Edited version of private advice

Authorisation Number: 1051897173888

Date of advice: 10 September 2021

Ruling

Subject: Partnership salary agreement

Question 1

If partnership profits are agreed, prior to the end of each income year, to be distributed to Partners based on the level of involvement in the Partnership's business, will this be taken into account in determining each partner's respective individual interest in the net income of the Partnership under subsection 92(1) of the Income Tax Assessment Act 1936?

Answer

Yes

Question 2

If the answer to question 1 is yes, is any amount of the Partners' share of the net income of the partnership personal services income of the respective representative of the partner under section 84-5 of the Income Tax Assessment Act 1997?

Answer

No

Question 3

If the answer to question 1 is yes, will the agreement to distribute Partnership profits based on level of involvement in the Partnership business result in a capital gain under Parts 3-1 and 3-3 of the Income Tax Assessment Act 1997?

Answer

No

This ruling applies for the following periods:

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Partnership is in the business of supplying XXXXX products.

Most of the Partners act in their capacity as the sole trustee of a respective discretionary trust.

Most of the individual directors for the trustees are actively involved in the day-to-day operations of the partnership business.

The Partnership has engaged a company to act as agent in managing the partnership business. There is no separate Agency Agreement, details of the Agents authority and undertakings are detailed in the Partnership Agreement. The company is not entitled to remuneration for acting as agent.

The directors of the company are not remunerated for acting as directors.

The Partners have agreed to split the profits of the Partnership in a manner which reflects the respective contributions of the Partners in running and managing the business through their respective representatives, as well as reflecting the equity contribution that each Partner has made. Each year, prior to 30 June, the Partners agree to an amount of 'partnership salary' to be paid to the Partners based on services provided by the Partner, or a representative of the Partner.

Relevant legislative provisions

Income Tax Assessment Act 1997

section 8-1

Division 84 of Part 2-42

section 84-5

Section 102-20

Section 104-5

Section 104-10

Section 104-25

Section 104-35

Income Tax Assessment Act 1936

Division 5 of Part III

Subsection 92(1)

Reasons for decision

Question 1

Summary

In determining each Partner's respective interest in the net income of the partnership, any agreement made to distribute the profit of the Partnership based on level of involvement in the Partnership business will be taken into account, provided it is made prior to the end of the income year.

Detailed reasoning

The assessing provisions in respect of partnerships are contained in Division 5 of Part III of the Income Tax Assessment Act 1936 (ITAA 1936).

Subsection 92(1) of the ITAA 1936 describes what will be included in the assessable income of a partner in a partnership. This amount is comprised of the individual interest of the partner in the net income of the partnership.

Taxation Ruling TR 2005/7 Income tax: the taxation implications of 'partnership salary' agreements (TR 2005/7) considers the assessability to a partner of what is referred to as 'partnership salary' drawn by the partner, whether or not the amount is for personal services provided by the partner.

'Partnership salary' is not a true salary, it describes any form of remuneration drawn by a partner from the partnership funds for acting in the partnership business, as agreed among the partners, where the "salaried" partner receives a fixed part of the profits of the partnership before the remaining part falls to be divided among the partners in the appropriate proportions. As paragraph 16 of TR 2005/7 explains:

'The courts have characterised agreements under which a 'partnership salary' is to be drawn by a partner from partnership funds as not creating a contract of employment or contract for the services of the partner, but rather as an agreement to vary the sharing of partnership profits between the partners...'

The agreement between partners to allow a 'partnership salary' to be drawn varies the recipient partners' interest in the partnership profits and losses. It is taken into account in determining that partner's interest in the net income of the partnership under subsection 92(1) of the ITAA 1936.

The recipient partner's interest in the net income of the partnership will include the partnership salary to the extent that there is available net income. However, the 'partnership salary' is still regarded as constituting part of the profits of the partnership. Where the profits of the partnership are not sufficient to cover the 'partnership salary' agreed, the amount is considered an advance of future profits and is assessed in a future year, when profits are sufficient. This is detailed in paragraph 9 of TR 2005/7:

'If in a particular income year the 'partnership salary' drawn by a partner exceeds the recipient partner's interest in the available net income of the partnership, the excess advanced to the partner is not, at that time, assessable income of the partner under subsection 92(1) of the ITAA 1936. Nor is an advance of future profits assessable under section 6-5 of the ITAA 1997. An advance of future profits is assessable to the partner in a future income year when sufficient profits are available the partners' interest is accounted for under subsection 92(1) of the ITAA 1936 in determining his or her interest in the net income of the partnership in that year.'

It is essential that a partnership salary agreement is put into place prior to the end of the financial year to be effective for tax purposes. Paragraph 10 of TR 2005/7 states:

'An agreement by the partners of a partnership to allow a partner to draw a 'partnership salary' is a contractual agreement among the partners to vary the interests of the partners in the partnership (and thus the partnership net income) between the partners. For such an agreement to be effective for tax purposes in an income year the agreement must be entered into before the end of that income year (FCT v. Galland (1986) 162 CLR 408; (1986) 18 ATR 33; (1986) 86 ATC 4885, AAT Case 5303 (1989) 20 ATR 3905; Case W79 89 ATC 705 (Galland)).'

