Edited version of your written advice

Authorisation Number: 1012710418185

Ruling

Subject: Deductibility of entitlement fees

Question 1

Are entitlement fees deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) and in which income year(s) may the deductions be claimed?

Answer

No, deductions are not allowable in any year

Question 2

Are entitlement fees deductible under section 40-880 of the ITAA 1997?

Answer

No

Question 3

Are entitlement fees deductible under any other provision of the ITAA 1997 or the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No

Question 4

Does any other provision of the ITAA 1997 or the ITAA 1936 deny a deduction for the entitlement fees incurred by the taxpayer?

Answer

No

This ruling applies for the following periods

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

Year ended 30 June 2015

Year ended 30 June 2016

Year ended 30 June 2017

Year ended 30 June 2018

Year ended 30 June 2019

Year ended 30 June 2020

Year ended 30 June 2021

Year ended 30 June 2022

The scheme commenced on

1 July 2009

Relevant facts

The taxpayer operates a business which provides a number of different services some of which require a licence.

All of these services have been offered by the business for a number of years. One of the activities requires the taxpayer to own a number of entitlements.

The entitlements were previously owned by another entity and sub-licensed by the taxpayer. In recent times new State regulatory rules have operated to allow the entitlements to be owned by the taxpayer.

The entitlements are issued for a period of 10 years and may be extended for up to two further years.

The taxpayer paid a non-refundable bond in order to participate in the process to obtain the entitlements.

The taxpayer was successful in the process and became liable for the whole of the price of the entitlements acquired.

The taxpayer is paying the purchase price of the entitlements by instalments.

Payment conditions for the entitlements are described in the Agreement between the taxpayer and the State. There is State legislation which governs the criteria to obtain, purchase and manage the entitlements. This includes the ability to transfer the entitlements and the process that will happen if the taxpayer forfeits the entitlements.

Assumptions

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 82KZL(1)

Income Tax Assessment Act 1936 Section 82KZMA

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 40-30

Income Tax Assessment Act 1997 Section 40-880

Income Tax Assessment Act 1997 Section 103-15

Income Tax Assessment Act 1997 Section 104-5

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 108-5

Reasons for decision

Question 1

Are entitlement fees deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) and in which income year(s) may the deductions be claimed?

Section 8-1 of the ITAA 1997 states the following:

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:

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

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

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

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

Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions (TR 97/7) sets out the Commissioner's view of the meaning of the term 'incurred'. As a broad guide, you incur an outgoing at the time you owe a present money debt that you cannot escape (paragraph 5 TR 97/7).

The term 'incurred in gaining or producing your assessable income', is to be read as meaning 'incurred in the course of gaining or producing your assessable income'. In Amalgamated Zinc (De Bavay's) Ltd v FC of T (1935) 54 CLR 295 at p 303, Dixon J said:

" The expression 'in gaining or producing' has the force of 'in the course of gaining or producing' and looks rather to the scope of the operations or activities and the relevance thereto of the expenditure than to purpose in itself."

The courts have held that for there to be a deduction under section 8-1 of the ITAA 1997 there must be a sufficient connection between the loss or outgoing and the production of assessable income. The loss or outgoing must be incidental and relevant to the earning of assessable income (Ronpibon Tin NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431; (1949) 4 AITR 236)

In your case:

• for many years you have operated a business and earn your assessable income by providing a range of services to patrons

• until recently you provided a service under a sub-licence owned by another entity

• a new regime was enacted so that you were able to hold entitlements in your own capacity

• you paid a non-refundable bond and subsequently successfully bade for entitlements

• the bond was allocated towards the total price of the entitlements

• a Minister's Agreement was executed

It is considered that in the relevant income year the taxpayer had a present money debt pertaining to the acquisition of the entitlements, which is an outgoing incidental and relevant to the taxpayer producing assessable income through the provision of services to its patrons.

Accordingly, the taxpayer's liability that arose in the relevant income year in obtaining gaming entitlements is an outgoing that is incurred for the purposes of section 8-1(1) of the ITAA 1997.

Are entitlement fees an outgoing of capital, or of a capital nature?

The first negative limb of section 8-1(2) of the ITAA 1997 denies a deduction for a loss or outgoing incurred where it is a loss or outgoing of capital, or of a capital nature.

Character of the advantage sought

The primary authority in determining whether an amount of expenditure is capital in nature is Dixon J's statement in Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) CLR 337 (the Sun Newspapers Case)

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 periodic 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.

