Edited version of private advice

Authorisation Number: 1012627517704

Ruling

Subject: Assessability of special payment

Questions and Answers

1. Is the special payment of received for early termination of the contract assessable as income according to ordinary concepts under section 6-5 of the Income Tax assessment Act 1997?

No

2. Is the receipt of the special payment of assessable as a capital gain?

Yes

3. Will the 50% capital gains tax discount apply?

Yes

This ruling applies for the following periods:

Year ending 30 June 2013

The scheme commenced on:

1 July 2012

Relevant facts and circumstances

Partnership A was established several years ago after 1985.

Partnership A consists of a number of trusts.

According to Partnership A's deed, the business to be conducted by the partnership was for producing and supplying a particular product (the product) to Company B.

An agreement between Partnership A and Company B was signed on date W (W Agreement) to supply Company B with the product for m years. The price of the produce was influenced by Partnership A's capital costs of establishing the business.

In order to commence the partnership business, Partnership A removed all equipment that had existed prior to the commencement of the partnership business and installed new equipment and processes to comply with Company B's requirements at a substantial cost.

The first delivery of the products to Company B was on date X.

A few years later, Company B requested an early termination of the W Agreement and proposed to replace it with a similar agreement (Y Agreement), which contained a schedule for Partnership A to supply the product to Company B for n years.

Company B was Partnership A's sole substantive customer throughout both the W Agreement and the Y Agreement.

Prior to completion of the contract, Company B advised Partnership A that due to insufficient sales, it would terminate the agreement and would pay Partnership A a one-off special payment as an early termination compensation payout. The special payment was negotiated between the two parties.

After termination of the Y Agreement, Partnership A decided to conduct a new business.

Relevant legislative provisions

Section 6-5 of the Income Tax Assessment Act 1997

Section 102-20 of the Income Tax Assessment Act 1997

Section 108-5 of the Income Tax Assessment Act 1997

Section 104-25 of the Income Tax Assessment Act 1997

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

Section 106-5 of the Income Tax Assessment Act 1997

Section 115-5 of the Income Tax Assessment Act 1997

Section 115-10 of the Income Tax Assessment Act 1997

Section 115-20 of the Income Tax Assessment Act 1997

Subsection 115-25(3) of the Income Tax Assessment Act 1997

Section 115-100 of the Income Tax Assessment Act 1997

Reasons for decision

1. Is the special payment income according to normal concepts under section 6-5 of the ITAA 1997?

'Ordinary income' is defined in section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) to mean income according to ordinary concepts. The legislation does not provide any specific guidance on what is meant by 'income according to ordinary concepts'. However, a substantial body of case law has evolved over time that identifies various factors that are taken into account in determining when an amount is 'income according to ordinary concepts'.

Ordinary income includes income that arises in the normal scope of a taxpayer's business. In addition, in limited circumstances, gains not within the ordinary scope of the taxpayers business may form part of ordinary income.

At common law, it may be said as a general principle that a compensation payment takes the character of the item which it replaces (C of T (NSW) v. Meeks (1915) 19 CLR 568; 21 ALR 244), though there is no necessary connection between the basis used to calculate an amount of compensation and the character of the compensation actually received (Californian Oil Products Ltd (in liq) v. FCT (1934) 52 CLR 28; (1934) 8 ALJR 195; (1934) 3 ATD 10).

Accordingly, an amount received in connection with the cancellation or variation of a contract or agreement made in the course of carrying on a business is usually of an income nature if the amount which it replaces would have been income. On the other hand, if the cancellation or variation affects the framework of the business or causes a substantial part of the business to be lost then the amount received may be of a capital nature.

In the Californian Oil Products Case, the compensation payment received by the taxpayer for cancelling the contract was held as a capital receipt, notwithstanding that it was to be paid in 10 half-yearly instalments. The taxpayer had been appointed as exclusive distributor and agent for an oil company's products in certain area. This was the taxpayer's only business. When the taxpayer agreed to cancel the agency agreement, the whole business ceased. The High Court held that compensation payment received by the taxpayer was compensation for abandoning the taxpayer's only business.

Another supporting case is Case Y24 91 ATC 268 (Case Y24). The taxpayer company was a 'contract carrier' of newspapers. As a result of the closure of a particular newspaper, the taxpayer's contract was terminated and the taxpayer was paid an amount. It was held that because the payment was compensation for the loss of the expectation of continuity of the taxpayer's contract, it was a payment of a capital nature. Once the contract was terminated, the purpose for which the taxpayer was established no longer existed.

By contrast, in Allied Mills Industries Pty Ltd v. FC of T (1989) 20 FCR 288; (1989) 93 ALR 157; 89 ATC 4365, the taxpayer gave up the right to exploit its sole distributorship of certain biscuit products. In return, it received a payment of an amount. The taxpayer distributed several products and the biscuits were a substantial part of its business. However, the biscuits were only a part of its business and the contract in question was only one of several made in the ordinary course of its business. The court felt that the distribution arrangements themselves yielded the profit. They did not simply provide the means of making profit. The payment was essentially designed to compensate the taxpayer for the loss of anticipated profits flowing from the termination of the contract. The court regarded the payment as being on the same footing as the profits themselves would have been, if they had been received. The amount was held to be income. The court stated (93 ALR 157 at page 164):

Normally in order for a contract to be regarded as a capital asset, it must be a contract which is of substantial importance to the structure of the business itself. This is a factual matter and inevitably a matter of degree. Here the appellant was not parting with a substantial part of its business or ceasing to carry on business as was the case in Californian Oil Products.

