Edited version of your written advice

Authorisation Number: 1012777020372

Ruling

Subject: Sale of Professional Practice

Question 1

Does the receipt of $X under the contract comprise a derivation of ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Was the amount received as part of Capital Gains Tax (CGT) event D1 under section 104-35 of the ITAA 1997?

Answer

Yes, however, the anti-overlap provisions will reduce any capital gain from CGT event D1 to nil.

Question 3

Can the small business CGT concessions under Division 152 of the ITAA 1997 be applied to reduce any resulting capital gain?

Answer

No

Question 4

If you terminate the contract prior to the original conclusion date, will the 'damages' payable to the purchaser represent a repayment of part of the original proceeds such that that portion will not be assessable during the Year ended 30 June 20XX?

Answer

Yes - in the event that damages are paid, you may seek an amendment to your assessment for the year ended 30 June 20XX to excise the damages amount paid.

This ruling applies for the following period

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The arrangement that is the 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 'Sale of Practice' contract, and

• the 'Provision of Services to Professional Practitioner' contract(the services contract).

You are a professional practitioner who carried on business as a sole trader at location A. The professional centre provided services to your business such as rooms, staff and billing in exchange for a service fee.

You entered into a contract with a company for the 'sale' of your professional practice to them for an agreed purchase price of $X. The payment was received as a single lump sum. Whilst the contract includes the sale of professional equipment, almost all of the contract price relates to the sale of goodwill.

You entered into the sale and services contracts simultaneously.

The sale contract provides:

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

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

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

• that you will render professional services from the premises of the purchaser at Location B for a period of at least five years (with certain hours to be worked) and you will render professional services only from that premises, and

• you must not, during the restraint period, render professional services at any place within a radius of 10 kilometres of the old or new premises.

Clause C of the sale contracts stipulates that you and the purchaser agree that:

• you and the purchaser are not partners and are not in an employee/employer relationship and you, in rendering professional services and doing other things, are at all relevant times an independent person and not doing so as the servant, agent, or otherwise 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 non-professional services to you and other professional 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 Clause C.

Clause D of the sale contract provides:

• you may terminate the deed any time between the 1^st anniversary and the 5^th anniversary providing that you provide three months written notice, and

• if you do so you agree to pay to the purchaser damages as a once only payment of $E (being equivalent to Z% of the purchase price, divided by the number of months (60) in the term of the practitioner contract) for each whole month in the period from the date specified in the Notice of Termination as being the last date that the professional will render services at the New Premises through to the due expiry of the initial term of 5 years under the Practitioner Contract.

The Provision of Services to professional Practitioner contract 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 provided by you;

• the purchaser will charge you X% of your professional fees for the use of the premises and services; and

• you must attend at the premises and render professional services at the premises within the hours agreed upon and the purchaser must not direct you as to how the professional services are to be performed.

The distance between your former premises and the new premises is around 10 Kilometres and you anticipate that most of your clients will move with you.

Relevant legislative provisions

Income Tax Assessment Act 1936 - subsection 170(10AA)

Income Tax Assessment Act 1997 - section 6-5

Income Tax Assessment Act 1997 - section 59-30

Income Tax Assessment Act 1997 - section 104-35

Income Tax Assessment Act 1997 - section 108-5

Income Tax Assessment Act 1997 - section 118-20

Income Tax Assessment Act 1997 - section 152-10

Reasons for decision

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Summary

In view of your entire circumstances, the receipt 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 professionally.

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 be transferred to the company as goodwill is indivisible from the business which you carry on. Accordingly, 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 Federal Commissioner of Taxation 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 your former practice is the same goodwill that currently exists in the new premises.

Transfer of Goodwill

You have been providing professional services at Location A for a period 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 that it is a relatively short distance between the locations (around 10 kilometres), it is likely that you will be bringing clients with you from your previous practice. Further, the company is not able to direct you as to how to provide professional 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 TR 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 company are not entering into a contract for employment and that you and not the company are providing the professional services.

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 XX 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 to Professional Practitioner' 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 company's premises.

2. You agree to pay X% of the fees billed to clients 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. Federal Commissioner of Taxation 98 ATC 2268, Federal Commissioner of Taxation v. Montgomery 99 ATC 4749; 42 ATR 475 (Montgomery), Federal Commissioner of Taxation 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. Federal Commissioner of Taxation; Dean v. Federal Commissioner of Taxation (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 company for a period of not less than five years. We consider that the real object of the outgoing by the company 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 by the company 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. Federal Commissioner of Taxation [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 company is providing you a place to practice and administrative services in return for you assigning X% 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 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 company's premises and the lease structure payments required with the company under the arrangement (that is, instead of set period lease payments, X% of the fess banked from the rendering of professional 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.

As we consider the restrictive covenant aspect of the contract a part of the broader transaction, any capital gain arising from CGT event D1 will be ignored by virtue of section 118-20.

Small Business CGT concessions

Certain capital gains can be reduced or eliminated by virtue of the small business CGT concessions under Division 152 of the ITAA 1997.

There are a number of different concessions available and before any can be applied, the basic conditions under section 152-10 of the ITAA 1997 must first be satisfied. Some particular concessions require additional conditions beyond the basic ones to be satisfied.

Amongst the basic conditions is the requirement under paragraph 152-10(1)(b) that the CGT event would have resulted in a gain.

In your case, due to the application of section 118-20 that will reduce any capital gain to nil, the requirement under paragraph 152-10(1)(b) will not be satisfied.

Accordingly, none of the small business CGT concessions under Division 152 of the ITAA 1997 can be applied.

Early termination of agreement

Section 59-30 of the ITAA 1997 provides that an amount you receive is not assessable income and is not exempt income for an income year if:

• you must repay it; and

• you repay it in a later income year; and

• you cannot deduct the repayment for any income year.

Furthermore, it does not matter if:

• you received the amount as part of a larger amount; or

• the obligation to repay existed when you received the amount or it came into existence later.

The Sale of Practice agreement has provisions whereby you may have to pay damages to the purchaser which are calculated by reference to the purchase price. The damages are $X (that is, the purchase price divided by 60 months) per month for each month still remaining on the contract.

Although the agreements that you have entered into refer to such payments as 'damages', it is more important to look at the character of the outgoing to determine their true nature.

In this case, the 'damages' are calculated by reference to the portion of the purchase price related to the remaining months on the contract and 'uplifted' by Z%.

As the damages are so closely related to the initial purchase price they can be considered a repayment of the 'unused' time left on the contract.

Accordingly, section 59-30 will apply to treat the amount as neither assessable or exempt income for the year ended 30 June 20XX.

As noted above, the full purchase price will be assessable to you as ordinary income for the year ended 30 June 20XX. In the event that damages are paid in a later year, you may amend your assessment to remove the amount of the damages from the initial sale proceeds.

If a repayment was to occur outside of your normal period of review, the table in section 170(10AA) of the ITAA 1936 allows an unlimited amendment period in order to apply section 59-30.