Private ruling: assessable income
Published: September 2014
Ruling period: Year ending 30 June 2015
Date scheme commenced: 1 July 2014

Ruling: Q1: Is the lump sum payment made by the partnership under the Retirement Deed considered a receipt of capital which will be assessed under the capital gains tax (CGT) provisions? | A1: Yes. | Q2: Is the individual eligible to reduce any capital gain made in relation to the lump sum payment under Division 152 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A2: Yes. | Q3: Is the lump sum payment, allocated from the Service Trust and paid to the Discretionary Trust under the Retirement Deed, considered a receipt of capital which will be assessed under the CGT provisions? | A3: Yes.

Relevant facts and circumstances: Upon entering the Partnership, the individual acquired an interest in the Partnership, including assets of the Partnership which belonged to the partners and involved the sharing of losses and liabilities between partners. The Partnership does not recognise goodwill, and therefore there was no consideration paid upon entering the Partnership. The administration, management entitlements and obligations of the partners are governed by the Partnerships Agreement. The Discretionary Trust is a beneficiary of the Service Trust, by virtue of the individual being a partner of the Partnership and therefore eligible as a general beneficiary under the Service Trust deed. The individual entered into the Partnership Retirement Deed to retire from the Partnership. Upon retirement, the Discretionary Trust also ceased being eligible as a general beneficiary of the Service Trust. Upon retirement as a partner and in consideration for the disposal of your interest in the Partnership, a lump sum consideration was received which included: • retirement allowances and • sabbatical expense allowance. With respect to the retirement allowances a portion comprised amounts calculated to be equal to unused annual leave and sabbatical leave accruals a portion comprised a retirement allowance based on average income for a number of financial years preceding retirement. The lump sum consideration paid upon retirement was allocated from the Partnership and Service Trust on a xx% to xx% split. The individual satisfies the maximum net asset value test for the purposes of the small business CGT relief. The individual is over 55 years of age.

Relevant legislative provisions: Income Tax Assessment Act 1936 Section 92. | Income Tax Assessment Act 1997 Section 104-25. | Income Tax Assessment Act 1997 Section 104-35. | Income Tax Assessment Act 1997 Section 108-5. | Income Tax Assessment Act 1997 Section 152-10. | Income Tax Assessment Act 1997 Section 152-15. | Income Tax Assessment Act 1997 Section 152-35. | Income Tax Assessment Act 1997 Section 152-40. | Income Tax Assessment Act 1997 Section 152-105. | Income Tax Assessment Act 1997 Section 328-125. | Income Tax Assessment Act 1997 Section 328-130.

Reasons for decision: Summary: The nature of a receipt, for the purposes of the ITAA 1997, is determined from the point of view of the recipient rather than that of the payer. Therefore, despite how your payment is described in the Partnership accounts or on your retirement statement, it is the nature of the receipt in your hands which determines how it is assessed. The lump sum payment was not a distribution of the net income of the partnership, but a distribution of your share of the equity of the Partnership. Therefore, the receipt by you of the lump sum under the retirement agreement is not assessable as ordinary income and instead is considered a receipt of capital and will be assessable under the capital gains tax provisions. Your retirement from the Partnership meant that you gave up your interest in the Partnership, and in any assets of the Partnership. 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. Taxation Ruling IT 2540 examines the CGT implications of a disposal of a partnership interest. Though it is expressed in terms of the former CGT provisions (of the Income Tax Assessment Act 1936 ) the discussion is still relevant for the purposes of the ITAA 1997. At paragraphs 13 and 14 it states: For large partnerships, which can have memberships numbering in the hundreds (for example, some major legal and accountancy partnerships) the situation is potentially complex. In some cases, the potential problems are overcome because the ownership of the assets used by the partnership is vested in a service company or trust. In other cases, it will generally be accepted, provided the evidence reasonably supports the conclusion that the partners are dealing with each other at arm's length. Any consideration paid or received on the acquisition or disposal of an interest in the partnership will be used for Part IIIA (CGT) purposes in determining the cost base or disposal proceeds of the interests in