Edited version of private advice

Authorisation Number: 1051543840163

Date of advice: 19 July 2019

Ruling

Subject: Income tax and GST issues

Question 1

Does a tax law partnership arise as a result of the agreement between Entity A and Entity B?

Answer

No

Question 2

Are the proceeds of the profit participation fee assessable as ordinary income?

Answer

Yes

Question 3

Are the proceeds paid by Entity A to Entity B an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997?

Answer

Yes

Question 4

Will Division 974 of the ITAA 1997 regarding debt and equity interests apply to the receipt of the profit participation fee?

Answer

No

Question 5

Will GST apply to the profit participation fee?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Entity A is an Australian company.

Entity A entered into an agreement on a specified date with Entity B (the agreement). A copy of this agreement has been provided.

Entity A and Entity B are not related entities.

Entity B is an Australian resident private company and is registered for GST.

Under the agreement:

·         Entity B will pay Entity A a profit participation fee, either up front or by instalments, subject to the mutual agreement of the two entities.

·         All costs, expenses and charges of the profit share venture must be paid by Entity A.

·         Entity A will bear all losses and any loss is not carried forward in the accounting of profit for any future activities with Entity B.

·         Entity A charges a fee.

·         Entity A grants Entity B the right to participate in the sharing of profit from its activities. This is for a period of a number of years.

·         Entity A will make decisions regarding all aspects. Entity B does not specifically participate in the management of the activities.

You have provided details of the amounts involved in the arrangement.

Entity A is actively pursuing similar agreements with other entities like Entity B in other locations. Entity A will to enter into a number of agreements of this type in Australia.

The agreement contains a range of duties for Entity B. These duties are not limited to passive duties.

You have provided projected figures for your activities.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 995-1

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 26-26

Income Tax Assessment Act 1997 division 70

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 division 974

A New Tax System (Goods and Services Tax) Act 1999 section 9-5

A New Tax System (Goods and Services Tax) Act 1999 section 9-20

A New Tax System (Goods and Services Tax) Act 1999 section 195-1

Reasons for decision

Question 1

Summary

A tax law partnership does not arise as a result of the agreement with Entity A and Entity B.

Detailed reasoning

Partnership

Partnership is defined in the various State and Territory partnership acts as 'the relation which subsists between persons carrying on a business in common with a view of profit'.

Subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936) defines partnership as 'an association of persons carrying on business as partners or in receipt of income jointly but does not include a company'.

Taxation Ruling TR 94/8 Income tax: whether business is carried on in partnership (including 'husband and wife' partnerships) provides guidance on whether business is carried on in partnership. Both the intention and the conduct of the parties are factors in determining the existence of a partnership.

Paragraph 10 of Taxation Ruling TR 94/8 provides that the essential element for a partnership to exist is the genuine intention of all parties to act as partners. This intention must be demonstrated by the conduct of the parties. The existence of a partnership is evidenced by the actual conduct of the parties towards one another and with third parties during the course of carrying on the business.

In this case, Entity A makes all the decisions in relation to the activities, and bears the risk of loss. Entity A and Entity B do not own assets jointly and do not have the intention to carry on a partnership. Entity A and Entity B share profits, but not losses and there is no public recognition of the partnership, nor joint registration. Accordingly there is no partnership interest created between Entity A and Entity B.

Question 2 & 3

Summary

The receipt of the profit participation fee is assessable to Entity A under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997). Accordingly, the profit share payment to Entity B will be deductible for Entity A under section 8-1 of the ITAA 1997.

Detailed reasoning

The treatment of the receipt of the profit participation fee may be considered as one of the following:

·         Receipt of a loan

·         Receipt of income

·         Receipt of capital

Receipt of a loan

The term debt is defined in GSTR 2002/2 as:

an amount due from one entity to another or a presently existing obligation to pay an ascertainable amount at a future time.

