Edited version of private advice

Authorisation Number: 1051787275811

Date of advice: 4 December 2020

Ruling

Subject: Deductibility of outgoings under a marketing service agreement

Question

Was the Initial Payment made by Company A in accordance with the Agreement with Company B an allowable deduction to Company A under section 8-1 of the Income Tax Assessment Act 1997 ('ITAA 1997')?

Answer

Yes

Question 2

Will any Quarterly Payment Amounts made by Company A in accordance with the Agreement with Company B allowable deductions to Company A under section 8-1 of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods:

Income tax year ending 31 December 20xx

Income tax year ending 31 December 20xx

Relevant facts and circumstances

Company A

Company A is the provisional head company of a multiple entry consolidated ('MEC') group.

Company A carries on several service-providing businesses.

Company B and Company B's Business

Prior to entering into the Agreement detailed below, Company B was a top-10 provider in Australia of the services it provided (referred to as the 'Business').

Overview of the Agreement

In 20xx, Company B announced its intention to exit the Business.

On the same date, Company A entered into a non-binding memorandum of understanding ('MOU') with Company B that addressed how clients of the Business who chose to migrate to Company A could be transitioned to Company A, and how employees associated with the Business could be transitioned from Company B to Company A. The MOU contemplated that the parties would enter into an 'asset sale agreement' pursuant to which Company B would 'transfer customer contracts and employees relating to the Business' to Company A.

Company A and Company B subsequently entered into the Agreement in 20xx. In substance, the Agreement provides for the process under which certain key 'Clients' and 'Employees' of the Business are to be transitioned into the existing business structure of Company A.

Under the Agreement, Company B is required to provide certain marketing services for Company A's benefit, including promoting Company A as the preferred replacement service provider, making introductions to particular Clients of the Business (determined at Company A's discretion from a list of 'In-Scope Clients'), and using reasonable endeavours to facilitate Company A being appointed as replacement service provider for those Clients

The Agreement contemplates that the process for the migration of the Clients who choose to transition to Company A and the transfer of the relevant Employees of the Business to Company A will occur on an incremental basis over a period of 18 months (and up to two years).

In practice, this will involve the following steps:

(a)  Company A will nominate which In-Scope Clients of the Business (if any) it wishes to engage, noting that Company A may decline to provide the service to a particular Client or require amendments to the terms of a Client Contract and that there is no requirement on the In-Scope Client to appoint Company A as their service provider.

(b)  Where Company A decides to accept a "Client Contract Transfer" (defined below) with respect to a Client, Company B must seek the consent of the relevant Client to novate their existing service provision contract(s). While Company B will use reasonable endeavours to obtain that consent and facilitate the transfer, all Clients must consent to the migration.

(c)   Company A will concurrently determine which Employees (if any) of the Business it wishes to engage based on its staffing requirements. Company A is not subject to any positive obligation to make any employment offers.

(d)  If Company A decides to engage any Employees of the Business, Company B must cooperate with Company A to facilitate the transition of those Employees across to Company A's existing business.

In consideration for Company B entering into the Agreement and performing its initial obligations thereunder, Company A was liable to pay Company B an initial non-refundable payment upon signing the Agreement ('Initial Payment').

The Initial Payment was, in substance, made in consideration for the marketing services to be performed by Company B in connection with the Clients of the Business for the benefit of Company A, and certain preparatory steps, including:

(a)  preparing, agreeing, implementing and complying with a 'Migration Plan' in relation to the transfer of each relevant Client and Employee; and

(b)  certain activities undertaken by Company B before entering into the Agreement, including meeting jointly with Company A and all In-Scope Clients to explain the transition proposal being offered and the benefits of transitioning to Company A.

In addition to the Initial Payment, it is contemplated that Company A may make further payments each quarter (each a 'Quarterly Payment Amount'). In effect, whether a Quarterly Payment Amount is to be paid for a quarter primarily depends on the number of Company B's Clients that choose to migrate to Company A and associated revenues realised by Company A in connection with those Clients. The calculation of the Quarterly Payment Amount was reached as a product of the commercial bargain struck by the parties and represents payment for the provision of services by Company B to Company A. In broad terms, the Quarterly Payment Amount depends on:

(a)  the revenues realised by Company A in the previous quarter in connection with any 'Transferring Clients' adjusted to reflect the total number of Clients that migrate to Company A as a result of successful referrals from Company B, less the Initial Payment and any amount payable by Company B for the previous quarters; plus

(b)  Company A's share of any severance payments owing to certain offshore employees; less

(c)   an amount reflecting the accrued entitlement of certain Australian employees that is assumed by Company A.

The 'Total Consideration' payable to Company B (being the Initial Payment plus any subsequent Quarterly Payment Amounts payable by Company A) is capped.

Company A have referred internally to the consideration payable under the Agreement as a 'referral payment' for each Client that chooses to migrate to Company A.

The Agreement does not provide Company B or Company A with any power to require a Client to transition to Company A, and an Employee always has the choice to leave their employment.