The indicators from the Sun Newspapers Case which point towards an expense being capital in nature are:

• The expenditure is related to the business structure itself. This includes the establishment, replacement or enlargement of the profit yielding structure of business rather the money earning process.

• The nature of the asset has lasting and enduring benefit to the business.

• The payment is made 'once and for all' being a single final provision for the future use or enjoyment of the asset or advantage rather than on a regular basis, such as weekly, monthly or yearly or for a specific period.

The taxpayer claims that no tangible asset or monopoly right is acquired as a result of the payments, the period of entitlement is limited, the taxpayer was already operating such a business so no new business commenced as a result of the payments being made and the outlays are periodic,

Do the payments enlarge the income producing framework?

In National Australia Bank Limited v Federal Commissioner of Taxation 97 ATC 5153 (the NAB Case) the Full Federal Court held that a $42 million payment to the Commonwealth for the right to make subsidised home loans to Australian Defence Force personnel was on revenue account as the

payment did not enlarge the framework within which the Bank carries on its ordinary activities of borrowing and lending; rather it increased the flow of the Bank's ordinary lending activities.

It is claimed that the entitlement fees should be deductible to the taxpayer under section 8-1 of the ITAA 1997 as the payments do not enlarge the framework in which the taxpayer carries on its business, but rather go to the continuity of the taxpayer's business.

In the NAB Case, the Full Federal Court ruled that the payments in increasing the flow of the Bank's ordinary lending activities obtained regular returns by means of regular outlay. It was determined that the payment was in the nature of a marketing expense and had a revenue rather than capital aspect.

In BP Australia Ltd v. Federal Commissioner of Taxation (1965) 112 CLR 386; (1965) 14 ATD 1; (1965) 9 AITR 615 (BP Australia Case) 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 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.

Unlike the NAB and BP Australia cases, it could not be said the advantage sought by the taxpayer in this instance was in the nature of marketing. The outgoing incurred by the taxpayer served to advantage that part of its business structure required for the provision of particular services to patrons, and not the process by which it operated to obtain regular returns by regular outlay.

Is there an enduring asset?

It is claimed that the entitlement fees do not secure the taxpayer an enduring asset, the licence period is quite short and on the expiry of the entitlements the taxpayer will cease to be able to operate the service unless it secures (an extension for up to two years) another allotment in the next auction where the State entity will (if the current legislation continues) allocate entitlements to successful bidders.

It is claimed that the position of the taxpayer is akin to that of the taxpayer in Federal Commissioner of Taxation v Citylink Melbourne Ltd 2006 ATC 4404 (City Link Case) in which the concession fees paid by the respondent to secure a right to design, construct, operate and impose a toll in respect of certain City Link roads for over 33 years were held to be on revenue account.

The main distinguishing feature between the taxpayer and the City Link Case is the period for which the right is acquired. In the taxpayer's case, payment for the entitlements are for an amount which is payable as a lump sum or as instalments. The instalments are not paid for a specified part of the ten year period and are not considered to be a periodical fee. The State entity sent the taxpayer a letter listing an Account Summary of the Total Value of Entitlements, the instalment received, total balance due, and a Payment Schedule of interest free instalments for the entitlements.

The City Link Case at paragraph 141 states:

Clause 3.1 of the Concession Deed stipulates that each concession fee is an annual liability payable semi-annually. For periods less than six months, the amount of the fee is adjusted pro-rata. The amount of the liability for concession fees corresponds precisely to the period to which a concession fee relates. Furthermore, while the concession fees represent a base fee, the additional concession fees were calculated on the basis of additional revenue which was generated within the particular period.

The City Link Case at paragraph 151, referring to an earlier decision for case, states:

The Full Court also found the concession fees were a periodical and recurrent expense of conducting the respondent's business operations rather than an expense to acquire a profit-making enterprise.

