Private ruling: Consolidation - Tax cost setting amount for non-contractual customer relationship
Published: July 2012
Ruling period: 2008 income year | 2009 income year | 2010 income year | 2011 income year | 2012 income year
Date scheme commenced: 2008 income year

Ruling: Q1: Will subsection 701-55(6) of the Income Tax Assessment Act 1997 (ITAA 1997) as amended by Tax Laws Amendment (2010 Measures No 1) Act 2010 apply to deem the tax cost setting amount allocated to the X's non-contractual customer relationship as 'incurred'? | A1: No. | Q2: Will Company B be entitled to a deduction under section 40-880 of the ITAA 1997 in respect of the expenditure incurred in relation to the X's non-contractual customer relationship? | A2: No.

Relevant facts and circumstances: Background Company A is a manufacturer and distributor of food products to X and Y. Company A's sales to X in Australia comprise approximately 80% of its total sales. The remaining 20% of its sales is to Y, which markets Company A's products under its own branding and sells to end customers predominately consisting of large supermarkets. Company A was established prior to 2005 when a company incorporated in and tax resident of country Z, entered into a joint venture with Y to enter the Australian market. Prior to the establishment of the joint venture, the food products were produced by Y, with the business relationship dating back to the early 1970's. Company A incorporated Company B, a wholly owned Australian resident subsidiary before 2010. In 2008 Company B purchased 100% of the existing shares in Company C. The sole asset of Company C was its 50% shareholding in Company A. On the same day, Company B acquired the remaining 50% shares in Company A in exchange for the issue of shares in Company B for a market value consideration. Company B elected to form an income tax consolidated group with effect from 2008 and the members of the consolidated group consisted of Company B (as head company of the tax consolidated group), and its wholly owned subsidiaries, Company A and Company C (together, the Company B Group). Company B engaged a tax agent to perform the tax cost setting process for the Company B Group. Based on the tax agent's Tax Consolidation Report, the ACA calculated for Company C was $XX and the ACA calculated for Company A was $XX. This ACA was allocated to the assets of Company C and Company A in accordance with the relevant consolidation provisions in the income tax law. Company B also sourced independent market valuations from Valuer 1 with respect to the assets of Company A as part of the acquisition and tax consolidation exercise. As part of this exercise, customer relationship "intangible" assets were separately identified and valued, being the X customer relationship valued at $XX million and the Y customer relationship valued at $XX million. The X Customer Relationship asset recognised in the accounts of Company B consists of two separate intangible assets, one relating to a contractual intangible asset (i.e. the value of entering into the Business Relationship Agreement with X), and the other relating to the non-contractual customer relationship intangible asset which values the estimated future maintainable earnings of the customer relationship with X which has no contractual basis. Valuer 2's valuation report dated 2011 has been prepared which values the non-contractual component of the X customer relationship at A$XX million and attributes a value of no more than A$XX to the contractual component of the X customer relationship. The Valuer 1 and Valuer2 valuations of the X customer relationship differ significantly on the basis that the Valuer 1's valuation is based on an indefinite effective life, whereas the Valuer2's valuation is based on a more conservative probability adjusted 20 year effective life. Due to the significant difference in the value in respect of the X customer relationship, Company B has decided to apply the more conservative market valuation of the X customer relationship in determining the appropriate tax cost setting amount for the X contractual and non-contractual customer relationship assets. In relation to the Y customer relationship, the significant portion of the value of the customer relationship rests with the supply contract as the term of the contract is automatically renewed and there is a 'best endeavours' minimum level of orders that Y should place with Company A. Accordingly, in allocating the tax cost setting amount between the contractual and non-contractual portion of the customer relationship, Company B has conservatively applied the entire tax cost setting amount to the contractual portion of the Y relationship.

