Private ruling: Capital gains tax implications on disposal of goodwill
Published: February 2013
Ruling period: Year ended 30 June 2010
Date scheme commenced: 1 July 2009

Ruling: Q1: Does the pre-capital gains tax (CGT) goodwill of the business combined with the post-CGT goodwill of an acquired business, retain its original pre-CGT character under Part 3-1 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No | Q2: Are you entitled to fully disregard any capital gain derived from the disposal of the goodwill of the business under subsection 104-10(5) of the ITAA 1997 when the business is sold? | A2: No | Q3: Are you entitled to partly disregard any capital gain derived from the disposal of the goodwill of the business (that part that is your pre-CGT interest in the goodwill of the partnership and part of the goodwill derived from your operations as a sole trader) under subsection 104-10(5) of the ITAA 1997 when the business is sold? | A3: Yes

Relevant facts and circumstances: You and your spouse at the time, purchased a business pre-1985. The business was run as a partnership, from inception until the late 1980's when, following a marriage breakdown and subsequent property settlement, your spouse ceased to be a partner in the partnership. You continued to operate the business as a sole trader until the late 1990's. In the late 1990's, you bought an established business, and subsequently merged your original business's client base into the acquired business. The original business outlet was subsequently closed as a result of this merger. You decided to merge the client base from the original business into the acquired business because you had calculated that it would be more financially beneficial to merge the client base and take staff, stock, customer monthly accounts and customers rather than appoint a manager, and continue paying additional rent and outgoings for original business. Due to the close proximity of the acquired business to the original business, you had estimated that you would retain approximately 66% of existing customers. Later calculations have shown that more than 55% of customers were retained from original business after the merger. You have provided information that shows that the average turnover of new business prior to the merger was $XXX and in the years after the merger, with the benefit of the additional client base from original business, the turnover increased to $XXX. You estimate that approximately 25% of the turnover of merged business was made up of original business's customers. You have calculated that pre-CGT goodwill originating from the partnership, and then after the marriage breakdown and subsequent property settlement, as a sole trader, to be $XXX. You state that you have combined your existing client base, staff, product lines, stock, customer monthly accounts and retail ambience into the newly acquired business and, that the nature of the two businesses are identical. Later, you decided to sell the businesses and retire. The business was sold to an employee of the business. You have lodged your income tax return for the relevant year, including the capital gains income for your business. You believe that the goodwill on the sale of the merged business, which includes a component of pre-CGT goodwill from the original purchase by the partnership, should be merged with the post-CGT goodwill of the partnership and retain its pre-CGT status, and therefore any capital gain made on the disposal can be disregarded.

Relevant legislative provisions: Income Tax Assessment Act 1997 Paragraph 108-5(2)(d) | Income Tax Assessment Act 1997 Paragraph 108-5(2)(b) | Income Tax Assessment Act 1997 Section 104-10 | Income Tax Assessment Act 1997 Subsection 106-5(3)

