Edited version of private advice

Authorisation Number: 1012613929854

Ruling

Subject: Income Tax - capital gains tax - CGT event A1 and maximum net asset value

Question 1

In the context of the disposal of one or more capital gains tax (CGT) assets (CGT event A1) under the terms of the Business Sale Agreement (BSA), does the existence of the obligation to pay part of the proceeds of sale to another entity under an employee agreement (EA) result in the company not being entitled to receive that part of the proceeds of disposal within the terms of section 116-20 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No. The company is considered to be solely entitled to the proceeds from the CGT event A1.

Question 2

In the context of the disposal by the company of one or more CGT assets (CGT Event A1) under the terms of the BSA, does a payment made by the company to discharge the obligation in favour of the other entity form part of the CGT cost base of the assets disposed of by the company within the terms of subsection 110-35(3) of the ITAA 1997 being incidental costs in relation to a CGT event?

Answer

No. The payment made under the terms of the EA does not form part of the cost base of the asset disposed.

Question 3

In the context of the disposal by the company of one or more CGT assets (CGT event A1) under the terms of the BSA, does a payment made by the company to the employee constitute an outgoing deductible within the terms of section 8-1 of the ITAA 1997?

Answer

No. The payment made under the terms of the EA is capital expenditure.

Question 4

Does the obligation on the part of the company to pay an amount to the other entity (reflected in the accounts of the company at 30 June 2013 as a current liability) constitute a liability for the purposes of section 152-20 of the ITAA 1997?

Answer

No. The obligation to make a payment under the terms of the EA is not considered a liability in existence 'just before' the CGT event A1.

This ruling applies for the following periods:

1 July 201X to 30 June 201Y

The scheme commenced on:

1 July 201X

Relevant facts and circumstances

The assets of the company were disposed of on 1 July 201X under a BSA.

On 2 April 20zz, the company and another entity entered into an emolyee agreement (EA) whereby, upon a disposal of the company/business, the entity would become entitled to receive a percentage of the proceeds of the sale of the business.

Other conditions attaching to entitlement to receive a proportion of sale proceeds were as follows:

• accepting an ongoing relationship with the purchaser (on acceptable terms) for at least the period during which there could be a purchase price adjustment under the BSA.

• the payment to be made in cash with some part or all of the cash withheld until any purchase price adjustment period had ended (subject to negotiation at the relevant time).

At 30 June 201X a liability has been recorded in the accounts of the company for the obligation to make a payment to the other entity reflecting the entitlement in respect of the disposal proceeds under the agreement executed on 1 July 201X.

There was no reference in the BSA to the other entity to which the payment was to be made.

The other entity did not have current equity rights in the company.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 51(1)

Income Tax Assessment Act 1997 section 6-10(3)

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 10-5

Income Tax Assessment Act 1997 section 103-10

Income Tax Assessment Act 1997 section 110-10

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 section 110-35

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 section 152-5

Income Tax Assessment Act 1997 section 152-15

Income Tax Assessment Act 1997 section 152-20

Reasons for decision

Question 1

Summary

Under section 103-10 of the ITAA 1997 you (the company) are considered to be entitled to receive money from a CGT event if it has been applied for your benefit including by discharging all or part of a debt you owe.

Detailed reasoning

In accordance with subsection 6-10(3) of the ITAA 1997 if an amount would be statutory income apart from the fact that you have not received it, it becomes statutory income as soon as it is applied or dealt with in any way on your behalf or as you direct. Income received from capital gains such as the sale of your business is to be included in your assessable income in accordance with the table provided in section 10-5 of the ITAA 1997 as an amount which is not 'ordinary income'.

Section 116-20 of the ITAA 1997 deals with the general rules about capital proceeds from a CGT event which include amounts which you have received and are 'entitled to receive'.

That statement is further clarified by section 103-10 of the ITAA 1997 which states that if money or other property has been applied for your benefit in relation to a CGT event (including the discharge of all or part of a debt owed) or has been applied at your direction, the CGT provisions apply as if that money or other property has actually been received by you.

A liability arises in the company because of a contract made in which it was agreed to pay the other entity proceeds from the sale of the business if there was still a business relationship at the time of the sale. This liability does not reduce the entitlement to the monies from the sale of the business.

The other entity was not a party to the sales contract. If the purchaser was directed to apply funds to the other entity at your direction, the funds would still be considered to have been applied for your benefit by discharging all or part of a debt that you owe and the monies would remain assessable income in your hands.

The existence of an obligation to pay an amount to another entity arising from and subsequent to entering into a BSA does not affect your entitlement to receive that part of the proceeds of disposal within the terms of section 116-20 of the ITAA 1997.

