Edited version of private advice

Authorisation Number: 1051999442531

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Date of advice: 5 July 2022

Ruling

Subject: Compensation

Question 1

Is the payment to the Taxpayer a payment to compensate for the loss of rights attached to their agreement for the purposes of section 104-25 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes. Capital Gains Tax (CGT) Event C2 occurred with the ending of the agreement.

This ruling applies for the following period: XXXX

Relevant facts and circumstances

The Taxpayer entered into a contractual arrangement with Manufacturer A after 20 September 1985 that entitled the Taxpayer to sell Manufacturer A's goods.

The agreement provides that the Taxpayer has no rights to goodwill from the use of Manufacturer A's trademarks.

Manufacturer A decided to cease manufacturing its goods.

The Taxpayer and Manufacturer A agreed to terminate the agreement.

Manufacturer A agreed to pay the Taxpayer an amount as compensation for terminating the agreement and for the Taxpayer granting full release of any claims under the agreement.

In the early years Manufacturer A's goods accounted for over 70% of the Taxpayer's sales, and

for the period prior to termination of the agreement for over 40% of all sales.

The Taxpayer determined their business would no longer be viable without the agreement with Manufacturer A. They formed this view by assessing the ongoing viability of the business without changes to their business including the introduction of new brands. Proactively entering into agreements to sell other brands was fundamental to the continued existence of the business.

Relevant legislative provisions

ITAA 1997 Section 6-5

ITAA 1997 Section 104-25

Reasons for decision

Issue 1

Question

Is the payment to the Taxpayer a payment to compensate for the loss of rights attached to their agreement for the purposes of section 104-25 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

The payment of Component 1 is a payment to compensate for the loss of the Taxpayer's rights attached to their agreement. Capital Gains Tax (CGT) Event C2 occurred with the ending of the agreement.

Detailed reasoning

Whether compensation for the termination of a contract is income or capital generally turns on the nature of the contract which generated the payment and the way in which the contract related to the Taxpayer's business structure.

Where the payment replaces lost profits and/or the existing business continues in largely the same form, then the payment is more likely to be on revenue account.

Where the payment is for the loss of the entirety or a substantial part of the recipient's profit yielding structure, such that the business ceases or the effect on the business is such that its nature is substantially transformed, then the payment is more likely to be capital in nature. (See e.g. Allied Mills Industries Pty. Ltd. v. Federal Commissioner of Taxation 89 ATC 4365, Moneymen Pty. Ltd. v. Federal Commissioner of Taxation 90 ATC 4615, ESSO Australia Resources Ltd (formerly ESSO Exploration and Production Australia Incorporated) v FC of T 98 ATC 4768).

Commrs of Inland Revenue v. Fleming & Co. (Machinery), Ltd. (1951) 33 T.C. 57, illustrates how you may apply these principles to determine whether your business continues in largely the same form or otherwise:

The sum received by a commercial firm as compensation for the loss sustained by the cancellation of a trading contract or the premature termination of an agency agreement may in the recipient's hands be regarded either as a capital receipt or as a trading profit... When the rights and advantages surrendered on cancellation are such as to destroy or materially to cripple the whole structure of the recipient's profit-making apparatus, involving the serious dislocation of the normal commercial organisation and resulting perhaps in the cutting down of ...staff previously required, the recipient of the compensation may properly affirm that the compensation represents the price paid for the loss or sterilisation of a capital asset and is therefore a capital and not a revenue receipt... On the other hand when the benefit surrendered on cancellation does not represent the loss of an enduring asset in circumstances such as those above mentioned - where for example the structure of the recipient's business is so fashioned as to absorb the shock as one of the normal incidents to be looked for and where it appears that the compensation received is no more than a surrogatum for the future profits surrendered - the compensation received is in use to be treated as a revenue receipt and not a capital receipt.

The Commissioner considers that the payment to the Taxpayer is compensation for the impact of Manufacturer A's decision on the Taxpayer's business such that the ending of the agreement would have caused a loss to the Taxpayer of over 40% of its business.

Accordingly, it is considered that, but for the seeking out of business ties/agreements with other manufacturers, the ending of the agreement would have brought the Taxpayer's business to an end. Proactively seeking out new business ties should not affect the taxation treatment of the amounts received.

In Allied Mills, the Court made the following observations:

30. The distribution arrangements between the appellant and Arnotts accounted for a substantial percentage of the turnover of the Grocery Products Division of the appellant. It is not appropriate, however, to view the separate divisions of the appellant as separate entities. The appellant is a large company arranged in a divisional structure and conducted as a single corporate concern. The separate divisions, whilst maintaining some degree of autonomy, are responsible to the same executive management and share common objectives and concerns. Indeed, the very distribution agreement in question was evaluated, not simply with respect to the Grocery Products Division to which it directly applied, but also with respect to the wider impact on the corporate body and in particular on the Flour, Starches and Flavour Division and the Edible Oils Division.

31. The activities and structures of the appellant as a whole must be considered in determining whether the rights of the appellant which were terminated by the 1977 agreement constituted a structural asset. Normally 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. Here the appellant was not parting with a substantial part of its business or ceasing to carry on business as was the case in Californian Oil Products. Furthermore the appellant was not disposing of part of the fixed framework of its business in the sense required by Van den Berghs v Clark. The contracts here in themselves yielded profit; they did not simply provide the means of making profit.

32. Also, the arrangements between the appellant, Peek Frean Australia and its parent and later, Arnotts, fluctuated considerably over the years of their existence in the sense that there was no element of permanence in them; they were varied not infrequently during a period of a few years and primarily with reference to matters concerning the distribution arrangements for the sale of Peek Frean products and Vita Weat biscuits. In no real sense therefore could the payment be considered as a payment for the giving up of a capital asset.

The Taxpayer acquired the business and developed it, since entering into the agreement in 1957, into what was essentially a seller of Manufacturer A's goods. To commence undertaking changes to the business structure in anticipation of the consequences of the termination of the agreement, i.e. recognising that the business would not survive without replacing the agreement with other manufacturers goods (similar to Manufacturer A's goods), should not lead to the conclusion that the agreement did not constitute a structural asset. Notwithstanding the declining percentage of sales of Manufacturer A's goods since 20XX, it accounted for a significant percentage of the Taxpayer's sales of those goods and overall business turnover at the time it was anticipated that the agreement would be terminated. This can be contrasted with Allied Mills where, although the loss of the contract significantly affected the profitability of one of their divisions, this was but one of eight divisions through which the company operated. The Taxpayer's very existence would not have been viable following the end of Manufacturer A but for changes made to the business including the creation of business ties/agreements with new manufacturers.

Accordingly, the Commissioner considers the payment to be capital in nature and would be treated under the capital gains tax provisions, including whether those provisions give rise to statutory income under section 6-10 of the ITAA 1997.

The asset being compensated for is the rights which attach to the agreement which has come to an end. No amount of the termination payment is considered compensation for the loss of goodwill. Relevantly, the agreement provides that the Taxpayer has no rights to goodwill from the use of Manufacturer A's trademarks.

Accordingly, Capital Gains Tax (CGT) Event C2 occurred with the ending of the agreement (section 104-25 of the ITAA 1997).

The Commissioner accepts that in these circumstances that both parties intended for the agreement to simply be extended and the Taxpayer's rights under the agreement were effectively acquired when the Taxpayer first entered into the agreement.