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Ruling

Subject: Business deductions

Question 1:

Is the weekly lease fee deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

Yes

Question 2:

Is the consultancy fee deductible under section 8-1 of the ITAA 1997?

Answer:

No

Question 3:

Does the consultancy fee form part of the cost base of the lease?

Answer:

Yes

Question 4:

If you exercise the option to purchase, is the amount credited for the weekly lease fee included in your assessable income?

Answer:

Yes

Question 5:

If you exercise the option to purchase, is the amount credited for the consultancy fee taken to be capital proceeds from capital gains tax (CGT) event C2?

Answer:

Yes

Question 6:

If you exercise the option to purchase, is the amount credited for the weekly lease fee and consultancy fee included in the cost base of the franchise business?

Answer:

Yes

This ruling applies for the following period:

Year ended 30 June 2011

The scheme commenced on:

1 July 2010

Relevant facts and circumstances

You entered into an agreement to lease a franchise business with an option to purchase.

The lease period is X years, and you can exercise your option to purchase at any time during the lease period.

You are required to pay a non refundable upfront payment of $X which is referred to as a consultancy fee, and a bond of $X.

You are also required to pay a weekly lease fee that is calculated with reference to the number of customers you serve each week.

The purchase price of the franchise is $X.

If you exercise your option to purchase the franchise, the consultancy fee, the bond (less any deductions made in accordance with the lease agreement) and a portion of the weekly lease fees you have paid will be credited against the purchase price.

The consultancy fee is not defined in the lease agreement; however you have provided the following information. The consultancy fee covers the entire lease period. It enables the lessee to contact the lessor for questions or advice in the running of the franchise. The contact that is made in relation to the consultancy fee is generally:

· initial for training and takeover

· a number of phone calls a week for advice

· a trip to the head office a number of times a year.

You have been employed in a franchise in another city and are familiar with the system the franchise uses.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 6-10

Income Tax Assessment Act 1997 Subdivision 20A

Income Tax Assessment Act 1997 Subsection 20-20(2)

Income Tax Assessment Act 1997 Section 103-10

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Paragraph 108-5(1)(b)

Income Tax Assessment Act 1997 Subsection 110-25(2)

Income Tax Assessment Act 1997 Subsection 116-20(1)

Reasons for decision

Summary

The weekly lease fees are deductible under section 8-1 of the ITAA 1997. If you exercise your option to purchase the franchise and receive a credit for a portion of the lease fees, this credit will be included in your assessable income as an assessable recoupment under subsection 20-20(2) of the ITAA 1997. This amount will be included in the first element of the cost base for the purchase of the franchise.

The consultancy fee is considered to be a capital expense and to have the true nature of a lease premium. It is therefore not deductible under section 8-1 of the ITAA 1997; however it will form part of the cost base for the acquisition of a CGT asset, being the lease. Upon the expiry or cancellation of the lease, CGT event C2 will occur. If you receive a credit for the consultancy fee as a result of exercising your option to purchase the franchise, this credit will represent capital proceeds from CGT event C2. This amount will also be included in the first element of the cost base for the purchase of the franchise.

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

Weekly lease fees

Lease fees, or periodical payments made in relation to the use and enjoyment of leased assets are generally deductible under section 8-1 of the ITAA 1997.

You will incur a weekly lease fee that is calculated in relation to the number of clients you serve. This expense is periodical and relates to your use and enjoyment of the leased assets. The fees are revenue in nature and accordingly, are deductible under section 8-1 of the ITAA 1997 in the year they are incurred.

Consultancy fee

Over time the Courts have formulated various indicators that are used in determining whether expenditure is of a capital or revenue nature. The indicator of the character of the advantage sought now prevails as the leading Australian test in determining whether expenditure is of a capital or revenue nature. As stated by the Full Court of the High Court in G.P. International Pipecoaters Pty Ltd v. FCT 90 ATC 4413 at page 4419:

...the character of the expenditure is ordinarily determined by reference to the nature of the asset acquired or of 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

However, as stated by the Privy Council in BP Australia Ltd v. FCT 1964 ATD: 112 CLR 386: 

The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in another. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is commonsense appreciation of all the guiding features which must provide the ultimate answer.

That answer depends on 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 (per Dixon J in Hallstroms).

A lease premium is not defined in Australian tax law. It is therefore necessary to consider its meaning from an ordinary or legal perspective. A lease premium is consideration paid to the lessor for the leasehold interest over the asset, that is, the grant of a lease.

If an amount paid or payable is properly regarded as consideration for the grant of a lease, then the amount is properly characterised as capital in nature. Legal or equitable rights that are not property, such as those granted under a lease agreement, are CGT assets within the meaning of paragraph 108-5(1)(b) of the ITAA 1997. Amounts payable to acquire those rights will form part of the cost base of the CGT asset. Upon extinguishment, or another event happening to those rights, they will be taken into account when calculating a capital gain or loss.

The terms of lease agreements entered into by a lessor and lessee are important, although not necessarily decisive, in determining the proper characterisation of an amount paid by a lessee. The courts will look to the true nature of the transactions between the lessor and the lessee, and are not bound by the label which the lessor and lessee attribute to the transactions (Taxation Ruling TR 96/24).