Relevant legislative provisions: Income Tax Assessment Act 1997 subsection 701-55(6) | Income Tax Assessment Act 1997 subsection 701-10(2) | Income Tax Assessment Act 1997 subsection 701-10(3) | Income Tax Assessment Act 1997 subsection 701-10(4) | Income Tax Assessment Act 1997 Division 705 | Income Tax Assessment Act 1997 section 40-880

Reasons for decision: Detailed Reasoning - Question1:: This question is prima facie directed to the issue of whether subsection 701-55(6) of the ITAA 1997 applies such that the tax cost setting amounts allocated to the purported customer relationship assets of the joining entity, Company A, could be deemed by that subsection as 'incurred'. However this question can only be answered if an underlying question, whether 'customer relationships' are an asset for consolidation cost setting purposes, is first answered. If not the amount of ACA allocated to 'customer relationships' would be allocated to another asset or assets and the issue of whether subsection 701-55(6) of the ITAA 1997 deems an amount 'as incurred' does not arise. It is necessary therefore to address the question of whether 'customer relationships' can validly be treated as a consolidation cost setting asset. In arguing for recognition of 'customer relationships' as consolidation cost setting assets the taxpayer has relied very heavily on the fact that such assets are recognised for accounting purposes. See discussion at pages 12-13 of the ruling request. However in considering what is an asset for consolidation cost setting purposes we must have regard to the provisions that address that issue and the statutory context in which they operate. Subsection 701-10(4) of the consolidation provisions of the ITAA 1997 provides that: 'Each asset's tax cost is set at the time the entity becomes a *subsidiary member of the group at the asset's *tax cost setting amount.' Subsection 701-10(2) of the ITAA 1997 identifies the assets to which this provision applies. It states: 'This section applies in relation to each asset that would be an asset of the entity at the time it becomes a *subsidiary member of the group, assuming that subsection 701-1 (the single entity rule) did not apply.' The object of this section, and Division 705 to which it relates, is to recognise the cost to the head company of such assets as an amount reflecting the group's cost of acquiring the entity (subsection 701-10(3) of the ITAA 1997). The term 'asset' is not defined in the ITAA 1997. The Explanatory Memorandum to the New Business Tax System (Consolidation) Bill (No. 1) 2002 states at paragraph 5.19 that [emphasis added]: 'An asset, for the purpose of the cost setting rules, is anything of economic value which is brought into a consolidated group by an entity that becomes a subsidiary member of the group.' Taxation Ruling TR 2004/13 Income tax: the meaning of an asset for the purposes of Part 3-90 of the Income Tax Assessment Act 1997, deals with the meaning of an asset for the purposes of Part 3-90 of the ITAA 1997. TR 2004/13 at paragraphs 5 and 6 states that [emphasis added]: 'an asset for the purpose of the tax cost setting rules is anything recognised in commerce and business as having economic value to the joining entity at the joining time for which a purchaser of its membership interests would be willing to pay. The business or commercial assets of a joining entity would include the things that would be expected to be identified by a prudent vendor and purchaser as having value in the making of a sale agreement in respect of all the membership interests in an entity and its business. These assets would also come within the scope of a due diligence examination undertaken on behalf of a prudent purchaser of such an entity and business. The commercial or business meaning of an asset in Part 3-90 is not limited to assets that would be recognised under accounting standards or statements of accounting concepts. Internally generated assets would not normally be disclosed in the financial statements of a joining entity prepared in accordance with generally accepted accounting principles when they do not possess a cost or other value that can be measured reliably. However, these assets would be identified under the wider criteria that apply for the consolidation tax cost setting rules.' Further, paragraph 19 states that: 'the presence of a legislative definition of a liability [in subsection 705-70(1) of the ITAA 1997] and the absence of such a definition for an asset shows that the identification and recognition of an asset for tax cost setting rules is not simply to be found by reference to definitions in accounting standards and statements of accounting concepts.' Hence the emphasis on recognising assets is on broader commercial or business usage rather than accounting practice. All assets of a joining entity that exist at the joining time are recognised as assets for tax cost setting purposes. Goodwill is one of those assets. Taxation Ruling TR 2005/17, Income tax: goodwill: identification and tax cost setting for the purposes of Part 3-90 of the Income Tax Assessment