Edited version of your written advice

Authorisation Number: 1013044735216

Date of advice: 18 August 2016

Ruling

Subject: Cash contribution to Employee Share Trust

Question 1

Will Company A obtain an income tax deduction in the 2016 income year pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) in respect of the irretrievable cash contribution made by Company A to the Trustee of the Employee Share Trust (EST) to fund the acquisition of shares by the Trustee to satisfy early vested and automatically exercised performance rights issued under the Company A's Incentive Plan?

Answer

No

Question 2

If the answer to Question 1 is No, then will the contribution referred to in Question 1 be deductible under section 40-880 of the ITAA 1997 commencing in the 2016 year?

Answer

Yes

Question 3

Will the Commissioner seek to make a determination that Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) applies to deny, in part or full, any deduction that Company A would otherwise be entitled to in respect of the irretrievable cash contribution referred to in Question 1 made by Company A to the Trustee of the EST?

Answer

No

This ruling applies for the following periods:

1 July 2015 to 30 June 2020

Relevant facts and circumstances

Company A is an Australian resident company that was until recently listed on the Australian Securities Exchange (ASX).

Company A established an employee share plan the Company A, Incentive Plan (the Plan), to provide eligible employees the ability to share in the ownership of Company A and to promote the long term success of Company A as a goal shared by all employees.

Company A may, at the discretion of the board, offer or issue Options or Rights which are rights to be issued, transferred or allocated a share upon the satisfaction of specified vesting conditions. The Options and / or Rights are Restricted Awards until they have been exercised or expire and an offer may specify a restriction period for shares issued, transferred or allocated on the exercise of the Options or Rights.

The Rules state that options and Performance Rights will be automatically exercised if a takeover bid within the meaning of the Corporations Act is made to acquire any issued Shares of the Company, in which case the Directors may in their sole discretion (unless, in the opinion of the Directors, an intention to make an equivalent offer to Participants to acquire their Performance Rights or relevant portion thereof is given) give written notice of the takeover bid to Participants and advise them that their Performance Rights will be automatically exercised within the period of 30 days from the date of the written notice.

Relevant clause of the Company A, Incentive Plan Rules (The Rules) states that:

a reorganisation is sanctioned by one or more of the following under the Constitution, Applicable Regulations or otherwise:

• a court;

• a General Meeting or other meeting of holders of the Company's securities; or

• a meeting of the Company's creditors; or

then the Board may give written notice to each Participant advising them that their Performance Rights will be automatically exercised within a specified period of up to 30 days after the occurrence of the relevant event.

The Plan is an 'employee share scheme' and the Options / Rights issued under the Plan are 'ESS interests', for the purposes of, and as those terms are defined in, section 83A-10.

Company A Employee Share Trust (EST)

The EST was established as a sole purpose trust to subscribe for, acquire, allocate, hold and deliver shares under the Plan for the benefit of eligible employees.

An independent party was the trustee of the EST set up in connection with the employee incentive plan instituted by Company A, governed by the Rules.

The EST has operated over its life as follows:

• The EST has been funded by regular contributions from Company A (i.e. for the purchase of shares in accordance with the Plan).

• Shares acquired by the Trustee have been allocated to the relevant employees following exercise of the Performance Rights.

• The Trustee has sold shares on behalf of an employee where permitted to do so by the employee.

Scheme of Arrangement

Company A entered into a Scheme Implementation Deed (SID) under which the acquiring company would acquire all Company A's issued shares pursuant to a Court-approved Scheme of Arrangement (SOA). The Scheme was approved by Company A's shareholders and by the Supreme Court of the relevant state.

A condition precedent to the Scheme being effective was that no options, performance rights or instruments will be outstanding or become outstanding or convertible into Company A Shares on or after the Implementation Date.

As far as the outstanding performance rights were concerned, the Scheme involved the following steps:

• Company A, Board waived the vesting and exercise conditions attaching to all of the performance rights then on issue in relation to the medium term and long term incentive plans.

• the Board exercised its discretion to automatically exercise all outstanding performance rights.

Employees who received the Company A shares acquired by the EST using the contribution by Company A to the EST are liable to tax under Division 83A on the full value of the shares in the 2016 tax year.

Relevant legislative provisions

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)

Subsection 8-1(1) of the ITAA 1997

Subsection 8-1(2) of the ITAA 1997

Paragraph 8-1(2)(a) of the ITAA 1997

Paragraph 8-1(1)(b) of the ITAA 1997

Subsection 40-25(7) of the ITAA 1997

Section 40-880 of the ITAA 1997

Subsection 40-880(2) of the ITAA 1997

Subsection 40-880(3) of the ITAA 1997

Subsection 40-880(4) of the ITAA 1997

Subsection 40-880(7) of the ITAA 1997

Subsection 40-880(8) of the ITAA 1997

Subsection 40-880(9) of the ITAA 1997

Subsection 40-880(5) of the ITAA 1997

Paragraph 40-880(5)(d) of the ITAA 1997

Paragraph 40-880(5)(f) of the ITAA 1997

Subsection 995-1(1) of the ITAA 1997

Section 83A-10 of the ITAA 1997

Former subsection 51(1) of the Income Tax Assessment Act 1936 (ITAA 1936)

Paragraph 26(g) of the ITAA 1936

Reasons for decision

Note: All subsequent legislative references are to the ITAA 1997 unless specified otherwise.

Question 1

Summary

The irretrievable cash contribution made by Company A to the Trustee of the EST to fund the acquisition of shares by the Trustee to satisfy the early vested and automatically exercised performance rights issued under the Plan is an outgoing of capital or of a capital nature and so is prevented by paragraph 8-1(2)(a) from being deductible under section 8-1, whether or not either of the conditions in subsection 8-1(1) is satisfied.

Detailed reasoning

Section 8-1 states:

(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.

(2) 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.

(3) A loss or outgoing that you can deduct under this section is called a general deduction.

In order to qualify for a deduction under section 8-1, any payment that you make must relevantly be:

• a loss or outgoing

• incurred

• in gaining or producing your assessable income or necessarily so incurred in carrying on a business for the purpose of gaining or producing your assessable income, and

• not constitute a loss or outgoing of capital or of a capital nature (other elements of the negative limb of subsection 8-1(2) are considered not presently applicable).

Each of these elements will be discussed in detail below.

Loss or outgoing

In order to qualify for a deduction, the payment made must constitute a loss or outgoing for the purposes of section 8-1.

In general terms, an amount is considered to be a loss or outgoing if that amount is considered to be a cost or expenditure, paid or transferred from one party to another, which reduces the property or assets, including cash resources, held by that party - see Ord Forrest Pty Ltd v. Federal Commissioner of Taxation (1973-1974) 130 CLR 124 (Ord Forest) per Gibbs J and Barwick CJ.

Incurred

For an outgoing to be deductible under section 8-1, it must have been incurred.

The Commissioner has set out, in Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions, his view on the proper interpretation of the term 'incurred' for the purposes of section 8-1 of the ITAA 1997. Paragraphs 4-6 relevantly state:

The Commissioner has set out, in Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions his view on the proper interpretation of the term 'incurred' for the purposes of section 8-1. Paragraphs 4-6 relevantly state:

1. There is no statutory definition of the term 'incurred'.

2. As a broad guide, you incur an outgoing at the time you owe a present money debt that you cannot escape. But this broad guide must be read subject to the propositions developed by the courts, which are set out immediately below.

