Private ruling: Capital gains tax - intangible assets – ending - capital versus income
Date of advice: 8 February 2018
Published: June 2018
Ruling period: Income year ending 30 June 20XX.
Date scheme commenced: 1 July 20XX.

Ruling: Q1: Is the Client Base a capital gains tax asset under section 108-5 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes. | Q2: Will capital gains tax event A1 occur on the disposal of your Client Base to Company A for the amount of $XXX,XXX under section 104-10 of the ITAA 1997? | A2: Yes. However, capital gains tax event C2 is the most relevant capital gains tax event in relation to the receipt of the $XX,XXX. | Q3: Will the payment of $XX,XXX received from Company A be assessable under either section 6-5 of the ITAA or section 15-2 of the ITAA 1997 ? | A3: Yes. It will be assessable under section 15-2 of the ITAA.

Relevant facts and circumstances: You have worked as an professional in public practice for a number of years, having various employers including Firm A, which was a relative’s business. You decided that you wanted to work for a large firm rather than taking over Firm A and Firm A was sold to Firm B. You worked briefly with Firm B to assist with the transitioning of Firm A’s clients prior to you commencing employment with Firm C. You took some of your existing clients with you when you commenced your employment with Firm C. Your Firm C employment agreement included restraint of trade clauses however they did not apply to any person or entities who were already your client immediately prior to you commencing employment with Firm C. You were approached by Company A while you were working at Firm C, who offered you a position with them. During the negotiations, you advised Company A that you had a small client base (the Client Base) that would come with you and they advised that while they were after you, your clients could come with you. It was agreed that you would not receive any payment for your Client Base and if in the future you acquired shares in Company B, who wholly owns Company A, consideration would be given at that time to reduce the purchase price of the Company B shares by an amount equal to the market value of your Client Base. Company A sent an offer of employment to you. You received a letter in relation to the transfer of your Client Base to Company A which included the following information and statements: ● a list of your clients and an estimate of their annual compliance fee; ● that any other clients referred to Company A in the future who had previously been clients of Firm A were eligible to be added to your client list; ● all clients were excluded from any restraint of trade clauses in your employment with Company A; ● in the event that you purchased equity in Company A in the future, consideration will be given to reducing the purchase price by the market value of your Client Base as provided at that time; and ● Company A will offer support, including legal action where appropriate, if Firm B alleged any breach of restraint of trade in respect of the clients included in your Client Base. ● You entered into an employment contract with Company A which contained restraint clauses which stated that you could not: ● provide or offer any services to any client which is the same, similar, or in competition with the services provided by the Group that Company A was connected to; or ● act on your own account, or for any other person, business or entity, to obtain the custom of any client with a view of obtaining custom of that client that is the same, similar, or in competition with Company A’s business. You commenced employment with Company A. You have recently been offered the opportunity to purchase shares in Company B. You discussed the pre-employment negotiation agreement with your current managing director at Company A who advised that as you would be buying your shares directly from an existing shareholder, it would not be possible for the share price to be reduced by the market value of your Client Base as agreed in your pre-employment negotiations. It was agreed that Company A would purchase your Client Base and you would use the sale proceeds to purchase the shares from the shareholder. You entered into a deed with Company A which outlines the following: ● an agreement had been made between you and Company A prior to you commencing your employment with Company A under which that in the future event of you purchasing shares in Company B, consideration would be given to reducing the purchase price of the shares by the market value of the Client Base you brought to the Group, being Company B and any and all subsidiary companies of that company; ● you intend acquiring shares in Company B by way of purchasing shares from an existing shareholder of Company A; ● instead of a reduction in the purchase price of the Company B shares, Company A will pay an agreed amount of $XX,XXX towards the consideration payable by you under the share transfer (the Client Fee); ● Company A acknowledges that it and/or the Group have received the benefit of the transfer of the Client Base; ● the Client Fee, net of Pay As You Go (PAYG) withholding if applicable, shall be payable by Company A upon the presentation of a private binding ruling decision by you; ● Company A’s obligation to pay the Client Fee is subject to Company A obtaining the written consent of a majority