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THE GOODWILL ROLL-OFF EFFECT IN PARTNERSHIPS

By Greg Pearson

This article draws from the High Court's decision in FC of T v Murry 98 ATC 4585 to examine the consequences for goodwill in two simple scenarios: the merger of two sole practices to form a partnership and the dissolution of a small partnership.

The article concludes, after lengthy analysis of statute and case authorities, that the goodwill of the businesses in these two scenarios would generally be destroyed rather than transferred to the new businesses. That has short and long term capital gains tax implications which are addressed.

The author has coined this as the "goodwill roll-off effect".

1. INTRODUCTION

This article was provoked by the High Court's decision in FC of T v Murry[1] to examine two not uncommon circumstances surrounding the birth and death of small partnerships. The High Court extensively considered the nature of goodwill in their decision and established the "legal definition" of goodwill, at least for taxation purposes, which is scrutinised in this article within a practical context. However, many of the majority's more interesting observations in that case were obiter dicta[2], albeit expressing the joint opinions of four High Court judges.[3] The obiter comments are thus extremely persuasive, if not absolutely binding.

The article expands upon the author's views that mergers of businesses (at least in the context of partnerships) and dissolutions of partnerships have the propensity to destroy the goodwill, if any, of the merged businesses or partnership. It is not the author's view that such would be the result in every instance - the extent of that propensity warrants further examination.

The destruction of goodwill is a capital gains tax ("CGT") event to be examined in light of the circumstances but, perhaps more importantly, this article demonstrates that it may be difficult in many circumstances to "roll-over" partnership goodwill into a newly formed business and thus preserve its CGT status (eg as pre-CGT and hence exempt on future transfer).

This article first considers the nature of partners' interests in partnership property, in order to understand the CGT consequences of changes to partnership goodwill. Following this, there is a discussion of some aspects of the nature of goodwill stated by the High Court and then an examination of the impact of those principles in light of the formation and dissolution of a simple partnership - the CGT aspects are explored at some length, as their application is not obvious in the circumstances.

This analysis remains relevant even though the so-called "small business goodwill concession" has been removed from the Income Tax Assessment Act 1997 (Cth) ("ITAA97")[4] and replaced with a more general "active asset" concession.[5] This is so because one must ascertain what the CGT consequences of an event are before any concessions can become relevant. Moreover, the thrust of this article is that goodwill, as an identifiable asset, may not continue in existence after relevant changes to businesses, which is an enquiry of relevance beyond the mere possibility of concessional treatment for any gains that may be made.

The destruction of goodwill in the simple circumstances explored in this article could be described as the "roll-off" effect for reasons that, hopefully, will become obvious.

2. PARTNERS' INTERESTS IN PARTNERSHIP PROPERTY

There are similarities between the nature of a partner's interest in partnership property as recognised at law (mainly in equity) and the interests recognised for CGT purposes. However, the ITAA97 creates some statutory fictions that are not apparent from a study of the law of partnership such that the tax provisions must be said to exist in a parallel, but different, world from that of equity.

2.1 In Equity

It would seem that equity treats each partner as having an equitable interest in each asset of the partnership, that interest being a chose in action ascertainable only on dissolution of the partnership. For example, the High Court in FC of T v Everett[6] said:

Although a partner has no title to specific property owned by the partnership, he has a beneficial interest in the partnership assets, indeed in each and every asset of the partnership... His share in the partnership consists of a right to a proportion of the surplus after the realization of the assets and payment of the debts and liabilities of the partnership [Bakewell v Deputy Federal Commissioner of Taxation (S.A.) [1937] HCA 11; (1937) 58 CLR 743, at p 770; Bolton v Federal Commissioner of Taxation (1965) ALR 481, at p 485; (1964) 9 AITR 385, at p 389]. Historically the interest of a partner in a partnership has been considered to be an equitable interest because it is a right or interest enforceable in equity and not at law (Bolton's Case). A partner's interest in the partnership is a chose in action assignable in whole or in part [Hocking v Western Australian Bank [1909] HCA 68; (1909) 9 CLR 738, at p 743].[7]

In Canny Gabriel Castle Jackson Advertising Pty Ltd v Volume Sales (Finance) Pty[8] Ltd, the High Court said much the same thing:

The nature of a partner's interest in the partnership property has often been explained. The partner's share in the partnership is not a title to specific property but a right to his proportion of the surplus after the realisation of assets and the payment of debts and liabilities. However, it has always been accepted that a partner has an interest in every asset of the partnership and this interest has been universally described as a "beneficial interest", notwithstanding its peculiar character. [9]

Rich J in Sharp v Union Trustee Co of Australia Ltd[10] expressed his view of a partner's interest in partnership property as follows:

Business partners own between them the whole of the partnership assets, and each proprietor has a proprietary interest in each and every item. But his interest is not a fixed proportion of each item, nor is it an immediately ascertainable quantity of the item. It is an indefinite and fluctuating interest, which at any given moment is in proportion to his share in the ultimate surplus coming to him if at that moment the partnership were wound up and its accounts taken. [11]

In United Builders Pty Ltd v Mutual Acceptance Ltd[12], Mason J (with whom Barwick CJ, Gibbs and Wilson JJ agreed) seemed to draw a distinction between a partner's interest in the partnership and his/her interest in partnership property when he observed that a partner's beneficial interest in each of the partnership assets:

... is of a special and non-specific kind... The vital consideration is that the partner's interest is in truth a chose in action, which, as Everett acknowledged, 'consists of a right to a proportion of the surplus after the realisation of the assets and payment of the debts and liabilities of the partnership' (1980) 143 CLR, at p 446. A mortgage or charge is considered to vest rights over that chose in action but it is not considered to carry any title to the specific assets until dissolution ... A fixed charge is appropriate to create a security over a partner's share... It gives rise to a present security over the chose in action which is the partner's share. Although it creates no specific interest in the partnership assets until dissolution, this is not because the charge is dormant; it is because the rights conferred by the charge relate to the existing chose in action and that the security over the chose in action confers no entitlement to the assets of the partnership until dissolution.[13]

2.2 For CGT

The view expressed by Mason J in United Builders seems to accord with the views of Parliament in the definition of a "CGT asset" for the purposes of the CGT provisions.[14] In this regard, s 108-5 provides:

Thus, the proprietary interest each partner has in the assets of a partnership is a CGT asset, including the interest in goodwill of the partnership. For the purposes of CGT, it is only necessary to consider a partner's interest in a partnership as a separate CGT asset to the extent that interest is not reflected in the partner's interests in each asset (s 108-5(2)(d)).

