Private ruling: Capital gains tax (CGT), non-commercial losses and assessable income
Date of advice: 21 September 2018
Published: November 2018
Ruling period: Year ended 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: Do the damages received for goodwill result in a capital gain under CGT event A1 under section 104-10 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No. | Q2: Are the damages received for the loss in value of your trading stock assessable under section 6-5 and considered income of the business activity for the purposes of the non-commercial loss rules? | A2: Yes. | Q3: Are the other damages received assessable under section 6-5 and considered income of the business activity for the purposes of the non-commercial loss rules by consequence of the grouping rule? | A3: Yes. | Q4: Is all of the pre-judgment interest you received assessable under section 6-5 of the ITAA 1997 and considered income of the business activity for the purposes of non-commercial losses? | A4: No it must be apportioned according to the heads of claim and declared according to the character of that head. | Q5: Is the post-judgment interest you received assessable under section 6-5 of the ITAA 1997? | A5: Yes, however it is not considered income of the business for the non-commercial loss rules.

Relevant facts and circumstances: You commenced operating a business activity in the 20XX financial year. In 20XX an agreement was entered into. On 20XX the agreement was repudiated. There were multiple heads of claim, including goodwill, decline in value of trading stock and other damages. Pre- and post-judgment interest was also awarded. You have losses deferred under the non-commercial loss rules.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 6-5 | Income Tax Assessment Act 1997 section 6-10 | Income Tax Assessment Act 1997 section 104-10 | Income Tax Assessment Act 1997 section 104-25 | Income Tax Assessment Act 1997 section 108-5 | Income Tax Assessment Act 1997 Division 35

Reasons for decision: Summary: No disposal of a severable or distinct part of the business has occurred, and therefore there has been no actual disposal of goodwill. It is not appropriate to utilise a look-through approach and CGT event C2 is the most appropriate in the circumstances. The amount of damages received for the decline in value of the cattle represents an award for loss or damage to an underlying asset. Therefore using a look-through approach the amount of compensation is appropriately attributable to the decline in value of the trading stock. This amount is included as income of the business activity for the purposes of Division 35 of the ITAA 1997. The award of compensation received for the other damages was not received for damage or loss caused to an underlying asset and takes the character of the income it replaces | Detailed Reasoning - Capital gains: A CGT asset is any kind of property or a legal or equitable right that is not property. Goodwill or an interest in it is specifically defined as a CGT asset (section 108-5 of the ITAA 1997). CGT event A1 occurs if you dispose of a CGT asset and a change in ownership occurs from you to another entity. However, a change in ownership does not occur if you stop being the legal owner of the asset, but continue to be its beneficial owner (section 104-10 of the ITAA 1997). CGT event C2 occurs when your ownership of an intangible CGT asset ends by the asset being released, discharged or satisfied. The time of the event is when you enter into the contract that ends the asset, or if there is no contract, then it is when the asset ends (section 104-25 of the ITAA 1997). | Detailed Reasoning - Receipt of compensation: The general rule at common law is that where a party sustains loss by reason of a breach of contract, that party is, so far as money can do it, to be placed in the same position as if the contract had been performed. Taxation Ruling 95/35: Income tax: capital gains: treatment of compensation receipts (TR 95/35) considers the CGT consequences for the recipient of the amount, and whether the amount should be included as assessable income. If an amount of compensation is not received in respect of any underlying asset, the amount relates to the disposal by the taxpayer of the right to seek compensation. Accordingly, any capital gain arising on the disposal of that right is calculated using the cost base of that right (paragraph 11 of TR 95/35). If the compensation relates directly to more than one asset, it is necessary to determine the most relevant assets and to apportion the compensation between those assets (paragraph 15 of TR 95/35). If the compensation receipt relates to more than one asset, the compensation needs to be apportioned between those assets. Similarly, if the amount received is for a number of heads of claim (eg lost profits, interest and punitive damages), the amount also needs to be apportioned between the items (paragraph 83 of TR 95/35). A temporary fluctuation in the value of goodwill does not represent either a permanent damage to or a permanent reduction in the value of goodwill (paragraph 25 of TR 95/35). In determining which is the most relevant asset it is often appropriate to adopt a look-through approach to the transaction or arrangement which generates the compensation receipt (paragraph 70 of TR 95/35). To show that the underlying asset is the most relevant asset, the compensation receipt must have a direct and substantial link with the underlying asset. If an asset has not been disposed