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Subject: Distribution Rights Payment

Question 1

Is the Distribution Rights Payment (Distribution Payment) made by Company A to Company B pursuant to the Distribution Agreement dated X June 2011 deductible under section 8-1 of the Income Tax Assessment Act 1997 ('ITAA 1997')?

Answer

Yes

Question 2

If the Distribution Payment is deductible under section 8-1 of the ITAA 1997, is the deduction incurred in the year of income ended 30 June 2011?

Answer

Yes

This ruling applies for the following period:

Year of income ended 30 June 2011

The scheme commenced on:

June 2011

Relevant facts and circumstances

Factual background

The Taxpayer

The taxpayer is the head company of a tax consolidated group. Company A is a wholly owned subsidiary of the taxpayer and forms part of the consolidated group. Company A's ordinary business is the creation and sale of a range of products.

Company A's products are sold or distributed through a wide range of business partners, intermediaries and outlets. Company A primarily uses others to distribute its products. Company A is involved in numerous arrangements where it provides products branded under another label.

There is a multitude of ways that customers are gained by Company A. Company A incurs a wide range of expenses in an effort to bring in income.

Company A has alliances and partnership arrangements with a number of other companies. These alliances constitute an important and significant means for Company A to market its products.

Company B

The other party to the contract (Company B) is also involved in the same industry as Company A. Company B held shares in a chain of subsidiaries through which it carried on its business. Company B arranged to dispose of part of its business and concentrate on its other business operations.

In June 2011, Company A acquired certain subsidiaries from Company B. This was done via the purchase of all of the shares in the top subsidiary. The consideration paid by Company A was $X. The consideration for the shares was based on a valuation of the net tangible assets of the subsidiaries. These assets are mainly the existing and run-off value of the subsidiaries' assets.

Company A's intention is to run down and eventually shut down the business operations conducted by the acquired subsidiaries. Any remaining liabilities will be transferred to Company A. In time, the business operations conducted by the acquired subsidiaries will be entirely conducted by Company A.

The Transaction

In addition to purchasing the shares in the top subsidiary, Company A entered into the Distribution Agreement with Company B in June 2011. The Distribution Agreement will commence on the Commencement Date specified in the contract and will expire on the xth anniversary of the Commencement Date, unless extended by agreement between the parties prior to expiry of the Distribution Agreement. The specific terms are contained in the Distribution Agreement.

On X June 2011, pursuant to the Distribution Agreement, Company A paid a Distribution Payment of $X to Company B. The Distribution Payment made to Company B does not form part of the consideration for the acquisition of the shares in the top subsidiary. The valuation and calculation of the Distribution Payment is based on expected business opportunities and income arising through using Company B's continuing distribution channel.

The Distribution Payment has been treated as an intangible or deferred expenditure in the books of account of Company A and will be amortised on a monthly basis over the contract period. The Distribution Payment was recognised as an asset under accounting standard AASB 138 Intangible Assets and is being amortised over the contract period. The accounting entries are:

Time of acquisition

Cr Cash $X

Dr Intangible Asset $X

Years 1 - x of contract

Cr Intangible asset $XX

Dr Amortisation Expense $XX

Under the Distribution Agreement Company A is also required to pay commission and profit share to Company B for Company A's products distributed by Company B. The Distribution Agreement is similar to a number of other distribution arrangements entered into by Company A.

The Distribution Agreement

Company A will license Company B to provide authorised services to clients in relation to certain products for the term of the Distribution Agreement. For a short transitional period, the products will be provided by one of the acquired subsidiaries. After the transitional period, Company A will provide the products. At all times the products distributed by Company B will be branded under Company B's brand label.

The relationship between Company A and Company B in relation to certain products is principal and agent. The relationship between Company A and Company B in connection with other services is client and service provider.

The intellectual property and goodwill owned by each of the parties remains with that party. Each party has granted the other party non-exclusive, royalty free licences over trade marks necessary for the purposes of carrying out terms of the Distribution Agreement.

