Edited version of your written advice

Authorisation Number: 1012843592283

Date of advice: 22 July 2015

Ruling

Subject: Novation of accommodation bonds

Question 1

Will the Red Pty Ltd (Red) or Blue Pty Ltd (Blue) derive ordinary income pursuant to section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) from the assumption of liability by the purchaser upon novation of the bonds?

Answer

No

Question 2

Does section 116-55 of the ITAA 1997 apply to the Red or Blue from the assumption of liability by the purchaser upon novation of the bonds to modify the calculation of capital proceeds pursuant to section 116-20?

Answer

No

This ruling applies for the following period

1 July 20xx to 30 June 20yy

The scheme commences on

1 July 20xx

Relevant facts and circumstances

1. Red is the owner of a business. The registered owner of the land, fixtures and fittings on which the business operates is Blue.

2. Approximately 50% of the land and buildings owned by Blue are pre-CGT assets.

3. Blue (as Lessor) entered into a lease agreement with Red (as Lessee) for the lease of the land, fixtures and fittings with which the facility operates.

4. Users of the facility are required to pay bonds, which are non-interest bearing deposits.

5. The bonds in Red's financial statements appear as liabilities because it does not have an unconditional right to defer settlement. The bonds are liabilities and are equal to the proceeds received, less retentions and amounts deducted at the election of the user. For this reason, Red submits that the bonds are not income or of an income nature.

6. Red's main liability is the amount owed to users in the form of refundable deposits or bonds, as defined by the Act. The refundable deposits are provided for in the Agreements entered into between the facility and the user, and:

a. a refundable deposit is repayable to the user upon them leaving the facility. The deposit is not secured.

b. the bond is not a repayment of rent, it is a loan.

7. Red's principal assets comprise of goodwill and plant and equipment.

a. Some of the plant and equipment is held by Red while the balance is held by Blue.

Proposed sale

8. Red and Blue propose to sell facility and all associated freehold property. Negotiations on the sale are still in progress however, a draft letter of offer was submitted by the Purchaser, which provides that:

a. the plant and equipment of the facility will be purchased as an ongoing concern

b. the land and buildings are proposed to be sold for consideration, and

c. the Purchaser will assume the responsibility for future repayments to existing users of the liabilities.

9. Blue will incur a loss on the disposal of the land and buildings and as such, the company will not derive a capital gain on the disposal of these assets.

10. It is proposed that under the sale agreement existing users of the facility will amend their existing agreements by removing Red and substituting the Purchaser as the other party of the agreement. Red will not receive any monies in respect of the novation of the agreements. As such, Red will not have amounts to bring to account in its Profit and Loss Statement in relation to the novated agreements. Rather, the novation will be accounted for by a debit to the 'Bonds' account and a credit to the 'Capital Reserve' account.

11. You contend that:

a. the business assets of Red are not subject to a liability by way of security over the asset

b. the assumption of liability by the Purchaser involves forgiveness of a debt by the departing user, which occurs on signature of the novation agreement, and

c. the liability to users is unsecured and as such, there are no means by which the capital proceeds are subject to an increase pursuant to section 116-55 of the ITAA 1997.

12. You claim that the assumption of liability in respect of the bonds by the Purchaser upon the novation of the Agreements will not result in Red or Blue deriving income according to ordinary concepts. Rather, you claim that the assumption of liability by the Purchaser will result in an economic gain as provided for in the debt forgiveness provisions of Division 245 of the ITAA 1997. That is, there will be a forgiveness of the debt. You have not sought a ruling on the debt forgiveness provisions of the ITAA 1997.

Relevant legislative provisions

Section 6-5 of the Income Tax Assessment Act 1997

Section 116-20 of the Income Tax Assessment Act 1997

Section 116-55 of the Income Tax Assessment Act 1997

Reasons for decision

Question 1

Will Red or Blue derive ordinary income pursuant to section 6-5 of the ITAA 1997 from the assumption of liability by the Purchaser upon novation of the bonds?

ORDINARY INCOME

13. Section 6-5 of the ITAA 1997 provides that a taxpayer's assessable income includes income according to ordinary concepts, known as ordinary income. However, the legislation does not provide guidance on the meaning of 'income according to ordinary concepts' in section 6-5. As such, guidance on the meaning of the term and for determining whether a receipt will be ordinary income can be found in case law.

14. In Scott v. Commissioner of Taxation (NSW) (1935) 35 SR (NSW) 215, Jordan CJ held that the meaning of 'income' was to be determined according to 'ordinary concept and usages'.

15. Ordinary income will generally have the characteristics of being periodic, recurring, and regular. Such characteristics of income have been emphasised by decisions in FC of T v. Dixon (1952) 86 CLR 540; 10 ATD 82 and Just v. FC of T (1949) 8 ATD 419.

