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An Overview of Hotel Management Contracts in Europe

While hotel lease contracts have traditionally been very popular in Europe and continue to be preferred or required by many institutional investors, management contracts have become increasingly prevalent as many other investors have sought to share further in their hotel’s trading profit and, at the same time, most major international hotel operators have become far less willing to offer leases.

A hotel management contract is defined as an agreement between a management company (or an operator), and a property owner, whereby the operator assumes responsibility for managing the property by providing direction, supervision, and expertise through established methods and procedures. The operator runs the hotel, on behalf of the owner, for a fee, according to specified terms negotiated with the owner. Negotiating the terms of a hotel management contract should not be approached lightly, as it can characterise the property’s identity for decades and produce differing results for owners. A well-negotiated management agreement should align the interests of both parties. As an owner, the major goals should be to select the management company that will maximise profitability and therefore the value of the asset, and to secure the best possible contract terms with that operator, while at the same time ensuring the operator is properly incentivised to maximise profitability.

As a result of a gradual shift in hotel investment trends over the past 30 years, owners have generally developed a much greater understanding of hotel operations, and have become more sophisticated in their selection of operators and in the negotiation of contract terms, often with the help of specialist advisory firms. It has become increasingly common in recent years for institutional and financial investors and private equity funds to invest in hotel assets. Such investors typically aim to separate ownership of the physical hotel asset from operation of the business. In addition, the investment interest and associated increase in the amount of capital available for hotel investment from this wider pool of investors has further contributed to the increased sophistication of hotel investors, who often have in-house hotel asset managers or engage speciality consultancies or asset management companies to help monitor and drive peak performance from the operator.

The most common of the management contract terms are listed below and described further in the following sections.
 
  1. Term
  2. Operating fees
  3. Operator performance test
  4. Approval rights
  5. FF&E and capital expenditure
  6. Territorial restrictions
  7. Non-disturbance agreements
  8. Operator guarantees
  9. Operator key money
  10. Termination rights
Please also refer to the comprehensive ‘HVS Hotel Management Contract Survey’ article written by Manav Thadani, MRICS, and Juie Mobar, based on a sample of 76 management contracts in Europe totalling 19,200 rooms. This survey is available in the HVS Bookstore.

1. Term

The term of a management contract is the duration the agreement is to remain in effect, generally calculated from the opening/effective date until the expiration of a specified number of years. Initial terms typically last between 15 and 25 years, depending on the brand and the positioning of the hotel as well as on the negotiating power between the owner and the operator.

More upscale operators, such as Four Seasons and Ritz-Carlton, may require longer initial contract terms, often ranging from 30 years up to 50 years, or even sometimes longer. As a general rule, the higher the market positioning of the hotel, the longer the initial term. In Europe, the average length of the initial term is 21 years[1]; the average initial term length has shortened in recent years. The following table shows the average length of the initial term for hotel management contracts in Europe by market positioning, according to the HVS Hotel Management Contract Survey.
 

Figure 1: Length of the Initial Term by Market Positioning


Renewal terms are usually based on either the operator having further extension rights, or upon the mutual consent of the owner and the operator. Renewal terms tend to occur in multiples of either five or ten years. Most contracts offer two extension terms (sometimes more) on the condition that six months’ written notice is given prior to the end of the current term.

For commercial reasons, brand operators prefer longer contract terms with renewal options in their favour, whereas flexibility is likely to be more important for owners and thus there is a preference for a shorter initial term and renewal options ideally only by mutual consent.

There has been a noticeable decrease in the average length of initial terms across Europe, which can be attributed to the following factors:
 
  • The proliferation of private equity vehicles in the hotel investment market in recent years has placed pressure on operators to offer more competitive, shorter initial terms, although these are generally coupled with more renewal options;
  • The increasing competition amongst hotel operators seeking to broaden their distribution network;
  • An increase in hotel investment in emerging markets along with the associated risks in such markets have led both operators and owners to negotiate contracts with shorter terms, to provide the opportunity to exit in the event of disappointing market conditions.

2. Operating Fees

Operators are remunerated with fees for the performance of their duties detailed in the contract. These management fees should be structured in such a way that they encourage the operator to maximise the financial performance of the hotel. Fees can be calculated by reference to various formulae. Typically, the operator’s fee will be split as follows:
 

  • A base fee, generally calculated as a percentage of gross operating revenue (ranging typically from 2% to 4%). While many owners would argue that an operator should ideally only receive fees based on the profit, not revenue, that the hotel generates, operators have successfully argued that they need to be protected with a certain amount of virtually ‘guaranteed’ income in order for them to be able to subsidise the costs of operating their organisations even during a severe market downturn when hotels’ operating profits may be significantly reduced or even, in the worst cases, non-existent for a period of time. There is evidence of the base management fee decreasing with a higher market positioning, as highlighted in the table below:

Figure 2: Base Management Fee By Market Positioning

 

  • An incentive fee based on a percentage of the hotel’s operating profit. While the base fee encourages the operator to focus on the top line, the incentive fee ensures that there is also an incentive to control operating costs. Incentive fee structures have a wide variety of forms in practice. These incentive fees are generally based on a percentage of either the gross operating profit (GOP) before the deduction of base management fee or, more usually, the adjusted GOP (AGOP), calculated by deducting the base fee from the GOP. The incentive fee can be structured differently, with examples including:
    • A flat fee structure, where the incentive fee is calculated as a percentage of GOP/AGOP. This percentage may be constant or scaled upwards throughout the term of the contract (usually by way of a ‘build-up’ in the first few years until the hotel’s expected year of stabilisation).
    • A scaled fee based on the level of the GOP or AGOP margin that is achieved. This fee structure certainly rewards the operator for a more efficient performance and is becoming increasingly common.
    • A fee linked to the available cash flow after an Owner’s priority return. The Owner’s priority return can be a fixed amount or a percentage of the initial (and sometimes future) capital investment. The operator will not receive its incentive fee until the owner’s priority return has been achieved for that year. This incentive fee structure is usually accompanied by provisions whereby the operator’s incentive fee is not ‘lost’, but only ‘deferred’, and then recouped in later years if and when the Owner’s Priority is exceeded by a sufficient amount to cover that year’s incentive fee as well as some or all of those incentive fees deferred from previous years. As deferred fees can create complications during the sale of a hotel (with purchasers often seeking a price reduction so they can cover this potential future liability that would ‘transfer’ to them), these types of incentive fee structures are becoming less popular with owners.
  • Other fees and charges can be claimed by the operator, and are related to items such as centralised reservations, sales and marketing, loyalty programmes, training fees, purchasing costs, accounting or other costs. These fees are often defined as a percentage – between 1% and 4% – of total revenue or rooms revenue (as applicable, and varying between different operators).

There is a rising trend observed in the industry where operators are accepting lower base fees in return for higher incentive fees of up to 15% of GOP, which are designed to more closely align the operator’s interests with that of the owner – to maximise the operating profit of the hotel, regardless of the revenue.

While a fixed incentive fee percentage ranging from 8% to 10% of AGOP was typical, it is becoming increasingly common to have scaled incentive fees. The tendency towards higher or scaled incentive fees versus higher base fees, rewards effective operators but also provides some protection for the owner’s cash flow/return in the event of poor operator performance or a market downturn.

3. Operator Performance Test

Performance tests allow an owner to terminate the management agreement should the operator fail to meet the agreed performance criteria after a period of build-up (test periods commence in the fourth year on average).

Two types of performance tests are typically used, often jointly:

  • Room revenue per available room (RevPAR) as a percentage of a mutually agreed upon competitive set (in Europe, the test is generally set somewhere between 80% and 95% of the weighted average RevPAR of the competitive set);
  • The GOP level for an operating year should not be less than the mutually agreed budgeted GOP level (usually starts at 80%, up to 90% of the budgeted GOP, depending on the negotiation strength of both parties).

As highlighted in the following graph, these two performance tests are often used jointly in European management contracts.

