Goodwill (CGT)

Goodwill is specifically included in the definition of CGT asset in paragraph 108-5(2)(b) of the Income Tax Assessment Act 1997 (Cth) (the ITAA)

As mentioned above, goodwill is not defined in the ITAA and therefore takes its meaning from general law.

CGT and goodwill as a single indivisible asset

In Murry, the High Court made a key characterisation of goodwill as a single indivisible item of property that is unique to each particular business. The implication being that goodwill of the business is inseparable for the underlying business itself (although not inseparable from the taxpayer who owns the underlying business).

Consequently, it is not possible to divide up and sell/dispose of goodwill in parts notwithstanding certain parts of the business may in fact contribute (perhaps even significantly) to the generation of goodwill.

The Murry decision explains that goodwill is something which is comprised of various sources which feed it into it but which are legally distinct from it. Goodwill is not something which is comprised of elements or parts whereby the disposal of that element or part means the disposal of a portion of the businesss goodwill for which that element or part is responsible. As such, For CGT purposes, the goodwill of each business is a single asset and not a collation of multiple CGT assets which contribute to it.

This concept is perhaps best articulated through an example.

Lets take James Pty Ltd which operates a cafe business through a corporate structure. James is an employee for the business who drums up significant revenue because of his likable personality. Here, James is a source of goodwill because he feeds into and contributes to the building up of the businesss goodwill. James decides to leave the business. Because goodwill is an indivisible and not comprised of elements, James departure does not involve the disposal of any goodwill. That is despite the reality that James departure will decrease the value of goodwill of the business. Therefore, for CGT purposes, the goodwill attributable to James charisma is not a separate CGT asset, nor will James departure trigger a CGT event. Goodwill remains entirely with the underlying business.

There are many potential sources of goodwill. For instance:

• items of the intellectual property
• efficient use of business assets
• advertising
• effective management practices
• any tangible, intangible and human assets that are used in such ways that custom becomes drawn to the business.

The relationship between goodwill of a business and other things

For taxation purposes, a taxpayer needs to be able to distinguish goodwill from other identifiable assets so as properly allocate value (and costs) between them.

This is important because the cost base of goodwill is separate from the cost base (or cost allocation) to other business assets. The allocation of costs to the correct CGT (or other) asset is necessary as capital gains or capital losses (or profits or losses) need to be determined against each CGT (or other) asset at the point in time a CGT event occurs in respect of that CGT asset.

Examples of assets which are often associated with goodwill but which are distinguishable, include things such as plant, entitlements, items of intellectual property, work in progress, get-up (which includes things such as trade names, logos, slogans, symbols, signs, colour schemes and visual images) and restrictive covenants.

The CGT regime is applicable to the taxpayer which owns the business and where a CGT event happens to a CGT event.

As mentioned, goodwill is considered a single CGT asset under the CGT regime. A CGT event occurs to goodwill when the goodwill is transferred or ceases. Typically, the sale of a business (which involves the transfer of goodwill) will trigger CGT event A1. That CGT event relates to the disposal of a CGT asset. The relevant conditions of A1 are set out in section 104-10 of the ITAA.

If instead the business ceases, CGT event C1 will generally be relevant. CGT event C1 is applicable where a CGT asset is lost or destroyed. The relevant conditions of C1 are set out in section 104-20 of the ITAA.

The taxpayer makes a capital gain under these CGT events if the capital proceeds are greater than the cost base of the CGT asset in hands of the taxpayer. The taxpayer makes a capital loss where the capital proceeds are less than the reduced cost base of the CGT asset in hands of the taxpayer.

The relevant capital gain or capital loss is then subject to the method statement in section 102-5 which congregates capital gains and losses and then applies reductions, discounts and concessions which enables the taxpayer to calculate its net capital gain that will be included in their assessable income.

To summarise (taking the example of a capital gain), the capital gain is added to other capital gains made by the taxpayer during the income year. Particular capital gains can then be reduced by capital losses, including prior year capital losses which are capable of being recouped. The remaining gains can then be discounted or disregarded (where that concession is available in respect of eligible gain/s), for example, under the general CGT discount or under the small business CGT concessions. The net capital gain for the income year is then added to the taxpayers assessable income. It is assessable income less allowable deductions which equals the taxpayers taxable income which subjected to applicable rates of tax.

The cost base of goodwill will depend on whether the taxpayer has started the business and organically generated goodwill or, alternatively, has acquired the goodwill as part of a business purchase.

