Q: Torres and Baker carried on a business together in partnership in Mosman, NSW. The partnership – Pets R – provided dog washing services. Torres decide to leave the partnership and start his own dog washing business as a sole trader.
In May 2017, Baker paid Torres $50,000 to secure agreement not to operate a similar business within a 10 km radius of Mosman. The payment was to preserve the goodwill of Pets R.
How should Baker treat the payment of $50,000 to Torres for income tax purposes?
A: An agreement where there is restraint of trade is commonly referred to as a “restrictive covenant”.
The general deduction provision in ITAA 97 s 8-1 allows a deduction for a loss or outgoing to the extent that it is incurred in gaining or producing the taxpayer s assessable income or is necessary incurred in carrying on a business for the purpose of gaining or producing the taxpayer assessable income. However, a deduction is not permitted under s 8-1 to the extent that the loss or outgoing is capital or of a capital nature.
In Sun Newspapers Ltd v FC of T (1936) 61 CLR 337, the high court held that a payment made by the taxpayer for an interest in a competing newspaper and for the competitor not to be associated for a period of three years with the publication of any other newspaper in the region was capital in nature. Therefore, the payment by Baker is capital or capital in nature as it was in relationship to the restrictive covenant to protect the profit-yielding structure of Pets R.
As the payment is on capital account, it would form part of the cost base of the CGT asset to which it relates to the goodwill of the business. However, as the expenditure is to preserve the goodwill of Pets R, it does not form part of the cost base of the goodwill of the business due to a specific exclusion in ITAA 97 s 110-25(5A).
There is nothing to prevent the amount from forming part of coat base of another CGT asset. The expenditure incurred by Baker relates to the acquisition of a right to enforce restrictions on Torres from operating a similar business in Mosman NSW. It could be argued that the expenditure relates to the first element of cost base – being the money paid in respect of acquiring the right (s 110-25(2)).
Thus, there is scope for the expenditure incurred by Baker to be business-related capital expenditure, which can be claimed over five years under ITAA 97 s 40-880. On this basis, Baker is entitled to deduct the $50,000 business-related capital expenditure equally over five income years at $10,000 each year, beginning from the 2016/17 income year.