However, the passages quoted above demonstrate that at law or in equity a partner's interest in each asset is "non-specific", "indefinite and fluctuating" and only ascertainable "after the realisation of the assets and payment of the debts and liabilities of the partnership". Such a CGT asset would be exceptionally difficult to deal with (in a different context, this was proved by the litigation in United Builders).

Some assistance in this regard is given by s 108-7 which provides:

Individuals who own a CGT asset as joint tenants are treated as if they each owned a separate CGT asset constituted by an equal interest in the asset and as if each of them held that interest as tenant in common.

Thus, it would appear to be Parliament's intention that:

This leaves no room for a non-specific, unascertained asset. The ITAA97 is requiring specificity and identification of that which is to be considered a CGT asset. This is so notwithstanding the true position at law or in equity, that a partner's interest in items of partnership property is inchoate and undefined until dissolution.

3. DEFINITION AND IMPORTANT FEATURES OF GOODWILL

The High Court in Murry stated several important features of goodwill that can assist in determining the legal consequences upon establishment of a partnership and dissolution in the circumstances discussed below.

The definition of goodwill in light of Murry has been the subject of many articles and thus this article does not consider the issue in depth.[15] However, some aspects of the definition and comments regarding the nature of goodwill are summarised below and referred to later in this article (by reference to the numbers allocated) as "features of goodwill". To a degree, the features are overlapping.

Murry raises an interesting issue: to what extent is the judgement merely obiter dicta? Technically, the provision under consideration, s 160ZZR of the Income Tax Assessment Act 1936 (Cth) ("ITAA36"), required the relevant taxpayer to have disposed of an interest in a "business" that includes an interest in "goodwill" for the relevant concession to apply.[16] The High Court identified in Murry the true issue for determination by the Court as the following:

The decisive question in determining whether the exemption provided by s 160ZZR(1)(a) applies in the present case is whether the sale of the licence was effectively the sale of a business of the taxpayer and her husband or the sale of an asset of their business. Since goodwill is an indivisible item of property which is distinct from and does not inhere in the assets of a business, the taxpayer did not dispose of goodwill if she and her husband merely sold an asset of the business.[17]

The taxpayers in Murry leased the taxi licence in question in the case to another party. The Court held that the other party conducted the "taxi business" and hence held the goodwill, if any, associated with that taxi licence. The Court could have held that Mr and Mrs Murry did not conduct any business in relation to the licence, but merely used it as a passive investment. That would have been the end of the matter, given the requirements of the section that there be a disposal of an interest in a business. However, the following comment suggests that this is not what the Court considered:

Prior to the sale, the taxpayer and her husband exploited the licence in another way. They exploited its economic potential by leasing it. In so far as the licence was relevant to their business, it produced rent.[18]

The taxpayers held another taxi licence which, it appears, they plied for trade and thus they did indeed conduct a business. The Court held that the licence was an asset of a business, but not a business itself. They also held that the licence did not contain any goodwill (nor was it a source of goodwill).[19]

Thus, the exploration as to the definition of goodwill by the High Court in Murry must be accepted as part of the ratio decidendi of the case and not obiter. Moreover, put at issue before the Court was the distinction, if any, between the sources of goodwill and goodwill itself - in the writer's opinion this discussion is also part of the ratio decidendi as being a necessary antecedent to defining goodwill. However, the discussion regarding the "same business test" discussed below was, it is submitted, merely obiter dicta as that issue was not before the Court for determination.[20]

3.1 Definition of Goodwill

The High Court defined goodwill as:

... the valuable right or privilege to use the other assets of the business as a business to produce income. It is the right or privilege to make use of all that constitutes 'the attractive force which brings in custom.' Goodwill ... is the legal right or privilege to conduct a business in substantially the same manner and by substantially the same means that have attracted custom to it. It is a right or privilege that is inseparable from the conduct of the business.[21]

The High Court also stated that "a person acquires goodwill when he or she acquires that right or privilege."[22] The definition provides the first feature of goodwill significant to the analysis below.

Feature 1: Goodwill is the legal right or privilege to conduct a business in substantially the same manner and by substantially the same means that have attracted custom to it.

The hypothesis to be tested is whether changes to the manner and/or means of conducting a business have the effect of creating a new business, with new goodwill and, in the process, destroying the old goodwill.

Further, the High Court majority considered that goodwill is a quality or attribute derived from other assets of a business, leading to the second feature of goodwill, allied to the first.

Feature 2: The existence of goodwill "depends upon proof that the business generates and is likely to continue to generate earnings from the use of the identifiable assets, locations, people, efficiencies, systems, processes and techniques of the business."[23]

This raises the argument that goodwill of a business will be new goodwill if the identity of the business changes, as evidenced by sufficient changes in the identifiable assets, locations, people, efficiencies, systems, processes or techniques of the business.

Because goodwill is attached to a "business", which may or may not be profitable, the High Court made the conclusion which is identified as Feature 3.

Feature 3: Goodwill can exist even where the business runs at a loss, even if it is of nil or nominal value.[24]

The comment in the definition that goodwill is inseparable from the conduct of the business also leads also to the fourth feature identified for the purposes of this exposition. Goodwill attaches to a "business" and "is inseparable from the business to which it adds value."[25] Thus, it cannot be sold in isolation from that business.[26] The High Court in Murry discussed the position of a shopkeeper's lease ending:

While the shop business exists, the goodwill of the business belongs to the shop proprietor. If the lease expires and is not renewed and the business ceases to exist, the goodwill comes to an end. A new lease to a person commencing a similar business from the premises may command a premium, but no part of the premium is paid for goodwill.[27]

Feature 4: If a "business" ceases to exist, then the goodwill associated with that business will also cease to exist.

