Edited version of private advice

Authorisation Number: 1052031860396

Date of advice: 9 September 2022

Ruling

Subject: Liabilities related to entity's CGT assets

Question

Will the payment constitute a liability when determining the net asset value of CGT assets of the Trust under subsection 152-20(1) of the Income Tax Assessment Act 1997?

Answer

Yes

This ruling applies for the following period:

1 July 2021 to 30 June 2022

The scheme commences on:

1 July 2021

Relevant facts and circumstances

Company A is the trustee for a Trust.

The Trust currently trades as Entity A operating in a service industry.

Individual A previously operated a service business which was established by the Trust.

Individual B was employed as a director of the business where they met Individual A.

Individual A approached Individual B with a plan to open a new service business.

Individual A informed Individual B of their intention to start the business and grow it with the ultimate aim of selling the business at a future time. It was known to both parties that Individual A would not continue with the plan to open the business without Individual B's assistance.

As part of the offer, Individual A promised Individual B that they would receive a share of the sale proceeds of the business as an incentive.

Individual B verbally promised Individual A that she would accept the offer once the business is established.

The business was established in early 20XX.

In 20XX, Individual B entered into a contract with the Trust.

The contact was between the Trust and Company B. Company B being Individual B's company.

The contract incorporated the verbal agreement between Individual A and Individual B in that Individual B would receive a share of the sale proceeds on the sale of the business (the Incentive Bonus).

Individual B's entitlement to remuneration is contained in the contract and provides for regular remuneration.

Individual B's entitlement to an additional Incentive Bonus was set out in contract between Company B and the Trust.

The Incentive Bonus payment of a percentage of the nett sale price was an incentive to motivate Individual B to bring the business to its peak in a two year period to ensure the business could be sold quickly and at a higher price.

In 20XX, the Trust entered into a Business Sale Agreement with Company C to sell the business and associated assets.

Company C is not a related party or associated to either Individual A or B.

The amount offered for the business is an offer from a genuine third party who is assumed to have done their due diligence on the business purchase.

On completion of the sale, Individual B had met all of their obligations under the contact. They had no further obligations to the business nor to the Trust.

In 20XX, Company B issued a tax invoice to the Trust representing the Incentive Bonus payment of a percentage of the nett sale price as a result of the sale of the business.

The balance sheet of the Trust did not recognise any liability for the provision for the payment of the Incentive Bonus. Even though the contingent liability was not on the balance sheet of the Trust, there was a contract which could be enforced by Individual B at the time of the sale.

In 20XX, Company C paid an amount to Company B and the Trust.

Relevant legislative provisions

Section 152-10 of the Income Tax Assessment Act 1997

Section 152-15 of the Income Tax Assessment Act 1997

Section 152-20 of the Income Tax Assessment Act 1997

Reasons for decision

Subdivision 152-A of the Income Tax Assessment Act 1997 (ITAA 1997) sets out the 'basic conditions' which must be satisfied in order for small business entities to qualify for any of the CGT small business concessions to reduce their capital gain by the various concessions in Division 152.

To qualify for the small business CGT concessions, at least one of the conditions in paragraph 152-10(1)(c) of the ITAA 1997 must be satisfied. One of these conditions is the maximum net asset value test in section 152-15. Under this test, the net value of the CGT assets of the taxpayer and certain related entities must not exceed $6 million just before the relevant CGT event.

The net value of the CGT assets of an entity is defined in subsection 152-20(1) of the ITAA 1997 as:

The 'net value of the CGT assets' of an entity is the amount (whether positive, negative or nil) obtained by subtracting from the sum of the market values of those assets the sum of:

                  (a)        the liabilities of the entity that are related to the assets; and

                  (b)        the following provisions made by the entity:

                          (i)        provisions for annual leave

                         (ii)        provisions for long service leave

                        (iii)        provisions for unearned income, and

                       (iv)        provisions for tax liabilities.

Taxation Determination TD 2007/14 Income tax: capital gains: small business concessions: what 'liabilities' are included in the calculation of the 'net value of the CGT assets' of an entity in the context of subsection 152-20(1) of the Income Tax Assessment Act 1997? (TD 2007/14) provides some guidance on the term liabilities when considering the meaning of net value of the CGT assets of an entity.

Paragraph 1 of TD 2007/14 states:

The term 'liabilities' in the context of subsection 152-20(1) of the Income Tax Assessment Act 1997 has its ordinary meaning. 'Liabilities' extend to legally enforceable debts due for payment and to presently existing legal or equitable obligations to pay either a sum certain or ascertainable sums. It does not extend to future obligations, expectancies or liabilities that are uncertain as both a theoretical and a practical matter (Commissioner of Taxation v. Byrne Hotels Qld Pty Ltd [2011] FCAFC 127 at 122) (Byrne Hotels).

