Edited version of your written advice

Authorisation Number: 1012936169414

Date of advice: 14 January 2016

Ruling

Subject: Costs associated with the sale of shares

Question 1

Are sale transaction costs incurred by the company in the sale of its own shares deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No. The expenditure was not incurred for the purpose of gaining or producing assessable income by the company.

Question 2

Are sale transaction costs incurred by the company in the sale of its own shares capital in nature and deductible as black hole expenditure under section 40-880 of the ITAA 1997?

Answer

No. The expenditure incurred is not business related capital expenditure.

Question 3

Can some or all of the sale transaction costs be included in the cost base of the shares under sections 110-25 and 110-35 of the ITAA 1997?

Answer

No. Incidental costs in relation to the CGT event (the sale of the shares) cannot be included in the cost base of the shares as they were not incurred by the owners of the shares.

This ruling applies for the following period:

1 July 2015 to 30 June 2016

Relevant facts and circumstances

The shareholders of the company sold all their shares to a new owner. A number of costs were incurred when the shares were sold including: seller's warranty and indemnity insurance, transaction success fees, legal fees and incidental costs of sale such as travel, meetings and printing.

Neither the buyers nor the sellers wanted to incur the cost of selling. Consequently, for the transaction to proceed, both parties agreed the company would pay all the costs of the sale transaction.

Copies of invoices have been provided which confirm that the company incurred the costs relating to the sale of the shares

Relevant legislative provisions

Income Tax Assessment Act 1997

Section 8-1

Section 40-880

Part 3-1

Section 104-10

Section 110-25

Section 110-35

Section 995-1

Reasons for decision

Question 1

Deductibility under section 8-1 of the ITAA 1997 - general principles

Subsection 8-1(1) of the ITAA 1997 provides that:

'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.'

Subsection 8-1(2) of the ITAA 1997 provides that:

'However, you cannot deduct a loss or outgoing under this section to the extent that:

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

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

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

d) a provision of this Act prevents you from deducting it'.

For the relevant expenses to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of the taxpayer's assessable income (Ronpibon Tin NL & Tong Kah Compound NL v Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR236; (1949) 8 ATD 431). With regards to the second limb, the High Court in John Fairfax & Sons Pty Ltd v Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 11 ATD 510 said that an outlay must be part of the cost of trading operations to produce income, that is, it must have the character of a working expense.

Also, in determining whether a deduction for relevant expenses is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634). The nature or character of the expenses follows the advantage that is sought to be gained by incurring the expenses.

The broad principles that have arisen from cases on the deductibility of expenses is that they must be 'incidental and relevant to' the gaining or producing assessable income, the expenditure must have the 'essential character' of a business expense and there must be a 'perceived connection' with the gaining or producing of income.

The interaction between the above principles was described by Hill J in FC of T v Firth 2002 ATC 4346 at p 4348 when he said:

"The positive tests require that there be a connection between the loss or outgoing on the one hand and the assessable income or business on the other. The nature of that connection has been expressed in different ways in the cases. It is sometimes said that there must be a 'perceived connection' between the loss or outgoing and the assessable income or business: FC of T v Hatchett 71 ATC 4184 at 4187 ... In other cases it has been said that the expenditure must be 'incidental and relevant' to the operations or activities regularly carried on by the taxpayer for the production of income: Ronpibon Tin NL & Tongkah Compound NL v FC of T (1949) 8 ATD 431 at 435; (1949) 78 CLR 47 at 56, FC of T v Smith 81 ATC 4114 at 4117. These ways of describing the connection that is a necessary prerequisite to deductibility are but part of the process of identifying the essential character of the expenditure in order to determine whether a particular loss or outgoing is in fact incurred in gaining or producing the assessable income or in carrying on a business which more directly contributes to the gaining or production of the assessable income: Lunney v FC of T (1958) 11 ATD 404; (1957-1958) 100 CLR 478 at 413 and 499 respectively." [emphasis added]

Conclusion

The relevant expenses have been incurred in the course of selling the shares in the company and are unrelated to the gaining or producing of assessable income by the business. Accordingly, a deduction is not available under subsection 8-1(1) of the ITAA 1997.

Question 2

Section 40-880

The object of section 40-880 of the ITAA 1997 is to make certain business capital expenditure deductible over five years if the expenditure is not deductible under another part of the Act; and another provision of the Act does not deny a section 40-880 of the ITAA 1997 deduction; and the expenditure relates to a business which is, was or is proposed to be carried on for a taxable purpose.

A key element within section 40-880 of the ITAA 1997 is the concept of "taxable purpose" which is relevantly defined in subsection 40-25(7) of the ITAA 1997 to mean "the purpose of producing assessable income". Section 995-1 of the ITAA 1997 further provides that something is done for a taxable purpose if it is done for the purpose of gaining or producing assessable income or in carrying on a business for the purpose of gaining or producing assessable income.

Subject to the limitations and exceptions contained in subsections 40-880(3) to 40-880(9) of the ITAA 1997, subsection 40-880(2) of the ITAA 1997 provides that 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 in relation to your business:

a) in relation to a business that used to be carried on

b) in relation to a business proposed to be carried on, or

c) 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.