Company A has estimated that the integration of Company B customers to their existing business will move them to a higher rank provider in the sector.

Reasons for decision

Question 1 Detailed reasoning

Subsection 8-1(1) allows the deduction for any loss or outgoing from assessable income, to the extent it is incurred in gaining or producing assessable income; or is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

However, subsection 8-1(2) prevents deductions for losses or outgoings to the extent that the loss or outgoing is:

•         of capital, or of a capital nature

•         of a private or domestic nature

•         incurred in relation to producing exempt or non-assessable non-exempt income, or

•         prevented from being deducted by another provision in the ITAA 1997.

The 'Initial Payment' is incurred in gaining or producing assessable income

Company A is the provisional head company of an Australian multiple entry consolidated ('MEC') Group.

To improve Company A's market share position in Australia, it entered into an Agreement for marketing services with Company B in 20xx.

The purpose of the Agreement is to establish the terms under which Company B will promote Company A as the preferred provider for services to Company B's customers. The Agreement also transfers relevant employees of Company B to Company A.

The Agreement provides that Company A must pay Company B an Initial Payment on execution of the Agreement in consideration for the Contract Transfers being supplied to Company A and the transfer of the workforce in place through Employment Offers.

The Initial Payment is an irrevocable payment by Company A and is not refundable to Company A in any circumstances.

Within 20 Business Days of the date of the Agreement, the Agreement requires Company A and Company B to prepare and agree on the Migration Plan. The Migration Plan provides a framework on the processes and terms on how Company B's Clients and employees can be transferred to Company A.

The Agreement then sets out how Company B must promote Company A to Company B's customers in relation to providing services in Australia ('Business') for two years from the date of the Agreement.

Based on the timing of payment of the Initial Payment (namely on execution of the Agreement), the Initial Payment appears to have two purposes. One is to allow for preparation and implementation of the Migration Plan. The other is for the marketing services to be performed by Company B in connection with the Clients of the Business for the benefit of Company A.

The Initial Payment incurred by Company A is made with the expectation that the Agreement will result in more customers for Company A's business, which will result in increased revenue for Company A. In addition, the terms of the Agreement will facilitate the recruitment of selected Company B staff, a normal activity undertaken by any business. There is sufficient nexus between the Initial Payment outgoing Company A makes and the income generating activities of Company A to satisfy the requirement of subsection 8-1(1).

Whether an outgoing or loss is capital or of a capital nature

The decision of the High Court in Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 ('Sun Newspapers') is the leading authority on the distinction between revenue and capital expenditure. Dixon J stated that there are three matters to be considered when deciding whether an expenditure is revenue or capital in nature. These are:

a) the character of the advantage sought by making the outgoing

b) the manner in which the advantage is to be used, relied upon or enjoyed by the taxpayer, and

c) the means adopted to obtain the advantage.

The character of the advantage sought by making the outgoing is the chief, if not the critical, factor that distinguishes revenue from capital outgoings: GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124.

In Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634 ('Hallstroms'), it was found that the answer to the revenue/capital question 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.'

The general principles were recently considered by the High Court in AusNet Transmission Group Pty Ltd v Federal Commissioner of Taxation [2015] HCA 25and Commissioner of Taxation v Sharpcan Pty Ltd [2019] HCA 36 ('Sharpcan'). In Sharpcan at [18], the High Court confirmed and outlined the following factors for consideration:

•                     First the identification of the advantage sought, which ordinarily involves

-                     Consideration of the manner in which it is to be used, and

-                     Whether the means of acquisition is a once-and-for-all outgoing for the acquisition of something of enduring advantage, or a periodic outlay to cover the use and enjoyment of something for periods commensurate with those payments.

•                     Once identified, the advantage is to be characterised by reference to the distinction between:

-                     the acquisition of the means of production and the use of them,

-                     establishing or extending a business organisation and carrying on the business,

-                     the implements employed in work and the regular performance of the work in which they are employed, and

-                     an enterprise itself and the sustained effort of those engaged in it.

These factors are considered for the present case.

The advantage sought by Company A

The advantages to Company A in entering into the Agreement, broadly, are an arrangement whereby Company B:

•         promotes Company A as the service provider of choice for Company B's customers, and

•         facilitates the transfer of nominated Company B employees who agree to be employed by Company A.

As stated above, the Initial Payment is incurred for Company B to prepare and implement the Migration Plan and to market Company A to Company B's customers. The Initial Payment (and Quarterly Payment Amounts) are expected to result in increased revenue for Company A.

Characterisation of the advantage sought by Company A

Company A's business is well established. The potential increase in scale of Company A's business from potential new customers is incremental. It is in line with increasing Company A's market share of the services in Australia.

In addition, when considering whether the Initial Payment is to 'extend the business', Company A will not be providing any new services or entering a new market as a result of the business they may gain from the Agreement. Company A already provides the same services within Australia for large market customers. In entering into the Agreement with Company B, it has identified potential customers that fit Company A's business and risk models, and Company B is required to promote Company A to its customers.