Figure 3: Type of Performance Tests


A performance test usually starts from year thee or year four, after stabilisation of the new hotel, generally known as the commencement year. The performance test is usually deemed to be failed if both the RevPAR and the GOP tests have been failed for two years in a row.

However, some unscrupulous operators have been known to sometimes artificially inflate RevPAR performance to meet the required standards, so the RevPAR test is not held as a reliable measurement tool by experts. It can also be challenging to agree the right competitive set and sometimes to find reliable RevPAR data for the competitive set. Furthermore, in case of a force majeure event or any peculiar event that is beyond the operator’s scope, then the performance test would not be applicable and the right of termination of the owner is not exercisable. Good performance tests are the ones that are enforceable, sensible and that truly reflect the relative position of the hotel.

Major operators usually negotiate a clause with a ‘right to cure’ in the event of a failed performance test, allowing the operator to make a compensation payment to the owner. The typical right to cure usually includes a specific/limited number of times that the operator has the right to cure during the term of the agreement.

We have seen recent management contracts which include performance tests based on TripAdvisor ratings and commentaries. However, these ratings are potentially influenceable by non-guests or biased by messaging bots. Other non-financial performance tests include the ones based on the number of materialised reservations generated through the operator’s distribution systems versus those that are generated by online travel agencies (OTA) or third parties.

For more information on management fee structures and performance clauses, please refer to the HVS San Francisco article ‘Hotel Management Fees Miss the Mark’ by Miguel Rivera, September 2011.

4. Approval Rights

Approval rights define the extent to which the owner’s consent is required for decisions impacting the hotel’s operation. This allows the owner to remain involved in key decisions regarding cash flow. In addition, if stipulated, an owner can place restrictions on expenditure (that is, purchasing systems, concessions or leases). These owner approval rights generally comprise:
 

  • Budget – the operator should submit an annual budget for the owner’s approval, usually 30 to 90 days prior to the start of the fiscal year. Owner approval of the annual budget is usually negotiated, but such approval may depend on the conditions of the performance test, and may therefore exclude certain line items. If both parties do not come to a consensus on a specific line item, an increasing number of agreements have provision for an independent expert to be appointed to adjudicate and provide a determination. In the meantime, the budgeted amount will be calculated using the last year’s approved amount, multiplied by the increase in the Consumer Price Index for that year. The annual budgeting exercise is one of the most collaborative activities between the owner and the operator during the life of a management contract;
  • Employment of key senior management positions – the management contract will specify whether the hotel’s employees are employed by the owner or the operator. Generally, each party prefers to pass the responsibility of employment to the other, because of liability issues. For most cases in Europe, the staff are officially employed by the owner. However, generally the operator has the responsibility of hiring and training the line-staff personnel. In a significant proportion of management agreements, owner approval is only required for the hiring of certain key management positions (that is, general manager, financial controller and, sometimes, director of sales and marketing and director of food and beverage). With the owner in most cases being the employer of the hotel’s staff, this enables continuity of employment – and the hotel’s operation – if and when the contract is terminated. Some senior management may be employed by the operator, with the payroll for those staff being charged back to the hotel operation. By and large, all contracts that require the owner’s prior consent for the appointment of senior personnel usually restrict the number of rejections by the owner to two or three candidates presented by the operator each time such a position is to be filled;
  • Outsourcing – this clause affects the decisions involving the appointment of an external service provider in relation to the hotel’s operations, such as engineering services or housekeeping. Usually, the terms of such contracts are no longer than 12 months. Owner’s consent is rarely required, unless the contract is significant and above a certain amount (similar to capital expenditure, for which consent is required) or has a duration longer than, say, 12 months;
  • Capital expenditure – detailed in the next section;
  • Leases and concessions – such clauses relate to the leasing out of hotel space to third parties, such as restaurants, spas, gift shops, beauty salons or retail outlets. Most owners will require restrictions on such agreements, as long-term agreements may complicate a future sale and may not always be the most profitable use of the space with the passing of time, or even in the first place.

5. FF&E and Capital Expenditure

To maintain the asset in a marketable condition and replace the furniture, fixtures and equipment (FF&E) of a hotel at regular intervals, a ‘sinking’ fund is created to raise capital for this periodic FF&E replacement, which is usually a percentage of gross revenue and somewhat dependent on the positioning/level of the hotel. Included in this category are all non-real-estate items that are typically capitalised rather than expensed, which means they are not included in the operating statement, but nevertheless affect an owner’s cash flow. Generally, management agreements include a reserve for replacement of FF&E of between 3% and 5% of gross revenue per month, with the lower percentage more likely to relate to budget hotels and the higher percentage to upper upscale and luxury hotels. This percentage often increases during the first few years of the hotel’s operation, until it reaches a stabilised amount, usually by year five but sometimes not until year ten, as shown in the following table.
 

Figure 4: FF&E Reserve Contribution


In some cases, the amount to be reserved may be dictated by the lenders financing the hotel. Typically, capital improvements are split into two categories:
 

  • Routine capital improvements: funded through the FF&E reserve account and required to maintain revenue and profit at present levels;
  • Discretionary capital improvements (also called ROI capital improvements): investments that are undertaken to generate more revenue and profit, such as the conversion of offices into meeting rooms. These require owner approval and are in addition to the funds expended from the reserve account. Capital expenditures are typically made in lump sums during hotel renovations. In general, soft goods for a typical full-service hotel should be replaced every six-eight years, and case goods should be replaced every 12-13 years.

Within a management contract, the owner is responsible for providing funds to maintain the hotel according to the relevant brand standards. If management chooses to postpone a required repair, they have not eliminated or saved the expenditure, but merely deferred payment until a later date. A hotel that has operated with a below average maintenance budget is likely to have accumulated a considerable amount of deferred maintenance. An insufficient FF&E reserve will eventually negatively impact the property’s standard or grading, and may also lead to a decline in the hotel’s performance and its value.

 

6. Territorial Restriction

An integral component of a market area’s supply and demand relationship that has a direct impact on performance is the current and anticipated supply of competitive hotel facilities. By including a territorial restriction (also sometimes referred to as an ‘area of protection’) in a management contract, an owner is assured that no other property with the same brand is allowed to open within a certain radius of the subject hotel, for a certain period of time (ideally being for the whole duration of the agreement) in order to minimize or even pre-empt any form of cannibalisation from the same brand, or sometimes also from another brand of the same company.

Depending on the location, the city size and the type of brand, this clause may vary significantly. Upscale/luxury hotels tend to have a territorial restriction area for a larger radius and for a longer period of time than budget/mid-market hotels. Additionally, operators with a larger portfolio of brands may be more agreeable to a larger period of time, or a shrinking restricted area for the exclusion of certain brands, or the exclusion of all brands. Operators will inevitably seek for a more flexible scheme, so that such a constraint does not interfere with the development of the operators’ other brands which are not direct competitors (for example, upscale brands compared to budget brands).

Therefore, to define the territorial restriction, the negotiations should be centred around the area of the exclusion clause, the brands that will be included in the clause, the period of time and also the provision of an independent impact study of the development of a similar brand on the subject property’s performance.

With the recent consolidation of the hotel industry (the Marriott/Starwood merger, the purchase of FRHI by Accor Hotels) negotiations are more and more focused on the risk of chain acquisition carve outs, the prospect for any hotel that is a member of a chain of hotels where it is intended that one or more of the hotels of the chain will be rebranded to the same brand as the subject hotel.

7. Non-Disturbance Agreement

Hotel management contracts often include a non-disturbance agreement. This is an agreement between the hotel operator, the owner and the owner’s lender. In the event of default or the owner’s insolvency, the lender takes over the ownership of the hotel, agrees not to terminate the existing management contract and remove the manager after a foreclosure. At the same time, the hotel operator agrees to stay and operate the hotel for the lender in case of insolvency or enforcement.

