Edited version of your written advice

Authorisation Number: 1051317974414

Date of Advice: 18 December 2017

Ruling

Subject: Income tax - Deductions - Other

Question 1

Are the payments made from the Partnership to the Retiring Partners, described in the Exit Agreement as being in respect of their ‘loss of future income earning capacity’, allowable deductions when calculating the net income of the Partnership as defined in section 90 of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No

Question 2

Do the payments referred to in question 1 represent an individual interest of the Retiring Partners in the net income of the Partnership for the purposes of section 92 of the ITAA 1936 such that the payments should be disclosed by the Partnership as distributions of its net income to the Retiring Partners when preparing the 201Y income tax return for the Partnership?

Answer

No

This ruling applies for the following period:

Year ended 30 June 201Y

Relevant facts and circumstances

The partners entered into a Partnership Agreement which includes provisions regarding the entry and exit of partners. Those provisions require that goodwill is to be recognised by the Partnership on entry and exit of a partner.

On the Departure Date, the Retiring Partners exited the Partnership.

As part of their exit, the Retiring Partners disposed of their respective interest in the Partnership to the Continuing Partners and their units in an associated trust to the Continuing Unitholders.

The consideration paid to the Retiring Partners was attributed in accordance with the Exit Agreement as follows:

PAYMENTS

The parties shall attribute consideration to each of the identifiable assets or asset classes being disposed as follows:

…

(d) The balance to be attributed to the Retiring Partners for loss of future income earning capacity.

Provided that nothing in this clause shall operate so as to increase the Payment amounts to be paid to either of the Retiring Partners to any amount above that set out in clause 1.1 (q)

Consistent with what is required by the Partnership Agreement on exit of a partner, the assets of the practice in respect of which interests were purchased by the Partnership in accordance with the Exit Agreement included goodwill.

Clause X of the Exit Agreement relates to the preparation of accounts and provides:

(a) The Continuing Partners will cause the accountants to the Partnership, … , to prepare a balance sheet as at the Departure Date and a profit and loss account for the period from 1 July 201X to the Departure Date for the Partnership ….

(b) The statutory accounts shall be prepared consistently with the bases on which accounts have been prepared in the three previous financial years.

In accordance with the Exit Agreement, financial statements were prepared by the accountants and approved by the Partnership and the Retiring Partners. In accordance with those financial statements, and in addition to the consideration paid to the Retiring Partners under the Exit Agreement, a lump sum payment was made to each of the Retiring Partners of $XXX representing their share of the Partnership’s profit for the financial year to the Departure Date.

The Exit Agreement sets out the entitlements of the Retiring Partners from the Departure Date as follows:

DEPARTURE DATE

…

(b) The Retiring Partners and Departing Unit Holders agree from Departure Date that:

(i) no further payments of any nature are payable to or on behalf of the Retiring Partners or the Departing Unit Holders; and,

(ii) notwithstanding clause 8, in consideration of receipt of the Payment Amount, each releases and discharges the Continuing Partners, Continuing Unit Holders, the Trustee and the Practice from any and all Claims in respect of any partnership entitlements, trust distribution, employment entitlements or any other form of remuneration or payment claim they had, may have had, or but for this Agreement, would have had against the Continuing Partners, Continuing Unit Holders, the Trust and the Trustee; and;

(iii) payment of the Payment Amounts will be in full and final discharge and settlement by the Continuing Partners and the Partnership of any claims against or entitlements from the Continuing Partners, the Trustee, the Trust and the Partnership in respect of any partnership entitlements, trust distribution, employment entitlements or any other form of remuneration or payment claim that the Retiring Partners and Departing Unit Holders have.

RECEIVABLES, DRAWS, FILE TRANSFERS AND WORK IN PROGRESS

(b) From the Departure Date, the Retiring Partners and Departing Unit Holders will no longer be:

(i) entitled to any profits from the Partnership (including any profits of a capital nature);

Both Retiring Partners are residents for tax purposes throughout the relevant period.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 90

Edited version of private ruling Page 3 of 6

Income Tax Assessment Act 1936 section 91

Income Tax Assessment Act 1936 section 92

Income Tax Assessment Act 1936 subsection 92(1)

Income Tax Assessment Act 1936 paragraph 92(1)(a)

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 Division 36

Income Tax Assessment Act 1997 section 290-150

Reasons for decision

Question 1

Summary

The payments made from the Partnership to the Retiring Partners in respect of their loss of future income earning capacity, per the Exit Agreement, are not allowable deductions when calculating the net income of the Partnership as defined in section 90 of the ITAA 1936.

Detailed reasoning

Section 90 of the ITAA 1936 defines ‘net income’ in relation to a partnership to mean the assessable income of the partnership calculated as if the partnership were a taxpayer who was a resident, less all allowable deductions (except for those deductions provided for under section 290-150 or Division 36 of the Income Tax Assessment Act 1997 (ITAA 1997)).

The net income of a partnership is therefore determined by reference to the taxation law rather than any act or statement of the partnership.

Section 8-1 of the ITAA 1997 allows a deduction for any losses and outgoings to the extent that they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, except where the losses or outgoings are capital, or of a capital, private or domestic nature.

A partnership is not a separate legal entity to that of its partners and, as such, cannot incur a deductible expense for tax purposes in relation to amounts paid to its partners (acting in that capacity). It follows that the payment by the Partnership to the Retiring Partners in respect of their loss of future income earning capacity cannot be taken into account as an allowable deduction (under section 8-1 of the ITAA 1997 or any other provision of that Act) in calculating the net income of the Partnership under section 90 of the ITAA 1936.

