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Ruling

Subject: The Agreement

Question 1

Does subsection 8-1(2) of the Income Tax Assessment Act 1997 (ITAA 1997) preclude a deduction in respect of the amount paid by Company A to Company B for the assignment of the Distributorship Agreement between Company B and Company C?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2007.

The scheme commences on:

1 July 2006.

Relevant facts and circumstances

Introduction

The ruling is in respect of the income tax treatment of an amount paid by Company A for the assignment of a distribution agreement, hereafter described as the Agreement.

Parties to the Transaction

The parties to the Transaction (as described below) that is the subject of this ruling are:

· Company A - resident public company and the head company of the Company A tax consolidated group (Company A TCG).

· Company D - Australian resident company and subsidiary member of the Company A TCG. It was established by Company A in July 2006.

· Company B - Australian resident private company and unrelated to Company A;

· Company B's Guarantors;

· Company C - non-resident public company

Documents

The Transaction that is the subject of this ruling has been ascertained from the following documents:

· the Application (including Appendices);

· Distributorship Agreement (Agreement) between Company B and Company C dated in June 2005;

· Business Sale and Purchase Agreement (BSP Agreement) - undated;

· Emails sent by the Applicant; and

· Media Release, 2006 Annual General Meeting and 2007 Annual Report as contained on Company A's website.

General Background

Company A was listed as a public company on the Australian Securities Exchange.

Company A's principal and continuing activities are in the industrial maintenance, commercial construction, utilities and resources sectors.

Prior to the acquisition of the Company B business in 2006 and which is described below:

Company A's business was broadly in the hiring of equipment.

Company A did not actively engage in the retail trade of equipment.

After the acquisition of Company B, Company A's website indicated that the Company B business complemented Company A's existing hire business. The website also referred to the expansion and future growth opportunities that the Company B acquisition presented to Company A.

Transaction

Acquisition of Company B

In August 2006 Company A acquired the Company B business (and holder of the Agreement).

The Applicant contends that acquisition of the Company B business provided, inter alia, the following benefits to Company A:

Securing the distribution agency for the equipment for the term of the Agreement; and

Procurement/ROI benefits via the wholesale purchase of the equipment at a discount on retail prices.

Business Sale and Purchase Agreement

Company D entered into the BSP Agreement with Company B and Company B Guarantors whereby Company B agreed to sell its Business and Assets and Company D agreed to buy the Business and the Assets for $X.

"Assets" in the BSP Agreement included, inter alia, all interest, right and title of Company B in the Agreement:

The "The Agreement" in the BSP Agreement means:

the distributorship agreement dated 1 June 2005 between Company C and Company A as varied by a letter between those parties and Company A dated July 2006.

In accordance with the BSP Agreement a Purchase Price of $X was paid by Company A for the Business and the Assets. A consideration amount of $Y was allocated to the Agreement. For this consideration, Company B assigned to Company D all Company B rights, title and interest in the Agreement.

The Effective Time for the BSP Agreement was August 2006.

The Agreement

The Agreement dated 1 June 2005 is an agreement between Company C and Company B whereby Company C grants Company B the exclusive right to purchase and sell Products in Australia on Company B's own account and risk during the life of the agreement and under the terms and conditions of the agreement.

One of the relevant terms of the Agreement was that it shall be automatically terminated after a period of two years commencing from the agreement date of 1 June 2005 (i.e. 1 June 2007). Both parties shall discuss the renewal of the Agreement six months prior to the date of termination.

Renewal and expiry of the Agreement

As mentioned above, the Agreement was to be automatically terminated on 1 June 2007. However, both parties "shall discuss the renewal" of the agreement six months prior to the date of termination.

Company A and Company C discussed renewal and Company C agreed to extend the Agreement for a further two years from 1 June 2007 to 1 June 2009.

A letter dated in July 2006 from Company C to Company A

· confirms that Company C had "…no objection to Company A acquiring Company B.."; and it

· confirms that Company C consents to the continuation of the Agreement with Company B post the Transaction by Company A and it also approves the extension of the Agreement on the same terms and conditions until 1 June 2009.

