The impact of this case on ATO policy is discussed in Decision Impact Statement: Tricare Group Pty Ltd v Commissioner of Taxation (2821 of 2011 ).
PE Hack SC DP
Administrative Appeals Tribunal, Brisbane
MEDIA NEUTRAL CITATION:
 AATA 298
PE Hack SC (Deputy President)
1. It appears to be a common practice for residents of retirement villages to reside in the retirement village in accordance with an agreement with the retirement village proprietor whereby the resident (or the resident's estate) shares with the retirement village proprietor the capital appreciation in that resident's unit once a new resident occupies the unit. The notion of capital appreciation in a leasehold interest which is not, in fact, transferred directly is somewhat surprising however it seems to be one which underlies the statutory scheme which governs retirement villages in Queensland.
2. The question which arises in the present case concerns the taxation treatment of such payments, described by the parties to the proceedings as "Share of Capital Appreciation Payment" or SOCAP. The principal argument of the applicant is that the payments are deductible under s 8-1 of the Income Tax Assessment Act 1997 (Cth)(ITAA 1997). The respondent, the Commissioner of Taxation, says that the payments made in the present case are capital in nature and thus not deductible. The applicant has alternative arguments which are detailed below.
The Retirement Villages Act
3. It is as well to start by examining the Retirement Villages Act 1999 (Qld) which regulates the rights and obligations of operators and residents of retirement villages. Section 5(1) of that Act defines a "retirement village" as,
"premises where older members of the community or retired persons reside, or are able to reside, in independent living units or serviced units, under a retirement village scheme."
A "retirement village scheme" is defined by s 7 as,
"a scheme under which a person -
- (a) enters into a residence contract; and
- (b) in consideration for paying an ingoing contribution under the residence contract, acquires personally or for someone else, a right to reside in a retirement village, however the right accrues; and
- (c) on payment of the relevant charge, acquires personally or for someone else, a right to receive 1 or more services in relation to the retirement village."
4. It is a sufficient description to say that s 10 of the Retirement Villages Act defines "residence contract" as a "...written contract...about residence in a retirement village entered into between a person and the scheme operator", however to be a residence contract a contract must, amongst other things, purport to give the person "an exclusive right to reside in an accommodation unit in the retirement village".
5. In the circumstances of the present case it is also necessary to have regard to the definitions of "ingoing contribution", "exit fee" and "exit entitlement". So far as is presently relevant, those terms are defined as s 14(1), 15(1) and 16 of the Retirement Villages Act as follows:
"An ingoing contribution is the amount payable by a person under a residence contract to secure the person's, or someone else's, right to reside in a retirement village, but does not include a recurrent payment for rent, fees or charges."
"An exit fee is the amount that a resident may be liable to pay to a scheme operator under a residence contract arising from -
- (a) the resident ceasing to reside in the accommodation unit to which the contract relates; or
- (b) the settlement of the sale of the right to reside in the accommodation unit."
"An exit entitlement is the amount that a scheme operator may be liable to pay to a former resident under a residence contract arising from -
- (a) the resident ceasing to reside in the accommodation unit to which the contract relates; or
- (b) the settlement of the sale of the right to reside in the accommodation unit."
6. Retirement village schemes are required to be registered. Information regarding the scheme is publicly available in a public information document which forms part of the residence contract. Section 45(1) of the Retirement Villages Act sets out details of the matters that must be included in a residence contract including, relevantly;
- (b) the ingoing contribution payable under the contact;
- (c) the exit fee payable under the contract;
- (d) the resident's exit entitlement;
By virtue of s 45(2) a provision of a residence contract is of no effect to the extent that it inconsistent with the Act.
7. The Retirement Villages Act deals as well with termination of the right to reside in a retirement village. It will suffice to say that a resident may terminate that right by giving of one month's written notice. A scheme operator may terminate for cause. A right to reside terminates on the death of the resident.
8. Division 5 of Part 3 of the Act is headed "Reselling resident's right to reside". It operates when a resident's right to reside is terminated, where the scheme operator has a controlling right to sell the right to reside in the unit and where the contract does not include provisions at least equivalent to those in Division 5. The division contains provisions about the process of resale of the right to reside in the accommodation unit, reinstatement and suchlike. However it is important to note that the Division, and the Act itself, is founded upon the notion that the right to reside is capable of being bought and sold. Given the arguments of the parties s 71(1) of the Retirement Villages Act has a particular relevance. It provides,
- "(1) A residence contract is enforceable against the following persons for the recovery of all or part of the exit entitlement -
- (a) a person who is a party to the contract;
- (b) a person who is not a party to the contract but who, when the contract was entered into -
- (i) was the scheme operator for the retirement village to which the contract relates; or
- (ii) owned the retirement village;
- (c) a person who is not a party to the contract but who, when the contract is to be enforced -
- (i) is the scheme operator; or
- (ii) owns the retirement village."
