Edited version of your private ruling

Authorisation Number: 1012453993676

Ruling

Subject: 'No goodwill' professional practice

Question 1

Does the Practice comply with Taxation Determination TD 2011/26 and Taxation Ruling IT 2540 and is considered to be a "no goodwill" incorporated professional practice?

Answer

No.

Question 2

If the Practice is not considered to be a "no goodwill" incorporated professional practice are they considered to be a personal services business (PSB)?

Answer

No.

This ruling applies for the following periods:

01 July 2012 to 30 June 2014.

The scheme commences on:

In the income year ending 2013

Relevant facts and circumstances

The Practice is seeking confirmation that it is a "no goodwill" practice. The Practice operates a number of clinics in remote country areas and receives state government grants to entice doctors to the remote areas. A copy of the Company Constitution was provided on request.

The Tax Agent (TAG) put forward the following query:

Does the TD 2011/26 apply to the Practice and thus sub section 116-30(1) of the ITAA 1997 will result in the calculation of the market value of the shares to be determined using a goodwill amount of NIL.

The situation has arisen where a doctor/shareholder of the Practice is considering redeeming their shares and taking their patients with them and will no longer require the services or facilities of the Practice. The TAG has asked if the goodwill is to be ignored in the valuation of the shares when redeemed/cancelled. The TAG has also stated that in the event it is decided that the Practice is a "goodwill practice" then the small business concessions (assuming the requirements are met) will apply and in addition shares can be owned by family members or other entities due to the Practice being a general business and not a personal services business.

The doctor operates one of the clinics of the Practice. The doctor is considering leaving the Practice and taking their patients with them. The goodwill of the Practice is considered to be NIL but the Practice does not have an agreement in place to provide evidence that it is a 'no goodwill' Practice

The Practice does not operate as a service trust and is merely a service entity providing all the normal services and facilities to medical practitioners.

The Practice has a number of shareholder doctors each operating their own clinic in separate locations:

The Practice was established and registered a number of years ago with x founding directors. Each doctor owns shares in the Practice.

The doctor was engaged to operate the clinic in a subsequent year and later offered a position of director/shareholder with the Practice which became effective in certain month 20xx.

It was agreed between the original x directors that upon the appointment of the new doctor as a director/shareholder, each of them would transfer 5% of their shares to the doctor at no cost.

At that time the TAG reviewed the legislation, IT 2540 & TR 2006/10 and formed the view that the Practice was a "no goodwill" practice but that even if it wasn't, the goodwill was worth NIL because it was almost impossible to procure doctors for remote country areas and the state government pays grants to entice doctors to these areas.

The shareholder doctors are paid 60% of the gross patient fees they generate plus their respective share of net profit by way of dividend at the end of each year.

Government grants and subsidies received by the Practice equate to approximately three times the net profit/dividends paid out to the owner/shareholder doctors.

All the employed professionals are paid and after their share of overheads have very little if any profit.

The approximate net assets of the Practice after taking into account outstanding leave entitlements is believed to be NIL (i.e. excluding goodwill).

No doctor has paid any price on admission to the Practice.

The Practice has always intentionally complied with IT 2540 since incorporation and has never used a Phillips/service trust. In the Practice each doctor:

· has their own professional indemnity insurance and is totally and completely at risk for all advice proved to their patients;

· has and uses their own provider number and all monies are generated in the doctor's name;

· owns each individual relationship with each patient;

· has complete and total control over all aspects of all engagements;

· each doctor is paid on a results basis only and pays the Practice for providing services/facilities;

· is responsible for their own tax, super and all leave entitlements;

· is seen by the general community as owning/operating their own clinic.

· is fully and totally responsible/liable for all errors and the rectification/remediation thereof;

· pay their own registrations, insurances etc;

· is free to choose the type of engagements he will undertake subject to the Australian Medical Association (AMA);

All parties deal strictly at arms length. The contractual agreement between the Practice and service providers (doctors) is a percentage basis of income generated from their individual provider number. Service providers are not contracted to the Practice allowing them to supply or cancel a contractual agreement without financial ramifications from either party (i.e. they can practice from any location they so choose and take their patients with them).

The founding doctor informed each doctor that the basis upon which they were allowed to enter was that it would cost them nothing to get in but if they left they would also get nothing.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 102-5;

Income Tax Assessment Act 1997 section 108-5;

Income Tax Assessment Act 1997 subsection 116-30(1);

Income Tax Assessment Act 1997 subdivision 152-C;

Income Tax Assessment Act 1997 section 328-110

Reasons for decision

Question 1

Detailed reasoning

Taxation Determination TD 2011/26 states that the Commissioner will accept when calculating the market value of the share when applying subsection 116-30(1) of the Income Tax Assessment Act 1997 (ITAA 1997), that the goodwill of a company can be taken to have a value of nil. Paragraph 2 of TD 2011/26 states that this approach will only apply for dealings at arm's length for admissions to, and exits from, the professional practice in the natural 'ebb and flow' of natural person practitioner-shareholders into and out of a company. For the approach to apply, all practitioner-shareholders must agree to follow the approach explained in this Determination, and all must agree that the cost base calculation for the purchaser will be the reflex of the capital proceeds approach outlined in the Determination.