3. The courts have been reluctant to attempt an exhaustive definition of a term such as 'incurred'. The following propositions do not purport to do this they help to outline the scope of the definition. The following general rules, settled by case law, assist in most cases in defining whether and when a loss or outgoing has been incurred:

(a) a taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitely committed in the year of income. Accordingly, 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. That is, subject to the principles set out below, it is not sufficient if the liability is merely contingent or not 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;

…

(d) whether there is a presently existing liability is a legal question in each case, having regard to the circumstances under which the liability is claimed to arise;

Expenditure incurred in gaining or producing your assessable income

In the case of Ronpibon Tin NL and Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47 (Ronpibon Tin), the High Court in its unanimous judgment set out the test for determining whether an outgoing is incurred in gaining or producing assessable income. The High Court stated:

For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end. The words "incurred in gaining or producing the assessable income" mean in the course of gaining or producing such income…

Notwithstanding the differences in other respects in the present provision, the expression "incurred in gaining or producing the assessable income" has been left unchanged and bears the same meaning. In brief substance, to come within the initial part of the sub-section it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income.

The High Court further stated:

The word "business" is defined by s. 6(1) to include profession, trade, employment, vocation or calling, but not occupation as an employee. The alternative in s. 51(1) therefore covers a wide description of activities. But in actual working it can add but little to the operation of the leading words, "losses or outgoings to the extent to which they are incurred in gaining or producing the assessable income." No doubt the expression "in carrying on a business for the purpose of gaining or producing" lays down a test that is different from that implied by the words "in gaining or producing". But these latter words have a very wide operation and will cover almost all the ground occupied by the alternative.

Expenditure incurred in carrying on a business for the purpose of gaining or producing your assessable income

In the case of Federal Commissioner of Taxation v Snowden & Wilson [1958] HCA 23; 99 CLR 431, the High Court stated:

The word 'necessarily' 'clearly … place[s] a qualification upon the degree of connexion between the expenditure and the carrying on of the business which might suffice in the absence of such a qualification.'

Motivation of taxpayer in incurring expense

The motives of the taxpayer in incurring an expense may be a possibly relevant factor in characterisation for the purposes of subsection 8-1(1) in some cases, especially where the outgoing has been voluntarily incurred. In the case of Magna Alloys and Research Pty Ltd v Federal Commissioner of Taxation 80 ATC, the Federal Court stated:

'Though purpose is not the test of deductibility nor even a conception relevant to a loss involuntarily incurred, in cases where a connection between an outgoing and the taxpayer's undertaking or business is affected by the voluntary act of the taxpayer, the purpose of incurring that expenditure may constitute an element of its essential character, stamping it as expenditure of a business or income-earning kind.'

Whether loss or outgoing is of a revenue or capital nature

In the case of British Insulated and Helsby Cables v Atherton [1926] AC 205, Viscount Cave stated that:

But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

At the beginning of his judgment in Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634, Dixon J referred to Lord Greene MR's remark in Inland Revenue Commissioners v British Salmson Aero Engines Ltd [1938] 2 KB 482 on the difficulty in some cases of distinguishing between capital and revenue, that:

There have been many cases that fall on the border-line. Indeed, in many cases it is almost true to say that the spin of a coin would decide the matter almost as satisfactorily as an attempt to find reasons.

In the following paragraph, Dixon J continued:

For myself, however, I am not prepared to concede that the distinction between an expenditure on account of revenue and an outgoing of a capital nature is so indefinite and uncertain as to remove the matter from the operation of reason and place it exclusively within that of chance, or that the discrimen is so unascertainable that it must be placed in the category of an unformulated question of fact.

Eight years previously, in Sun Newspapers & Anor v Federal Commissioner of Taxation (1938) 61 CLR 337 (widely regarded in Australia as the leading authority on the distinction between capital and revenue outgoings), Dixon J had stated:

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organization set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss.

He followed this statement with an extended commentary on the practical difficulties in making the distinction between expenditure and outgoings on revenue account and on capital account which contained the following passage:

In the attempt, by no means successful, to find some test or standard by the application of which expenditure or outgoings may be referred to capital account or to revenue account the courts have relied to some extent upon the difference between an outlay which is recurrent, repeated or continual and that which is final or made "once for all", and to a still greater extent upon a distinction to be discovered in the nature of the asset or advantage obtained by the outlay.

Dixon J then proceeded to set out three principles to assist in making the revenue/capital distinction. Those principles, cited many times in the years since, are as follows.

…(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 payment or by making a final provision or payment so as to secure future use or enjoyment.

In Hallstroms Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634, Dixon J had made a similar point when he said:

What is an outgoing of capital and what is an outgoing on account of revenue 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.

In W Nevill & Company Ltd v Federal Commissioner of Taxation (1937) 56 CLR 290 Dixon J explained why a payment to cancel the agreement to employ an additional managing director as a measure to increase business efficiency was on revenue account in the following terms:

In the present case the payment of a lump sum to secure the retirement of a high executive officer may have been unusual. But it was made for the purpose of organizing the staff and as part of the necessary expenses of conducting the business. It was not made for the purpose of acquiring any new plant or for any permanent improvement in the material or immaterial assets of the concern. The purpose was transient and, although not in itself recurrent, it was connected with the ever recurring question of personnel.

In Federal Commissioner of Taxation v Citylink Melbourne Ltd (2006) 228 CLR 1, the High Court found that the payment of a fixed annual 'base concession fee' as part of the consideration the taxpayer gave to the Victorian Government in return for a concession to construct and operate a toll road system was a revenue deduction.

In her judgment, Crennan J, with whom Gleeson CJ, Gummow, Callinan and Heydon JJ agreed, observed that the taxpayer did not acquire permanent ownership of the roads or associated land. She said:

Unlike periodic instalments paid on the purchase price of a capital asset, the concession fees are periodic licence fees in respect of the Link infrastructure asset, from which the [taxpayer] derives its income, but which are ultimately 'surrendered back' to the State. Accordingly, they are on revenue account.

In Federal Commissioner of Taxation v South Australian Battery Makers Pty Ltd (1978) 14 CLR 645 Gibbs ACJ stated, having just cited Dixon J's three principles from Sun Newspapers quoted above:

However the present case cannot be resolved simply by applying these tests. The real problem in the case is not to determine the character of the advantage sought, once it has been identified, but to decide what was the advantage sought by the taxpayer by making the payments.

This remark is more easily understood in light of the facts of the case. The taxpayer was a wholly-owned subsidiary of Associated Battery Makers of Australia (Abmal), in turn a wholly-owned subsidiary of a UK incorporated company. In 1963, Abmal entered into negotiations with the South Australian Housing Trust to establish a factory in South Australia. The Trust, eager to encourage industrial development, offered to erect buildings on selected land which would be leased to Abmal for 16 years at a net equivalent to 10% of the final cost of the project. The amounts outlaid by the Trust would be amortised by a portion of the rent payments and Abmal would have an option to purchase during the term of the lease for the amount which had not been recouped to the Trust or amortised in this way.

