Edited version of private advice

Date of advice: 8 July 2020

Subject: Work in progress, assessable income and capital gains tax

Question 1

Will the transfer of work in progress (WIP) from the Partnership to NewCo be included in the assessable income of the Partners pursuant to section 15-50 or section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Will the transfer of the WIP from the Partnership to NewCo be assessable to the Partners, pursuant to their respective partnership interest, as a CGT event A1 under section 104-10 of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods

1 June xx to 30 June xx

The scheme commences on

1 July xx

Relevant facts and circumstances

All references are to the ITAA 1997 unless stated otherwise.

The relevant facts and circumstances are as follows:

1.            The Partners trade in a Partnership.

2.            The Partnership carries on a professional business (the Business).

3.            The Partners in the Partnership wish to commence operating their Business as an incorporated entity (NewCo).

4.            The Partnership, in operating the Business, has the following assets:

a.            work-in-progress of open client files/matters (the WIP)

b.            debtors for invoiced client matters, either interim and or final

c.             depreciating assets

d.            potential goodwill

5.            The Partnership will transfer the WIP to NewCo for no consideration.

6.            The steps the parties will undertake to restructure the business can be summarised as follows:

a.            NewCo will be incorporated and 50% of the shares will be issued to each of the Partner's discretionary trusts (making up 100% of the total shares on issue)

b.            Once NewCo has been incorporated, the Business currently being operated by the Partnership and the Business assets will be transferred to NewCo for no consideration.

7.    The WIP is partially completed work that has not reached the stage where a recoverable debt has arisen.

8.    Where a recoverable debt has been created, the amount is brought to account as a receivable of the Partnership (to which the payment is owed) and reflected in 'debtors'.

9.    The Partnership and NewCo are not dealing with each other at arm's length

10.  The Partnership prepares its accounts for tax purposes on an accrual basis.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 15-50

Income Tax Assessment Act 1997 section 25-95

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 106-5

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 Division 116

Income Tax Assessment Act 1997 section 116-5

Income Tax Assessment Act 1997 section 116-10

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 section 116-30

Further issues for consideration

Any capital gain made by the Partners on the transfer of WIP to NewCo is unlikely to meet the requirements in Division 115 to be a discount capital gain.

TA 2013/3 - Purported alienation of income through discretionary trust partners

Reasons for decision

Question 1

Summary

The value of WIP does not constitute assessable income under section 15-50 unless an amount is received; or under section 6-5 unless there is a recoverable debt.

Detailed reasoning

Section 15-50 states that your assessable income includes a "work in progress amount" that you receive. A "work in progress amount" has the meaning given in section 25-95. Subsection 25-95(3) states that an amount is a "work in progress amount" to the extent that:

a.    an entity agrees to pay the amount to another entity (the recipient), and

b.    the amount can be identified as being in respect of work (but not goods) that has been partially performed by the recipient for a third entity but not yet completed to the stage where a recoverable debt has arisen in respect of the completion or partial completion of the work.

In this case:

a.    there will be no cash payment or other consideration provided by NewCo to the Partnership for the Business WIP when it is transferred, and

b.    there is no other agreement for a payment to the Partners for the value of the WIP

As the Partners will not receive a work in progress amount it is not included in their assessable income under section 15-50.

Under subsection 6-5(1) assessable income includes income according to ordinary concepts, which is called ordinary income. Subsection 6-5(2) explains for an Australian resident assessable income includes ordinary income derived directly or indirectly from all sources during the income year.

Under subsection 6-5(4) in working out whether you have derived an amount of ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct.

Taxation Ruling TR 98/1 - Income tax: determination of income; receipts versus earnings provides the following guidance regarding when income is derived under the earnings, also referred to as accruals, method at paragraphs 9-11:

Earnings method

9. The 'earnings' method is often referred to as the 'accruals' method or the 'cash and credit' method. Under the earnings method, income is derived when it is earned. The point of derivation occurs when a 'recoverable debt' is created.

10. The term 'recoverable debt' is used to describe the point of time at which a taxpayer is legally entitled to an ascertainable amount as the result of having performed an agreed task. A taxpayer may have a recoverable debt even though, at the time, they cannot legally enforce recovery of the debt.

11. Whether there is, in law, a recoverable debt is a question to be determined by reference to the contractual agreements that give rise to the legal entitlement to payment, the general law and any relevant statutory provisions.

As the Partnership prepares its accounts for tax purposes on an accruals basis it will be considered to have derived assessable income in relation to the WIP once a recoverable debt arises. Taxation Ruling TR 93/11 Income tax: assessability of income on an accruals basis: when professional fees are derived at paragraph 3 notes:

...it is necessary to determine, when, on a proper construction of the contract or arrangement, a recoverable debt is created such that the professional person is not obliged to take any further steps before becoming entitled to the payment. A fee is 'recoverable' in the relevant sense even if time to pay has been allowed...

