies the maximum net asset value test during the 30 June 2011 income year and this condition is satisfied.

Condition (d)

Did your goodwill satisfy the active asset test?

An active asset is defined by subsection 152-40(1) of the ITAA 1997 as an asset that you own (whether tangible or intangible) and is used or held ready for use in the course of carrying on your business. Additionally, paragraph 152-40(1)(b) of the ITAA 1997 states that an intangible asset that you own and is inherently connected with your business will also be an active asset.

In your case, the goodwill was both actively used in your business as well as being inherently connected with it, and hence is considered an active asset. Furthermore, the goodwill was used in your business for the period from commencement until the agreement was entered into and this condition is satisfied.

All of the basic conditions are satisfied.

Small business retirement exemption

Subdivision 152-D of the ITAA 1997 provides a small business CGT concession known as the small business retirement exemption. Under section 152-300 of the ITAA 1997 you can choose to disregard a capital gain from a CGT event happening to a CGT asset of your small business if the capital proceeds from the event are used in connection with your retirement.

Special rules for a company or trust

Section 152-305 of the ITAA 1997 contains the general provisions that allow exemption of the capital gain. If you are a company or a trust you can disregard all or part of a capital gain if:

(a) the basic conditions in Subdivision 152-A of the ITAA 1997 are satisfied for the capital gain

(b) the entity satisfies the significant individual test under section 152-50 of the ITAA 1997, and

(c) the company or trust conditions in section 152-325 of the ITAA 1997 are satisfied.

Significant individual

An individual is a significant individual in a company if they have a 'small business participation percentage' in the company of at least 20 per cent (section 152-55 of the ITAA 1997). The 20 per cent can be made up of direct and indirect percentages.

An individual's direct small business participation percentage in a company is the percentage of:

· the voting power in the company

· any dividend that the company may pay or

· any distribution of capital that the company may make.

An entity satisfies the significant individual test if the entity had at least one significant individual just before the CGT event.

CGT Concession Stakeholder

An individual is a concession stakeholder of a company if they are a significant individual or a spouse of a significant individual in the company if the spouse has a small business participation percentage in the company that is greater than zero.

Section 152-65 of the ITAA 1997 provides that an individual's small business participation percentage in a company is equal to the sum of his/her direct and indirect small business participation percentage in the company. This percentage is based on the individual holding of the legal and equitable interest in shares in the company. Where an individual does not have entitlements to any distribution of the company during the year of income and capital the individual is deemed to have a zero participation percentage.

Under section 152-325 of the ITAA 1997 a company must make a payment to at least one of its CGT concession stakeholders if the company receives an amount of capital proceeds from a CGT event for which it makes a choice under this Subdivision.

Choosing the amount to disregard.

Under section 152-315 of the ITAA 1997 you can choose to disregard all or part of each capital gain to which this Subdivision applies. However for a company the choice must be made in a way that ensures the CGT retirement exemption limit of each individual for whom the choice is made is not exceeded.

The amount chosen for the asset is its CGT exempt amount and the exempt amount must be specified in writing. If a payment is made to more than one CGT concession stakeholder, the amount of each such payment is to be worked out by reference to each individual's participation percentage. One or more of the percentages may be nil, but all of the percentages must add up to 100%.

The company must make the choice by the day it lodges its income tax return for the income year in which the relevant CGT event happened.

If a CGT concession stakeholder is under 55 years of age just before the company makes a payment, the company must make the payment to the CGT concession stakeholder by contributing it on their behalf to a complying superannuation fund.

The company cannot claim a deduction for the payment. The contribution is treated as a personal contribution of the CGT concession stakeholder. The individual cannot deduct the contribution. It is not assessable income of the complying superannuation fund.

To satisfy this requirement the company must pay the amount directly into a complying superannuation fund by the later of seven days after it makes the choice for the retirement exemption or seven days after it receives an amount of capital proceeds from the CGT event.

Failure to do this will mean the conditions are not satisfied and the retirement exemption will not be available.