The hotel operator can be confident in keeping the value of the management contract, and in having a direct contractual relationship with the lender. On the other hand, the lender knows the operator can’t leave the contract immediately on insolvency or a default, which is potentially disruptive to the business.

8. Operator Guarantees

An operator guarantee ensures that the owner will receive a certain level of profit or net operating income. If this level of profit is not achieved by the operator, the operator guarantees to make up the difference to the owner through their own funds. For example, if the contract states a guarantee of €1,000,000 per annum, and the operator only achieves €800,000, the operator will then make up the remaining €200,000 from their own resources.

Operator guarantees are not to be confused with an owner’s priority return, which reflects the hurdle of a particular performance (such as GOP) before receiving the incentive fee. For example, if the owner’s priority return is equal to €1,000,000 and the GOP achieved in a particular year is €800,000, then the operator will not receive an incentive fee. If the GOP in a particular year is €1,200,000, then the incentive fee will be payable.

It is typical when such guarantees exist that there is a provision for the operator to ‘claw back’ any payments made under a guarantee out of future surplus profits. Equally typical is the tendency for the operator to place a limit (‘cap’) on the total guaranteed funds within a specified number of years. When the operator fails to receive an incentive fee, this is sometimes referred to as a ‘stand aside’. Some contracts allow for this to be paid once future profits are earned to cover the shortfall.

The current trend is for a shift away from operator guarantees. Over the last 15 years, operators have been placing limits on guarantees to exclude force majeure factors in order to cover their future liability. As such, operators will generally require higher fees in return for an operator guarantee and this may not always be cost-effective for the owner. In addition, most contracts will include a cap on the level of operator guarantee, as noted above.

9. Operator Key Money

A more prevalent way to incentivise owners and secure contracts is when operators use their balance sheet to offer either key money or sliver equity.

Key money, in the context of management contracts, can be defined as a financial contribution from the operator to the owner’s investment cost related to the development of the hotel. Often regarded as an evidence of the operator’s genuine interest in the engagement, key money can be a valuable resource to help a brand expand into new markets without the high development costs and to seal the deal for trophy assets.

Many operators offer the key money as a ‘loan’ to the owner, which could be either towards the hotel’s development or its preopening, or to cover part or all of a renovation in the case of the re-branding of an existing hotel. However, key money comes at the expense of something else, usually higher fees and/or a longer term.

Moreover, almost all operators require the owner to repay a prorated amount of the outstanding key money, with or without interest, if the contract is terminated prior to the end of the term or an agreed part thereof.

For existing properties, key money may be offered at the time of signing or after the capital improvements (recommended by the operator) have been completed. Conversely, for new hotels, key money is mostly offered as the last funding available to the owner, paid on the opening of the hotel.
According the the HVS Hotel Management Contract Survey, a large majority of the European contracts that offer key money are for upscale/upper upscale/luxury hotels.

However, key money does not entitle the operator to an actual equity share in the investment. In today’s highly competitive market, some operators now assume an actual ownership position in the hotel. An increasingly common tool is minority equity stake where the operator makes a financial contribution in return of a stake (from less than 5% to 30%) in the ownership of the hotel. Under such an arrangement, if the hotel performs well the operator directly realises a return for the investment. Equity contributions by management companies may help to align the interests of the owner with the management company.

The benefit of reducing an owner’s need to use their own cash is a powerful incentive. However, owners should also be aware of the potential risks or trade-offs associated with forming equity partnerships with management companies. More partners imply more parties to split the profits, and less owner equity means a higher chance of losing control of the property. In addition, the relationship with the management company as an equity contributor may limit the owner’s ability to terminate the management agreement[2].

10. Termination Rights

Each party may choose to terminate the hotel management agreement for a variety of reasons: bankruptcy, fraud, condemnation, unmet performance standards, sale. As hotels are becoming more mainstream assets, owners are getting more mature and vigilant on the conditions for termination and the associated operator fees.

Owners can negotiate the right to terminate the contract upon the sale of the hotel to a third party. This clause gives flexibility to the owner or to any potential investor as it allows the owner to realise the investment and sell the hotel unencumbered. The operator is compensated with a termination fee from the owner. The termination fee is usually an amount equal to the average management fees earned by the operator in the preceding two-three years (24 to 36 months) prior to the date of termination, ‘multiplied by’ either (i) the remainder of the term (years/months) or (ii) a multiple of two, three, five or any other as agreed upon.

With a more upscale brand, the operator will be more sensitive to not being ‘kicked out’ because they have substantially invested in sales and marketing to create an upscale brand. Operators will also argue that an early termination could be damaging to their brand.

Termination without cause allows the owner to terminate the contract without any justification. The termination fee under this provision is normally calculated in a similar method as for the termination upon sale. Termination without cause, or on sale, is more common in contracts with independent operators.

The operator performance test mentioned earlier allows the owner to terminate the contract if the operator fails to meet the performance expectations and does not use its cure rights. The testing periods for most performance termination clauses begin three years after the opening of the hotel or the inception of the contract to allow the hotel to reach stabilised operating levels, and the performance failure usually has to persist for two consecutive years.


Other causes for termination consist of operator misconduct, condemnation, bankruptcy and default.
We should stress here that management contracts without termination on sale provisions obviously reduce flexibility on exit. It is usually worse when the operator has an equity stake in the property. An owner should always look for the most flexible management contract terms that can be negotiated.
 

Current and Future Trends

While owners have become far more knowledgeable in recent years, major global operators have also become larger and more powerful, particularly given the recent consolidation and mergers and acquisition of hotel operators in the industry, and therefore the reduction in competition has made it more difficult to negotiate with them.

It is also reasonable to state that there is a move towards agreements with third-party operators. As the hotel is becoming a more mainstream asset and owners are gaining a better understanding and maturity, third-party operators (TPO) are on the rise. Well established in the US market, this model, relatively new in Europe, is now growing rapidly, bringing more flexibility to owners and allowing them in some instances to defer the responsibility of the staff to the TPO’s balance sheets. A hotel managed by a TPO is very often combined with a franchise for a major hotel brand.

Another trend is the emergence of ‘manchises’ and hybrid management contracts, whereby hotel owners engage a hotel operating company for an initial period of time, say three to five years, after which the contract transfers to a franchise contract in which the owner assumes management responsibility and retains the operator’s brand, in exchange of an annual franchise fee payment. To the outside world, there is no apparent change. This is particularly advantageous to help hotel operating companies launch new brands, enabling strict operating controls to be established in the initial years as the brand is going through its ‘ramping up’ period.
 

Conclusion

Hotel Management contract negotiation can be a long and complex process. This negotiation should satisfy both the operator and the owner to help ensure an effective and trustful relationship between the two parties, while taking into consideration the asset value. On one hand, the operator will require stability in cash flow with a longer-term contract. On the other hand, the owner will primarily look for flexibility from an exit perspective, visibility on the profit and loss of the asset and transparency on the fee structure, and from that goal, the owner may use a third-party operator, which could be more aligned with their interests. The main goal when negotiating is to avoid uncertainty and conflict, and look for clarity and trust in order to maximise each parties’returns. This is critical to ensuring that responsibilities and best practices are met and the business is run successfully.


Notes:
1) The terms mentioned in this article only cover some of the major characteristics of the contract. Today’s management agreements are defined by a variety of formats and level of detail. Some contracts are becoming much more complex and comprise new terms not discussed in this article. It is therefore important to review the contract terms in detail. Each party should be assisted by an external independent legal advisor in order to deal with these complex legal documents.


2) For an overview of the operating models (leases, management contracts, franchises), please refer to our article titled 'Decisions, Decisions... Which Hotel Operating Model is Right for You'. Click here to view.
 