This passage is referenced to City Link Melbourne Ltd v FC of T 2004 ATC 4945, paragraph 70, which states:

With respect to the learned Primary Judge the present is not a case where Transurban agreed to pay a lump sum in instalments, where it would, no doubt, be correct to describe the Concession Fee as being 'a single concession fee'. In the event that the State defaulted in its obligations there would be no obligation thereafter to pay further instalments. Further in certain situations Transurban would, if not itself in default, not be obliged to pay the Concession Fee. In essence the Concession Fee was no different from the rental that would be payable for the parking station lease to which reference was made. To say that if that lease continued the rental was a lump sum because (unless there were rental escalations) it would be possible to calculate the total amount payable does not convert periodic rental to a single lump sum amount having the character of capital. The rental, like the Concession Fee here is payable for the use and occupation of or the right to conduct the operation in periods commensurate with the obligation to make payment. It should, accordingly be seen to be periodical and recurrent and thus a cost of conducting the business operations rather than a cost of acquiring a profit making enterprise.

In contrast to the features of City Link Melbourne Ltd v FC of T 2004 ATC 4945, the Entitlement Related Agreement does not consider the State defaulting in its obligations and the consequence on the taxpayer's obligation to pay instalments. However, the agreement may be terminated by agreement in writing between the taxpayer and the Minister.

The payments made in accordance with the agreement are not paid for the right to conduct the operation for periods commensurate with the obligation to make payment.

In conclusion, it is considered the Commissioner cannot rely on the City Link Case to make a conclusive decision on capital versus revenue for the taxpayer as it is considered the facts in the City Link Case and the taxpayer's circumstances are different and a close analogy cannot be made.

As to whether the entitlements are an enduring asset, the term enduring was referred to by Rich J at page 547 in Herring v. FCT (1946) 72 CLR 543, who stated that

by enduring it is not meant that the asset or advantage should last forever. It is a matter of degree and only one element to be considered.

In this case the taxpayer directly acquired from the State entitlements which replaced the entitlements it sub-licenced from another entity. The entitlements are legal rights which fall within the definition of a 'CGT asset' in section 108-5 of the ITAA 1997.

It is considered that the outgoing was incurred to acquire the entitlement assets because of the enduring benefit the entitlements have to the taxpayer's business. The enduring benefits include:

• the term of the entitlements is 10 years;

• without the entitlements the taxpayer cannot offer services from its premises to patrons;

• the conditions imposed on entitlements include regional and municipal limits on the numbers of entitlements, giving the holder a level of exclusivity

• the taxpayer may transfer entitlements in accordance with the provisions of the relevant act

• if the taxpayer defaults in making its instalment of purchase price payments, the proceeds arising from the allocation of an entitlement forfeited (less any State-owned amounts) must be paid to the taxpayer who forfeited that entitlement.

Even though there are default provisions in the Minister's Agreement and the relevant act which may result in a forfeiture of entitlement(s) if an instalment is not paid, it is considered unrealistic to conclude that the taxpayer is only buying the benefit of the entitlements for a period shorter than the entire 10 year term.

It is considered that the benefit of the entitlements is not refined to any period other than the full 10 year term of the entitlements.

The taxpayer expects that the allocation process is to occur each 10 years so that they will be able to hold a successive series of entitlements such that they can continue to operate that aspect of their existing business. In these circumstances, the enduring benefit of the entitlements extends past the initial 10 year term.

It is considered that an enduring asset of at least 10 years is attained through the entitlement fees and the outlays are capital in nature.

Quarterly payments

In the NAB Case a lump sum payment of $42 million was ruled to be a revenue expense. The decision was made that the payment was in the nature of a marketing expense and had a revenue rather than capital aspect.

In this case the taxpayer had the choice of paying the purchase price upfront or paying by interest free instalments. The choice made was to pay by interest free instalments. As above, the entitlement fees purchased an enduring asset and the outlay is capital in nature. The purchase of an enduring asset, paid in a lump sum or by instalments, is still a capital outlay. The method of payment does not change the character of the outgoing from capital to revenue in nature.

Summary

The court cases in NAB, BP Australia and City Link cases, are not considered appropriate to determine that the entitlement fees are on revenue account.

The entitlement fees allow the business to enlarge. Without the entitlement fees the taxpayer would not be able to operate part of its business and generate income from it. The revenue allows the taxpayer's business to enlarge.

The entitlement fees allow an enduring asset of at least 10 years to be attained.

Although the entitlement fees were paid in interest free instalments rather than a lump sum, as the fees purchased an enduring asset, the outlays remained capital in nature rather than on revenue account.

The entitlement fees are considered to be capital and are not deductible under section 8-1(2)(a) of the ITAA 1997. A deduction is not allowable in any year.

