+ Business Succession Law Update - Autumn 2008

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Ineffective change of trustee and consequent breach of trust

Many advisers are unaware that in the absence in the terms of a deed of settlement, of a specific formula to change a trustee, in order for the change in trustee to be effectual, the parties must abide by section 6(1) of the Trustee Act 1925 (NSW).

A good example of the mischief that can occur when section 6(1) is not complied with is the case of Commonwealth Bank Australia –v- Nick Frisina Pty Limited (Unreported No. 907 of 1999 [NSWSC]).

Earn-out arrangements and the sale of business

A standard earn-out arrangement is any transaction in which an income-earning asset (often a business or the underlying business owning assets such as shares in a company which is carrying on a business) is sold for consideration that includes the creation of an “earn-out right” in the seller of the asset. This is a right to an amount calculated by reference to the earning generated by the asset for a defined period following the sale (generally a period between 1 and 5 years).

From the seller’s perspective, under a standard earn-out arrangement, the earn-out right is not an entitlement to money for the purposes of calculating the seller’s capital proceeds from the happening of CGT event A1 (the sale of the asset). It is “other property… received” by the seller in respect of the disposal of the asset sold – see s 116-20(1) ITAA 1997.

This means that the seller’s capital proceeds from the event include the market value of the right (worked out at the time of the CGT event).

The earn-out right is property (and therefore a CGT asset), in the hands of the seller. It commences to be owned and is acquired (for CGT purposes) at the time when the contract for the sale of the original asset is made.

Generally, the seller’s ownership of an earn-out right will come to an end when satisfied by the payment of an amount or amounts by the buyer, or by expiring without any amounts becoming payable. In each of these situations, CGT events C2 (cancellation, surrender and similar endings) happens.

TR 2007/D10 released in October 2007, discusses these matters in more detail.

Share Buybacks

There are a range of reasons why a company would consider buying back its shares. In the case of private family companies, the main reason would be to return surplus funds and to enable a retiring proprietor to be bought out.

There are five types of buybacks but under section 588G of the Corporations Act, directors can be held liable to pay the company compensation if the company is or becomes insolvent when the company enters into the buyback agreement. Accordingly, they should not be undertaken without careful consideration of the financial consequences to the company.

Confidential information and sale contracts

Confidential information is not property in a strict sense, at least in Australia. Nevertheless, Mid-City Skin Cancer and Laser Centre [2006] NSWSC 844 confirms that the right to have confidential information remain confidential is an ‘equitable right’, and therefore “property” .

The case indicates that this right is an asset distinct from the goodwill of the business. But if information is merely a source of the goodwill of the business, (e.g., where it is in fact simply know-how, information or knowledge) then it is not an asset separate from the goodwill of the business.

To remove any doubt about the matter, we recommend that in a sale of business agreement, the parties make it clear that equitable rights of confidentiality are being assigned, and that any sale contract or associated deeds explicitly provide for it.

Work Choices – “Many a slip twixt the cup and the lip”.

Not all companies are ‘trading corporations’. It is only “trading corporations” with up to 100 employees that do not fall within the current unfair dismissal regime. In Garvey – v – Institute of General Practice Education Incorporated [2007] NSW IRComm 159, the employer challenged the NSW IRC’s jurisdiction to hear an application for relief from unfair dismissal based on its contention that it was a trading corporation.

The primary source of the employer’s revenue came from federal government funding but, it also earned income from providing teaching services to a university. However only 0.029% of the total income of the employer came from those teaching services.

That was not enough. The Full Bench said that a corporation can only be a ‘trading corporation’ if trading is a substantial trading activity of the corporation and not merely a peripheral activity. The employer’s challenge failed.

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