Edited version of private advice

Authorisation Number: 1051769003680

Date of advice: 21 October 2020

Ruling

Subject: Deductions - advisor costs

Question

Are the costs incurred by the Company associated with engaging advisors in relation to the business deductible over five years under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997) in the relevant years?

Answer

Yes

Period covered by the Ruling

1 July XX to 30 June XX

The scheme commences on

1 July XX

Relevant facts and circumstances

Background

The Company is a private company incorporated in Australia. The Company operates a business.

The Company was approached by another firm that was interested in acquiring the business. Following this approach, the Company directors decided to consult with an advisor on the offer and investigate what opportunities were available and in the best interests of the business.

The advisor recommended a number of options to the Company directors, which included, preparing a prospectus, setting up a dataroom, testing the market and seeking equity investors with the potential to grow the business.

As a result, the Company incurred costs on a range of advisors to provide strategic advice on the best approach and outcomes for the Company, its business and its shareholders.

The advisor, together with a commercial law firm, provided advice and services to assist the Company directors to consider:

·         the commercial opportunities that were available

·         the most appropriate means of realizing those opportunities; and

·         whether the best interests of the Company's business would be served by a change in ownership; or the introduction of an equity partner.

The Company directors had an opportunity to consider the introduction of an equity partner to the business. As they were in negotiations on this deal, some new legislation was put to Parliament that was likely to have a significant impact on their industry. As a result of the uncertainty this new legislation posed, the potential equity partner withdrew from the process. The new legislation for the industry was passed and came into effect. The advisors recommended the Company directors work through the legislative changes first and then consider going back to the market.

The Company directors worked through the legislative changes and continued to look at ways to grow and innovate. They identified arrangements which enabled the business to increase the range of services it was able to offer in the marketplace.

A new potential equity partner then approached the Company to explore an arrangement with the proposal involving an equity split. This approach was made by a private equity group who submitted an indicative offer to acquire a major portion of the Company.

The deal with the private equity group included new capital sources being introduced to the business. There was a greater likelihood of growth for the Company's business presented by the introduction of the private equity partner as a new investor who was willing to raise greater amounts of capital.

The private equity group were interested in acquiring the Company as well as other businesses which they believed were suitable synergistic acquisitions. The Company's business would continue as part of the new larger group. It was proposed that a new company would buy the shares of the Company and issue the current shareholders with a cash amount and shareholding in the new company with the new investor holding the majority portion. The new company then planned to obtain finance to purchase other acquisitions.

The Company incurred further costs at this time on advisors to provide strategic advice on the best outcome for the Company, its business and its shareholders.

Due to uncertainties in the market related to Covid-19, the private equity group withdrew their offer to invest in the Company.

The opportunities that the Company was exploring during the ruling period involved investors from private equity groups and the current owners/founders remaining involved in the business by staying on as directors and retaining an ownership interest. Private equity groups were attracted to the Company as it was in a position for business expansion with the founders remaining involved in the business. The advisor costs and associated expenditure incurred throughout the ruling period relate to circumstances where the directors were seeking to work through the opportunities presented to them and what was in the best interest of the business.

Advisor engagement

The Company directors engaged the advisors to advise and assist in exploring opportunities for the business. The advisors provided the Company with advice during the ruling period, on offers presented to them and subsequently commenced more formal due diligence processes and transaction tasks. This process required engagement with additional advisors for legal advice and the provision of data room facilities.

The advisors provided the following services to the Company as detailed in the advisor engagement letter. The scope of work under contract included, but was not limited to:

·         developing a financial model of the business including growth options and/or potential investor synergies

·         advice as required in preparation for the introduction of a new investor

·         advising on potential investors to approach and a tailored approach strategy for each

·         project managing the transaction including developing a marketing strategy for the business

·         distributing a flyer and/or other information as required

·         advising and assisting in the preparation of management presentations

·         assisting with the development of data room information

·         advising on the preferred transaction structure

·         contacting agreed potential investors

·         advising on indicative offers and the selection of an investor or short list of potential investors

·         coordination of management presentations and communications with potential investors.

The role of all other advisors was to provide services that were ancillary and/or supportive (but independent of) the advisors and included legal and financial due diligence, providing legal and commercial support in relation to the proposed transactions.

Law firm engagement

The Company entered into an agreement with a corporate and commercial law firm. The engagement of the law firm was to provide advice to the Company's directors acting as an independent legal advisor. The legal services provided by the law firm were directed towards the execution of the transaction that the Company directors had determined was in the best interests of the Company's business and its shareholders.