Abmal assigned its interest in the lease to the taxpayer. The option to purchase was, at Abmal's request, granted to Property Options, the issued shares of which were held in trust for a subsidiary of Abmal's parent company. In the end, the option was not exercised. The taxpayer was, at all relevant times, the lessee of the land and had used the premises for the purposes of its business of manufacturing batteries.

The taxpayer claimed deductions for rental expenses for the relevant years, which the Commissioner disallowed in part on the grounds that each payment comprised two parts: one attributable to the right of possession under the lease, and so of a revenue nature; and the other attributable to the amortisation of the cost or price of the land and buildings which Property Options had an option to buy, and so of a capital nature.

The taxpayer successfully contested the matter in the NSW Supreme Court, and the Commissioner appealed to the High Court. Gibbs ACJ, referring to his earlier words quoted above, stated:

I have said that in deciding whether outgoings made by a taxpayer are of a revenue or of a capital nature, it is necessary to consider "the character of the advantage sought". In my opinion, in principle, that must mean the character of the advantage sought by taxpayer for himself by making the outgoings. Of course, as I have already indicated, a taxpayer may derive an advantage if someone else, such as a subsidiary, acquires an asset. But the fact that someone else incidentally derives an advantage of a capital kind in which the taxpayer does not share is not enough to give the outgoings the character of capital.

He said that while this view was implicit in the leading authorities such as Sun Newspapers, it was, 'expressly supported and illustrated by the decision in Poole and Dight v Federal Commission of Taxation (1970) 122 CLR 427'.

The High court decided, by a majority of three to two (Gibbs ACJ being of the majority) in favour of the taxpayer, holding that the advantage sought and obtained by each payment of rent was the right to continue in occupation as lessee of its business premises for the appropriate period, and so was an advantage of a revenue nature. That others obtained, to its knowledge, another advantage, even if it were of a capital nature, was not the advantage sought or obtained by the taxpayer.

The taxpayer was therefore in a similar position to Mrs Dight in Poole and Dight. In that case, Mr Poole and his daughter Mrs Dight (and Mr Poole's wife and another daughter) were members of a partnership carrying on a business of farmers and graziers. The partnership agreement provided that the business of the partnership should be carried on upon specified parcels of land, one of which was held by Mr and Mrs Poole as lessees as tenants in common. Mr and Mrs Poole were entitled to apply to have the tenure of that parcel converted to a grazing homestead freeholding lease and did so. The terms of the new lease were such that each annual payment of rent counted towards the purchase price, and on payment of the balance during the terms of the lease, the lessees were entitled to a grant in fee-simple of the land comprised in the lease, subject to certain conditions regarding development or improvement.

In the relevant year, a rental payment on the land was made by the partnership and was recorded as a rental expense of the partnership. The Commissioner added the amount of the rental expense to the partnership income and made corresponding adjustments to the assessable income of each of the appellants according to their respective shares in the net income of the partnership. Mr Poole and Mrs Dight appealed against their assessments, and the case eventually came before the High Court.

Walsh J held that from the standpoint of the partnership, the rental payment was on revenue account, as it was paid for the use of the land and could not be disregarded in computing the net income of the partnership. However, this did not assist Mr Poole, as the partnership had discharged an obligation which, between himself and the Crown, lay upon him as lessee. He obtained the benefit for a payment on his behalf of an outgoing which if paid by him would have been an outgoing of a capital nature. Therefore his income should appropriately include, in addition to his share of the net income of the partnership (as adjusted), that same share of the rental payment, leading to Mr Poole being liable for the tax already assessed.

Mrs Dight's position was quite different. She had no interest in the lease, having merely the right under the partnership agreement to the use of the land and no other rights. She would get no benefit from the acquisition of an estate in fee simple by payment of the balance of the purchase price. Therefore, the payment made by the partnership was not related in any way to the acquisition by her of a capital asset.

Walsh J held that her appeal should be allowed and ordered that her assessment be varied to reduce her taxable income by her share of the amount of the rental payment made by the partnership.

In John Fairfax & Sons Pty Ltd v Federal Commissioner of Taxation (1959) 101 CLR 30 Dixon, by then Chief Justice of the High Court, quoted the earlier cited passage of Viscount Cave in British Insulated and Helsby Cables (supra), and while not disagreeing with it, pointed out its limitations in the following words:

That is an affirmative proposition. But it is hardly necessary to say that it is a logical fallacy to turn it round and say that an expenditure cannot be attributable to capital unless it is made once for all and is made with a view to bringing into existence an asset or an advantage for the enduring benefit of trade. Nor did Viscount Cave L.C. mean to say that no expenditure falling outside his proposition could be of a capital nature.

Immediately before this, he had said:

It is not in my opinion right to say that because you obtain nothing positive, nothing of an enduring nature, for an expenditure, it cannot be an outgoing on account of capital.

To put these remarks in context, John Fairfax & Sons involved the deductibility or otherwise of legal expenses incurred in defending the taxpayer's title to shares the taxpayer had been allotted in a newspaper group in the context of a battle for control of the group between the taxpayer and another newspaper group. The High Court decided that the legal expenses were part of the cost of acquiring the shares and so were on capital account. Menzies J put it as follows:

To make a payment to acquire or to defend the acquisition of a favourable position from which to earn income or to enter into arrangements that will yield income is not generally an outlay incurred either in gaining or in carrying on business for the purpose of gaining assessable income; such a payment in the case of a trading company, occurs at a stage too remote from the receipt of income to be so regarded. To be deductible an outlay must be part of the cost of trading operations to produce income, i.e., it must have the character of a working expense. What the appellant wanted in taking up the shares in Associated Newspaper Ltd was to keep Consolidated Press Ltd out, and to gain the opportunity to make profits of the sort which the accounts show that it made, but that does not mean that payments in connection with the acquisition of the shares or for the defence of the acquisition of shares were incurred in carrying on the profit-making business.

In BP Australia Ltd v Commissioner of Taxation of the Commonwealth of Australia [1965] 3 All ER 209, Lord Pearce, delivering the judgment of the Privy Council, said of Viscount Cave's proposition in British Insulated and Helsby Cables (supra):

Those words are useful as an expression of general principle of prima facie indications, but the benefit in the particular case was the foundation of a fund that would endure for the whole life of the company and provides no analogy to the present case.

He continued (having earlier cited as 'a valuable guide to the traveller in these regions' Dixon J's principles in Sun Newspapers (supra) quoted above):

The solution to the problem is not to be found by any rigid tests 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 the other. One consideration may point so clearly that it dominates other and vague indications in the contrary direction. It is a common sense appreciation of all the guiding features which must provide the ultimate answer. Although the categories of capital and income expenditure are distinct and easily ascertainable in obvious cases that lie far from the boundary, the line of distinction is often hard to draw in border line cases; and conflicting considerations may produce a situation where the answer turns on questions of emphasis and degree. 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 Hallstrom's Case). As each new case comes to be argued felicitous phrases from earlier judgments are used in argument by one side and the other. But those phrases are not the deciding factor, nor are they of unlimited application. They merely crystallize particular factors which may incline the scale in a particular case after a balance of all the considerations has been taken.

