Edited version of your written advice

Authorisation Number: 1051232890975

Date of advice: 14 June 2016

Ruling

Subject: Deductibility of Transaction Costs

Question 1

Are the Transaction Costs deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)

Answer

No

Question 2

(a) Are the Transaction Costs for invoice A and B entirely deductible as incurred in managing G Company’s tax affairs under section 25-5 of the ITAA 1997?

(b) If No to (a), are the Transaction Costs for the invoice A deductible under section 25-5 of the ITAA 1997 as incurred in G Company’s tax affairs to the extent the costs were for:

… calculating income tax payable for G Company …?

Answer

(a) No

(b) Yes

Question 3

Is the balance of the Transaction Costs incurred by G Company deductible under section 40-880 of the ITAA 1997?

Answer

Yes

Relevant facts and circumstances

G Company carries on a business for the purposes of deriving assessable income.

Transaction costs were incurred by G Company order to identify potential growth opportunities including considering various proposals and the selected Transaction.

Professional advisors were engaged for this purpose. The proposals affected G Company’s structure and its trading operations.

The process resulted in the Transaction with H Company.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 8-1(1)

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

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

Income Tax Assessment Act 1997 subsection 8-1(2)

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 subsection 25-5(1)

Income Tax Assessment Act 1997 section 40-880

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

Income Tax Assessment Act 1997 paragraph 40-880(2)(a)

Income Tax Assessment Act 1997 paragraph 40-880(2)(b)

Income Tax Assessment Act 1997 paragraph 40-880(2)(c)

Income Tax Assessment Act 1997 paragraph 40-880(2))d)

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

Income Tax Assessment Act 1997 subsections 40-880(5) to (9)

Reasons for decision

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

Question 1

Summary

The Transaction Costs are not deductible under section 8-1.

Detailed reasoning

Section 8-1 is the general provision for allowable deductions. This section states:

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

(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.

The Commissioner considers that the Transaction Costs are not deductible under section 8-1 as the costs were an outgoing of capital, or of a capital nature pursuant to paragraph 8-1(2)(a).

The decision of the High Court of Australia in Sun Newspaper Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 23; (1938) 1 AITR 403 (Sun Newspapers) is the leading authority on the distinction between revenue and capital expenditure. The general rule is found in the frequently quoted statement of Dixon J as he then was at 359-360 where he said:

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 organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss…As general conceptions it may not be difficult to distinguish between the profit yielding subject and the process of operating it. In the same way expenditure and outlay upon establishing, replacing and enlarging the profit-yielding subject may in a general way appear to be of a nature entirely different from the continual flow of working expenses which are or ought to be supplied continually out of the returns or revenue.

The classic formulation of the matters to be considered in determining whether a loss or outgoing is of a capital or revenue nature is that of Dixon J at 363 in the Sun Newspapers case where his Honour said:

There are l think three matters to be considered:

(a) the character of the advantage sought, and in this its lasting quantities 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 the payment or by making a final provision or payment so as to secure future use or enjoyment.

1. The character of the advantage sought

Sun Newspapers highlights that expenditure in establishing, replacing and enlarging the profit-yielding (i.e. business) structure is capital and is to be contrasted with working or operating expenses.

The character of the advantage sought by G Company in incurring the Transaction Costs was to facilitate the growth of its business, that is, to enlarge its profit-yielding structure.

2. The manner in which the advantage is to be used, relied upon or enjoyed

The second test in Sun Newspapers requires an examination of the manner in which the benefit obtained is to be used, relied upon or enjoyed.

It is likely that all business expenditure is made with the intention of securing some commercial advantage. It is necessary to establish the effect of the expenditure and how long the effect is likely to endure. Where the expenditure results in an intangible benefit or advantage, it is necessary to establish whether the asset is sufficiently substantial and has substantial enduring benefit to count as capital.