As 'partnership salaries' are considered a distribution of partnership profits, it is not an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) and it does not form part of the calculation of net income or loss of the partnership under section 90 of the ITAA 1936.

The Partnership is a partnership in the ordinary sense, that is an association of persons carrying on a business as partners. 'Persons' is a reference to any type of entity considered a person for legal purposes. The Partnership consists of different types of partners including individuals, companies and corporate trustees, all of these entities are 'persons' for legal purposes. Thus TR 2005/7 is applicable to this arrangement as described in paragraph 4 of the Ruling.

Various members of the Partnership provide services to the Partnership in the form of active participation in the business. As some of the members are companies, or corporate trustees, the services are provided by the individual directors of those companies on behalf of the Partner.

Each year, prior to 30 June, the Partners agree to an amount of 'partnership salary' to be paid to the Partners based on services provided by the Partner, or a representative of the Partner.

The 'partnership salary' amounts are considered to be part of the Partnership profits, which are distributed to the 'salaried' Partners before the remaining part of the profit falls to be divided amongst the Partners in accordance with the Partnership agreement.

As detailed in paragraph 8 of TR 2005/7, the agreement to allow a partnership salary to be drawn varies the recipient partners interest in the partnership profits and losses. It is taken into account in determining that partners interest in the net income of the partnership under subsection 92(1) of the ITAA 1936. The recipient Partners interest in the net income will include the Partnership salary to the extent that there is available net income.

Question 2

Summary

The amount of the Partner's share in the net income of the Partnership is not considered to be personal services income in the hands of the representative of the Partner that has provided services to the Partnership.

Detailed reasoning

Personal Services Income (PSI) is income that is mainly a reward for an individual's personal efforts or skills (or would mainly be such a reward if it was the income of the individual).Taxation Ruling TR 2001/7 Income tax: the meaning of personal services income (TR 2001/7) explains in more detail the meaning of PSI contained in Division 84 of Part 2-42 of the ITAA 1997. TR 2001/7 states the following:

29. The meaning of personal services income is wider than that which might otherwise be the case under the common law, but it does not include income that is mainly:

• from an entity supplying goods or granting a right to use property;

• generated by assets an entity holds; or

• generated by the business structure.

30. Where personal services are provided that are ancillary to:

(a) the sale or supply of goods;

(b) the granting of a right to use property;

(c) the supply and use of assets that have a significant role in the generation of the income; or

(d) the generation of the income by the business structure,

the income so generated is not personal services income.

The income of the Partnership is derived from the sale of goods, it is not PSI.

As described in TR 2005/7 at paragraph 15:

'A partnership is not a legal entity with its own personality and existence separate and distinct from the partners (Rose v. FC of T (1951) 84 CLR 118) and the ITAA 1936 does not modify this principle for the purposes the income tax law. A partner is an owner of the partnership business with his or her co-partners, and is entitled, with his or her partners, to an undivided share in all the assets of the business. The relations between the partners, including their share of the profits and assets of the business and the distributions and payments of funds are agreed internally between the partners.'

As the Partnership is not a separate legal entity, the income from the Partnership in the hands of the Partners is a distribution of those Partnership profits. As the income of the Partnership is not PSI, the distribution of that income to the Partners is also not PSI. This principle is not altered where there is an individual representative providing services on behalf of the Partner. The agreement between the Partners to share the profits is a profit distribution agreement, not a contract for the services of a Partner and not a contract of employment. This is made clear in TR 2005/7 at paragraph 16:

'The courts have characterised agreements under which a 'partnership salary' is to be drawn by a partner from partnership funds as not creating a contract of employment or contract for the services of the partner, but rather as an agreement to vary the sharing of partnership profits between the partners (for example Ellis v. Joseph Ellis & Co [1905] 1 KB 324, Mackinlay (Inspector of Taxes) v. Arthur Young McClelland Moores & Co, [1990] 2 AC 239 (MacKinlay)). An agreement to pay a 'partnership salary' to a partner for his work as a partner is an internal agreement as to how the partnership funds will be applied as between the partners, and is enforceable on the taking of partnership accounts. A 'partnership salary' is a distribution of partnership funds to a partner, and does not have the character of an expense of the partnership (MacKinlay).'

In conclusion, the representatives of the Partners, providing services to the Partnership, are not considered to be receiving PSI as the income of the Partners is not PSI.

Question 3

Summary

The agreement to pay a 'partnership salary' in a given year, will not result in a capital gain.

Detailed reasoning

A capital gain may arise when a CGT event happens to a CGT asset or a part of a CGT asset. Partnership interests are included as CGT assets.