Later he asked:

Finally, were these sums expended on the structure within which the profits were to be earned or were they part of the money earning process?

In Federal Commissioner of Taxation v Foxwood (Tolga) Pty Ltd (1981) 147 CLR 278, the taxpayer was a subsidiary of Foxwood Limited (Foxwood). It was a service company which made its employees available to another subsidiary of Foxwood for a fee. On 30 June 1976 it sold its business to its parent company. Under the terms of the sale agreement, Foxwood took over all the taxpayer's employees, and after that date, was liable to make holiday, sick leave and long service leave payments accruing or owing before or after that date to those employees, provided that the taxpayer paid to Foxwood an amount to be determined as the employees' accrued entitlement for long service leave and holiday and sick pay as at that date.

Accordingly, the taxpayer paid Foxwood the amount determined on 30 June 1976 and sought to deduct the majority of the amount, corresponding to the amount the taxpayer would have been obliged to pay its employees for long service leave and annual holiday entitlement if the employment had been terminated on 30 June 1976. (In fact, the services of the employees were terminated by Foxwood shortly after the sale.)

The effect of the State legislation governing employees' entitlement to long service leave was that none of them was entitled to be paid anything by the taxpayer. However, the period of service of each employee with the taxpayer would be taken into account in calculating the length of his or her service with the new employer (Foxwood) and would be deemed to be service with that employer. The same statute, together with the relevant Award, provided that on termination, an employee was entitled to be paid the amount of his or her holiday pay, or a fraction thereof, depending on the employee's period of service.

In Federal Commissioner of Taxation v Swan Brewery Company Ltd 91 ATC 4637, the taxpayer, expended a sum of what it called 'takeover defence costs' following a takeover offer in procuring an independent report on the offer for the information of shareholders (as required by statue), solicitor's advice in relation to the offer and in relation to the preparation of a statutorily required statement, and printing costs of the statement. The Full Federal Court, though finding that the expenditure did not satisfy either of the positive limbs of former subsection 51(1) of the ITAA 1936, made the following obiter observation:

That is not to say that such expenditure could never be so characterized. It may be that the directors of a trading corporation may perceive a takeover offer to carry an inherent threat to the continuation of the corporation's business and impairment of its income-earning activities. In a particular case it may be obvious to a board that the takeover offer can only lead to a reduction of circulating capital applied in the business and curtailment of the ability of the business of the corporation to gain or produce assessable income. In such a case it may be argued that expenditure incurred by directors on behalf of the corporation in order to better inform shareholders of the worth of their capital interest and to urge their resistance to the takeover offer was directed to the maintenance of the business activities of the corporation in the best interests of the shareholders and the company rather than to discharge of a separate duty to shareholders to assess the adequacy of a bid to acquire proprietorship of the share capital of the corporation. (See Morgan (Inspector of Taxes) v. Tate & Lyle Ltd. [1955] A.C. 21.)

The Commissioner's view on this obiter is as stated in Taxation Ruling IT 2656 Income tax: deductibility of takeover defence costs, as follows:

18. However, it is questionable whether any reliance may be placed in Australia on the decision in Tate & Lyle. In F.C. of T. v. Snowden & Wilson Pty. Ltd. (1958) 99 CLR 431, Taylor and Webb JJ (although in the minority, they were the only judges to directly consider Tate & Lyle) cast considerable doubt on applicability of Tate & Lyle in Australia. Taylor J (see 99 CLR at 451) put the case of Tate & Lyle aside, saying that it "is of no assistance in applying the provisions of s 51(1)". While Webb J. pointed out the considerable difference between the relevant Australian and United Kingdom legislation (see 99 CLR at 440). A similar conclusion was reached by Menzies J in John Fairfax & Sons Pty. Ltd. v. F. C. of T. (1958-1959) 101 CLR 30 at 51, where his Honour stated that due to the differences in the legislation the fact that the decision in Tate & Lyle would allow a deduction does not mean that a deduction is allowable in Australia (see also the Privy Council's comments in Inland Revenue Commissioners v. Appuhamy [1963] 2 AC 127 at 134 that English authorities are not necessarily applicable to non-United Kingdom legislative rules).

19. Even if the reasoning in Tate & Lyle was to be applied in Australia, it is more than likely that it would be concluded that a deduction is not allowable. For, as Lord Reid observed ([1955] AC at 55) "...the company's position is unchanged; it retains its assets and continues to carry on its business. All that happens is that the new shareholders can alter its policy; but a change of shareholders does not interest the company as a trader, and expenditure to prevent a change of shareholders can hardly be expenditure for the purposes of the trade" (see also Lord Morton of Henryton's comments at [1955] AC at 38).

20. Additionally, the Full Federal Court's observations are considered to be inconsistent with the trading operations test in John Fairfax and it is considered more appropriate to apply the test in John Fairfax. It is therefore considered that a deduction would not be allowable in the circumstances referred to in the Full Federal Court's decision in Swan Brewery.

21. The fact that the takeover defence costs are likely to take the form of legal or accountancy expenses or consultancy fees is not of itself significant in determining whether the costs are deductible under subsection 51(1) [now section 8-1].

In Spotlight Stores Pty Ltd v Federal Commissioner of Taxation [2004] FCA 650, the taxpayer, a retail business, restructured the way it paid bonuses to its employees in 1997 via the establishment of a trust fund to which it transferred $15m from which bonuses were to be paid to employees over coming years. Soon afterward, the trust loaned back $15.8m to the taxpayer. The taxpayer claimed the $15m as a deduction for the relevant year. The Commissioner denied the deduction, relying on several alternative grounds, one of which was that the payment was a loss or outgoing of capital or of a capital nature.

Merkel J held that the payment was on revenue account (although the deduction was ultimately denied because Part IVA of the ITAA 1936 applied). He stated:

From a practical and business point of view the criteria stated by Dixon J in Sun Newspapers Limited v FC of T (1938) 61 CLR 337 at 363 ("Sun Newspapers") point to the $15 million contribution being on revenue, rather than capital, account. The contribution was made as part of the restructuring of Spotlight's annual employee bonus scheme by implementing the Post-1997 Scheme as from 1 July 1997. The advantage sought by the contribution was securing the prepayment of bonuses so as to obtain the trust and confidence of Spotlight's employees from year to year in the Post-1997 Scheme, which was expected to yield improved staff retention rates, lower staff turnover and improved staff morale, efficiency, productivity and loyalty. The incentive given to staff by the Post-1997 Scheme was expected to result in the enhancement of Spotlight's profit for each year in which the scheme operated. That advantage did not have a lasting quality as it could only be expected to be enjoyed during each annual period in which the Post-1997 Scheme operated…

The manner in which the advantage was to be used and enjoyed was the maintenance, from year to year, of Spotlight's employees' trust and confidence in the Post-1997 Scheme thereby improving Spotlight's annual profitability. Thus, the advantage, being from year to year, was recurrent.

In so far as the contribution was concerned, the means adopted to obtain the advantage was the prepayment of the bonuses expected to become payable (by payment or being part of the employees' Reserves) over the succeeding five years, which was commensurate with the periods in which the advantage was expected to be enjoyed….

It follows from the foregoing that the purpose of the payment was transient and connected with "the ever recurring question of personnel."