Where a loss or outgoing gives rise to a benefit of an enduring nature, the loss or outgoing is more likely to be capital in nature. The test arose to prominence in British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 where it was held that an employer contribution to establish a staff pension fund was capital in nature on the basis that it brought into existence an asset of 'enduring benefit’. Viscount Cave LC stated at 192 that:

When an expenditure is made, not only once and for all, but with a view to bring into existence an asset or advantage for the enduring benefit of a trade, l 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.

It is noted that the term 'enduring’ does not mean that the asset or advantage should last forever. This was supported in Commissioner of Taxes v. Nchanga Consolidated Cooper Mines Ltd [1964] 1 All ER 208 in which it was stated that 'permanent’ does not mean 'perpetual’.

G Company incurred the various Transaction Costs in the course of conducting a strategic review to capitalise on growth opportunities referred to in the Relevant facts and circumstances. G Company’s consider growth opportunities resulted in the Transaction which enabled G Company to achieve the growth opportunities.

In conclusion it is considered that the transactions costs rendered a significant enduring benefit for G Company.

3. The means adopted to obtain it

The third test in Sun Newspapers is the means adopted to obtain the benefit.

There is a distinction between operating a business and expanding a business. In Hallstroms Pty Ltd v. Federal Commissioner of Taxation(1946) 72 CLR 634, Dixon J as he then was referred at 647 to the general consideration that:

… the contrast between [expenditure on capital or revenue account] 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.

Many judgments in relation to the deductibility of expenditure refer to the statement by Viscount Cave in British Insulated and Helsby Cables Ltd v. Atherton (1926) AC 205 at pages 213-214:

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 a 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.

In G Company’s circumstances, the Transaction Costs are not a recurrent business expense but amount to one-off payments in consideration for the analysis of growth opportunities.

Legal expenses

G Company’s Transaction Costs are of capital or are of a capital nature as the Transaction was concerned with the enlargement of G Company’s profit-yielding structure. Where the Transaction Costs are legal expenses, they are nevertheless not deductible under section 8-1 as they remain losses or outgoings of capital, or are of a capital nature.

Conclusion

Upon consideration of the three factors in Sun Newspapers, the Commissioner considers that the Transaction Costs were outgoings of capital or of a capital nature.

It is not necessary to consider if the payments satisfy the positive limb in subsection 8-1(1).

Question 2

Summary

The fees paid for 'Tax Due Diligence’ are not deductible under section 25-5 as these fees were not incurred by G Company in managing its tax affairs.

Professional service fees paid for 'Tax Advisory as Tax Agent’ are not entirely deductible under section 25-5 as the majority of these fees were not incurred by G Company in managing its tax affairs.

The fees were deductible pursuant to section 25-5 to the extent the fees for:

… calculating income tax payable for G Company …

Detailed reasoning

Section 25-5 allows a deduction for incurred in managing one’s own tax affairs which includes complying with a legal obligation in relation to an entity’s tax affairs.

Subsection 25-5(1) states:

You can deduct expenditure you incur to the extent that it is for:

(a) managing your *tax affairs; or

(b) complying with an obligation imposed on you by a *Commonwealth law, insofar as that obligation relates to the *tax affairs of an entity; ...

The exclusions in subsections 25-5(2) and 25-5(4) are relevant. These subsections provide:

(2) You cannot deduct under subsection (1):

...

(e) a fee or commission for advice about the operation of a *Commonwealth law relating to taxation, unless that advice is provided by a *recognised tax adviser.

...

(4) You cannot deduct capital expenditure under subsection (1). However, for this purpose, expenditure is not capital expenditure merely because the tax affairs concerned relate to matter of a capital nature.

Meaning of tax affairs

The expression 'tax affairs’ was not then defined, but 'tax’ was defined in effect to mean income tax assessed under the ITAA 1997 and / or the ITAA 1936.

Subsection 995-1(1) states that 'tax’ means:

(a) income tax imposed by the Income Tax Act 1986, as assessed under this Act; or

(b) income tax imposed as such by any other Act, as assessed under this Act.

Meaning of recognised tax adviser

Subsection 995-1(1) defines a 'recognised tax adviser’ to mean a registered tax agent or a legal practitioner.