Your circumstances

In your case, Partnership A was established to supply a particular product (the product) to Company B. An agreement between Partnership A and Company B was signed on date W (W Agreement) to supply Company B with the product for m years

In order to commence the partnership business, Partnership A removed all equipment that had existed prior to the commencement of the partnership business and installed new equipment and processes to comply with Company B's requirements at a substantial cost. The first delivery of the products to Company B was on date X

A few years later, Company B requested an early termination of the W Agreement and proposed to replace it with a similar agreement (Y Agreement), which contained a schedule for Partnership A to supply the product to Company B for n years. Company B was Partnership A's sole substantive customer throughout both the W Agreement and the Y Agreement.

Prior to completion of the contract, Company B advised Partnership A that due to insufficient sales, it would terminate the agreement and would pay Partnership A, a one-off special payment as an early termination compensation payout. The special payment was negotiated between the two parties. After termination of the Y Agreement, Partnership A decided to conduct a new business.

On entering into Agreement Y with Company B, Partnership A acquired the right to provide services to Company B from which the partnership was able to earn income. This right formed the basis for Partnership A's business. Partnership A's business existed in order to provide the product to Company B under Agreement Y. This agreement was of substantial importance to the structure of the business itself (Allied Mills Case). Company B was Partnership A's only substantive customer.

When the right to provide services to Company B ceased, Partnership A ceased to carry on business. The termination of the Agreement Y caused Partnership A's business to end. The termination of Agreement Y was of critical importance to the framework and structure of Partnership A's business such that its termination represented the end of the business. The amount received was to compensate for the loss of this right and the loss of their means of making profit. The amount was received by Partnership A in circumstances which were similar to those in the California Oil Case and Case Y24 and can be characterised as a receipt of capital.

Accordingly the special amount will not be included in Partnership A's assessable income under section 6-5 of the ITAA 1997

2. Is the special payment assessable as a capital gain?

Under section 102-20 of the ITAA 1997 a capital gain or loss arises as a result of a capital gains tax (CGT) event occurring to a CGT asset.

A right is an intangible CGT asset under section 108-5 of the ITAA 1997. When Agreement Y was terminated, Partnership A received a special payment (compensation) for the loss of its right to provide the product to Company B and for its means of making a profit. Partnership A was compensated for the loss of its business with Company B, its sole customer.

Section 104-25 of the ITAA 1997 provides that CGT event C2 happens when a taxpayer's ownership of an intangible CGT asset ends by the asset being cancelled. Upon termination of Agreement Y, CGT event C2 happened to each partner of the partnership.

There are special rules for partnerships. Under section 106-5 of the ITAA 1997, a capital gain or capital loss arising from a CGT event that happens in relation to a partnership or to one of its assets is made by the partners individually, not the partnership. A partnership cannot make a capital gain or capital loss. This means that any capital gain or loss that arises belongs proportionately to each individual partner, depending on each partner's interest as per the partnership agreement. In the case of Partnership, the four partners are trusts.

The special payment received by Partnership A is the capital proceeds for the event. The acquisition date of Partnership A's rights under Agreement Y is the date that Partnership A entered the agreement under section 109-5 of the ITAA 1997.

Under subsection 104-25(3) of the ITAA 1997, the partners in Partnership A made a capital gain as the capital proceeds from the cancellation of the Agreement Y were more than the cost base of Agreement Y .

3. Will the 50% CGT discount apply?

Subdivision 115-A of the ITAA 1997 sets out the requirements for a capital gain to be a discount capital gain.

Section 115-5 in subdivision 115-A of the ITAA 1997 allows an entity to claim a discount on a capital gain where the capital gain was made by an eligible entity. Under section 115-15 of the ITAA 1997 the gain must be made after 21 September 1999.

Section 115-10 of the ITAA 1997 is the provision which states who can make a discount capital gain. To be eligible for the capital gains tax discount the capital gain must have been made by:

(i)    an individual,

(ii)   a complying superannuation entity,

(iii)  a trust; or

(iv)  a life insurance company in relation to a discount capital gain from a capital gains tax event in respect of a capital gains tax asset that is a complying superannuation/FHSA asset.

As mentioned above, there are special rules for partnerships which mean that any capital gain or loss that arises belongs proportionately to each individual partner, depending on each partner's interest as per the partnership agreement.

Under section 115-100 of subdivision 115-B of the ITAA 1997 the relevant discount percentage for a trust is 50%. In the case of Partnership A, the requirements of subdivision 115-A and 115-B of the ITAA 1997 are met. The rights Partnership A held pursuant to Agreement Y were held by Partnership A for a period of longer than 12 months as required by section 115-20 of the ITAA 1997. Further CGT event C2 is not a capital gain excluded from being a discount capital gain under subsection 115-25(3) of the ITAA 1997. Accordingly each of the partners of Partnership A will qualify for the 50% CGT discount.