[1]From a sample of 76 management contracts in Europe with results compiled in the following article:Thadani, Manav, mrics & Mobar, Juie. ‘HVS Hotel Management Contract Survey’. HVS India. August 2014.
[2]Isenstadt, Todd & Detlefsen, Hans. ‘Hotel Management Companies and Equity Contributions: Benefits And Risks’. HVS Chicago. August 2014.
contentspara
What this Ruling is about

1

Ruling

6

A - Transactions with a profit-making purpose

6

B - Conversion of stream of income to a lump sum

17

Date of effect

21

Explanations

22

A - Transactions with a profit-making purpose

27

B - Conversion of stream of income to a lump sum

59

Examples

71

A - Transactions with a profit-making purpose

72

B - Conversion of stream of income to a lump sum

95

Preamble

This Ruling, to the extent that it is capable of being a 'public ruling' in terms of Part IVAAA of theTaxation Administration Act 1953, is a public ruling for the purposes of that Part. Taxation Ruling TR 92/1 explains when a Ruling is a public ruling and how it is binding on the Commissioner.

What this Ruling is about

1. This Ruling provides guidance in determining whether profits from isolated transactions are income and therefore assessable under subsection 25(1) of the Income Tax Assessment Act 1936. In this Ruling, the term 'isolated transactions' refers to:

(a)
those transactions outside the ordinary course of business of a taxpayer carrying on a business; and
(b)
those transactions entered into by non-business taxpayers.

2. The Ruling sets out our views as to the application of the decision of the Full Court of the High Court of Australia in FC of T v. The Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; 18 ATR 693.

3. In that case, the taxpayer company made an interest bearing loan to a subsidiary. Three days later, as had always been intended, the taxpayer assigned the right to receive interest income from the loan in return for a lump sum. The Court relied on 2 strands of reasoning in holding that the amount received by the taxpayer was income:

(a)
The amount in issue was a profit from a transaction which, although not within the ordinary course of the taxpayer's business, was entered into with the purpose of making a profit and in the course of the taxpayer's business.
(b)
The taxpayer sold a mere right to interest for a lump sum, that lump sum being received in exchange for, and as the present value of, the future interest it would have received. The taxpayer simply converted future income into present income.

4. The Ruling does not purport to provide a definitive exposition of the principles underlying the Myer decision because its full implications will only completely emerge from consideration of the decision in later Court cases.

5. The Ruling does not consider the application of section 25A the capital gains and capital losses provisions (Part IIIA) or Division 6A of Part III.

Ruling

A - Transactions with a profit-making purpose

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.

9. The taxpayer must have the requisite purpose at the time of entering into the relevant transaction or operation. If a transaction or operation involves the sale of property, it is usually, but not always, necessary that the taxpayer has the purpose of profit-making at the time of acquiring the property.

10. If a transaction or operation is outside the ordinary course of a taxpayer's business, the intention or purpose of profit-making must exist in relation to the transaction or operation in question.

11. The transaction may take place in the course of carrying on a business even if the transaction is outside the ordinary course of the taxpayer's business.

12. For a transaction to be characterised as a business operation or a commercial transaction, it is sufficient if the transaction is business or commercial in character.

13. Some matters which may be relevant in considering whether an isolated transaction amounts to a business operation or commercial transaction are the following:

(a)
the nature of the entity undertaking the operation or transaction;
(b)
the nature and scale of other activities undertaken by the taxpayer;
(c)
the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained;
(d)
the nature, scale and complexity of the operation or transaction;
(e)
the manner in which the operation or transaction was entered into or carried out;
(f)
the nature of any connection between the relevant taxpayer and any other party to the operation or transaction;
(g)
if the transaction involves the acquisition and disposal of property, the nature of that property; and
(h)
the timing of the transaction or the various steps in the transaction.

14. It is not necessary that the profit be obtained by a means specifically contemplated (either on its own or as one of several possible means) when the taxpayer enters into the transaction. It is sufficient that the taxpayer enters into the transaction with the purpose of making a profit in the most advantageous way and that a profit is later obtained by any means which implements the initial profit-making purpose. It is also sufficient if a taxpayer enters into the transaction with the purpose of making a profit by one particular means but actually obtains the profit by a different means.

Summary

15. If a taxpayer carrying on a business makes a profit from a transaction or operation, that profit is income if the transaction or operation:

(a)
is in the ordinary course of the taxpayer's business (see paragraph 32 for an explanation of the circumstances in which a transaction is in the ordinary course of business) - provided that any gross receipt from the transaction or operation is not income; or
(b)
is in the course of the taxpayer's business, although not within the ordinary course of that business, and the taxpayer entered the transaction or operation with the intention or purpose of making a profit; or
(c)
is not in the course of the taxpayer's business, but
(i)
the intention or purpose of the taxpayer in entering into the transaction or operation was to make a profit or gain; and
(ii)
the transaction or operation was entered into, and the profit was made, in carrying out a business operation or commercial transaction.

16. If a taxpayer not carrying on a business makes a profit, that profit is income if:

(a)
the intention or purpose of the taxpayer in entering into the profit-making transaction or operation was to make a profit or gain; and
(b)
the transaction or operation was entered into, and the profit was made, in carrying out a business operation or commercial transaction.

B - Conversion of stream of income to a lump sum

17. An amount received for the transfer of a right to an income stream severed from the property to which it relates is income according to ordinary concepts. Future income is simply converted into present income. This is the case even if the income stream is produced by a contractual right rather than by the relevant property.

18. The above principle does not apply if:

(a)
the right to income is not related to any underlying property e.g. a right to an annuity; or
(b)
the right is related to underlying property which the transferor has not previously owned e.g. the transferor owns a right to income under a licence contract granting a right to use a trademark which the taxpayer has not owned.

19. An amount received in these circumstances could be income even if the second strand of reasoning in Myer does not apply. For example, if the transfer of the right to receive income is in the ordinary course of the taxpayer's business or if the first strand of reasoning in Myer applies.

20. If a taxpayer transfers a right to an income stream, having previously disposed of the underlying property to which that right relates and retained the right to income, an amount received for that transfer is income.

Date of effect

21. This Ruling sets out the current practice of the Australian Taxation Office and does not contain any change in interpretation. Consequently, it applies (subject to any limitations imposed by statute) for years of income commencing both before and after the date on which it is issued.

Explanations

The Myer Case

22. In Myer, the taxpayer was the parent company in a group which carried on business predominantly in the areas of retail trading and property development. As part of a group reorganisation in March 1981, the taxpayer lent $80 million to a subsidiary for a period just exceeding 7 years at an interest rate of 12.5% per annum.

23. Three days later, as had always been intended, the taxpayer assigned to a finance company its right to receive the interest payable over the remainder of the loan period. As consideration for the assignment, the finance company paid the taxpayer company $45.37 million in a single sum. The sum was calculated on the basis of the outstanding interest payable discounted at the rate of 16% per annum.

24. The Commissioner treated the lump sum of $45.37 million as assessable income for the year ended 30 June 1981. On appeal, both the Supreme Court of Victoria and the Full Court of the Federal Court of Australia held that the amount was a non-assessable capital receipt.

25. The Commissioner then successfully appealed to the Full High Court. In a joint judgment, Mason ACJ, Wilson, Brennan, Deane and Dawson JJ held that the amount was income under both subsection 25(1) as income according to ordinary concepts and the second limb of paragraph 26(a) (now subsection 25A(1)) as a profit arising from the carrying on or carrying out of a profit-making undertaking or scheme.

26. The Full Court relied on two alternative reasons for its decision:

(a)
The amount in issue was a profit from a transaction which, although not within the ordinary course of the taxpayer's business, was entered into with the purpose of making a profit and in the course of the taxpayer's business.
(b)
The taxpayer sold its mere right to interest for a lump sum, that lump sum being received in exchange for, and as the present value of, the future interest it would have received. The taxpayer simply converted future income into present income.