of; and has not been permanently damaged or permanently reduced in value the taxpayer is not able to demonstrate that link. It follows that the compensation cannot be directly related to that asset. In those cases, the most relevant asset may be the right to seek compensation or the notional asset (paragraph 82 of TR 95/35). In considering the effect on the goodwill it is necessary to consider whether the taxpayer has disposed of his or her goodwill or whether it has been permanently damaged. The goodwill of a business continually fluctuates in value and a taxpayer is not entitled to reduce the cost of that goodwill for those temporary fluctuations. Generally it is very difficult for the taxpayer to demonstrate that there has been some permanent damage to, or permanent reduction in value of the goodwill. Rather than an actual disposal of that goodwill or a temporary fluctuation in the value of the goodwill (paragraphs 228 – 233 of TR 95/35). | Detailed Reasoning - Goodwill: Taxation Ruling 1999/16: Income tax: capital gains: goodwill of a business (TR 1999/16) provides the Commissioner’s view about the capital gains consequence of disposal of the goodwill of a business. If a business owner disposes of their entire business, goodwill may be transferred with that business. CGT event A1 (section 104-10 ITAA 1997) happens to the goodwill of the business. A change in ownership of a business can occur if it is a discrete part of the business, either geographically or by reference to the products or services of the business in some other way. If a business owner is carrying on a business at one or several locations and part of the business is sold, questions arise whether: (a) several business are carried on; or (b) one business is carried on; And whether what is sold is: (c) an entire, self-contained business that a purchaser could conduct; or (d) something less than a discrete business (paragraphs 70 – 72 of TR 1999/16). It is a question of fact whether the owner has disposed of a discrete business that a purchaser could conduct or has merely disposed of a collection of business assets. The question is determined having regard to all of the circumstances (and not solely from the purchaser’s perspective) including whether: ● sufficient relevant assets are sold to enable the purchaser to carry on the business the vendor had carried on, ● the assets sold are accompanied or carry with them the legal right, privilege or entitlement to conduct the business and ● what is sold is sold as a self-contained business. If a business owner disposes of part of their business, an important consideration is whether the effect of the transaction is to put the purchaser in possession of a going concern the activities if which the purchaser could carry on without interruption (paragraph 74 of TR 1999/16). A disposal of part of a business operation that does not constitute a discrete business in its own right is not merely the disposal of a collection of assets of a business without goodwill. Even if the business operation disposed of is a severable part of the business (but not a discrete business) this does not involve a disposal of any part of the goodwill of the business. The sale of a series of assets separate from the business itself does not involve any disposal of goodwill. For goodwill to be disposed of, there must be a business disposed of to which the goodwill attaches (paragraph 78 of TR 1999/16). If one or more (identifiable) assets of a business are disposed of, and not a discrete business, and the sale proceeds exceed the market value of the separate assets, the extra receipt is not for goodwill (there being no business disposed of). The extra receipt increases the capital proceeds received by the vendor for the assets and increases the acquisition cost of the assets to the purchaser. It is to be apportioned on a reasonable basis over the assets (paragraph 79 of TR 1999/16). Scientific, technical, industrial or commercial knowledge or information (such as know-how) are not goodwill. The knowledge or information is not property. Nor is it a CGT asset. It might be the source of goodwill but it is separate from goodwill. The knowledge or information is valuable and its value can be brought to account or realised separately from the business itself and from the goodwill of the business. Goodwill does not attach to the knowledge or information. Rather goodwill attaches to the business that uses the knowledge or information (paragraph 101 of TR 1999/16). | Detailed Reasoning - Application to the circumstances: “Goodwill” The Vendor and the Purchaser reached an agreement which was described as being for the sale of a business. One of the terms of the agreement was that for the sum of $1,000,000 for a term described as the disposal of “goodwill”. The agreement was for half of the trading stock belonging to the Vendor to be leased to the Purchaser for a period, with title to transfer at the end of this period. The Purchaser repudiated the agreement and title to the trading stock had not passed. The Vendor retained title to the trading stock and was compensated for its decline in value as at the date of the breach with interest. No trading stock was actually disposed of. The Commissioner does not consider that a discrete or severable part of the business has been disposed of. Accordingly, no goodwill has been disposed of, nor has it been permanently reduced in value. As there has been no actual disposal of goodwill, CGT event A1 cannot have occurred in relation to