shareholder of Company B to the payment; ● you acknowledge that each of the restraints referred to a restrain clause your employment contract applies in relation to the clients set out in the attached Client Base: ● you warrant that: ● there are no circumstances known, or which should be known by you, that may lead to one or more of the clients included in the client list included with the deed ceasing to remain a client of the Group in the foreseeable future; ● there are no claims, disputes, legal proceedings, arbitration proceedings or government enquiries, either present or threatened, in respect of any of the clients included in the client list and you do not know of any circumstance which may result in any of them arising ● a copy of your Client Base, naming your clients, outlining the value of each client, with a total value of $X,XXX. You have always been an employee and have never owned a specific practice.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 6-5 | Income Tax Assessment Act 1997 Section 15-2 | Income Tax Assessment Act 1997 Part 3-1 | Income Tax Assessment Act 1997 Part 3-1 | Income Tax Assessment Act 1997 Part 3-3 | Income Tax Assessment Act 1936 Paragraph 26(e) | Fringe Benefits Tax Assessment Act Subsection 136(1)

Reasons for decision: Summary: The payment of $XX,XXX will be assessable under section 15-2 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: You entered into an arrangement with Company A under which the acquisition price of any shares that you were offered in Company B would be reduced by the market value of your Client Base. It is now proposed that you will receive the amount of $XX,XXX from Company A so that you can purchase shares in Company B directly from a shareholder. We have considered the following when determining how the $XX,XXX will be assessed: | Detailed Reasoning - Section 6-5 of the ITAA 1997: Section 6-5 of the ITAA 1997 provides that your assessable income includes income according to ordinary concepts, which is called ‘ordinary income’. The legislation does not provide guidance on the meaning of 'income according to ordinary concepts' in section 6-5 of the ITAA 1997. However, guidance in determining whether a receipt will be ordinary income can be found in case law. Ordinary income will generally have the characteristics of being periodic, recurring, and regular. Such characteristics of income have been emphasised by decisions in the FC of T v Dixon (1952) 86 CLR 540: 10 ATD 82 ( Dixon case ) and Just v. FC of T (1949) 8 ATD 419. As Dixon CJ and Williams J stated in their decision in the Dixon case : Because the £104 was an expected periodical payment arising out of circumstances which attended the war service undertaken by the taxpayer and because it formed part of the receipts upon which he depended for the regular expenditure upon himself and his dependants and was paid to him for that purpose, it appears to us to have the character of income… However, a one-off payment may also be characterised as ordinary income where the payment has a sufficient connection with services rendered. Section 6-5 of the ITAA 1997 is limited to receipts of a revenue nature. In practical terms, section 15-2 of the ITAA 1997 will generally only apply to receipts that are of a capital nature as section 6-5 of the ITAA 1997 would apply in preference to revenue receipts. | Detailed Reasoning - Section 15-2 of the ITAA 1997: Section 15-2 of the ITAA 1997 has the equivalent meaning of the former paragraph 26(e) of the Income Tax Assessment Act 1936 (ITAA 1936) and relates to assessable income including allowances, gratuities, compensation, benefits, bonuses and premiums provided to you in respect of, or for or in relation directly or indirectly to, any employment of or services rendered. Section 15-2 of the ITAA 1997 is relevant in the context of benefits etc. provided in respect of or in relation to: ● employment; or ● services rendered. ● Cases concerning paragraph 26(e) of the ITAA 1936 will continue to be relevant in considering the application of section 15-2 of the ITAA 1997 with the courts having consistently indicated that paragraph 26(e) of the ITAA 1936 was not limited to employment situations and that it can apply to payments for services rendered in the absence of an employer/employee relationship. With respect to the applicability of this provision, the critical issues to be considered are whether there was is direct or indirect connection between the payment received and the services provided to an employer. | Detailed Reasoning - Directly or indirectly related to employment: The phrase ‘in respect of’ in relation to the employment of an employee is defined in subsection 136(1) of the Fringe Benefits Tax Assessment Act (FBTAA) to include ‘by reason of, by virtue of, for or in relation directly or indirectly to, that employment’. The meaning of this phrase was considered by the Federal Court in J & G Knowles v. Federal Commissioner of Taxation [2002] 96 FCR 402; 2000 ATC 4151; 44 ATR 22 ( Knowles case ) and Starrim Pty Ltd v. Federal Commissioner of Taxation [2000] FCA 952; 2000 ATC 4460; 44 ATR 487 ( Starrim case ). In Knowles case the Full Federal Court considered the judgements in Smith v. FCT (1987) 164 CLR 513; 19 ATR 274; 87 ATC 4883 and Federal Commissioner of Taxation v. Rowe (1995) 60 FCR 99; 31 ATR 392; 95 ATC 4691 before concluding that it is not sufficient