Company B has agreed not to distribute similar products or services supplied by any other person. Company A will not directly market its products to clients serviced by Company B. Company B must obtain Company A's written consent prior to it accepting a further appointment as authorised representative of a third party. Consent is not to be unreasonably withheld.

The other services to be provided by Company B mainly relate to the transfer of its subsidiaries to Company A.

Company A will make commission payments to Company B for the provision of the products. Commission is calculated as a proportion of income received less a number of government charges, taxes, fees and levies. Company A will also make annual profit share payments to Company B if specified expense targets in the Distribution Agreement are satisfied. The Distribution Payment is calculated by reference to the estimate of the same income and profits to be earned under the arrangement. The Distribution Payment is based on an estimate of the income and profits to be earned on Company A's products over the life of the agreement.

Company A and Company B will also make specified Portfolio Growth Payments to each other depending on the growth or reduction in total income over a financial year.

In the event of the termination of the Distribution Agreement, Company B must repay an amount equal to the Distribution Payment, on a pro rata basis over the life of the Distribution Agreement.

The valuation of the acquired subsidiaries

The value of the acquired subsidiaries was assessed as the sum of the following four components:

· net tangible assets,

· cost to close the entity,

· cost to administer the entity prior to closing, and

· adjustments to return net tangible assets to a best estimate value.

The valuation of the Distribution Agreement

The value of the distribution arrangement was calculated using a discounted cash flow model which included a number of assumptions. The model took into account increased costs identified during due diligence, ongoing running costs and implementation costs, forecast business growth, the Weighted Average Cost of Capital and synergistic savings.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subdivision H in Division 3 of Part III

Income Tax Assessment Act 1936 Section 82KZMA

Income Tax Assessment Act 1936 Subsection 82KZMA(3)

Income Tax Assessment Act 1936 Paragraph 82KZMA(3)(c)

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Subsection 8-1(1)

Income Tax Assessment Act 1997 Subsection 8-1(2)

Income Tax Assessment Act 1997 Section 8-5

Income Tax Assessment Act 1997 Subsection 8-5(2)

Reasons for decision

Question 1

Subsection 8-1(1) of the ITAA 1997 allows a deduction for any loss or outgoing to the extent that it is 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. However, subsection 8-1(2) of the ITAA 1997 restricts the deduction. To the extent that the loss or outgoing is of capital, or of a capital nature, it is not deductible.

The first positive limb of section 8-1 of the ITAA 1997 requires that the loss or outgoing be incurred in gaining or producing assessable income. Company A is engaged in a business where it sells products to the public through agents. It incurs expenditure through its marketing activities in order to gain income from the sale of its products. The first limb allows a deduction for this expenditure provided that it has the required immediate nexus to earning the income.

The second positive limb of section 8-1 of the ITAA 1997 provides a deduction for losses or outgoings necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. Where a taxpayer carries on a business, the second limb broadens the scope to allow a deduction for expenditure necessarily incurred as part of the cost of trading operations to produce income.

The Distribution Payment is paid by Company A to Company B for the purpose of bringing about the distribution of the company's products under Company B's brand name. It is therefore incurred in gaining the income which form Company A's assessable income. Even if it is considered not to be directly incurred in the course of gaining or producing the assessable income, it would be incurred as part of the cost of carrying on the business which is carried on by Company A. The positive limb of section 8-1 of the ITAA 1997 is therefore satisfied.

Subsection 8-1(2) of the ITAA 1997 restricts the availability of a deduction if the loss or outgoing is of capital, or of a capital nature. The matters to be considered in determining whether a loss or outgoing is of a capital or revenue nature is described by Dixon J in Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers) where his Honour said:

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.

In GP International Pipecoaters Pty Ltd v. Federal Commissioner of Taxation (1990) 170 CLR 124, 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.

