Edited version of your written advice

Authorisation Number: 1012727589384

Ruling

Subject: Disposal of goodwill or Isolated commercial transaction

Question 1

Will the receipt of the amount of $x, or any part thereof, be attributable to the disposal of goodwill and consequently assessed under the capital gains tax provisions of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

No

Question 2

Will the receipt of the amount of $x, or any part thereof, constitute the derivation of ordinary income under section 6-5 of the ITAA 1997?

Answer:

Yes

Question 3

Does a capital gains tax (CGT) event happen in relation to the proposed contract of sale of your business?

Answer:

Yes, CGT event D1, but the anti-overlap provisions will reduce any capital gain by the amount of income assessed under section 6-5 of the ITAA 1997

Question 4

If the sale is a CGT event, are you entitled to apply the 50% discount in Division 115 of the Income Tax Assessment Act 1997 (ITAA 1997) to the capital gain?

Answer:

Not applicable, the amount will be assessed as ordinary income

Question 5

If the sale is a CGT event, will the goodwill be considered an active asset for the purposes of the CGT small business concessions?

Answer:

Not applicable, the amount will be assessed as ordinary income

This ruling applies for the following period

Year ended 30 June 2015

The scheme commenced on

1 July 2014

Relevant facts

The arrangement that is subject of the private ruling is described below. This description is based on the following documents. These documents form part of, and are to be read with this description. The relevant documents are:

• your private ruling application;

• the draft sale contract;

• the services contract.

You operate a business as a sole trader.

Your activities involve providing services from one centre for the past three years, with a service fee payable by you for administration services and premises. The service fee was a percentage of your fees.

You previously provided your services in a different centre/location.

You have been approached by a representative from a company to entice you to return to the centre/location you previously ran your business from.

You are considering entering into an agreement for the 'sale' of your business to the company for an agreed purchase price. The payment will be a one off payment. The agreement does not provide for a refund of the payment for any reason. While some equipment will be sold, nearly all of the contract prices relates to the sale of 'goodwill'.

You are proposing to enter into the following agreements to sell the business;

1. a 'Sale of Practice' agreement; and .

2. a 'Provision of Services' agreement between the company and yourself.

The 'Sale of Practice' agreement provides:

• it is for the 'sale of the business including what is described as the 'goodwill' of the business

• that the purchaser will not acquire or be responsible for the title to, or lease of, or other arrangement under which you occupied the old premises

• that the purchaser will not acquire or be responsible for any arrangements with suppliers of services used by the practice at the old premises.

• That you will render services from the premises of the purchaser for a minimum period (with certain hours to be worked) and you will render services only from these premises.

• you must not, during the restraint period, render services at any place within a radius of x kilometres of the old or new premises

Regarding your relationship, you and the purchaser agree that:

• you and the purchaser are not partners and are not in an employer/employee relationship and you, in rendering services and doing other things, are at all times an independent person and not doing so as the servant or agent or otherwise on behalf of the purchaser

• you are responsible for insurance, worker's compensation (if any), taxation deductions and payments (if any), superannuation, and provision of holidays, in respect of yourself

• the purchaser only supplies services other than your professional services to you and other practitioners at the new premises

• the purchaser does not provide professional services to any person or hold itself out as doing so

• you must not purport to act, or hold out that you are acting, as the servant or agent or otherwise on behalf of the purchaser in respect of any matter, whether in rendering professional services or otherwise; and

• you must at all times indemnify the purchaser in relation to each and all of the matters in this Clause.

The 'Provision of Services' agreement provides;

• the purchaser must provide services for you, such as; administrative services, clerical staff, facilities, plant and equipment as deemed necessary by the purchaser for you to render professional services from the premises.

• The purchaser will render your accounts in respect of all professional services rendered by you

• The purchaser will charge you a percentage of your fees for the use of the premises and services

• You must attend at the premises and render services at locations within the premises during the hours agreed upon and the company must not direct you as to how the services are to be performed.

You satisfy the small business entity test in relation to your aggregated turnover being under $2 million. You do not have any affiliates or connected entities.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 6-5

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Subsection 104-35(1)

Income Tax Assessment Act 1997 Subsection 104-35(3)

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Subsection 104-10(4)

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 Section 118-20

Reasons for decision

Summary

In view of your entire circumstances, the receipt for the amount of $x will comprise a derivation of income under ordinary principles under section 6-5 of the ITAA 1997. We consider the true nature of the payment primarily represents an inducement payment for you to enter into the services contract whereby you commit to surrender a percentage of your fees in return for the provision of administrative services and a location from which to practice.

The contract purports to purchase goodwill however the facts provided demonstrate that the only goodwill you hold is 'personal goodwill' that relates to your reputation, skills or attributes. Accordingly, this personal goodwill cannot be transferred as you continue to trade.