A - Transactions with a profit-making purpose

27. The starting point in this area of the law is the statement of the Lord Justice Clerk (the Right Honourable J.H.A. Macdonald) in Californian Copper Syndicate (Limited and Reduced) v. Harris (1904) 5 TC 159 at 165-166 that:


'It is quite a well settled principle, in dealings with questions of Income Tax, that where the owner of an ordinary investment chooses to realise it, and obtains a greater price for it than he originally acquired it at, the enhanced price is not profit ... assessable to Income Tax. But it is equally well established that enhanced values obtained from realisation or conversion of securities may be so assessable where what is done is not merely a realisation or change of investment, but an act done in what is truly the carrying on, or carrying out, of a business. ... What is the line which separates the two classes of cases may be difficult to define, and each case must be considered according to its facts; the question to be determined being - Is the sum of gain that has been made a mere enhancement of values by realising a security, or is it a gain made in an operation of business in carrying out a scheme of profit-making?'

28. In Blockey v. FC of T (1923) 31 CLR 503 Isaacs J, in considering whether a profit from the purchase and sale of wheat scrip in an isolated transaction was assessable income, said at 508-509:


'But if a man, even in a single instance, risks capital in a commercial venture - say, in the purchase of a cargo of sugar or a flock of sheep - for the purpose of profit making by resale and makes profit accordingly, I do not for a moment mean to say he has not received "income" which is taxable. I intimated during the argument that this was possible; and I leave it open.'

29. The above statement of Isaacs J in Blockey was discussed by Mason J (as he was then) in FC of T v. Whitfords Beach Pty Ltd (1982) 150 CLR 355 at 376; 82 ATC 4031 at 4042; 12 ATR 692 at 705. His Honour agreed with the view that a profit made on the sale of property acquired for the purpose of profit-making by sale, when the purchase and sale is an isolated transaction not undertaken in the course of carrying on a business, could be income.

30. The view of Mason J was accepted and elaborated upon by the Full High Court in Myer at 163 CLR 209-210, 87 ATC 4366-7, 18 ATR 697:


'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. Nor does the fact that a profit or gain is made as the result of an isolated venture or a "one-off" transaction preclude it from being properly characterized as income (Whitfords Beach 150 CLR at 366-367, 376; 82 ATC at 4036-4037, 4042; 12 ATR at 695-696, 705). The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit.'

Profits or gains in the ordinary course of business

31. In Myer, the High Court spoke of profits or gains made in the ordinary course of carrying on a business being income. The Court went on to say that, because a business is carried on with a view to profit, such profits or gains are invested with a profit-making purpose and are thereby stamped with the character of income.

32. It is not completely clear what the High Court meant in referring to 'profits or gains made in the ordinary course of carrying on a business'. However, we consider that there are two types of profits or gains which come within that description, namely:

(i)
a profit or gain arising from a transaction which is itself a part of the ordinary business of a taxpayer (judged by reference to the transactions in which the taxpayer usually engages) - provided that the gross receipts from the transaction lack the character of income (Commercial and General Acceptance Ltd v. FC of T (1977) 137 CLR 373 at 381; 77 ATC 4375 at 4380; 7 ATR 716 at 722); and
(ii)
a profit or gain arising from a transaction which is an ordinary incident of the business activity of the taxpayer, although not a transaction entered into directly in its main business activity e.g. profits of insurance companies and banks on the sale of investments are generally income (Chamber of Manufactures Insurance Ltd v. FC of T (1984) 2 FCR 455; 84 ATC 4315; 15 ATR 599 and C of T v. Commercial Banking Co. of Sydney (1927) 27 SR(NSW) 231).
(Support for this view is found in the judgment of Hill J in Westfield Ltd v. FC of T 91 ATC 4234; (1991) 21 ATR 1398.)

Profits or gains in isolated transactions

33. The views expressed in Whitfords Beach and Myer that profits from isolated transactions can be assessable income must be looked at in the context of the facts involved in those cases. In Myer, the taxpayer was carrying on a large business at the time it entered into the transactions and, in Whitfords Beach, the taxpayer company embarked on a substantial business venture.

34. Nevertheless, there is a strong line of reasoning through the judgments in Whitfords Beach and Myer that suggests that profits made by a taxpayer who enters into an isolated transaction with a profit-making purpose can be assessable income. In Myer, at 163 CLR 213; 87 ATC 4369; 18 ATR 699-700, the Full High Court had this to say about the nature of profits from isolated transactions:


'It is one thing if the decision to sell an asset is taken after its acquisition, there having been no intention or purpose at the time of acquisition of acquiring for the purpose of profit-making by sale. Then, if the asset be not a revenue asset on other grounds, the profit made is capital because it proceeds from a mere realisation. But it is quite another thing if the decision to sell is taken by way of implementation of an intention or purpose, existing at the time of acquisition, of profit-making by sale, at least in the context of carrying on a business or carrying out a business operation or commercial transaction.'

35. A profit from an isolated transaction is therefore generally assessable 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.

36. The courts have often said that a profit on the mere realisation of an investment is not income, even if the taxpayer goes about the realisation in an enterprising way. The expression 'mere realisation' is used to contradistinguish a business operation or a commercial transaction carrying out a profit-making scheme (Myer at 163 CLR 213; 87 ATC 4368-4369; 18 ATR 699-700). If a transaction satisfies the elements set out in paragraph 35 it is generally not a mere realisation of an investment.

37. In considering whether a profit is assessable income, it is important not to apply the principles enunciated in Myer as if they are statutory tests. They are general principles, not conclusive tests, to be considered in deciding whether a profit is income.

Taxpayer's intention or purpose

38. The intention or purpose of the taxpayer (of making a profit or gain) referred to in Myer 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. This is implicit from what the Court said, in the passage quoted in paragraph 30 above:


'..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..'.
(R.W. Parsons, 'Income Taxation In Australia', The Law Book Company Limited, 1985 at p. 202 also refers to '...the objective inference of profit-purpose, which may be thought to be required by the ordinary usage notion [of an isolated business venture]'.)

39. If the taxpayer is a company, the purposes of those who control it are its purposes (Whitfords Beach at 150 CLR 370; 82 ATC 4039; 12 ATR 701).

40. 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. This is clear from specific statements of the Federal Court in the following cases: FC of T v. Cooling 90 ATC 4472 at 4484; 21 ATR 13 at 26; Moana Sand Pty Ltd v. FC of T 88 ATC 4897; 19 ATR 1853; AGC Investments Ltd v. FC of T 91 ATC 4180; 21 ATR 1379. See also Forwood Down and Co Ltd v. Commissioner of Taxation (WA) (1935) 53 CLR 403 (especially Evatt J) and Jacobs J. in London Australia Investment Co Ltd v. FC of T 77 ATC 4398 at 4409-4411; 7 ATR 757 at 770-772.

41. The taxpayer must have the requisite purpose at the time of entering into the relevant transaction or operation. If a transaction or operation involves the sale of property, it is usually necessary that the taxpayer has the purpose of profit-making at the time of acquiring the property. However, as the High Court decisions in White v. FC of T (1968) 120 CLR 191; 15 ATD 173 and Whitfords Beach demonstrate, that is not always the case. (See also Menzies J in FC of T v. N.F. Williams (1972) 127 CLR 226 at 245; 72 ATC 4188 at 4192-4193; 3 ATR 283 at 289 and Whitfords Beach Pty Ltd v. FC of T (F.C.) 79 ATC 4648 at 4659; 10 ATR 549 at 567).

42. For example, if a taxpayer acquires an asset with the intention of using it for personal enjoyment but later decides to venture or commit the asset either:

(a)
as the capital of a business; or
(b)
into a profit-making undertaking or scheme with the characteristics of a business operation or commercial transaction,
the activity of the taxpayer constitutes the carrying on of a business or a business operation or commercial transaction carrying out a profit-making scheme, as the case may be. The profit from the activity is income although the taxpayer did not have the purpose of profit-making at the time of acquiring the asset.

43. If a transaction or operation is outside the ordinary course of a taxpayer's business, the intention or purpose of profit-making must exist in relation to the transaction or operation in question (FC of T v. Spedley Securities Limited 88 ATC 4126 at 4130; 19 ATR 938 at 942).