With the exception of part of invoice A the Commissioner considers that the relevant Transaction Costs were not incurred in managing G Company’s tax affairs. The fees were not incurred towards lodging a tax return or statement, in the course of an ATO Audit or to comply with a Notice. Nor were the fees incurred for complying with a Notice or another obligation imposed on G Company by a Commonwealth law that relates to the tax affairs of another entity.

The Commissioner considers that, to the extent the sub-itemised amount on invoice A refers to:

- calculating income tax payable for G Company ...

that this extent is deductible to G Company as costs of managing its tax affairs pursuant to section 25-5.

The remainder of invoice A, and the other amounts which make up the Transaction Costs, are not deductible as costs incurred by G Company in managing its tax affairs pursuant to section 25-5.

Question 3

Summary

The balance of the Transaction Costs incurred by G Company is deductible under section 40-880.

Detailed reasoning

Section 40-880 provides a deduction for certain business related capital expenditure costs which would otherwise not be deductible for Australian income tax purposes.

As set out in subsection 40-880(1), the object of section 40-880 is:

… to make certain *business capital expenditure deductible over 5 years if:

(a) the expenditure is not otherwise taken into account; and

(b) a deduction is not denied by some other provision; and

(c) the business is, was or is proposed to be *carried on for a *taxable purpose.

Subsection 40-880(2) provides that:

You can deduct, in equal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur:

(a) in relation to your *business;

(b) in relation to a business that used to be *carried on; or

(c) in relation to a business proposed to be carried on; or

(d) to liquidate or deregister a company of which you were a *member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary that carried on a business.

There are various limitations and exceptions to the business capital expenditure deductions in section 40-880 set out in subsections 40-880(3)-(9).

G Company continued to carry on the same business after the ownership restructure was facilitated. The balance of the Transaction Costs were expenditure incurred in relation to either G Company’s business (paragraph 40-880(2)(a)) or a business that G Company proposed to carry on (paragraph 40-880(2)(c)).

Capital expenditure you incur in relation to your business

The expression 'capital expenditure you incur in relation to your business’ is not defined in the legislation; however guidance as to its meaning is provided in both Taxation Ruling TR 2011/6: Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues (TR 2011/6) and in the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No.1) Bill 2006 (the Explanatory Memorandum).

Paragraph 70 of TR 2011/6 sets out the Commissioner’s view that:

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. Establishing that the expenditure is in relation to the relevant business is the threshold step in determining whether the expenditure can be deducted …..

This is supported in paragraph 2.10 of the Explanatory Memorandum which states that:

A key principle in determining the deductibility of business capital expenditure is the relationship between the expenditure and the business. This nexus will be a question of fact and in determining the relationship of the expenditure to the business, the former business or the prospective business, and when the expenditure is incurred, are necessarily considered.

In considering the phrase 'in relation to’ contained within subsection 40-880(2), paragraph 2.25 of the Explanatory Memorandum states:

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

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

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

In that case, Toohey and Gummow JJ also observed:

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

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

In First Provincial Building Society Limited v. FC of T 95 ATC 4145; 30 ATR 207, Hill J considered the phrase 'in relation to’ in the context of former paragraph 26(g) of the ITAA 1936. Hill J 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 a merely remote relationship was insufficient.

It is therefore necessary to consider the legislative context of subsection 40-880(2) in order to determine if there is a sufficient and relevant connection between the expenditure which is incurred and a particular business. In discussing the types of business capital expenditure to which subsection 40-880(2) applies, paragraphs 2.19, 2.20 and 2.22 the Explanatory Memorandum state:

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

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

Taxpayers can deduct the following specific the following specific types of capital expenditure:

…

● expenditure to raise equity for your business;

…

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

G Company incurred the balance of the Transaction Costs (the capital expenditure) for the reasons set out in the Relevant facts and circumstances.

The majority of expenses were incurred in respect to professional advice in relation to the Transaction which included the provision of professional services.

It must be considered whether there is sufficient and relevant connection between each item of expenditure incurred by G Company and its business or the business which G Company proposed to carry on.