In determining the true nature of transactions, the character of the advantage sought must be ascertained; it must be determined whether what was being obtained was a capital asset. There have been a number of cases that have determined that an option to purchase is an indicator that the advantage sought was a capital asset (F.C. of T. v. South Australian Battery Makers Pty Limited 78 ATC 4412; (1978) 140 C.L.R. 645).

In this case, you entered into an agreement that gave you the right to use the franchise system and intellectual property and to use the business premises and equipment. The agreement included an option to purchase. A non-refundable consultancy fee was paid on commencement of the lease. The agreement itself does not define or explain the consultancy fee. You have provided information to explain the consultancy fee entitles you to ongoing training and support in relation to the running of the franchise business. There is no indication that the fee has been calculated with reference to the value of the provision of services that will be provided.

The consultancy fee is non-refundable if the lease agreement is terminated for some other reason than the purchase of the business; this supports the argument that the fee relates to the granting of the lease rather than the provision of ongoing future services.

The reason that the consultancy fee was payable was that you entered into the lease agreement. You secured a number of rights as a result of the lease including the right to access training and advice. However, these rights are common in franchise related agreements. Although the assistance is provided as a result of the lease agreement, we consider that the consultancy fee relates to the overall acquisition of the lease rights. The payment is best described as a lease premium and is capital in nature.

As the payment is capital in nature it is not deductible under section 8-1 of the ITAA 1997. However, the payment was made in respect of acquiring a CGT asset, the lease, and will therefore for part of the first element of the cost base of the lease.

Assessable recoupment

Section 6-10 of the ITAA 1997 provides that a taxpayer's assessable income includes statutory income amounts that are not ordinary income but are included in assessable income by another provision.

Section 10-5 of the ITAA 1997 lists those provisions applicable to section 6-10 of the ITAA 1997 referring to assessable income. Included in that list is recoupment for certain losses and outgoings that are deductible under Subdivision 20-A of the ITAA 1997.

Subsection 20-20(2) of the ITAA 1997 provides that an amount you have received as a recoupment of a loss or outgoing is an assessable recoupment if:

· you received the amount by way of insurance or indemnity; and

· you can deduct the amount for the loss or outgoing for the current year, or you have deducted it or can deduct an amount for it for an earlier income year, under any provision of the ITAA 1997.

If you exercise your right to purchase the business, you will receive a credit on the purchase price for a portion of the weekly lease fees you have paid, up to $X. You will be taken to have received this amount by way of indemnity as it will indemnify you against a portion of the purchase price. As previously discussed, you are entitled to deduct an amount for the weekly lease fees you pay under section 8-1 if the ITAA 1997.

Accordingly, the amount that you receive as a credit of the weekly lease fee will be included in your assessable income under subsection 20-20(2) of the ITAA 1997.

Capital proceeds of CGT event C2

CGT event C2 happens under section 104-25 of the ITAA 1997 if your ownership of an intangible CGT asset ends by the asset:

· being redeemed or cancelled

· being released, discharged or satisfied

· expiring

· being abandoned, surrendered or forfeited

· if the asset is an option - being exercised; or

· if the asset is a convertible interest - being converted.

As previously discussed, a lease is a CGT asset. When the lease ends, either by way of expiry or by way of you exercising your option to purchase the business, CGT event C2 will occur.

Capital proceeds from a CGT event include any money you have received, or are entitled to receive, in respect of the CGT event happening. If you exercise your option to purchase the business, you will receive a credit of the consultancy fee, or lease premium, towards the purchase price of the business.

Section 103-10 of the ITAA 1997 provides that you are taken to have received money in relation to a capital gains tax event if it has been applied for your benefit (including by discharging all or part of a debt you owe) or as you direct.

If you exercise your option to purchase, section 103-10 of the ITAA 1997 will apply to you and you will be taken to have received the amount you will be credited for the consultancy fee, or lease premium. This amount will be applied for your benefit, against the purchase price of the franchise.

In this case the cost base of the lease, being the premium paid, will be equal to the capital proceeds. Accordingly you will make a nil capital loss or gain in these circumstances.

Note:

If you do not exercise your option to purchase the business, CGT event C2 will still occur upon expiry of the lease. In these circumstances, you will not receive any capital proceeds from the event and will incur a capital loss equal to the cost base of the lease (being the consultancy fee, or premium paid to acquire it).

Cost base of franchise

The cost base of a CGT asset consists of five elements. The first element of the cost base is the total of:

· the money you paid, or are required to pay, in respect of acquiring it; and

· the market value of any other property you gave, or are required to give, in respect of acquiring it.

If you exercise your option to purchase, you will receive a credit against the purchase price for a portion of the weekly lease fees and the consultancy fee, or lease premium that you have paid. As discussed above, the weekly lease fees will be treated as an assessable recoupment and included in your assessable income.

Additionally, you will be treated to have received the consultancy fee as capital proceeds in relation to CGT event C2 as it will be applied for your benefit towards the purchase price.

Accordingly, both of these amounts that will be credited towards the purchase price will still form part of the first element of the cost base for the purchase of the business.

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