16. In FC of T v. Myer (1987) 163 CLR 199, the High Court held that a receipt from an isolated transaction may be characterised as ordinary income where there is a profit-making intention in the course of carrying out a business operation or commercial transaction.

17. The main characteristics that are generally applicable to a receipt being considered as income are:

a. received periodically and regularly

b. received for personal services (for example, salary and wages)

c. received from property and investment returns (for example, dividends and interest)

d. relied upon or expected

e. earned

f. for the replacement of income; and

g. derived by way of a profit making intention or carrying on a business.

18. Therefore, ordinary income generally bears a direct relationship to some form of input or investment made by the taxpayer. It is important to note however, that it is not necessary for all of these characteristics to exist in order for a receipt to be considered under ordinary concepts.

Ordinary income or statutory income?

19. Not every receipt of cash or non-cash benefit by a taxpayer is ordinary income according to the legislation. Capital receipts are not ordinary income and are not assessable under section 6-5 of the ITAA 1997. However, section 102-5 of the ITAA 1997 provides that capital receipts are to be included in a taxpayer's assessable income as statutory income.

20. The distinction between capital and income is important, as capital receipts frequently have substantially different treatment under the tax law than ordinary income, often with considerable tax concessions available for certain taxpayers or certain capital gains tax (CGT) events.

21. Despite the legislation not providing a specific definition of whether a receipt is income or capital, there is a considerable amount of case law that explains the distinction between the two types of receipts. In particular, in Federal Commissioner of Taxation v. Smith (1981) 11 ATR 538, 81 ATC 4114 (Smith's case), Gibbs, Stephen, Mason and Wilson JJ use the analogy of a tree and its fruit. The Justices explain that capital can be likened to the tree, with an ability to earn in the future. Fruit on the other hand demonstrates characteristics more similar to income; it is the fruit that is derived periodically and bears a direct relationship to some investment (the tree).

Application to your circumstances

22. Red and Blue are currently in negotiations to sell the business of the facility. As part of the sale, it is proposed that the Purchaser will assume the liability of the bonds. This will be achieved through a novation of the existing agreements with the users, removing Red/Blue as a party of the agreements and replacing them with the Purchaser. Neither Red nor Blue will receive any monies in relation to these novated agreements. Consequently, Red will not have amounts to bring to account in its Profit and Loss Statement in relation to the novated agreements. Rather, the novation will be account for by a debit to the 'Bonds' account and a credit to the 'Capital Reserve' account.

23. Similar to the example provided in Smith's case, the facility can be likened to a tree. The business of the facility has the ability to earn in the future, with the sale of which being capital in nature. As the bonds are payments made by users to secure their position in the facility, which are refundable on departure, they do not bear the general characteristics of income. The assumption of liability of the bonds by the purchaser, for no consideration, does not have the general characteristics of income under ordinary concepts. Using the analogy of a tree and its fruit, the assumption of liability cannot be seen as the production of income (that is, the fruit).

24. Consequently, the Commissioner does not consider the assumption of the liability for no consideration by the purchaser in relation to the bonds as income according to ordinary concepts pursuant to section 6-5 of the ITAA 1997. However, the assumption of liability may satisfy the requirements of statutory income and therefore necessarily be included in the assessable income for Red or Blue.

Question 2

Does section 116-55 of the ITAA 1997 apply to Red or Blue from the assumption of liability by the Purchaser upon novation of the bonds to modify the calculation of capital proceeds pursuant to section 116-20?

CAPITAL GAINS TAX (CGT)

25. Subsection 102-5(1) of the ITAA 1997 provides that the assessable income of a taxpayer includes any net capital gains made during the income year.

26. Section 102-20 of the ITAA 1997 provides that a capital gain or loss can only occur if a CGT event happens. CGT events are simply the different types of transactions which may result in a capital gain or loss, and are not limited to the sale of assets. Division 104 of the ITAA 1997 lists and explains each CGT event.

What is the relevant CGT asset?

27. A CGT asset is defined in subsection 108-5(1) of the ITAA 1997 as being any kind of property or a legal or equitable right that is not property. Whether or not rights under contract will be considered as one asset or separate CGT assets is dependent on the particular circumstances of the case. However, as stated in paragraph 1 of Taxation Determination TD 93/86 Income tax: capital gains: are the totality of rights under a contract considered to be the one asset, or is each right considered to be a separate asset for CGT purposes? (TD 93/96), generally the totality of rights under a contract will be regarded as the one CGT asset for the purposes of Parts 3-1 and 3-3 of the ITAA 1997.

28. The example in TD 93/86 helps illustrate the circumstances when rights will be considered a single asset or separate assets for CGT purposes. In this example, Maria enters into an agreement to purchase rights to market a particular product in Australia. Consistent with paragraph 1, these rights are one asset for CGT purposes. However, if Maria then assigns some of her rights to market the product in Western Australia, South Australia and the Northern Territory to Peter, then this would constitute a disposal of part of her asset. The asset held by Peter is a single asset in his hands, distinct from the remaining asset held by Maria.

