Edited version of private advice

Authorisation Number: 1052350860894

Date of advice: 17 January 2025

Ruling

Subject:Deductions - capital expenditure

Question 1

Can you deduct payments made under Schedule 3 of the Deed under section 8-1 of the Income Tax Assessment Act 1997?

Answer 1

No.

This ruling applies for the following period:

Income tax year ended 30 June 20XX

The scheme commenced on:

1 October 20XX

Relevant facts and circumstances

You operate a legal practice.

During the income year ended 30 June 20XX you entered into the transaction detailed in the Deed (the sale and transfer transaction) to acquire assets of the Transferor.

The Transferor operated a legal practice business under a business name. Individual T (the Covenantor) is the sole director of the Transferor and was the responsible solicitor in respect of the client files prior to the sale and transfer transaction.

Terms of the sale and transfer transaction

Clause XX of the Deed sets out the agreement for the sale of assets and transfer of client files as follows:

•                     Sale of Assets and transfer of Client Files

-              The Transferor agrees to sell the Assets to the Transferee and transfer the Client Files to the Transferee in consideration for the payment of the Purchase Price from the Transferee; and

-              the Transferee agrees to buy the Assets and accept the transfer of the Client Files and pay the Purchase Price to the Transferor

on the terms of this Deed.

For the purpose of the Deed, the word 'Assets' is defined in clause X of the Deed to mean:

•                     the Safe Custody Documents

•                     the Goodwill of the Business

•                     the Client Contact List, and

•                     the Client File List.

Relevantly, clause X of the Deed also defines the following terms:

•                     'Safe Custody Documents' means documents held by the Transferor for or on behalf of clients in safe custody as set out in Attachment X - XXX XXX Documents List

•                     'Goodwill' means the goodwill of the Business arising from the conduct of the Business by the Transferor before Completion

•                     'Client Contact List' means the names and contact details of the client of the Business (whether active or inactive, past or present) held by the Transferor as at the date of Completion

•                     'Client File List' means the list of Client Files in Attachment X - Client File List (current as at the date of this Deed)

•                     'Client Files' means active client files, in paper and/or electronic form, of the Business as at the Date of Completion, and includes all Documents relating in any way to the Client File

•                     'Completion' means the completion of the transfer of the Client Files and the sale of the Assets in accordance with clause X, and

•                     'Completion Date' means the date which is 14 days after the date of this Deed or such other later date as agreed in writing by the parties.

Under clause XX of the Deed, the title to and the risk of the Assets:

•                     remained solely with the Transferor until Completion, and

•                     passed to you on and from Completion.

Under clause XX of the Deed, you took possession of the Assets and accepted transfer of the Client Files at Completion.

In relation to the Client Files, clause XX of the Deed provides:

•                     Transferee's obligations after Completion - Client Files

From the date a Client file is transferred to the Transferee, the Transferee shall assume and perform the legal services required to be performed in respect of each such Client File, and will perform such legal services as it sees fit.

Purchase price in respect of the sale and transfer transaction

Clause X of the Deed sets out the terms of the sale in relation to the purchase price as follows:

•                     Purchase Price and payment

•                     Purchase Price

In consideration of the Transferor agreeing to transfer the Client Files and sell the Assets to the Transferee, the Transferee must pay the Purchase Price to the Transferor as follows:

•                     by payment of the Deposit on the date of the Deed and in accordance with clause X; and

•                     the balance of the Purchase Price in accordance with the Compensation structure set out in Schedule X.

Transferee's Payment Obligations

On Completion, the Transferee shall be liable to pay the Compensation to the Transferor, such payment to be made by as specified in Schedule X, unless otherwise agreed in writing.

Relevantly, clause X of the Deed defines the following terms:

•                     Purchase Price means the Deposit and the Compensation

•                     Deposit means the amounts specified in Item X of Schedule X

•                     Compensation means the compensation payable by the Transferee to the Transferor as described in Schedule X

Item X of Schedule X to the Deed lists the Deposit as $X.

Clause XX of the Deed provides that the Deposit vested in you on Completion.

The Compensation structure set out in Schedule X to the Deed is as follows:

•                    Compensation

-              The Transferor retains all debtors up to the Date of Completion.