Accounting treatment

For accounting purposes, the Agreement was treated by Company A as a separate identifiable asset which was capitalised and amortised on a straight-line basis over its useful life. The accounting treatment is summarised as follows:

· At acquisition, Company D paid $d to acquire the Agreement. Company A's management decided to amortise the carrying value on a straight-line basis over 10 years. The accounting amortisation profile is noted below.

· In the 2008 income year, Company A reassessed the carrying value of the Agreement for accounting purposes and subsequently impaired the carrying value. Accordingly, the revised carrying value (pre the 2007 income year amortisation) was for accounting purposes was a lower amount. The useful life was also adjusted to 3 years.

· In the 2009 income year, a carrying value of nil was left as at 30 June 2009.

Company A has treated the accounting amortisation as non-deductible for income tax purposes.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

For the amount paid by Company A in respect of the assignment of the Agreement to be deductible, it must satisfy the condition in subsection 8-1(1) of the ITAA 1997, and not be precluded by subsection 8-1(2) of the ITAA 1997.

Section 8-1 of Division 8 of the ITAA 1997 provides that:

8-1(1) You can deduct from your assessable income any loss or outgoing to the extent that:

(a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

8-1(2) However, you cannot deduct a loss or outgoing under this section to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature; or

(b) it is a loss or outgoing of a private or domestic nature; or

(c) it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or

(d) a provision of this Act prevents you from deducting it.

The positive and negative limbs provide two separate tests, both of which must be applied to all losses and outgoings. The two positive limbs require a connection or nexus between the "loss or outgoing" and the earning of assessable income. It is enough, however, for either of the positive limbs to be satisfied for a deduction to be allowed.

The meaning of the phrase "losses and outgoings" was discussed in Amalgamated Zinc (De Bavay's) Ltd v FC of T (1935) 54 CLR 295. Latham CJ said (at p 303):

The phrase 'losses and outgoings actually incurred in gaining or producing the assessable income' may, in relation to outgoings, be read as meaning that the outgoings must be an expenditure which has an effect in gaining or producing income, eg the purchase price of goods which are subsequently sold.

In this case it is accepted that the amount paid by Company A upon assignment of the Agreement is connected to the business activities undertaken by Company A and the earning of its assessable income for the purposes of both positive limbs. However, a deduction for the amount paid will be denied under the first negative limb if it is considered to be capital or capital in nature (paragraph 8-1(2)(a) of the ITAA 1997).

There is no statutory criterion for determining whether a loss or outgoing is of capital or of a capital nature in ITAA 1997. The concept of "capital'' is normally contrasted with that of "revenue''. No deduction is allowed if a particular loss or outgoing is "on capital account'' but a deduction is allowed if the loss or outgoing is "on revenue account''.

The courts have formulated a number of tests to determine whether a loss or outgoing is capital or revenue in nature.

The leading Australian test of whether a loss or outgoing is of a capital nature is whether it relates to the taxpayer's "profit yielding structure''. This test, which requires an enquiry as to whether the expenditure relates to the structure within which the profits are earned or whether it relates to part of the money-earning process, derives from remarks of Dixon J in Sun Newspapers Ltd & Associated Newspapers Ltd v. FC of T (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403 (Sun Newspapers). It has been consistently followed by Australian courts.

In applying the test Dixon J referred to three matters which were to be examined. He said (at p 363):

There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

Character of the advantage sought

The character of the advantage sought provides important direction. It provides the best guidance as to the nature of the expenditure because it says the most about the essential character of the expenditure itself. The decision of the High Court in G P International Pipecoaters Pty Ltd v. Commissioner of Taxation (1990) 170 CLR 124 at 137; (1990) 90 ATC 4413 at 4419; (1990) 21 ATR 1 (G P International) at 7 emphasised this, stating:

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: Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 61 C.L.R 337, at p.363

The character of the advantage sought by making the expenditure can be determined by examining whether the expenditure secures an enduring benefit for the business. This test was outlined in British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 (British Insulated) and it suggests that if a loss or outgoing gives rise to a benefit of an enduring nature, the loss or outgoing is more likely to be capital in nature. At 213 - 214 Viscount Cave stated:

But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

By using the term "enduring'' it is not meant that the asset or advantage should last forever. It is a matter of degree (Herring v FC of T (1946) 72 CLR 543 per Rich J at p 547).

