Edited version of your written advice

Authorisation Number: 1013073482937

Date of advice: 19 August 2016

Subject: Project licence fees

Question 1

Will the licence payments incurred by Entity P be deductible pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Will Division 250 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to Entity P in relation to its interest in the Project?

Answer

No

Relevant facts and circumstances

Entity P will enter into an Agreement to ensure the design and construction of an asset and provide services in respect of the asset for Entity S ('the Project').

The Project comprises a design and construction phase followed by a services phase. At the conclusion of the Project, Entity P's rights to access the asset under the Agreement will come to an end and Entity S will maintain its unencumbered legal ownership of the facility. Entity P will have no underlying proprietary right in the facility asset.

Entity S will grant Entity P a non-exclusive licence to access the areas necessary to carry out its contracted duties for the duration of the Project. Entity P will pay licence fees to Entity S over the duration of the services phase for the right to enter access the asset in order to provide the contracted services. The rights revert to Entity S at the relevant time.

Entity S will pay Entity P over the construction phase amounts which will match the costs incurred by Entity P. Entity S will also pay Entity P amounts during the services phase to operate the asset.

Entity P will subcontract the design and construction of the asset, and the provision of services.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 paragraph 8-1(1)(a)

Income Tax Assessment Act 1997 paragraph 8-1(1)(b)

Income Tax Assessment Act 1997 paragraph 8-1(2)(a)

Income Tax Assessment Act 1997 paragraph 8-1(2)(b)

Income Tax Assessment Act 1997 paragraph 8-1(2)(c)

Income Tax Assessment Act 1997 paragraph 8-1(2)(d)

Income Tax Assessment Act 1997 Division 230

Income Tax Assessment Act 1997 subsection 230-20(4)

Income Tax Assessment Act 1997 Division 250

Income Tax Assessment Act 1997 section 250-1

Income Tax Assessment Act 1997 section 250-15

Income Tax Assessment Act 1997 paragraph 250-15(a)

Income Tax Assessment Act 1997 paragraph 250-15(b)

Income Tax Assessment Act 1997 paragraph 250-15(c)

Income Tax Assessment Act 1997 paragraph 250-15(d)

Income Tax Assessment Act 1997 paragraph 250-15(e)

Income Tax Assessment Act 1997 subparagraph 250-15(d)(i)

Income Tax Assessment Act 1997 subparagraph 250-15(d)(ii)

Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision

All legislative references are to provisions of the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.

Summary

The licence payments will be deductible under section 8-1.

Detailed reasoning

The licence payments incurred by Entity P will be deductible pursuant to section 8-1. The payments will be incurred in gaining or producing Entity P's assessable income for the purposes of paragraph 8-1(1)(a) and will not be outgoings of capital or of a capital nature for the purposes of paragraph 8-1(2)(a).

Taxation of Financial Arrangements (ToFA) rules

The TOFA rules contained in Division 230 set out the income tax treatment of gains and losses made on financial arrangements. Subsection 230-20(4) provides that if the TOFA rules apply then section 8-1 will not apply. Prior to considering whether section 8-1 applies it is necessary to consider if the TOFA rules apply to the payments and receipts under the licence.

The Commissioner accepts that payments made in respect of the licence will not be subject to the TOFA rules. Should the licence constitute a 'financial arrangement' for the purposes of Division 230, it is the subject of an exception as 'an arrangement that is a licence to use real property' pursuant to paragraph 230-460(2)(e).

Pursuant to the licence, Entity P will be enabled to access to the asset in order to perform the services. The licence will be an arrangement that gives Entity P the right to use the asset in order to perform its contracted obligations and therefore will not be subject to the TOFA rules.

Section 8-1 of the ITAA 1997

Section 8-1 provides:

8-1(1) You can deduct from your assessable income any loss or outgoing to the extent that:
(a)  it is incurred in gaining or producing your assessable income; or

(b)  it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

8-1(2) However, you cannot deduct a loss or outgoing under this section to the extent that:

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

Paragraph 8-1(1)(a): Are the payments incurred in gaining or producing Entity P's assessable income?

The connection between a taxpayer's outgoings and the generation of assessable income was considered in Ronpibon Tin NL and Tongkah Compound NL v FC of T (1949) 78 CLR 47. The High Court of Australia stated at 56-57 that:

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.

and:

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.

Under the Agreement, Entity P must perform its contractual obligations to provide the Services or ensure the provision of the Services. In return, Entity P will derive assessable income from Entity S.

As part of the arrangements under which Entity P is to perform the Services, Entity S will grant Entity P a licence to access the asset. Entity P will make the payments in exchange for the right.

