Private ruling: Taxation implications of proposed sale of an incorporated business
Date of advice: 8 September 2017
Published: January 2018
Ruling period: Year ended 30 June 2017 | Year ended 30 June 2018
Date scheme commenced: 1 June 2016

Ruling: Q1: Is the Purchase Price under the arrangement, comprising the Upfront Payment and the Earn-Out amounts, payable to the Taxpayer as part of the arrangement with a third party (“New Co”) income according to section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes, the Purchase Price payable to the Taxpayer as part of the arrangement with New Co is income according to section 6-5 of the ITAA 1997. | Q2: Are the Earn-Out amounts payable to the Taxpayer as part of the arrangement with New Co assessable as a dividend according to section 44 of the Income Tax Assessment Act 1936 (ITAA 1936)? | A2: Yes, where the payments to the Taxpayer are not ordinary income under section 6-5 of the ITAA 1997, the payments will represent a dividend to the extent that the payments are made out of profits pursuant to section 44 of the ITAA 1936. | Q3: Are the Earn-Out amounts payable to the Taxpayer as part of the arrangement with New Co assessable as a deemed dividend according to Division 7A of the ITAA 1936? | A3: Yes, to the extent the payments are not out of profits and to the extent that there is a distributable surplus, the Earn-Out amounts will constitute a deemed dividend under section 109C of the ITAA 1936.

Relevant facts and circumstances: This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling. ● The Taxpayer is a professional. ● The Taxpayer operated their business as a sole trader for a number of years, however since 2016 has operated it through a proprietary limited company of which they are the sole director, shareholder and secretary. ● The Taxpayer has operated under a number of trading names, however has been operating their business under the current trading name for approximately three years. ● The business currently employs a number of staff. The proprietary limited company invoices to third parties under the agreement. The proposed new structure ● The Taxpayer has been approached by a third party (New Co) to acquire 100% of the shares in the company they operates. ● It is proposed that the Taxpayer would be a shareholder in New Co. ● It is proposed that the Taxpayer will receive 40% of the issued shares in entity and receive an amount of cash. ● New Co will borrow from a bank to fund the payment of the Purchase Price. ● Some of the key aspects of the arrangement are: - Payment of an upfront payment and ongoing payments which are conditional upon certain events occurring; - An option is granted to the Taxpayer to acquire a number of shares in the entity and an option is granted in favour of New Co to require the Taxpayer to acquire additional shares in the entity; and - A non-competition clause restricting the ability of the Taxpayer to operate or be involved in a similar business in a certain geographical location for a period of time after the completion date or whilst the Taxpayer holds shares in the entity. - If the Taxpayer leaves within 2 years the Earn-Out amount will be reduced. It is anticipated the Taxpayer would be remunerated for their personal services they provide by way of salary and wages. - Net profit remaining after expenses, interest and taxes (if any) will be available for distribution to shareholders of New Co as dividends. Dividends would be payable subject to working capital requirements, debt repayments as well as current and future operations. - the Taxpayer is required to provide a personal guarantee (secured via the Taxpayer’s title to their residential premises) that the business will continue to perform at the level modelled by New Co to calculate the upfront and later payments.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 6-5. | Income Tax Assessment Act 1936 section 44. | Income Tax Assessment Act 1936 section 109C. | Income Tax Assessment Act 1936 section 109J. | Income Tax Assessment Act 1936 section 109L. | Income Tax Assessment Act 1936 section 109Y.