CGT retirement exemption limit

An individual's CGT retirement exemption limit is $500,000 reduced by the CGT exempt amounts of CGT assets specified in choices previously made by or for the individual under this Subdivision.

X is considering making payments to significant individuals under Subdivision 152-D of the ITAA 1997. These taxpayers are CGT concession stakeholders, as they have a small business CGT participation percentage of greater than 20 per cent in the company.

If all of the above requirements are met X should be eligible to make the choice under the relevant provision.

Dividend streaming

Section 204-30 of the ITAA 1997 applies where a company streams the payment of franked distributions to its shareholders in such a way that the imputation benefits attaching to the distribution are received by those shareholders who derive a greater benefit from them and other shareholders receive lesser imputation benefits, or no imputation benefits.

The terms 'stream' and 'streaming' are not defined in the Act. However, the Explanatory Memorandum to the New Business Tax System (Imputation) Bill 2002 defines streaming as:

3.28 Streaming is selectively directing the flow of franked distributions to those members who can most benefit from imputation credits.

And goes on to say:

3.29 The law uses an essentially objective test for streaming, although purpose may be relevant where future conduct is a relevant consideration. It will normally be apparent on the face of an arrangement that a strategy for streaming is being implemented. The distinguishing of members on the basis of their ability to use franking benefits is a key element of streaming.

3.30 Thus, streaming is unlikely to occur when a corporate tax entity, in making franked distributions, distinguishes between 2 classes of members, both of which comprise members who can and who cannot benefit from imputation credits. However, where one class is predominantly able to use imputation credits, and the other is predominantly not, it may be apparent that an arrangement is streaming, notwithstanding the presence in each class of a small minority of the other type of member.

3.31 Broadly speaking, any strategy directed to defeating the policy of the law by avoiding wastage of imputation benefits through directing the flow of franked distributions to members who can most benefit from them to the exclusion of other members, may amount to streaming. While it is not possible to specify in detail every combination of circumstances which can constitute the streaming of franking credits (which in some cases may involve questions of degree), some guidance is given below.

X is seeking to make an equal total payment to each shareholder of X before lodgement of the 30 June 2011 tax return. Ordinarily, this payment would constitute a dividend and would be assessable under section 44 of the Income Tax Assessment Act 1936 (ITAA 1936).

Subsection 152-315(5) of the ITAA 1997, and the example following, allows X to make two choices under section 152-305 of the ITAA 1997 in respect of its CGT concession stakeholders. The section requires X to specify in writing the percentage of each CGT asset's CGT exempt amount that is attributable to each of the CGT concession stakeholders. The example makes it clear that the percentage chosen can be different for each CGT concession stakeholder.

Where a choice is made, subsections 152-325(9) to (11) of the ITAA 1997 apply so that the payment is not to be treated a dividend to the recipient or interposed entities. However, where the percentages chosen for each of the CGT concession stakeholders under section 152-305 of the ITAA 1997 are different, this may result in one taxpayer receiving a frankable dividend, while the other taxpayer would receive a payment for the same amount that is exempt under the retirement exemption contained in Subdivision 152-D of the ITAA 1997.

The anti-streaming provisions in Subdivision 204-D of the ITAA 1997 broadly apply where franking credits are selectively directed to members who can benefit most from imputation credits. In particular, subsection 204-30(3) of the ITAA 1997 outlines the consequences if the streaming provisions apply.

The provisions detail examples of circumstances where this will be seen to have occurred. It is noted, in this case, that the shareholders of X would be eligible to an equal franking credit in respect of any franked distribution received.

Subsection 204-30(8) of the ITAA 1997 lists some circumstances in which a shareholder will be deemed to have received a greater benefit from franking credits than another. The list is not exhaustive. However, none of those circumstances appear to apply in this case.

Furthermore none of these entities are foreign residents. The shareholders are entitled to a tax offset under Division 207 of the ITAA 1997.

The Commissioner agrees that a differential percentage chosen in respect of the significant individuals under section 152-315 of the ITAA 1997 will not constitute dividend streaming under Subdivision 204-D of the ITAA 1997. Therefore subsection 204-30(1) of the ITAA 1997 will not have application to X.