The occasion of each payment will be found in what will be productive of Entity P's assessable income. Each payment will be an outgoing incurred by Entity P in gaining or producing its assessable income for the purpose of paragraph 8-1(1)(a).

Having satisfied the positive limb in subsection 8-1(1), the payments must also not fall within any of the negative limbs in subsection 8-1(2).

Negative Limbs

The relevant negative limb in subsection 8-1(2) is whether the payments are capital, or of a capital nature.

Paragraph 8-1(2)(a): Will the payments be outgoings of capital, or of a capital nature?

The courts have established a number of principles or tests to be applied in determining whether a loss or outgoing is capital, or of a capital nature (as opposed to being of a revenue nature). In Sun Newspapers Ltd v FC of T (1938) 61 CLR 337 (Sun Newspapers) at 359 Dixon J said:

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organisation 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.

and at 363:

There are, I think, three matters to be considered [in determining whether expenditure is on revenue or capital account], (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 a 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 the payment or by making a final provision or payment so as to secure future use or enjoyment

Character of the advantage sought

In considering these matters in Hallstroms Pty Ltd v FC of T (1946) 72 CLR 634 Dixon J said (at 646-647):

…it may be useful to recall the general consideration that the contrast between the two forms of expenditure [income and capital] corresponds to the distinction between the acquisition of the means of production and the use of them; between establishing or extending a business organisation and carrying on the business; between the implements employed in work and the regular performance of the work in which they are employed; between an enterprise itself and the sustained effort of those engaged in it…. 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.

and at 648:

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...

In Colonial Mutual Life Assurance Society Ltd v FC of T (1953) 89 CLR 428 at 454 Fullagar J said:

The questions which commonly arise in [determining whether expenditure is on revenue or capital account] are (1) What is the money really paid for? - and (2) Is what it is really paid for, in truth and in substance, a capital asset?

In FC of T v CityLink Melbourne Limited 2006 ATC 4404 (CityLink), Crennan J (with whom Gleeson CJ, Gummow J, Callinan J and Heydon J agreed) of the High Court of Australia stated at 4427 that:

The characterisation of an outgoing depends on what it is calculated to effect to be judged from a practical and business point of view…The character of the advantage sought by the making of the expenditure is critical.

Advantage Sought

In FC of T v Star City Pty Ltd (2009) FCR 39 at 51-52, Goldberg J said:

The primary judge correctly identified the relevant principles to apply in determining whether [the outgoing] was an item of revenue or of capital and in determining the character of the advantage sought and the characterisation of the [outgoing]. In particular, the primary judge observed that an examination of the character of the advantage sought was assisted by asking two questions: What was the [outgoing] really paid for; and, is what it was really paid for, in truth and in substance, a capital asset? Her Honour accepted that the answer to these questions…depended upon what the expenditure was calculated to effect from a practical and business point of view.

The character of the advantage sought provides important guidance as to the nature of the expenditure because it says the most about the essential character of the expenditure itself. The decision of the High Court in GP International Pipecoaters Pty Ltd v Commissioner of Taxation (1990) 170 CLR 124 at 137; (1990) 90 ATC 4413 at 4419; (1990) 21 ATR 1 at 7 emphasised this, stating:

The character of expenditure is ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure, for the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid: Sun Newspapers Ltd. and Associated Newspapers Ltd. v Federal Commissioner of Taxation (1938) 61 C.L.R 337, at p.363 …

When the matters stated by Dixon J in the Sun Newspapers Case are considered, the character of the advantage sought by making the expenditure is the chief, if not the critical factor in determining the character of what is paid. The nature or character of the expenditure will therefore follow the advantage that is sought to be gained by incurring the expenditure.

In terms of the character of the advantage which is sought by Entity P, the periodic payments enable Entity P to use the facility asset to perform the contracted services and to obtain payments from Entity S.

The licence payments are, from a practical and business point of view, expenditure calculated to effect Entity P's provision of contracted services. Each payment secures Entity P's right to access and use the facility asset to provide the services for the period to which the licence relates.

The character of the advantage sought by Entity P is the fulfilment of its obligations to deliver the contracted services to Entity S, allowing derivation of assessable income.

Each licence payment is a recurring expense for Entity P and represents an outgoing in the ordinary course of carrying on Entity P's business rather than an outgoing to establish or enlarge its business organisation or structure. This advantage does not have any lasting quality or enduring benefit beyond the period to which the licence relates.

In relation to the character of the advantage sought by the expenditure it is necessary to examine whether the expenditure secures an enduring benefit for the business. This test was outlined in British Insulated and Helsby Cables Ltd v Atherton [1926] AC 205 at 213-214 by Viscount Cave where he stated:

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.

