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Ruling

Subject: Taxation implications on retirement payment

Question 1

Is the receipt of the lump sum payment, paid by the Partnership to you under a Partner Retirement Deed, considered a receipt of capital which will be assessed under the capital gains tax (CGT) provisions of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

Yes

Question 2

Are you eligible to disregard the capital gain made on the surrender of your partnership interest under the CGT 15-year exemption concession for small business?

Answer:

Yes

This ruling applies for the following period

Year ended 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts and circumstances

You became a partner of a large professional firm.

The Partnership does not recognise goodwill, and therefore there was no consideration paid on entering the Partnership.

On entering the Partnership, you acquired an interest in the Partnership, including assets of the Partnership which belong to the partners and involving the sharing of losses and liabilities between the partners.

The administration, management entitlements and obligations of the partners are governed by the Partnership Agreement.

You entered into a retirement agreement (Partner Retirement Deed) to retire from the Partnership.

In consideration for the disposal of your interest in the Partnership a lump sum consideration was paid, which included a retirement allowance payment.

The pertinent clauses of the Partnership Agreement are:

· Clause X - which establishes that on entering the Partnership the partner acquires an interest in the Partnership;

· Clause X - which covers the detail related to the disposal of the Partnership interest upon retirement, including calculation of retirement entitlement and, an agreement providing that the Partnership does not recognise goodwill and that goodwill will have no monetary value. It also details that the Partnership and retiring partner release each other from all claims on account of the Partnership.

· Clause X - which imposes certain restrictions (with respect to future activities) on the former partner including; not soliciting or accepting business from clients of the Partnership, not using the Partnership's logo or service mark, or, not conducting a similar business or activity for a certain period of time.

The pertinent clauses of the Retirement Deed include;

· Clause X - which clarifies that the taxpayer will cease to be a partner on and from the retirement date

· Clause X - which acknowledges certain restrictions on the retiring partner under the Partnership Agreement post retirement

· Clause X - which emphasises the continuing obligations that the retiring partner agrees to under the Partnership Agreement

· Clause X - which provides that the retiring partner relinquishes any claims they may have against the Partnership.

You state that you satisfy the maximum net asset value test for the purposes of the small business CGT relief.

You are over 55 years of age.

You had a continuing interest as a partner until the date of their retirement.

Relevant legislative provisions

Income Tax Assessment Act 1997 Paragraph 108-5(2)(d)

Income Tax Assessment Act 1997 Section 104-25

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

Income Tax Assessment Act 1997 Paragraph 104-25(2)(a)

Income Tax Assessment Act 1997 Section 108-5

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 Section 152-10

Income Tax Assessment Act 1997 Section 152-15

Income Tax Assessment Act 1997 Subsection 152-10(1A)

Income Tax Assessment Act 1997 Subsection 152-10(1B)

Income Tax Assessment Act 1997 Subsection 152-35(1)

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

Income Tax Assessment Act 1997 Section 328-125

Income Tax Assessment Act 1997 Section 328-130

Income Tax Assessment Act 1997 Section 152-105

Reasons for decision

Surrender of your partnership interest

The nature of a receipt, for the purposes of the Income Tax Assessment Act 1997 (ITAA 1997), is determined from the point of view of the recipient rather than that of the payer. Therefore, despite how your payment is described in the Partnership accounts or on your retirement statement, it is the nature of the receipt in your hands which determines how it is assessed.

The lump sum payment was not a distribution of the net income of the partnership, but a distribution of your share of the equity of the Partnership. Therefore, the receipt by you of the lump sum under the retirement agreement is not assessable as ordinary income and instead is considered a receipt of capital and will be assessable under the capital gains tax provisions.

Your retirement from the Partnership meant that you gave up your interest in the Partnership, and in any assets of the Partnership. Paragraph 108-5(2)(d) of the ITAA 1997 provides that a partner's interest in a partnership is a CGT asset. It is a chose in action.

Taxation Ruling IT 2540 examines the capital gains tax (CGT) implications of a disposal of a partnership interest. Though it is expressed in terms of the former CGT provisions (of the Income Tax Assessment Act 1936) the discussion is still relevant for the purposes of the ITAA 1997. At paragraphs 13 and 14 it states:

For large partnerships, which can have memberships numbering in the hundreds (for example, some major legal and accountancy partnerships) the situation is potentially complex. In some cases, the potential problems are overcome because the ownership of the assets used by the partnership is vested in a service company or trust. In other cases, it will generally be accepted, provided the evidence reasonably supports the conclusion that the partners are dealing with each other at arm's length. Any consideration paid or received on the acquisition or disposal of an interest in the partnership will be used for Part IIIA (CGT) purposes in determining the cost base or disposal proceeds of the interests in the partnership assets that the partnership interest represents. This will mean that if, for example, the partnership arrangement is such that no amount is payable for the acquisition or disposal of goodwill, it will be accepted for the purposes of Part IIIA (CGT) that the value of the goodwill is nil. This treatment will also apply to partners of smaller partnerships who deal with each other at arm's length, where those dealings take place in an ordinary commercial context.

In the case of large professional partnerships, where the partners' dealings with each other are at arm's length, it will only be where consideration is paid by a partner on entering the partnership or where a partner receives a payment on leaving the partnership that Part IIIA (CGT) will have any practical effect. Where consideration is neither paid by a person on entering the partnership, nor received on retirement from the partnership, the partner will not realise a capital gain or incur a capital loss on the disposal of particular assets. However, as noted above, the admission or retirement of a partner may affect the proportionate ownership of the partnership assets by the individual partners and therefore may affect the extent of a continuing partner's interest in the partnership. This would be relevant in the event of a subsequent disposal of the partnership assets for consideration, or where consideration is paid to a partner on retirement from the partnership.