9. The facts are largely agreed. The applicant is the head company of a consolidated group of companies that includes a company I shall call "the purchaser". On 23 December 2005 the purchaser purchased from an unrelated entity (the vendor) a retirement village (the Village) at a price in excess of $4m. The sale included,
- "(a) the freehold estate in the Land and all improvements and fixtures on it;
- (b) the Plant and Equipment;
- (c) the benefit of the leases;
- (d) the Intellectual Property; and
- (e) the benefit of the Services Contracts that are not to be terminated by the vendor ..."
The term "lease" was defined by the contract to mean,
"the agreement or agreements (including a public information document and lease) entered into by a person in connection with his or her right to occupy a Unit that are disclosed in Schedule 1 ..."
The units and the then residents were listed in the Schedule.
10. The transactions in issue in these proceedings involve residents whom I shall describe as Mr and Mrs B, Ms C, Ms S, Mr and Mrs P, and Ms W. Each of them became a resident at a time when the vendor was the registered proprietor of the Village and the scheme operator. Each of them ceased being a resident after the vendor had conveyed its interest to the purchaser and after the purchaser had become the registered proprietor and scheme operator of the Village.
11. Mr and Mrs B took up residence in the Village in February 2004 pursuant to a registered lease. They paid an ingoing contribution of $145,500.00 to the vendor. Their lease was described a "Half Capital Appreciation Lease", that is, they were, in effect, entitled to 50% of the amount by which a replacement resident's ingoing contribution exceeded the ingoing contribution that they had paid. The lease required them to pay exit fees, calculated as a percentage of the replacement resident's ingoing contribution. The percentage started at 7.5% in the first year and increased by 2.5% annually to a maximum of 25% after seven years.
12. Mr and Mrs B terminated their lease in February 2006, just short of the second anniversary of the commencement of the lease. The unit they had leased was subsequently leased to a resident who paid an ingoing contribution of $185,000.00. The purchaser, by then the scheme operator of the Village, repaid their ingoing contribution of $145,500.00 and the sum of $19,750.00 representing half of the "capital appreciation" calculated by reference to the replacement resident's ingoing contribution
13. Ms C became a resident of the Village in October 2002 pursuant to a registered lease. She paid an ingoing contribution of $142,750.00. Her lease was a Half Capital Appreciation Lease. The lease was terminated by the death of Ms C in June 2006. The replacement resident paid an ingoing contribution of $215,000. the purchaser paid to Ms C's estate her ingoing contribution ($142,750.00) and half capital appreciation of $36,125.00 less exit fees of $32,250.00 and other minor adjustments.
14. Ms S became a resident of the Village in September 1996. She paid an ingoing contribution, described in the lease as a "Security Bond", of $120,000.00. Her lease was a Quarter Capital Appreciation Lease and was registered. The lease was terminated by the death of Ms S in July 2006. The replacement resident paid an ingoing contribution of $215,000.00. the purchaser paid the estate of Ms S the capital appreciation payment of $23,750.00 and charged exit fees of $53,750.00 and other costs.
15. Mr and Mrs P became residents of the Village in March 2003 and paid an ingoing contribution of $140,500.00 to the vendor. Their lease, which was registered, was a Half Capital Appreciation Lease. It was terminated in June 2006. The replacement resident paid an ingoing contribution of $186,500.00. The purchaser repaid Mr and Mrs P the ingoing contribution of $140,500.00 and half of the capital appreciation, an amount of $23,000.00. It charged exit fees of $27,975.00.
16. The last resident, Ms W, entered the Village in November 1994. The documentation supporting her lease described the ingoing contribution as a loan and the amount of that loan was $110,000.00. The loan agreement contained terms that had a similar effect as the other agreements except that the exit fee was calculated as a percentage of the ingoing contribution made by Ms W, not, as in the other examples, a percentage of the replacement resident's ingoing contribution. The loan agreement described Ms W's arrangement as a Quarter Capital Appreciation Loan. On termination of the lease in March 2007 the purchaser repaid the loan of $110,000.00 to Ms W, made a 25% capital appreciation payment of $19,750.00 and recovered an exit fee of $27,500.00.
