Edited version of your written advice

Authorisation Number: 1051209163281

Date of Advice: 5 April 2017

Ruling

Subject: Deductibility of business expenses under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)

Question 1

Is Company A entitled to claim a deduction under section 8-1 of the ITAA 1997 for the payment to Company B?

Answer

Yes.

Question 2

Is Company A entitled to claim a deduction under section 8-1 of the ITAA 1997 for the payment of professional fees to a third party?

Answer

Yes.

This ruling applies for the following periods:

Financial year ending 20XY

Relevant facts and circumstances

1. Company A is an Australian resident company for income tax purposes.

2. Company A is wholly owned by Company B.

3. Company A acts as an agent for Company B.

4. Company A charged Company B GST on payments received for services. Company A remitted the GST collected to the Commissioner.

5. The Commissioner and Company A entered into a Deed of Settlement ('the Deed') whereby Company A was to be refunded an agreed portion of the GST previously remitted ('the Settlement Amount'). Pursuant to the Deed, Company A was required to include the Settlement Amount as assessable income in its income tax return for the year in which the Commissioner allocates the settlement amount to the taxpayer's Running Balance Account.

6. The Settlement Amount was credited to Company A's Running Balance Account.

7. Company A paid professional fees to a third party in accordance with a contract for services entered into by Company A. In accordance with the Contract, the third party provided advice in respect of the overpaid GST and negotiated on Company A's behalf to secure a GST refund from the Australian Taxation Office.

8. Company A also paid an amount to Company B. This amount was a reimbursement of GST originally paid by Company B for services provided by Company A.

9. The amount will be declared as taxable income of Company B and will be taxed accordingly.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

All legislative references are made to the ITAA 1997 unless otherwise stated.

Question 1

Is Company A entitled to claim a deduction under section 8-1 for the payment to Company B?

Detailed reasoning

Section 8-1 allows a deduction for a loss or outgoing to the extent that it is incurred in gaining or producing your assessable income (paragraph 8-1(1)(a)), or it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income (paragraph 8-1(1)(b)). Paragraphs 8-1(1)(a) and 8-1(1)(b) are alternatives, known as the 'positive limbs'. In the event one paragraph is satisfied the other need not be considered.

Notwithstanding satisfying a positive limb, subsection 8-1(2) states that you cannot deduct a loss or outgoing under this section to the extent that it is a loss or outgoing of capital, or of a capital nature; or it is a loss or outgoing of a private or domestic nature; or it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or a provision of the ITAA 1997 prevents you from deducting it. These are referred to as the 'negative limbs'.

Positive Limbs

The terms 'loss' and 'outgoing' are not defined in income tax legislation. Similarly, there is minimal definitional guidance provided by case law to assist in the interpretation of their meaning. It is not contentious that the term 'outgoing' covers an outflow of funds from a business. The Macquarie Dictionary defines an 'outgoing' as 'an amount of money expended'. The payment made by Company A to Company B constitutes an 'outgoing' for the purposes of section 8-1.

It is accepted that Company A is carrying on a business for tax purposes.

Broadly speaking, business expenditure is deductible as a general deduction under section 8-1 if it has the necessary and relevant connection with the operation or activities which directly gain or produce assessable income (Charles Moore and Co (WA) Pty Ltd v FC of T, Ronpibon Tin NL v FC of T, FC of T v DP Smith (1981) 147 CLR 578; (1981) 11 ATR 538; 81 ATC 4114). Where a taxpayer carries on a business for the purpose of gaining or producing assessable income, provided that a loss or outgoing can be objectively viewed as a necessary or natural consequence of the taxpayer's income earning activities, it will be incidental and relevant to the income earning activities of the taxpayer and deductible as a revenue deduction in the hands of the taxpayer under section 8-1, except to the extent that it meets any of the negative limbs in section 8-1.

It is uncontroversial to note that section 8-1 does not require a strict tracing of an expense to an amount of assessable income in order for a deduction to be allowed (Herald and Weekly Times Limited v Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169). A line of authorities have established that there will be a link between a loss or outgoing and the derivation of income where there is a sufficient nexus (Amalgamated Zinc (De Bavay's) Limited v The Federal Commissioner of Taxation (1935) 54 CLR 295;(1935) 3 ATD 288, Ronpibon Tin No Liability v The Federal Commissioner of Taxation (1949) 78 CLR 47; 4 AITR 236; (1949) 8 ATD 431, Charles Moore and Co (W.A.) Pty Ltd v Federal Commissioner of Taxation (1956) 95 CLR 344;(1956) 6 AITR 379; (1956) 11 ATD 147). An amount will qualify as a deduction pursuant to the second positive limb of section 8-1 where the outgoing in question has a sufficient nexus with activities directed towards producing assessable income.

