Edited version of your written advice

Authorisation Number: 1012889472617

Date of advice: 9 October 2015

Ruling

Subject: Characterisation of lump sum payment

Question 1

Is the lump sum payment received by you ordinary income pursuant to section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Is the lump sum payment received by you subject to capital gains tax pursuant to Part 3-1 of the ITAA 1997?

Answer

No

This ruling applies for the following period:

Year ended 30 June 2015

The scheme commences on:

1 July 2014

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.

You (a trust) are a financial service business which provides financial planning services.

One major source of income received by you since your establishment was a 'margin share'. This margin share was a share of the 'override commission' receivable by the 'primary agent' from particular platform providers with which the primary agent is a licence holder, and was determined on the basis of the amount of the override commission received by the primary agent which was directly attributable to the services provided by you, i.e. the volume of business or investment generated by you for your clients on the respective platforms.

The margin share of the override commission ('the margin share') payable to you was being paid monthly, on the whole, but arrived in parts throughout any given month following the receipt of the override commission by the primary agent from each respective platform provider.

The margin share received by you was treated as ordinary income and included in the calculation of your net income pursuant to section 95 of the Income Tax Assessment Act 1936 (ITAA 1936).

The primary agent has rationalised its group structure. As a consequence of this reorganisation, the margin share to which you were previously entitled has ceased. The primary agent continues to be entitled to, and receive, override commissions from the platform providers but will not pass any of that on as a margin share to you.

Instead, as part of a negotiated agreement between the primary agent and you, the primary agent was to make a lump sum payment to you. Details relating to the lump sum payment to you include as follows -

• it is a one-off lump sum of $X, an amount based on a three times multiple of the margin share received by you over the 12 month period ending 31 December 20XX;

• it was due to be made by the primary agent within 14 days of the 'completion date'; and

• it does not fully vest with you until the expiration of three years from the date of its receipt. Therefore, should you depart from the primary agent's dealer group network prior to the expiration of this three year period, you will be required to pay an amount of the lump sum payment, based on a pro-rata basis, back to the primary agent.

The primary agent made the lump sum payment to you, as agreed.

Pursuant to subsection 230-455(1) of the ITAA 1997, Division 230 of that Act does not apply to assess you on your gains or losses from financial arrangements. You have not made an election pursuant to subsection 230-455(7) of the ITAA 1997 to have Division 230 apply to your financial arrangements.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 95

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 paragraph 104-25(1)(d)

Income Tax Assessment Act 1997 subsection 104-25(3)

Income Tax Assessment Act 1997 subsection 108-5(1)

Income Tax Assessment Act 1997 section 118-20

Income Tax Assessment Act 1997 subsection 118-20(2)

Income Tax Assessment Act 1997 Division 230

Income Tax Assessment Act 1997 subsection 230-455(1)

Income Tax Assessment Act 1997 subsection 230-455(7)

Reasons for decision

Question 1

Section 6-5 of the ITAA 1997 provides that the assessable income of a taxpayer includes income according to ordinary concepts (ordinary income). The phrase 'income according to ordinary concepts' is not defined in the ITAA 1997, but has been held by the courts to include income from rendering personal services, income from property and income from carrying on a business.

Other characteristics of income that have evolved from case law include receipts that are earned, expected, relied upon, and have an element of periodicity, recurrence or regularity.

When determining whether a receipt is on revenue or capital account it is appropriate to have regard to the entire context in which the payment was made. Ultimately, the characterisation accorded to the lump sum payment received by you from the primary agent depends on the purpose of the payment and the circumstances of its receipt: Tinkler v. Federal Commissioner of Taxation (1979) 29 ALR 663; 79 ATC 4641; (1979) 10 ATR 411 per Brennan J at ALR 667; ATC 4644; ATR 414.

Under the terms of the original agreement, you were regularly paid a margin share, being a share of the override commission receivable by the primary agent from platform providers. This margin share was based on the volume of business or investment generated by you for your clients on the respective platforms. The payment was directly attributed to the provision of services provided by you in the course of carrying on your financial service business and, as such, formed part of your ordinary income and was included in the calculation of your net income pursuant to section 95 of the ITAA 1936.

Under the terms of the subsequent agreement with the primary agent, you were paid a lump sum. This payment has been made in satisfaction of future margin shares to which you would otherwise have been entitled to receive but for the reorganisation, as evidenced by the fact that the calculation of the payment was based on a three times multiple of the margin share received by you over the 12 month period ending 31 December 20XX.

The issue of whether the commutation of an entitlement to periodic payments to a lump sum affects assessability was considered in Coward v. FC of T 99 ATC 2166; 41 ATR 1138. In that case Matthews J found that payments made to replace income take on the character of the payment they replace and that the method of payment does not alter the character of the payment. See also FC of T v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 442; 10 ATD 82 where Fullagar J held that an amount paid in substitution for another amount takes the character of the substituted amount.

It follows that the lump sum payment, paid in substitution for regular payments of ordinary income (i.e. the margin share), retains the character of the margin share payments.

The fact that the lump sum payment does not fully vest with you until the expiration of three years from the date of its receipt confirms that it is a payment to be earned by you in the course of carrying on your financial service business (under the licence of the primary agent's dealer group) for that period of time. This factor supports the assertion that the lump sum payment was made in substitution for the margin share and, consequently, supports the characterisation of the lump sum payment as a receipt of ordinary income.

Your right to receive the margin share is not considered to have been a capital asset of your business. In Allied Mills Industries Pty Ltd v FC of T (1989) 20 FCR 288; (1989) 20 ATR 457; 89 ATC 4365 the Full Federal Court said that "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." In deciding that the payment in question was of an income nature, the Full Federal Court took into account the fact that the taxpayer was not parting with a substantial part of its business, ceasing to carry on its business, or disposing of part of the fixed framework of its business. "The contracts… yielded profit; they did not simply provide the means of making profit."

Having agreed to the receipt of the lump sum payment in substitution for the margin share, you have not parted with or lost a substantial part of your financial service business, or ceased to carry on your financial service business, nor have you disposed of the fixed framework of your financial service business.

Based on all of the above, the lump sum payment paid to you is ordinary income pursuant to section 6-5 of the ITAA 1997.

Question 2

Under subsection 108-5(1) of the ITAA 1997 a CGT asset is any kind of property or a legal or equitable right that is not property. Your contractual right to receive the margin share was a CGT asset according to the broad definition in subsection 108-5(1) of the ITAA 1997.

Upon the primary agent's payment of the lump sum in satisfaction of your contractual right to future margin shares, your ownership of that right was surrendered. This surrender of the contractual right gave rise to CGT event C2 (paragraph 104-25(1)(d) of the ITAA 1997).

Generally, a capital gain will be made from this CGT event where the capital proceeds from the ending of the ownership of the asset are more than the asset's cost base (subsection 104-25(3) of the ITAA 1997). However, pursuant to section 118-20 of the ITAA 1997, a capital gain made from a CGT event is reduced where, because of the event, a provision of the ITAA (outside of Part 3-1) includes an amount in assessable income. The gain will be reduced to zero if it doesn't exceed the amount included (subsection 118-20(2) of the ITAA 1997).

As the lump sum payment (for the reasons set out in response to question 1) forms part of your assessable income pursuant to section 6-5 of the ITAA 1997, and the amount of the lump sum payment could not be exceeded by any capital gain made by you under section 104-25 of the ITAA 1997, that capital gain is reduced to zero and is not subject to capital gains tax.