Section 104-25 of the ITAA 1997 states that CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset:

a) being redeemed or cancelled; or

b) being released, discharged or satisfied; or

c) expiring; or

d) being abandoned, surrendered or forfeited; or

e) if the asset is an option - being excised; or

f) if the asset is a convertible interest - being converted

The time of the event is:

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

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

An interest in a partnership is considered an intangible asset.

The capital gain the taxpayer makes from CGT event C2 is equal to the difference between the proceeds received from the event happening and the cost base of the asset (subsection 104-25(3) of the ITAA 1997).

In your case, you did not pay anything on being admitted to the Partnership and there was no goodwill associated with the Partnership. Nonetheless, your interest in the Partnership was a CGT asset. As a result of leaving the Partnership your interest in the Partnership has ended.

CGT event C2 happened. The event happened when the agreement between the parties that resulted in the resignation was made (paragraph 104-25(2)(a) of the ITAA 1997). You made a capital gain equal to the difference between the payment you received from the Partnership and the cost base of your interest in the Partnership. Although you did not pay any consideration to acquire your interest, your cost base can include other costs you incurred to acquire the interest or costs that relate to the resignation occurring.

Restrictive covenant

The Partner Retirement Deed entered into contains a restrictive covenant in which it stipulates that you will, among other things;

· not solicit or accept business from clients of the Partnership,

· not use the Partnership's logo or service mark

· not conduct a similar business or activity for a certain period of time.

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:

· 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);

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

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

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

A right created under a restrictive covenant is a CGT asset. 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 partnership is a CGT event D1 under subsection 104-35(1) of the ITAA 1997.

In your case, the agreement contains exclusive dealing and restraint clauses. These clauses satisfy the definition of a restrictive covenant and CGT event D1 will happen at the time the contract is entered into.

However, as it is considered that you were dealing at arm's length in entering into the agreement and, no proceeds were specifically allocated to a restrictive covenant, we will treat the granting of the covenant as being ancillary to the surrender of your partnership interest.

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 surrender of your partnership interest and is attributable to CGT event C2.

Small business CGT concession eligibility and the active asset test

Section 152-10 of the ITAA 1997 contains the basic conditions you must satisfy to be eligible for the small business capital gains tax (CGT) concessions. These conditions are:

(a) a CGT event happens in relation to a CGT asset in an income year.

(b) the event would have resulted in the gain

(c) at least one of the following applies:

(i) you are a small business entity for the income year

(ii) you satisfy the maximum net asset value test in section 152-15 of the ITAA 1997

(iii) 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 or

(iv) the conditions in subsection 152-10(1A) or (1B) of the ITAA 1997 are satisfied in relation to the CGT asset in the income year.

(a) the CGT asset satisfies the active asset test in section 152-35 of the ITAA 1997.

Section 152-40 of the ITAA 1997 provides the meaning of 'active asset'. A CGT asset will be an active asset at a time if, at that time, you own the asset and the asset was used or held ready for use by you, an affiliate of yours, or by another entity that is 'connected with' you, in the course of carrying on a business. However, an asset whose main use is to derive rent can not be an active asset.

Sub-section 152-35(1) of the ITAA 1997 states that a CGT asset satisfies the active asset test if:

· you have owned the asset for 15 years or less and the asset was an active asset of yours for a total of at least half of the period of ownership, or

· you have owned the asset for more than 15 years and the asset was an active asset of yours for a total of at least 7 and a half years.

Subsection 152-40(1) of the ITAA 1997 provides that an asset is an active asset if the asset is an intangible asset you own and is inherently connected with a business that is carried on (whether alone or in partnership) by you, your affiliate, or an entity connected with you.

In your case, your interest in the Partnership is an intangible asset. It was through this interest that you carried on a business of an accountancy practice in partnership with others. Your interest in the Partnership is inseparable from the business (and therefore inherently connected with the business) that you carried on. As such, the interest is considered an active asset. As your partnership interest was necessarily employed as an active asset throughout the whole period that you held it, the active asset test is satisfied.

You have stated that you, as an individual, satisfy the maximum net asset value test (MNAV) under section 152-15 of the ITAA 1997. Importantly, for the purposes of the MNAV test, the firm is not an entity connected with you under section 328-125 of the ITAA 1997 (as you did not hold a 40% or more interest in the partnership), nor an affiliate under section 328-130 of the ITAA 1997 (as an individual, or another partner, is not your affiliate merely because of the nature of the business relationship you share). Therefore, the net asset value of the CGT assets of the firm, are not relevant for the MNAV calculation.

Accordingly, based on the information provided, you satisfy all the necessary basic conditions to be eligible for the CGT concessions for small business.

Small business 15-year exemption

Section 152-105 of the ITAA 1997 provides that an individual can entirely disregard any capital gain if all of the following conditions are satisfied:

(a) you satisfy the basic conditions

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

(c) you are either:

i. 55 or over at the time of the CGT event and the event happens in connection with your retirement; or

ii. permanently incapacitated at the time of the CGT event.

In your case:

· you satisfy the basic conditions

· you owned the CGT asset for over 15 years

· you were over the age of 55 at the time of the event

· the event happened in connection with your retirement

Based on the information provided, you are eligible for the 15-year exemption concession. Accordingly, you may disregard any capital gain made on the surrender of your partnership interest.