In John Smith & Son v. Moore (1921) 2 AC 13 (John Smith) the coal contracts which Lord Haldane and Lord Summer thought were acquired at the expense of capital had a very short term. By reselling coal bought under the contracts the taxpayer made his profit. "But," said Lord Haldane, "he was able to do this simply because he had acquired, among other assets of his business, including the goodwill, the contracts in question. It was not by selling these contracts, of limited duration though they were, it was not by parting with them to other" (coal) "masters, but by retaining them, that he was able to employ his circulating capital in buying under them. I am accordingly, of the opinion that, although they may have been of short duration, they were none the less part of his fixed capital."

Furthermore, an expenditure can be an outgoing of a capital nature even though no enduring benefits arise. In John Fairfax & Sons Ltd v. Federal Commissioner of Taxation (1959) 7 AITR 346: 101 CLR 30 (John Fairfax), Dixon CJ said at page 36 at:

It is not, in my opinion, right to say that because you obtain nothing positive, nothing of an enduring nature, for an expenditure it cannot be an outgoing on account of capital

The manner in which it is to be used, relied upon or enjoyed

This factor looks at the purpose of the expenditure and in the case of an asset acquisition, how that asset is used. Case law suggests that if the expenditure relates to the business's "fixed capital'' they are capital in nature but if they relate to its "circulating capital'' they are of a revenue character.

In John Smith, the House of Lords used the distinction between fixed and circulating capital to hold that a sum expended to purchase certain contracts and forming part of the sum expended on the purchase of the total assets of a business was capital in nature. Lord Haldane held that, as the purchaser had acquired the contracts among other interests of the business as part of the capital of the business, they became his fixed capital. As quoted above "It was not by selling these contracts ... but by repaying them, that he was able to employ his circulating capital by buying under them.''

In QCT Resources Limited v. FC of T 97 ATC 4079 (QCT Resources) a company paid $9.2m in respect of "overburden removal work-in-progress" as part of the purchase price of a coal mine. The Full Federal court held that the $9.2m was on capital account. In that case Drummond J stated:

If an outgoing can be seen from the entire context in which it occurs, including any contract under which it may have been paid, to be the whole or to form part of the consideration given for the acquisition of a capital asset, that will be practically decisive of it being an outgoing on capital account.

The means adopted to obtain it

This factor considers the recurrent nature of the expenditure. Basically, if expenditure is recurring, it is more likely to be revenue in nature. Conversely, if it is a one-off expenditure, it is more likely to be capital in nature.

This test is supported in Vallambrosa Rubber Co Ltd v Farmer (1910) 5 TC 529 (Vallambrosa), where Lord Dunedin said (at p 536):

I do not say that this consideration is absolutely final or determinative; but in a rough way I think it is not a bad criterion of what is capital expenditure as against what is income expenditure to say that capital expenditure is a thing that is going to be spent once and for all, and income expenditure is a thing that is going to recur every year.'

The words "every year'' are not to be taken literally, but mean pursuant to a continuous demand (Ounsworth v Vickers Ltd (1915) 6 TC 671 per Rowlatt J at p 675).

In this case it is considered that the amount of $d paid by Company A in August 2006 is of capital or of a capital nature for the purposes of subsection 8-1(2) of the ITAA 1997 for the following reasons:

· The Agreement provided Company A with enduring benefits, namely, the exclusive right to purchase and sell the Company C equipment within Australia. The fact that the Agreement expired after three years in the hands of Company A does not mean that the expenditure incurred is a regular outgoing and should be regarded as being on revenue account. In any case, although this exclusive right lasted for approximately three years, it was capable of being extended beyond June 2009 in accordance with the Agreement. This indicates the enduring nature of the benefits that the Agreement could have provided in the future: see G P International, British Insulated and John Fairfax.