In Heather v PE Consulting Group Ltd [1973] 1 All ER 8 the taxpayer company carried on a management consultancy business whose professional staff held university degrees or professional qualifications. The shares in the taxpayer were owned by a holding company. The shares in the holding company were owned as to 41% by the group's pension fund and as to 59% by outside shareholders. Following drastic changes in management made on two occasions by the outside shareholders which upset the senior professional staff, a scheme was introduced to enable the employees to obtain control over the taxpayer company. A trust fund was set up to purchase shares in the taxpayer company or the holding company to be hold by or for the benefit of employees of the taxpayer company.

Under the scheme the taxpayer company was to make annual payments to the trustees to fund the acquisition of shares in the taxpayer company and the holding company so as to gain control. These payments were deductible because the company's objective was to obtain the goodwill of it staff and to ensure that control of the company would remain in their hands.

Lord Denning MR stated:

The question--revenue expenditure or capital expenditure--is a question which is being repeatedly asked by men of business, by accountants and by lawyers. In many cases the answer is easy; but in others it is difficult. The difficulty arises because of the nature of the question. It assumes that all expenditure can be put correctly into one category or the other; but this is simply not possible. Some cases lie on the border between the two; and this border is not a line clearly marked out; it is a blurred and undefined area in which anyone can get lost. Different minds may come to different conclusions with equal propriety. It is like the border between day and night, or between red and orange. Everyone can tell the difference except in the marginal cases; and then everyone is in doubt. Each can come down either way.

In delivering his judgment, he stated:

It seems to me that the purpose of these payments was to provide an incentive for the staff, to make them more contented and ready to remain in the service of the taxpayer company, and also to help in the recruitment of new staff. … One of the objects here was to remove the possibility of outside interference with the business of the taxpayer company. … This company is dependent on a large number of graduates and professional men. The object of the scheme is to keep their goodwill and to secure that the control will remain in their hands.

In Federal Commissioner of Taxation v Star City Pty Limited [2009] FCAFC 19, Goldberg J (with whom Dowsett and Jessup JJ agreed), emphasised the importance of the principle that the characterisation of a payment of an outgoing, the advantage sought by it, and whether it is an outgoing of revenue or capital, may be determined having regard to the circumstances surrounding, and leading up to, the payment, the whole factual matrix and the context in which the payment was made. This is consistent with a number of authorities including Rotherwood Pty Ltd v Commissioner of Taxation (1996) 64 FCR 313, Tyco Australia Pty Ltd v Federal Commissioner of Taxation [2007] FCA 1055, W T Ramsey v Inland Revenue Commissioners [1982] AC 300 , Inland Revenue Commissioners v Duke of Westminster [1936] AC 1, Jupiters Limited v Deputy Commissioner of Taxation 2002 ATC 4022 and Federal Commissioner of Taxation v Broken Hill Pty Co Ltd (2001) 179 ALR 593.

In AusNet Transmission Group Pty Ltd v Federal Commissioner of Taxation [2015] HCA 25, the appellant taxpayer acquired assets from Power Net Victoria (PNV), a state-owned electricity transmission company, in the context of Victoria's privatisation of its publicly owned electricity supply industry. These assets included a transmission licence in relation to which certain statutory charges were imposed on PNV as holder of the licence that became payable by AusNet when it acquired the licence. The Commissioner denied AusNet a deduction for the charges and AusNet appealed that decision to the High Court. The question before the Court was whether the statutory charges were payments of capital or of a capital nature within the meaning of paragraph 8-1(2)(a).

In their joint judgment, French CJ, Kiefell and Bell JJ referred to Royal Insurance Co v Watson [1897] AC 1 in which the purchaser of an insurance business agreed, as part of the purchase arrangements, to pay a fixed salary to a continuing employee with an election to commute the salary to a gross sum and terminate the employment. The salary, whether or not commuted, was found to be part of the consideration for the purchase of the business and so an outgoing of a capital nature. Their Honours said:

The key factor in characterisation in that case which is of considerable significance in the present appeal, was that the contested payment was part of the consideration for the acquisition of the business.

Later, they said, with reference to their earlier citations of Dixon CJ in Hallstroms (1946) 72 CLR 634 and Fullagar J in Colonial Mutual Life (1953) 89 CLR 428 (both as quoted above):

The critical question must always be - what was the expenditure calculated to effect from the taxpayer's point of view? What was the taxpayer paying the money for?

They said further:

AusNet did not pay the charges in order to reimburse the State for excess revenue it might generate as licence holder. From a practical and business point of view, the assumption of the liability to make the expenditure was calculated to effect the acquisition of the Transmission Licence and the other assets of the subject of the Asset Sale Agreement. The Transmission Licence was an intangible asset, but was properly viewed as part of the structure of the business. Without it, acquisition of the rest of the assets was pointless. If it were revoked after acquisition, the whole business structure would collapse.

The plurality concluded that the charges paid by AusNet were of a capital nature, a conclusion with which Gageler J, in a separate judgment, concurred, stating:

Here … we have a transaction of a purely business nature in which AusNet (on the one hand) and PNV and the State (on the other hand) can safely be assumed to have had full regard to the value of the assets which AusNet was acquiring from PNV. The imposts to be imposed through the making of the Order in Council were not held out by the State to be negotiable in the events which led up to the Asset Sale Agreement. The non-negotiable imposts were nevertheless plainly taken into account by AusNet in setting the additional amount it was prepared to bid as the "Total Purchase Price" which, when added with stamp duty and the imposts, came to be referred to in recital F of the Asset Sale Agreement as "the total payments to the State in connection with the privatisation of [PNV]. The amount AusNet was prepared to bid might well have been different had the revenue cap truly been "reset" and had the imposts not been imposed. But we are not concerned with hypotheticals. In the form in which the parties were content to enter into the transaction, the non-negotiable imposts and the additional amount which AusNet was prepared to bid and which the State was prepared to accept as the "Total Purchase Price" were together in a real commercial sense the price which AusNet committed to pay to the State in order to acquire assets of PNV.

A recent case, AusNet usefully surveyed many of the decided cases dealing with the revenue / capital distinction, but without breaking any new ground. As the Commissioner commented in his Decision Impact Statement on the case, the decision was in accordance with established principles.

A recent case, AusNet usefully surveyed many of the decided cases dealing with the revenue / capital distinction, but without breaking any new ground. As the Commissioner commented in his Decision Impact Statement on the case, the decision was in accordance with established principles.

Application to the facts

Was the loss or outgoing incurred, and if so, when?

A loss or outgoing was incurred when the Board of Company A exercised its discretion to vest and automatically exercise all the then outstanding performance rights and Company A paid a cash contribution to the Company A EST for the purpose of purchasing ordinary shares in Company A to satisfy the exercise of the performance rights for the benefit of the relevant employees, all of which was done to facilitate the Scheme.

Was the loss or outgoing incurred in gaining or producing assessable income?