In considering the phrase 'in relation to' contained in subsection 40-880(2) of the ITAA 1997, paragraph 2.25 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No.1) Bill 2006 (the 'EM') states:

'The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business. The concept used to establish this character or requisite relationship between the expenditure incurred by the taxpayer and the business carried on (current, past or prospective) is 'in relation to'. The connector 'in relation to' allows the appropriate latitude to enable the deductibility of qualifying capital expenditure incurred before the business commences or after it has ceased.'

The phrase 'in relation to' was considered by the High Court in PMT Partners Pty Ltd (in liquidation) v Australian National Parks and Wildlife Service (1995) 184 CLR 301. Brennan CJ, Gaudron and McHugh JJ observed, in considering the application of the Commercial Arbitration Act 1985 (NT), at 313:

Inevitably, the closeness of the relation required by the expression 'in or in relation to' in s 48 of the Act, indeed, in any instrument, must be ascertained by reference to the nature and purpose of the provision in question and the context in which it appears.

In that case, Toohey and Gummow JJ also observed:

It is apparent that the words 'in or in relation to' are particularly wide…Cases concerning the interpretation of this phrase in other statutory contexts are of limited assistance. However, the cases do show that the words are prima facie broad and designed to catch things which have sufficient nexus to the subject. The question of sufficiency of nexus is, of course, dependent on the statutory context (at 330)

The connection which is required by the phrase 'in relation to' is a question of degree. There must be some "association" which is "relevant" or "appropriate". The question of the relevance or appropriateness of the connection is a question that cannot be divorced from the particular statutory context (at 331)

In First Provincial Building Society Limited v Commissioner of Taxation (1995) 56 FCR 320; 95 ATC 4145; (1995) 30 ATR 207, Hill J considered the phrase 'in relation to' within the context of paragraph 26(g) of the Income Tax Assessment Act 1936. He considered the words 'in relation to' in that context included a relationship that may be either direct or indirect, provided that the relationship consisted of a real connection, but that a merely remote relationship is insufficient.

It is therefore necessary to consider the legislative context of subsection 40-880(2) of the ITAA 1997 in order to determine whether there is a sufficient and relevant connection between the incurring of the expenditure and a particular business. In discussing the types of business capital expenditure to which subsection 40-880(2) of the ITAA 1997 applies, paragraphs 2.19 and 2.20 of the EM state:

Expenditure on the structure by which an entity carries on (or used to or proposes to carry on) their business and on the profit yielding structure of the business would ordinarily be expected to be of a capital nature. Capital expenditure can also relate to a business's operations or the entity that will carry on the business.

The structure covers the legal entity (such as a company) or the legal relationship (such as a partnership or trust) that is the entity that carries on the business for a taxable purpose and that holds the business assets.

These paragraphs indicate that capital expenditure incurred on the structure by which an entity carries on, or used to or proposes to carry on their business, on the profit yielding structure of the business, or relating to the business's trading operations, are capable of being described as capital expenditure incurred 'in relation to' that business for the purpose of subsection 40-880(2) of the ITAA 1997. Whether such capital expenditure is incurred 'in relation to' the particular business will depend on whether there is a sufficient and relevant connection between the incurring of the expenditure and that business on the facts of the particular case.

On the other hand, capital expenditure in relation to the ownership of the business structure may not be considered to be business related expenditure. As paragraph 84 of TR 2011/6 points out:

'In contrast, expenditure relating to the ownership of the entity carrying on the business is not business related capital expenditure unless it can be demonstrated that the change of ownership serves an objective of the business.'

Whether capital expenditure is truly a business expense turns on the particular facts and circumstances and is a matter of impression and judgement. Determining whether the expenditure has the character of a business expense can be approached by asking what the expenditure is for, in the sense of identifying the need or object that the expenditure serves. If the facts show that the expenditure satisfies the ends of the relevant business then it will have the character of a business expense.

The facts of this case do not lead to the conclusion that the expenditure is a business related expense or that the change of ownership serves an objective of the business.

Conclusion

The expenditure incurred by the company is not eligible for a deduction under section 40-880 of the ITAA 1997 as it relates to the sale of the business and not to the profit yielding structure of the business. The expenditure is unrelated to business's trading operations and does not serve an objective of the business.

Question 3

Under paragraph 110-25(3) of the ITAA 1997 the second element of a CGT asset's cost base is the incidental costs you incur. The incidental costs may be incurred in acquiring the CGT asset or incurred in relation to a CGT event involving the asset.

The incidental costs which may be included in a CGT asset's cost base are listed in paragraphs 110-35(2) to 110-35(10) of the ITAA 1997.

Where an asset is being disposed of, the incidental costs can typically include marketing expenses, conveyancing costs and remuneration for the services of a surveyor, valuer, auctioneer, broker or legal adviser.

In this instance, certain expenses were incurred which relate to the sale of the shares in the company (the relevant CGT assets), such as seller's warranty and indemnity insurance, transaction success fee, legal fees and other incidental costs.

Although these expenses could be regarded as expenses which fall under the second element of a CGT asset's cost base, they cannot be included in the cost base of the shares in the company as the expenditure was not incurred by the owners of the shares.

It should also be noted paragraph 40-880(5)(f) of the ITAA 1997 precludes these expenses from being treated as black hole expenditure. The paragraph states:

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

(f) 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;'

Conclusion

As the expenditure was not incurred by the vendors of the shares, any incidental costs relating to the GCT event cannot be included in the cost base of the shares.

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