Paragraphs 17 through to 19 of TD 2007/14 states:

17. The term 'liabilities' is not defined for the purposes of the 'net value of the CGT assets' definition. Accordingly, it has its ordinary meaning reflecting the context in which it is used. The Macquarie Dictionary, revised 3rd edition, defines liability to mean: 'an obligation, especially for payment; debt or pecuniary obligation'.

18. In the context of subsection 152-20(1), 'liabilities' extend to legally enforceable debts due for payment and to presently existing legal or equitable obligations to pay either a sum certain or ascertainable sums. The term does not extend to future obligations or expectancies. The question of whether the term 'liabilities' extends to contingent liabilities was considered by the Full Federal Court in Commissioner of Taxation v. Byrne Hotels Qld Pty Ltd [2011] FCAFC 127.

19. A 'contingent liability' is a liability which will become due only on the occurrence of an event that may or may not happen. An example is a possible obligation to pay damages in future if the judgment in a pending lawsuit is unfavourable.

Paragraphs 21 and 22 of TD 2007/14 states:

21. The 'liabilities of the entity that are related to the assets' in subsection 152-20(1) include liabilities directly related to particular assets that are themselves included in the calculation, for example, a loan to finance the purchase of business premises.

22. The 'liabilities of the entity that are related to the assets' also include liabilities that, although not directly related to one particular asset, are related to the assets of the entity more generally, for example, a bank overdraft or other short term financing facility that provides working capital for the operation of the business.

Greenwood J in Commissioner of Taxation v. Byrne Hotels Qld Pty Ltd [2011] FCAFC 127 reached a conclusion about the real estate agent's commission which he held to be a liability at the relevant time. Although he referred to the agent's commission as a contingent liability or a contingent burden (at paragraphs 123, 125, 126, 127), he noted (at paragraph 122) that, while the agent's entitlement to be paid its commission was dependent on the contingency of the taxpayer entering into the sale contract, immediately before the signing of the contract all terms had been agreed and nothing remained to be done by the agent to perfect its entitlement to the commission. The only contingency was the formality of signing. Greenwood J went on to say (at paragraph 122):

just before the CGT event, a liability resided in the taxpayer arising out of the pre-existing contract with [the agent] subject only to the translation of the decision already made to sell...into the act of execution of the contracts. Just before the CGT event the obligation was not 'truly contingent' in the sense of being 'uncertain as both a theoretical and practical matter'.

And further at paragraphs 124 and 125:

However, it is important to recognise that just before the CGT disposal event occurred by entering into the written instruments with MGW thus giving legal effect to the decision to sell on the terms of the contracts, the obligation had arisen subject to the formal step of signing.

Just before the CGT disposal event, the taxpayer was a ready and willing seller and the buyer was a ready and willing buyer, intending to complete the transaction by settlement of each contract......Although the liability of the entity was, just before the CGT disposal event, a contingent one, the [potential] events subsequent operated as a qualification on the obligation rather than matters which, properly construed, give rise to a conclusion about the nature of the relationship between the agent and the taxpayer such that no obligation concerning the benefits and burdens of the contract subsisted.

Company B entered into a contract with the Trust which included payment of an incentive Bonus payment of a percentage of the nett sale price of selling the business. This obligation remained in place provided that Individual B (through Company B) was working/employed as a consultant to the business at the time of the sale. This effectively retained Individual B's services/expertise to the business. It can be inferred that the purpose of entering the contract was to attract and grow the business to a larger extent through their ability to run the business more effectively, and/or attract more business through their reputation and expertise.

Just before the CGT A1 event, being the signing of the business sale agreement between the Trust and Company C, a liability resided in the Trust arising out of the pre-existing contract with Company B. This liability was subject to the selling of the business, and entering into the act of execution of the agreement with Company C.

In the context of subsection 152-20(1) of the ITAA 1997, 'liabilities' extend to legally enforceable debts due for payment and to presently existing legal or equitable obligations to pay either a sum certain or ascertainable sums.The payment representing the incentive bonus payment of the nett sale price satisfies subsection 125-20(1) as it's a liability relating to the business just before sale.

Accordingly, the incentive bonus constitutes a liability of the Trust under subsection 152-20(1) of the ITAA 1997 just before the CGT event. The payment is a liability related to the CGT assets of the business and should be taken into account when determining the net asset value of the CGT assets of the Trust.