17. Since becoming the registered proprietor and scheme operator of the Village the purchaser has entered into similar arrangements with other residents. The Village has just over 100 units and, according to the evidence of the applicant's director, the average length of stay is 12 years. Exit fees, the director said, are "the primary income source retained by [the purchaser]". In a passage from his affidavit to which the Commissioner objected (on the grounds of relevance) the director described the offer of payment of SOCAP as an incentive to the residents to reside there rather than at other available options. It was necessary, he said, for the purchaser to offer competitive pricing, including the offer of a SOCAP.
18. The evidence of the director to which objection has been taken by the Commissioner has some relevance. It provides a setting against which the character of the payments in issue need to be considered. I overrule the Commissioner's objection to the admissibility of paragraphs 20 to 25 of his affidavit.
19. The applicant's income tax assessment dated 1 February 2008 for the year ended 30 June 2007 excluded the total of $122,375.00 representing the capital appreciation payments made by the purchaser to (or to the estates of) Mr and Mrs B ($19,750.00), Ms C ($36,125.00), Ms S ($23,750.00), Mr and Mrs P ($23,000.00) and Ms W ($27,500.00). The applicant lodged a notice of objection dated 10 November 2009. On 10 May 2010 the Commissioner disallowed that objection, on the basis that the capital appreciation payments were,
"costs incidental to the acquisition of the Village and therefore capital and not deductible ..."
The arguments of the parties
20. The applicant contends that the payments of $122,375.00 are deductible under s 8-1 of the ITAA 1997. It relies on s 8-1(1)(b) of the ITAA 1997 which allows a deduction of a loss or outgoing to the extent that,
"it is necessarily incurred in carrying on a business for the purpose of gaining or producing ... assessable income."
And, submits the applicant, deductibility is not precluded by s 8-1(2) of the ITAA 1997 which denies deductibility to "a loss or outgoing of capital, or of a capital nature."
21. The Commissioner contends that the payments were not deductible. They were not outgoings incurred in carrying on a business to gain or produce assessable income; they were payments made "in relation to the acquisition of the Village and are capital in nature."
"the inference is to be drawn that the applicant undertook to discharge the [the vendor's] liability to repay the IC, the ingoing contribution, and to pay the SOCAP."
22. Next, and if its primary contention is not accepted, the applicant says that SOCAP is deductible under the "blackhole expenditure" provisions in s 40-880 of the ITAA 1997. That provision allows capital expenditure that is related to a business and that is not otherwise deductible to be deducted in a straight line over five years provided that the deduction is not denied by some other provision. It is unnecessary for present purposes to consider the operative parts of s 40-880 of the ITAA 1997; the Commissioner accepts that they are satisfied. The argument focussed upon the exceptions set out in s 40-880(5)(d) of the ITAA 1997 in these terms:
- "(5) You cannot deduct anything under this section for an amount of expenditure you incur to the extent that:
- (d) it is in relation to a lease or other legal or equitable right;..."
In this part of the argument the Commissioner submitted that SOCAP were payments "in relation to a lease".
23. The final argument for the applicant, again put in the alternative to its primary contention regarding deductibility under s 8-1 of the ITAA 1997, concerns the exit fees paid to it by departing residents on the termination of leases. The argument, stripped to its bare essentials, is that if, contrary to the applicant's case, SOCAP is on capital account then the exit fees must also be on capital account.
Deductibility under S 8-1
24. An outgoing is deductible under s 8-1 of the ITAA 1997 if it satisfies one of the positive limbs of sub-section (1) and is not excluded by the negative limb. Here, as has been noted, the applicant relies on the second positive limb i.e. "necessarily incurred in carrying on a business". Of that limb the High Court said recently
"In Ronpibon Tin, the overlap between the limbs of the predecessor section to s 8-1(1) of the ITAA, which often renders the second limb otiose, was noted. It was held that a loss or outgoing will be 'necessarily incurred in carrying on' a business if it is 'clearly appropriate' or 'adapted' for the carrying on of the business. Restating the test another way, the loss or outgoing will be 'necessarily incurred' if it is 'reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business'." [footnotes omitted]
25. Here, there can be no doubt that the purchaser was carrying on a business. That business generated income from two major sources - the reimbursement of recurring expenditure in the operation and maintenance of the retirement village and its facilities, and exit fees paid by departing residents. It is the latter which represented the purchaser's primary income source.
