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Ruling

Subject: Deductibility of media production costs

Question

Are media production costs incurred by the company deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 2010

Year ended 30 June 2011

The scheme commences on:

1 July 2009

Relevant facts and circumstances

1. The Company is involved in the production of media products.

2. The Company holds the copyright to each media product once it is produced.

3. During the tax years ended 30 June 2010 and 30 June 2011, the Company incurred media production costs in relation to a number of media products.

4. The Company also received contributions from third parties in return for a portion of the profits derived by the Company in its exploitation of their media products.

5. The main sources of revenue for the Company from its media products are typically derived within the first one to two years of the products release. Other trailing revenues can also be generated over a longer period of time.

6. The Company has licensed all of its distribution rights to a number of its media products to a sales agent.

7. All income derived from the above activities is treated as assessable income.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Section 8-1 of the ITAA 1997 allows a deduction for any loss or outgoing incurred in gaining or producing assessable income, or that is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income except to the extent that such loss or outgoing is, inter alia, of capital, or of a capital nature.

For losses and outgoings incurred in carrying on a business, the term 'necessarily incurred in' is taken to mean 'clearly appropriate or adapted for' (Ronpibon Tin NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431; (1949) 4 AITR 326).

The Company carries on a business of producing media products. The Company generates revenue from its media products. The expenditure is integral to the production of the Company's business income and therefore the expenditure is considered to be 'necessarily incurred in' the course of carrying on that business.

However, it must also be determined whether or not the expenditure is excluded from deductibility on the basis that it is capital, or of a capital nature.

Capital or of a capital nature

In Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403 (Sun Newspapers), Dixon J made the distinction between capital and revenue at 61 CLR 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.

More recently in GP International Pipecoaters Pty Ltd v. Federal Commissioner of Taxation (1990) 170 CLR 124; 21 ATR 1; 90 ATC 4413 the High Court pointed out that the character of expenditure is ordinarily determined by reference to the nature of the asset acquired and that the character of the advantage sought by the making of the expenditure is a critical factor in determining the character of what is paid.

In the present instance, the subject of the acquisition is the copyright associated with the production by the Company of its media products.

Character of advantage sought

In considering the character of the advantage sought and the light it sheds on the character of the expenditure, it is necessary to take into account numerous factors including Omnilab's intentions and the form and manner of the transactions. Dixon J in Hallstroms Pty Ltd v F.C. of T. (1946) 72 CLR 634 at 648 (Hallstroms case) highlighted the need to consider:

...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.

The comments of Windeyer J in BP Australia Ltd v. Federal Commissioner of Taxation (1965) 112 CLR 386; (1965) 14 ATD 1; (1965) 9 AITR 615 show the need to focus on what the taxpayer got in return for the expenditure:

Regard ought therefore to be had to what it was sought to acquire and to the relation of that to the taxpayer's undertaking or business. These, rather than the form of the transaction or the mechanics of the acquisition, are what appear to me to be deciding factors. In other words, it is what the particular taxpayer got for his money, rather than how he got it that is important.

The Commissioner considers that the Company's intentions are relevant, though not solely decisive, in determining the character of the advantage sought. In this regard, reference is made to the comments of Lord Wilberforce in Regent Oil Co Limited v Strick (Inspector of Taxes) (1965) 3 All ER 174.

The case of Regent Oil concerned the treatment of payments made by an oil company to a garage proprietor to secure the sale of their petrol. The form of the tie was known as a lease-sub-lease transaction, whereby the proprietor granted the suppliers a lease of the premises for the period of the tie in consideration for the payment of a lump sum. The lump sum was calculated on the gallonage likely to be sold during the period of the lease plus a nominal rent.

In determining that the lump sum payments were expenditure of a capital nature, Wilberforce J made the following comments:

On behalf of the taxpayers it was said that we must look through the transparent form of the lease-sub-lease to some underlying commercial reality and that, having performed this penetration, we should see that this was merely part of Regent's normal marketing operations, or, alternatively, that the payments were nothing but disguised rebates. I cannot accede to this. Without embarking here on the question how far it is permissible in taxation matters to go behind the legal forms which the parties have chosen, where these forms are not a mere sham, I am satisfied that in this case form and substance fully coincide.

The Commissioner's decision regarding what the media product expenditure of the Company was calculated to effect is based on both the form and substance, that is, the 'underlying commercial reality' of the transaction.

The applicant has stated that the expenditure by the Company was incurred to derive revenue from the consistent production of its media products. Also, rather than contributing to the Company's profit yielding structure or business entity structure, the expenditure was undertaken as part of the normal course of carrying out the Company's daily operations.