Reasons for decision: Summary: Is the Purchase Price under the agreement, comprising an Upfront Payment and the Earn-Out amounts, payable to the Taxpayer as part of the arrangement with New Co income according to section 6-5 of the ITAA 1997? Summary Yes, the Purchase Price payable to the Taxpayer upon entering into the arrangement with New Co is income according to section 6-5 of the ITAA 1997 to the extent it does not represent the value of the business assets, including the business goodwill, a value for which has not been provided. Detailed reasoning Section 6-5(1) of the ITAA 1997 defines your assessable income as including ordinary income. This section defines ordinary income as ‘income according to ordinary concepts’. The transaction The Taxpayer is a professional who incorporated their business recently. Prior to that, the Taxpayer operated their business as a sole trader. Over the course of their career, the Taxpayer has built up a reputation in their field which has resulted in significant personal goodwill. | Detailed Reasoning - Goodwill: Personal goodwill is non-transferable. By its nature, personal goodwill attaches to an individual and cannot be transferred by sale. It can be used by a business by employment of the individual who holds the goodwill or by other agreements. It was held in Commissioner of Taxation (Cth) v. Krakos Investments Pty Ltd (1995) 61 FCR 489 ( Krakos ) on page 497 that: Personal goodwill has no relationship to premises but follows the person to whom it is attached. It is incapable by its very nature of being directly assigned to another , although it may be availed of by another securing the services of the person to whom the goodwill attaches and perhaps by that person agreeing not to work for another or in competition.” (Emphasis added) Currently the incorporated business exploits the goodwill of the Taxpayer in carrying out its business operations. However, that does not mean that the personal goodwill that has historically rested in the Taxpayer is now held by the incorporated business. We accept that the incorporated business has generated a small amount of goodwill in the business, which would comprise of the following: (a) The business name, which has been used for a short time. (b) The location where the business is conducted. (c) The incorporated business website. (d) The business structure, including administrative support and ongoing employees. (e) The business protocols. This small amount of business goodwill would have been transferred to the business upon incorporation. No valuation of this goodwill has been provided and we do not accept the assertion that the methodology used to calculate the Purchase Price, reflects the value of the business goodwill because there is no acknowledgement that a significant portion of the goodwill that New Co is seeking to gain access to is personal to the Taxpayer. According to paragraph 127 of Taxation Ruling TR 1999/16 Income tax: capital gains: goodwill of a business (TR 1999/16), personal goodwill is defined as: The source of goodwill comprised of the particular personal skills and abilities, reputation, character and personality possessed by persons working in a business. The majority of the goodwill available to the incorporated business is from the personal skills, abilities and reputation of the Taxpayer as a professional with an established reputation in the locality. This view is supported by the discussion in Commissioner of Taxation v. Murry (1998) 193 CLR 605 ( Murry ) at paragraph 52: [W]here goodwill is largely the product of the personality of the owner or one or more employees of a business, much of the goodwill of the business will disappear upon the cessation of the connection between that person or persons and the business . (Emphasis added) Upon the sale to New Co, it will only be the components of business goodwill set out above that will be transferred. This is supported by paragraph 59 of TR 1999/16: Other sources of goodwill continue to draw custom to the business even though the owner or employee has no further connection with the business and, in that respect, the goodwill can be sold. The process through which New Co plans to transition the Taxpayer out of the business will not involve a transfer of the Taxpayer’s personal goodwill to the incorporated business. Rather, the Taxpayer’s continued involvement with will increase the business goodwill of the incorporated business and/or the personal goodwill of the other individuals involved in the business over time. We accept that this could successfully achieve the aim of New Co in undertaking this transaction, being to maintain New Co’s earnings after the point at which the Taxpayer leaves the business. This will not, however, be an incremental transfer of the Taxpayer’s personal goodwill. We note that it has been argued that the agreements the incorporated business has with a number of entities to provide services is part of the goodwill of the incorporated business. The evidence