Company A acquired the business from Company B through the purchase of all of the shares in the top subsidiary. The acquisition price of the shares in the top subsidiary was based on the best estimate of the net tangible asset value plus the costs to administer and close the entity. The acquisition price included the full value of the existing business of the subsidiaries. The nature of that transaction must be considered when considering the Distribution Payment. The share acquisition price constitutes a separate capital payment for the shares. The advantage sought and obtained is the acquisition of capital assets of the subsidiaries.

Company A entered into the separate Distribution Agreement appointing Company B to distribute Company A's products to the public under Company B's brand name. No part of the value of the shares in the top subsidiary was included in the calculation of the Distribution Payment amount. The Distribution Payment amount was separately calculated by reference to the estimate of the new income and additional profits to be earned under the new arrangement. The calculation of the Distribution Payment amount is based solely on a discounted cash flow model of expected new opportunities and income arising through the new distribution channel over the life of the Distribution Agreement. The advantage sought is an income stream over several years rather than the acquisition of a capital asset. Further, after the specified term of the contract, there will be no remaining asset as Company B will no longer be tied to Company A.

From a practical and business point of view, the Distribution Payment expenditure:

· expanded the existing Company A distribution network,

· tied Company B to Company A as a sole distributor of Company A's products marketed under Company B's name,

· secured for Company A, the use of the Company B brand name and reputation for a fixed period of time,

· was one of numerous similar arrangements used to market Company A's products under different brand names, and

· did not include commission and other payments made by Company A to Company B based on actual sales.

The judgments in BP Australia Ltd v. Federal Commissioner of Taxation (1965) 112 CLR 386; (1965) (BP Australia) and National Australia Bank v. Federal Commissioner of Taxation 97 ATC 5153 (NAB) are relevant to this case.

In BP Australia, the company claimed deductions for amounts paid as trade ties to service station proprietors so that those proprietors would deal exclusively in its products for a fixed period. The payments were calculated by reference to expected sales by the service stations. The payments were for fixed periods and it was accepted that further payments may have to be made to service station proprietors after the fixed periods ended. The Privy Council held that the real object of the outgoing was not the tied network but the orders that would flow from it. The tie agreements were a temporary solution that were of a recurrent nature. The advantage sought was the promotion of sales by up to date marketing methods which had become necessary and the expenditure was therefore deductible as being on revenue, rather than capital, account.

In BP Australia, it was said that the benefit of the payment was to increase the gallonage of sales whether immediate or ultimate. The payment was made based on what competition rendered necessary. The Company A payment is designed to tie Company B to Company A in relation to sales of Company A's products under Company B's brand. As in BP Australia, there are other traders in the market place who may wish to obtain distribution of their products through the particular retailer.

BP Australia also considered the issue of recurrence of expenditure. In relation to recurrence of expenditure, there was no evidence in BP Australia that fresh payments would be made at the end of the term. The current Distribution Agreement is for only for a limited number of years and Company A may have to pay additional amounts to Company B if it wishes to extend the agreement. As in BP Australia, there is no evidence that Company B can request a new payment after the contract expires but the reasonable inference is that Company B can and will do so. Further, as in BP Australia, this is not a single transaction but one of a series of similar transactions undertaken by Company A.

In BP Australia, it was again pointed out that there is a demarcation between the cost of creating, acquiring and enlarging the permanent structure of a business and the cost of earning the income of the business. This can be seen where a trader buys out a rival to acquire his goodwill. In this case, Company A has separately acquired the business and goodwill of the subsidiaries' businesses under the separate agreement to buy the shares of the top subsidiary. The Distribution Agreement does not expand Company A's business and does not provide Company A with any part of the remaining goodwill of Company B. It merely provides one more distributor who will generate income for Company A through the sale of its products. The practical advantage provided to Company A by the Distribution Agreement is the increased sale of its products.