Reasons for decision: Detailed Reasoning - Partner's interest in goodwill: Paragraph 108-5(2)(d) of the ITAA 1997 provides that a partner's interest in a partnership is a CGT asset. It is a chose in action. A partner's interest in goodwill of the partners' business is also a CGT asset (paragraph 108-5(2)(b) of the ITAA 1997). Section 104-10 of the ITAA 1997 provides that CGT event A1 occurs when your ownership in a CGT asset (eg. goodwill, or interest in goodwill, of a business) is transferred to another entity. The time of the event is when you enter into a contract for the disposal. Taxation Ruling TR 1999/16 discusses capital gains and the goodwill of a business. Paragraph 25 of TR 1999/16 states: The whole of the goodwill of a business is either pre-CGT goodwill (subject to Division 149 - about when an asset stops being a pre-CGT asset - see paragraph 90) or post-CGT goodwill. The goodwill of a particular business cannot be characterised as partly pre-CGT goodwill and partly post-CGT goodwill. Goodwill is a composite asset. This is further explained in paragraph 64 of TR 1999/19 which states: If a pre-CGT business is combined with another business acquired post-CGT and they are conducted as one business without the pre-CGT business losing its essential nature or character, the goodwill of the post-CGT business is subsumed into the goodwill of the pre-CGT business and all of the goodwill of the business is taken to have been acquired before 20 September 1985. The goodwill of each of the businesses coalesce without any disposal of the goodwill of the post-CGT business. The pre-CGT business must not lose its essential nature or character in the sense that it must remain the same business and not be overwhelmed by the post-CGT business in such a way that it has become a different business. The purchase of the post-CGT business must involve merely organic growth of the pre-CGT business or an expansion or accretion to it in reasonable proportions or it gives rise to a new, different business and its goodwill is a new asset. Based on the information provided it appears that the two businesses were integrated into one consolidated business and the pre-CGT business did not lose its essential nature or character, that is, it remained the same business and was not overwhelmed by the post-CGT business in such a way that it became a different business. However, the cause for concern in your situation is the acquisition of a post-CGT interest in the goodwill of the partnership business, not goodwill itself. In this context paragraph 26 of TR 1999/16 states: However, an interest in goodwill, unlike goodwill itself, is not a composite asset. For example, a partner who owns a pre-CGT interest in a pre-CGT business might later acquire a post-CGT interest in the business. On acquiring the post-CGT interest in the business (with an associated post-CGT interest in the pre-CGT goodwill of the business), that interest in the business is not subsumed into the partner's pre-CGT interest in the business (and the associated pre-CGT interest in goodwill). Therefore, where a partner acquires successive fractional interests in a partnership asset, the original fraction and each additional fraction are treated as separate CGT assets where this is necessary to preserve the relevant acquisition dates (eg to determine pre-CGT/post-CGT status, availability of CGT discount to each fractional interest). This CGT treatment continues to apply in relation to partnership assets in which a partner acquires a 100% interest (subsection 106-5(3) of the ITAA 1997). It follows that where one partner ('the buyer') purchases the balance of the assets that comprise a partnership business, the relevant CGT assets thereby acquired are the additional fractional interests in each of the assets. Those additional fractional interests are not subsumed into the pre-existing interest already held by the former partner for the purposes of determining the relevant dates of acquisition. We consider that this principle applies equally to goodwill. TR 1999/16 states that goodwill is a 'composite asset' and, as such, must have a single acquisition date. However, in the case of a partner who subsequently acquires the entirety of partnership goodwill, the relevant CGT assets are the fractional interests successively acquired by the buyer. Each of those fractional interests has a separate acquisition date for CGT purposes. In your case, while it appears that the two businesses were integrated into one consolidated business, the fact remains that you acquired a post-CGT interest in the goodwill of the partnership business, not goodwill of the business itself, on the demise of the partnership. Accordingly, the post-CGT interest in goodwill of the partnership business you acquired on the demise of the partnership was not subsumed into your pre-CGT interest in the goodwill of the partnership business. The post-CGT interest and the pre-CGT interest remain separate assets for CGT purposes. Therefore, all of the goodwill of the consolidated business is not considered to have been acquired before 20 September 1985 and the capital gain made on disposal of the goodwill of the consolidated business can not be fully disregarded under subsection 104-10(5) of the ITAA 1997. | Detailed Reasoning - Apportionment of goodwill: As your original interest in the goodwill of the partnership business is a pre-CGT asset, and the acquisition of the new business was integrated into one consolidated business with original business, part of the calculated goodwill of your sole trader business will be subsumed into your pre-CGT interest in the goodwill of the partnership and will retain its pre-CGT status. However, part of this calculated goodwill will also accrue to your post-CGT interest in the goodwill which you acquired at the demise of the partnership. We consider that any further goodwill generated, until the disposal of the business, will also need to be apportioned between pre-CGT goodwill and post-CGT goodwill on a reasonable basis. Accordingly, you are not entitled to fully disregard the amount calculated as pertaining to goodwill originating from the partnership, and then as a sole trader. You will instead need to apportion the goodwill calculated on a reasonable basis between pre-CGT and post-CGT goodwill, thereby allowing for part of the goodwill calculated to be excluded from the capital gains tax calculation on the sale of the merged business.

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