indicates that these agreements were entered into prior to the incorporation of the business and therefore the Taxpayer used their relationships with the entities, experience and personal reputation to secure the agreements. The primary argument put forward is that the incorporated business uses two dominant types of goodwill, ‘pure personal goodwill’ and ‘transferable personal goodwill’. It was asserted that the ATO erred by not distinguishing between these two components of personal goodwill. We reject the submission that personal goodwill can be split into ‘pure personal goodwill’ and ‘transferable goodwill’. The courts have considered personal goodwill to be wholly non-transferable by its nature, as seen in Murry and Krakos. The Commissioner’s view is in line with the High Court, as shown in paragraphs 59 and 127 of TR 1999/16. The concepts of ‘pure personal goodwill’ and ‘transferrable goodwill’ originated from a valuation context and in family law cases for dividing asset pools, but this does not change the treatment of goodwill for taxation purposes. There is no legal basis for this split to be applied in a taxation context, and your submissions have not addressed the legal principles underpinning the tax law treatment of goodwill. In concluding that the entirety of the Purchase Price is not for goodwill, we are not departing from the valuation methodology in paragraph 47 of TR 1999/16. The Commissioner agrees with the general proposition that the value of the business goodwill is the difference between the value of the business less the other business assets. As discussed above, no amount of the Purchase Price can be attributable to the purchase of the Taxpayer’s personal goodwill because it is not transferable, and the small amount of business goodwill held by the incorporated business has not been valued. In light of this, the majority of the Purchase Price must be for something other than the assets of the business, including its goodwill. | Detailed Reasoning - Effect of restrictive covenant: Under the arrangement, the Taxpayer is subject to a restrictive covenant preventing them from gaining other employment while holding shares in New Co for a specified period of time. It has also been submitted that the Taxpayer will continue employment for a time after the sale of the incorporated business, however, there is currently nothing in the agreements that compels them to do so. No amount is stipulated in the contract for the value of the restrictive covenant itself, therefore none of the proceeds are directly attributable to the restrictive covenant. See paragraph 106 of TR 1999/16. Paragraph 107 of TR 1999/16 says the intended purpose of a restrictive covenant in a sale of business contract is to facilitate the transfer of the goodwill of the business and to protect the goodwill disposed of by the vendor of the business. In this context the business goodwill being referred to is that held by the incorporated business, as discussed above. The restrictive covenant assists to transition the Taxpayer out of the business and transfer the business goodwill, through ensuring that the Taxpayer does not work elsewhere which would have enabled them to use their personal goodwill to benefit another entity. However it does not allow or assist the Taxpayer to transfer their personal goodwill. As personal goodwill is not able to be transferred via sale, we do not accept your contention that the Purchase Price payable to the Taxpayer is referable to the component of the goodwill that can be transferred – being the business goodwill. As a result we consider that any portion of the Purchase Price in excess of the value of the business assets including the business goodwill (for which you have not provided a valuation) is income under section 6-5 of the ITAA 1997 for any of the following reasons. | Detailed Reasoning - Payment to use personal goodwill: The premium that is paid above the value of the capital assets and nominal business goodwill can be considered a payment for the continuing use of the Taxpayer’s personal goodwill and to prevent the Taxpayer from competing at another organisation. The Taxpayer’s personal goodwill is a capital asset in their hands. It is clear that the incorporated business’s continued access to that goodwill is crucial to transition the business to a position where the Taxpayer can leave without a significant financial impact to the business. The Taxpayer is being paid an income stream for the use of their personal goodwill that is assessable as ordinary income. | Detailed Reasoning - Inducement payment: Alternatively, a portion of the Purchase Price, can be characterised as being an inducement to The Taxpayer to dispose of their interest in the incorporated business which is income under section 6-5 of the ITAA 1997. Inducement payments were considered in Federal Commissioner of Taxation v. Montgomery (1999) 198 CLR 639 (“ Montgomery ”), where a law firm received an inducement payment to sign a lease at a new property. At