The Initial Payment is a payment made by Company A to Company B upon signing of the Agreement. Together with the Quarterly Payment Amounts, these payments comprise the recurrent consideration that Company A pays Company B under the Agreement.

While the Initial Payment (and Quarterly Payment Amounts) provide an exclusive right to Company A to be promoted by Company B to its customers relating to the services previously provided by Company B, there is no obligation for Company B's clients to become Company A's customers for the services. Company A also did not acquire any of the business infrastructure that Company B had established for its customers. The Initial Payment secured access to a new body of customers. It secured a promise from Company B to prepare and implement a Migration Plan and provide marketing services. These factors point to the payment being a revenue rather than a capital aspect.

The advantage sought from Company A is in the nature of carrying on Company A's business. Therefore, the Initial Payment does not have the character of a capital outlay.

In summary, the advantages Company A seeks to attain (being the promotion of Company A as the preferred provider and employer for Company B's customers and employees) are for a limited and relatively short duration of time. In making the Initial Payment (and Quarterly Payment Amounts) allows Company A to expand its business customer base (National Australia Bank Limited v The Commissioner of Taxation of the Commonwealth of Australia [1997] FCA 1394) and potentially increase its business income. The Initial Payment is therefore not capital or in the nature of capital.

For completeness, the Initial Payment is not:

•         of a private or domestic nature; or

•         incurred in relation to producing exempt or non-assessable non-exempt income; or

•         subject to another provision in ITAA 1997 that would prevent the deduction.

Therefore, the Initial Payment made according to the Agreement is deductible to Company A under section 8-1.

Question 2 Detailed Reasoning

Company A can deduct the Quarterly Payment Amounts if the conditions under section 8-1 are met, as explained in the reasoning for Question 1.

It is accepted that the outgoings made are sufficiently connected to Company A's generation of income as they relate to the marketing services to be provided by Company B and for the reasons given in Question 1.

Are the outgoings for Quarterly Payment Amounts capital in nature?

The Quarterly Payment Amounts are periodic, quarterly payments. The Agreement outlines the three components that are the basis of the Quarterly Payment Amount.

After each quarter, Company A must prepare and provide to Company B a Consideration Statement, being a statement that sets out:

(i)            The relevant details and calculations in accordance with the Consideration Model, plus

(ii)   An amount equal to 50% of the aggregate of the severance payments paid to all Transferring Employees located overseas in the Quarter just ended, less

(iii) An amount equal to 70% of the aggregate amount of the Transferring Employee Allowances (namely Employment Entitlement of Transferring Employee in Australia) with an Employee Transfer Date in the Quarter just ended.

The Quarterly Payment determined is equal to the 'Final Payment' calculated at the end of that quarter, less the sum of all previous Quarterly Payments and the Initial Payment.

The elements of the calculation above show the rationale for the Quarterly Payment Amounts. The elements are contingent on the success of the Agreement achieving the goals from the perspective of Company A - the 'Quarterly Payment' is calculated based on a percentage of revenue received from clients who transfer to Company A under the Agreement, while the adjustments for transferring employees are calculated on the basis of staff successfully transferring to Company A under the Agreement.

The Quarterly Payment Amount as determined from the calculation above is used to determine the 'price' of the Agreement. Each of these elements is but one component that Company B and Company A have negotiated to arrive at the negotiated price for the Agreement.

The Quarterly Payment component is analogous to an advertising, promotional or marketing fee paid on the business referred from Company B to Company A. The Agreement with Company B is intended to expand Company A's business customer base. The Quarterly Payment relates to the number of Transferring Clients migrated to Company A in the previous quarter less the Initial Payment. This recurrent payment is computed as a fee based on the number of Client Transfers made and does not have the character of a capital payment.

The total consideration that is payable from Company A to Company B (being the Initial Payment added to all Quarterly Payment Amounts) is capped.

In applying the same reasoning as in the reasoning for Question 1, the Quarterly Payment Amounts are not payments made to ensure an 'enduring benefit'. Company B and Company A are both bound by the Agreement for the two-year duration of the Agreement whether or not any Quarterly Payment Amount is payable, or payable in any particular quarter, or if the cap has been reached. After this time, the Agreement has no further value to Company A or effect to Company B.

The components of the Quarterly Payment Amounts that relate to employment entitlements of the Transferring Employees form a contribution made by Company A as part of the commercial bargain struck between the parties. These components represent adjustments to the referral payment payable by Company A for the services provided by Company B and therefore does not detract the revenue nature of the outlay.

The Quarterly Payment Amount outgoings calculated under the Consideration Model are not capital in nature.

For completeness, the Quarterly Payment Amounts calculated under the 'Consideration Model' are not:

•         Of a private or domestic nature; or

•         incurred in relation to producing exempt or non-assessable non-exempt income; or

•         subject to another provision in ITAA 1997 that would prevent the deduction.

Therefore, the Quarterly Payment Amounts made according to the Agreement are deductible to Company A under section 8-1.

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