for the purposes of the FBTAA to conclude that there is a causal connection between the benefit and the employment. At paragraph 26 the Court said: Whatever question is to be asked, it must be remembered that what must be established is whether there is a sufficient or material, rather than a, causal connection or relationship between the benefit and the employment. At paragraphs 28 and 29, the Court said: While the width of the definition of “fringe benefit” was designed to capture benefits that, in truth, were other than remuneration, the stated purpose suggests that asking whether the benefit is a product or incident of the employment will be helpful. If it is not then the benefit is likely to be extraneous to the employment and will not bear FBT, notwithstanding that the employment might have been a causal factor in the provision of the benefit. In particular, the fact that a benefit is provided to a director because it was authorised by that director will not, of itself, be sufficient to characterise the benefit as one which is “in respect of” the employment. Without more, it is not a product of incident of that office. To put the matter another way, although the process of characterising the benefit provided in a particular case can involve questions of fact and degree, it is not sufficient for the purposes of the FBTAA merely to enquire whether there is some causal connection between the benefit and the employment: see FCT v Rowe (1995) 60 FCR 99 at 114 and 123; 31 ATR 392 at 404 and 412; 95 ATC 4691 at 4703 and 4710. Although Brennan, Deane and Gaudron JJ observed in Technical Products (at 47), that the requisite connection will not exist unless there is “some discernible and rational link” between the 2 subject matters which the statute requires to be linked, as was pointed out by Dawson J (at 51), the connection must be “material”. In Starrim Lindgren J. further considered the phrase ‘in respect of’ in relation to a private company which provided benefits to a husband and wife who were its only shareholders and directors. In considering whether the benefits were provided in respect of their employment as directors, Lindgren J said at paragraph 52: Fourthly, the decision of the full court in Knowles establishes that the required relationship between the provision of a benefit and the employment is not established merely by the existence of some or a causal relationship, and, in particular, that it is not established by nothing more than the fact that the employee has been able to cause the benefit to be provided to him by reason of his or her office as a director of the employer. There must be a “sufficient” or “material” relationship between the employment and the provision of the benefit. The closer the benefit or gain is to the workplace or employment, the more likely it is to be ordinary income (or be subject to fringe benefits tax). In Federal Commissioner of Taxation v. Smith (1986) 86 ATC 4463 ( Smith case ), a taxpayer received a payment for completing a management certificate course. Once the court accepted that the payment would not have been made if the relationship of employer and employee had not existed, it was impossible to deny that employment was not a contributory cause of the payment. The payment was therefore causally connected to the taxpayer's employment by the bank and was assessable under paragraph 26(e) of the ITAA 1936. | Detailed Reasoning - Services rendered: The expression "services rendered" refers to situations not encompassed by the term "employment". "Services rendered" was considered in FC of T v Holmes 95 ATC 4476 ( Holmes case) where was held to be assessable on his share of a salvage reward payment. Although the obligation to make the payment to the taxpayer was contingent upon the success of the salvage operation, there was a real connection between the payment received and the services rendered by him in the course of the salvage operation. The payment was a reward for the services rendered by the taxpayer and fell squarely within the language of former s 26(e) of the ITAA 1936. | Detailed Reasoning - Capital gains tax: The capital gains tax (CGT) provisions are contained in Parts 3-1 and 3-3 of the ITAA 1997. Broadly, the provisions include in your assessable income any assessable gain or loss made when a CGT event happens to a CGT asset that you own. A CGT asset is: ● any kind of property; or ● a legal or equitable right that is not property. CGT event A1 happens if you dispose a CGT asset and your ownership interest in the asset is transferred to another entity. 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. The general rule of applying CGT events if more than one CGT event happens, with the exception of CGT events D2 and H2, is that the one that applies is the one that is most specific to the taxpayer’s situation. The anti-lap provisions contained in section 118-20 of the ITAA 1997 operate to ensure that amounts which are assessable income outside of the CGT provisions are not also taxed as capital gains to ensure that the amount is not taxed twice. That is, where a CGT event occurs which causes an amount to be assessable income and also results in a capital gain for CGT purposes, the full amount is included in assessable income and the capital gain amount is reduced by that amount. | Detailed Reasoning - Application to your situation: Your Firm C employment