ATO ID 2003/105: Income or capital - payment on termination of an agreement to provide services
Date of decision: 12 November 2002
Year of income: Year ended 30 June 2001
Business line: Private Groups and High Wealth Individuals

Issue
Is an amount received by the taxpayer for the termination of an agreement to provide services assessable as income according to ordinary concepts under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision
No. The amount received for the termination of an agreement to provide services is not assessable as income according to ordinary concepts under section 6-5 of the ITAA 1997.

Facts
The taxpayer entered into an agreement to provide services to another party. This agreement represented the whole business carried on by the taxpayer. This agreement was terminated by the other party. The taxpayer accepted an amount as compensation for the termination of the agreement. On accepting the payment, the taxpayer lost the right to provide services to the other party. The taxpayer was put out of business by the termination of the agreement. The compensation was paid as a lump sum and without any break up of component parts being communicated to the parties. The taxpayer signed a Deed of Release on receiving the payment. The Deed of Release provided that the payment was in full and final satisfaction of all suits, claims and/or demands whatsoever which the taxpayer 'has or may hereafter have in or arising out of the agreement or its termination'

Reasons for decision
Summary: 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. Ordinary income is income according to ordinary concepts (subsection 6-5(1) of the ITAA 1997). 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. On the other hand, if 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. In Californian Oil Products Ltd (in liq) v. Federal Commissioner of Taxation (1934) 52 CLR 28; (1934) 3 ATD 10 ( Californian Oil ) the taxpayer under a number of agreements agreed to be an agent of an oil company for the sale of the oil company's petroleum products. By mutual consent the latest agency agreement was cancelled and the taxpayer was to receive a payment. The amount was not calculated by reference to lost earnings though it was to be paid by way of a series of equal instalments. It was held by the High Court that the payment was a capital amount. In Allied Mills Industries Pty Ltd v. Federal Commissioner of Taxation (1989) 20 FCR 288; (1989) 20ATR 457; 89 ATC 4365 ( Allied Mills ) the taxpayer gave up the right to exploit its sole distributorship of certain biscuit products. In return it received a payment of an amount. 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 Federal Court felt that the distribution arrangements themselves yielded the profit. They did not simply provide the means of making profit. The payment was essentially designed to compensate the taxpayer for the loss of anticipated profits flowing from the termination of the contract. The Federal Court regarded the payment as being on the same footing as the profits themselves would have been, if they had been received. The amount was held to be income. The court said: '...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 Bergs v. Clarke, ([1935] AC 431 at 442). The contracts here in themselves yielded profit; they did not simply provide the means of making profit...' On entering into the agreement with the other party, the taxpayer acquired the right to provide services to the other party from which they were able to earn income. This right formed the basis for the taxpayer's business. The taxpayer's business existed in order to provide the services under the agreement. This agreement was of 'substantial importance to the structure of the business itself' ( Allied Mills ). When the right to provide services to the other party ceased the taxpayer ceased to carry on business. The amount received was to compensate for the loss of this right and the loss of their means of making profit. The amount was received by the taxpayer in circumstances which were similar to those in the Californian Oil case and is to be characterised as a receipt of capital. Accordingly this amount is not included in the taxpayer's assessable income under section 6-5 of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1997 section 6-5 subsection 6-5(2) section 104-25
Case references: Allied Mills Industries Pty Ltd v. Federal Commissioner of Taxation (1989) 20 ATR 457 (1989) 20 FCR 288 89 ATC 4365
Subject references: Income Business income Income of a capital nature