For common law purposes, the essence of a loan is that it involves the obligation to repay the amount borrowed (Commissioner of Taxation v. Radilo Enterprises Pty Ltd (1997) 34 ATR 635) and it required the existence of a debtor-creditor relationship.

In order to be a loan, there must be the creation of a debtor/creditor relationship between the two parties and Entity A must have an obligation under the agreement to repay the amount borrowed.

The arrangement entered into between Entity A and Entity B does not have the characteristics of a loan as:

·         Under the terms of the agreement there is no security for Entity B to resort to in the event of default;

·         Entity B is only entitled to a share of the net profits from particular activities. There is no recourse to the assets which generate the revenue;

·         There is no presently existing obligation under the agreement for Entity A to repay the contribution amount, now or in the future. The arrangement merely provides for Entity B to receive a share of the net revenue from specific activities at a certain percentage.

Therefore, the receipt of the profit participation fee is not considered to be the receipt of loan funds.

Receipt of income or capital

As mentioned, the profit participation fee amount received by Entity A may be assessable:

·         As ordinary income under section 6-5 of the ITAA 1997, on revenue account, as a result of carrying on a business; or

·         As statutory income under the Part 3-1 of the ITAA 1997, (section 102-5 of the ITAA 1997)

Where the profit from the sale of the rights to participate in profit is made as a result of Entity A carrying on a business of selling rights to participate in profit, the profit will be assessable as ordinary income.

The question of whether a business is carried on is a matter of fact and degree to be determined in the circumstances of each case.

The courts have developed a series of indicators that are applied to determine the matter on the particular facts. No one factor is decisive. The indicators must be considered in combination and as a whole. Whether a 'business' is carried on depends on the large or general impression.

Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? (TR 97/11) sets out the relevant factors:

·         whether the activity has a significant commercial purpose or character

·         whether the taxpayer has more than just an intention to engage in business.

·         whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity.

·         whether there is regularity and repetition of the activity.

·         whether the activity is of the same kind and carried on in a similar manner to that of ordinary trade in that line of business.

·         whether the activity is planned, organised and carried on in a businesslike manner such that it is described as making a profit.

·         the size, scale and permanency of the activity.

·         whether the activity is better described as a hobby, a form of recreation or sporting activity.

Considering the facts applied to the relevant factors, Entity A has the intention of engaging in the business of selling rights to participate in profit and based on projections, anticipates making a profit from the activities. There is a level of regularity and repetition. The activities are planned and organised in a businesslike manner and with a number of agreements expected, has businesslike scale. Furthermore, the activities do not fit within the realm of a hobby, a form of recreation or sporting activity.

In this case, it is evident that there is a reasonable expectation that Entity A is undertaking their activity with the prospect of making a significant commercial or financial gain from it. Therefore, the receipt of the profit participation fee is assessable under section 6-5 of the ITAA 1997.

Profit share payment

Subsection 8-1(1) of the ITAA 1997 provides that a person can deduct from their assessable income any loss or outgoing to the extent that it is incurred in gaining or producing assessable income or it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

As discussed, selling rights to participate in profits forms part of the ordinary course of business of Entity A. Accordingly, the profit share payment will be deductible for Entity A under section 8-1 of the ITAA 1997.

Question 4

The debt and equity tests in Division 974 of the ITAA 1997 help you work out the difference between a debt interest and an equity interest for tax purposes.

The tests determine if a return on an interest in an entity is:

·         frankable and non-deductible (like a dividend)

·         deductible to the entity and not frankable (like interest payments).

The categorisation is based on the economic substance of an arrangement rather than its legal form. If an equity interest is not a share in legal form then it is called a non-share equity interest.

Subsection 974-70(1) of the ITAA 1997 provides:

A scheme gives rise to an equity interest in a company if, when the scheme comes into existence:

a)    the scheme satisfies the equity test in subsection 974-75(1) in relation to the company because of the existence of an interest; and

b)    the interest is not characterised as, and does not form part of a larger interest that is characterised as, a debt interest in the company, or in a connected entity of the company, under subdivision 974-B.