Enduring benefit for the business

In CityLink, the High Court of Australia considered the deductibility of concession fees paid by a taxpayer to the State of Victoria in consideration for the right to design, construct, operate and impose a toll in respect of certain City Link roads. The concession fees were payable in two instalments per year and adjusted pro-rata for any part year periods. The majority of the High Court found that the concession fees did not secure any enduring asset in terms of the roads built but, rather, resulted in the acquisition of the right to build, operate and earn a profit from the tolls charged for the use of those roads for the duration of the concession period. Crennan J (with whom Gleeson CJ, Gummow J, Callinan J and Heydon J agreed) applied the 'three matters' laid down by Dixon J in Sun Newspapers in determining that 'concession fees' paid to the State in respect of a public private partnership arrangement were on revenue account and, in addition to the quote set out above, Crennan J further stated, at 4427 (paragraph 154) that:

The concession fees are only payable during the term of the concession period. The respondent does not acquire permanent ownership rights over the roads or lands used. All rights granted under the Concession Deed revert to the State at the expiry of the concession period [cf Cliffs International Inc v Federal Commissioner of Taxation (1979) 142 CLR 14]. Unlike periodic instalments paid on the purchase price of a capital asset, the concession fees are periodic Project Agreement in respect of the Link infrastructure assets, from which the respondent derives its income, but which are ultimately "surrendered back" to the State. Accordingly, they are on revenue account.

Entity P will not acquire permanent ownership rights over the asset. All rights granted under the licence will revert to Entity S on the expiry or termination of the licence.

Further, the licence payments do not reflect the purchase price of a capital asset. Accordingly, this factor supports the view that the payments are on revenue account.

Therefore, the Commissioner regards the payments as revenue in nature and the character of the payments is not altered by virtue of the fact that the payments will occur over an extended period of time.

Accordingly, the payments incurred are not capital, or of a capital nature and therefore, will not fall within any of the negative limbs in subsection 8-1(2).

Summary

Division 250 will not apply to Entity P as this entity is not entitled to a deduction for capital allowances for the decline in value of an asset, nor for capital expenditure in relation to an asset in respect of the Project.

Detailed reasoning

Division 250 denies or reduces capital allowance deductions that would otherwise be available in relation to an asset if the asset is put to a tax preferred use and the taxpayer has insufficient economic interest in the asset.

The general test for application of Division 250 is set out in section 250-15 which provides that the Division will apply to a taxpayer and an asset at a particular time if:

(a)  the asset is being *put to a tax preferred use; and

(b)  the *arrangement period for the *tax preferred use of the asset is greater than 12 months; and

(c) *financial benefits in relation to the tax preferred use of the asset have been, will be or can reasonably be expected to be, *provided to you (or a *connected entity) by:

(i)  a *tax preferred end user (or a connected entity); or

(ii)  any *tax preferred entity (or a connected entity); or

(iii)  any entity that is a foreign resident; and

(d)  disregarding this Division, you would be entitled to a *capital allowance in relation to:

(i)  a decline in the value of the asset; or

(ii)  expenditure in relation to the asset; and

(e)  you lack a *predominant economic interest in the asset at that time.

Each of the conjunctive requirements in paragraphs 250-15(a)-(e) must be present for the general test to be satisfied. If one of the paragraph requirements is not present, it is sufficient to conclude that the general test is not satisfied and accordingly, that Division 250 does not apply.

The terms of the Agreement are such that Entity P will have no underlying proprietary right in the asset.

Entity P will undertake the business required under the contracted services of ensuring the construction of the asset and the provision of contracted services. It will conduct this business by subcontracting the services. The income it receives from Entity S is incidental and relevant to its activities of providing the contracted services and will be included in its assessable income.

The payments Entity P makes to the subcontractors under the relevant agreements are made in the ordinary course of its business. These payments are not capital, or of a capital nature. Entity P will be reimbursed for its costs.

In order for Division 250 to apply, Entity P must, among other things, be entitled to deductions for capital allowances pursuant to Division 40 or for expenditure on project works pursuant to Division 43. On the basis that the payments incurred by Entity P are deductible under section 8-1, the payments are not capital or of a capital nature and it is therefore not necessary to consider if Entity P is, or will be, entitled to claim a deduction for capital allowances under Division 40 or for expenditure on project works pursuant to Division 43.

Therefore, as section 8-1 applies to all expenditure incurred by Entity P, Division 250 does not apply to Entity P, and thus Entity P is not entitled to a deduction for capital allowances, as required by paragraph 250-15(d).

As Entity P does not satisfy one of the conjunctive requirements for Division 250 to apply, in this circumstance the paragraph 250-15(d) requirement, Division 250 does not apply.

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