In the former circumstance, the cost base of goodwill is reasonably limited. That is because most costs will tend to be assigned to other identifiable assets of the business. That said, the cost base of goodwill could technically include any eligible second, third or fifth element expenditure as set out in section 110-25. The most common expenditure in a goodwill context is capital expenditure to the extent it is incurred to establish, preserve or defend the taxpayers title to, or right over, the goodwill.

The cost base does not include any expenditure incurred in carrying out the business which:

• has the character of a working expense of the business, or
• the cost of trade operations of the business, or
• expenditure that is not a general deduction to the taxpayer under section 8-1 or another section such as section 40-880 which deals with blackhole expenses, or
• any amount which reflects the taxpayers own efforts and services in generating goodwill, or
• costs incurred in acquiring knowledge or information, or
• costs incurred in establishing and maintaining the get-up of a business, or
• capital expenditure to the extent it is incurred to increase the value of goodwill. There is a specific exclusion for fourth element expenditure in relation to goodwill which means such expenditure may not be able to be recognised in any way for taxation purposes.
• costs which are included in cost base (or cost) of another asset.

For purchased goodwill, the cost base in an arms length transaction is the consideration paid. For a non-arms length transaction, the first element of the cost base will be the market value of the asset, but only where what the taxpayer paid to acquire the goodwill was more than its market value at the time of acquisition.

In the context of a business sale, the ATO expresses in TR 1999/16 that they will tend to accept the amount a vendor and purchaser allocate to goodwill as the capital proceeds for its disposal. However, that is provided that all of the following conditions are met:

• The vendor owns the goodwill of the business and is entitled to dispose it and has actually disposed of the goodwill in disposing of the business.
• The parties are dealing with each other at arms length in transacting the sale and in allocating the capital proceeds.
• 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, except in relation to a restrictive covenant. An identifiable asset in terms of the accounting standards could include, non-exhaustively:
  • Work in progress
  • The get-up of a business (e.g., its business or trade name, logos, slogans, symbols, signs, colour schemes and visual images) to the extent to which it is capable of being individually identified and specifically recognised in financial statements; and
  • Scientific, technical, industrial or commercial knowledge or information (e.g., know-how and mining, quarrying or prospecting information) to the extent to which it is capable of being individually identified and specifically recognised in financial statements.
• The amount of capital proceeds attributed to goodwill, when added to the proceeds attributed to all off balance sheet assets and identifiable assets of the business, equals the total proceeds received for the sale of the business.

A regular contention is whether taxpayers are dealing at arms length in transacting the sale and allocating the sale proceeds to goodwill. A key determining factor is whether the amount allocated to goodwill is above or below the market value of the goodwill.

Absent arms length conditions, the market value substitution rule in section 116-30(2) may apply to replace the amount allocated to goodwill with its market value.

The ITAA does not set out a defined method for valuing goodwill and it is therefore up to the taxpayer to design an appropriate valuation method. In TR 1999/16, the ATO recognise that there are a range of potential valuation methods but tend to prefer the following valuation method for goodwill on the sale of a profitable business:

Goodwill equals the present value of the predicted earnings of the business less the sum of the market values of off balance sheet assets and all identifiable net assets – in terms of the accounting standards – other than goodwill of the business disposed of (subject to the restrictive covenant exception set-out in TR 1999/16).

This method will typically not be appropriate for a non-profitable business.

Note for those interested, the Placer Dome decision provides some guidance on the suitability of valuation methods, albeit in a state taxes context. That case involved a taxpayer relying on a discounted cash flow model which was rejected as a valuation method.

In the context of a business acquisition, the purchaser taxpayer generally acquires goodwill on the date the contract of purchase is entered into. If goodwill is acquired other than under a contract, it is acquired when the vendor of the goodwill stops being its owner.

However, in the context of internally generated goodwill, the taxpayer acquires the goodwill when they start the work that results in the creation of the goodwill (section 109-10). The precise point in time this occurs is a question of fact which depends on a consideration of all the relevant circumstances.

As established in Murry, the goodwill of a business is an indivisible asset. That means internally generated goodwill is merely an expansion of existing goodwill. Therefore, different events which contribute to internally generated goodwill are not to be distinctly recognised. This concept is best explained with an example.

