Edited version of your written advice

Authorisation Number: 1013001832290

Date of advice: 26 April 2016

Ruling

Subject: CGT treatment of consideration received under contractual agreement

Question 1

Is the consideration received in accordance with the Amendment Contract by the taxpayer on capital account for taxation purposes?

Answer

No

Question 2

With regard to the consideration received by the taxpayer according to the terms of the Amendment Deed, is the taxpayer subject to the small business relief and consequentially permitted to apply the small business CGT concession?

Answer

N/A as the answer to Question 1 is that the consideration is No.

Question 3

In relation to the creation of the contractual right, being the expansion of the restraints on activities as set out in the Amendment Deed, at what point in time did the CGT event occur?

Answer

N/A as the answer to Question 1 is that the consideration is No.

Relevant Facts and Circumstances

1. The taxpayer is a resident of Australia for taxation purposes

2. The taxpayer works in the medical industry.

3. The taxpayer established an office located within an existing medical practice.

4. The taxpayer entered into the Sale of Office Deed

5. The taxpayer entered into the Provision of Services Contract (Services Contact).

6. The taxpayer entered into an Amendment of Contracts Deed (Amendment Contract) in relation to the Sale of Office deed and the Provision of Services Contract with Company A.

7. As a result of entering the Amended Contract, the taxpayer was to receive a lump sum payment from Company A within X days of the execution of the deed.

8. We note the following points (inter alia) relevant in the Sale of Office Deed:-

• Clause 8.1 provides that the 'New Premises' nominated by the Purchaser to be located within a distance from the GPO of the closest capital city.

9. We note the following points (inter alia) relevant in the Services Contract:-

• Clause 6.1 requires that the taxpayer attends and render services from the specified location and during the specified hours.

10. We note the following points (inter alia) relevant in the Amendment Contract:-

• Clause 3.2 of the Amendment Contract expressly states that the lump sum payment of $XXX,XXX is payable for:

a) The extension of the term of the Services Contract effected under clause 4 and 5.3 of the Amendment Contract ; and

b) The expansion of the restraints effected by clause 5.7 of the Amendment Contract.

• Clause 4 of the Amendment Contract amends clause 2 of the Services Contract to extend the duration of the Services Contract for an addition Z years.

• Clause 5.1 extends the geographic distance from the GPO of the closest capital city

• Clause 5.3 amends clause 9.2(a) and 9.2(b) of the Sale of Office Deed (dealing with duration) to extend the duration for an additional Z years

• Clause 5.7 amends clause 18.2(a) of the Sale of Office Contract (dealing with restraints) for an additional Z years.

Relevant legislative provisions

Section 6-5 of the Income Tax Assessment Act 1997 (Cth)

Reasons for decision

Question 1

Is the consideration received in accordance with the Amendment Contract by the taxpayer on capital account for taxation purposes?

Summary

The receipt of the lump sum is properly to be characterised as a derivation of income under ordinary principles under section 6-5 of the ITAA 1997.

Detailed reasoning

1. The characterisation of the receipt in the hands of the recipient is necessary in order to provide an answer to the question at issue. Such characterisation is decided in light of the facts, the true nature of the transaction and the arrangement. Such characterisation is not restricted solely to the legal form of the documents executed. All relevant circumstances should be taken into account Federal Coke Co Pty Ltd v FCT (1977) 7 ATR 519; 15 ALR 449; 34 FLR 375. Hence, in examining the character of the $XXX,XXX receipt in the taxpayer' hands, it is necessary to have regard to the nature of the obligations and relationships established under the legal documents.

2. Clause 3.2 of the Amendment Contract expressly states that the lump sum payment of $XXX,XXX is payable for:

a) The extension of the term of the Services Contract effected under clause 4 and 5.3 of the Amendment Contract ; and

b) The expansion of the restraints effected by clause 5.7 of the Amendment Contract.

3. Clause 4 of the Amendment Contract amends clause 2 of the Services Contract to extend the duration of the Services Contract for an additional Z years. Clause 5.3 amends clause 9.2(a) and 9.2(b) of the Sale of Office Deed (dealing with duration) to extend the duration for an additional Z years

4. Clause 5.7 amends clause 18.2(a) of the Sale of Office Contract (dealing with restraints) for an additional Z years.

5. No specific amounts or proportion of the total amount were assigned for each of these amendments.

6. The effect of the amendments contained in clause 3.2(a) was that the taxpayer was paid the lump sum. In exchange for that lump sum, the taxpayer agreed to continue to perform services for an additional Z years.