the cattle business. Accordingly, a look-through approach is not appropriate. The right to seek compensation is a CGT asset that was satisfied and constituted a CGT event C2 occurring. Decline in value and losses of cattle The amount of compensation that was awarded to the Vendor was calculated according to the market value of the trading stock as at the date of repudiation. In this instance, a look-through approach is appropriate, as there has been damage caused to the underlying asset and it is for this damage that the compensation is awarded. As the original agreement detailed a payment to be made for the sale of the trading stock, the compensation takes on this nature and is deemed to be income of the business activity from the sale of trading stock. Accordingly, this receipt can be included as income of the business activity for the 20XX financial year (when considering the non-commercial loss provisions in Division 35 of the ITAA 1997). Other damages The amount of compensation awarded for the failure to satisfy the other term was calculated on the basis that there was a term of the agreement that had not been satisfied at the time of the breach. The Vendor had not received a payment from the Purchase for the term. The Commissioner considers that a look-through approach is appropriate in the circumstances, are assessable under section 6-5 of the ITAA 1997 and form part of the income of the business activity for non-commercial loss purposes. | Summary: How pre-judgement interest is to be assessed depends upon the head of claim for which it is received. In the circumstances, part of the pre-judgement interest has been received for the loss and decline in value of the cattle and so will be appropriately included as ordinary income (section 6-5 of the ITAA 1997). Part of the pre-judgement interest relates to the satisfaction of the right to seek compensation as a capital receipt and is statutory income (section 6-10 of the ITAA 1997). Post-judgment interest is assessable as ordinary income (section 6-5 of the ITAA 1997). | Detailed Reasoning - Reasons for Decision: An award for damages at common law may include amount of pre- and post-judgement interest. Pre-judgement interest is generally based on an amount calculated over the period between the date when the cause of action happened and the date on which the judgement was made. Post-judgement interest is payable where a judgement is made ordering the payment of money. The post judgement interest is payable from that specific date until the money is actually paid. Pre-judgement interest has been found to take the character of the underlying issue being determined. These payments may either be considered income according to ordinary concepts (section 6-5 of the ITAA 1997) or they may be considered a capital receipt and statutory income (section 6-10 of the ITAA 1997). It is a question of fact to be determined in each case whether any part of the compensation received by a taxpayer is in the nature of interest. The Commissioner considers that any amount which is in the nature of interest, and which can be identified as interest, and whether paid as part of the compensation or separately, constitutes assessable income of the taxpayer under the general provisions. It may also represent part of the consideration for the disposal of either the underlying asset or the right to seek compensation (paragraph 246 of TR 95/35). The case of Whitaker v Federal Commissioner of Taxation (1998) 82 FCR 261; 98 ATC 4285; (1998) 38 ATR 219 (Whitaker’s case) provided that where an amount of pre-judgement interest is awarded for the pain and suffering of the plaintiff, then this amount will be considered a capital receipt. In this case the interest was not calculated based on a sum ascertained before the judgement. Black CJ stated at 335 in Whitaker’s case: In other contexts the characterisation of an amount ordered to be paid as ‘interest’ as compensation for the loss or detriment suffered by a person by being kept out of his or her money would point to an amount receivable as income rather than as capital… I would also add that the position here differs greatly from the commercial situation in which interest is payable as the price of being kept out of a specific or calculable sum… In Atlas Tiles Ltd v Briers (1978) 144 CLR 202; (1978) ATR 142 at CLR 223; ATR 155, Barwick CJ said, If the award of damages for such an injury destroying or diminishing his earning capacity were merely a matter of replacing those lost earnings, the amount of the award would be taxable… Application to your circumstances The Vendor was awarded pre-judgement interest and post-judgment interest. The pre-judgement interest that was awarded stems from several heads of claim and will need to be apportioned between them on a reasonable basis. The amount attributable to the decline in value of trading stock is income according to ordinary concepts and assessable under section 6-5 of the ITAA 1997. This amount is included in the assessable income of the business activity. The pre-judgement interest received for the other heads of claim will be a capital receipt as the assets are the contractual rights that were repudiated as at the date of the breach. The amount of post-judgement interest that was awarded is considered to be income according to ordinary concepts under section 6-5 of the ITAA 1997. The amounts of interest will be assessable in the financial year in which they were received into the solicitor’s Trust Account for the Vendor’s benefit.