agreement created a CGT asset, being your Client Base, which enabled you to take any person or entity that was already your existing client immediately before commencing with Firm C with you when you left their employment. You were approached by Company A while you were working for Firm C. At that point you had a number of clients in your Client Base which you had obtained during your employment prior to commencing at Firm C. During the pre-employment negotiations with Company A it was agreed that your existing clients could come with you to Company A. It was also agreed that you would not receive any payment for your Client Base and if in the future you acquired shares in Company B and consideration would be given at that time to reduce the purchase price of the Company B shares by an amount equal to the market value of your Client Base. You state that you wanted the following outcomes from your pre-employment negotiations with Company A: ● to retain the ownership of your Client Base in the event of leaving Company A; and ● if you were to eventually buy equity in Company A, then your buy-in price would be reduced by the value your Client Base to avoid paying for your own Client Base when purchasing the Company A equity. You have been offered shares in Company B which are owned by a shareholder. As a result, you will receive an amount of $XX,XXX so that you can purchase the shares from the shareholder instead of having the acquisition price reduced by the market value of the Client Base. Consequently, the question being posed in this situation is whether the benefit obtained, being the receipt of $XX,XXX, is a reward for service/employment or the exploitation of a valuable right independent of that service/employment is based on whether the right has an existence independent of the employment relationship. Prior to you commencing your employment with Company A you had a CGT asset, being your Client Base. It is viewed that when you entered into your agreement with Company A that an intangible asset was created for CGT purposes, being your right as against Company A to receive the market value of your Client Base if you were offered equity in Company B in the future. A CGT event A1 will occur on the disposal of the Client Base. However, CGT event C2 will also occur as a result of your right ending due to Company A making the payment of $XX,XXX. It is viewed that in this situation that the most relevant CGT event is C2. We have taken the following into consideration when determining whether the $XX,XXX will be assessable under either section 6-5 of the ITAA 1997 or section 15-2 of the ITAA 1997. The terms of the pre-employment negotiations indicate that it was anticipated that you would be offered shares while employed by Company A. As the benefit, being either the market value reduction on the purchase price of the shares or the $XX,XXX, received by you was dependent on you being employed at Company A and being offered shares after you commenced your employment, it can be viewed that your activities to facilitate and assist with the complying of the necessary conditions played a part in the provision of payment to you. Additionally, Company A would not be paying you the $XX,XXX for your right if the pre-employment negotiation agreement did not exist. The fact that you are now receiving the amount of $XX,XXX for the ending of the right instead of having the acquisition price of the shares reduced by the market value of your Client Base will not alter the fact that the amount is being received is relation to your employment, either directly or indirectly. There is a discernible and rational link between you receiving the payment from Company A and your employment, being a product or incident of your employment, which is therefore not only a contributory cause but a proximate cause for the payment of the $XX,XXX to you. While the payment will be capital payment, it is also a benefit and a payment made and performed by Company A, your employer. It is not viewed that the $XX,XXX will be assessable under section 6-5 of the ITAA 1997 as it will not have the characteristics of ordinary income and it will not be revenue in nature. Therefore, the $XX,XXX will be included in your assessable income in the income year in which it is received under section 15-2 of the ITAA 1997. The basic CGT provisions will still apply even if the calculation results in there being no capital gain or loss, or the capital gain or capital loss is being disregarded in accordance with section 118-20 of the ITAA 1997. Therefore, any capital gain or capital loss will still need to be calculated for the CGT event C2. Section 118-20 of the ITAA 1997 will reduce any capital gain made on the ending of the right to the extent that payment will be assessed under section 15-2 of the ITAA 1997. | Detailed Reasoning - Conclusion: Your Client Base is a CGT asset for CGT purposes. You also have an intangible asset, being the right, when you entered into your agreement with Company A under which they would reduce the acquisition price of any shares offered to you by the market value of your Client Base. CGT event A1 will occur on the disposal of your Client Base. However, CGT event C2 which will occur when your right ends and is considered to be the more relevant CGT event in this situation. The payment of $XX,XXX will be assessable under section 15-2 of the ITAA 1997.