However, the Commissioner's position is that in incurring the expenditure, the Company secured the copyright for each of its media products, including the rights to current and future revenues arising from the media products. This resulted in an enlargement of the profit yielding structure of the business. Based on this, it is considered to be clear what the expenditure was calculated to effect from a practical and business point of view (Hallstroms case). As a result, the media product expenditure is of capital, or of a capital nature.

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

All business expenditure is likely to be made with the intention of securing some commercial advantage. What is necessary to establish is the effect of the expenditure and how long it will likely endure. Where the expenditure results in an intangible benefit or advantage, it is necessary to establish whether the asset is sufficiently substantial and enduring to count as capital.

The 'enduring benefit test' 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. The test arose to prominence in British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 where it was held that an employer contribution to establish a staff pension fund was capital in nature on the basis that it brought into existence an asset of 'enduring benefit'. Viscount Cave LC at 192 made the following statement on the characteristics of capital expenditure:

When an expenditure is made, not only once and for all, but with a view to bring into existence an asset or advantage for the enduring benefit of a trade, l 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.

It is noted that the term 'enduring' does not mean that the asset or advantage should last forever. This was supported in Commissioner of Taxes v. Nchanga Consolidated Cooper Mines Ltd [1964] 1 All ER 208 in which it was stated that 'permanent' does not mean 'perpetual'.

In St George Bank Ltd v. FC of T [2008] FCA 453, interest payments made under a debenture by an Australian bank to its US subsidiary company were not deductible because the advantage sought was the maintenance of the expansion and strengthening of the bank's capital standing and the satisfaction of the regulatory capital requirements as a condition of its banking licence. Allsop J discussed at paragraph 76:

I reject the submission of SGB that a characterisation of the advantage calculated to be effected by the payment of interest must be limited to the maintenance of the loan and that to do otherwise, is, impermissibly, to ignore legal form. The advantage sought and obtained by the payment of interest under the Debenture was the maintenance of the loan as an integral part of the establishment and maintenance of a structural strengthening of the capital base of SGB and the SGB Group. The advantage was the underpinning and continuation of the capital raising and its funding by paying dividends through the integral and integrated mechanism of the loan from the special purpose vehicle which was a conduit, LLC. The advantage sought from the periodic payment of interest was one that accrued to SGB itself - the maintenance of the expansion and strengthening of its and its group's capital standing as an aspect of the structure of its business and the satisfaction of the RBA of capital adequacy ratios as a condition of its banking licence. It would be misleading and inadequate to describe the advantage calculated to be effected by the payment of interest as the temporary maintenance of a loan providing funds for SGB. The advantage sought was the maintenance and continuation of the overall addition to the enhancement of SGB's and the group's capital structure by funding LLC for the sole purpose of paying dividends to the extent LLC was not prohibited from doing so.

When the matters stated by Dixon J in the Sun Newspapers case are considered, 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. The nature or character of the expenditure will therefore follow the advantage that is sought to be gained by incurring the expenditure. If the advantage to be gained is of a capital nature, then the expenditure incurred in gaining the advantage will also be of a capital nature.

The main sources of revenue for the Company from its media products are typically derived within the first one to two years of a products creation. However, other trailing revenues can also be generated over a longer period of time.

For these reasons, it is considered that the media product expenditure incurred by the Company, does bring into existence advantages of enduring benefit for the Company. These advantages include the rights to current and future revenues arising from the products. Therefore, the media product expenditure is of capital, or of a capital nature.

The means adopted to obtain it

Where expenditure is recurring, it is more likely to be revenue in nature. On the other hand, it is capital in nature if it is made once and for all.

In this case, it is accepted that in carrying out its business of producing media products, the Company incurs expenditure associated with those products on a regular and continuous basis.

However, as the Company secures the rights to current and future revenues arising from the production of each of its products, it is considered the rights associated with each product represent a separate asset (copyright) of enduring benefit to the Company. Further, the expenditure incurred for each product is considered to be directly related to a particular media product. Therefore, it is considered that the expenditure incurred in the production of each product represents a 'final provision or payment so as to secure future use or enjoyment'.

For these reasons, it is considered that the means adopted to obtain the advantage for the Company support the conclusion that the expenditure is capital, or of a capital nature.

Conclusion

It is considered that as a result of incurring the media product expenditure, the Company secures an advantage of enduring benefit by the creation of assets (i.e. copyrights to its products). As these assets are part of the company's profit-yielding structure, the investment expenditure is of capital, or of a capital nature.

Accordingly, the Company will not be entitled to a deduction under section 8-1 of the ITAA 1997 for the expenditure incurred in the production of its media products.

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