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Ruling

Subject: Deductibility of expenditure incurred under a contract

Question 1

Is a deduction allowable under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for expenditure incurred under the 'purchase agreement'?

Answer

No

This ruling applies for the following period:

1 July 2010 to 30 June 2011

The scheme commenced on:

29 June 2011

Relevant facts and circumstances

You have entered into an arrangement to purportedly acquire credits to reduce your carbon emissions ('emission credits').

You stated that you entered into this arrangement as part of your marketing and advertising activities.

You entered into two agreements:

· a purchase agreement, and

· a licence agreement.

For the purposes of describing the Scheme to which this Ruling applies, there are no other agreements, whether formal or informal, and whether or not legally enforceable, which you, or any of your associates, will be a party to, which are part of the Scheme.

Purchase Agreement

The purchase price is payable in two instalments as follows:

· a small deposit payable on the date the agreement was executed (the 'first instalment'); and

· the remainder being payable within 10 days of you receiving deliver from the seller (the 'final instalment').

The seller will give you a delivery notice as soon as practicable following completion of the projects producing the emission credits.

The delivery notice will:

· trigger the requirement to make the final instalment; and

· give you 20 day's notice of the delivery of the necessary documents to confer on you all rights in, title to and interest in the emission credits.

Delivery requires the seller to send you all relevant documents, or such other steps which may be required to confer on you all rights in, title to and interest in the emission credits.

If you have not received a delivery notice within three years of the date the contract was executed, you will be entitled to terminate the purchase agreement. If you elect to terminate the purchase agreement, you will not be entitled to repayment of any part of the purchase price paid prior to the termination date, nor will any unpaid amount of the purchase price become payable.

Licence agreement

Pursuant to the licence agreement you have been granted the non-exclusive right to publish, reproduce, adapt and otherwise fully exploit the intellectual property for the term of the licence.

The intellectual property consists of a number of logos for use in your advertising.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Question 1:

Is a deduction allowable under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for expenditure incurred under the purchase agreement?

Section 8-1 of the ITAA 1997 allows a deduction for any loss or outgoing to the extent that:

· it is incurred in gaining or producing your assessable income; or

· necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income (subsection 8-1(1) of the ITAA 1997).

However, you cannot claim a deduction under section 8-1 for a loss or outgoing to the extent that it is an expense that is capital, private or domestic in nature (subsection 8-1(2) of the ITAA 1997).

Meaning of 'incurred'

In order for an expense to be deductible under section 8-1 of the ITAA 1997 for an income year it must first be established that the expense was incurred during the income year.

The term 'incurred' is not defined in the Act. The ATO view of the meaning of the term 'incurred' in the context of section 8-1 is set out in Taxation Rulings TR 94/26 and TR 97/7.

Paragraph 6 of TR 97/7 provides that 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 (See for example W Nevill & Co Ltd v. FC of T (1937) 56 CLR 290; 4 ATD 187 per Latham CJ and FC of T v. James Flood Pty Ltd (1953) 88 CLR 492 at 507-508 per Dixon CJ). 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 (also see paragraph 3 or TR 94/3).

Paragraph 6 of TR 94/26 provides that whether there is a presently existing pecuniary liability is a question which must be determined in light of the particular facts of each case, and especially by reference to the terms of the contract or arrangement under which the liability is said to arise.

In Coles Myer Finance Pty Ltd v FC of T 93 ATC 4214, at 4222, Deane J made the following comment about the meaning of the term 'incurred':

…the critical question is not whether, as a matter of legal analysis, the liability is theoretically contingent or defeasible; rather, whether the entity was 'definitively committed' or 'completely subjected' to the obligation to make the payment in the future even though it had not yet come under an immediate obligation enforceable by law to do so.

In Commissioner of Taxation v Malouf [2009] FCAFC 44 the taxpayer, as a partner in a partnership, contracted to purchase vacant land with the intention of building a retirement village at a subsequent date. An initial deposit was pad in 1999 with the remainder due after the completion of the first stage of building. The first stage of building never occurred. The taxpayer claimed his share of the partnership loss resulting from a deduction claim for the full purchase price in 1999. The Commissioner disallowed it. The Court agreed with the Commissioner's approach.