In Quality Publications Australia Pty Ltd v FCT [2012] FCA 256 in considering whether the company had received money or an entitlement to receive money, the Federal Court found that the mechanism for a "payment by direction" of the consideration on behalf of another company did not have the effect of changing or extinguishing the entitlement of the company to receive payment in respect of the disposal of its business.

A similar principle can be applied in this situation as the income tax law has determined that a debt owed to the company, even if it is applied a debt owing to another entity is still considered to be 'applied at your direction' and the entitlement to receive the payment is not extinguished.

Question 2

Summary

The payment to another entity under the terms of the EA does not form part of the cost base of the business.

Detailed reasoning

Subdivision 110-A of the ITAA 1997 discusses the cost base of a CGT asset and the relationship between the asset and the CGT event. The CGT event which has occurred for the company is CGT event A1 which is the disposal of a CGT asset.

Section 110-10 of the ITAA 1997 contains a table which sets out rules about cost bases which are not relevant to some CGT events. None of the modifications are required for CGT event A1.

The general rules relating to the cost base of an asset are contained in subsection 110-25(3) of the ITAA 1997. There are five elements of cost base and you have requested that the Commissioner consider the inclusion of the payment to an employee under an EA in the cost base of the asset which has been sold.

In particular you requested that the cost be considered under subsection 110-35(3) of the ITAA 1997 which deals with the cost of transfer of an asset. This cost forms part of the second element of the cost base which is the incidental cost you incur.

An exhaustive definition of the types of incidental costs is included in section 110-35 of the ITAA 1997. In stating that the definition is exhaustive indicates that an incidental cost not described in the ten incidental costs contained within section 110-35 cannot be included in the cost base of the asset under that provision.

Subsection 110-35(1) of the ITAA 1997 states that there are a number of incidental costs you may have incurred. With the exception of the ninth they are costs you may have incurred:

• to acquire a CGT asset, or

• that relate to a CGT event

The payment made to another entity in satisfaction of the EA which was entered into in 20zz was a CGT event C2 for other entity as it was cancellation, surrender or similar ending of a right which the other entity had in the company. That CGT event is an event of the other entity, and not of the company. The payment made in satisfaction of the contract is not a cost in relation to the CGT event A1 of the company and cannot be included in the cost base for that CGT event.

Question 3

Summary

A deduction is not allowable in terms of section 8-1 of the ITAA 1997 as the expenditure is not considered to be incurred in carrying on a business and is considered to be capital in nature.

Detailed reasoning

In order to consider the issue, two questions need to be answered in determining whether the expense is deductible under section 8-1 of the ITAA 1997. The first is whether the expense has the essential character of expenditure which is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income in terms of subsection 8-1(1) of the ITAA 1997 with emphasis on the words 'in carrying on a business'. The second question considers whether the exclusory provisions of subsection 8-1(2) of the ITAA 1997 apply.

The expenditure is a necessary expense in terms of the EA and the company has been carrying on a business. These facts are not in dispute.

Taxation Ruling TR 95/33 at paragraph 11 states:

Where, having regard to the overall objective circumstances, there is an obvious commercial connection between the loss or outgoing and the carrying on of the taxpayers' business, it will not be generally necessary to have regard to the taxpayer's subjective purpose, motive or intention.

There is an obvious commercial connection between the EA payment and the business which was carried on. It is therefore unnecessary to consider the subjective purpose, motive or intention of the payment.

What must be examined is the relationship between the expenditure incurred and whether it was incurred in carrying on the business for the purpose of gaining or producing assessable income.

There must be a clear connection between the outgoing and the assessable income being derived. Payments made to an entity which provide services during the operation of a business are clearly related to the carrying on of that business. However a payment made under an EA upon the sale of a business cannot be seen as an ongoing expense attributable to the efforts of the business to derive assessable income.

This is supported by Union Trustee Co Ltd V FCT (1935) 53 CLR 263, where Rich J said:

It is not enough that it was made in the course of business. It must appear that it is an outgoing incurred for the production of assessable income. There must be a connection between the purpose of the payment and the further pursuit of gain, the production of income.

The payment made under the EA is an expense incurred without an expectation of repetition. Expenses incurred in implementing the sale of the business including a 'one off' payment cannot be seen as an ongoing expense attributable to the efforts of the business to derive assessable income. The payment made under the EA is an expense of a capital nature incurred to conclude the income producing activities of the business.

Question 4

Summary

Liabilities to make a payment under the terms of the EA had not matured into a presently payable debt before the GCT event A1 occurred.

Detailed reasoning

Section 152-5 of the ITAA 1997 sets out the basic conditions of relief for small business entities in relation to capital gains. One of the basic conditions states that the entity must be a small business or the net value of assets that the entity and related entities own must not exceed $6 million.