Lets take Ciana Pty Ltd which commences a bakery business that trades as Cianas Bakery. From its inception, the business has goodwill. The business initially relies on word on mouth to attract its customers. However, after some time the company decides to invest in social media advertising to attract more customers. Revenue increases dramatically and the bakery develop an attractive brand. Here, the growth in goodwill which is attributable to the advertising efforts is not separate goodwill. That is, it would be incorrect to say that Ciana Pty Ltd could recognise pre-advertising goodwill and separately post-advertising goodwill, or that Ciana Pty Ltd could recognise advertising-related goodwill. The growth of brand attributable to marketing efforts is simply an expansion of existing goodwill.

The same principle applies where an existing business expands in other ways, for example, by opening up a new facility.

That said, it is worth bearing in mind that there will be different outcomes where there is an expansion event which actually results in a new business being established. For example, where Ciana Pty Ltd decides to used the profits generated by the business to start up a candle store. It could very well be that the new store is a separate business from the existing bakery. In that scenario, goodwill could be separated between the two businesses meaning the bakery would have its own goodwill and the candle store would have its own goodwill. There is further discussion on that concept later in this article.

As established in Murry, goodwill is inextricably linked to a business.

That means that a taxpayer can only acquire goodwill by starting a new business or from acquiring it from another business where the taxpayer purchases the underlying the business and the rights necessary to conduct the business in the same way.

The question which then arises is what to do when a business fundamentally changes. What happens to the goodwill?

In TR 1999/16, the ATO broadly takes the view that the goodwill of the first business (the CGT asset) ceases to exist and that new goodwill is acquired over the new business (as a separate CGT asset).

The cessation of goodwill following the change of business will generally trigger CGT event C1 which relates to the loss or destruction of a CGT asset. The trigger of this event enables the taxpayer to realise a capital loss over the goodwill of the first business. Per section 116-25, there is no market value substitution rule when calculating capital proceeds.

The new business is then deemed to have acquired goodwill. The newly acquired goodwill is a separate CGT asset from the goodwill of the first business. The acquisition date of the new goodwill is an important consideration as it may impact on the taxpayers ability to satisfy the requirements of eligibility under a number of CGT concessions. That includes the disregard of CGT for an asset acquired prior to 20 September 1985, eligibility for the general CGT discount for an asset acquired at least 12 months before a relevant CGT event and eligibility under the small business CGT concessions.

The key question is under what circumstances a business changes so fundamentally so as to result in there being a new business and newly acquired goodwill. The answer is ultimately a question of fact which depends on a close consideration of all the relevant circumstances.

In TR 1999/16, the ATO sheds some light on relevant factors to consider:

the nature of the new business operation or activity

• the types of customers that the business operation or activity attracts
• the extent to which the business operation or activity:
  • is subject to the same integrated management and control as the existing business;
  • is treated for banking and accounting purposes as an extension of the existing business or as a separate business;
  • uses one or more different trading names; and
  • is related to or dependent on the existing business in a practical, economic or commercial sense.

Generally, the business will not be of the same essential nature or character where:

• through a planned or systematic process of change within a reasonable period of time, a business changes its essential nature or character; or
• there is a sudden and dramatic change in the business brought about by either the acquisition or the shedding of activities on a considerable scale.

The business does not tend to undergo a change of essential nature or character in response to:

• a mere expansion or contraction of activities
• a mere change to the way a business is carried on
• organic growth
• expansion or diversification of a business by way of (a) adopting new compatible operations; or (b) servicing different clients; or (c) offering improved products or services.
• situations where portions of the operations of a business are discarded in an ordinary commercial way.
• situations where the types of customers a business attracts changes as the business evolves over the years.

The term business here carries its ordinary meaning under general law and broadly refers a course of conduct carried on for the purpose of profit and involves notions of continuity and repetition of actions. It is an undertaking or going concern in which an entity or entities use assets, knowledge, skills, human resources and other things required in continuing activities or transaction for commercial purposes.

Some complexity can arise in situations where a taxpayer with a business acquires another business. The tax-related question to be answered is whether the acquired business goodwill forms part of the existing businesss goodwill (i.e. subsumed) or whether the acquired businesss goodwill should remain a separate asset linked the acquired business.

The appropriate treatment of the acquired businesss goodwill depends on the way the purchaser deals with the acquired business. For goodwill to subsume, the two businesses may need to merge and be conducted as one business and without the acquired business losing its essential nature or character.

If the acquired businesss goodwill is subsumed, the cost base of the acquired goodwill is added to the cost base of the existing business. Otherwise, the two businesss goodwill will remain separate.