Moreover, the High Court quoted Barwick CJ in Geraghty v Minter[28] where he said: "goodwill is not something which can be conveyed or held in gross: it is something which attaches to a business. It cannot be dealt with separately from the business with which it is associated." The comments of Hill J in FC of T v Krakos Investments Pty Ltd[29] to the effect that a business could have different types of goodwill (such as "site goodwill" or "monopoly goodwill") were rejected by the High Court in Murry[30]. So-called "types" of goodwill are thus to be read as references to sources of goodwill, not as separate goodwill assets.

The High Court majority made the following comment:

Goodwill is inseparable from the conduct of a business. It may derive from identifiable assets of a business, but it is an indivisible item of property, and it is an asset that is legally distinct from the sources - including other assets of the business - that have created the goodwill. Because that is so, goodwill does not inhere in the identifiable assets of the business, and the sale of an asset which is a source of goodwill, separate from the business itself, does not involve any disposition of the goodwill of the business.[31]

Feature 5: Goodwill is an indivisible asset of a business - it is not made up of many parts but may derive from many sources.[32]

It is thus critical to identify "a business" in order to identify the existence of goodwill.

3.2 Importance of the Sources of Goodwill

The High Court particularly addressed the sources of goodwill, their analysis providing insight into the consequences of the transactions contemplated later in this article. The sources of goodwill are to be distinguished from goodwill itself,[33] they are but one of the three "aspects" of goodwill - "property, sources and value."[34]

The High Court raised the prospect of a "same business test" to determine whether goodwill has ceased, changed or been transferred. The majority noted:

... as long as the business remains the "same business", the goodwill acquired or created by a taxpayer is the same asset as that which is disposed of when the goodwill of the business is sold or otherwise transferred... In determining whether the "same business" is being carried on, the sources of the goodwill may have changed so much that, although the business is of the same kind as previously conducted, it cannot be said to be the same business.[35]

The High Court noted that a disposition of some of the sources of goodwill should not be seen as comprising a disposal of any goodwill unless a business is disposed with them. This is so even if the disposition results in a diminution in the value of the goodwill of the business.[36] Other comments of the majority shed further light on their views:

... where goodwill is largely the product of the personality of the owner or one or more employees of a business, much of the goodwill of the business will disappear upon the cessation of the connection between that person or persons and the business. Nevertheless, habit may continue to draw custom although the owner or employee has no further connection with the business. These illustrations also show that, although the goodwill of a business may be derived from one or more sources, it can continue to exist notwithstanding that the sources of the goodwill have gone.[37]

Feature 6: Thus, a transfer of goodwill would normally require the transfer of "the business" comprising "all those matters and things essential to the existence of the goodwill."[38]

Arguably, then, if those things so identified as essential to the existence of the goodwill (see Feature 2 for example) are incapable of transfer, then the goodwill cannot be transferred. Moreover, if those things so identified as essential to the existence of the goodwill cease to exist or be associated with the identified business, then arguably the goodwill will also have ceased to exist.

Feature 7: "Unless a business is transferred to the person to whom an asset of the business is transferred, the transfer of the asset does not transfer any part of the goodwill of the business."[39]

This suggestion of a "same business test" is clearly obiter dicta by the High Court. The Court did not cite any authority for this opinion. However, it flows logically and necessarily from the definition of goodwill laid down by the Court, as discussed above. Goodwill being a species of property inherent to a business, it is logical that if the business changes then the goodwill may also change. Thus, it is the writer's opinion that this untested point is correct and will ultimately be held to be so.

4. STARTING THE PARTNERSHIP

4.1 Legal Consequences in Relation to Goodwill

Consider the formation of a simple accounting partnership between A and B. Presume that both A and B formerly conducted independent accounting practices as sole traders. They decide to merge their practices and form a partnership. In relation to goodwill, the formation of the partnership raises the issue as to whether:

Firstly, it must be recalled that goodwill as a form of property is capable of transfer. The conditions for transferring it, as established by the High Court in Murry, include:

It would seem, therefore, that if the new partnership's operations were sufficiently identifiable with the sole practices, then it is possible that the individuals' goodwill can be effectively transferred to the joint operation. In favour of this result would be factors such as:

However, the trading name will almost certainly be different and it is possible that the merged business draws custom from different sources (eg larger business clients) than previously. It is also unlikely that the business would be located in the same premises as previously. All those factors suggest that new goodwill will be created because it cannot be said to be the "same business" as the two former practices, simply combined.

Perhaps diminishing the importance of these latter issues in some circumstances would be that:

It is still necessary, for the individuals' goodwill to be transferred to the partnership operations, that there be identity of the combined business with the former businesses carried on independently. Upon critical analysis, this may be difficult. In particular, partnership is a relationship between persons in connection with a business. Once there are no longer two separate businesses, can it be said that the goodwill associated with those can continue in existence? Do not the High Court's comments in Murry result in a conclusion that a new business and thus new goodwill is created? Just because the new business has an immediate value drawn from having acquired the sources of the goodwill of the individual practices does not mean that it is identifiable as the goodwill of the former practices.

Take the following comments of the High Court in Murry:

But, as long as the business remains the "same business", the goodwill acquired or created by the taxpayer is the same asset as that which is disposed of when the goodwill of the business is sold or otherwise transferred. In determining whether the "same business" is being carried on, the sources of the goodwill may have changed so much that, although the business is of the same kind as previously conducted, it cannot be said to be the same business.[40]

In making the above statements, the footnotes suggest we compare these comments to the "same business test" expounded by Gibbs J of the High Court in Avondale Motors (Parts) Pty Ltd v FC of T[41] in relation to the tests for carrying forward losses of companies in s 80E of the ITAA36. By referring to this case, the High Court seems to be suggesting that the issues addressed for the purposes of that test are synonymous with the issue under consideration here.

