Edited version of private advice

Authorisation Number: 1052059168962

Date of advice: 23 December 2022

Ruling Subject: Goodwill

Question

Did Mr A make a capital gain under Division 104 of the Income Tax Assessment Act 1997 (ITAA 1997) as a result of the sale of the accounting practice (the practice)?

Answer

No.

Question 2

Did Co. A make a capital gain pursuant to CGT event A1 under section 104-10 of the ITAA 1997 as a result of the disposal of goodwill in connection with the sale of the practice?

Answer

Yes.

This ruling applies for the following periods:

Income year ended 30 June 20XX

Income year ending 30 June 20XX

Relevant facts and circumstances

Mr A started the practice as a sole practitioner prior to 20 September 1985.

In 19XX, the practice began to be conducted by Co. A, a company owned and controlled by Mr A.

For each year during which the practice was conducted by Co. A, the income of the practice was paid to Mr A on the basis that it was treated as his personal exertion income.

In 19XX, Co. A received a private ruling from the Commissioner confirming that no goodwill will be disposed of by Co. A if Mr A were to operate the practice as a sole practitioner again.

The reason for this ruling decision was that the goodwill of the practice at the time was considered to be personal goodwill and therefore was incapable of being transferred to Co. A in 19XX (when the practice began to be conducted by Co. A) and remained with Mr A since it was originally acquired (i.e. prior to 20 September 1985).

Mr A did not revert to being a sole practitioner and continued to conduct the practice in Co. A until 20XX.

Since 20XX, and pursuant to the terms of a License Agreement, Co. A granted a license of the practice to the Trust.

The Trust is a discretionary trust established for the benefit of Mr A and his family. For each year during which the practice has been conducted by the Trust, the income of the practice, included in the net income of the Trust, has been allocated to Mr A on the basis that it was treated as his personal exertion income.

The loyalty of the clients to the practice has always been to Mr A personally. The nature and character of the business undertaken has not changed since its creation.

Co. A has recently entered into a contract for sale in respect of the practice to an unrelated party. Mr A will retire as a practitioner upon settlement of the contract.

Relevant legislative provisions

Income Tax Assessment Act Division 104

Income Tax Assessment Act section 104-10

Income Tax Assessment Act subsection 104-10(1)

Income Tax Assessment Act subsection 104-10(2)

Income Tax Assessment Act subsection 104-10(3)

Income Tax Assessment Act section 104-25

Income Tax Assessment Act subsection104-25(1)

Income Tax Assessment Act subsection 104-25(5)

Income Tax Assessment Act section 108-5

Income Tax Assessment Act paragraph 108-5(2)(b)

Reasons for decision

Subsection 104-10(1) of the ITAA 1997 provides that CGT event A1 happens if you dispose of a CGT asset.

Subsection 104-10(2) of the ITAA 1997 provides:

You dispose of a CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law. However, a change of ownership does not occur if you stop being the legal owner of the asset but continue to be its beneficial owner.

Most CGT events (like CGT event A1) involve a CGT asset. A CGT asset is defined in section 108-5 of the ITAA 1997 and includes any kind of property. Paragraph 108-5(2)(b) of the ITAA 1997 confirms that goodwill is a CGT asset.

Goodwill is not defined in the tax law. For the purposes of the definition of CGT asset in section 108-5, goodwill has the meaning it bears under the general law. It is the legal definition of goodwill as explained by the High Court in FC of T v Murry 98 ATC 4585 (Murry), rather than its accounting and business definitions, which applies.

In Murry, the High Court set out the principles of goodwill for tax purposes. It said that:

Goodwill is inseparable from the conduct of a business. It may derive from identifiable assets of a business, but is an indivisible item of property, and it is an asset that is legally distinct from the sources...that have created the goodwill. Because this is so, goodwill does not inhere in the identifiable assets of a business, and the sale of an asset which is the source of goodwill, separate from the business itself, does not involve any disposition of the goodwill of the business.[1]

Paragraph 12 of Taxation Ruling TR 1999/16 Income Tax: capital gains: goodwill of a business (TR 1999/16) states:

... goodwill is the product of combining and using the tangible, intangible and human assets of a business for such purposes and in such ways that custom is drawn to it. The attraction of custom is central to the legal concept of goodwill. Goodwill is a quality or attribute that derives among other things from using or applying other assets of a business. It may be site, personality, service, price or habit that obtains custom...

In addition, it is not accurate to describe goodwill as being composed of elements. Instead, it is more accurate to refer to goodwill as having sources.[2] It exists as its own intangible property separate and legally distinct from the assets from which it emanates. The Commissioner interprets this to mean that goodwill is separate from other assets including intangible assets and items of intellectual property such as trademarks, patents, copyright or registered designs.[3]

For this reason, goodwill cannot be dealt with on its own, nor can it be severed into parts identified by reference to their source. It is one part of a complete whole. In this context, Barwick CJ in Geraghty v Minter (1979) 142 CLR 177 described goodwill as 'in itself...indivisible, though its value, when realized (sic), may be shared in proportions'.[4]

Relevantly, paragraph 59 of TR 1999/16 explains that personal goodwill is not transferable. It says:

If a sole practitioner disposes of their business, the part of the goodwill of the business that emanates from their personality, reputation, skills or attributes is not transferable. Similarly, if key employees of the sole practitioner are not employed by the purchaser on the disposal of the business, any part of the goodwill that emanates from their personality, reputation, skills or attributes is also not transferable. However, other sources of goodwill continue to draw custom to the business even though the owner or employee has no further connection with the business and, in that respect, the goodwill can be sold.

(emphasis added)

The personal attributes possessed by Mr A and comprising his personal goodwill are so intimately identified with, and inseparably attached to, Mr A that his withdraw from the business diminishes the value of its goodwill. They are inherently unique to Mr A and are therefore incapable of transfer.

There will therefore be no change of ownership in respect of Mr A's personal goodwill at settlement of the contract for sale of the practice for the purposes of constituting a disposal to which CGT event A1 under section 104-10 of the ITAA 1997 applies.

Subsection 104-25(1) of the ITAA 1997 provides that CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset:

(a) being redeemed or cancelled; or

(b) being released, discharged or satisfied; or

(c) expiring; or

(d) being abandoned, surrendered or forfeited; or

(e) if the asset is an option - being exercised; or

(f) if the asset is a convertible interest - being converted.

Mr A's personal goodwill will be abandoned or surrendered (i.e. end) when settlement of the contract for sale of the practice happens and Mr A retires.

Mr A is not expected to make a capital gain under section 104-25 of the ITAA 1997 from the ending of his personal gain as there will be no capital proceeds from the ending. In any event, any capital gain (if it were to arise) or capital loss made by Mr A in respect of the ending of his personal goodwill is disregarded under subsection 104-25(5) of the ITAA 1997 because that asset was acquired before 20 September 1985 (at the time of its original creation).

Although the personal skills and attributes of Mr A that have contributed to goodwill are not transferable, any payment made by the purchaser of the practice under the contract for sale for the goodwill built up from those attributes and other sources will give rise to CGT event A1 for Co. A.

Pursuant to subsection 104-10(3) of the ITAA 1997, the time of that event for Co. A was when it entered into the contract for the disposal.

[1] FC of T v Murry [1998] HCA 42.

[2] FC of T v Murry [1998] HCA 42.

[3] Taxation Ruling TR 1999/16, paragraph 27.

[4] Geraghty v Minter (1979) 142 CLR 177, at 181.