Subsection 974-75(1) of the ITAA 1997 provides that a scheme satisfies the equity test in relation to a company if it gives rise to an item set out in the table contained in that subsection. The table then specifies four qualifying items:

In this context returns include a return of an amount invested in the interest.

Relevantly item 2 of the table relates to an interest that carries a right to a return that is effectively contingent on economic performance. An example of this would be an interest where the returns are dependent on the company's profits.

In relation to item 2 of the table, the interest must also be a financing arrangement.

Section 974-130 of the ITAA 1997 defines a financing arrangement. A scheme is a financing arrangement for the entity if it is entered into or undertaken:

·         to raise finance for the entity;

·         to fund another scheme or part of another scheme that is the financing arrangement under paragraph (a), or

·         to fund a return, or part of another scheme that is a financing arrangement under paragraph (a).

The interest will not be an equity interest if it satisfies the definition of a debt interest is subdivision 974-B of the ITAA 1997.

Tax effects of equity interests

Subsection 26-26(1) of the ITAA 1936 essentially prevents any deduction for distributions in respect of a non-share equity interest.

You cannot deduct an amount paid on an equity interest as a general deduction and cannot deduct a non-share distribution or a return that has accrued on a non-share equity interest.

Application to your situation

The interest in this case would normally satisfy the requirements of Item 2 of the table in section 974-75(1) as the return on the profit participation fee in contingent on the economic performance of specific activities carried on by Entity A. As the definition of financing arrangement is broad; the profit participation scheme would normally be considered to be a financing arrangement on the basis that the arrangement was entered into to raise up-front finance for Entity A. The arrangement would not be a debt interest.

However, and as noted above, in this case sale of rights to participate in profit forms part of the ordinary course of business for Entity A. Rather than raising finance, the amounts received are ordinary income. Therefore, on this basis, the debt equity rules in Division 974 of the ITAA 1997 do not apply.

Question 5

Under section 9-5 A New Tax System (Goods and Services Tax) Act 1999 (GST Act), an entity makes a taxable supply if:

(a)  it makes the supply for consideration; and

(b)  the supply is made in the course or furtherance of an enterprise that the entity carries on; and

(c)  the supply is connected with Australia, and

(d)  the entity is registered or required to be registered for GST.

However, a supply is not a taxable supply to the extent that it is GST-free or input taxed.

In this case, it is accepted under the terms of the arrangement, Entity A makes a supply for consideration of a specified amount. The supply is the grant of a right to receive a share of the profit from certain activities run by Entity A.

As the requirements in paragraphs (a) to (d) of section 9-5 of the GST Act are satisfied, and the supply is neither GST-free nor input taxed under the provisions of Divisions 38 and 40 of the GST Act respectively, the supply by Entity A to Entity B of the right to a share of the profit from activities run by Entity A is a taxable supply under section 9-5 of the GST ActReview rights when we have declined to make a ruling

We have declined to make your private ruling on one of your questions, and have given you the reasons. This decision may be reviewable under the Administrative Decisions (Judicial Review) Act 1977 (ADJR).

The ADJR provides you with two main rights.

1.    You can send a written notice to the Commissioner requiring him to provide a written statement of:

·         the findings of material questions of fact

·         the evidence these findings were based upon, and

·         the reasons for his decision.

2.    You can apply to the Federal Court of Australia or the Federal Circuit Court for a review of the decision.

If you decide to apply to the Federal Court or the Federal Circuit Court for a review of the decision, we suggest you seek professional advice on how to progress. In addition, the Court will be able to provide you with some direction and assistance about the process.

An application must be lodged within 28 days of the issue date on your Notice of private ruling.

You may lodge your application for review at the Federal Court or Federal Circuit Court in the State or Territory in which you ordinarily reside, or the State or Territory listed in the address for the ATO shown on your Notice of private ruling.

You can find more information on the Federal Court website fedcourt.gov.au,or the Federal Circuit Court fedcircuitcourt.gov.au

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