Charging and remitting GST to the Commissioner is an ordinary incident of carrying on a business in Australia, subject to the registration requirements outlined in Part 2-5 of A New Tax System (Goods and Services Tax) Act 1999 ('the GST Act'). The charging and remitting of GST is incidental and relevant to, and only required by virtue of, the specific business activities by which Company A generates income in Australia. This does not automatically mean that the repayment of refunded GST will be incidental and relevant to carrying on a business in Australia and will therefore be deductible. However, it influences the characterisation of the payment as being incidental and relevant to carrying on a business.

Taxation Ruling TR 95/33 Income tax: subsection 51(1)- relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings (TR 95/33) clarifies what is specifically required to fulfil the requirements of the second positive limb. Applying the principles from Fletcher and Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613, the ruling states at paragraph 36:

It may be necessary and relevant to have regard to the taxpayer's subjective purpose, motive or intention…for determining whether the expenditure was incurred in carrying on the business of the taxpayer for the purpose of gaining or producing assessable income.

It is important to note that the repayment of the refunded GST to Company B was voluntary. Nothing in the Settlement Deed required Company A to return the refunded GST to the original customer. For this reason, the subjective purpose of Company A should be considered.

When determining deductibility under the second positive limb in circumstances where a payment is voluntary, considering whether the payment was intended to achieve a business end becomes relevant. TR 95/33 refers to the case of Magna Alloys & Research Pty Ltd v Commissioner of Taxation of the Commonwealth of Australia [1980] FCA 180; 33 ALR 213; 80 ATC 4542; 11 ATR 276; 49 FLR 183 at 80 ATC 4548-4549; 11 ATR 283-284 (Magna Alloys), where Deane and Fisher JJ at 80 ATC 4559;11 ATR 295 said:

Where an outgoing [is] not involuntary…the controlling factor is that, viewed objectively, the outgoing must, in the circumstances, be reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business being carried on for the purpose of earning assessable income. Provided it comes within that wide ambit, it will, for the purposes of s.51(1) be necessarily incurred in carrying on that business if those responsible for carrying on the business so saw it.

The term 'necessarily' does not require that the outgoing be unavoidable or logically necessary. Rather, it requires that the outgoing is 'clearly appropriate or adapted for' the ends of the business. While this is a subjective determination to be made by the taxpayer carrying on the business, objectively it can also be concluded that the outgoing is clearly appropriate in these circumstances as Company A is acting as a conduit to return the overpaid GST to the original payer.

While a deduction would not ordinarily be allowed for GST paid or refunded, the current circumstances can readily be distinguished from situations where the ordinary approach is appropriate. The facts in this case are distinguishable because ordinarily, where a GST refund is provided and then reimbursed to an original consumer, the refunded amount would not be included in the assessable income of the taxpayer. In this case, Company A is, under the Deed, required to characterise the Settlement Amount as assessable income in its income tax return for the income tax year. The outgoing to Company B therefore has a direct nexus with an amount of assessable income. Company A does not benefit economically from this transaction, but is acting merely as a conduit to return what is effectively refunded GST. As such, in this specific circumstance, it is considered that the outgoing is 'clearly appropriate' and there is sufficient connection for the payment to be taken as 'necessarily incurred in' the course of carrying on Company A's business, satisfying the second positive limb of section 8-1.

Negative Limbs

None of the negative limbs outlined in paragraphs 8-1(2)(a)-(d) are applicable to deny a deduction in these circumstances.

Capital or capital in nature

The payment to Company B is not capital or capital in nature as it is not being paid for a capital asset, or to secure an enduring benefit for Company A. In Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403 (Sun Newspapers), Dixon J provided an authoritative guide on whether expenditure is of a capital or revenue nature, emphasising that capital expenditure relates to the profit-yielding structure whereas costs associated with the continual running of the business are best characterised as revenue expenditure.

ATO Interpretative Decision ATO ID 2004/648 Income tax Deductions: annual operating fee paid by taxi licensee states that, drawing from Sun Newspapers, the following characteristics are accepted as an indication that an outgoing is on capital account:

the expenditure is related to the business structure itself, that is, the establishment, replacement or enlargement of the profit yielding structure rather than the money earning process; or the nature of the advantage has a lasting and enduring benefit; or the payment is 'once and for all' for the future use of an asset or advantage rather than being recurrent and ongoing.

In making the payment to the Company B, Company A does not secure any enduring benefit or capital advantage for itself. Company A is merely returning to a customer an amount of money that they were not required to remit. The payment does not have a capital nature.