Act 1997, provides guidance as to the identification and valuation of goodwill for the purposes of Part 3-90. Paragraph 5 states that: 'Goodwill can be valued for the purposes of Part 3-90 of the ITAA 1997 using a residual value approach except in situations where the law has recognised that a residual value approach will not identify goodwill, as legally defined'. The residual value approach entails working out the difference between the market value of each business of the entity and the market value of the net identifiable assets of each business of the entity. Paragraph 7 states [emphasis added]: 'In identifying assets and liabilities for the purpose of working out the value of the net identifiable assets of each business of the entity, both the commercial notion of assets and liabilities and the commercial basis of working out their value are used. This is because assets in consolidation cost setting are the assets that would be identified for commercial or business purposes in an acquisition.' Paragraph 9 states: 'The assets taken into account for the commercial residual value calculation are the commercial or business assets of the business. The identity of these assets may differ from assets identified in accounting reports and the values may also be different.' In the joint majority judgment of Gauldron J, McHugh J, Gummow J, and Haynes in. Commissioner of Taxation (Cth) v. Murry [1998] HCA 42; 193 CLR 605; 155 ALR 67; 72 ALJR 1065 the nature and character of goodwill is discussed at length: [13] 'Goodwill is also an accounting and business term as well as a legal term. The understanding of accountants and business persons as to the meaning of the term differs from that of lawyers. That has added to the difficulty of achieving a uniform legal definition of the term, particularly since accounting and business notions of goodwill have proved influential in the valuation of goodwill for legal purposes.' More critically the essential character of goodwill as the force that brings customers through the door of a business is identified. [20] ……….' A business may have goodwill for legal purposes even though its trading losses are such that its sale value would be no greater than its "break-up" value. Once the courts rejected patronage as the touchstone of goodwill in favour of the "added value" concept, it might seem impossible for a business to have goodwill for legal purposes when its value as a going concern does not exceed the value of the identifiable assets of the business. But the attraction of custom still remains central to the legal concept of goodwill. Courts will protect this source or element of goodwill irrespective of the profitability or value of the business. Thus, a person who has sold the goodwill of a business will be restrained by injunction from soliciting business from a customer of the old firm F29 even though the value of that firm is no greater than the value of its identifiable assets.' The relationship of goodwill to the other assets of a business is also discussed. [24] 'The goodwill of a business is the product of combining and using the tangible, intangible and human assets of a business for such purposes and in such ways that custom is drawn to it. In Federal Commissioner of Taxation v. Williamson F36 Rich J described the goodwill of a business as referable "in part to its locality, in part to the way in which it is conducted and the personality of those who conduct it, and in part to the likelihood of competition, many customers being no doubt actuated by mixed motives in conferring their custom." It is common to describe goodwill as being composed of elements. F37 However, goodwill is a quality or attribute that derives inter alia from using or applying other assets of the business. Much goodwill, for example, derives from the use of trade marks or a particular site or from selling at competitive prices. But it makes no sense to describe goodwill in such cases as composed of trade marks, land or price, as the case may be. Furthermore, many of the matters that assisted in creating the present goodwill of a business may no longer exist. F38 It is therefore more accurate to refer to goodwill as having sources than it is to refer to it as being composed of elements. In Muller F39 Lord Lindley referred to goodwill as adding value to a business "by reason of" situation, name and reputation, and other matters and not because goodwill was composed of such elements. [25] Many of the sources of goodwill are not themselves property. Nor are they assets for accounting purposes. Thus, manufacturing and distribution techniques, the efficient use of the assets of a business, superior management practices and good industrial relations with employees, may be sources of the goodwill of a business because they motivate service or provide competitive prices that attract customers. Yet they are neither property, nor assets for accounting purposes. [26] In some businesses, price and service may have little effect in attracting custom. The goodwill of such businesses may derive almost wholly from their location. This will