26. It is correct to say, as does the Commissioner, that the payments of SOCAP in issue here were not made to induce the recipients to enter into the leases or to continue to comply with the terms of the leases. But that submission seems to me to miss the point. Frequently there will be no direct correlation between business expenditure and business receipts; that is the whole point of the second positive limb of s 8-1 of the ITAA 1997. In the ordinary case, that is, where the payment of SOCAP is made by the original lessor, payments are an ordinary and usual incident of the business of a retirement village. They are payments that the lessor has contracted to make to the resident once the right to reside has come to an end and a new right to reside has been granted to another resident. It is in the nature of the business of retirement villages that the offer of a payment of SOCAP is the expectation of those contemplating acquiring the right to reside. In the ordinary case, then, my view is that the payment of SOCAP was part of the price of carrying on business.
27. But the Commissioner contends that the payments of SOCAP in the present case are in a different category. They were not outgoings necessarily incurred in carrying on the business of the retirement village because the purchaser had not contracted with the recipients of the payments. These payments, according to the Commissioner, were made in discharge of the liability that the purchaser undertook
28. I am unable to accept the argument. It is unnecessary to resort to notions of inferred contractual undertakings. The source of the purchaser's obligations is much more direct and is to be found in s 71(1)(c) of the Retirement Villages Act. The five residence contracts in issue here, including the obligation to make payments of SOCAP, were enforceable against the purchaser. The purchaser did not need to undertake to the vendor to discharge the liability to pay SOCAP. Nor was it necessary for the residence contracts to be novated. The statute made the residence contract enforceable against the purchaser and thus obliged it to, amongst other things, make the contracted payments of SOCAP. The discharge of a statutory obligation is, in my view, equally part of the price of doing business.
29. It follows that I consider that the payments of SOCAP were deductible under the second positive limb of s 8-1 of the ITAA 1997.
30. It remains then to consider the Commissioner's second argument, that the payments were payments of capital and thus deductibility was precluded by s 8-1(2) of the ITAA 1997. It is well-settled that,
"The character of expenditure is ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure, for the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid"
G.P. International Pipecoaters Pty Ltdv Federal Commissioner of Taxation 90 ATC 4413; (1990) 170 CLR 124, 137.
Those matters are to be determined by an examination of,
"what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.";
Hallstroms Pty Ltdv Federal Commissioner of Taxation (1946) 72 CLR 634, 648.
31. The Commissioner submits that on that analysis the payments of SOCAP were made to discharge the purchaser's liability undertaken in, and for the purpose of, acquiring the capital asset of the retirement village. The advantage sought in undertaking the liability was the acquisition of the retirement village, a capital acquisition. As will appear, I do not agree with that characterisation.
32. The error, in my view, in the Commissioner's approach is the notion of characterising the liability to make SOCAP payments as one arising from an undertaking by the purchaser to the vendor to make the payments. I do not regard that as the source of the obligation; the source, as I have sought to explain, is s 71 of the Retirement Villages Act.
33. The five residence contracts in issue here specified the obligations owed by the vendor as scheme operator to the residents. In the case of Mr & Mrs B, for example, those obligations are described as "Covenants of the Scheme Operator" in the Standard Terms Document
- • an obligation to insure buildings and improvements;
- • an obligation to keep the retirement village properly maintained and in a state of good and serviceable repair;
- • an obligation to engage a manager; and
- • an obligation to maintain and monitor an emergency call system.
There was no express assignment, so far as I am aware, of the burden of those obligations. The benefits of the leases were expressly assigned by clause 10.1 of the purchase contract and "the benefit of the Leases" was included in clause 2.1 in describing the property sold. On the Commissioner's argument, the costs of the purchaser in meeting those obligations, must also be liabilities undertaken in, and for the purpose of, acquiring the capital asset of the retirement village.
34. The presence of s 71 of the Retirement Villages Act made it unnecessary for there to be an express assignment of the obligations of the vendor under the residence contracts. That Act had the effect of making the residence contracts enforceable against the purchaser, no other assignment was necessary. When viewed in this way it is not necessary to resort to "inferred undertakings" and the obligations can then be viewed, not as obligations undertaken for the purpose of acquiring an asset, but as obligations that were part and parcel of the operation of the retirement village.
35. It follows that I consider that the payments in issue here were deductible under s 8-1 of the ITAA 1997. I would set aside the objection decision of 10 May 2010 and substitute a decision that the objection be allowed in full. It is not necessary to consider the other arguments raised by the applicant.