Prepayment rules

Subsection 82KZMA of the Income Tax Assessment Act 1936 (ITAA 1936) states:

82KZMA(1) Overview. Section 82KZMD sets the amount and timing of deductions for expenditure that a taxpayer incurs in a year of income (the expenditure year), if:

(a) apart from that section, the taxpayer could deduct the expenditure for the expenditure year under:

(i) section 8-1; or

(ii) section 355-205 (R&D expenditure) or 355-480 (earlier year associate R&D expenditure);

of the Income Tax Assessment Act 1997; and

(b) the requirements in subsections (2), (3), (4) and (5) are met.

As stated above, the taxpayer cannot deduct the outgoing under section 8-1(2)(a) of the ITAA 1997.

Subsection 82KZMA(4) of the ITAA 1936 prescribes that the expenditure must not be 'excluded expenditure'.

Subsection 82KZL(1) of the ITAA 1936 lists what the term 'excluded expenditure' means. Relevant to this case paragraph (d) of the definition of 'excluded expenditure' states:

to the extent that it is a capital nature and cannot be deducted under:

(i) section 355-205 (R&D expenditure); or

(ii) section 355-480 (earlier year associate R&D expenditure);

of the Income Tax Assessment Act 1997;

The case does not involve research and development (R&D) under Division 355 of the ITAA 1997 and therefore the outgoing cannot be deducted under either section 355-205 or 355-480 of the ITAA 1997.

As the outgoings are considered to be of a capital nature the outgoing meets the definition of 'excluded expenditure' under subsection 82KZL(1) of the ITAA 1936.

Accordingly, subsection 82KZMA(4) of the ITAA 1936 is satisfied and therefore section 82KZMD of the ITAA 1936 does not apply to set the amount and timing of deductions.

Question 2

Are the entitlement fees deductible under section 40-880 of the ITAA 1997?

Section 40-880 of the ITAA 1997 states the following:

Object

40-880(1) The object of this section is to make certain business capital expenditure over 5 years if:

(a) the expenditure is not otherwise taken into account; and

(b) deduction is not denied by some other provision; and

(c) the business is, was or is proposed to be carried on for a taxable purpose.

Deduction

40-880(2) You can deduct, in equal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur:

(a) in relation to your business; or

(b) in relation to a business that used to be carried on; or

(c) in relation to a business proposed to be carried on; or

(d) to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business.

…

40-880(5) You cannot deduct anything under this section for an amount of expenditure you incur to the extent that:

…

(d) (d) it is in relation to a lease or other legal or equitable right; or

(a) …

(b) it could, apart from this section, be taken into account in working out the amount of a capital gain or capital loss from a CGT event;

40-880(6) The exceptions in paragraphs (5)(d) and (f) do not apply to expenditure you incur to preserve (but not enhance) the value of goodwill if the expenditure you incur is in relation to a legal or equitable right and the value to you of the right is solely attributable to the effect that the right has on goodwill.

Each entitlement is a right for the taxpayer to operate a part of a business for 10 years. Without the entitlement that part of the business cannot be operated. The entitlement is considered to be a legal right and is denied a deduction by subsection 40-880(5)(d) of the ITAA 1997.

The entitlements are also considered to be an intangible CGT asset. The information sheet confirms that there is an Entitlement Transfer Market allowing entitlements to be transferred or traded. At the time of transfer or trading of an entitlement there is the potential for a capital gain or loss.

When an entitlement is transferred or traded, CGT event A1 'Disposal of a CGT asset' is triggered as listed in section 104-5 of the ITAA 1997. CGT event A1 is discussed in section 104-10 of the ITAA 1997

SECTION 104-10 Disposal of a CGT asset: CGT event A1

104-10(1) CGT event A1 happens if you dispose of a CGT asset.

104-10(2) You dispose of a CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law.

When an entitlement is transferred or traded, a CGT asset is disposed of, and there is a change in ownership of an entitlement from the taxpayer to another taxpayer.

Alternatively if the entitlement expires CGT event C2 'Cancellation, surrender and similar endings' is triggered as discussed in section 104-25 of the ITAA 1997

SECTION 104-25 Cancellation, surrender and similar endings: CGT event C2

104-25(1) CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset:

…

(c) expiring;

The term 'intangible asset' is not defined in the ITAA 1997 and therefore has its ordinary meaning. The Macquarie Concise Dictionary (3^rd ed) defines 'intangible' as '1. incapable of being perceived by the sense of touch, as incorporeal or immaterial things; …3. (of an asset) existing only in connection with something else, as the goodwill of a business.', while 'intangible assets' are defined in CCH Macquarie Dictionary of Accounting 1991 as 'assets with no easily identifiable form, such as goodwill, research and development, copyrights, franchises, and exploration and evaluation costs.'