44. It is not our view, nor has it ever been, that all receipts or profits of a business are income. For example, when a taxpayer derives a profit from a transaction outside the ordinary course of carrying on its business and the taxpayer did not enter that transaction with the purpose of making a profit, the profit is not assessable income.

In the course of carrying on a business

45. The transaction may take place in the course of carrying on a business even if the transaction is outside the ordinary course of the taxpayer's business. As the Full High Court said in Myer at 163 CLR 215; 82 ATC 4370; 18 ATR 701:


'If the profits be made in the course of carrying on a business that in itself is a fact of telling significance. It does not detract from its significance that the particular transaction is unusual or extraordinary, judged by reference to the transactions in which the taxpayer usually engages, if it be entered into in the course of carrying on the taxpayer's business.'

Business operation or commercial transaction

46. If a taxpayer enters into a transaction in the course of carrying on a business, it is not necessary to consider whether it is a business operation or commercial transaction. However, it is necessary to consider this issue if the taxpayer is not carrying on a business or if the transaction or operation is not in the course of the taxpayer's business, e.g. if a sole trader carrying on a retail business acquires shares.

47. For a transaction to be characterised as a business operation or a commercial transaction, it is sufficient if the transaction is business or commercial in character (see Whitfords Beach at 150 CLR 379; 82 ATC 4044; 12 ATR 707). Whether a particular transaction has a business or commercial character depends very much on the circumstances of the case.

48. In Myer, the High Court did not set out guidelines as to what constitutes a business operation or commercial transaction. However, it did regard the following instances as being such operations or transactions:

(i)
A syndicate purchased a mining property for the purpose of resale at a profit, rather than deriving income from mining operations on the property, and later sold the property at a profit (Californian Copper Syndicate v. Harris).
(ii)
A company engaged in exploiting a particular invention by granting licences under patents acquired additional patents in relation to the invention and, as always contemplated, sold those patents at a profit (Ducker v. Rees Roturbo Development Syndicate Ltd [1928] AC 132).
(iii)
A partnership purchased a complete spinning plant with a view to resale at a profit, having no intention of using the plant to derive income from spinning, and later sold the plant at a profit (Edwards v. Bairstow [1956] AC 14).
(iv)
A company which owned beachfront land suffered a change in ownership and then procured changes of zoning, developed the land as a residential subdivision and sold the vacant subdivided lots for a profit of several million dollars (Whitfords Beach).

49. In very general terms, a transaction or operation has the character of a business operation or commercial transaction if the transaction or operation would constitute the carrying on of a business except that it does not occur as part of repetitious or recurring transactions or operations. Some factors which may be relevant in considering whether an isolated transaction amounts to a business operation or commercial transaction are the following:

(a)
the nature of the entity undertaking the operation or transaction (Ruhamah Property Co. Ltd. v. F C of T (1928) 41 CLR 148 at 154; Hobart Bridge Co. Ltd. v. FC of T (1951) 82 CLR 372 at 383; FC of T v. Radnor Pty Ltd 91 ATC 4689; 22 ATR 344). For example, if the taxpayer is a corporation with substantial assets rather than an individual, that may be an indication that the operation or transaction was commercial in nature. However, if the taxpayer acts in the capacity of trustee of a family trust, the inference that the transaction was commercial or business in nature may not be drawn so readily;
(b)
the nature and scale of other activities undertaken by the taxpayer (Western Gold Mines N.L. v. C. of T. (W.A.) (1938) 59 CLR 729 at 740);
(c)
the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained;
(d)
the nature, scale and complexity of the operation or transaction;
(e)
the manner in which the operation or transaction was entered into or carried out. This factor would include whether professional agents and advisers were used and whether the operation or transaction took place in a public market;
(f)
the nature of any connection between the relevant taxpayer and any other party to the operation or transaction. For example, the relationship between the parties may suggest that the operation or transaction was essentially a family dealing and not business or commercial in nature;
(g)
if the transaction involves the acquisition and disposal of property, the nature of that property (Edwards v. Bairstow; Hobart Bridge 82 CLR at 383). For example, if the property has no use other than as the subject of trade, the conclusion that the property was acquired for the purpose of trade and, therefore, that the transaction was commercial in nature, would be readily drawn; and
(h)
the timing of the transaction or the various steps in the transaction (Ruhamah Property 41 CLR at 154). For example, if the relevant transaction consists of the acquisition and disposal of property, the holding of the property for many years may indicate that the transaction was not business or commercial in nature.

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.'

Whether there must be a purpose of profit-making by the very means by which the profit was in fact made

51. Assuming that both of the elements set out in paragraph 35 are met, if taxpayer earns a profit by the exact means it contemplated at the time of entering the transaction, the profit is clearly income (see Myer, especially the passage set out in paragraph 30 above). The simplest example is where a taxpayer acquired property for the purpose of selling it at a profit and later did sell it at a profit . What if, however, at the time a taxpayer enters a transaction with a profit-making purpose it contemplates a number of possible methods of making that profit or it did not have in mind any particular means of making the profit?

52. This issue was considered recently by the Full Federal Court in Westfield Limited v FC of T. At 91 ATC 4243; 21 ATR 1408, Hill J (with whom Lockhart and Gummow JJ agreed) said:


'...where a transaction falls outside the ordinary scope of the business, so as not to be a part of that business, there must exist, in my opinion, a purpose of profit-making by the very means by which the profit was in fact made. So much is implicit in the decision of the High Court in Myer.'

53. His Honour limited this broad statement when he pointed out:


'There may be a case, the present is not one, where the evidence establishes that the taxpayer has the purpose or intention of making a profit by turning an asset to account, although the means to be adopted to generate that profit have not been determined: cf Steinberg v Federal Commissioner of Taxation (1972-75) 134 CLR 640; 75 ATC 4221; 5 ATR 594...
While a profit-making scheme may lack specificity of detail, the mode of achieving that profit must be one contemplated by the taxpayer as at least one of the alternatives by which the profit could be realised. Such was the case in Steinberg.'

54. His Honour then said:


'But, even if that goes to far, it is difficult to conceive of a case where a taxpayer would be said to have made a profit from the carrying on, or carrying out, of a profit making scheme, where, in the case of a scheme involving the acquisition and resale of land, there was, at the time of acquisition, no purpose of resale of land, but only the possibility (present, one may observe, in the case of every acquisition of land) that the land may be resold. The same may be said to be the case where subsection 25(1) is involved.'

55. The Commissioner unsuccessfully applied to the High Court for special leave to appeal against the Full Federal Court decision. The application was refused on the basis that the case turned on its own particular facts.

56. In our view a profit made in either of the following situations is income:

(a)
a taxpayer acquires property with a purpose of making a profit by which ever means prove most suitable and a profit is later obtained by any means which implements the initial profit-making purpose (Steinberg; Premier Automatic Ticket Issuers Ltd v. FC of T (1933) 50 CLR 268 at 300; Myer, especially at 163 CLR 211; 87 ATC 4367; 18 ATR 698); or
(b)
a taxpayer acquires property contemplating a number of different methods of making a profit and uses one of those methods in making a profit.

57. We also consider that an assessable profit arises if a taxpayer enters into a transaction or operation with a purpose of making a profit by one particular means but actually obtains the profit by a different means. Thus, a taxpayer may contemplate making a profit by sale but may ultimately obtain it by other means (such as compulsory acquisition, through a company liquidation or a distribution in specie) that were not originally contemplated.

58. Dicta of Hill J in Westfield have been cited as being contrary to this view. However, our view follows from the earlier Full Federal Court decision in Moana Sand Pty Ltd v. FC of T. In a joint judgment the Court (Sheppard, Wilcox and Lee JJ) applied the Myer decision and held that a profit on the disposal of land by means of compulsory acquisition was income according to ordinary concepts. The Court reached this conclusion notwithstanding the finding of fact that the taxpayer acquired the land for 2 purposes. The purposes were working and/ or selling the sand and thereafter holding the land until it became 'ripe' for subdivision, when it would be sold either to another family company for the purpose of subdivision or to a third party subdivider, whichever gave the largest financial return to the taxpayer. In any event, the law on the issue raised in paragraph 57 above is not clear and, in our view, needs further judicial elucidation.