Section 152-15 further clarifies this statement by indicating that you satisfy the maximum net asset value test if, just before the CGT event, the sum of the

(a) the net value of the CGT assets of yours;

(b) the net value of the CGT assets of any entities connected with you;

(c) the net value of the CGT assets of any*affiliates of yours or entities connected with your affiliates (not counting any assets already counted under paragraph (b)).

does not exceed $6 million.

Paragraph 152-20(1)(a) of the ITAA 1997 states that the net value of the CGT assets of an entity is the amount (whether positive, negative or nil) obtained by subtracting from the sum of the market values of those assets the sum of the liabilities of the entity that are related to the assets.

Taxation Determination TD 2007/14 states at paragraph 22:

The 'liabilities of the entity that are related to the assets' also include liabilities that, although not directly related to one particular asset, are related to the assets of the entity more generally, for example, a bank overdraft or other short term financing facility that provides working capital for the operation of the business.

On 2 April 20ZZ the company and another entity entered into an EA whereby, upon a disposal of the company/business, the other entity would become entitled to receive a percentage from the sale of the business subject to certain conditions including that the other entity maintain a relationship with the company until the time of sale.

There were further conditions attached to the EA including that the other entity accept an ongoing relationship with the purchaser (on acceptable terms) where required for at least the period during which there could be a 'purchase price adjustment' and the payment to the other entity was to be made in cash with some part or all of the cash withheld until any purchase price adjustment period had ended (subject to negotiation at the relevant time).

You submitted that the liability to pay the other entity an amount which:

• cannot be fully determined until the expiry of the purchase price adjustment period,

• is subject to the other entity agreeing to maintain a relationship with the purchaser where required (subject to acceptable terms) subsequent to the sale of the business for at least the purchase price adjustment period and

• some part or all of the cash is to be withheld until the purchase price adjustment period has ended

is a liability which exists 'just before' the sale of the business.

The term 'liabilities' in the calculation of 'the net value of the CGT assets' of an entity in subsection 152-20(1) of the ITAA 1997 does not include contingent liabilities.

The term 'liabilities' as used in subsection 152-20(1) of the ITAA 1997 to determine the net value of the CGT assets of an entity has its legal meaning. It extends to a legally enforceable debt which is due for payment and to a presently existing obligation to pay either a sum certain or an ascertainable sum. It does not extend to contingent liabilities, future obligations or expectancies.

There is specific provision within subparagraphs 152-20(1)(b)(i) to (iv) of the ITAA 1997 for specific provisions to be included in the cost base of an asset for the purposes of calculating the maximum net asset value and those expenses include provisions for annual leave, long service leave, unearned income and provisions for tax liabilities. Whilst the expenses are provisional they will also certainly be encountered or 'fallen upon'.

Section 152-15 of the ITAA 1997 specifies the time at which a taxpayer must satisfy the maximum net asset value test. It is the time 'just before the CGT event'. There is no other way to interpret that moment of time than to say it is the moment that is just before the CGT event.

In the Administrative Appeals Tribunal (AAT) case 'Re Taxpayer and FCT' (2010) 79 ATR 510 it was determined that real estate commissions could be taken into account as a liability (for the purposes of satisfying the maximum net asset value test) because they were "inextricably" related to the disposal of the asset that triggered the CGT event. The Commissioner appealed against this decision to the Full Federal Court in the case Federal Commissioner of Taxation v Byrne Hotels Qld Pty Ltd [2011] FCAFC 127 (Byrne Hotels).

In the Byrne Hotels case, Greenwood J stated (with Dowsett J agreeing) that in the context of the maximum net asset value test in s 152-15 of the ITAA 1997 (described as 'MNAV' in the passage) and the assessment of liabilities related to those entities under s 152-20(1):

Section 152-15 requires that the MNAV test be assessed 'just before' the CGT event. This means that, for the purposes of s 152-20(1), the taxpayer is required to calculate liabilities that are related to the CGT assets 'just before' the CGT event. The section is deliberately aimed at a 'moment in time'. The wording of 'just before' indicates that the legislature intended to exclude from the MNAV test the effects of the CGT event arising on or after the CGT event. The test is whether a particular obligation, as at the 'just before' time, is a liability. That is, whether at that time the obligation involves any kind of property or a legal or equitable obligation that is not property. If a contingent liability fits that definition, it is to be accounted for. If, however, as at the 'just before' time, an obligation cannot be classified as a liability, irrespective of whether a liability arising only as a consequence of the CGT event is subsequently incurred, it cannot be accounted for under s 152-20(1).

You have argued that the obligation to pay the other entity is a right to part of the proceeds from the business sale and should be considered a liability related to the assets for the purposes of calculating the net asset value under the MNAV test.

TD 2007/14 states

Liabilities that are related to the assets

21. The 'liabilities of the entity that are related to the assets' in subsection 152-20(1) include liabilities directly related to particular assets that are themselves included in the calculation, for example, a loan to finance the purchase of business premises.