The payment made by Company A to the Company A EST for the purpose of purchasing ordinary shares in Company A to satisfy the exercise of the said performance rights granted under the Plan to facilitate the Scheme lacks any connection with the operations of Company A which more directly gain or produce Company A's assessable income, and are not incidental or relevant to the operations and activities regularly carried on by Company A for the production of that income. Neither did the vesting and exercise of the performance rights or the subsequent payment to the EST occur in the ordinary course of the Plan's operation, but rather those actions were solely necessitated by, and facilitated, the Scheme for the takeover of Company A. Accordingly, the cash contribution was not incurred in gaining or producing Company A's assessable income and so the condition in paragraph 8-1(1)(a) is not satisfied.

Was the loss or outgoing necessarily incurred in carrying on a business for the purposes of gaining or producing assessable income?

The irretrievable cash contribution was incurred in the context of the Scheme which is not part of carrying on the ordinary business or trading of Company A. The immediate purpose of the payment was to facilitate the Scheme. The payment was concerned with the ownership structure of Company A and neither the payment nor the occasion of the outgoing has any connection to the carrying on of Company A's ordinary business so as to have the character of an ordinary working expense of the business or a cost of the company's trading operations to produce income as part of a normal incident of business.

Is the loss or outgoing capital or of a capital nature?

Of the four categories of exclusions listed in paragraphs 8-1(2)(a) - (d) (the negative limbs), the payments made by Company A in relation to the early vested and exercised performance rights are plainly not of a private or domestic nature, are not incurred in relation to gaining or producing Company A's exempt income or non-assessable non-exempt income and are not prevented from being deducted by any provision of the income tax law (outside subsection 8-1(2)). It remains to be considered whether a deduction would be denied under paragraph 8-1(2)(a) on the basis that the payment represents a loss or outgoing of capital, or of a capital nature.

The irretrievable cash contribution made by Company A to the Trustee of the EST to fund the acquisition of shares by the Trustee to satisfy early vested and automatically exercised performance rights issued under the Plan was an outgoing of capital or of a capital nature and so is prevented by paragraph 8-1(2)(a) from being deductible under section 8-1 whether or not either of the conditions in subsection 8-1(1) is satisfied. This is so for the following reasons.

The expenditure was incurred as a consequence of the Company A Board waiving the vesting and exercise conditions attaching to all of the performance rights then on issue to ensure that a 100% takeover by the acquiring company happened. None of this relates to Company A's ordinary trading operations. As emphasised by Goldberg J in Star City (supra), it is important in the present case to have regard to the entire factual matrix, the surrounding circumstances and background, and the context of the payment, including what led up to the payment in question.

Company A entered into the SID with the acquiring company under which it would acquire all of the issued capital of Company A via the Scheme. This required not only that the existing shareholders dispose of their shares to the acquiring company but that any options and rights to acquire Company A's shares in the future, such as had been granted to certain employees under the Plan, be extinguished.

A condition precedent to the Scheme being effective was that no Executive Incentive Arrangements or any other securities, options, performance rights or instruments will be outstanding or become outstanding or convertible into Company A Shares on or after the Implementation Date.

The implementation of the Scheme brought about a reorganisation situation, opening the way for the Board to exercise the discretions granted it by the Rules for the Performance Rights to be automatically exercised. The Board resolved to automatically exercise the Performance Rights which had the effect of extinguishing all existing rights in Company A, facilitating a 100% takeover by the acquiring company.

The contribution was not made in the ordinary course of Company A's business or in response to an ongoing continual demand of the business. Neither did the early vesting and exercise of the rights, and the subsequent contribution, arise in the ordinary course of the Plan's operation. This was an extraordinary event for Company A and for the Plan (the fact that the Plan may contemplate and provide for a possible eventuality of a takeover or reorganisation does not change the extraordinary nature of such an event). The Scheme (itself an unusual extraordinary event for Company A) was the driver and motivator for the early vesting and automatic exercise of the performance rights which led to the incurrence of the expenditure. There is no evidence that Company A regularly, waived vesting and exercise conditions attached to performance rights issued under the Plan, and consequently made contributions to the Trustee of the EST to satisfy early vested performance rights.

The facts of this case show that the occasion of the outgoing was found in the Scheme and the requirement to deliver 100% interest in Company A to the acquiring company by the completion of the Scheme and for the Scheme to be effective. The acquisition of Company Aby the acquiring company is considered to dominate the circumstance and constitute the guiding element in the characterisation of the contribution made by Company A to the EST (following the test laid down in BP Australia (supra)). In this context, the cash contribution was inextricably linked to the takeover by the acquiring company which is a capital transaction. If those performance rights had still existed after the implementation of the Scheme, the only way to satisfy them would have been to apply for the issue of new shares, as the acquiring company would have acquired all those on issue. This would result in Company A ceasing to be wholly-owned by the acquiring company. The early vesting and exercise of the performance rights and the subsequent contribution to the Trustee of the EST to satisfy the exercise of the said rights, sterilised any future possibility of a dilution of acquiring company 100% ownership in Company A ever occurring (post implementation of the Scheme).

In applying Dixon J's tests in the Sun Newspapers case to the relevant expenditure incurred by Company A, it is apparent that the expenditure (being the cash contribution to satisfy early vested Performance Rights) was not incurred as part of the ordinary business operations of the company. The expenditure was incurred as part of changing the capital structure of Company A from that of having publicly traded securities to being wholly-owned by the acquiring company. This created an ongoing shareholder relationship with the acquiring company for the enduring benefit of Company A's trade. The takeover was seen as a strategic acquisition which aimed to drive incremental profitable growth as a result of scale, client coverage and additional capabilities and skills as well as an increase in competitiveness in the market place.

The decision to vest and automatically exercise the performance rights in question was inter-conditional and inter-dependent on the Scheme becoming Effective and the Scheme provided a benefit of an enduring nature to Company A and altered the profit-yielding structure of Company A.

Furthermore, Company A's position is not supported by the decision in W Nevill and Co as the cash contribution did not facilitate, or remove an obstacle to, the day-to-day trading operations. The cash contribution did not in true substance represent a commuted payment for the release of an ongoing, regular, recurring operating expense of the business but was made to satisfy early vested and exercised performance rights, which was essential to consequently enabling a 100% takeover by the acquiring company. The cash contribution facilitated and secured the transition and delivery of Company A's business and assets into the control of the acquiring company through the privatisation of Company A.

Moreover, Company A's position is not supported by the decision in PE Consulting Group Ltd (supra) as the contribution was not made in the connection with incentivising the employees to remain in the service of Company A's business or to ensure that control of Company A would remain in the employees' hands. Instead, the cash contribution removed an obstacle, being the outstanding performance rights, to achieving a successful 100% change of control of Company A from its existing shareholders (and anyone with claims to ownership interests in Company A such as holders of the performance rights) to the acquiring company.

The Commissioner does not consider Swan Brewery (supra) or Federal Commissioner of Taxation v Consolidated Fertilizers Ltd. to be of assistance to your contentions. Consistent with the Commissioner's position as set out in Taxation Ruling IT 2656 Income tax: deductibility of takeover defence costs, the Commissioner considers that both Swan Brewery (supra) and Consolidated Fertilizers (supra) affirm the Commissioner's view that the contribution paid by Company A to the EST is capital or capital in nature.