B - Conversion of stream of income to a lump sum

59. In Myer, the Full High Court distinguished the assignment of the right to receive interest from Inland Revenue Commissioners v. Paget [1938] 2 KB 25 where the English Court of Appeal held that the proceeds of the sale of interest coupons attached to foreign bearer bonds were capital. At 163 CLR 218, 87 ATC 4371, 18 ATR 703-704 the Full High Court said:


'But the interest which becomes due is not the produce of the mere contractual right to interest severed from the debt for the money lent. Interest is regarded as flowing from the principal sum....... The source of interest is never the mere covenant to pay. Interest is not like an annuity. ......If a lender who sells a right to interest severed from the debt were regarded as disposing of an income-producing right, Paget would indicate that the price should be treated as capital. But the contractual right is not the source of the interest to which it relates: a contractual right severed from the debt is not the structure which produces that income.'

60. At 163 CLR 219, 87 ATC 4372, 18 ATR 704, the Court continued:


'Unlike the sale of the coupons in Paget, the sale of a right to interest severed from the debt is not a sale of a tree of which the future payments are the fruit. The present case may thus be distinguished from the view of the facts which was the foundation of the decision in Paget. If Paget is not to be distinguished in this way, we should be unable to accept its authority for the purposes of the Act.'

61. From the above passages, it is clear that if a stream of income can be regarded as flowing from property (rather than merely from a contractual right to that income) consideration received for the transfer of the right - without transfer of the property to which the contractual right relates - is income according to ordinary concepts.

62. As the Full High Court was apparently willing to accept that Paget is not good authority in Australia, the Myer decision left open the assessability under subsection 25(1) of a lump sum received for the transfer of a contractual right to a stream of income without the property to which it relates where the income is properly regarded as produced by the contractual right e.g., a royalty stream. This issue was recently considered in Henry Jones (IXL) Limited v. FC of T 91 ATC 4663, 22 ATR 328.

63. In Henry Jones the taxpayer and a subsidiary entered into a 10 year agreement in December 1981 with two arm's length companies under which the taxpayer and the subsidiary granted a licence to the other companies to use certain labels in return for royalties spread over the term of the contract. In May 1982 the taxpayer and the subsidiary assigned their rights to receive the royalties to a finance company for a lump sum of $7.6 million. Before it entered into the licence agreement, the taxpayer intended to assign the rights under it for lump sum.

64. The Full Federal Court held that the receipt was assessable income under subsection 25(1) on the basis of the second strand of reasoning in Myer. Hill J (with whom Jenkinson and Heerey JJ. agreed on this issue) said at 91 ATC 4675; 22 ATR 341:


'Notwithstanding some doubt, I think Myer must be taken as establishing that, except in the case of the assignment of an annuity where the income arises from the very contract assigned, an assignment of income from property without an assignment of the underlying property right will, no matter what its form, bring about the result that the consideration for that assignment will be on revenue account, as being merely a substitution for the future income that is to be derived. Thus, the fact that the future income may be secured by an agreement, and that the assignment is of the right title and interest of the assignor in that agreement will not affect the result.'

65. Thus, an amount received for the transfer of a right to an income stream severed from the property to which it relates is income according to ordinary concepts. Future income is simply converted into present income. This is the case even if the income stream is produced by a contractual right rather than by the relevant property.

66. Myer and Henry Jones did not squarely address the case of a taxpayer assigning a right to a stream of income for a lump sum in the following 3 situations:

(a)
The taxpayer's right is unrelated to any other property but is not an annuity.
(b)
The taxpayer's right is related to underlying property which the taxpayer has never owned e.g. the taxpayer (like the assignee in Henry Jones) owns a right to income under a licence contract granting a right to use a trademark which the taxpayer has not owned.
(c)
The taxpayer previously disposed of the underlying property to which the right to income relates and retained that right e.g. a taxpayer sold a trademark but, under the sale agreement, retained a right to a share of the income from licences granting the right to use that trademark.

67. The second strand of reasoning in Myer does not apply if the right to income transferred is unrelated to any other property. The reasoning in both Myer and Henry Jones emphasises the fact that the right to income was severed from the underlying property. There is no such severing if a taxpayer transfers a right to income which is unrelated to any other property. An annuity is an example of such a right - it is not the only right to a stream of income which does not fall within the second strand of reasoning in Myer.

68. Similarly, the second strand of reasoning in Myer does not apply if the taxpayer transferring a right to income has never owned the underlying property. In terms of the analogy of the tree and the fruit referred to in Myer, the transfer of the right to income is the sale of the tree of which the future payments are the fruit.

69. An amount received in the situations considered in paragraphs 67 and 68 could be income even if the second strand of reasoning in Myer does not apply. For example, it would be income if the transfer of the right to income is in the ordinary course of the transferor's business or if the first strand of reasoning in Myer (the profit-making purpose strand) applies.

70. We consider that the second strand of reasoning in Myer does apply if the transferor previously disposed of the underlying property to which the right to income relates and retained that right. The taxpayer has severed a right to income from its total interest and disposed of it separately from the underlying property. The fact that the right was disposed of after the underlying property rather than before (as it was in Henry Jones) does not affect the character of the receipt. The receipt would have been income if the right to income had been disposed of before the underlying property. It is also income if it is disposed of after the underlying property. In terms of the analogy of the fruit and the tree, the taxpayer has taken the fruit from the tree, sold the tree and later sold the fruit.

Examples

71. The following examples are illustrations of the way in which the above principles are applied. It is important to remember, especially in applying the first strand of reasoning in Myer (the profit-making purpose strand), that whether a profit constitutes income depends very much on the circumstances of the particular case. Consequently, the answers given in the following examples are not determinative of our views on cases with similar, but different, facts.

A - Transactions with a profit-making purpose

Example 1

72. Ms Donovan, a public servant, purchased 10,000 shares in a listed public company at a price of $1 each and sold them 18 months later for $2 each. During that period, the company paid one small dividend. Donovan was not carrying on a business of trading in shares. A significant purpose of Donovan in acquiring the shares was to make a profit from an increase in the value of the shares.

73. The profit made on the sale of the shares is not income. The transaction was merely an investment, not a business operation or commercial transaction.

Example 2

74. Mr Leary carried on a pharmacy business as a sole trader. He acquired a residential property and leased the property to an arm's length party for 3 years, bringing small net returns. Leary then sold the property at a large profit during a property boom. He had no previous dealings in property, other than as lessee of his shop premises.

75. Mr Leary's profit is not income because the acquisition and sale of the residential property was not a business operation or commercial transaction. It was the acquisition and sale of an investment, even if a significant purpose of Leary in acquiring the property was profit-making.

Example 3

76. A taxpayer owned shares in a public company with a market value of $100,000. The taxpayer's shareholding had been built-up over a period of 5 years and acquired at a cost of $40,000. In acquiring the shares the taxpayer hoped to build up a nest egg for her retirement. The taxpayer sold the shares to her 4 children for $80,000 and used the proceeds in purchasing a unit in a retirement home.

77. The profit made is not income. The transaction was not business or commercial in character. The sale of the shares below their market price and the fact that the purchasers are family of the taxpayer indicate that the transaction was essentially a family dealing.

Example 4

78. Mr Goldfinger purchased a number of gold bars for $100,000 and, following a sharp rise in the price of gold, sold the gold bars one week later for $110,000. Goldfinger did not carry on a business and had no previous dealings in gold.

79. The profit of $10,000 is income and assessable under subsection 25(1). It can be inferred from the objective circumstances (especially the quick sale following a rise in price and the fact that the asset had no immediate use other than as an object of trade) that profit-making was a significant purpose of Goldfinger in acquiring the gold bars. Furthermore, the substantial amounts of money involved and the nature of the asset traded lead to the conclusion that the transaction was commercial in nature.