the partnership assets that the partnership interest represents. This will mean that if, for example, the partnership arrangement is such that no amount is payable for the acquisition or disposal of goodwill, it will be accepted for the purposes of Part IIIA (CGT) that the value of the goodwill is nil. This treatment will also apply to partners of smaller partnerships who deal with each other at arm's length, where those dealings take place in an ordinary commercial context. In the case of large professional partnerships, where the partners' dealings with each other are at arm's length, it will only be where consideration is paid by a partner on entering the partnership or where a partner receives a payment on leaving the partnership that Part IIIA (CGT) will have any practical effect. Where consideration is neither paid by a person on entering the partnership, nor received on retirement from the partnership, the partner will not realise a capital gain or incur a capital loss on the disposal of particular assets. However, as noted above, the admission or retirement of a partner may affect the proportionate ownership of the partnership assets by the individual partners and therefore may affect the extent of a continuing partner's interest in the partnership. This would be relevant in the event of a subsequent disposal of the partnership assets for consideration, or where consideration is paid to a partner on retirement from the partnership. Section 104-25 of the ITAA 1997 states 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 excised; or f) if the asset is a convertible interest - being converted The time of the event is: a) when you enter into the contract that results in the asset ending; or b) if there is no contract - when the asset ends. An interest in a partnership is considered an intangible asset. The capital gain the taxpayer makes from CGT event C2 is equal to the difference between the proceeds received from the event happening and the cost base of the asset (subsection 104-25(3) of the ITAA 1997). You did not pay anything on being admitted to the Partnership and there was no goodwill associated with the Partnership. Nonetheless, your interest in the Partnership was a CGT asset. As a result of leaving the Partnership your interest in the Partnership has ended. In this case, the individual did not pay anything on being admitted to the Partnership and there was no goodwill associated with the Partnership. Nonetheless, the individual's interest in the Partnership was a CGT asset. As a result of leaving the Partnership the individual's interest in the Partnership has ended. We consider that the amounts that relate to annual and sabbatical leave were also paid in respect to the surrender of your interest in the partnership. This is due to the fact that the individual was not an employee and did not have entitlements to annual leave. Therefore, CGT event C2 happened when the agreement between the parties that resulted in the resignation was made (paragraph 104-25(2)(a) of the ITAA 1997). The individual made a capital gain equal to the difference between the lump sum payment you received from the Partnership and the cost base of your interest in the Partnership. Although the individual did not pay any consideration to acquire the interest, the cost base can include other costs incurred to acquire the interest or costs that relate to the resignation occurring. Restrictive covenant The Partner Retirement Deed entered into contains a restrictive covenant in which it stipulates that you will, among other things; • not solicit or accept business from clients of the Partnership, • not use the Partnership's logo or service mark • not conduct a similar business or activity for a certain period of time. The Commissioner's definition of a restrictive covenant in subparagraph 6(a) of Taxation Ruling TR 95/3 is 'an agreement between two or more parties to refrain from doing some act or thing'. Examples of restrictive covenants are provided in paragraph 35 of TR 95/3 and include: • a covenant by an employee to an employer in which the employee promises to refrain from doing some act (e.g. not to disclose special processes, trade connections and trade secrets of the employer); • a restrictive (negative) covenant preventing an employee from competing in another business or opening a new business; • a restriction on competition, enforced by an agreement separate from an employment agreement, which comes into effect after employment ceases; • a contract of employment stipulating exclusive service by the employee during its term A right created under a restrictive covenant is a CGT asset. Such a right constitutes a CGT asset as defined in section 108-5 of the ITAA 1997, and is either a proprietary right (paragraph 108-5(1)(a) of the ITAA 1997) or a legal or equitable, non-proprietary right (paragraph 108-5(1)(b) of the ITAA 1997). The