Edited version of your written advice

Authorisation Number: 1051430328661

Date of advice: 25 September 2018

Ruling

Subject: Income tax- assessable income- ordinary income

Question 1

Is compensation received for termination of a contract which has resulted in loss of opportunity to earn further income, assessable income?

Answer

Yes

Question 2

Is the compensation payment received for termination of a contract capital in nature?

Answer

No.

Question 3

Is the compensation payment a taxable supply under section 9-40 of the Goods and Services Act 1999 (GST Act)?

Answer

Yes

This ruling applies for the following period:

Year ending 30 June 2018

The scheme commenced on:

1 July 2017

Relevant facts and circumstances

You are a sole trader operating a business.

You provide services in relation to the sale of communication systems and data.

You sub-contract to a communications company.

You receive commission income from the company for the services you provide.

The company holds a number of the agreements with other communication companies and businesses to provide communication systems and data.

One agreement was terminated due to a restructure within a communication company.

You were issued with a tax invoice for a payment of $XX, XXX.

The amount of $XX, XXX was paid for no longer having the rights to future income from the company’s contract for the provision and supply of communication systems and data

The amount of $XX, XXX was made up of commissions income.

You also received commission income from contracts held with other businesses.

Your business activity has not ceased as a result of the termination of the contract.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 subsection 6-5(2)

A New Tax System (Goods and Services Tax) Act 1999 section 9-5

A New Tax System (Goods and Services Tax) Act 1999 subsections 9-10(1)

A New Tax System (Goods and Services Tax) Act 1999 subsections 9-10 (2)

Reasons for decision

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a taxpayer includes income according to ordinary concepts (ordinary income).

Ordinary income has generally been held to include three categories, namely income from rendering personal services, income from property and income from carrying on a business such as commission income, incentive payments, dividends, gratuities, lease payments and hire charges.

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year.

An amount received in connection with the cancellation or variation of a contract or agreement made in the course of carrying on a business is usually of an income nature if the amount which it replaces would have been income. Where the cancellation or variation affects the framework of the business or causes a substantial part of the business to be lost then the amount received will be of a capital nature (Californian Oil Products Ltd (in liq) v. Federal Commissioner of Taxation (1934) 52 CLR 28; (1934) 3 ATD 10).

In Allied Mills Industries Pty Ltd v. Commissioner of Taxation (1989) 20 FCR 288; 89 ATC 4365 (Allied Mills’ Case), the taxpayer received a lump sum payment for giving up the right to manufacture and distribute certain biscuits. The taxpayer distributed several products and the biscuits were a substantial part of its business. However the biscuits were only a part of its business and the contract in question was only one of several made in the ordinary course of its business. The Full Federal Court held that the lump sum payment was revenue – the taxpayer did not part with a substantial part of its business or cease to carry on business, nor did it dispose of the fixed framework of the business (Van den Bergs v. Clarke, ([1935] AC 431 at 442). The lump sum was found to be compensation for the termination of the arrangements between the parties, which was properly characterised as a payment for the loss of profits cause by the termination.

Your circumstances are similar to Allied Mills’ Case in that you received a lump sum payment for the termination of services provided under an agreement. The payment represents a loss of commission income for current and future earnings and is ordinary income. The payment made was not to compensate for a loss of a substantial part of your business activity nor was the payment made for the disposal of part of your business structure. Accordingly, the payment is assessable as ordinary income under section 6-5 of the ITAA 1997 as the payment is not capital in nature.

Goods and services tax

In order for a payment to be consideration for a supply, there needs to be a nexus between the consideration and the supply. It is not sufficient for there to be a supply and a consideration. The consideration must be for the supply that is made.

Essentially, a supply is something which passes from one entity to another. The supply may be one of particular goods, services or something else.

The term 'supply' is defined very broadly in section 9-10 of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act) as 'any form of supply whatsoever'. Given the broadness of the term 'supply', an out-of-court settlement may relate to a supply.

Goods and Services Tax Ruling 2001/4 sets out the Commissioner’s views relating to GST consequences of court orders and out-of-court settlements. In relation to the meaning of supply, paragraphs 22 and 25 of GSTR 2001/4 says:

22. Essentially, a supply is something which passes from one entity to another. The supply may be one of particular goods, services or something else.