-              From the Date of Completion, the Transferee pays the Transferor X% of fees recovered ... on Client Files regardless of when those fees are ultimately recovered and regardless of whether the work is undertaken by the Covenantor or another employee of the Transferee, up to a total amount of $X.

-              The Transferee pays the Transferor X% of fees recovered ... on client matters introduced to the Transferee by the Transferor or the Covenantor between the Date of Completion and DD MM 20YY (Referred Client Matters), regardless of when those fees are ultimately recovered and regardless of whether the work is undertaken by the Covenantor or another employee of the Transferee, up to a total amount of $X. Any new matters for clients named in the Client Contact List will be Referred Client Matters, unless the Transferee can establish that the client was an existing client of the Transferee prior to the Date of Completion.

Clause X of Schedule 3 to the Deed is as follows:

•                     Reporting, invoicing and payment

-              On the X day of each calendar month the Transferee will provide a report to the Transferor, setting out the fees recovered on Client Files and Referred Client Matters in the preceeding month, as well as the calculation of the amount due to the Transferor in accordance with the Compensation structure set out above (Report).

-              Within X Business Days of receipt of a Report, the Transferor will:

o        issue a tax invoice to the Transferee in the amount specified in the Report; or

o        notify the Transferee that it disputes an an amount specified in the Report and issue a tax invoice for any undisputed amount.

The Transferee will pay the Transferor's tax invoices within X days of receipt.

The parties agree to work together in good faith to amicably resolve any payment disputes.

Other relevant clauses of the Deed

Clause X sets out the agreement terms in relation to income and profits from the Assets and Client Files as follows:

•                     Income and profits

•                     Income and profits

All income, profits, rights and benefits of the Assets and the Client Files:

-              in respect of the period before Completion, belong to the Transferor; and

-              in respect of the period on and from Completion, belong to the Transferee, subject to the Compensation requirements set out in this Deed.

Pre-Completion WIP

The Transferor will, before Completion, or as soon as reasonably possible after Completion, invoice all Pre-Completion WIP and is responsible for collection of same. The Transferee does not by this Deed or otherwise acquire any interest or entitlement to the Pre-Completion WIP.

Clause X of the Deed defines the term 'Pre-Completion WIP' to mean the value of all legal services performed and recorded by the Transferor in relation to the Client Files prior to Completion.

Relevant legislative provisions

Income Tax Assessment Act 1997 8-1

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

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

Income Tax Assessment Act 1997 paragraph 8-1(2)(a)

Reasons for decision

Deductions under section 8-1 of the Income Tax Assessment Act 1997

You can deduct from your assessable income any loss or outgoing to the extent that:

•                     it is incurred in gaining or producing your assessable income; or

•                     it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income (subsection 8-1(1) of the ITAA 1997).

However, you cannot deduct a loss or outgoing under section 8-1 of the ITAA 1997 to the extent that:

•                     it is a loss or outgoing of capital, or of a capital nature; or

•                     is a loss or outgoing of a private or domestic nature; or

•                     it is incurred in gaining or producing your exempt income or your non-assessable non-exempt income; or

•                     a provision of the Act prevents you from deducting it (subsection 8-1(2)).

Loss or outgoing of capital, or of a capital nature

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) discusses determining whether expenditure is capital in nature.

Whether expenditure is capital in nature is determined on the facts of each case having regard to the principles established by case law (TR 2011/6, paragraph 13). Paragraphs 64 to 68 further explain:

66.          The classic test for determining whether expenditure is of a capital or revenue nature is explained in the following passage from the judgment of Dixon J in Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 23; (1938)1 AITR 403 (Sun Newspapers):

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 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...

67.          The character of the advantage sought provides important direction. It provides the best guidance as to the nature of the expenditure as it says the most about the essential character of the expenditure itself. This was emphasised in the decision of the High Court in G.P. International Pipecoaters v. Federal Commissioner of Taxation (1990) 170 CLR 124; 90 ATC 4413; (1990) 21 ATR 1.