paragraph 118, the High Court majority ruled that the amounts were income, not capital, because the firm “exploited its capital to obtain the inducement amounts”; the capital exploited was the business’ goodwill which would have attracted high-end tenants to the new building. The use of capital to make a gain or profit is income according to ordinary concepts. In this arrangement, The Taxpayer will be paid the Purchase Price for the sale of their shares in the incorporated business and as an inducement to enter into the arrangement. Section 116-40 of the ITAA 1997 requires a reasonable apportionment of the total payment between the capital proceeds for the sale of the shares and the inducement payment. The portion that is the inducement payment is assessable income under section 6-5 of the ITAA 1997. | Detailed Reasoning - Isolated transaction: The Upfront Payment may also be considered to be profit from an isolated transaction. The most detailed guidance of whether the Upfront Payment in question is income of this nature, is contained in Taxation Ruling 92/3 Income Tax: Whether profits on isolated transactions are income (‘TR 92/3’). The relevant paragraph of TR 92/3 states: 6. Whether a profit from an isolated transaction is income according to 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 (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. If the transaction in question is commercial in nature, the determination will turn on a consideration of the taxpayer’s intention based on circumstantial fact. Paragraph 7 of TR 92/3 requires the ATO to determine the relevant intention or purpose of the taxpayer objectively after considering the facts and circumstances of the case. Federal Commissioner of Taxation v. The Myer Emporium Ltd (1987) 87 ATC 4363 is the leading authority for the assertion that an isolated profit can be assessed as income. The taxpayer, Myer , was the parent company group in the business of retail trading and property development. The taxpayer loaned funds to a subsidiary repayable with interest. Three days later, as intended, the taxpayer assigned its right to receive the interest in consideration for a lump sum payment. This was a transaction which clearly fell outside the ordinary course of the taxpayer’s business (property development). Nonetheless, the payment was treated as income. Central to the judgment was the taxpayer’s intention in entering into the transaction, it was said at page 4367: Generally speaking, however, it may be said that if the circumstances are such as to give rise to the inference that the taxpayer’s intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer’s business. This passage confirms that where a transaction occurs outside the scope of ordinary business activities, it may still be considered an isolated transaction if the nature of such a transaction is ‘commercial’ and there was intention to make a profit at the time of entering into the transaction. Objective intention or purpose According to paragraph 7 of TR 92/3, the Commissioner must objectively determine the intention or purpose of the taxpayer. Paragraph 8 of TR 92/3 states the profit-making intention does not have to be the sole purpose or even dominant intention in entering the transaction. Furthermore, Commissioner of Taxation v. Cooling (1990) 90 ATC 4472 at page 4481 states the contextual background surrounding the transaction in question is important when making an objective decision on a taxpayer’s intention: While obliging the court to accept documents or transactions found to be genuine, as such, the court is not compelled to look at a document or transaction in blinkers, isolated from any context to which it properly belongs. Up until recently, the Taxpayer operated a sole trader business, providing services and to clients. The Taxpayer had been operating their business for some time primarily trading under their own name. The current trading name has been used only recently. Over the history of their business, the Taxpayer has relied on their personal goodwill to generate business. Information provided about New Co business model indicates that they plan to undertake a similar arrangement with other similar businesses through the use of separate acquisition companies acquiring 100% of the shares in an incorporated business. Therefore, The Taxpayer would not have been able to enter into the transaction in the structure proposed without first incorporating their business. This supports the conclusion that the sole or dominant purpose of the Taxpayer incorporating business was to facilitate the sale to New Co with a view to profit. In the course of carrying on a business or commercial transaction Paragraph 12 of TR 92/3 states that for a transaction to be a commercial transaction, it is sufficient that the transaction is business or commercial in character. Paragraph 49 of TR 92/3 lists factors to consider in determining whether a transaction is commercial in nature. The following points consider those factors as they apply