Private ruling: Lump sum payment
Published: March 2015
Ruling period: Year ended 30 June 2014
Date scheme commenced: 1 July 2013

Ruling: Q1: Is the lump sum payment received from entity A assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes. | Q2: Is the lump sum payment received from entity A included in your assessable income as a capital gain from CGT event D1? | A2: No. | Q3: If the answer to question 2 is yes, will you be able to access the small business concessions under Division 152 of the ITAA 1997? | A3: Not applicable as the answer to question 2 is no.


Relevant legislative provisions: Income tax Assessment Act 1997 Section 6-5 | Income tax Assessment Act 1997 Section 17-5 | Income tax Assessment Act 1997 Section 102-5 | Income tax Assessment Act 1997 Section 104-35 | Income tax Assessment Act 1997 Section 118-20

Reasons for decision: Detailed Reasoning - Ordinary assessable income: Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes the ordinary income they derived directly or indirectly from all sources, whether in or out of Australia, during the income year. The legislation does not provide any specific guidance on what is meant by 'income according to ordinary concepts'. However, a substantial body of case law has evolved to identify various factors that indicate whether an amount is income according to ordinary concepts. In Scott v Commissioner of Taxation (NSW) (1935) 35 SR (NSW) 215; 3 ATD, Jordan CJ stated: …the word income is not a term of art, and what forms of receipts are comprehended within it, and what principles are to be applied to ascertain how much of those receipts ought to be treated as income, must be determined in accordance with the ordinary concepts and usages of mankind, except in so far as the statute states or indicates [to the contrary]… A frequent characteristic of income receipts is an element of periodicity, recurrence or regularity, even if the receipts are not directly attributable to employment or services rendered ( FC of T v Dixon (1952) 86 CLR 540 and FC of T v Blake 84 ATC 4661). However, periodicity, recurrence or regularity is not always essential for an amount to be income. For example, the proceeds of an isolated transaction, even if received as a lump sum, may be income ( FC of T v Myer Emporium Ltd 87 ATC 4363), while instalments of a capital sum, even though received regularly from one source, are not income. Equally, an unsolicited lump sum payment which is unlikely to be repeated is generally not income according to ordinary concepts ( FC of T v Harris 80 ATC 4238), while lump sum damages will nevertheless be assessable where they are compensation for losses of an income nature only. Further, personal earnings from the performance of services, whether as an employee or otherwise, are clearly income even if the services are performed, and/or the rewards received, irregularly. It is also important to determine the character of the payment in the recipient's hands ( Scott v FC of T (1966) 117 CLR 514 at p. 526; Hayes v FC of T (1956) 96 CLR 47 at p. 55; Federal Coke Co. Pty. Ltd. v FC of T (1977) 34 FLR 375 at p. 402 per Brennan J. That does not mean that the motive of the person in making the payment will be irrelevant but it will not be determinative. The test to be applied will be objective rather than subjective ( Hayes at p. 55). Based on the Agreement, the payment made to you appears to have been a one-off lump sum payment by entity A to you. Thus, it is necessary to consider whether the payment has the character of income. | Detailed Reasoning - Incentive/ inducement payments: Based on case law precedents, incentive/inducement payments paid to taxpayers as lump sums can be assessable income. Lump sum payments made to two taxpayers to ensure they remained in employment was held to be assessable income in McLean & Anor v FC of T (1996) 32 ATR 647; 96 ATC 4443 ( McLean ) and Dean & Anor v FC of T (1997) 37 ATR 52; 97 ATC. In the Federal Court decision in McLean , Northrop J stated the following at 96 ATC 4447: In the present case, the Tribunal held that the retention payments received by the taxpayers constituted income derived by them within paragraph 25(1)(a) of the Assessment Act . In my opinion, the Tribunal was not in error in so concluding. In my opinion all the facts of this case point to the conclusion that the receipt of the retention payments by the taxpayers was related to their activities as employees and as continuing to be employees with the result that in substance and reality the amounts received were the product of the income-earning activity on the part of each taxpayer. The nature of the payments is made clear by a reference to the contents of the letters written to them by Elders Resources. The payment was made as an inducement to each taxpayer to continue in his employment for a period of at least one year. If the taxpayer voluntarily left his employment, the amount of the payment was reduced but otherwise the payment was for the specified sum. The fact that this was not to be paid on a periodic basis does not detract from the true nature of the receipt of the payment. The continual employment was at the very heart of the receipt of the payment the amount of which was calculated having regard to the salary of the taxpayer. There is no similarity between the facts of this case and those discussed in Dickenson v. FC of T (1957) 11 ATD 157; (1958) 11 ATD 415; (1957-1958) 98 C.L.R. 460. In Pickford v FC of T 98 ATC 2268; 40 ATR 1078 ( Pickford ), the taxpayer was an employee of E Ltd who had been granted options to purchase ordinary shares in his employer's parent company pursuant to an employee share scheme. However, the options would lapse immediately if the taxpayer ceased to be an employee of E Ltd. W Ltd made an