Partnership Interest

A partnership interest is a share in the surplus upon realisation of the partnership assets after the payment of partnership liabilities. This is discussed in FC of T v Everett (1980) 80 ATC 4076 (Everett), at [4079]:

'His share in the partnership consists of a right to a proportion of the surplus after the realization of the assets and payment of the debts and liabilities of the partnership (Bakewell v. D.F.C. of T. (S.A.) (1937) 58 C.L.R. 743, at p. 770; Bolton v. F.C. of T. (13 A.T.D. 378, at p. 382)). Historically the interest of a partner in a partnership has been considered to be an equitable interest because it is a right or interest enforceable in equity and not at law (Bolton).'

Included in a partnership interest is also a right to receive a share of the profits of the partnership. These rights are determined by the partnership agreement or in the absence of the necessary clauses, by the relevant state legislation. The right to a share of partnership profits is inseverable from the actual partnership interest and therefore cannot be disposed of separately. In Everett the High Court stated the following:

'The fundamental consideration, as we see it, is that the partner's fractional interest is an entire chose in action; it is capable of division by assignment into further fractions, but it is not capable of division by assignment so that the right to participate in partnership profits which is inherent in the interest is hived off from the rest of that interest. Consequently, a partner's entitlement to participate in profits is not separate and severable from the interest of the partner.'

The interest in the profits of the partnership is separate from the actual division of those profits amongst the partners. Taxation Determination TD 2015/19 Income tax: if a retiring partner is entitled to an amount representing their individual interest in the net income of the partnership for an income year, will section 92 of the Income Tax Assessment Act 1936 apply? (TD 2015/19) Paragraph 24:

'At general law, a partner has an individual interest in the net income of a partnership, even though the precise amount of their interest cannot be determined until the accounts are prepared in respect of the relevant period.[6] This interest exists independently of any actual division of profits or net income, reflecting that the collective income earned by the partnership belongs to the partners according to their partnership shares.[7] ...'

The effect of an agreement to pay a 'partnership salary' is that the partner receives a fixed part of the profits of the partnership before the remaining part falls to be divided among the partners in the appropriate portions. The partnership salary still forms part of the profits of the partnership. In other words, the 'partnership salary' amounts drawn by the partner during the year are advances. In paragraph 17 of TR 2005/7 it is stated:

'The entitlement of a partner to a distribution of profits is merely a part of his fractional interest as a partner in the partnership profit; it is not severable from his interest as a partner (FC of T v. Everett (1980) 143 CLR 440; (1980) 10 ATR 608; (1980) 80 ATC 4076 at CLR 450; ATR 613; ATC 4081). The effect of an agreement to pay a 'partnership salary' is that the partner receives a fixed part of the profits of the partnership before the remaining part falls to be divided among the partners in the appropriate proportions. The amounts distributed to the partner are brought into account in computing that partner's interest in the profits or assets of the partnership. However, the 'partnership salary' is still regarded as constituting part of the profits of the partnership (Watson v. Haggitt [1928] AC 127, MacKinlay). In other words, the 'partnership salary' amounts drawn by the partner during the year before partnership accounts are taken and the partnership profit (or loss) ascertained are merely advances.'

CGT Events

CGT events are listed in the table at section 104-10 of the ITAA 1997. When deciding if a CGT event has happened in relation to a taxpayer, each such occurrence must be considered in light of all possible CGT events. The following CGT events are relevant in the current situation:

•         A1 - Disposal of a CGT asset

•         C2 - Cancellation, surrender and similar endings

•         D1 - Creating contractual or other rights.

By agreeing to pay 'partnership salaries' the Partners of the Partnership have effectively agreed to pay specified Partners an advance on their share of the Partnership profits for that year. They have not extinguished any Partners right to a share in Partnership profits, these profits will still be divided amongst the Partners in their specified portions, after the 'partnership salary' is paid.

In addition, the decision to pay a 'partnership salary' has not varied the Partners interest in the Partnership. Each Partner still has a right to a share in the surplus upon realisation of the Partnership assets after the payment of Partnership liabilities. The share of this surplus is not altered by the agreement.

The effect of the 'partnership salary' agreement is to vary the way the Partnership profits are distributed and can be described as an advance of those profits. A Partner's entitlement to participate in the profits of the Partnership is not separate and severable from the interest of the Partner. Changing the way the profit is distributed does not change the Partner's entitlement to participate in the profits of the Partnership nor does it alter the interest of the Partner.

CGT event A1 can only occur if there is a change of ownership of the CGT asset. As there has not been a change of ownership of the partnership interest, CGT event A1 has not occurred.

CGT event C2 occurs when an intangible asset has come to an end by way of cancellation, surrender, discharge, etc. As the interests in the partnership continue to exist, CGT event C2 has not occurred.

CGT event D1 may occur when contractual, legal or equitable rights in another entity have been created. The 'partnership salary' agreement has not resulted in any new rights being created. The partnership interest is an equitable right which has existed since the partners entered the partnership. There is no right to partnership profits created as this right is already in existence at the time of the agreement.

As the agreement to distribute Partnership profits based on level of involvement in the Partnership business does not meet any of the requirements of the relevant CGT events it can be concluded that there is no CGT event. As there is no CGT event, there is no capital gain.