25. Subsection 9-10(2) refers to two aspects of a supply; the thing which passes, such as goods, services, a right or obligation; and the means by which it passes, such as its provision, creation, grant, assignment, surrender or release.

Paragraphs 106 to 109 of GSTR 2001/4 state:

106. Where the only supply in relation to an out-of-court settlement is a 'discontinuance' supply, it will typically be because the subject of the dispute is a damages claim. In such a case, the payment under the settlement would be in respect of that claim and not have a sufficient nexus with the discontinuance supply.

107. In most instances, a 'discontinuance' supply will not have a separately ascribed value and will merely be an inherent part of the legal machinery to add finality to a dispute which does not give rise to additional payment in its own right. They are in the nature of a term or condition of the settlement, rather than being the subject of the settlement.

108. We do not consider that the inclusion of a 'no liability' clause in a settlement deed alters this position. 'No liability' clauses are commonly included in settlement agreements and we do not consider their inclusion to alter the substance of the original dispute, or the reason payment is made.

109. We consider that a payment made under a settlement deed may have a nexus with a discontinuance supply only if there is overwhelming evidence that the claim which is the subject of the dispute is so lacking in substance that the payment could only have been made for the discontinuance supply.

A supply related to an out-of-court settlement may have occurred prior to the settlement, or it may be created by the terms of the settlement itself. There may be more than one supply that is related to a settlement. In addition, the subject of the dispute may not be a supply at all.

Supplies that are related to an out-of-court settlement fall within the three categories of supply described below:

1. Earlier supply - the subject of the dispute is an earlier transaction in which a supply was made involving the parties.

2. Current supply - a new supply created by the terms of the settlement.

3. Discontinuance supply - in finalising a dispute, the terms of a settlement will generally ensure no further legal action in relation to that dispute, provided that the terms of the settlement are complied with. This often takes the form of a plaintiff releasing a defendant from some (or all) of the existing claims and from further claims and obligations in relation to that dispute.

In most instances, a 'discontinuance' supply will not have a separately ascribed value and will merely be an inherent part of the legal machinery to add finality to a dispute which does not give rise to additional payment in its own right. They are in the nature of a term or condition of the settlement, rather than being the subject of the settlement.

The term 'consideration' is also very broadly defined in the GST Act. Consideration includes any payment, or any act or forbearance, in connection with, in response to or for the inducement of a supply of anything.

In terms of whether a payment pursuant to a settlement relating to proceedings before a court, paragraph 9-15(2A)(b) of the GST Act makes it clear that such payment does not prevent it from being consideration for a supply.

A sufficient nexus between a payment made under an out-of-court settlement and a supply must exist to create the 'supply for consideration' relationship.

In determining whether a sufficient nexus exists between supply and consideration, regard needs to be had to the true character of the transaction. An arrangement between parties will be characterised not merely by the description which parties give to the arrangement, but by looking at all of the transactions entered into and the circumstances in which the transactions are made.

Where a sufficient nexus exists between the payment made under a settlement and an earlier supply, a current supply or a discontinuance supply, the payment will be consideration for that supply.

In relation to a discontinuance supply, a payment made under a settlement deed may have a nexus with a discontinuance supply only if there is overwhelming evidence that the claim which is the subject of the dispute is so lacking in substance that the payment could only have been made for the discontinuance supply.

When a dispute is finalised, either by a court giving judgment or through negotiation of a settlement, the unsuccessful party in the action may be required to pay the costs or part of the costs that have been incurred by the successful party in bringing or defending the claim.

Where the terms of an out-of-court settlement include a dissection and itemisation of the payment into the heads of claim, that itemisation will be accepted as representing the amounts of these relevant parts to the extent that it is made on a reasonable basis.

Where no dissection is made and the payment has sufficient nexus to a supply and an item of damages which is not a supply, the payment needs to be apportioned into amounts representing these relevant parts in order that the correct GST consequences result. The apportionment should be determined by the parties on a reasonable basis.

Application to your case

The compensation payment provided to you was made up of commissions for existing and new business related to the supply of communication services and GST component. We consider that there is an earlier supply and discontinuance supply. There was consideration for these supplies and you are liable to pay GST.