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This edited version has been archived due to the length of time since original publication. It should not be regarded as indicative of the ATO's current views. The law may have changed since original publication, and views in the edited version may also be affected by subsequent precedents and new approaches to the application of the law.

You cannot rely on this record in your tax affairs. It is not binding and provides you with no protection (including from any underpaid tax, penalty or interest). In addition, this record is not an authority for the purposes of establishing a reasonably arguable position for you to apply to your own circumstances. For more information on the status of edited versions of private advice and reasons we publish them, see PS LA 2008/4.

Edited version of your written advice

Authorisation Number: 1013032878351

Date of advice: 10 June 2016

Ruling

Subject: Business - deductible expenses, Capital Gains Tax and cost base

Questions and answers

This ruling applies for the following period

1 July 2011 to 30 June 2012

Relevant facts and circumstances

The original company was incorporated and changed its name to the Company.

The business of the Company is distribution of software from overseas suppliers to customers. For example, 'Y' and 'Z' are two information technology products that the Company has imported and marketed; both have returned income.

Company X, an overseas company, holds patents in many countries for their Service.

For Company X's service (the Service) to be successful all relevant parties need to agree to approve the Service.

The Company undertook months of research into the Service.  

A large amount of the time was spent on the Agreement and with professionals to arrive at a suitable Agreement.

Time and effort was undertaken to discover, test and choose an appropriate billing/ecommerce system (backend billing system) for the smooth operation of the Service.

Various consultants were contacted, however, final engagement with the consultants occurred only after the contract was signed, even with the Non-disclosure Agreements, the Company felt it needed to keep the Service quiet, prior to signing, because other parties may have wanted the rights.

Research showed the potential high rental cost which may be imposed for the Service. However, at the time, it was thought that the high rental cost could be overcome.

The Company entered into the Agreement with Company X.

A licence fee of $xx.xx was paid by the Company to Company X for the Service. The payment was made before fully completing the investigation into the Service's viability and prior to any engagement with any of the major players. It was necessary to risk making the payment because the payment secured the Company's position as the exclusive representative, with exclusive rights, to use the Service.

Legal fees of $xx.xx were paid for the associated legal documents.

The Company director believed the Service would become profitable and the total outlay of $xx.xx has been retained as an intangible asset in the Company's books, without depreciation.

After a number of years of marketing the director of the Company has decided the Service will not succeed.

The Agreement terminated; the Agreement had specific goals which had to be met within a timeframe and these were not achieved.

Relevant legislative provisions

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 40-30

Income Tax Assessment Act 1997 subsection 40-880(1)

Income Tax Assessment Act 1997 subsection 40-880(2)

Income Tax Assessment Act 1997 subsection 40-880(3)

Income Tax Assessment Act 1997 subsection 40-880(4)

Income Tax Assessment Act 1997 subsection 40-880(5)

Income Tax Assessment Act 1997 paragraph 40-880(5)(d)

Income Tax Assessment Act 1997 paragraph 40-880(5)(f)

Income Tax Assessment Act 1997 subsection 40-880(6)

Income Tax Assessment Act 1997 subsection 40-880(7)

Income Tax Assessment Act 1997 subsection 40-880(8)

Income Tax Assessment Act 1997 subsection 40-880(9)

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 110-25

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

Income Tax Assessment Act 1997 subsection 110-25(3)

Income Tax Assessment Act 1997 Section 110-35

Income Tax Assessment Act 1997 Section 995-1

Reasons for decision

Subsection 8-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for any loss or outgoing to the extent that:

However, subsection 8-1(2) of the ITAA 1997 provides that a loss or outgoing is not deductible to the extent that:

In determining whether a deduction 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; (1946) 8 ATD 190; (1946) 3 AITR 436 per Dixon J). The nature or character of the expenses follows the advantage which is sought to be gained by incurring the expenses.

Where an expense arises as a consequence of the day to day activities of a business, the object of the expenditure is devoted towards a revenue end and the expenses are deductible (Herald & Weekly Times v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169).

However, where the expenditure is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403).

Application to your circumstances

The licence fee and legal expenses incurred by the Company, to secure the Company's position as the exclusive representative with exclusive rights to use Company X's Service, are a set up/structural cost and are an outgoing of capital, or of a capital nature.