Company A's position is not supported by the decision in Spotlight Stores (supra) which involved a contribution that was properly characterised as being a provision of benefits to employees and not capital in nature. Unlike in Spotlight Stores, here the contribution was not made in the ordinary course of the operation of the EST or the Plan and was not made in the same way or for the same reasons as other historical contributions made to the EST. Instead, the contribution was made pursuant to the Scheme, which was directed at facilitating and securing the 100% acquisition of Company A shares by the acquiring company and towards ensuring the performance rights that were on issue pre-takeover were dealt with and disposed of. This resulted in the holders of the performance rights being treated in the same way as other ordinary shareholders in Company A.

Finally, Company A has sought to further rely on Draft Taxation Ruling TR 2014/D1 Income tax: employee remuneration trust arrangements to argue that any capital advantage resulting in from vesting and exercise of the performance rights in the context of the takeover of Company A should be ignored on the basis that it (if any) would be very small or trifling. However, the facts of this case show that the essential purpose and character of the contribution was to facilitate the 100% takeover of Company A. The inter-conditionality and inter-dependence between the Scheme's effectiveness and the disposition of the said performance rights demonstrates that there is nothing trivial about the capital advantage sought to be achieved through the Scheme implementation. This is further evidenced by the fact that the cash contribution resulted in issuing new shares by Company A to the EST for each performance right, allocating these to the affected employees who then participated in the Scheme which was implemented shortly after the contribution was made and received the Scheme consideration. Additionally the Scheme Booklet provides that upon the Scheme becoming Effective, the holders of the performance rights were to be allocated with Company A shares and would then participate in the Scheme.

As such, the Commissioner considers that contribution was not a contribution made to or in respect of the employment of Company A employees but rather was made to enable the 100% takeover over by the acquiring company.

Question 2

Summary

The irretrievable cash contribution made by Company A to the Trustee of the EST to fund the acquisition of shares by the Trustee to satisfy early vested and automatically exercised performance rights issued under the Plan is deductible under section 40-880, commencing in the 2016 income year.

Subsection 40-880(2) allows a taxpayer to deduct capital expenditure it incurs 'in relation to' its business in equal proportions over a period of 5 income years, beginning in the year the expenditure was incurred. However, subsection 40-880(3) limits the deduction by reference to the extent the business is carried on for a taxable purpose.

'Business' is a defined term in subsection 995-1(1) and 'includes any profession, trade, employment, vocation or calling, but does not include occupation as an employee.'

'Taxable purpose' is also a defined term in subsection 995-1(1) and has the meaning given by subsection 40-25(7). This includes the 'purpose of producing assessable income', itself a term defined in subsection 995-1(1) as follows:

[S]omething is done for the purpose of producing assessable income if it is done:

(a) for the purpose of gaining or producing assessable income; or

(b) in carrying on a *business for the purpose of gaining or producing assessable income.

Paragraph 2.47 of the Explanatory Memorandum to Tax Laws Amendment (2006 Measures No. 1) Bill 2006 (the EM) states:

A taxpayer whose business is not carried on for a taxable purpose cannot deduct expenditure to that extent. This limitation is not an annual test: that is, it is not to limit deductions to only the income years in which the business is carried on for a taxable purpose. The test as to the taxable purpose of the business is applied - as at the time the expenditure is incurred - to the taxable purpose of the business by reference to all known and predictable facts in all years.

Apart from subsection 40-880(3), there are various other limitations and exceptions intended to confine section 40-880 to a provision of last resort. Most of these are set out in subsection 40-880(5), which provides that the taxpayer cannot deduct anything under section 40-880 for an amount of expenditure it incurs to the extent that:

(a) it forms part of the cost of a depreciating asset the taxpayer holds, held or will hold;

(b) it is deductible under another provision;

(c) it forms part of the cost of land;

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

(e) it would, apart from section 40-880, be taken into account in working out an assessable profit or deductible loss;

(f) it could, apart from section 40-880, be taken into account in working out the amount of a capital gain or capital loss from a CGT event;

(g) a deduction for it would be expressly denied under another provision if it was not of a capital nature;

(h) another provision expressly prevents it being taken into account as described in paragraphs (a)-(f) above for a reason other than that it is of a capital nature;

(i) it is of a private or domestic nature; or

(j) it is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income.

Subsections 40-880(4) and (7)-(9) set out further exceptions, but they are not presently relevant.

Meaning of 'in relation to'

The phrase 'in relation to' employed in subsection 40-880(2) is not defined in the legislation and so takes its ordinary meaning. Paragraph 2.25 of 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 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 at 330:

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. …

and at 331:

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 which cannot be divorced from the particular statutory context.

In First Provincial Building Society Limited v. Commissioner of Taxation (1995) 56 FCR 320; 95 ACT 4145; (1995) 30 ART 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 either be direct or indirect, provided that the relationship consisted of a real connection, but that a merely remote relationship is insufficient (ATC 4155; ATR 218).

It is therefore necessary to consider the legislative context of subsection 40-880(2) in order to determine whether there is a relevant and appropriate association between the incurrence of the expenditure and a particular business. Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues outlines, at paragraphs 15-17, the circumstances in which certain capital expenditure would be considered to be in relation to a business, as follows:

15. The expression 'in relation to' denotes the proximity required between the expenditure on the one hand and the former, current or proposed business on the other. For capital expenditure to be 'in relation to' a business, there must be a sufficient and relevant connection between the expenditure and the business.

16. The closeness of the association or connection must objectively support the conclusion that the capital expenditure is a business expense of the particular business.

17. Whether capital expenditure is truly business expenditure is determined by the facts. If the facts show that the expenditure satisfies the ends of the relevant business, it will have the character of business expenditure.

Paragraphs 69-92 of TR 2011/6 provide further explanation as to the Commissioner's view in respect of the term 'in relation to a business'. At paragraphs 72-75, the Commissioner states that the use of the expression 'in relation to' in subsection 40-880(2), in contrast to the term 'in carrying on' used in section 8-1, indicates that the test for the purposes of section 40-880 is not as demanding or strict as that in section 8-1. However, the words 'in relation to' still require a sufficiently relevant connection between the business and the expenditure.

At paragraphs 82-84 of TR 2011/6, the Commissioner contrasts expenditure incurred in establishing a business with expenditure relating to the ownership of a business. These paragraphs relevantly state:

82. In many cases, the description of what the expenditure is for will be enough to demonstrate the relationship with the former, proposed or existing business. The connection will be readily evident. For example, capital expenditure incurred to establish the structure (that is, the entity) that is to carry on a proposed business has a clear connection with that proposed business…

83. There is an immediate connection between expenditure of this type and the relevant business because establishing the structure by which the business will be owned and operated is an essential prerequisite to the conduct of the business itself. The occasion of the outgoing can only be explained by reference to the business…

84. 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. [emphasis added]

Application to the facts

As was concluded in answering question 1, the relevant expenditure, being the contribution made to the Trustee of the EST, was an outlay of a capital nature.

The facts establish that Company A was carrying on a profit yielding business, at the time the expenditure was incurred.

Company A incurred the relevant expenditure for the purpose of enabling the EST to acquire shares in Company A to satisfy the then outstanding performance rights that had been vested and automatically exercised by the Board pursuant to the powers contained in the Rules.

