Wholesaler Pty Ltd has 3 purchase contracts (for Products X, Y, and Z) with three different suppliers, as well as 3 sales contracts (with department store A for Product X, with department store B for Product Y, and with department store C for Product Z).

The seller that supplies Wholesaler with Product X cancels the 10-year contract when the contract still has 4 years to run. The contract for the purchase of Product X represents 20% of the Wholesaler's buying costs, though sales of Product X account for 80% of its total revenue. The seller (that canceled the contract) gives Wholesaler $2 million as compensation for canceling the remainder of the contract. In its own internal documents, the seller that compensated Wholesaler stated that $1.5 million of this was calculated on the basis of future loss of profits, and $0.5m was for a loss of Wholesaler's reputation due to the cancellation. As it turned out, the reputation loss of Wholesaler was very limited and it quickly recovered its reputation in a matter of months.

Required: Discuss whether any part of the $2 million constitutes ordinary income.

Answer rating: 100% (QA)

Solution Given Purchase contract of wholesaler Pty ... View the full answer