7. The effect of the amendments in clause 3.2(b) was that the existing restraints that were contained in the original Sale of Office Contract were to continue for a further Z years.

8. The question to be answered is whether the lump sum paid to the taxpayer is properly to be characterised as ordinary income or capital.

9. In Williams J Dickenson v FCT (1958) 98 CJR 460 at 483; 7 AITR 257, (Dickenson) it was held that a lump sum for a restriction of the garage and premises to one brand of product for 10 years, effectuated by means of a lease and sublease of the premises as well as a personal covenant in the nature of a sale price for a substantial and enduring detraction from pre-existing rights, had the character of capital. It was said that 'the appellant's business constituted a profit yielding organisation of a definite structure under his control and he received the money as part of an inducement to change a feature in it.'

10. In FC of T v Montgomery 99 ATC 4749; 42 ATR 475 (Montgomery), the inducement received by the taxpayer for executing an agreement to lease business premises was held by the majority to be ordinary income. The majority of the Court held that the taxpayer had not given up, or given up the use of, any capital asset in return for the receipt.

11. The principles from these cases is that a payment received in consideration for the recipient undertaking to not use a specified asset or to trade only with the other party in agreement are of a capital nature (see Dickenson). However, if the circumstances are that the amount received the amount received is intended to replace profits which otherwise would have been made, the receipt of the payment may of a revenue nature (see Montgomery).

12. In your ruling request you referred to Dickenson v Federal Commissioner of Taxation (1958) 98 CLR 460.

13. In Dickenson's case, the payment 'appears to represent a quid pro quo for giving up a substantial sphere of activity which would otherwise be open to [Mr Dickenson]'. The restraint was giving up a 'substantial sphere of activity' in that Mr Dickenson was restrained from selling anything other than Shell oils and from holding an interest in other garages or service stations within a geographic distance for a period of time.

14. The Commissioner is of the view that the taxpayer's case is distinguishable from that of Dickenson. In the taxpayer' case, the restraint is not one which the Commissioner will characterise as being a 'substantial sphere of activity'. The contracts required that the taxpayer perform services for for a specific number of weeks per financial year and for no less than a specific number of hours per week (see sub-clause 9.2(b) of the Sale of Office Deed). Accordingly, while this arrangement minimises opportunities for the taxpayer to derive income elsewhere, it is not properly characterised as requiring that the taxpayer give up a substantial sphere of activity.

15. Further, by extending the geographic distance, the taxpayer is able to perform their services on site. The Private Ruling request quotes from a letter provided to the taxpayer from a representative from the business. Letter provided.

16. This letter supports our view that the taxpayer is not subjecting themselves to any further restraint of their activities as they continued to provide services at the business without the need to provide the services remotely. Accordingly, increasing the geographic distance does not increase any existing restraints on the taxpayer.

17. The Explanatory Memorandum accompanying Taxation Laws Amendment Act (No 4) 1992 states not all things often referred to as "rights" will be assets for CGT purposes. Personal liberties and freedoms, such as the freedom to work or trade will not be assets for CGT purposes.

18. The taxpayer was required under the original services contract to perform services for the business for a specified number hours per week for specified number of weeks per calendar year. Hence, the taxpayer only has a small opportunity (given the need for rest and recuperation) to take up other work providing services and not hiring employees (as required by clause 6.1 of the Service Agreement). This did not change with the Amendment Contract. As such, no valuable right was given up as a consequence of entering into the Amendment deed.

19. Your verbal contention is that the proper construction of the amendments contract is that the consideration paid as a lump sum is attributable to all of the amendments listed in clause 4 and 5 of the amendment contract. This would include a payment for the geographical located being increased. We do not agree. The amendment contract was executed as a deed. Accordingly, no consideration is necessary for all subclauses. Sub-clause 3.2 of the Amendment Contract makes clear that the lump sum is payable for specific amendments at clause 4 and sub-clause 5.3 (see subclause 3.2(a) and sub-clause 5.7 (see sub-clause 3.2(b) of the Amendment Contract. No consideration is attributed to any other amendments of the original contracts.

20. Your written contention was the consideration for the extension of the term of the Service Contract was already accounted for in the increase of the monthly rebate to a higher amount. As a result, the lump sum is consideration for the expansion of the restraint on activities. We do not agree. We believe that the proper construction of the contract is that sub-clause 3.2 of the Amendment Contract expressly states that the lump sum payment is payable for the extension of the term of the Services Contract (clause 4 of the Amendment Contract) and certain terms of the term of the Sale of Practice Deed (sub-clauses 5.3 and 5.7 of the Amendment Contract).