Even if there was another source of goodwill it is arguable that this could not be transferred to the company as goodwill is indivisible from the business which you carry on. Accordingly, if you were to enter into the proposed agreements you, and not the company, would continue to carry on the business of providing professional services and you would not, in effect, have disposed of the practice or any goodwill attached to it.

Detailed reasoning

The Nature of Goodwill

The leading authority on the definition of goodwill is the majority judgement of the High Court in FCT v Murry (1999) 39 ATR 129, Gaudron, McHugh , Gummow and Hayne JJ at paragraph 4:

Section 160A defines ``asset'' to include ``goodwill'', but neither Pt IIIA nor the Act generally attempts to give any special meaning to the term. Goodwill is inseparable from the conduct of a business. It may derive from identifiable assets of a business, but it is an indivisible item of property, and it is an asset that is legally distinct from the sources - including other assets of the business - that have created the goodwill. Because that is so, goodwill does not inhere in the identifiable assets of a business, and the sale of an asset which is a source of goodwill, separate from the business itself, does not involve any disposition of the goodwill of the business.

The commissioner's view on the definition of goodwill is found at paragraph 12 of Taxation Ruling TR 1999/16 adopting the principles of Murry:

Goodwill is the product of combining and using the tangible, intangible and human assets of a business for such purposes and in such ways that custom is drawn to it. The attraction of custom is central to the legal concept of goodwill. Goodwill is a quality or attribute that derives among other things from using or applying other assets of a business. It may be site, personality, service, price or habit that obtains custom. It is more accurate to refer to goodwill as having sources than it is to refer to it as being composed of elements. Goodwill is a composite thing. It is one whole. It is indivisible item of property that is legally distinct from the sources from which it emanates. It is something that attaches to a business and is inseparable from the conduct of a business. It cannot be dealt with separately from the business with which it is associated.

Further at paragraph 21 it is explained that a business need not be identical from its commencement to its disposal for it to have the same goodwill:

The business does not need to be identical from its acquisition to its disposal. If the essential nature or character of the business is not changed, the business remains the same business for the CGT goodwill provisions. A business owner may expand or contract activities, or change the way in which a business is carried on, without ceasing to carry on the same business provided the business retains it essential nature or character

In applying the above principles to your facts, you carry on a business of providing professional services as a sole trader. Regardless of the location where you practise and who provides administrative services, the business will retain the same essential nature and character. Consequently, the goodwill that was created during your time in practice is the same goodwill that currently exists.

Transfer of Goodwill

You have been providing professional services at various locations for intermittent periods of time. Consequently the nature of the goodwill that exists in the business you carry on is solely that which is described as personal goodwill, being that which is based on your reputation and skill.

Given it is some distance between the locations, it is unlikely that you will be bringing clients with you from your previous practice and the sole source of goodwill would best be described as your good reputation. Further, the purchaser is not able to direct you as to how to provide your services nor do they have an entitlement to any of your profits outside of the arrangement for administrative services.

The Commissioner's view on the transferability of personal goodwill is provided by paragraph 59 of Taxation Ruling 1999/16:

If a sole practitioner disposes of their business, the part of the goodwill of the business that emanates from their personality, reputation, skills or attributes is not transferable. Similarly, if key employees of the sole practitioner are not employed by the purchaser on the disposal of the business, any part of the goodwill that emanates from their personality, reputation, skills or attributes is also not transferable.

The proposed contracts are explicit in providing that you and the purchaser are not entering into a contract for employment and that you and not the purchaser are providing the professional services (clause 10.1. service agreement).

Additionally, even if there was some other component of the goodwill that was transferrable, the purported sale of goodwill would still be ineffective. Under the proposed contract you have a legal obligation to continue to carry on your business of providing professional services. Goodwill is inseparable from the conduct of the business (see Murry at [4],[20] and [36]), so it is impossible to effectively transfer goodwill where you continue to carry on that business.

Characterisation of the Receipt

The characterisation of the receipt in the hands of the recipient is necessary in order to provide an answer to the questions at issue. Such characterisation is decided in light of the facts, the true nature of the transaction and the arrangement. Such a characterisation is not restricted solely to the documents executed. All relevant circumstances should be taken into account.

Hence, in examining the character of the obligations and relationship established under the legal documents, the true nature of the obligations and relationship are not determined by the labels given to them.

Clause 2.1 of the Sale of Practice Agreement provides that you agree to sell, and the Purchaser agrees to buy, for the purchase price, your practice, which includes the goodwill of the practice, and other items listed in Schedule 1.