In that case, Gibbs J stated that "same business" imports "identity not merely similarity" - it is not sufficient that it is "the same kind" of business. He also noted that it was simply a question of fact. Gibbs J held that the taxpayer company in question was not carrying on an identical business because it had changed its name, locations, directors, employees, stock and plant, suppliers and customers. By analogy to the hypothetical under consideration, there is likely to be a change in name (strictly speaking) and location. Suppliers, customers, employees and principals are likely to be drawn from the previous practices and thus there would be some identity of these. However, of more fundamental consequence is the fact that the principals, on becoming partners, now draw on each other's reputations and skills and have fiduciary obligations towards one another in respect of the partnership assets and business - this suggests that the underlying dynamics of the partnership business are not legally identical to the fundamental dynamics of the partners' former practices.

The Commissioner refers to maintaining "the essential identity of the business" before and after the changes in order to satisfy the same business test.[42] In Taxation Ruling TR 99/9, the Commissioner, after considering judicial pronouncements on this issue, expresses his view that "identical" as used by Gibbs J in Avondale Motors does not mean identical in all respects:

...what is required is the continuation of the actual business carried on immediately before the change-over. Nevertheless, it is not sufficient that the business carried on after the change-over meets some industry wide definition of a business of the same kind; nor would it be sufficient for there to be mere continuance of business operations from immediately before the change-over into the period of recoupment, if the business had so changed that it could no longer be described as the same business.... In making the analysis it needs to be acknowledged that a company may expand or contract its activities without necessarily ceasing to carry on the same business. The organic growth of a business through the adoption of new compatible operations will not ordinarily cause it to fail the same business test provided the business retains its identity; nor would discarding, in the ordinary way, portions of its old operations. But, if through a process of evolution a business changes its essential character, or there is a sudden and dramatic change in the business brought about by either the acquisition or the loss of activities on a considerable scale, a company may fail the test.[43]

Later in that ruling, the Commissioner notes (drawing heavily from Gibbs J's judgement in Avondale Motors) that:

A business may be the same, even though there have been some changes in the way in which it is carried on, provided the identity of the business is not changed.[44]

Further:

However, as a practical matter, expansion or reduction of business activities, if carried to a sufficient extreme, is likely to amount to more than a mere change in the scale of the business carried on by the taxpayer and so may result in a change in the identity of the business. In particular, a sudden and dramatic expansion or contraction brought about by the acquisition or loss of activities on a considerable scale could mean the same business is no longer being carried on. As Walton J observed in Rolls-Royce Motors Ltd v. Bamford [(1976) 51 TC 319 at 344]:

There is all the difference in the world between an organic growth of trade and a sudden and dramatic change brought about by either the acquisition or loss of activities on a considerable scale.[45]

Whilst the Commissioner's comments in Taxation Ruling TR 99/9 are not law, they appear to be strongly supported by Gibbs J's comments in Avondale Motors and have significant resonance with the High Court's comments and examples provided in Murry.

Drawing on the High Court's specific comments relating to goodwill in Murry, it can be said that goodwill ceases to exist where the "business" to which it is attached ceases (Feature 4) and that new goodwill will be created if the identity of the business changes, as evidenced by sufficient changes in the identifiable assets, people, locations, efficiencies, systems, processes or techniques of the business (Feature 2). This is not dissimilar to the comments made by the Commissioner quoted above.

It is arguable on many levels, and drawing on the analogies made to the same business test set out for the carry forward of tax losses discussed above, that the individual businesses have ceased to exist - and therefore the goodwill associated therewith has ceased to exist also.

The definition of goodwill given by the High Court also provides some insight in this situation: goodwill is "the legal right or privilege to conduct a business in substantially the same manner and by substantially the same means that have attracted custom to it" (Feature 1). Arguably then, where a business is no longer conducted in substantially the same manner and by substantially the same means it will no longer be the same business - and thus any goodwill associated therewith will not be the same. If it is not the same goodwill, then the existing goodwill attached to the individual practices must have ceased to exist in the process of forming the new partnership. This is supported by the High Court's comments suggesting a "same business test" to ascertain whether goodwill has been newly acquired in an organically developing business (Features 4 to 6) - particularly where the sources of goodwill have changed significantly.

Whilst a transfer of goodwill would normally require the transfer of "all those matters and things essential to the existence of the goodwill" (Feature 6), the implications of Features 1, 4 and 5 are that an effective transfer of goodwill would ordinarily require an identity of the "business" before and after the transfer. This obviously led to the High Court's consideration of a "same business test" to determine the provenance of certain goodwill, as discussed above. The author is compelled to agree with that conclusion, based on the above analysis.

The circumstances outlined may be such that there is some identity between the separate practices and the partnership operation. For example, the use of the identifiable assets, locations, people, efficiencies, systems, processes and techniques of the partnership business may be able to be traced from the former practices to the new operation. But that does not seem to answer the question - a "business" is something organically different to the assets used in it and it is identity of business before and after the formation of the partnership that is questionable. A partnership is legally and practically different to a sole practice. Moreover, the legal relationship between the partners and with respect to partnership property almost precludes there being identity with the former sole practice businesses.

Where there is limited identity of assets, locations, people, efficiencies, systems, processes and techniques between the individual practices and any new businesses, the goodwill is not likely to be the same goodwill as that attaching to the business conducted in partnership. If the business is no longer able to be identified as the same, the goodwill associated therewith will have ceased to exist. Where the processes by which the business operates alter sufficiently, it will mean that a new business has commenced, with new goodwill - the old goodwill having disappeared as a legal consequence.

This analysis leads to the conclusion that an attempt to merge goodwill of two businesses into one combined business will often result in the legal consequence that the existing goodwill is destroyed in favour of the creation of new goodwill in the new business. It will be rare that the merger of two businesses represents the "organic growth" of both, in the words of the Commissioner. But, in particular, it is difficult to conceive that the essential identity of a business is maintained when it is subsumed into and merged with the other in the manner contemplated.

That is not to say that the goodwill of an existing larger business would necessarily be affected by the acquisition of or merger with a smaller business which is then subsumed into the larger. Such circumstances raise significant issues which are beyond the scope of this paper but which warrant some considerable analysis.

4.2 CGT Consequences on Formation

For there to be CGT consequences, a CGT event must occur. If there is more than one CGT event potentially applicable, then s 102-25(1) requires you to "use ... the one that is the most specific to your situation." There are three more likely CGT events that could potentially apply in the contemplated circumstances with regard to the goodwill, events A1 (s 104-10), C1 (s 104-20) and C2 (s 104-25).