The Partners have advised in the facts to this ruling that the WIP is partially completed work that has not reached the stage where a recoverable debt has arisen.

Therefore, as no amount is received for the WIP and it is not a recoverable debt no amount will be included in the assessable income of the Partners when it is transferred to NewCo under section 15-50 or section 6-5.

Question 2

Summary

The transfer of the WIP from the Partnership to NewCo will be assessable to the Partners, pursuant to their respective partnership interest, under the CGT provisions in Part 3-1.

Detailed reasoning

Section 106-5 is relevant to partnerships and capital gains and losses. Under subsection 106-5(1) any capital gain or capital loss from a CGT event happening in relation to a partnership or one of its CGT assets, is made by the partners individually. Each partner's gain or loss is calculated by reference to the partnership agreement, or partnership law if there is no agreement.

Section 108-5 describes what a CGT asset is. Under paragraph 108-5(1) a CGT asset is:

(a) any kind of property; or

(b) a legal or equitable right that is not property.

Paragraph 108-5(2) states that to avoid doubt, these are CGT assets:

(a) part of, or an interest in, an asset referred to in subsection (1);

(b) goodwill or an interest in it;

(c) an interest in an asset of a partnership;

(d) an interest in a partnership that is not covered by paragraph (c).

Taxation Ruling TR 1999/16 Income tax: capital gains: goodwill of a business considers the CGT provisions and goodwill. This ruling also discusses WIP and explains at paragraph 38 that:

38. Work in progress of a business is separate and distinct from the goodwill of the business. This is so whether the work in progress has been completed to a stage at which a recoverable debt has arisen in relation to it or whether it is incomplete and there is no legal liability to pay for it. Because work in progress does not form part of the goodwill of a business, the concession in section 118-250 does not apply to any amount attributed to the work in progress.

In considering the measurement of goodwill TR 1999/16 at paragraph 43 also lists WIP as an "identifiable asset":

43.(c) the parties do not allocate to goodwill an amount that should be properly attributed to an off balance sheet asset or an 'identifiable asset' (in terms of the accounting standards) distinct from goodwill..."Identifiable asset' in terms of the account standards (without comprising an exhaustive list) includes:

(i) work in progress

WIP as an identifiable asset and a legal or equitable right that is not property, is a CGT asset as described in subparagraph 108-5(1)(b).

Section 104-10 concerns the disposal of a CGT asset. Under subsection 104-10(1) CGT event A1 happens if you dispose of a CGT asset.

You dispose of a CGT asset if a change of ownership occurs from you to another entity, the time of the event under subsection 104-10(3) is when you enter into the contract for the disposal, or if there is no contract, when the change of ownership occurs.

You make a capital gain if the capital proceeds from the disposal are more than the asset's cost base. You make a capital loss if the capital proceeds are less than the asset's reduced cost base (subsection 104-10(4)).

Division 116 is relevant to capital proceeds. Section 116-5 explains that section 116-20 sets out the general rules about capital proceeds. The capital proceeds from a CGT event are the total of (a) the money you have received, or are entitled to receive, in respect of the event happening; and (b) the market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).

Section 116-10 has modifications to the general rules. Under subsection 116-10(2) the first is a market value substitution rule, it is relevant if:

¢you receive no capital proceeds from a CGT event; or

¢some or all of the capital proceeds cannot be valued; or

¢you did not deal at arm's length with another entity in connection with the event.

Under subsection 116-30(1) if you received no capital proceeds from a CGT event, you are taken to have received the market value of the CGT asset that is the subject of the event. The market value is worked out as at the time of the event.

Subsection 116-30(1) has the following Example:

You give a CGT asset to another entity. You are taken to have received the market value of the CGT asset.

In the proposed arrangement, the Partners will dispose of their interest in an identifiable asset, being the WIP of the Partnership, for no consideration to NewCo. The relevant CGT event in relation to this disposal is CGT event A1.

As no consideration will be received for this disposal, the market value substitution rule in subsection 116-30(1) deems each Partner to receive capital proceeds equal to their share of the market value of the WIP of the Partnership.

In this case the disposal of the WIP is not assessable under any provisions other than the CGT provisions. The CGT exemptions referred to in section 100-30, specifically the anti-overlap provisions in section 110-20, do not apply. Therefore, the transfer of WIP from the Partnership to NewCo will be assessable to the Partners, pursuant to their respective partnership interest, under the CGT provisions in Part 3-1.

ATO view documents

Taxation Ruling TR 93/11 Income tax: assessability of income on an accruals basis: when professional fees are derived

Taxation Ruling TR 98/1 - Income tax: determination of income; receipts versus earnings

Taxation Ruling TR 1999/16 Income tax: capital gains: goodwill of a business