Application to your circumstances

29. As explained above, it is proposed that existing users of the facility will give effect to a novation of the existing agreements such that Red and/or Blue will be removed as a party of the agreements and replace with the Purchaser. Neither Red nor Blue will receive any monies in respect of the novation of the agreements.

30. In order to determine the CGT consequences of the sale of the facility, it is necessary to correctly identify the CGT assets being disposed.

31. Consistent with TD 93/86, the totality of rights under a contract will be regarded as the one CGT asset for the purposes of Parts 3-1 and 3-3 of the ITAA 1997. That is, the facility in its entirety, including the totality of rights (coupled with obligations) under the contract of sale, and not the allocated licence, would be the relevant CGT asset.

What is the relevant CGT event?

32. Section 104-5 of the ITAA 1997 sets out a list of CGT events. CGT event A1 is the disposal of a CGT asset pursuant to subsection 104-10(1). Subsection 104-10(2) of the ITAA 1997 states that a taxpayer will dispose of a CGT asset if a change of ownership occurs from the taxpayer to another entity.

33. Paragraph 104-10(3)(a) of the ITAA 1997 provides that the timing of the CGT event will be when the contract to dispose of the asset is entered into by the taxpayer.

Application to your circumstances

34. Pursuant to paragraph 104-10(3)(a), the CGT event will occur when the facility is disposed of, that is at the time the parties have executed the contract of sale.

CGT asset subject to a liability by way of security over the asset

35. Division 116 of the ITAA 1997 provides a number of rules regarding the calculation of the capital proceeds from a CGT event. The general rule is provided by section 116-20 which states that the capital proceeds from a CGT event are the total of:

a. the money an entity receives, or is entitled to receive, in respect to the CGT event, and

b. the market value of any other property an entity receives, or is entitled to receive.

36. Modifications to the general rule of section 116-20 of the ITAA 1997 are found in sections 116-25 to 116-110. With regards to the assumption of liability from a CGT event, section 116-55 provides that the capital proceeds are increased if another entity acquires the CGT asset (that is the subject of the event) subject to a liability by way of security over the asset. In such a case, the capital proceeds from the CGT event are increased by the amount of the liability the other entity assumes.

37. The term 'liability' as contained in section 116-55 of the ITAA 1997 is not defined by the legislation. Consequently, the term takes on its ordinary meaning. The Macquarie Dictionary defines 'liability' to mean an obligation, especially for payment, debt or pecuniary obligations (opposed to asset).

38. The legislation also does not define the term 'security' and as such, the term takes on its ordinary meaning. The Macquarie Dictionary defines 'security' to mean "something given or deposited as surety for the fulfilment of a promise or an obligation, the payment of a debt, etc". In relation to section 116-55 of the ITAA 1997, the modification will only apply in circumstances where the CGT asset is subject to a secured liability over it. This meaning is supported by the example provided for in section 116-55 of the ITAA 1997, which illustrates that a buyer of land becomes responsible for an outstanding mortgage, being a liability by way of security over the land.

Application to your circumstances

39. The capital proceeds received from the sale of the facility is provided by section 116-20, being the total of:

a. the money received, or is entitled to be received, in respect to the sale, and

b. the market value of any other property received, or entitled to be received.

40. As the novated bonds are part of the sale of the facility, Red and Blue are required to include the market value of these bonds in calculating the capital proceeds pursuant to subsection 116-20(1) of the ITAA 1997.

41. In order to determine whether subsection 116-55 of the ITAA 1997 will also apply to modify the proceeds from the sale, it is necessary to establish whether the liability is one by way of security over the asset.

42. The bonds received are payments made by users to enable them to access the facility. Red records the bonds in its financial statements as liabilities because it does not have an unconditional right to defer settlement. The bonds are liabilities and are equal to the proceeds received, less retentions and amounts deducted at the election of the user.

43. The repayment of the bonds to users is a liability incurred by the facility and is a liability transferred to the Purchaser. That is, the Purchaser will be liable to repay the bond upon the user's departure from the facility. This means that the Purchaser of the facility will purchase a CGT asset subject to a liability, and the purchase price will be reduced to reflect the novated liability.

44. Although the Purchaser will be liable to repay the bonds upon departure of the user, this does not amount to security over an asset which the user could deal with to satisfy their loan. That is, it is not consistent with the general business meaning of the word 'security' which refers to an asset pledged to guarantee repayment of a loan, providing the lender with a right to that secured asset and the ability to take it into their possession in the case of default. The user will have recourse against the Purchaser for repayment of the bond but he/she will have no secured asset to access or deal with in order to satisfy the debt.

45. Consequently, the bonds are not liabilities by way of security over the asset, being the facility, but are part of the carrying on of the business of the facility. Section 116-55 of the ITAA 1997 therefore does not apply to modify the capital proceeds from the sale of the facility.