The potential application of CGT events D1 (s 104-35) and H2 (s 104-155) can be disregarded as these only operate residually where another CGT event does not operate (s 102-25) and the analysis below demonstrates that either CGT event C1 or C2 will occur in the circumstances.

The CGT assets of concern for the purposes of this analysis are each principal's interest in the goodwill of his/her practice.

4.2.1 CGT Event A1

CGT event A1 (s 104-10) applies where ownership of a CGT asset changes. This requires the CGT asset to continue in existence, under different ownership.

As discussed above, the legal consequence of formation of the partnership in the manner under contemplation is that the goodwill of the former sole practices ceases to exist - thus, it cannot be said to have been "transferred."

As the goodwill ceases to exist, it cannot be said that there is a transfer of the goodwill from the sole proprietors to themselves, as partners as tenants in common. If one of them could be said to be carrying on the "same business" as formerly (perhaps where a smaller practice has been subsumed into a larger practice), then the legal consequences may be different - however, that is beyond the scope of this article and it is an issue that needs to be dealt with separately.

4.2.2 CGT Event C2

CGT event C2 (s 104-25) applies where your ownership of an intangible CGT asset ends by the asset:

1. being redeemed or cancelled; or
2. being released, discharged or satisfied; or
3. expiring; or
4. being abandoned, surrendered or forfeited.

These words must be compared to those of CGT event C1, which applies where a CGT asset is "lost or destroyed." As s 102-25 requires us to apply the CGT event that is the most specific to the situation, it is necessary to determine which of the words of the ITAA97 most specifically apply to the situation under consideration. The choice, logically, is between the events described in CGT event C2, most specifically abandonment, and the events described in CGT event C1. There are important consequences as to whether the event falls within CGT event C1 or C2, discussed below at 4.4.

Without discussing them at length, it is not considered that any of the events in C2 apply to the circumstances. All the terms are susceptible to various meanings and uses. Whilst this article is not intended to be an exposition on statutory interpretation, it would seem that the weight of authority is that words which have acquired an established legal meaning should be given that meaning unless a contrary intention appears from the context. Otherwise, words should be given their ordinary, dictionary meaning that best promotes the purpose and context of the particular provision.[46] In reviewing various sources to determine the meanings of these undefined terms in the ITAA97,[47] the following reasons suggest why none are applicable to the circumstances.

▪ "Redemption" or "cancellation" would ordinarily require the action of another as regards the rights concerned - here the action is by the owners of the proprietary rights (the goodwill) themselves. The concepts suggest a contractual or other right existed in that other party to so redeem or cancel the property rights - clearly not the case as concerns goodwill in normal circumstances.

▪ "Release" can be seen in a similar light to redemption and cancellation. It is an act of another as regards rights they have against the owner of the goodwill or the goodwill itself - and again, in normal circumstances goodwill will not be the subject of such rights.

▪ "Discharge" normally conveys that obligations, usually contractual, imposed upon someone have been met, so that the obligations no longer exist. "Satisfaction" would have a similar meaning. Goodwill cannot be considered in that light, as it does not impose obligations that can be discharged or satisfied, as those terms are commonly understood.

▪ Nor does the goodwill end by "expiring". That term connotes a pre-existing time frame within which the rights exist - ceasing to exist after that time frame expires. Goodwill is not normally subject to a pre-existing time frame and thus the ending would not have arisen as a result of expiry in the hypothetical posed.

▪ "Surrender" requires agreement with another party, who will benefit from the surrender, which is clearly not the case where the goodwill ceases to exist in the manner contemplated.

▪ "Forfeiture" requires the taking away of some right or property as a consequence of the non-performance of an obligation or as a penalty for some act. Clearly, the goodwill is not forfeited in these circumstances.

▪ "Abandonment" deserves further conside-ration, because it could be argued that leaving an existing business to commence a new one is abandonment of the old business, and hence abandonment of the goodwill attached to the business. It is submitted, however, that abandonment requires a voluntary, deliberate act effected in relation to property with the intention that the property should thereby cease to be owned by that person so acting. It normally suggests that the property is thereafter capable of being possessed by someone else, although that is not always the case when the term is used in normal parlance. Further, the term usually conveys that the property would continue in existence after abandonment - again, examples can be found where abandonment causes the thing to cease to exist. The analysis above shows that this definition is not particularly satisfied in the hypothetical circumstances because:

It is the latter point which is most significant - an "accidental" or inadvertent loss of goodwill does not seem to properly satisfy the notion of abandonment. It is submitted that where the goodwill ceases to be owned as a legal consequence of an act not effected to achieve that purpose, it should not constitute abandonment for the purposes of the CGT provisions.

The conclusion to be drawn from the above analysis is that CGT event C2 has not occurred in the present circumstances.

4.3 CGT Event C1

CGT event C1 (s 104-20) applies where a CGT asset is "lost or destroyed." The view formed in this article is that the legal effect of formation of the partnership in the circumstances is to destroy any goodwill associated with the sole practices.

Because that is a legal consequence flowing from the formation of the partnership in the manner contemplated, it is submitted that the goodwill can best be described as having been destroyed rather than abandoned. Some comfort may be taken from similar views expressed by the Commissioner in Taxation Ruling TR 1999/16, albeit in relation to less specific circumstances and without disclosure of his reasoning in coming to such a conclusion.

In the context, the most apt meanings of the terms "lost" and "destroyed" are:[48]

The conclusion here is that the word "destroyed" is the most apt to describe the effect on the goodwill of the sole practices in the hypothetical. Even if both CGT events C1 and C2 seemed applicable, it is submitted that CGT event C1 should be applied in preference to CGT event C2 as the more specific provision, due to the application of s 102-25.

There is one cause for concern in the choice of CGT event C1 over CGT event C2 in these circumstances (as explained at 4.4 below, the section may be critical). CGT event C2 is specifically limited to "intangible" CGT assets. "Intangible" is not defined in the ITAA97 and thus has its ordinary meaning as "not able to be sensed by touching, as non-material things",[49] where goodwill is clearly an intangible item. CGT event C1 is not so restricted. Thus, an argument may be put that CGT event C2 is the more specific to the circumstances and is thus to be preferred to CGT event C1 by operation of s 102-25.