Example 5

80. Hungry Ltd, a public company, made a takeover bid for another public company, Morsel Ltd, in which it already held a 15% interest. Shortly after, Ravenous Ltd also made a takeover bid for Morsel. Ravenous' takeover bid was successful and Hungry's failed. Hungry sold to Ravenous the shares it had acquired in Morsel at a large profit.

81. Hungry was a holding company in a group of companies. Many of the entities in the company group had previously been involved in takeovers of other companies. Hungry had not previously been involved in a takeover attempt and had only disposed of shares in the course of restructuring the company group. From the time Hungry began to acquire shares in Morsel the directors of Hungry had hoped to acquire control of Morsel - they were not interested in a 'passive investment'. The contingency plan of the directors in the event that control could not be obtained was to dispose of the shares in Morsel at a profit.

82. The profit on the sale of the shares is income. A substantial, but not dominant, purpose of Hungry in acquiring the shares was to dispose of them at a profit because the contingency plan was to dispose of the shares at a profit. Furthermore, the acquisition and sale of the shares was effected in the course of the taxpayer's business.

Example 6

83. Conglomerate Ltd, a large public company, made a takeover bid for Awful Ltd, the owner of lands containing a large mineral deposit. Conglomerate intended to obtain control of Awful and expedite the mining of the deposit. The takeover bid was unsuccessful and Awful did not commence mining operations. Conglomerate held its Awful shares for about 2 years before selling the shares at a profit.

84. Assuming that the unsuccessful takeover bid was not made in the ordinary course of Conglomerate's business, the profit on the sale of the shares is not income. The evidence shows that Conglomerate acquired the shares to obtain control of Awful and derive dividends generated by mining activities of that company, not to make a profit from the sale of the shares.

Example 7

85. A family company acquired 500 hectares of land, which had been used as a grazing property, for $1 million. The company was formed for the purpose of acquiring the land and Mr and Mrs Soil owned all the shares in the company and were the directors. Four years after acquisition, the Soils sold all their shares in the company to an arm's length party for $2 million.

86. The Soils maintain that the property was purchased for use as a grazing property but the land was never so used after the company acquired it. The Soils had no knowledge of, or experience in, grazing but on several occasions they had been involved in the purchase and resale of land. Furthermore, under local government legislation, the land had been zoned for residential development before the company acquired it.

87. The profit made by the Soils is income. The objective evidence establishes that the Soils incorporated the company and arranged for the company to acquire the land with the purpose of making a profit from the anticipated appreciation in the value of the land.

88. The profit from the appreciation in the value of the land could have been realised in a number of ways. For example, the company could have sold the land, the shares in the company could have been sold or the company could have been placed in voluntary liquidation and the land distributed in specie by the liquidator. It is not necessary that the Soils planned each step which led to the making of the profit. It is sufficient that the Soils intended to make a profit from the appreciation of the land when they entered the transaction and that the intended profit was made.

89. Furthermore, the acquisition of the land through the company and the subsequent sale of the shares in that company was a business operation or commercial transaction because of the following factors: the use of a corporate structure, the large amounts of money involved and the Soils' other dealings in land.

Example 8

90. Mr Develop has been involved in property development, mainly through a company group he controls, for many years. In recent years, each acquisition of property by the group has been effected by a different company. Thus, each company in the group of more than 50 companies has been involved in only one acquisition, development and sale of property. Over the last 5 years the companies have made profits totalling more than $50 million from the development and sale of properties.

91. The profits derived by each of the companies from the development and sale of property are income. In determining whether a company has the purpose of profit-making, the acts and intentions of the natural persons who control the company should be examined. The actions of Mr Develop in repeatedly using companies he controls to make profits from the development and sale of property indicate that the purpose of each company in acquiring property was profit-making.

92. Furthermore, the acquisition, sale and development of the properties undertaken by the companies amount to a business operation or commercial transaction. The scale of the activities, the nature of the entities (members of a large group of companies), and the business-like way in which the companies have carried out their development activities indicate that the transactions were business or commercial in nature.

Example 9

93. Mr Bates purchased a motel in a country town intending to carry on a business as the owner and operator of that motel. He ran the motel for 7 years earning moderate returns and then sold it at a large profit. Mr Bates had not previously purchased property other than a house in which he had lived.

94. The profit on the sale of the motel is not income. It cannot be inferred from the objective facts that Mr Bates acquired the motel with a purpose of making a profit (as distinct from income from the carrying on a business). Furthermore, the sale of the motel was not made in the ordinary course of carrying on a business. The motel was a structural asset of the business.

B - Conversion of stream of income to a lump sum

Example 10

95. A company carried on a manufacturing business and also derived income from the rental of a large number of properties. The company assigned to an unrelated party its right to receive rental income from the properties in return for a lump sum.

96. The lump sum received is income. There has been a transfer of a right to a stream of income from property without the underlying property. The company has converted future income to present income.

Commissioner of Taxation
30 July 1992

Previously released in draft form as EDR 72

References

ATO references:
NO 92/5371-8

ISSN 0813 - 3662

Subject References:
- business operation
- commercial transaction
- income
- isolated transactions
- lump sum
- ordinary course of business
- profit-making purpose
- profits
- purpose
- stream of income

Legislative References:
- ITAA 25(1)

Case References:
AGC Investments Ltd v. FC of T
91 ATC 4180
21 ATR 1379


Blockey v. FC of T
(1923) 31 CLR 503
Californian Copper Syndicate (Limited and Reduced) v. Harris
(1904) 5 TC 159
Chamber of Manufactures Insurance Ltd v. FC of T
(1984) 2 FCR 455
84 ATC 4315
15 ATR 599
Commercial and General Acceptance Ltd v. FC of T
(1977) 137 CLR 373
77 ATC 4375
7 ATR 716
F C of T v. Commercial Banking Co. of Sydney
(1927) 27 SR(NSW) 231
FC of T v. Cooling
90 ATC 4472
21 ATR 13
Ducker v. Rees Roturbo Development Syndicate Ltd
[1928] AC 132
Edwards v. Bairstow
[1956] AC 14
Forwood Down and Co Ltd v. Commissioner of Taxation (W.A.)
(1935) 53 CLR 403
Henry Jones (IXL) Limited v. FC of T
91 ATC 4663
22 ATR 328
Hobart Bridge Co. Ltd. v. FC of T
(1951) 82 CLR 372
London Australia Investment Co Ltd v. FCof T
(1977) 138 CLR 106
77 ATC 4398
7 ATR 757
Moana Sand Pty Ltd v. FC of T
88 ATC 4897
19 ATR 1853
FC of T v. The Myer Emporium Ltd
(1987) 163 CLR 199
87 ATC 4363
18 ATR 693
Inland Revenue Commissioners v. Paget
[1938] 2 KB 25
Premier Automatic Ticket Issuers Ltd v. FC of T
(1933) 50 CLR 268
FC of T v. Radnor Pty Ltd
91 ATC 4689
22 ATR 344
Ruhamah Property Co. Ltd. v. FC of T
(1928) 41 CLR 148
FC of T v. Spedley Securities Limited
88 ATC 4126
19 ATR 938
Steinberg v. FC of T
(1972-75) 134 CLR 640
75 ATC 4221
5 ATR 594
Western Gold Mines N.L. v. C of T (W.A.)
(1938) 59 CLR 729
Westfield Ltd v. FC of T
91 ATC 4234
(1991) 21 ATR 1398
White v. FC of T
(1968) 120 CLR 191
15 ATD 173
Whitfords Beach Pty Ltd v. FC of T (F.C.)
79 ATC 4648
10 ATR 549
FC of T v. Whitfords Beach Pty Ltd (H.C.)
(1982) 150 CLR 355
82 ATC 4031
12 ATR 692
FC of T v. N.F. Williams
(1972) 127 CLR 226
72 ATC 4188
3 ATR 283

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