Edited version of private advice

Authorisation Number: 1052127016286

Date of advice: 8 June 2023

Ruling

Subject: Deductibility of payments

Question 1

Will the Payments be deductible as a general deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

If the answer to question one is No, will the Payments be deductible under 40-880 of the ITAA 1997?

Answer

Not applicable.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XY

The scheme commenced on:

Date in 20XX

Relevant facts and circumstances

Entity A conducts a business.

Entity A and Entity B entered an arrangement for the benefit of the clients of Entity A.

Some of the clients of Entity A used the services of Entity B. Entity A did not recommend or advise their clients to do this.

Entity B has gone into administration.

Under the Deed of Company Arrangement (DOCA), the distributions to creditors will occur using a tiered approach. A percentage of distributions may be made based on Entity B's performance and ability to produce net profit over several years.

Many of Entity A's clients have been financially impacted.

While Entity A denies it has liability in respect of, or responsibility for, any losses suffered or which will be suffered by its clients due to their dealings with Entity B, and makes no admissions in relation to those matters, it remains concerned about the financial well-being of its clients.

As a gesture of generosity, Entity A has proposed to make Payments to its clients (the Payments) with the amount and timing of such payments to be determined as between Entity A and the impacted clients. The terms of the Payments are set out in a draft deed of release, which has been provided.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 40-880

Reasons for decision

All references made in these reasons for decision are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated

Question 1

Summary

The Payment will be deductible as a general deduction under section 8-1.

Detailed reasoning

Subsection 8-1(1) provides that 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.

However, subsection 8-1(2) prevents deductions for losses or outgoings 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 Payments will be deductible under section 8-1 if either of the positive limbs in subsection 8-1(1) are satisfied and it does not fall within the negative limbs in subsection 8-1(2).

To be deductible under section 8-1, the positive limbs in subsection 8-1(1) require there to be a nexus between the payment by Entity A and the gaining or production of its assessable income, or the carrying on of its business for that purpose.

We agree that the positive limbs in subsection 8-1(1) will be satisfied in respect of the Payments. As noted in paragraphs 12 and 13 of Taxation Determination TD 2016/14 Income tax: is an outgoing incurred by a business taxpayer for a gift provided to a former or current client deductible under section 8-1 of the Income Tax Assessment Act 1997?

Losses or outgoings are incurred in gaining or producing assessable income where they are 'incidental and relevant to that end' (Ronpibon). Where a taxpayer is carrying on a business for the purpose of gaining or producing assessable income, voluntary expenditure incurred for business needs may be deductible. It is the taxpayer who decides whether the expenditure 'is dictated by the business ends to which it is directed' (Snowden & Willson).

If a taxpayer provides a gift that is characterised as being made for the purpose of producing future assessable income, the outgoing incurred on the gift will be incidental and relevant to gaining or producing assessable income. The taxpayer's outgoing is 'dictated by the business ends to which it is directed' and is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

Entity A produces its income through carrying on a business, and as part of this Entity A and Entity B entered an arrangement for the benefit of the clients of Entity A.

In determining whether subsection 8-1(2) prevents deductions for the Payments, in Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commission of Taxation (1938) 5 ATD 87; (1938) 61 CLR 337, Dixon J formulated the following test, stating at 363:

There are, I think, three matters to be considered

(a)  the character of the advantage sought, and in this its lasting qualities may play a part;

(b)  the manner 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.

As noted from Commissioner of Taxation v Sharpcan Pty Ltd [2019] HCA 36 at 18

Authority is clear that the test of whether an outgoing is incurred on revenue account or capital account primarily depends on what the outgoing is calculated to effect from a practical and business point of view. Identification of the advantage sought to be obtained 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 periodical 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; 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; and between an enterprise itself and the sustained effort of those engaged in it. Thus, an indicator that an outgoing is incurred on capital account is that what it secures is necessary for the structure of the business.

The Payments are described as a 'gesture of generosity' for existing clients. The amount and timing of the Payments will be determined between Entity A and the impacted client.

In context, the advantage the Payments may provide Entity A would be in securing/maintaining good relations with its clients and avoiding possible claims. This would arguably affect the reputation and goodwill of Entity A's business.

In Magna Alloys & Research Pty Ltd v. Commissioner of Taxation of the Commonwealth of Australia [1980] FCA 180 (Magna Alloys), the taxpayer company incurred legal expenses in defending several of its directors and agents who were charged in relation to the marketing practices adopted in selling the company's products. Although the defence was unsuccessful, the Court held that the legal expenses were deductible.

In making their decision, the Court found that expenditure incurred to protect the reputation and goodwill of a business is not of a capital nature where the attack on the reputation arose out of the day-to-day activities of the business. As noted by Brennan J:

Nor was the expenditure an outgoing of a capital nature. The capital of the business was in no way increased by the expenditure incurred. True it is that the expenditure protected the reputation and goodwill of Magna's business, but the attack which was made arose out of the day to day selling activities of that business and it was the business purpose of vindicating the methods by which it was conducted that brings the expenditure within sec. 51(1). Though goodwill is a capital asset of a business it is frequently earned and maintained by the daily activities of those engaged in the business. The valuable if intangible asset of goodwill frequently grows out of activities the cost of which is a charge on revenue account ...

Making the Payments may assist in protecting Entity A's reputation and goodwill, however the reason for the Payments has arisen from the day-to-day operation of its business. The arrangement between Entity A and Entity B was part of the service Entity A provided to its clients.

The Payments relate to the ordinary operation of Entity A's business, rather than establishing or extending the profit-making structure of the business itself.

Additionally, we agree that:

• the nature of the Payments will not be made with a view to bring into existence any asset or any advantage for the enduring benefit of Entity A's business, and
• the Payments are not 'once and for all' expenditure as there will be multiple Payments made to numerous impacted clients with the amounts and timing of such Payments to be agreed between Entity A and the impacted clients.

Considering the remaining criteria in subsection 8-1(2), the Payments 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 Income Tax Assessment Act 1997 that would prevent the deduction.

Accordingly, the Payments will be deductible for Entity A under subsection 8-1(1) and are not excluded by subsection 8-1(2).

Question 2

Not applicable.

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