Moreover, at least one author[50] has suggested that "in practical terms CGT event C1 may be confined to tangible assets." This would seem to have been more pertinent under the similar provision of the previous Act, s 160N of the ITAA36, which was expressed to be subject to the other provisions of that Part, including s 160M(3)(b) (the predecessor of CGT event C2) which only applied to intangible assets. However, s 160N was not specifically restricted in its application to tangible assets - it was merely made subordinate to s 160M(3)(b) in the circumstances where they would otherwise both be applicable.

Moreover, the changes effected to the legislation via the enactment of the ITAA97 cannot be ignored - the provisions were purposely and extensively re-written. The residual nature of s 160N in the ITAA36 has been deliberately altered in the ITAA97 such that the provision's reincarnation as CGT event C1 appears in no way limited to tangible assets nor otherwise limited by CGT event C2. CGT event C1 has not been made subsidiary, by the new language, to CGT event C2. It is submitted that the interpretation of the ITAA36 provision, even if correct, has no bearing on the ITAA97 replacement given the deliberate changes made in the wordings of the provision.

Thus, the issue seems to revolve around the question as to whether CGT event C2 is the more specific because it deals with intangible assets only or whether CGT event C1 is the more specific because an event described therein appears to be more apt to apply in the hypothetical circumstances. It is submitted that the latter is the better view - if the wording of CGT event C2 is not particularly apt to describe the event under consideration, it seems difficult to see how the limitation to intangible assets cures that inaptitude.

Thus, it is contended that the CGT event most specific to the circumstances is CGT event C1 - specifically, that the formation of the partnership in the manner contemplated has destroyed the goodwill of the sole practices. The circumstances, on this analysis, do not result in any goodwill being "rolled-over" by the proprietors to the new partnership.

4.4 Market Value Substitution Rule

Why is the relevant CGT event so important? The reason is the manner in which any gain or loss on the CGT event is calculated. To calculate a capital gain for a CGT event, the "capital proceeds" received are normally deducted from the "cost base" of the CGT asset the subject of the event.

The capital proceeds are normally the money or the value of property received (or entitled to be received) in respect of the CGT event: s 116-20(1). Obviously, the partners would argue that they have received no money or property in connection with the loss of the goodwill associated with the former sole practices. However, there are several modifications which can be made to the proceeds a taxpayer receives or is deemed to receive for CGT events, the most common of which is the "market value substitution rule" (s 116-30). Under that rule, market value can be substituted for the capital proceeds received by a taxpayer and thus a tax liability can be generated even where no consideration for the event is actually received.

The market value substitution rule generally has automatic application where no capital proceeds are received for a CGT event (s 116-30(1)). This would be so for all of the transactions contemplated in CGT event C2, except where the ownership ends due to expiry (s 116-30(3)(a)(i)). Accordingly, if CGT event C2 applied, a market valuation of the goodwill would be required and, adding to the statutory fiction, it must be calculated as if the CGT event "had not occurred and was never proposed to occur" (s 116-30(3A)). Thus, the proprietors would need to calculate any capital gain on the transaction as if they received full value for their goodwill, on a going concern basis. The result would almost necessarily result in a tax liability even though nothing is actually received by the proprietors and, in fact, they are legally bereft of their goodwill as a result of the formation of the partnership.

However, the market value substitution rule does not apply where no capital proceeds are received for CGT event C1 (s 116-25). Hence, where no capital proceeds are received for the destruction of goodwill, there can be no deemed capital gain giving rise to a tax liability. Depending on the cost base in the goodwill, if any, there may be a capital loss incurred by the proprietors on this CGT event.

It would seem that the new small business concessions announced by the Treasurer[51] as part of the Ralph Review of Business Taxation would be irrelevant in relation to the goodwill in the circumstances. Those concessions are to provide relief for capital gains made upon retirement of business proprietors - this analysis demonstrates that there is no capital gain in the circumstances and thus no relief is necessary.

4.5 Calculation of Gain or Loss - Capital Proceeds

If the partners had commenced their sole practices prior to 20 September 1985, then the result of the establishment of the partnership would be that:

If the partners had commenced their sole practices after 19 September 1985, the result would be:

Pursuant to s 104-20(3), the proprietor will make a capital gain if the capital proceeds from the loss or destruction are more than the asset's cost base; a capital loss will be made if the capital proceeds are less than the asset's cost base. There appear to be no capital proceeds, as defined, received by either proprietor in the hypothetical circumstances - consequently, they may have incurred a capital loss on entry into the partnership (depending on whether they can establish a cost base in their goodwill).

"Capital proceeds" are defined in s 116-20(1) as follows:

It is clear that neither has received any money (from the other) in respect of the destruction of their goodwill. Nor has either received any property in respect of that destruction. Whilst their mutual promises and covenants (express and implied by law) on entering into partnership may constitute "consideration" under contract law, it would not appear that they amount to "property" for the purposes of s 116-20(1).

According to Gummow and Lockhart JJ of the Federal Court, for something to be "property" it must be "definable, identifiable by third parties, capable in its nature of assumption by third parties, and have some degree of permanence or stability."[52] However, citing Mason J in The Queen v Toohey; Ex parte Meneling Station Pty Ltd,[53] Gummow and Lockhart JJ observed that assignability was not always necessary if, for example, an item were made inalienable by statute, so long as the thing was inherently capable of assignment or assumption. This definition is not satisfied in the present circumstances, particularly as the personal promises of fidelity implied by law as between partners are inherently incapable of being assigned. They are only capable of observance, personally, by the partners between whom they exist. Nor are they readily definable or identifiable such as to come within the ambit of the definition.

Regardless, any capital proceeds must be received "in respect of" the destruction of the former businesses' goodwill. But, the mutual promises are made in respect of the agreement to form a partnership and not in respect of the former practices.

Thus, no capital proceeds are received by either partner on forming this partnership and no capital gain can arise.