offer of employment to the taxpayer which included a payment of $20,000 as compensation for the potential capital gain that may have been available to the taxpayer in respect of the shares to which he would have been entitled had he remained an employee of E Ltd. The Commissioner ruled that the payment was assessable as ordinary income, and affirmed this decision at the objection stage. At the Administrative Appeals Tribunal, DJ Trowse (Member) upheld the Commissioner's decision, stating at page 2271 that: 14. The facts of this matter, when viewed objectively, leave the Tribunal in no doubt that the agreement to pay the $20,000 was an integral part of the offer made by W Ltd and accepted by the applicant. To exclude the $20,000 is to omit one of the main attractions from the overall salary package which, in the Tribunal's opinion, should be regarded as a single bundle of entitlements attaching to the offer of employment with W Ltd. 15. A consideration of all the material including the letter containing the offer (T3) leads the Tribunal to the conclusion that, irrespective of the description furnished to the amount in contention, it represented a straightforward inducement for the applicant to enter the employment of W Ltd. Furthermore, the Tribunal is satisfied that the source of the payment is to be found in the service to be rendered by the applicant to W Ltd and that it was in the nature of a benefit for future service. It is also the Australian Taxation Office (ATO) view that the lump sum retention bonuses paid by the Australian Defence Forces (ADF) in order to encourage serving members to remain within the ADF for a fixed period are assessable as ordinary income (see ATO Interpretative Decision ID 2003/373). Notably, where these ADF members failed to complete the required period of service, they were contractually obliged to repay part of the retention bonus based on the incomplete part of the service. | Detailed Reasoning - Application to your circumstances: As stated in the Agreement, the amount paid to you was paid, prime facie in consideration for you entering into the Agreement for a fixed term. Indeed, where you breached the terms of the Agreement, or entity A terminated it, you were required to pay back an amount of the lump sum payment for each whole month remaining until the term of the Agreement expired. It can thus be concluded that the character of the payment in your hands was an inducement for you to provide your services to entity A for the duration of the Agreement (in association with an agreement to abide by the 'restraint' provisions of the Agreement both for the term of the service and for six months afterward). As per the decision in Pickford , the payment was thus an 'integral part' of the Agreement, being part of '…a single bundle of entitlements…', and a 'straightforward inducement' to secure your future services for entity A over the period of the Agreement. It is also analogous to the retention bonus payments made to ADF members, which required a repayment of the lump sum to the extent the taxpayer did not complete the contracted period of service. It is acknowledged that the payment made to you was in the context of a business rather than employment relationship. However, it is considered that the principles established in these case law decisions in relation to such incentive/inducement payments are equally applicable to a business service contract. On that basis, the amount received by you is considered to be assessable as ordinary income under section 6-5 of the ITAA 1997. | Detailed Reasoning - Isolated transaction: It is also arguable that the payment made to you is assessable as a business profit or gain, including a gain made as part of an isolated transaction. Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income provides guidance for determining whether profits from isolated transactions are assessable as ordinary income under section 6-5 of the ITAA 1997. Paragraphs 6-8 of the Ruling state: 6. Whether a profit from an isolated transaction is income according to the ordinary concepts and usages of mankind depends very much on the circumstances of the case. However, a profit from an isolated transaction is generally income when both of the following elements are present: (a) the intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain; and (b) the transaction was entered into, and the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction. 7. The relevant intention or purpose of the taxpayer (of making a profit or gain) is not the subjective intention or purpose of the taxpayer. Rather, it is the taxpayer's intention or purpose discerned from an objective consideration of the facts and circumstances of the case. 8. It is not necessary that the intention or purpose of profit-making be the sole or dominant intention or purpose for entering into the transaction. It is sufficient if profit-making is a significant purpose. Thus, in order to determine whether your motive for entering into the transaction was to make a profit it is necessary to consider your intention or purpose from an objective consideration of the facts and circumstances rather than your subjective intention or purpose. Discussing the decision in FC of T v. Cooling [1990] FCA 204; 90 ATC 4472; 21 ATR 13, paragraph 50 of TR 92/3 states that: 50. The principal case since Myer in which a profit-making transaction has been held to be a business operation or commercial transaction is FC of T v. Cooling . There, the Full Federal Court (Lockhart, Gummow and Hill JJ) held that a payment received by a firm of solicitors as an incentive for it to relocate to new premises was income according to ordinary concepts. At the relevant time in the city where the firm practised, it was an ordinary incident of