Private or domestic in nature

Nothing in the facts suggests that the payment is private or domestic in nature.

Incurred in gaining or producing exempt or NANE income

Nothing in the facts suggests that the payment was incurred in gaining or producing exempt or NANE income.

A provision of ITAA 1997 denies deductibility

The payment will not be prevented from being deductible under a specific provision of the ITAA 1997.

Conclusion

Accordingly, Company A is entitled to an income tax deduction in accordance with section 8-1 for the payment made to Company B.

Question 2

Is Company A entitled to claim a deduction section 8-1 for the payment of professional fees to a third party?

Detailed reasoning

As outlined above, section 8-1 allows a deduction for a loss or outgoing to the extent that it is incurred in gaining or producing your assessable income or it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. However, you are not entitled to a deduction where the loss or outgoing is of capital, or a capital nature; of a private or domestic nature; is incurred in gaining or producing your exempt or non-assessable non-exempt income; or another provision of the ITAA 1997 denies you a deduction for the expenditure.

Positive limbs

Company A made a payment to a third party in accordance with a professional services contract. This constitutes an 'outgoing' for the purposes of section 8-1.

An expense will generally be 'incurred' when you have a current legal obligation to pay for the goods or services. In accordance with the contract, the fee became payable when the amounts were quantified by the Commissioner and credited to Company A's Running Balance Account. Further, the fee has already been paid to the third party. This expense has therefore been incurred for the purposes of section 8-1.

The Deed entered into with the ATO required Company A to include the GST refund as assessable income. Therefore, there is a direct nexus between the services for which the payment was made and the derivation of assessable income. It was by virtue of the services conducted by the third party that Company A was able to obtain the GST refund. The payment was thus incurred in gaining Company A's assessable income, being the refunded GST, as the third party only received the payment if a refund was obtained.

It is noted that the professional fees cover more than securing a GST refund from the Commissioner on Company A's behalf. The services also include the provision of advice in respect of GST. This portion of the payment also satisfies the requirements of the first positive limb in section 8-1, as those services have a direct nexus with producing the assessable income of Company A.

The professional fee is structured to cover a package of activities performed by the third party, all of which are related to the GST-related rights and obligations of Company A. Analysis of court decisions and their impact on the prospects of success for any potential GST refunds for Company A are all necessary elements of the package of activities carried on by the third party that ultimately resulted in the refund being obtained by Company A.

Consequently, the professional fees paid to the third party meet the requirements for deductibility of outgoings outlined in the positive limbs of section 8-1.

Negative Limbs

None of the negative limbs outlined in paragraphs 8-1(2)(a)-(d) are applicable to deny a deduction in these circumstances.

Capital or capital in nature

For professional fees to be deductible, they must clearly be of a revenue nature and not of a capital nature. A weighing of the factors in Sun Newspapers is required in determining the nature of an outgoing. The payment does display a number of characteristics indicative of capital expenditure: it was a one-off payment and an enduring benefit can be identified in that Company A is no longer required to withhold and remit GST in the future. However, it can equally be argued that the expenditure is related to the revenue earning process rather than the business structure itself, in that the requirement to withhold and remit GST is intrinsically linked with the day to day commercial activities of Company A.

It was noted in Magna Alloys that whilst expenditure on legal expenses may serve to protect the reputation and goodwill of a business, this will not make the expenditure capital in nature if the taxpayer is defending the way in which it operated its commercial activities in the course of carrying on its business. While the fees in question in this case are not legal expenses, the focus in Magna Alloys with regards to the nature of the expenses revolved around whether the expense was ultimately connected with the way the entity operated its commercial activities, despite an enduring benefit being identifiable.

Although an enduring benefit may arguably have been secured by the payment, in that Company A no longer has the requirement to withhold and remit GST in the future, that requirement is so closely connected to the day-to day commercial activities of Company A that the expense should be deductible under section 8-1 as a revenue, rather than a capital expense.

Private or domestic in nature

Nothing in the facts suggests that the payment is private or domestic in nature.

Incurred in gaining or producing exempt or NANE income

Nothing in the facts suggests that the payment was incurred in gaining or producing exempt or NANE income.

A provision of ITAA 1997 denies deductibility

The professional fees will not be prevented from being deductible under a specific provision of the ITAA 1997.

Conclusion

Company A is therefore entitled to an income tax deduction in accordance with section 8-1 for the professional fees paid to the third party.

The rulings in the register have been edited and may not contain all the factual details relevant to each decision. Do not use the register to predict ATO policy or decisions.

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