to this case: (a) The transaction is being undertaken through two corporations (the incorporated business and New Co) which have been or will be established for this purpose. (b) The Purchase Price of the business consisting of multiple options, prescriptive requirements for the investment of components of the consideration and potential earnouts which demonstrate a high level of sophistication and complexity. (c) The Taxpayer is represented by professional tax advisors. (d) The property sold as part of the agreement is that which is necessary for and fundamental to the operation of the the incorporated businessbusiness. (e) the incorporated business was only incorporated after the sale was in serious contemplation. Prior to the proposed transaction, the Taxpayer’s ordinary course of business was in the provision of services to clients. While the transaction falls outside the Taxpayer’s ordinary course of business, any profit (not otherwise assessable) is still considered to be income from an isolated transaction because the Taxpayer has intended to profit from a commercial transaction. | Detailed Reasoning - Question 2: Are the Earn-Out amounts payable to the Taxpayer as part of the arrangement with New Co assessable as a dividend according to section 44 of the Income Tax Assessment Act 1936 (ITAA 1936)? Summary Yes, if the payments to the Taxpayer are not ordinary income under section 6-5 of the ITAA 1997, the payments will represent a dividend to the extent that they are made out of profits pursuant to section 44 of the ITAA 1936. Detailed reasoning A payment of money or transfer of property to a shareholder out of the profits of a private company is an assessable dividend under section 44 of the ITAA 1936. Subsection 44(1) of the ITAA 1936 relevantly provides: The assessable income of a shareholder in a company (whether the company is a resident or a non-resident) includes: (a) if the shareholder is a resident: (i) dividends (other than non-share dividends) that are paid to the shareholder by the company out of profits derived by it from any source. (ii) … (b) …. (c) …. The subsection does not apply to a dividend (or non-share dividend) to the extent to which another provision of this Act that expressly deals with dividends includes some or all of the dividend (or non-share dividend) in, or excludes some or all of the dividend (or non-share dividend) from, the shareholder’s assessable income. The word dividend is defined in subsection 6(1) of the ITAA 1936 to include: (a) Any distribution made by a company to any of its shareholders, whether in money or other property. In the Taxpayers circumstances, it is proposed that under the arrangement they will become a shareholder of New Co following the exchange of scrip in the incorporated business for scrip in New Co and the payment of the Upfront Payment. At the time the Earn-Out amounts are paid the Taxpayer will be a shareholder in New Co. As already noted, the Commissioner considers that the amounts proposed to be paid by New Co to the Taxpayer for their shares in the incorporated business which include the payments described as an Earn-Out amount, are grossly in excess of the value of those shares based on the value of the business assets. If the Upfront Payment exceeds the value of the shares then all of the Earn-Out amounts are, in the Commissioner’s view, something other than for the sale of shares. Alternatively, if the value of the business assets exceeds the Upfront Payment, then the Earn-Out amounts less that difference are, in the Commissioner’s view, something other than for the sale of shares. In either case, the amount which cannot be characterised as being for the sale of shares (“the relevant amount”) requires testing for the purposes of section 44 of the ITAA 1936. As is explained in TR 2014/5 Income tax: matrimonial property proceedings and payments of money or transfers of property by a private company to a shareholder (or their associate) the meaning of distribution is of wide import. 58. The meaning of 'distribution' in context has been judicially considered and held: 1. to at least involve a dealing out or bestowal; 6 2. to encompass a very broad range of applications of company property and money to shareholders while the company is a going concern; 7 3. to undoubtedly be of wide import and concerned with the manner in which the shareholder receives the benefit of the dividend, emphasising that, in whatever manner the dividend reaches the shareholder it is to be regarded as assessable income; 8 4. to not require the existence of the conditions necessary to declare a lawful dividend under the Corporations Act 2001 ('Corporations Act'). 