All income derived by the business is assessable in Australia. The Company does not derive any exempt or non-assessable non-exempt income, known as NANE income.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 40-25(7)

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 Subsection 40-880(3)

Income Tax Assessment Act 1997 Subsection 40-880(4)

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

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

Reasons for Decision

All legislative references are to the ITAA 1997 unless otherwise indicated.

Summary

The costs incurred by the Company associated with engaging advisors in relation to the business are deductible over five years under section 40-880 in the relevant years.

Detailed reasoning

Section 40-880 applies to certain business expenditure of a capital nature from 1 July 2005.

According to subsection 40-880(1) the object of section 40-880 is to make certain business capital expenditure deductible, usually over five 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.

Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues sets out the Commissioner's views on the interpretation of the operation and scope of section 40-880.

Paragraph 23 of TR 2011/6 states that determining the amount allowable as a deduction under section 40-880 is a multi-step process:

·         first it is necessary to determine initial entitlement under subsection 40-880(2); and

·         then the limitations and exceptions in the subsequent subsections must be considered.

Establishment of an initial entitlement to a deduction

Capital business expenditure

A leading judgment on whether an outgoing is capital or capital in nature is Dixon J's judgment in Sun Newspapers Ltd & Anor v Federal Commissioner of Taxation 61 CLR 337 5 ATD 87. In that case, Dixon J held that:

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.

In this case advisor costs were incurred by the Company to provide strategic advice and assist in exploring new investor opportunities for the business and provide legal and commercial support. These expenses relate to the business structure or the ownership of that structure and were not incurred as part of the normal business operations or the continuous process by which the Company derives its income. Therefore, the advisor costs are capital expenses.

In relation to your business

Subject to the limitations and exceptions contained in subsections 40-880(3) to (9), subsection 40-880(2) provides that you can deduct, in equal proportions over a period of five 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

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

(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.

In identifying for the purposes of subsection 40-880(2) the business that is most relevant to the expenditure, TR 2011/6 at paragraphs 20-22 provide that it is necessary to look at the Company's overall business rather than a particular undertaking or enterprise within the overall business. In this case, the provision of services described in the facts is considered the Company's relevant businesses for the purposes of subsection 40-880(2).

The relevant provision in this case is paragraph 40-880(2)(a) as the Company carried on their businesses at the time that they incurred the expenditure.

For a deduction to be allowable under paragraph 40-880(2)(a) you must incur capital expenditure 'in relation to' your business. ATO Interpretative Decision ATO ID 2007/109 Income Tax Capital Allowances: business related costs - in relation to your business notes that there needs to be a sufficient and relevant connection between the taxpayer's incurrence of the expenditure and the taxpayer's business.

In interpreting the phrase 'in relation to' in paragraph 40-880(2)(a) and subsection 40-880(2) generally, paragraph 2.25 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 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 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 J and Gummow J 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...

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 FC of T 95 ATC 4145; 30 ATR 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 be direct or indirect, provided it consisted of a real connection, but merely remote relationship is insufficient.

It is therefore necessary to consider the phrase 'in relation to' in the context of paragraph 40-880(2)(a) in order to determine whether there is a sufficient and relevant connection between the expenditure incurred and the business of the Company.

In discussing the types of business capital expenditure to which subsection 40-880(2) applies, the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 states:

2.19. 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.

2.20. 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.

These paragraphs indicate capital expenditure incurred on the structure by which an entity carries on business, on the profit yielding structure of the business, or relating to the business's trading operations, is capable of being capital expenditure incurred 'in relation to' that 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 that business on the facts of the particular case.

The Company incurred capital expenditure in engaging advisors to explore opportunities to determine the future direction of the business. The strategic review by the advisors involved financial and operational analysis of the business. The decision by the directors of the Company was to find a strategic partner to help grow the business. The private equity investor would provide business acumen, expertise in mergers and acquisitions and access to capital.

The decision to bring on a private equity investor involved structural changes to the business. Under the proposed restructure, the Company would share a common parent entity and the legal advisors and other professional advisors provided assistance in connection with the proposed transactions and restructure.

The financial and legal advisers performed a variety of legal, accounting and other professional services in relation to the proposed transactions, including drafting and reviewing contracts and conducting financial and tax due diligence.

On the facts of this case, capital expenditure on the advisor costs was incurred to provide advice and support on the structure by which the business would be carried on. The purpose was to explore and seek opportunities to realise the strong growth potential of the business. Accordingly, the advisor costs have a sufficient and relevant connection with the Company's business for the purposes of paragraph 40-880(2)(a).