For the same reasons as just expressed, it is submitted that our new partners will not enjoy the benefit of a cost base in their newly acquired goodwill, as they have given no money or property to "acquire" the new goodwill: s 110-25(2).

In conclusion, it would seem that it is generally impossible for proprietors to "roll-over" goodwill into newly formed partnerships. The next section explains further that they cannot take their goodwill with them when they roll out of a partnership on dissolution. This is dubbed in this article the "roll-off effect", and it is a consequence of the examination of the nature of goodwill by the High Court in Murry.

This analysis is unaffected by the changes recently made to the so-called goodwill concession. The circumstances do have an affect as regards later dealings with the goodwill of the relevant business, as discussed above.

5. ENDING THE PARTNERSHIP

5.1 Legal Consequences in Relation to Goodwill

Presume we have the same simple accounting partnership as discussed at 3 above, with two partners, A and B. They carry on business under the name "A and B", but now wish to dissolve that partnership, amicably, and go their own separate ways - each to conduct business as a sole trader. They agree that they will take their share of the furniture and fittings and work in progress. They cancel the lease over the current partnership's premises, but one will employ the partnership's receptionist/secretary. Neither will trade under the name "A and B", although they may refer to themselves as former principals of "A and B."

This article focuses solely on the CGT consequences for goodwill of the partnership in these circumstances. Regardless of the financial stability of the practice, there will likely be goodwill associated with it, according to the High Court (Feature 3).

To determine the CGT consequences, it is necessary to determine what happens to the partnership goodwill in the circumstances proposed.

The commentary of the High Court in Murry together with the analysis of the "same business test" discussed above at 3 persuasively indicate that the goodwill of the partnership ceases to exist upon dissolution of the partnership business where the business formerly carried on in partnership ceases to be so carried on. This is so even though the partners are attempting to split their firm and walk away with their share of the partnership assets, including the share of goodwill represented by their efforts in the business. But, it would seem that attempt is legally unsuccessful.

In a two-person professional partnership the key sources of goodwill are likely to be the two partners. Here, those partners are separating and going into their own businesses. That will doubtless result in a diminution of the value of the partnership's goodwill, but that does not mean that any goodwill has been transferred (Features 6 and 7).

Goodwill will cease to exist where the "business" to which it is attached ceases (Feature 4). Here, the partnership business is arguably ceasing. It may be argued to the contrary that the business is being split and carried on as two businesses carved from the one.

But, consider the definition of goodwill provided by the High Court as "the legal right or privilege to conduct a business in substantially the same manner and by substantially the same means that have attracted custom to it" (Feature 1 - emphasis added). Arguably, where a business is no longer conducted in substantially the same manner and by substantially the same means it will no longer be the same business - and thus any goodwill associated therewith will not be the same. This is supported by the High Court's comments in Murry suggesting a "same business test" to ascertain whether goodwill has been newly acquired in an organically developing business (Feature 6) - particularly where the sources of goodwill have changed significantly. Clearly, this is no organic development.

Consider also that a transfer of goodwill would normally require the transfer of "all those matters and things essential to the existence of the goodwill" (Feature 6). An effective transfer of goodwill would ordinarily require an identifiable "business" to be transferred, which would require transfer of the right or privilege to conduct the business together with all/most of those things the use of which is likely to ensure that the business continues to generate earnings, namely the use of the identifiable assets, locations, people, efficiencies, systems, processes and techniques of the business.

Where there is limited identity of assets, locations, people, efficiencies, systems, processes and techniques between the former partnership business and any new businesses, the goodwill is most unlikely to be the same goodwill as that attaching to the business conducted in partnership. If the business is no longer able to be identified as such, the goodwill associated therewith will have ceased to exist - on my reading of Murry, it cannot be said to have been carved up between the former partners in those circumstances.

Whether the partnership business can be said to have ceased or whether the goodwill is simply not the same goodwill as attaching to the former partnership, are different sides of the same coin - one is a necessary consequence of the other. Where a business ceases, the goodwill associated with it ceases to exist. Where the processes by which the business operates alter sufficiently, it will mean that a new business has commenced, with new goodwill - the old goodwill having disappeared as a legal consequence.

These features of the hypothetical scenario posed for consideration suggest the new practices to be carried on by the former partners are not identifiable as discrete parts of the business carried on formerly in partnership:

Taken together, these facts on the authority of Murry show that the partners will not take their share of the firm's goodwill with them when they set up their own independent businesses. The business carried on together will cease and, accordingly, any goodwill associated with that business will cease to exist. When each of them establishes their own private practice, any goodwill will be newly created - even if in part attributable to reputation from the previous partnership.

5.2 CGT Consequences of Dissolution

As discussed above at 3.2, for there to be CGT consequences, a "CGT event" must occur. If there is more than one CGT event potentially applicable, then s 102-25(1) requires "you" to use "... the one that is the most specific to your situation." The same three CGT events discussed in relation to the consequences of formation of the partnership are again highlighted on dissolution: events A1 (s 104-10), C1 (s 104-20) and C2 (s 104-25). Again, potential application of CGT events D1 (s 104-35) and H2 (s 104-155) may be disregarded then as these only operate residually where another CGT event does not operate: s 102-25.

The CGT assets here under consideration are each partner's interest in the goodwill of the partnership. Each partner is considered to have a separate interest in the partnership's goodwill, which interest is a CGT asset in its own right for the purposes of CGT (see discussion above at point 1(b)).

5.2.1 Identifying the Correct CGT Event

As discussed fully above at 3.2, the most specific CGT event is CGT event C1: destruction of the goodwill of the partnership.

It is possible to envisage some circumstances where one of the partners could retain the entire partnership goodwill upon dissolution, but only where that partner could be said to be carrying on the "same business" (perhaps where the use of the former trading name is authorised). But the circumstances under consideration are different, with different legal consequences.

The goodwill in these circumstances ceases to exist, and is no longer capable of being possessed by anyone. This is a consequence of the termination of the partnership agreement, rather than as a conscious act effected for the purpose of relinquishing the goodwill. The legal effect of termination is thus to destroy any goodwill associated with the business, as a legal consequence flowing from the dissolution of partnership in the manner contemplated. Again, the Commissioner's views expressed in Taxation Ruling TR 1999/16 are congruent to my own, even though expressed in relation to less specific circumstances and without disclosure of his reasoning.