The entitlements are considered to be intangible assets as they cannot be physically touched, are not in an easily identifiable form, and their existence allows the taxpayer to operate gaming machines to generate revenue and build goodwill in its business.

When a CGT event occurs, the capital gain or loss needs to be calculated requiring determination of the cost base. The first element of the cost base is set out in subsection 110-25(2) of the ITAA 1997 as follows:

The first element is the total of:

(a) the money you paid, or are required to pay, in respect of acquiring it;

Requirement to pay money is discussed in section 103-15 of the ITAA 1997 as follows:

This part and Part 3-3 apply to you as if you are required to pay money or give other property even if:

(a) you do not have to pay or give it until a later time; or

(b) the money is payable by instalments.

The taxpayer purchased entitlements over several interest free instalments. The total amount of money that the taxpayer has paid, or will be required to pay, is the total of the interest free instalments. The requirement to pay includes amounts not paid until a later time or paid in instalments. The cost base of each entitlement is therefore the total of the interest free entitlements divided by the number of entitlements.

Therefore the full amount of the interest free instalments forms the cost base of each entitlement and is taken into account in calculating the capital gain or loss from a CGT event being the transfer, trade or expiry of an entitlement.

The full expenditure of the interest free instalments on the entitlements, being taken into account in calculating the capital gain or loss from a CGT event, is denied a deduction by subsection 40-880(5)(f) of the ITAA 1997.

Paragraphs 40-880(5)(d) and (f) of the ITAA 1997 do not apply if the value of the rights (entitlements) is solely attributable to goodwill. According to Taxation Ruling TR 1999/16 Income tax: capital gains: goodwill of a business (TR 1999/16) goodwill is one CGT asset separate and distinct from other assets of the business. A fundamental asset of the taxpayer is the entitlement granted by the relevant Acts and the value and usefulness of the entitlement is greatly enhanced by the agreement between the taxpayer and the State. As such the value of the entitlements under the agreement has value to the taxpayer that is not solely attributable to goodwill, and thus paragraphs 40-880(5)(d) and (f) of the ITAA 1997 are not impacted by subsection 40-880(6) of the ITAA 1997.

Question 3

Are the entitlement fees deductible under any other provision of the ITAA 1997 or the Income Tax Assessment Act 1936 (ITAA 1936)?

A Special Purpose Financial Report has been prepared for the taxpayer. The entitlements have been given the accounting treatment of being recognised as an intangible asset, recorded at fair value, being the present value of the entitlements, and amortised over the useful life of the entitlements, mainly 10 years. In the Special Purpose Financial Report an amortisation of intangibles expense was included in business expenses. An income tax deduction in relation to the entitlement fees has not been claimed by the taxpayer.

(b) A deduction for depreciation in relation to a capital asset may be allowed dependent on the effective life of the asset. A depreciating asset is discussed in section 40-30 of the ITAA 1997 as follows:

40-30(1) A depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used, except:

(a) land; or

(b) an item of trading stock; or

(c) an intangible asset, unless it is mentioned in subsection (2).

40-30(2)These intangible assets are depreciating assets if they are not trading stock:

(a) mining, quarrying or prospecting rights;

(b) mining, quarrying or prospecting information;

(ba) geothermal exploration rights;

(bb) geothermal exploration information;

(a) items of intellectual property;

(b) in-house software;

(a) IRUs;

(b) spectrum licences;

(c) datacasting transmitter licences;

(d) telecommunications site access rights.

The entitlements are considered to be an intangible asset but is not listed in subsection 40-30(2) of the ITAA 1997. Therefore a deduction for depreciation for the entitlements is not allowable under subsection 40-30(1)(c) of the ITAA 1997.

There does not appear to be any provision of either the ITAA 1997 or ITAA 1936 which allows a deduction for the entitlement fees.

Question 4

Does any other provision of the ITAA 1997 or the ITAA 1936 deny a deduction for the entitlement fees incurred by the taxpayer?

There does not appear to be any provision of either the ITAA 1997 or ITAA 1936 other than sections 8-1 and 40-880 of the ITAA 1997 which deny a deduction for the entitlement fees.

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