TD 2011/26 provides the following conditions at paragraph 3 that a company must comply with:

Where a 'no goodwill' professional partnership has incorporated or a new 'no goodwill' incorporated professional practice has commenced, the following features must be displayed by the incorporated professional practice (the company) in order that it qualifies as a 'no goodwill' company for the purposes of this Determination:

(a) The original shareholders in the company are all natural person practitioners who previously held a fractional interest in the 'no goodwill' partnership prior to the restructure (or would have been eligible to hold a fractional interest had the practice first operated as a partnership);

(b) The provision of a share or shares to the practitioner-shareholder at the time of incorporation and in the post-incorporated environment must be reflective of that person's status as an active practitioner in the practice and must be held by that person both legally and beneficially;

(c) The company is a proprietary limited company that adopts a constitution or shareholder agreement, or both, that regulates the basis

· for admission to shareholding, and

· buy-back, cancellation or transfer of shares in the company, and

· the amount that is paid for it, and

· all the shareholders agree to be bound by it; and

(d) The constitution or shareholder agreement, or both, provide that any share dealing effecting practitioner-shareholders joining or leaving the practice will be attended by an amount of consideration (including possibly nil consideration) calculated on the basis that the value of the goodwill of the company is nil.

Paragraph 21 of TD 2011/26 states:

Where the incorporated professional practice and its shareholders do not satisfy the conditions described in paragraphs 2 to 3 of this Determination the Commissioner's post-incorporation approach cannot be applied.

The Practice has been established under a constitution and the document does not cover or regulate admission and buy-backs of shares in the company. Nor does it cover or regulate the amount that is to be paid on joining or leaving the practice. Also the Practice does not have a shareholder agreement to cover and regulate admission and buy-backs of shares in the company.

Without the required documentary evidence, it is concluded, that the Practice is not able to be considered a 'no goodwill' incorporated professional practice.

Question 2

Detailed reasoning

To be a PSB the income is to be from personal services as opposed to income from a business structure and the following requirements will need to be considered.

The measure contained in Divisions 84 to 87 of the ITAA 1997 only applies if a taxpayer has income that is personal services income (of an individual). The definition of personal services income is contained in subsection 84-5(1) of the ITAA 1997 which states:

Your ordinary income or statutory income, or the ordinary income or statutory income of any other entity, is your personal services income if the income is mainly a reward for your personal efforts or skills (or would mainly be such a reward if it was your income).

The definition refers to income (including ordinary income or statutory income of any entity) that is mainly a reward for an individual's personal efforts or skills. Subsection 84-5(3) of the ITAA 1997 extends the definition of personal services income to income that is for doing work or for producing a result. The result must be produced from the service provider's personal effort or skills.

The reference to the income that is mainly a reward for the personal efforts or skills of a service provider requires a conclusion as to the substance of contractual arrangements between the relevant parties.

Whether the provision of the personal efforts or skills of a service provider to a service acquirer is the chief or the principal component of a contract will depend on the terms and conditions of that contract.

Income from a business structure is not personal services income

The alienation measure does not apply to businesses that have a substantial profit-yielding structure. The distinction between income that is mainly a reward for personal efforts or skills and income from a business structure will need to be made having regard to factors such as the number of arms length employees or others engaged to perform work, the presence of goodwill, the extent to which income-producing assets are used to derive the income, the nature of the activities carried out, the size of the operation and the extent to which the income is dependent upon a particular individuals own personal skills, efforts or expertise.

Taxation Ruling TR 2001/7 Income tax: the meaning of personal services income provides examples of the distinction between income derived from personal services and income derived from the supply and sale of goods, use of income-producing assets, and business structure.

Income Taxation Ruling IT 2639 Income tax: personal services income expands upon the factors that are considered for whether income is from a business structure or from personal services. Income derived by a firm or practice which has substantial income producing assets, or many employees, or both, is more likely to be generated from the income yielding structure of the business rather than from the rendering of personal services.

Paragraph 8 of IT 2639 states that the extent of the connection between the income concerned and the services rendered by the particular taxpayer involved is crucial in determining whether or not the income is the personal services of the individual or whether it is from a business structure. The paragraph identifies factors that need to be considered in determining whether a taxpayer derives income from personal services, although no one factor is determinative. The factors identified are the nature of the taxpayers activities, the extent to which the income depends upon the taxpayers own skill and judgement, the extent of the income producing assets used to derive the income and the number of employees and others engaged. These factors are discussed below.

Paragraph 10 of IT 2639 states that, as a general rule of thumb, if there are as many non-principal practitioners as there are principal practitioners, then this may indicate that the income is from the business structure rather than from the personal services of an individual. Paragraph 11 of IT 2639 defines a practitioner as professional and non professional staff whose function is to derive material fees for the practice. The term practitioner does not include clerical or support staff.

However, all the factors listed in paragraph 8 of IT 2639 need to be considered.