leasing premises of the type in question to receive incentive payments. Hill J (with whom the other judges agreed on the subsection 25(1) issue) said that where a taxpayer operates from leased premises, the move from one premises to another and the leasing of the premises occupied are acts of the taxpayer in the course of its business activity. At 90 ATC 4484; 21 ATR 27 Hill J concluded: 'In my view the transaction entered into by the firm was a commercial transaction; it formed part of the business activity of the firm and a not insignificant purpose of it was the obtaining of a commercial profit by way of the incentive payment.' | Detailed Reasoning - Application to your circumstances: In your ruling application, it is contended that you entered into the Agreement for commercial and personal reasons and that profit-making by reason of receiving the lump sum payment was not a significant purpose. In the ruling application, it is further contended that the payment was not a reward for services. However, your statements are not consistent with the full terms of the Agreement accepted by you. According to the Agreement, the payment was clearly made to you by entity A for only two stated purposes being: (1) as consideration for you entering into the Agreement to work for entity A for a fixed period of X years; and (2) for agreeing to the restraints set out in the Agreement. Thus, based on the 'facts and circumstances of the case…', we cannot accept that the objective purposes of the payment was limited to those contended in the ruling application. Rather, viewed objectively, the significant purpose of the payment is directly stated in the Agreement to be you entering into an agreement to provide services, and for your agreeing to abide by restraints placed on you by entity A during the course of this service and for a period afterward. Thus, it is considered that objectively, your intention or purpose in entering into the transaction was to make a profit or gain from your agreement to provide services to entity A, including a profit or gain through the receipt of the lump sum payment. | Detailed Reasoning - Commercial transaction: You entered into the Agreement with entity A in the course of carrying on your business as a professional. Indeed, the Agreement and the payments made under it solely relate to you entering into the arrangement under which you would provide your services for a fixed period, and would agree to be bound in the undertaking of this business by certain restraints of trade. As contended by you, it is considered that the payment was not received as part of a transaction which was outside the course of your normal business. Rather, it was directly related to the gaining of profit or gain from the undertaking of this business through the Agreement with entity A. It is considered that the transaction represented by the Agreement '…was entered into, and the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction.' Indeed, as per Cooling , it is considered that the: …transaction entered into…was a commercial transaction; it formed part of the business activity of the firm and a not insignificant purpose of it was the obtaining of a commercial profit by way of the incentive payment. By entering into the Agreement and receiving a lump sum which is directly related to your business of deriving personal services income, it is considered that the transaction meets the requirements of paragraph 6 of TR 92/3 as a gain or profit arising from an isolated transaction, and that this gain was not made outside the ordinary course of your business. | Detailed Reasoning - Capital gains: Under subsection 102-5(1) of the ITAA 1997, your assessable income includes your net capital gain (if any) for the income year. A net capital gain is worked out in accordance with the method statement set out in subsection 102-5(1) of the ITAA 1997. A capital gain or loss arises when a CGT event occurs. A summary of CGT events is set out in section 104-5 of the ITAA 1997. Section 104-35 of the ITAA 1997 deals with CGT event D1 and states the following: CGT event D1 happens if you create a contractual right or other legal or equitable right or other legal or equitable right in another entity. Example: You enter into a contract with the purchaser of your business not to operate a similar business in the same town. The contract states that $20,000 was paid for this. You have created a contractual right in favour of the purchaser. If you breach the contract, the purchaser can enforce that right. The time of the event is when you enter into the contract or create the other right. You make a capital gain if the capital proceeds from creating the right are more than the incidental costs you incurred that relate to the event. You make a capital loss if the capital proceeds are less. Example: To continue the example: If you paid your lawyer $1,500 to draw up the contract, you make a capital gain of: $20,000 - $1,500 = $18,500 Taxation Ruling TR 95/3 Income tax and capital gains: application of subsections 160M(6) and 160M(7) to restrictive covenants and trade ties sets out the ATO view on the taxation treatment of consideration received for granting restrictive covenants and trade ties. For the purposes of the Ruling, a restrictive covenant is an agreement between two or more parties to refrain from doing some act or thing. The Ruling considers the taxation treatment of payments for restrictive covenants under former subsections 160M(6) (which has been replaced by section 104-35 of the ITAA 1997) and 160M(7) of the ITAA 1936 (which has been replaced by section 104-155 of the ITAA 1997) both before and after the 1992 amendments to those provisions. Despite the fact that the Ruling refers to former subsections 160M(6) and (7) of the