Any deduction the Company is entitled to under section 40-880 is subject to limitations set out in that section, as discussed further below.

Taxable purpose

Once the relevant business is determined for the purposes of subsection 40-880(2), subsections 40-880(3) or (4) may apply to limit deductibility of the capital expenditure to the extent that it relates to that business being carried on for a taxable purpose.

Subsections 40-880(3) and (4) both contain a 'taxable purposes test' which applies to the expenditure identified in subsection 40-880(2) by reference to the extent to which it relates to carrying on the business for a 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. Subsection (4) relates to the business of another entity from which you derive assessable income.

In this case paragraph 40-880(2)(a) applies and therefore the issue is the extent to which the business that the taxpayer carries on is for a taxable purpose. The definition of 'taxable purpose' is provided in subsection 40-25(7) to include the purpose of producing assessable income. The term 'purpose of producing assessable income' is further defined in subsection 995-1(1) as being either:

·         for the purpose of gaining or producing assessable income

·         in carrying on a business for the purpose of gaining or producing assessable income.

The Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 further explains:

2.47 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.

The application of subsection 40-880(3) requires that you determine, as at the time the capital expenditure was incurred, the extent to which your business will be carried on for a taxable purpose by reference to all known and predictable facts in all years.

Paragraph 27 of TR 2011/6 notes that if the expenditure relates to the whole of the business but part of the business is carried on to derive exempt income or non-assessable non-exempt income then to that extent the expenditure will not be deductible.

For the purposes of applying subsection 40-880(3) to the expenditure, which is the subject of this ruling, it is necessary to determine, as at the time the expenditure was incurred, the taxable purpose of the business of the Company taking into account all known and predictable facts in all years. A deduction under subsection 40-880(2) for the expenditure will be allowable only to that extent.

It is considered that the proposed transaction and advisor costs were made in relation to the current business of the Company.

All income derived by the Company is assessable. The Company does not derive any exempt income or any non-assessable non-exempt income. Considering all the facts, at the time the Company incurred the advisor costs, they were carrying on the business for a taxable purpose. As such, subsection 40-880(3) will not apply to limit the Company's deduction under section 40-880.

Other limitations

Subsections 40-880(5) to (9) set out other limitations and exclusions to claiming a deduction under section 40-880.

There are further possible restrictions which are contained in subsections 40-880(5), 40-880(8) and 40-880(9). The proposed transaction and advisor costs incurred by the Company are not subject to the limitations in subsection 40-880(3) or (4) and the exceptions contained in subsections 40-880(5), (8) and (9):

·         expenditure which forms part of the cost of a depreciating asset: paragraph 40-880(5)(a)

·         expenditure is deductible under another provision: paragraph 40-880(5)(b)

·         expenditure that forms part of the cost of land: paragraph 40-880(5)(c)

·         expenditure in relation to a lease or other legal or equitable right: paragraph 40-880(5)(d)

·         the expenditure would otherwise be taken into account in working out a profit included in the taxpayer's assessable income or a loss that they can deduct: paragraph 40-880(5)(e)

·         the expenditure could be taken into account in working out the amount of a capital gain or capital loss from a CGT event: paragraph 40-880(5)(f)

·         another provision would make the expenditure non-deductible if it was not of a capital nature: paragraph 40-880(5)(g)

·         another provision expressly prevents the expenditure being taken into account as described in paragraphs 40-880(5)(a) to (f) for a reason other than the expenditure being of a capital nature: paragraph 40-880(5)(h)

·         the expenditure is of a private or domestic nature: paragraph 40-880(5)(i)

·         the expenditure is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income: paragraph 40-880(5)(j)

·         the expenditure is excluded from the cost of a depreciating asset or the cost base or the reduced cost base of a CGT asset because of a market value substitution rule: subsection 40-880(8)

·         the expenditure is a return of an amount previously received or a return on or of debt or equity: subsection 40-880(9).

On the facts of this case, subsections 40-880(5) to (9) do not apply to limit or exclude deductibility of the proposed transaction and advisor costs incurred by the Company under section 40-880.

The proposed transaction and advisor costs were incurred engaging advisors, to provide strategic advice, explore new investor opportunities for the business and to provide legal and commercial support. These limitations and exceptions do not apply.

Therefore, the Company is entitled to deduct the advisor costs in equal proportions over five income years from the time the expenses were incurred pursuant to subsection 40-880(2).

Conclusion

The Commissioner considers that the expenditure which is the subject of this ruling is capital expenditure which is incurred 'in relation to your business' and is eligible for a deduction under paragraph 40-880(2)(a).

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