21. We consider that the lump sum payment was not related to a restrictive covenant of a capital nature because there was no restraint of a CGT asset. The payment received from Company A did not result in any capital asset being given up or the use of any capital asset being given up in return for the payment.

22. Looking at the obligations and relationships established under the legal documents, the taxpayer had received the lump sum under the Amendment agreement for the continued rendering of their personal services and this constitutes ordinary income under section 6-5 of the ITAA 1997.

Question 1(b)

In the alternative, is the practical effect of the Amendment Deed that the sale of the taxpayer's goodwill in the business, which effectively is the disposal of a capital asset and is on capital effect?

23. We do not consider that the lump sum payment was made for the goodwill of the office. The Amendment Contract makes clear what the payment relates to (see paragraphs 2-4 above). However, for completeness, we believe that if the lump sum payment included a payment relating to goodwill, it is the personal goodwill of the taxpayer.

24. Taxation Ruling TR 1999/16 is about the goodwill of a business. Paragraphs 12 and 59 state:

Goodwill is a composite thing. It is one whole. It is an 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.

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. However, other sources of goodwill continue to draw custom to the business even though the owner or employee has no further connection with the business and, in that respect, the goodwill can be sold. [Emphasis added]

25. Your email states that the taxpayer provided services run through Company B and that the goodwill of this company is accrued through the personal services rendered by the taxpayer. You further contend that the reality is that the goodwill attaches to the business. We do not agree.

26. Your Private Ruling request contends that the effect of the Amendment Contract is that the taxpayer has sold the office to the business for consideration equal to the lump sum amount. This consideration, you contend, is derived from the value of the goodwill accrued in the practice. Your other email quotes from TR1999/16 and in particular example 7 which looks at the circumstance where a taxpayer ('Sarah') sells her home based legal practice to a local partnership of solicitors. Your contention is that this example is similar, if not identical, to the taxpayer's circumstances. We do not agree with these contentions.

27. Firstly, the lump sum payment is expressly attributed to the amendments listed in sub-clause 3.2 of the amendment contract. Secondly, example 7 Taxation Ruling TR 1999/16 is premised on the payment received by 'Sarah' being for the sale of her practice and the entering into a restrictive covenant. As discussed above, the lump sum payment is expressly attributed to the amendments listed in sub-clause 3.2 of the amendment contract. No part of the payment is attributable to any sale of a practice. Example 7 makes clear that the personal skills and attributes are not assignable.

28. The Private Ruling request quotes from a letter provided to the taxpayer from a business representative. Letter provided

29. This comment from the business representative makes clear that it is the taxpayer personally who was well known to the businesses in the area. As such, any goodwill that had been developed was personal to the taxpayer. This developed good reputation (a source of goodwill), cannot be sold as a CGT asset on the open market. Instead, the taxpayer's good reputation could only receive offers of inducement for their personal services of good repute. Paragraph 59 of TR 1999/16 states 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.

30. In FC of T v Montgomery 99 ATC 4749; 42 ATR 475 (Montgomery), the inducement received by the taxpayer for executing an agreement to lease business premises was held by the majority to be ordinary income. The majority said:

The inducement amounts received by the firm did not augment the profit-yielding structure of the firm. The lease was acquired as part of that structure; the inducement amounts were not.

…the firm used or exploited its capital (whether its capital is treated for this purpose as being the agreement to take premises or its goodwill) to obtain the inducement amounts…the firm was then "of a size which makes it a particularly attractive tenancy target''…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...

31. In McLean v FCT; Dean v FCT (1996) 32 ATR 647 (McLean), 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".

32. The above quoted letter from the business to the taxpayer demonstrates that the payment received was connected to the quality of the taxpayer's personal reputation and skills, which made them an "attractive target" for the business to retain. Further, the 'continual employment of [The taxpayer] was at the very heart of the receipt' of the lump sum payment. Accordingly, we consider the payment is revenue in nature (per the examples of Montgomery and McLean). As previously stated (per TR 1999/16) the taxpayer' reputation and skills are not, in themselves, capital in nature.

Question 2

With regard to the consideration received by the taxpayer according to the terms of the Amendment Deed, is the taxpayer subject to the small business relief and consequentially permitted to apply the small business CGT concession?

Not applicable as the answer to Question 1 is that the consideration is correctly to be accounted for on revenue account.

Question 3

In relation to the creation of the contractual right, being the expansion of the restraints on activities as set out in the Amendment Deed, at what point in time did the CGT event occur?

Not applicable as the answer to Question 1 is that the consideration is correctly to be accounted for on revenue account.