9 In the Commissioner’s view, an appropriation of monies from a private company to a shareholder ostensibly for the sale of shares but which is excessive in terms of the true value of those shares, is open for characterisation as something else, and in the present instance to be characterised as a dividend for tax purposes. In the present instance there is, to the extent of the “relevant amount”, an appropriation of private company funds to a shareholder which is within the judicially determined meaning of the word “distribution” as per the above. It is then further explained in TR 2014/5: 60. In terms of whether a distribution has been paid out of profits, the Commissioner has previously explained in paragraphs 15 and 16 of Taxation Ruling TR 2003/8: Income tax: distributions of property by companies to shareholders - amount to be included as an assessable dividend: 15. In deciding whether, as a question of fact, a distribution has been made out of profits derived by the company in cases where the distribution is not formally acknowledged as such, a substantive approach should be adopted. There does not need to be a formal debiting of an account of profit of the company. So long as the market value of the company assets exceeds the total amount (as shown in its books of account) of its liabilities and share capital what remains is profits. If the distribution is not debited to share capital the distribution is one of profits. 16. Such an approach was adopted by the NSW Supreme Court in Masterman v. FCT 85 ATC 4015. In reaching its decision that the payment to shareholders in that case was a payment out of profits derived by the company, the court noted (at page 4030) that the company was solvent and that there was no evidence that the relevant payment was out of non-profit sources, and that 'commonsense would require that the company be kept solvent and that only surplus amounts not putting that requirement at risk be paid out'. A dividend for tax purposes 61. It follows for tax purposes that it does not matter whether a dividend is intended or predicated upon any particular process. Rather, a factual enquiry is required as to whether there is a distribution to a shareholder and whether it is made out of profits. In the present case, that factual enquiry shows that in respect of the “relevant amount” there is an appropriation of private company monies to you and at a time that you are a shareholder. Therefore, provided there are profits available in New Co at the time of each appropriation, all of the necessary ingredients for the finding of a dividend for tax purposes are present: ● you are a shareholder of New Co; ● there is an appropriation of the “relevant amount” to the Taxpayer; and ● it is paid out of the profits of the company. For these reasons, the payment of the “relevant amount” will constitute a dividend pursuant to section 44 of the ITAA 1936. | Detailed Reasoning - Question 3: Are the Earn-Out amounts payable to the Taxpayer as part of the arrangement with New Co assessable as a deemed dividend according to Division 7A of the ITAA 1936? Summary Yes, to the extent the payments are not out of profits and to the extent that there is a distributable surplus, the Earn-Out amounts will constitute a deemed dividend under section 109C of the ITAA 1936. Detailed reasoning Section 109C of Subdivision B of Division 7A of the ITAA 1936 states: 109C(1) When a private company is taken to pay a dividend. A private company is taken to pay a dividend to an entity at the end of the private company’s year of income if the private company pays an amount to the entity during the year and either: a) The payment is made when the entity is a shareholder in the private company or an associate of such a shareholder; or b) A reasonable person would conclude (having regard to all the circumstances) that the payment is made because the entity has been a shareholder or associate at some time. Section 109C goes on further to explain that (in subsection 109C(2)) the amount of the dividend is equal to the amount paid, subject to the distributable surplus of the private company and (in subsection 109C(3)) that a payment is a payment or credit made to, on behalf of or for the benefit of the entity. Further that the payment can also be the transfer of property to the entity. According to the Facts outlined in this ruling, even though the Taxpayer will not be a shareholder in New Co at the time of entering into the arrangement and receiving the Upfront payment, they will be a shareholder in New Co at the time the ‘Earn-Out amounts are made under the arrangement. As such the provisions of subsection 109C(1) of Division 7A of the ITAA 1936 are therefore considered to apply to the arrangement to the extent that the payment is made by the private company to a shareholder, and consequently that payment is treated as a dividend. Subdivision D of Division 7A considers circumstances where payments and loans are not treated as dividends. In particular section 109J states: | Detailed Reasoning - 109J Payments discharging pecuniary obligations not treated as dividends.: A private company is not taken under section 109C to pay a dividend because of the payment of an amount, to the extent that the payment: a) discharges an obligation of the private company to pay money to the entity; and b) is not more than would have