22. The 'liabilities of the entity that are related to the assets' also include liabilities that, although not directly related to one particular asset, are related to the assets of the entity more generally, for example, a bank overdraft or other short term financing facility that provides working capital for the operation of the business.

The other entity has a legal, enforceable right to payment which arises subsequent to the sale of the business. The right to payment is not a part of the business sale but is an application of the sale proceeds (which are to be finally determined subsequent to the 'purchase price adjustment period') and is not considered a liability related to the asset which is the business.

Whilst the right to payment to the other entity of certain amounts subsequent to the sale of the business existed before the CGT event, the liability arising from that right does not exist until after the CGT event which is the sale of the business and subsequent to the conclusion of the purchase price adjustment period.

In the Byrne Hotels case in paragraph 124 it was stated 'The obligation to pay the agreed commission or, put differently, discharge the burden of the contract, was a provisional obligation.'

It is further stated that:

121. Just before entering into the contracts on 24 October 2003, the taxpayer found itself in a position where it had entered into a contract with Jones Lang which by 24 October 2003 had been on foot for almost four months with a bundle of activities having been performed by Jones Lang in providing the single service in discharging contractual duties and obligations to the taxpayer; Jones Lang had found a buyer ready, willing and Board authorised to buy; the taxpayer was ready and willing to sell and had, immediately before picking up the pen to sign the sale contracts, decided to sell; Jones Lang was the effective cause, within the term, of a contract of sale that occurred, as it turned out, also within the term, although Jones Lang was entitled to be paid the agreed commission even if the contract of sale had been made outside the term of the exclusive agency.

122. Jones Lang's entitlement to be paid its agreed commission fee was, of course, dependent upon the taxpayer entering into a contract of sale and in that sense the contingency had not fallen in. However, immediately before the signing of the contract, all terms, plainly enough, had been agreed with MGW; the document was in final form ready to be signed; nothing remained to be done by Jones Lang as a matter of any performance of its duties or obligations to perfect its entitlement to the agreed commission. The only contingent thing to be done was the formality of the signing by Michael Byrne to reduce to writing the sale already agreed to be made. Just before the CGT event, a liability resided in the taxpayer arising out of the pre-existing contract with Jones Lang, subject only to the translation of the decision already made to sell the land and business (on the terms agreed with MGW), into the act of execution of the contracts.

128. Properly construed, a liability (albeit contingent in the ways discussed) had arisen in the entity by the moment in time described in the Act as "just before the CGT event" and the liability, calculated by reference to the formula in the annexure to the contract, is to be brought to account in the calculation of the net value of the CGT asset of the taxpayer entity for the purpose of determining satisfaction (or otherwise) of the maximum net asset value test under the Act.

The relationship between the liability which was admittedly contingent but inextricably connected with the asset which was being sold has been finely drawn. The liability owed to the agent existed with certainty before 'picking up the pen to sign the contracts' and the real estate agent was the effective cause of the sale.

The same cannot be said for the EA which had been recorded in the accounts as at 30 June 201X reflecting the obligation to make a payment to the employee under the disposal agreement executed on 1 July 201X.

The liability to pay the another entity an amount determined at the conclusion of the purchase price adjustment period subject to certain conditions being met by the other entity (on acceptable terms) does not have the same intrinsic relationship to the sale of the business as the real estate agent fees discussed in the Byrne Hotels case. The payment to be eventually determined and paid cannot be said to be a liability existing 'just before' the CGT event which was the sale of the business.

It has been argued in this case that the employees right to part of the proceeds from the business sale should be a liability related to the assets for the purposes of calculating the net asset value and that the legal obligation to pay the right existed before the execution of the contract of disposal.

It is considered when taking into account the arguments set forth that the EA was not legally enforceable prior to the sale of the business. It remained a contingent liability not related to the asset which was the subject of the capital gain of which the amount owed under the contract was not quantifiable or payable until the conclusion of the purchase price adjustment period. It therefore was not a liability which could be taken into account in the calculation of the maximum net asset value test 'just before' the sale of the business.

Further issues for you to consider

A CGT event D1 occurred when the company created contractual rights in the employee under the EA. CGT event C2 occurred when the other entity's ownership of the intangible CGT asset which was the right to payment of an amount determined by the value of the proceeds from the sale of the business (subject to conditions) was released, discharged or satisfied.

Although the timing of the CGT event C2 was determined by the sale of the business and subsequent expiration of the purchase price adjustment period, and the value calculated for payment was based upon the sale price of the business, that does not make the payment part of the CGT event A1 which was the sale of the business by the company.

Capital expenditure incurred in relation to a business that used to be carried on may be considered under the provisions of section 40-880 of the ITAA 1997. That matter has not been addressed in this ruling.