The Court held having regard of the terms of the contract the partnership was not entitled to a deduction in full because the 'pecuniary liability was not incurred at the time of entering into the contract, but would only be incurred upon settlement' (Commissioner of Taxation v Malouf (Malouf) [2009] FCAFC 44, at [50]).

In reaching that conclusion, the Court noted that 'the major portion of the value which the [partnership] obtained under the contract related to a development which did not exist at the time the contract was entered into by the parties.' It also noted that on the terms of that contract, the partnership's obligation to pay the full purchase price was dependant on further performance of the vendor, and would only arise if and when that performance was completed (Commissioner of Taxation v Malouf [2009] FCAFC 44, at [48]).

Did you incur expenditure under the Purchase Agreement during the 2010-11 income year?

Initial instalment

Pursuant to the purchase agreement you were required to pay part of the purchase price upon execution of the agreement. Therefore, the initial instalment was incurred by you during the relevant income year.

Final instalment

You will only be required to pay the final instalment when and if a delivery notice is issued to you by the seller. Therefore, your liability to make the final instalment is contingent upon:

a. the seller issuing you a delivery notice within three years; or

b. the seller issuing you a deliver notice after three years where you have not exercised your right to terminate the purchase agreement.

These contingencies are not merely theoretical because, in addition to the actual generation of the emission credits of the quality and quantity required under the purchase agreement, positive action is required from the seller before your obligation to pay the final instalment arises. As was the case in Malouf, you will only be obliged to pay the final instalment if the emission credits comes into existence and the seller undertakes further action.

Therefore, you have not incurred a loss or outgoing in respect of the final instalment. You are not definitively committed to paying the final instalment at the time you enter into the purchase agreement. Rather, you will only become definitely committed to paying the final instalment at an indeterminate point in the future, if and when the above contingencies are satisfied.

As such, you did not incur the final instalment in the relevant income year.

Character of the expenditure

An expense will be deductible under section 8-1 if its essential character is that of the expenditure that has a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income (provided that the expenditure is not of a capital, private or domestic nature). The essential character of an expense is a question of fact to be determined by reference to all circumstances (paragraph 2 of Taxation Ruling TR 95/33).

The courts have held that to have the character of the expenditure that has sufficient connection with the income producing activities of the taxpayer, the expenditure must be incurred in the circumstances where it is conducive to the gaining of assessable income, or to the carrying on of a business by the taxpayer (Magna Alloys & Research Pty Ltd v FC of T 80 ATC 4542, at 4549; Taxation Ruling TR 2006/2). Its occasion must be found in whatever is productive of actual or expected assessable income (Payne v FC of T 2001 ATC 4027, at 4030). Essential to this inquiry is the determination of what is productive of the assessable income (FC of T v Day [2008] HCA 53, at [31]).

In Magna Alloys & Research Pty Ltd v FC of T 80 ATC 4542, at 4249, Brennan J said:

But in ascertaining whether this connection exists the character of the taxpayer's undertaking or business must be known; and in order to say what the relationship to the undertaking or business is borne by the incurring of expenditure, it is necessary to identify what the expenditure is for. Thus, in FC of T v The Midland Railway Co. of Western Australia Ltd. (1952) 85 C.L.R. 306, Dixon J referring to a number of considerations which bore upon deductibility of the payments there in question said (at p.313):

"The second consideration is that what governs the issue is the business purposes for which the outgoing was incurred from the point of view of the taxpayer company. The controlling factors are those which arise from the character of the business or undertaking and the relation which the expenditure or the liability to make it bore to the carrying on of the business or the gaining of assessable income.''

In Day the majority of the High Court observed that:

That no narrow approach should be taken to the question of what is productive of a taxpayer's income is confirmed by cases which acknowledge that account should be taken of the whole of the operations of the business concerned in determining questions of deductibility.