Additionally (and in any event), the payment by the Partnership to the Retiring Partners in respect of their loss of future income earning capacity is, for the reasons set out in explanation to question 2 of this ruling, an outgoing of capital or capital in nature, and therefore is not deductible under section 8-1 of the ITAA 1997 on that basis.

Question 2

Summary

The payments by the Partnership to the Retiring Partners in respect of their loss of future income earning capacity do not represent an individual interest of the Retiring Partners in the net income of the Partnership for the purposes of section 92 of the ITAA 1936.

Those payments should therefore not be disclosed in the Partnership’s income tax return for the income year ended 30 June 201Y as distributions of the Partnership’s net income to the Retiring Partners.

Detailed reasoning

In accordance with section 91 of the ITAA 1936, the Partnership is required to furnish a return of its income and, in doing so, is required to determine and disclose therein the individual interests of the partners in its net income for the year.

So much of a partner’s individual interest in the net income of a partnership of the year of income as is attributable to a period when the partner was a resident is included in the assessable income of the partner pursuant to paragraph 92(1)(a) of the ITAA 1936.

Amounts to which a partner is entitled upon retirement from a partnership are discussed in Taxation Determination TD 2015/91. In characterising an amount to which a partner becomes entitled upon their retirement from a partnership, TD 2015/9 states that it is necessary to consider what the amount represents, relates to or is attributable to (paragraph 17). To that end, paragraph 16 of TD 2015/19 states that it is necessary to identify whether (or the extent to which) such amount:

● represents the partner’s share of partnership net income;

● is assessable in the partner’s hands on revenue account on another basis; or

● otherwise relates to the disposal of the partner’s interest in partnership assets.

A partner’s individual interest in the net income of the partnership is a question of fact, to be determined by reference to any relevant documents, including the partnership agreement and the partnership’s accounting records (paragraph 23 of TD 2015/19).

While each case turns on its facts, the Commissioner also notes at paragraph 27 of TD 2015/19

that:

… an amount to which a partner is entitled upon retirement from a professional partnership will commonly be brought to account under section 92 only. This reflects the fact that most or all identifiable assets used in the partnership may be held by a service entity; and the partners may agree that nothing will be paid or received in respect of partnership goodwill upon entering or exiting the partnership.

Does the payment represent the partner’s share of partnership net income?

Each Retiring Partner’s share of partnership net income (being $XXX), calculated for the period 1 July 201X to the Departure Date; prepared as at the Departure Date in accordance with the Partnership Agreement and the Exit Agreement; and agreed to by both the Partnership and the Retiring Partners, was paid to them separate to the consideration paid to them under the Exit Agreement (including that which was attributed for their loss of future income earning capacity).

On an assessment of the prevailing facts, it is considered that the sum of $XXX represents each of the Retiring Partner’s complete interest in their share of partnership net income for the relevant period, and that the payment made to them by the Partnership for their loss of future income earning capacity therefore does not to any extent.

Is the payment assessable in the partner’s hands on revenue account on another basis?

Paragraph 30 of TD 2015/19 cites payments relating to partially completed work, or payments representing consideration for services rendered or a return on the investment of capital as examples of amounts that may be assessable in a partner’s hand on revenue account, but on a basis other than section 92 of the ITAA 1936.

There is no evidence to suggest that the payments made to the Retiring Partners in respect of the loss of future income earning capacity relate to any other type of assessable revenue, or that the Retiring Partners would have been entitled to such payments on any revenue basis had they remained in the Partnership.

Does the payment relate to the disposal of the partner’s interest in partnership assets?

As the payments by the Partnership to the Retiring Partners in respect of their loss of future income earning capacity do not represent their share of partnership net income, and are not assessable on other revenue account, it is open to conclude that the payments relate to the disposal of the Retiring Partners’ interest in partnership assets.

The Exit Agreement states that the consideration paid to the Retiring Partners upon their retirement on the Distribution Date (defined as the ‘Payment Amount’) shall be attributed to “each of the identifiable assets or asset classes being disposed”. The loss of future income earning capacity for the Retiring Partners is listed as one such asset or asset class being disposed of by the Retiring Partners.

The payments made by the Partnership in respect of the Retiring Partners’ loss of future income earning capacity are therefore considered to:

● represent the disposal of a capital asset by the Retiring Partners, being the surrender of their right to a share of future profits as a partner of the Partnership;

● have been part of the cost to the Partnership to acquire all of the assets of the Retiring Partners (for an amount the Partnership was willing to pay to acquire those assets, and the Retiring Partners were willing to accept); and

● be an outgoing of capital, or an outgoing capital in nature.

As the payments by the Partnership in respect of the loss of future income earning capacity of the Retiring Partners do not represent their individual interests in the net income of the Partnership for the purposes of section 92 of the ITAA 1936, the Partnership should not include these payments as distributions of the Partnership’s net income to the Retiring Partners in its income tax return for the income year ended 30 June 201Y.

Whilst this outcome differs to that which commonly arises upon a partner’s retirement from a professional partnership, as noted in paragraph 27 of the TD 2015/19, the facts relating to this ruling materially differ to those which commonly prevail and are contemplated by that paragraph.

Principally, that is that amounts were payable, and in the case of the Retiring Partners, were paid, in respect of partnership goodwill (valued at market value) upon entering and exiting the Partnership, in accordance with the terms of the Partnership Agreement.