Edited version of your private ruling

Authorisation Number: 1012566641412

Ruling

Subject: Deductibility of accrued creditors on sale of business

Questions and Answers:

1. Can your former partnership claim deductions in relation to partnership creditors that were on its books of account on the date the other share in your former partnership business was sold?

Yes. However, the value of trading stock held on that date is assessable income to the partnership.

2. As a sole trader, can you claim as deductions, or include in your CGT cost base, payments you subsequently make to the partnership creditors that were on the business books on the date the other share in your former partnership business was sold?

No. However, the value of trading stock held on that date is a deductible amount to you, as sole trader.

This ruling applies for the following period:

Year ended 30 June 2013

The scheme commences on:

1 July 2012

Relevant facts and circumstances

You were a partner in a business partnership that operated a business of trading in goods. On the sale date, you bought your partner's share of the business owned and operated by the partnership. As part of the sale contract, you agreed to accept legal responsibility for all creditors (as well as other expenses such as rent, outstanding loans, staff entitlements) of the partnership, as they existed on the sale date.

The business interest you acquired comprised of goodwill, plant and equipment, Iicences, work in progress, stock in trade, debtors, cash in bank, cash on hand, lease security deposit and any other business assets.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 70-100

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Section 110-50

Income Tax Assessment Act 1997 Section 118-20

Income Tax Assessment Act 1997 Section124-140

Reasons for decision

Summary

The earnings method is appropriate to determine business income derived from a trading business. As a broad guide, where you operate on an earnings basis, you incur an outgoing at the time you owe a present money debt that you cannot escape. As your former partnership operated on an earnings basis, it incurred the relevant creditor expenses when the relevant amounts became payable. Therefore, your partnership (rather than you, as a sole trader) can claim deductions for the relevant deductible amounts included in the partnership creditors at the date of sale.

However, the trading stock rules in section 70-100 of the Income Tax Assessment Act 1997 (ITAA 1997) result in your partnership losing any advantage gained from its deduction for trading stock creditors since the value of the trading stock notionally disposed of (with the ending of the partnership) is assessable income to the partnership.

Further, although you, as a sole trader, cannot claim a direct deduction when making payment to the relevant trading stock creditors, you indirectly receive a commensurate deduction for the value of the trading stock acquired when you acquired the other partnership interest.

As for non-trading stock creditors, as section 110-25 of the ITAA 1997 only allows specific expenditures to be included in the CGT cost base of a CGT asset, it is expected none of the relevant creditor payments you were obligated to make would fall into your CGT cost base.

Detailed reasoning

Deductibility of accrued business expenses

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are necessarily incurred in carrying on a business for the purpose of producing assessable income, except where the outgoings are of a capital, private or domestic nature.

Taxation Ruling TR 98/1, which is about the determination of income: receipts versus earnings, explains, in most cases, the earnings method is appropriate to determine business income derived from a trading business. Under the earnings method, income is derived when it is earned. The point of derivation occurs when a 'recoverable debt' is created.

Similarly, under the earnings method, a deduction is incurred when the taxpayer is 'completely subjected' to the loss or outgoing. The point of deductibility occurs when an 'amount payable' is created. Where taxpayers operate on an earnings basis, Taxation Ruling TR 97/7, which is about the meaning of 'incurred' for the purposes of section 8-1, explains:

To qualify for deduction under section 8-1 a loss or outgoing must have been incurred.

As a broad guide, you incur an outgoing at the time you owe a present money debt that you cannot escape.

A taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitively committed in the year of income. Accordingly, a loss or outgoing may be incurred within section 8-1 even though it remains unpaid, provided the taxpayer is 'completely subjected' to the loss or outgoing. That is…it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum…

In your case, the creditors on the books of account of your former partnership, on the day the partnership business ended, show your former partnership was 'completely subjected' to the loss or outgoing, even though they remained unpaid. Therefore, those deductible creditor amounts were incurred and are thus deductible by your former partnership (rather than by you, as a sole trader, who would also be expected to operate on an earnings basis).

Trading stock rules

The general rules in section 70-100 of the ITAA 1997 provide if the interests in an item of trading stock change then the law may treat it as being a disposal outside the ordinary course of business. This happens when there is not a complete change in interests but the item ceases to be trading stock of the original entity.

This disposal outside the ordinary course of business would normally be treated as occurring at market value. However, if the item is an asset of the new owners business, and all the owners agree, they can elect to roll it over for the value at which the original entity would have taken it into account at the end of the year. A 25% continuity of interests is required for this election to be available.

In summary, the election available in section 70-100 of the ITAA 1997 facilitates the scheme of Division 70 that you can effectively defer a deduction on the acquisition of an item of trading stock to the income year in which income from that item is assessed.

As provided for in subsection 70-100(5) of the ITAA 1997, if this election is made, the elected value of the trading stock is included in the transferor's assessable income for the income year that includes that day. Further, the transferee is treated as having bought the item for the same value on that day.

In your case, you may elect, under section 70-100 of the ITAA 1997, to value your acquisition of your former partnership's trading stock at its cost. The effect of this, in relation to creditors related to trading stock, is two-fold:

· For your former partnership ('the transferor'), there is a deemed disposal of the relevant trading stock at its cost, resulting in assessable income to the partnership that will offset any advantage gained by the deductible trading stock expense incurred.

· For your sole trader business ('the transferee'), a deductible expense is incurred due to your acquisition of the relevant trading stock from your former partnership at its cost. Therefore, although payments you make to creditors in relation to trading stock will not be directly deductible to you, a commensurate or indirect deduction will arise from the value of the trading stock transferred from your former partnership to you.

CGT cost base

Section 110-25 of the ITAA 1997 lists those specific expenditures that can form part of the cost base of a CGT asset. In addition, section 110-50 of the ITAA 1997, which is about partnership interests acquired after 7.30 pm on 13 May 1997, in general, excludes from the CGT cost base expenditure related to interests in partnership assets that either is deductible or has been recouped by either the taxpayer or the partnership.

Section 108-5 of the ITAA 1997, which is about CGT assets, includes debts owed to you as CGT assets. However, debts you owe to others are not your CGT assets since they are CGT assets, i.e., rights, held by your creditors against you (refer to ATO ID 2002/744). Section 118-20 of the ITAA 1997 is an anti-overlap provision, which provides a capital gain you make from a CGT event is reduced if, because of the event, a tax provision includes an amount in your assessable income.

Subdivision 124-C of the ITAA 1997 is about statutory licences being CGT assets. Subsection 124-140(2) of the ITAA 1997 states the first element of the CGT cost base and reduced cost base of a new licence includes any amount you paid to get it. However, the initial expense for obtaining a statutory licence is not the same as an annual renewal fee, which is a deductible expense (refer to ATO ID 2004/648).

In your case, the CGT assets you acquired were goodwill, licenses, debtors and a lease. It is expected none of your relevant creditors expenditure would both: (i) relate to goodwill, obtaining a license or lease or creation of debtors; and (ii) meet the specific requirements of sections 110-25 and 110-50 of the ITAA 1997. Therefore, it is expected your relevant creditors expenditure would not form part of the CGT cost base of any CGT asset you purchased. Further, as noted, annual renewal frees for statutory licences are revenue rather than capital expenditure.

(As for proceeds you receive from your CGT rights against any business debtors, these proceeds will be included in your ordinary assessable income and thus not be capital proceeds, due to the overlap provision in section 118-20 of the ITAA 1997.)