creation of such a right in favour of the partnership is a CGT event D1 under subsection 104-35(1) of the ITAA 1997. In this case, the agreement contains exclusive dealing and restraint clauses. These clauses satisfy the definition of a restrictive covenant and CGT event D1 will happen at the time the contract is entered into. However, as it is considered that the individual was dealing at arm's length in entering into the agreement and, no proceeds were specifically allocated to a restrictive covenant, we will treat the granting of the covenant as being ancillary to the surrender of the partnership interest. We therefore accept that no part of the capital proceeds is attributable to the restrictive covenant CGT event D1. The total of the capital proceeds is for the surrender of the individual's partnership interest and is attributable to CGT event C2. Section 152-10 of the ITAA 1997 contains the basic conditions you must satisfy to be eligible for the small business capital gains tax (CGT) concessions. These conditions are: (a) a CGT event happens in relation to a CGT asset in an income year. (b) the event would have resulted in the gain (c) at least one of the following applies: (i) you are a small business entity for the income year (ii) you satisfy the maximum net asset value test in section 152-15 of the ITAA 1997 (iii) you are a partner in a partnership that is a small business entity for the income year and the CGT asset is an asset of the partnership or (iv) the conditions in subsection 152-10(1A) or (1B) of the ITAA 1997 are satisfied in relation to the CGT asset in the income year. (a) the CGT asset satisfies the active asset test in section 152-35 of the ITAA 1997. Section 152-40 of the ITAA 1997 provides the meaning of 'active asset'. A CGT asset will be an active asset at a time if, at that time, you own the asset and the asset was used or held ready for use by you, an affiliate of yours, or by another entity that is 'connected with' you, in the course of carrying on a business. However, an asset whose main use is to derive rent can not be an active asset. Sub-section 152-35(1) of the ITAA 1997 states that a CGT asset satisfies the active asset test if: • you have owned the asset for 15 years or less and the asset was an active asset of yours for a total of at least half of the period of ownership, or • you have owned the asset for more than 15 years and the asset was an active asset of yours for a total of at least 7 and a half years. Subsection 152-40(1) of the ITAA 1997 provides that an asset is an active asset if the asset is an intangible asset you own and is inherently connected with a business that is carried on (whether alone or in partnership) by you, your affiliate, or an entity connected with you. In this case, the individual's interest in the Partnership was an intangible asset. It was through this interest that the individual carried on a business in partnership with others. The individual's interest in the Partnership is inseparable from the business (and therefore inherently connected with the business) that was carried on. As such, the interest is considered an active asset. As the partnership interest was necessarily employed as an active asset throughout the whole period that the individual held it, the active asset test is satisfied. It was stated that the individual satisfies the maximum net asset value test (MNAV) under section 152-15 of the ITAA 1997. Accordingly, based on the information provided, the individual satisfies all the necessary basic conditions to be eligible for the CGT concessions for small business. Retirement exemption If you are an individual, you can choose to disregard all or part of a capital gain if: • you satisfy the basic conditions • you keep a written record of the amount you choose to disregard, and • if you are under 55 years old just before you choose to use the retirement exemption, you make a personal contribution equal to the exempt amount to a complying superannuation fund or retirement savings account (RSA). In this case, the individual satisfies the basic conditions for the small business concessions. As the individual is over 55 years of age they are not required to make a personal contribution equal to the exempt amount to a complying superannuation fund or RSA. Provided the individual keeps a written record of the amount disregarded they are entitled to apply the small business retirement exemption. In this case, the Discretionary Trust received a payment from the Service Trust because the individual retired as a partner from the Partnership. Consequently, the Discretionary Trust's rights with respect to the Service Trust came to an end. Accordingly, CGT event C2 was triggered when the Deed was entered into. As the Discretionary Trust has held an interest in the Service Trust for more than 12 months, they are entitled to apply the 50% discount.