Accordingly, the expenses are not deductible under section 8-1 of the ITAA 1997.

Depreciation

Division 40 of the ITAA 1997 allows a deduction for the decline in value of a depreciating asset that is held for any time during a year of income.

Section 40-30 of the ITAA 1997 specifies what is and is not an asset for the purposes of Division 40 of the ITAA 1997. Section 40-30 of the ITAA 1997 relevantly states:

The definition of intellectual property is found within section 995-1 of the ITAA 1997. It includes the rights (including equitable rights) that an entity has under a Commonwealth law as the patentee, or a licensee, of a patent or the equivalent rights under a foreign law.

However a deduction in relation to intellectual property is only allowable from the year that the intellectual property is first used for the purpose of producing assessable income. That is, a deduction for the decline in value of a depreciating asset is allowable to the extent the asset is used for a taxable purpose.

Application to your circumstances

The Company entered into the Agreement and made a payment to secure a licence to Company X's Service. The Service did not eventuate and as a consequence, no assessable income was derived.

Accordingly, the Company is not entitled to deductions under Division 40 of the ITAA 1997 for the payment made to secure a licence to Company X's Service.

Deduction under section 40-880 of the Income Tax Assessment Act 1997

The object of section 40-880(1) of the ITAA 1997 is to make certain business capital expenditure deductible over 5 years if:

Subject to the limitations and exceptions contained in subsections 40-880(3) to (9), subsection 40-880(2) provides that you can deduct, in equal proportions over a period of five income years starting in the year in which you incur it, capital expenditure you incur:

However, under subsection 40-880(5)(d) and 40-880(5)(f) of the ITAA 1997 you cannot deduct anything under this section for an amount of expenditure you incur to the extent that it is in relation to a lease or other legal or equitable right; or it could, apart from this section, be taken into account in working out the amount of a capital gain or capital loss from a Capital Gains Tax (CGT) event.

Application to your circumstances

The Company incurred expenses in relation to the purchase of a licence and associated legal costs for Company X's Service.

However, a deduction is not available to the Company, for the purchase of Company X's licence fee for the Service, under section 40-880 of the ITAA 1997, because it is excluded under subsections 40-880(5)(d) to the extent that it is in relation to a lease or other legal or equitable right.

Further, under subsection 40-880(5)(f) of the ITAA 1997 the expenses incurred in purchasing Company X's licence and the associated legal fees are excluded because they can be taken into account in working out a capital gain or capital loss from a CGT event.

Accordingly, the Company is not entitled to a deduction under section 40-880 of the ITAA 1997.

Capital Gains Tax

You make a capital gain or capital loss when a CGT event happens to a CGT asset.

Section 108-5 of the ITAA 1997 provides that a CGT asset is any kind of property or a legal or equitable right that is not property.

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

A capital gain or capital loss in most cases is determined by reference to the proceeds received and the assets cost base or reduced cost base. You can make a capital gain or loss only if a CGT event happens. As such, calculating the assets cost base becomes relevant when a CGT event happens.

Section 110-25 of the ITAA 1997 tells us that the cost base of a CGT asset consists of 5 elements:

First element

Under subsection 110-25(2) of the ITAA 1997 the first element of the cost base is the total of the money paid, or required to be paid, and the market value of the property given, or required to be given, in respect of the acquisition of the asset.

Second element

The second element of the cost base is the incidental costs you incurred (subsection 110-25(3) of the ITAA 1997).

Section 110-35 of the ITAA 1997 provides that incidental costs are costs you may have incurred:

Application to your circumstances

When the company entered into the Agreement to purchase Company X's Service, it acquired rights. In particular, the Company acquired the right to be the exclusive representative, with exclusive rights to use Company X's Service. This right is an intangible CGT asset. The Company paid Company X an amount of $xx.xx for that right.

CGT even C2 happened when the rights acquired under the Agreement was cancelled by the termination of the Agreement.

Therefore, the amount paid for the right will form part of the first element of the cost base.

The Company incurred legal expenses in relation to the Agreement; remuneration for the services of a legal adviser is included in the list of incidental costs and form part of the second element of the cost base.

Note: Capital losses can be applied to any capital gains that are made in the same income year. Any unapplied net capital losses can be carried forward and applied against any capital gains that have been made during the next income year, and so on, until they have been applied against future capital gains.

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