ITAA 1936, which have now been repealed, it applies in the same way to the rewritten provisions. Paragraphs 17-19 of TR 95/3 state the following: 17. Again, if a restrictive covenant relates both to a current period of employment and to a period after the end of that employment, the portion of the consideration received that relates to the period of employment is assessable under subsection 25(1) [now section 6-5] or paragraph 26(e) [now section 15-2]. That portion also comes within the new subsection 160M(6) (with the new subsection 160M(7) as a backup) if the restrictive covenant was entered into on or after 26 June 1992. However, the application of the new subsection 160M(7) requires that there is an existing asset at the time of entry into the covenant - e.g. trade secrets, trade connections or goodwill of value. Subsection 160ZA(4) applies to reduce any capital gain to the extent that the amount is assessable as ordinary income. 18. The portion of the consideration that relates to the period after the end of the employment is assessable under the new subsection 160M(6). 19. If the contract does not apportion the payment, the amount reasonably attributable to the period of employment needs to be estimated by the parties to the contract, according to the terms of the contract and any other relevant facts. If it is not possible to make any reasonable apportionment, the whole amount is assessable under the new subsection 160M(6) if the restrictive covenant was entered into on or after 26 June 1992. The following example, which assists in explaining how this principle would work in practice, is set out at paragraphs 128 and 130 of TR 95/3, as follows: | Detailed Reasoning - Example 3: 128. Penelope enters into an employment contract with her employer Tracey Bros. The terms of the contract require her to remain with her employer for three years to develop certain trade secrets and on termination of the contract, Penelope is prevented from entering into competition with Tracey Bros for a further two years. In consideration for entering into the contract, Penelope receives $500,000; the contract states that $200,000 relates to the current period of employment and $300,000 relates to the period after employment. | Detailed Reasoning - Post 1992 amendments made by the TLAA (No 4): 130. That portion of the receipt which relates to employment is assessable under subsection 25(1) because that term of the contract comes into effect immediately. The portion relating to the period following the employment is assessable as a capital gain under subsection 160M(6) (with subsection 160M(7) as a backup). Note : If the contract did not apportion the payment and it is not possible to make any reasonable apportionment, the whole amount would be assessable under subsection 160M(6) (where a post 1992 arrangement) or subsection 160M(7) (where a pre 1992 arrangement). | Detailed Reasoning - Application to your circumstances: As the payment under the Agreement is not solely for the restraints you agreed to both during the period of the Agreement and for a short period after it ended, it is considered that the principles set out in TR 95/3 do not apply in this case. The restraints follow as a natural consequence of the positive obligations of you to provide full-time services for entity A for a period and as such, it is considered that no part of the payment made relates specifically to the restraints. That is, the payment is prime facie an inducement paid to you in order to obtain your services for a period. Even if part of the payment was considered to be in respect of the restraint after the Agreement ceased, it is not possible to apportion the amount attributable to that restraint as the payment under the Agreement is a lump sum and there is no evidence that there was any separate bargaining/negotiation regarding that restraint. Furthermore, under the Agreement, you are required to repay an amount for each whole month remaining until the term of the expiry of the Agreement if entity A terminates the Agreement in accordance with its terms or you breach the Agreement. This means that if the Agreement was terminated in the first month, you would be required to pay back the whole of the payment. This further indicates that no amount paid under the Agreement is attributable to the restraint after the Agreement ends. Finally, even if the lump payment was considered to be assessable as a capital gain arising from CGT event D1, the amount of that capital gain would be reduced to nil under section 118-20 of the ITAA 1997 as a result of the payment also being included in your assessable income under section 6-5 of the ITAA 1997.

You commenced working in your field several years ago. | Over the next several years you built up your business. | In 20XX you commenced discussions with entity A. | Entity A offered you the opportunity to move to centre C in city B. | The offer with entity A included several significant commercial and personal benefits for you. | You commenced working with entity A. | The next month you entered into an Agreement with entity A to work for a X year period. | Pursuant to the Agreement and in return for a % payment of your gross fees, you were relieved of the significant commercial and personal burden associated with the substantial administrative work at your previous work place. | As a result you had the opportunity to concentrate on your professional work. | In consideration for you entering into the Agreement for a fixed term and for agreement to certain restraints, entity A agreed to make a lump sum payment. | Under the agreement if you breach the conditions of the agreement you must pay entity A a payment for each whole month remaining until the term of the expiry of the agreement at the time of the breach.