The ability to merge the cost base of an acquired business with an existing business becomes a matter of particular consequence in circumstances where the existing business acquired its goodwill pre-CGT (i.e. before 20 September 1985). That is because it gives the purchaser the ability to purchase goodwill acquired post-CGT and essentially convert it to pre-CGT goodwill because of its merging with the goodwill of the existing business. Of course, there are limitations to that ability. In particular, in TR 1999/16 the ATO take the position that the pre-CGT business must not lose its essential nature or character in the sense that it must remain the same business and not be overwhelmed by the post-CGT business in such a way that it has become a different business. The purchase of the post-CGT business must involve merely organic growth of the pre-CGT business or an expansion or accretion to it in reasonable proportions or it gives rise to a new, different business and its goodwill is a new asset. Clearly, the intention here is to prevent a taxpayer with a pre-CGT business from acquiring post-CGT business for the purposes of converting its goodwill into pre-CGT. Remembering that a CGT event which occurs in relation to a pre-CGT asset will have any capital gain or loss disregarded for the CGT purposes (meaning any capital gain is effectively tax-free).

The ruling gives the example of a taxpayer operating a pre-CGT supermarket. The taxpayer acquired a bakery outlet after 19 September 1985 and – as a matter of fact – integrated it into the supermarket in one consolidated business and later sold the consolidated business. In that instance, the whole of the amount received for the goodwill of the integrated business is taken to have been acquired before 20 September 1985 (subject to Division 149). If, on the other hand, the two businesses are – as a matter of fact – separate and distinct businesses, the goodwill attached to the additional business is acquired after 19 September 1985.

As flagged by in the ruling, it is important to consider the potential application of Division 149 which may cause a CGT to asset to lose its pre-CGT status. That provision applies where there is a change to the majority underlying interest in a CGT asset.

As addressed under the above heading, what constitutes a business under general law also has important implication in the context of a business or asset sale. What amounts to a business will inform whether what is sold is the entire self-contained business that the purchaser could continue to operate without interruption, or something short of a discrete business. Anything short of the transfer of the whole business (and the relevant rights) will not involve the transfer of goodwill. A common example might be the sale of a collection of business assets without the transfer of rights necessary to continue to conduct the same business. Again, this is based on the notion established in Murry that goodwill is inextricably linked to a business. Consequently, unless there is a transfer that qualifies as a transfer of an entire business, goodwill is not transferred.

The answer to the question of whether a disposal is of a business or something less than a business requires a weighing up of all the relevant circumstances which inform whether the incoming taxpayer has been transferred sufficient assets and legal rights to enable them to conduct the same business.

The transfer of a business (with a consequential transfer of goodwill) can be supported by factors such as the express assignment of goodwill to the purchaser, as well as the assignment of such things as outstanding contracts, trading stock and business premises. Conversely, there the likelihood of a transfer is reduced where management functions or activities are required to be added in order to conduct the business.

Note that it is not essential that the purchaser actually continue to carry on the acquired business. Commonly, the acquired business would be subsumed into a larger existing business. Alternatively, the business may be acquired from a competitor and wound up simply to prevent that business from competing.

In a situation where there is something short of a transfer and the sale proceeds exceed the market value of the separate assets, the extra receipt is not for goodwill (there being no business disposed of). Instead, the extra receipt increases the capital proceeds received by the vendor the assets and increases the acquisition cost the asset to the purchaser. The excess amount generally needs to be apportioned on a reasonable basis over the various assets.

Restrictive covenants

Goodwill is a separate CGT asset from a restrictive covenant. However, in TR 1999/16 the ATO takes an approach which allows a vendor and purchaser dealing at arms length in a business to allocate a specific part of the sale proceeds of the business sale contract to the disposal of goodwill (and not the restrictive covenant). That is provided the vendor and purchaser do not specifically allocate an amount in respect of the restrictive covenant.

Goodwill and the CGT discount

Goodwill which is subject to a CGT event may be eligible for discount under the general CGT discount (50% for individuals and trusts, 1/3 for superannuation funds).

The taxpayer must meet the various tests set out in Division 115 of the ITAA including that there has been at least 12 months between the acquisition of the CGT asset and the date of the CGT event which occurred in respect of it.

Remember that the general CGT discount is not available to companies.

Goodwill as an active asset

Goodwill can also count as an active asset under the small business CGT concessions contained in Division 152.

As such, a capital gain made in respect of a CGT event which occurs to goodwill may be discounted or exempted under those concessions if the taxpayer meets the relevant requirements of eligibility.