68.          If expenditure produces some asset or advantage of a lasting character for the benefit of the business it will be considered to be capital expenditure. As stated in Sun Newspapers at 355 per Latham J, an enduring benefit does not require that the taxpayer obtain an actual asset, it may be a benefit which endures, in the way that fixed capital endures. Menzies J in John Fairfax & Sons Pty Ltd v. Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 11 ATD 510; (1959) 7 AITR 346 concluded that a capital expense can also result in the reduction of capital. In Foley Brothers Pty Ltd v. FC of T (1965) 13 ATD 562; (1965) 9 AITR 635, outgoings incurred for the purpose of altering the organisation or structure of the profit-yielding subject (including its demise) were considered to be of a capital nature.

Earnouts and deferred consideration arrangements

Earnout and deferred consideration arrangements are often employed as a way of structuring the sale of a business (including business assets or an interest in an entity carrying on business) to deal with uncertainty about its value. They create a contingent right to a future payment (or other financial benefit) that is unascertainable at the time the right is created.

In a standard earnout or deferred consideration arrangement, the buyer agrees to pay the seller additional amounts if the relevant conditions are met. The seller holds the contractual right.

Are the payments made by you under Schedule 3 of the Deed deductible under section 8-1 of the ITAA 1997?

The Deed records the terms of a transaction (the acquisition and transfer transaction) under which you agreed to buy assets and accept transfer of client files of the business of the Transferor and lists the relevant assets as:

•                     the Safe Custody Documents - being documents held by the Transferor for or on behalf of clients in safe custody;

•                     the Goodwill of the Business - being the goodwill of the Transferor's business arising from the conduct of the business by the Transferor before completion of the acquisition and transfer transaction (Completion);

•                     the Client Contact List - being the names and contact details of the clients of the Transferor's business (whether active or inactive, past or present) held by the Transferor as at the date of Completion; and

•                     the Client File List - being a list of Client Files of the Business in an attachment to the Deed.

Under the Deed, on and/or from the date of Completion:

•                     you took possession of the Assets and accepted transfer of the Client Files (clause XX),

•                     the title to, and risk in relation to, the Assets passed to you (clause XX),

•                     you assumed the legal services required to be performed in respect of each Client File, to perform as you see fit (clause XX), and

•                     all income, profits, rights and benefits from the Assets and the Client Files belonged to you, subject to the payments set out in Schedule 3 (clause XX).

•                     Under the Deed, the consideration for the acquisition and transfer transaction includes:

•                     the $X deposit, which vested in you on Completion, and

•                     the Compensation, being the amounts payable described in Schedule 3, which sets out two types of payments:

­        X% of any fees recovered on the Client Files from the date of Completion, up to a total of $X (clause XX), and

­        X% of any fees recovered on new client matters introduced by the Transferor or Individual T between the date of Completion and DD MM 20YY (clause XX).

Payments under both clauses, XX and XX, are payable to the Transferor, regardless of whether the work is undertaken by Individual T or by another of your employees.

Clause X of the Deed discusses 'Pre-Completion WIP', which relates to services in relation to the Client Files that were performed by the Transferor prior to Completion. Clause XX specifies that you did not acquire any interest or entitlement to the Pre-Completion WIP. Further, Schedule X of the Deed does not indicate any part of the payments therein are to satisfy any obligation in respect of the Pre-Completion WIP or for any other purpose.

As set out in clauses XX and XX of the Deed and applying the definitions of 'Purchase Price' and 'Compensation' in clause X, the payments in Schedule X are consideration for the acquisition of the assets and transfer of the Client Files to you.

The Assets and Client Files are used by you to generate income as part of your business structure, not as trading stock. The Assets provide long-term, enduring benefit to your business, to increase your earning capacity.

Although the payments may have some regularity, the amounts are not for temporary or periodical use or enjoyment of the Assets and Client Files.

The payments are dependent on:

•                     the recovery of fees on the Client Files, and

•                     the introduction of client matters by the Transferor or Individual I, and the recovery of fees from those matters, and

•                     only represent a portion of the income you are entitled to earn from the Client Files after Completion.

After the maximum amounts of $X and $X for the payments are reached, the consideration for the acquisition and transfer will be satisfied.

It is considered that the payments made under Schedule X are an earnout or deferred consideration arrangement in respect of the acquisition of assets from the Transferor and, as such, are expenses of a capital nature.

As the outgoings are of a capital nature, as a consequence of the exclusion in paragraph 8-1(2)(a) of the ITAA 1997 you cannot deduct the outgoings under section 8-1.

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