Subsection 40-880(2) requires identification of the business in relation to which the relevant capital expenditure was incurred. Paragraph 21 of TR 2011/6 states that:

The reference in paragraph 40-88092)(a) to 'your business’ is a reference to the taxpayer’s overall business rather than a particular undertaking or enterprise within the overall business …

G Company carried on a relevant business. Analysis was carried out to identify growth opportunities. The Transaction was undertaken after extensive advice was provided and considered.

The nature of the Transaction affected the manner, in which G Company carried on or proposed to carry on its business, and was undertaken to facilitate growth of the business.

The Commissioner accepts that there is a clear and direct nexus between the capital expenditure incurred by G Company and its business or the business it proposed to carry on. Accordingly, the expenditure is capital incurred 'in relation to’ the business of G Company for the purpose of paragraph 40-880(2)(a) and / or paragraph 40-880(2)(c).

G Company’s circumstances are consistent with Example 6 set out in TR 2011/6 which states:

Example 6

85. Company B approaches Company A with a merger proposal. To evaluate the proposal Company A incurs capital expenditure on professional fees for legal, corporate and tax advice and for the performance of financial due diligence. The object of the expenditure is to determine the commercial merit of the proposal including the effect on the company’s structure and its trading operations. The expenditure is in relation to Company A’s business for the purpose of paragraph 40-880(2)(a).

Limitations and exceptions

Taxable purpose

Subsection 40-880(3) provides that:

You can only deduct the expenditure, for a *business that you *carry on, used to carry on or propose to carry on, to the extent that the business is carried on, was carried on or is proposed to be carried on for a *taxable purpose.

The term 'taxable purpose’ is relevantly defined as 'the purpose of producing assessable income’; paragraph 40-25(7)(a) and section 995-1.

The business referred to in this subsection is the business to which the relevant paragraph in subsection 40-880(2) applies. In this case it is accepted that paragraph 40-880(2)(a) or paragraph 40-880(2)(c) applies and therefore the issue is the extent to which the business that G Company proposes to carry on, will be carried on for a taxable purpose.

Paragraph 2.47 of the Explanatory Memorandum 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.

Subsection 40-880(3) requires a conclusion as at the time the capital expenditure was incurred as to the extent to which the business is or will be carried on for a taxable purpose by reference to all known and predictable facts in all years; in accordance with the Commissioner’s view set out in paragraph 157 of TR 20011/16.

The Commissioner accepts that G Company will carry on its business for the purpose of producing its assessable income, and that at the time G Company incurred the relevant capital expenditure, G Company did not intend to derive exempt income or non-assessable non-exempt income from the business in the foreseeable future. Therefore, as G Company was to carry on its business for a taxable purpose, subsection 40-880(3) does not operate to deny or limit the amount of the balance of the Transaction costs which G Company may deduct under section 40-880.

G Company did not incur the expenditure for a business that another entity carries on or proposed to carry on. Therefore subsection 40-880(4) does not apply in G Company’s circumstances.

Subsections 40-880(5)-(9) set out further limitations and exclusions to deductibility under section 40-880. The limitations and exclusions are concerned with whether amounts of business capital expenditure have other tax recognition under Australian income tax legislation.

The extent to which an amount is deductible under section 25-5 (as discussed in the Detailed reasoning for Question 2), is also not deductible under section 40-880; paragraph 40-880(5)(b).

For the balance of the Transaction costs, the Commissioner considers that none of those limitations and exceptions applies in G Company’s circumstances. In particular, the balance of the expenditure will not form part of working out a capital gain or capital loss from a CGT event that happens to G Company for the purposes of paragraph 40-880(5)(f).

Therefore, a deduction for the balance of the Transaction Costs incurred by G Company which resulted in the Transaction is deductible over 5 years under subsection 40-880(2).

Conclusion

The balance of the Transaction costs which is the subject of this ruling is business capital expenditure which is deductible under paragraph 40-880(2)(a) and / or paragraph 40-880(2)(c).

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