Accordingly, the contribution made by Company A to the Trustee of the EST was expenditure relating to the ownership structure of Company A as it resulted in issuing new shares which were then acquired by the acquiring company as part of the Scheme implementation process and it eliminated the existence of rights that may potentially be exercised to acquire shares in Company A in the future. All of this was done in the context of Company A's obligation to deliver 100% of its issued capital to the acquiring company in accordance with the terms of the SID.

The business objective behind the takeover was to ensure the integration between Company A and the acquiring company to bring together their complementary strengths with the aim of building a powerful leader in the region by bringing new capabilities and extending the industry expertise of both organisations.

The complementary customer bases and solid synergies between the two entities will assist both companies to become more competitive, to broaden service offering to customers, and to achieve, from Company A's perspective, the following ongoing business benefits:

• better assisting Company A's clients by offering greater availability of local expertise, accessing global capabilities and providing a broader set of solutions and services to existing customers and a more seamless integration and delivery of those services

• providing greater opportunities for Company A staff to work with a wider range of clients and in providing a wider range of services, and to take advantage of wider career opportunities, and

• furthering Company A's strategy of becoming a growth oriented, client focused, pure-play leader within the industry.

Accordingly, the relevant expenditure is considered capital expenditure relating to the change in the ownership of Company A that serves an objective of Company A's business. It is therefore business related capital expenditure that falls within subsection 40-880(2). The business is evidently carried on for a taxable purpose, so subsection 40-880(3) does not limit the extent of the expenditure that may be deducted under subsection 40-880(2).

On balance, given the context and the circumstances in which the payment was made, the character of the payment to the EST was such that neither the purpose nor expected effect was to preserve or increase the value of employment contracts or goodwill for the following reasons as a whole:

• The purpose and expected effect of the payment was the removal of an impediment to an impending takeover of the company.

• The payment to the EST was not 'remunerative' in nature on the basis the payment, which was not made in the ordinary course of the share plan, was made for the purpose of, and to have the effect of, putting the employees on the same footing as shareholders.

• There was no holding period or performance lock on the resulting shares issued and acquired using the contribution by Company A to the EST i.e. the shares can be dealt with immediately without any precondition for continued employment with Company A.

• On the day the takeover was completed, the merger integration process (which was independent of the decision to terminate and deal with outstanding performance rights) was not yet completed and key management and leadership positions within the merged structure were still undetermined/unannounced (they were finalised and announced only after the takeover completed) - there was no way of knowing or predicting (with some reasonable or non-trivial level of certainty or probability), at the time of the payment of the contribution by Company A to the EST, whether key executives who received the shares through the termination of the outstanding performance rights would be motivated to stay or perform at a higher level (and if so, for how long), given the state of organisational flux and change and the need for ongoing consolidation and rationalisation as the post-merger integration ran its course. Certain key senior executives/leadership left Company A following its takeover by the acquiring company to pursue other endeavours/retired following the takeover. There was no certainty or probable expectation of employee morale/satisfaction/loyalty/productivity as a result of the payment.

• The dominant context of the payment was to satisfy a liability or obligation (at least an equitable one if not a legal/contractual one) to the holders of the performance rights once they became unvested and exercised, and does not relate to an asset of Company A.

None of the exceptions in subsection 40-880(5) apply to the expenditure. Specifically, we address two of the exceptions as follows.

Paragraph 40-880(5)(d) excludes an amount of expenditure from being deductible under section 40-880 to the extent the expenditure was in relation to a lease or other legal or equitable right. The Commissioner's views are set out at paragraphs 223 to 244 (inclusive) of TR 2011/6, and relevantly state:

235. In the absence of a definition or guidance in the 2006 Explanatory Memorandum the expression 'in relation to a lease or other legal or equitable right' takes on its ordinary meaning shaped by the context of the provision. That context shows that paragraph 40-880(5)(d) relates to rights granted over the use of physical and intangible business assets and that at a practical level the paragraph does not have a wide operation because the other, more specific exceptions in subsection 40-880(5) capture the majority of expenditure relating to leases or other legal or equitable rights.

236. The rights to which paragraph 40-880(5)(d) is directed are those similar to leases in that they give the taxpayer a right to exploit the asset with which the right is associated. In other words, the right is carved out of an asset but falls short of full ownership of the asset. Examples of such rights include profits à prendre, easements and other rights of access to land. The rights however are not limited to rights associated with land.

It is considered that the expenditure in question was not incurred in relation to the types of rights intended to be captured under paragraph 40-880(5)(d). Accordingly, paragraph 40-880(5)(d) does not apply.

Paragraph 40-880(5)(f) prevents expenditure that could be taken into account in working out a capital gain or capital loss from a capital gains tax (CGT) event from being deductible under section 40-880. In most cases, capital proceeds and cost base (or reduced cost base) are taken into account in working out the amount of a capital gain or capital loss from a CGT event. Therefore, capital expenditure which reduces capital proceeds from a CGT event or forms part of the cost base (or reduced cost base) of a CGT asset could be taken into account in working out the amount of a capital gain or capital loss from a CGT event for the purposes of paragraph 40-880(5)(f). It is considered that, in the present facts and circumstances, and having regard to the context in which the expenditure was incurred (all of which are explained in detail in answering question 1), the essential character of the payment made by Company A to the EST and what it was practically and commercially calculated to achieve was to facilitate the delivery of 100% of Company A to the acquiring company by sterilising other forms of non-share ownership interests/rights that may potentially convert into shares in Company A in the future which would cause Company A to cease being a wholly-owned subsidiary of the acquiring company. On the facts, it is considered that the expenditure was not made to acquire any CGT asset or to increase or preserve the value or the ownership of any CGT asset of Company A. Accordingly, paragraph 40-880(5)(f) does not apply.

Therefore, Company A is eligible to claim a deduction under section 40-880 for the contribution made to the Trustee of EST to fund the acquisition of shares in Company A to satisfy the early vested and automatically exercised performance rights.

Question 3

Summary

The Commissioner will not seek to make a determination that Part IVA of the ITAA 1936 applies to deny, in part or full, any deduction that Company A would otherwise be entitled to in respect of the irretrievable cash contribution made by Company A to the Trustee of the EST to fund the subscription for Company A shares by the Trustee to satisfy early vested automatically exercised rights issued under the Plan.

Detailed reasoning

Law Administration Practice Statement PS LA 2005/24 (draft) Application of General Anti-Avoidance Rules (PS LA 2005/24 (draft)) deals with the application of the general anti-avoidance rules, including Part IVA of the ITAA 1936. Before the Commissioner can exercise the discretion in respect of Part IVA under subsection 177F(1) of the ITAA 1936, three requirements must be met:

1. there must be a scheme within the meaning of section 177A of the ITAA 1936

2. a tax benefit must arise based on whether a tax effect would have occurred, or might reasonably be expected to have occurred if the scheme had not been entered into or carried out, and

3. having regard to the matters in subsection 177D(2) of the ITAA 1936, the scheme is one to which Part IVA of the ITAA 1936 applies (dominant purpose).

On the basis of an analysis of these requirements, the Commissioner will not seek to make a determination that Part IVA of the ITAA 1936 applies to deny, in part or in full, any deduction claimed by Company A in respect of irretrievable contributions to the Trustee of the EST to fund the subscription for Company A shares by the Trust to satisfy the early vested and automatically exercised performance rights.

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