The nature of the taxpayer's activities

The activities of salary and wage earners and professionals practising on their own account clearly generate personal services income. Radiologists or pathologists who operate on their own account, however, often employ many technical staff and operate an array of technical equipment. Their income is generated from the business structure rather than from their rendering of personal services. The activities of consultants, salespersons, journalists, life insurance agents and tradespersons are also likely to give rise to income from personal services. These examples are far from being exhaustive.

The extent to which the income depends upon the taxpayer's own skill and judgment

The more the income producing activities involve the exercise of the taxpayer's own skill and judgment the more probable it is that the income will be derived from personal services rather than from the business structure.

The extent of the income producing assets used to derive the income

The more substantial the income producing assets employed within a practice the more likely it is that the income of the practice will be derived from the business structure rather than from the rendering of personal services. For example, the array of equipment used by radiologists and pathologists may often suggest that their income is being derived from the business structure. However, minor equipment such as the drawing board of an architect or the heart monitor/blood pressure machine of a medical practitioner would not suffice to change what would otherwise be personal service income into income from the business structure. The expression "income producing assets" is used in this context to include any investment of the practice in tangible business assets such as premises, fixtures and fittings, plant, equipment and industrial or intellectual property (whether owned or leased). However, the significance of these assets would have to be weighed against their relevance to the derivation of income - given the other factors mentioned in this paragraph.

The number of employees and others engaged

The more substantial the number of employees, practitioners or technicians used in a practice the more probable it is that the income is derived from the business structure rather than from the rendering of personal services (see Henderson v. FC of T 70 ATC 4016; (1970) 1 ATR 596). For example, large accounting and legal firms with tens, or even hundreds, of practitioners but without extensive or substantial equipment would also be considered to be generating their income from their business structure.

Application to your circumstances

Based on the information provided in this case, the Practice consists of more non-principal practitioners than principal practitioners. The income producing activities involve the skill and judgement of both the non-principal practitioners and the principal practitioners. The fees are generated by all practitioners rather than being dependent upon the personal services of one particular individual. The principal practitioners receive a percentage of the net profit by way of a dividend paid annually plus a percentage of the government grants and subsidies received by the Practice. The income producing assets utilised by the practitioners are provided by the Practice. The use of the premises, which would be considered a substantial asset, the size of the business and the existence of goodwill would indicate the existence of a business structure. It is therefore concluded that the income of the practice is income from a business structure. As the income is not considered personal services income, it is not required to be attributed under the personal services income rules and those rules do not apply to the Practice.

Further issues for you to consider

Small business concessions:

'Goodwill' for the purposes of the definition of 'CGT asset' in section 108-5 of the Income Tax Assessment Act 1997 (ITAA 1997) has the meaning it bears under the general law. As explained by the High Court in Federal Commissioner of Taxation v. Murry (1998) 193 CLR 605; 98 ATC 4585; (1998) 39 ATR 129 (Murry's Case), it is the legal definition which applies, rather than its accounting and business definitions.

The legal definition has three different aspects being property, sources and value. According to the High Court in Murry's Case, it is not appropriate to single out only one of the aspects of the goodwill and regard that asset as being goodwill for legal purposes; rather it is the overall concept which constitutes the legal meaning of goodwill.

According to Taxation Ruling TR 1999/16 Income tax: capital gains: goodwill of a business, goodwill is a single CGT asset for those purposes. If a taxpayer commences business and starts to create goodwill, the goodwill of the business is acquired when the taxpayer starts the work that results in the creation of the goodwill (subsection 109-10, item 1 of the ITAA 1997).

Taxation Ruling IT 2540 states at paragraph 13 that will be generally accepted, provided the evidence supports the conclusion, that partners are dealing with each other at arm's length. Any consideration paid or received on the acquisition or disposal of an interest will be used for Part IIIA purposes in determining the cost base or disposal proceeds of the interests in the assets that the interest represents. This will mean that if, for example, the 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 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.

To qualify for the small business CGT concessions in Sub-Division 152-C of the Income Tax Assessment Act 1997 (ITAA 1997), a taxpayer must satisfy the basic conditions for relief in section 152-10 of the ITAA 1997

The conditions for the small business CGT concessions are outlined in subsection 152-10(1) of the ITAA 1997:

(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) at least one of the following applies:

(i) the taxpayer is a "small business entity" for the income year;

(ii) the taxpayer satisfies the maximum net asset value test;

(iii) you are a partner in a partnership that is a small business entity.

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

Section 328-110(1) of the ITAA 1997 provides the meaning of small business entity:

You are a small business entity for the income year if:

(a) you carry on a business in the current year; and

(b) one or both of the following applies:

(i) you carried on a business in the income year (the previous year) before the current year and your aggregated turnover for the previous year was less than $2 million;

(ii) your aggregated turnover for the current year is likely to be less than $2 million.

TR 1999/16 states at paragraph 3 of the addendum:

A capital gain attributable to goodwill may now qualify for the small business CGT concessions in Division 152, including the small business 50% active asset reduction in Subdivision 152-C.

Section 102-5 of the ITAA 1997 provides how to work out your capital gain if you dispose and have made a capital gain on the disposal of Goodwill.