However, the purported purchase is contingent on you signing a separate agreement being the 'Provision of Services' Contract. The two main legal obligations imposed on you for entering into these two agreements are that:

1. You provide professional services for a period of five years at the purchaser's premises.

2. You agree to pay 50% of the fees billed in return for the provision of administrative services.

Inducements

In recent years, lease inducements, received as part of a business enterprise, have been considered by the Courts on a number of occasions: Pickford v FC of T 98 ATC 2268, FC of T v Montgomery 99 ATC 4749; 42 ATR 475 (Montgomery), FC of T v The Myer Emporium Ltd (1987) 87 ATC 4363 and FC of T v Cooling 90 ATC 4472 (Cooling).

About lease inducements received as part of a business enterprise, in FC of T v. Cooling, Hill J stated:

Where a taxpayer operates from leased premises, the move from one premises to another and the leasing of the premises occupied are acts of the taxpayer in the course of its business activity just as much as the trading activities that give rise more directly to the taxpayer's assessable income.

In McLean v FCT; Dean v FCT (1996) 32 ATR 647, retention payments made by a parent company to the senior managers of a subsidiary, as an incentive to ensure they remained in the employ of the subsidiary after it was sold, were assessable as ordinary income. Northrop J found that, in substance and reality, the payments were the product of the managers' income-earning activities and that the "continual employment was at the very heart of the receipt".

In your case, although the agreement precludes you from being an employee, our view is the payments you received were inducements to provide your professional services as a contractor with the purchaser for a period of not less than five years. We consider that the real object of the outgoing by the purchaser under the contract is the income that would flow from it.

As already explained we do not view the proposed contract of sale as an effective transfer of goodwill. We consider the objective character of the offerings made were, in themselves, inducements.

Assessable income from an isolated transaction

The Commissioner's view on whether profits on isolated transactions are assessable income under ordinary concepts is contained in Taxation Ruling TR 92/3. Profit from an isolated transaction is generally income when both:

• the intention and purpose for the taxpayer in entering into the transaction was to make a profit or gain and the transaction was entered into; and

• the profit was made in the course of carrying on a business or in carrying out a business operation or commercial transaction.

In Montgomery v FCT [1999] HCA 34, the majority judgement of the High Court held that inducement payments paid to a firm of solicitors to take up a lease were assessable income and not of a capital nature, Gaudron, Gummow, Kirby and Hayne JJ at [118]:

….. The firm used or exploited its capital in the course of carrying on its business, albeit in a transaction properly regarded as singular or extraordinary. And the sums it received from the transactions were not as growth or increment of value in its profit-yielding structure - the receipts came in or were derived for the separate use, benefit and disposal of the firm and its members as they saw fit.

It is considered that the principles in the above case apply to your factual circumstances as even though you have not entered into a lease for a fixed price, the purchaser is providing you a place to practice and administrative services in return for you assigning 50% of the fees you charge. Both charging fees to clients and paying expenses such as lease and administrative fees are revenue, and not capital, in nature.

Even though this is an isolated commercial transaction there is a clear profit making intention or purpose, and the transaction is entered into in the course of carrying on your business, and therefore the receipt of the payment will be assessable as ordinary income under section 6-5 of the ITAA 1997.

Restrictive Covenant

While under the sales contract there is a covenant (clause 4.2) which restricts you to only practice from the new premise for a period of five years. We consider that this is incidental to your activity of deriving income from provisions of personal professional services on the purchaser's premises and the lease structure payments required under the arrangement (that is, instead of set period lease payments, 50% of the fess banked from the rendering of services is charged). Accordingly, as there is no amount of the payment that is specifically allocated to the restrictive covenant, we will treat the granting of the covenant as merely being part of the contract entered into between the relevant parties for the provision of services.

CGT event and anti-overlap provisions

CGT event D1 happens if a taxpayer creates a contractual right or other legal or equitable right in another entity (subsection 104-35(1) of the ITAA 1997).

A right created under a restrictive covenant is a CGT asset which is separate from the goodwill of a business. 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 purchaser is a CGT event D1 under subsection 104-35(1) of the ITAA 1997.

In your case, the contracts contain exclusive dealing and restraint clauses. These clauses satisfy the definition of a restrictive covenant and CGT event D1 will happen at the time the contracts are entered into.

A capital gain will arise on CGT event D1 happening if the capital proceeds from creating the right are more than the incidental costs you incurred that relate to the event. You can make a capital loss if those capital proceeds are less (subsection 104-35(3) of the ITAA 1997).

However, where a transaction gives rise to both ordinary income and a capital gain for capital gains tax (CGT) purposes, the anti-overlap provisions in section 118-20 of the ITAA 1997 would operate to reduce any capital gain arising as a result of relevant CGT events by the amount of income assessed under section 6-5 of the ITAA 1997.