However, as the High Court also observed in Spriggs v FC of T; Riddell v FCT (2009) ATC 20-190, in order to determine deductibility it is necessary to consider the scope of the taxpayers business. This in turn necessitates '… both a wide survey and an exact scrutiny of the taxpayer's activities' (Spriggs v FC of T; Riddell v FCT (2009) ATC 20-190 at [60]).

Initial instalment

You incurred the initial instalment under the purchase agreement as part consideration for the emission credits that may be delivered to you if, and when, they are generated and if, and when, there is a system in place for trading such credits. You have entered into the purchase agreement voluntarily as part of the wider arrangement, including the licence agreement, for the purpose of advertising and marketing your business.

On the basis of the information you provided to the Commissioner, and additional limited factual enquires, and having considered that material in making both a wide survey and a exact scrutiny of your activities, it is considered that there is insufficient material upon which it can be concluded that either the initial, or the final, instalment is sufficiently connected with your business.

Final instalment

As explained in the discussion under the heading 'Meaning of incurred' above, the final instalment has not been incurred in the relevant income year. A deduction is not allowable for the final instalment under section 8-1 of the ITAA 1997.

As explained above, even if it was assumed that the final instalment was incurred in the 2010-11 income year the information that forms the basis of this ruling does not establish a sufficient connection between the instalment and your business. Accordingly, a deduction would still not be allowable for the final instalment under section 8-1 of the ITAA 1997.

Loss or outgoing of a capital or of a capital nature

If, contrary to the discussion above, it is assumed that section 8-1(1) of the ITAA 1997 is satisfied it is then necessary to consider section 8-1(2) of the ITAA 1997 and, in particular, whether the loss or outgoing is capital or of a capital nature.

In determining whether the loss or outgoing is capital or of a capital nature the starting point is the often repeated statement of Dixon J in Sun Newspapers Ltd & Associated Newspapers Ltd v. FC of T (1938) 61 CLR 337,at 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.

Another consideration is whether the outlay is a periodic one covering the use of the asset or advantage during each period, or whether the outlay is calculated as a single final provision for the future use or enjoyment of the asset or advantage.

Paragraph 5 of Taxation Determination TD 95/44 states:

Distinguishing capital from revenue expenditure is a question of fact and degree. Relevant considerations include: whether the expenditure relates to the business structure itself or the process of operating it; the nature of the asset or advantage sought (including its lasting qualities); and the degree of recurrence (see Sun Newspapers Ltd & Associated Newspapers Ltd v. FC of T (1938) 61 CLR 337; 5 ATD 87).

If it is assumed that there is a sufficient connection between the initial and/or the final instalment and your business then it is necessary to consider the character of the advantage obtained by that expenditure and how that advantage was obtained. Both the initial and the final instalments are one off payments. There appears to be no express, or implied, time limit on your ability to rely on the purchase agreement in your marketing and advertising activities.

We consider the better view is that the initial and final instalments achieve an enduring benefit of a capital or of a capital nature.

ATO view documents

Taxation Ruling TR 94/26 Income tax: subsection 51(1) - meaning of incurred - implications of the High Court decision in Coles Myer Finance

Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of incurred - timing of deductions

Taxation Ruling TR 95/33 Income tax: subsection 51(1) - relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings

Taxation Ruling TR 2006/2 Income tax: deductibility of service fees paid to associated service entities: Phillips arrangements

Taxation Determination TD 95/44 Income tax: can research and development expenditure incurred by a business be deductible under section 8-1 of the Income Tax Assessment Act 1997 ('the 1997 Act')?

Other references (non ATO view, such as court cases)

Chacmol Holdings Pty Ltd v Handberg [2005] FCAFC 40)

Coles Myer Finance Ltd v. Commissioner of Taxation (1993) 176 CLR 640

Commissioner of Taxation v Malouf [2009] FCAFC 44

FC of T v Day [2008] HCA 53

Magna Alloys & Research Pty Ltd v FC of T 80 ATC 4542

Payne v FC of T 2001 ATC 4027

Spriggs v FC of T; Riddell v FCT (2009 ATC 20-190)

Sun Newspapers Ltd & Associated Newspapers Ltd v. FC of T (1938) 61 CLR 337; 5 ATD 87

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