In NAB, the bank was required to pay a lump sum (but further amounts were payable if loan quotas were exceeded) to the Commonwealth in order to have the exclusive right to make advances to Australian Defence Force personnel for a 15 year period. The lump sum was based on an estimate of the number of loans likely to be made by NAB and further payments were required if this reasonable estimate was exceeded. The Full Federal Court held that the payment was of a revenue nature as it did not enlarge the framework within which the Bank carried on its activities. Rather, it was incurred as part of the process by which the Bank operated to obtain regular returns by means of regular outlay. The Full Federal Court determined that the payment was in the nature of a marketing expense and had a revenue rather than capital aspect.

Company A has not entered into a transaction where it makes an estimate of future commission income and makes an upfront payment based on that income and further commission payments if that estimate is exceeded. However, the upfront payment is based on the future income stream from sales by Company B discounted to a present value. Separate commission payments are made for sales of Company A's products by Company B.

In a similar manner to BP Australia and NAB, the advantage sought by Company A in this instance was in the nature of marketing. The expenditure outlaid by Company A on this occasion resulted in a new brand being added to Company A's existing stable of brands. But Company A did not acquire ownership of the brands, i.e. it merely acquired the right to use the brand name for a specified period in the particular market. Company A merely commenced marketing its existing products under a new name and a new distribution channel. This arrangement is being carried out in a similar manner to Company A's existing operations, where its products are already marketed under a variety of brand banners, through various agents. Company A sought to enlarge its operations by increasing its market share and removing competitors, but did so via its existing process of marketing products using well known third party brand names.

Neither Company A nor Company B have assigned goodwill as part of the Distribution Agreement. Both have granted licences to each other to use brand names as part of the arrangement. A monopoly has not been granted to Company A to use Company B's name because Company B continues to use the name to market its other products and can, with Company A's permission, enter into other distribution arrangements.

The Distribution Agreement is not a single once and for all payment. As pointed out in BP Australia, the distribution arrangement is for a limited number of years. At the end of the contract period, a new contract may be required to extend the distribution arrangement. The length of the contract is neutral, it does not point to either a capital or revenue purpose.

In determining whether an item of expenditure falls to be capital or revenue, no one single factor is determinative. Rather, all relevant factors must be considered collectively. In this case, the Distribution Agreement is a separate transaction to the share acquisition. Assets are not acquired under the Distribution Agreement. After examining all the relevant factors, it is considered that the expenditure in entering the Distribution Agreement is not capital in nature.

The Distribution Payment is deductible under section 8-1 of the ITAA 1997 in the year of income ended 30 June 2011.

Question 2

Subsection 8-1(1) of the ITAA 1997 only allows a deduction for a loss or outgoing to the extent that it has been incurred in gaining or producing assessable income in a year of income.

Taxation Ruling 97/7 Income Tax: section 8-1 - meaning of 'incurred' - timing of deductions, discusses when a deduction is incurred by a taxpayer. As pointed out in paragraph 6 of Taxation Ruling TR 97/7:

The courts have been reluctant to attempt an exhaustive definition of a term such as 'incurred'. The following propositions do not purport to do this, they help to outline the scope of the definition. The following general rules, settled by case law, assist in most cases in defining whether and when a loss or outgoing has been incurred:

· a taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitively committed in the year of income. Accordingly, a loss or outgoing may be incurred within section 8-1 even though it remains unpaid, provided the taxpayer is 'completely subjected' to the loss or outgoing. That is, subject to the principles set out below, it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum;

· a taxpayer may have a presently existing liability, even though the liability may be defeasible by others;

· a taxpayer may have a presently existing liability, even though the amount of the liability cannot be precisely ascertained, provided it is capable of reasonable estimation (based on probabilities);

· whether there is a presently existing liability is a legal question in each case, having regard to the circumstances under which the liability is claimed to arise;

· in the case of a payment made in the absence of a presently existing liability(where the money ceases to be the taxpayer's funds) the expense is incurred when the money is paid.

Company A is an accruals taxpayer which is required to prepare its accounts in accordance with the relevant Australian Accounting Standards. Company A entered into the Distribution Agreement with Company B in June 2011. Under the Distribution Agreement, Company A was required to make the Distribution Payment to Company B in June 2011. The payment was made in June 2011 by Company A by cheque provided to Company B.