often be the case where there is no nearby competitor and custom is drawn from nearby residents or those who must pass by the site of the business. The lack of competition resulting from an enforceable restrictive covenant may also enhance the goodwill of a business. F40 The existence of statutory monopolies in respect of the products of a business such as patents or trade marks may also attract custom to an extent that is unachievable in similar businesses. [27] Goodwill may also be the product of expenditures rather than the use of assets. F41 Thus, money spent on advertising and promotions, although charged against annual earnings rather than capitalised, may generate brand, product or business name recognition that helps to generate revenue. And part at least of the moneys expended on wages, labour relations and customer services may result in creating goodwill for a business. [28] Goodwill may also be the product in whole or in part of circumstances external to the business or its locality. Thus, the revenues of a business may be largely due to imperfect or inefficient competition or extensive market penetration.' Legal goodwill is not therefore the same as goodwill for accounting purposes. Its sources can be property assets, expenditures or the mere circumstances of the business. However the fact that accounting practices may identify something as an asset does not mean such an accounting asset is a source of goodwill and separate to goodwill. Taxation Ruling TR 2005/17 identifies legal goodwill as the relevant goodwill for consolidation cost setting purposes and provides guidance on how such goodwill can be calculated. A residual value approach is supported using the market value of assets otherwise identified for consolidation cost setting purposes. Taxation Ruling TR 2004/13 requires a commercial or business asset to be capable of being identified separately to goodwill: 12. There are other assets that would be recognised under Part 3-90 because they are things of economic value in commerce and business that are not recognised under other Parts of the ITAA 1936 or the ITAA 1997. An asset within this category would be information or knowledge that can be identified within an entity as a separate commercial or business asset. Where the asset is identifiable as a separate business or commercial asset it is distinguished from the goodwill of the business. Examples of information and knowledge that may constitute commercial or business assets include secret formulae, client lists and mailing lists. As with goodwill a customer relationship is inseverable from a business. Absent clear evidence of commercial or business practice relevant to Australian circumstances it is not clear how customer relationship can be separated from goodwill other than relying on accounting convention. It is equally the case that the value attributed to the asset must be separate to goodwill value. However the methodology provided in the valuation of the customer relationship assets merely assumes that the whole of the value of the excess profits from the business with X and Y is attributable to contracts or customer relationships in accordance with the accounting convention. There is no consideration of the contribution to earnings of legal goodwill. It is therefore considered that the taxpayer has not established that a 'customer relationship' asset as described in the ruling request is a separate commercial or business asset to goodwill such that it should be treated as an asset for consolidation cost setting purposes. | Detailed Reasoning - The impact on ACA allocations: Goodwill is worked out as a residual of the net commercial or business asset value of the joining entity for consolidation cost setting (Taxation Ruling TR 2005/17 paragraph 7). The value of goodwill for cost setting purposes increases by the value of any purported asset that is no longer recognised for cost setting. The amount of ACA allocated to goodwill therefore increases by the amount previously allocated to the asset or assets no longer recognised - in this case the customer relationship assets. | Detailed Reasoning - Does subsection 701-55(6) deem the tax cost setting amount 'as incurred'?: No. Company A has no history of dealing with a business or businesses for a profit making purpose such that goodwill could be treated as being a revenue asset. Goodwill is therefore a capital asset exclusively subject to capital gains tax provisions. No provision would therefore apply to include an amount in assessable income or allow a deduction in respect of the asset such that subsection 701-55(6) of the ITAA 1997 could apply. | Detailed Reasoning - Question 2:: As a 'customer relationship' asset as described in this ruling request is not an asset for consolidation cost setting purposes such assets will not receive an allocation of ACA. It follows that there will be no tax cost setting amount to which subsection 701-55(6) of the ITAA 1997 can apply and therefore no expenditure incurred to which section 40-880 of the ITAA 1997 could apply.

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