been required to discharge the obligation had the private company and entity been dealing with each other at arm’s length. In order to determine whether section 109J could apply it is therefore necessary to determine whether the payment received by the Taxpayer is arm’s length consideration for the sale of the shares in the incorporated business. As discussed above, the Commissioner considers that the consideration the Taxpayer receives for the transfer of the shares in the incorporated business should be reflective of the value of the assets of the business plus the small amount of goodwill contained within the business since the Taxpayer began using its trading name and the incorporated business was incorporated. The Commissioner considers that the amounts proposed to be paid by New Co to the Taxpayer for their shares in the incorporated business which includes the payments described as an ‘earn-out’ payment, are grossly in excess of the value of those shares based on the value of the business assets (including the business goodwill). As such the payments proposed to be made to the Taxpayer exceed an arm’s length consideration for the sale of the shares and therefore section 109J of the ITAA 1936 will only operate to the extent the payment represents arm’s length consideration. If the Upfront Payment exceeds the market value of the business assets at the time of sale, then the Earn-Out amounts are not arm’s length consideration in respect of the sale of shares and no part of the Earn-Out amounts will be excluded from the operation of section 109C of the ITAA 1936 by reason of section 109J of the ITAA 1936. Alternatively, if the market value of the business assets at the time of sale exceeds the Upfront Payment then section 109J of the ITAA 1936 will operate to stop section 109C of the ITAA 1936 applying to the Earn-Out amounts but only to the extent of the excess. Section 109L of the ITAA 1936 considers further circumstances where certain payments or loans are not treated as dividends. 109L(1) [Where payment or loan included in income] A private company is not taken under section 109C or 109D to pay a dividend because of a payment or loan the private company makes to an entity, to the extent that the payment or loan would be included in the entity’s assessable income apart from this Division (as it operates in conjunction with section 44). 109L(2) [Where exclusion due to this Act] In addition, a private company is not taken under section 109C or 109D to pay a dividend because of a payment or loan that the private company made to an entity to the extent that a provision of this Act (other than this Division) has the effect that the payment or loan is not included in the entity’s assessable income even though it would otherwise be included. It has already been determined in Question 2 that the Earn-Out amounts to be made to the Taxpayer will be assessable as a dividend under section 44 of the ITAA 1997 to the extent that the payments are paid out of the profits of the company. As such section 109L of the ITAA 1936 may operate to exclude the payment as a deemed dividend made to a shareholder of a private company under section 109C of the ITAA 1936 if the amounts are assessable as a dividend under section 44 of the ITAA 1936. However, should the payments be determined not to be paid out of the profits of the company, a deemed dividend will arise under section 109C of the ITAA 1936. The final consideration as to whether the total amount or a lesser amount of the Earn-Out amounts payable by New Co to the Taxpayer are assessable as a deemed dividend is whether, in accordance with subsection 109C(2) of the ITAA 1936, the private company has a distributable surplus as outlined in section 109Y of the ITAA 1936. 109Y(1) Reduction of amounts of dividends. If, apart from this section, the sum of all the dividends a private company is taken under this Division to pay at the end of the year of income would be more than the company’s distributable surplus for that year, the amount of each of those dividends is worked out under subsection (3). If the Commissioner considers the company’s accounting records significantly undervalue or overvalue its assets or undervalue or overvalue its provisions, the Commissioner may substitute a value that the Commissioner considers is appropriate. Conclusion The Commissioner is of the opinion that to the extent the Earn-Out amounts are not paid out of profits of the company a deemed dividend will arise to the Taxpayer under section 109C of the ITAA 1936. The amount of the deemed dividend arising will be dependent upon the distributable surplus within New Co at the end of the year of income within which the Earn-Out amounts are made to the Taxpayer. NB: in determination of distributable surplus the portion of the Earn-Out amounts not shielded by section 109J of the ITAA 1936 will be “Division 7A amounts” and therefore be an additional item in terms of the calculation of distributable surplus under section 109Y of the ITAA 1936.