· By acquiring the Agreement, Company A was given the right to actively engage in the retail trade of the equipment, an area of business in which it did not previously engage. Furthermore, the Agreement provided access to purchase equipment additions at wholesale prices rather than retail. This would suggest that the payment made to acquire the Agreement relates more to Company A's "profit yielding structure" and should be properly characterised as expenditure which extended the profit-yielding subject of Company A's business (ie. the price paid for the right to carry on an additional business in retail) as well as enabling access to future income streams given Company A's ability to purchase cranes at a cheaper cost. The payment is not considered to be part of the process by which Company A operates to obtain regular returns by means of regular outlay: see QCT Resources.

· The amount of $d paid for the acquisition of the Agreement formed part of the overall purchase consideration given by Company A for the acquisition of all the assets of the Company B business. This clearly supports an argument for the amount paid being on capital account: see John Smith and QCT Resources.

· The payment made by Company A for the Agreement was made at the time of acquisition as a lump sum payment. Although this factor in itself is not enough to treat the expenditure as capital in nature, in combination with the other factors, it provides greater support for the capital argument: see Vallambrosa.

· The Agreement was reflected in Company A's financial accounts as a separate identifiable asset which was capitalised and amortised on a straight line basis over its useful life. In the 2007 income year (the year of acquisition of the Agreement), Company A's management decided to amortise the carrying value of $d on a straight line base over 10 years. Whilst not determinative, the accounting treatment may assist in ascertaining its true nature. It forms part of the overall picture which must be considered in determining the correct characterisation of the payments (Travelodge Papua New Guinea Ltd v. Chief Collector of Taxes (1985) 16 ATR 867; 85 ATC 4432). In this instance, it would seem that Company A's management expected the Agreement to provide long term benefits to its business, lending support that the true character of the expenditure made by Company A for the acquisition of the Tadano Agreement is capital and not revenue.

The above reasoning which supports a capital argument is consistent with Labrilda Pty Ltd v. DFC of T 96 ATC 4304; 32 ATR 206 (Labrilda), United Energy Limited v. FC of T 97 ATC 4796; 37 ATR 1 (United Energy), Case G37 75 ATC 231 (Case G37), Case B31 70 ATC 148 (Case B31) and Case L35 79 ATC 184 (Case L35).

In Labrilda, a service station operator's one-off payment to a petrol company to obtain the right to use the petrol company's signage, trade name, etc, and participate in the company's marketing program was held to be non-deductible capital expenditure. Sender and Ryan JJ said that these "rights acquired were capital in nature, albeit constituting a wasting asset."

In United Energy, the Full Federal Court held that franchise fees charged by the Victorian government in respect of electricity distribution companies, were not deductible. The Court said that the essential character of the advantage gained by the franchise fee was immunity from competition for a specified period from other distribution companies for customers in the licence area. The immunity was of enduring benefit to the taxpayer and the fee was therefore of a capital nature.

In Case G37, part of the overall purchase price for a takeover was allocated to the cost of unexecuted contracts held by the vendor. It was held that the cost of acquiring unexecuted contracts was an outgoing of a capital nature.

In Case B31 the Board held that the acquisition of a right to conduct the business of a drive-in theatre was going to the business entity, structure or organisation rather than the process by which the organisation operates from day to day. It has, therefore, a capital character.

In Case L35 the Board recognised as assets of a business the licence, or right, to carry on that business and the earning power arising from the fact that paying customers come to the business ie. goodwill. The existence of goodwill and possession of a licence are indeed real assets.

Conclusion

The amount paid by Company A for the assignment of the Agreement is part of the total sum expended by Company A on the purchase of the total assets of Company B. Effectively, the amount paid served to enlarge Company A's business operations and not the process by which it operated to obtain regular returns by regular outlay.

Therefore, the amount paid by Company A is considered to be of capital or of a capital nature and therefore precluded from a deduction under subsection 8-1(2) of the ITAA 1997.

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