Paragraph 16 of Taxation Ruling TR 97/7 refers to W Nevill & Company Ltd v. FC of T (1937) 56 CLR 290 at 302, where it was said:

'the word used is 'incurred' and not 'made' or 'paid'. The language lends colour to the suggestion that, if a liability to pay money as an outgoing comes into existence, [the section is satisfied] even though the liability has not been actually discharged at the relevant time ... it is only the incurring of the outgoing that must be actual; the section does not say in terms that there must be an actual outgoing - a payment out.'

Paragraph 17 of Taxation Ruling TR 97/7 states:

This proposition was recently confirmed by the High Court in FC of T v. Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52 (Energy Resources) when, quoting from James Flood, it said (ATC at 4539; ATR at 56):

'Section 51(1) "has been interpreted to cover outgoings to which the taxpayer is definitively committed in the year of income although there has been no actual disbursement".'

By entering into the Distribution Agreement in June 2011, Company A entered into a legally binding commitment to pay Company B in June 2011. This commitment meant it had incurred a liability on the date it entered into the Distribution Agreement to pay the contracted amount to Company B in June 2011.

Taxation Ruling TR 94/26 Income Tax: section 8-1 - meaning of 'incurred' - implications of the High Court decision in Coles Myer Finance discusses when an amount which has been incurred is properly referrable to a particular year of income. At paragraph 7, it is stated:

In our opinion there are certain cases in which three criteria must be met before an expense satisfies either limb of subsection 8-1(1):

(a) as previously stated, there is a presently existing liability (called the jurisprudential approach by the High Court in Coles Myer Finance);

(b) the loss or outgoing which arises as a consequence of that liability is of a revenue character; and

(c) all or part of the loss or outgoing is properly referable to the particular year in question.

At paragraph 8, it is explained that these three criteria must be satisfied in all cases involving:

(a) financing transactions; or

(b) a liability accruing daily; or

(c) a liability accruing periodically.

In the case of the Distribution Agreement, there is no financing element involved. The amount of the Distribution Payment is calculated as the discounted or net present value of the predicted future cash flows. There is a liability to pay the full amount of the contracted Distribution Payment in June 2011 and the payment was made in June 2011. The amount does not accrue daily over the term of the contract. In the event of the termination of the Distribution Agreement, Company B must repay Company A an amount equal to the contracted payment calculated on a pro rata basis over the full contract term. But this termination payment is not based on the actual sales of Company A's products by Company B. It is calculated on a straight line basis and is not connected to sales. It does not impact on the initial liability of Company A to make the full Distribution Payment to Company B.

Subsection 8-5(2) of the ITAA 1997 provides that some provisions of the Act prevent a deduction that could otherwise be deductible, or limit the amount that can be deducted.

Subdivision H in Division 3 of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) applies to certain advance expenditure of taxpayers. Section 82KZMA of the ITAA 1936 sets out the amount and timing of deductions for certain prepaid expenditure. Among other requirements, paragraph 82KZMA(3)(c) states that the expenditure must be incurred in return for the doing of a thing under the agreement that is not to be done wholly within the expenditure year.

The Distribution Payment is only one of a number of payments which Company A is required to pay to Company B under the Distribution Agreement. Company A will also make commission payments to Company B relating to the provision of products and related services. Company A and Company B will further make other specified payments to each other depending on the growth or reduction in total income for products and services supplied over a financial year. Additionally, there is a profit share arrangement between Company A and Company B.

As there are a number of separate payments paid to Company B for products and services provided under the Distribution Agreement, it is not possible to link any particular activity to the Distribution Payment. There is no evidence that Company B is required to do a thing outside the expenditure year in return for receiving the Distribution Payment. Accordingly, paragraph 82KZMA(3)(c) is not satisfied.

It is accepted that the Distribution Payment is incurred in June 2011 when the contract is signed and is incurred in the year ended 30 June 2011.

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