5.2.2 Calculating the Capital Gain or Loss

As discussed above at 3.2, the capital proceeds for the event will be nil and the market value rule does not apply.

Thus, if the partnership was established prior to the introduction of CGT on 20 September 1985, on the authority of Murry the goodwill will likely be a pre-CGT asset and not subject to the CGT provisions for events that occur in relation to it.[54] The consequences of the dissolution would then be:

If the partnership was established after 20 September 1985, then the goodwill is a post-CGT asset, with the consequences that:

6. CONCLUSION

The events described in this paper are quite simple. The tax result is also "simple", however the reasoning processes required to prove the result are very complex.

The article has been conceived from comments made to the author by accountants over the years who are or have been in small partnerships. The result is unlikely to have been considered a likelihood by those accountants.

Moreover, the conclusions reached have far greater practical importance than simply in relation to partnerships - for example, in relation to business acquisitions and mergers generally. It may or may not suit taxpayers that goodwill can so easily disappear by virtue of changes to a business. The roll-off effect may disturb some planning and will not always be anticipated.

Greg Pearson is a Lecturer in the Faculty of Law at the University of Newcastle. The primary focus of his teaching is taxation, but he also teaches in other commercial areas such as partnership and company law. Greg is also a barrister of the Supreme Court of NSW and consults to a range of main-ly business clients in his specialties

[1] 98 ATC 4585 ("Murry")

[2] For example, the Court suggested that a small professional practice would be unlikely to have goodwill (ibid 4597). However, this article assumes that there is some goodwill in the hypothetical partnerships in order to examine the effect of the proposed formation and dissolution in light of the law, both as established by the High Court and as expressed in the more general discussion.

[3] Gaudron, McHugh, Gummow and Hayne JJ formed the majority. Kirby J dissented.

[4] The former s 118-250 was repealed as of 11.45 am EST on 21 September 1999.

[5] See Treasurer, Press Release 58, 21 September 1999, Attachment E, now embodied in s 152-205 of the ITAA97 and the machinery provisions relevant to that section.

[6] [1980] HCA 6; (1980) 143 CLR 440.

[7] Ibid 447 (per Barwick CJ, Stephen, Mason and Wilson JJ).

[8] [1974] HCA 22; (1974) 131 CLR 321.

[9] Ibid 327 (per McTiernan, Menzies and Mason JJ).

[10] [1944] HCA 35; (1944) 69 CLR 539.

[11] Ibid 551 (per Rich J).

[12] [1980] HCA 43; (1980) 144 CLR 673 ("United Builders").

[13] Ibid 688.

[14] References to CGT provisions are to ITAA97, Pts 3-1 to 3-3.

[15] See, for example, P Mroczkowski, '"The Cat, The Dog, The Rat And The Rabbit': Identifying And Valuing 'Goodwill' after FCT v Murry" (1999) 2(2) Journal of Australian Taxation 212; M Walpole, "When Is Goodwill not Goodwill?" (1999) 2(1) Journal of Australian Taxation 48.

[16] 6 Section 160ZZR reduced by half the capital gain attributable to goodwill on the disposal of an interest in a business.

[17] 98 ATC 4585, 4596 (per Gaudron, McHugh, Gummow and Hayne JJ).

[18] Ibid 4597.

[19] Ibid 4598.

[20] Ibid 4594-4595.

[21] Ibid 4590.

[22] Ibid 4594.

[23] Ibid 4598.

[24] Ibid.

[25] IRC v Muller & Co's Margarine Limited [1901] AC 217, 221-222 (per Lord Lindley) quoted in Murry 98 ATC 4585, 4589.

[26] IRC v Muller & Co's Margarine Limited [1901] AC 217, 223 (per Lord Macnaghten) quoted in Murry 98 ATC 4585, 4590.

[27] 98 ATC 4585, 4597.

[28] [1979] HCA 42; (1979) 142 CLR 177, 181 quoted in Murry 98 ATC 4585, 4590 and 4592.

[29] (1996) 32 ATR 7, 15.

[30] 98 ATC 4585, 4592-4593.

[31] Ibid 4587.

[32] Ibid 4593.

[33] Ibid 4592.

[34] Ibid 4590.

[35] Ibid 4594-4595.

[36] Ibid 4592.

[37] Ibid 4596.

[38] Ibid 4591.

[39] Ibid 4592.

[40] Ibid 4594-4595.

[41] [1971] HCA 17; 71 ATC 4101; (1971) 124 CLR 97 ("Avondale Motors").

[42] ATO Case Decision Summary, CSD 10080; Taxation Ruling TR 99/9 para 38.

[43] Paragraph 13.

[44] Paragraph 38, citing as authority the UK Court of Appeal in Laycock v Freeman, Hardy & Willis (1938) 22 TC 288; [1939] 2 KB 1; [1938] 4 All ER 609.

[45] Paragraph 40.

[46] See, for example, Deputy Commissioner of Land Tax v Hindmarsh [1912] HCA 27; (1912) 14 CLR 334 and more generally, AI McAdam & TM Smith, Statutes (3rd ed, 1993).

[47] The New Shorter Oxford English Dictionary, (1993); The Macquarie Dictionary (2nd rev, 1987); Osborn's Concise Law Dictionary (8th ed, 1993); David M Walker, The Oxford Companion to Law (1980); Black's Law Dictionary (6th ed, 1990).

[48] Ibid.

[49] The Macquarie Dictionary (2nd Rev, 1987).

[50] Gordon Cooper, Cooper’s TLIP Capital Gains Tax (1999), para [12 030].

[51] Treasurer, above n5.

[52] Hepples v FC of T 90 ATC 4497, quoting the dictum of Lord Wilberforce in National Provincial Bank Ltd v Ainsworth [1965] UKHL 1; (1965) AC 1175.

[53] [1982] HCA 69; (1982) 158 CLR 327.

[54] 98 ATC 4585, 4594.

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