Edited version of private ruling

Authorisation Number: 1011494682055

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Ruling

Subject: Deductibility of a payment made a franchisee to a franchisor

Question 1

Is a payment made to a franchisor in accordance with a Franchise Agreement, triggered by the sale of shares in the franchisee company, deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Does a payment made to the franchisor in accordance with the Franchise Agreement, triggered by the sale of shares in the franchisee company, form part of the cost base of the franchise business for capital gains tax purposes?

Answer

Yes. The payment forms part of the cost base of the franchise business for capital gains tax purposes and should be included in the fourth element of the cost base of the franchise business under subsection 110-25(5) of the ITAA of 1997.

Question 3

Is a payment made to the franchisor in accordance with the Franchise Agreement, triggered by the sale of shares in the franchisee company, deductible over five years under section 40-880 of the ITAA of 1997.

Answer

No. The limitation listed in paragraph 40-880(5)(f) of the ITAA of 1997 will apply so as to exclude a deduction under section 40-880 of the ITAA of 1997.

Relevant facts and circumstances

The taxpayer conducts a franchise business.

Recently, shares in the taxpayer were sold. Under the terms of the Franchise Agreement, the sale of shares triggered a payment from the franchisee to the franchisor representing a percentage of the increase in value of the franchise business as determined by valuation.

The payment was for the fee applicable to providing consent to a dealing in the shares and was calculated in accordance with the definition of 'agreed consideration' stipulated in the Franchise Agreement.

This payment represented a percentage of the increase in value of the franchise business as determined by valuation.

Reasons for decision

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Question 1

Summary

The payment made to the franchisor in accordance with the Franchise Agreement, triggered by the sale of shares in the franchisee company, is not deductible under section 8-1 of the ITAA 1997 as the payment is considered to be an outgoing of a capital nature.

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a general deduction for a loss or outgoing to the extent that it is incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

However, no deduction is allowed where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

Section 8-1 of the ITAA 1997 requires that there be a nexus between the loss or outgoing and the income producing activities of the taxpayer. That is, there must be sufficient connection between the loss or outgoing and the production of assessable income.

The existence of a sufficient connection requires that the loss or outgoing incurred in gaining or producing assessable income, or in carrying on a business for that purpose, must be incidental and relevant to the income producing activities or business operations of the taxpayer. To be considered incidental and relevant the occasion of the loss or outgoing should be found in whatever is productive of the assessable income: Ronpibon Tin NL & Tong Kah Compound NL v. FC of T (1949) 78 CLR 47;(1949) 56 ArgLR 785;[1949] ALR 785;[1949] ALR 875;23 ALJ 139;(1949)

The loss or outgoing must also have the 'essential character' of an income producing or business expense: Lunney v FC of T; Hayley v FC of T (1958) 100 CLR 478.

To be deductible as expenditure necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, a loss or outgoing must have the character of a working or operating expense of the taxpayer's business or be an essential part of the cost of its business operations: John Fairfax & Sons Pty Ltd v. FC of T [1959] ALR 267;(1959) 66 ALR 267;101 CLR 30;(1959) 11 ATD 510;1959 - 0227A - HCA;32 ALJR 370;(1959) 7 AITR 346.

Paragraph 8-1(2)(a) of the ITAA 1997 denies a deduction for losses or outgoings of capital or of a capital nature.

There is no statutory definition of capital expenditure. The courts have provided criteria that indicate whether a loss or outgoing is capital or revenue in nature.

In British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 it was held that expenditure is of a capital nature where it is made with a view to bringing into existence an asset or an advantage (tangible or intangible) for the 'enduring benefit' of a business. This test was outlined by Viscount Cave at 213-214 where he stated:

But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

In Sun Newspapers and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403) (Sun Newspapers), one of the leading cases on the distinction between capital and revenue outgoings, Dixon J pointed out that expenditure in establishing, replacing and enlarging the profit-yielding structure itself is capital and is to be contrasted with working or operating expenses.

In Sun Newspapers Dixon J referred to three matters to be considered when determining whether an outgoing is of a capital nature:

· the character of the advantage sought;

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

· the means adopted to obtain the advantage.

The lasting or recurrent character of the advantage is an important factor in the first two elements. The third element requires a consideration of the way the outlay is made, that is, whether the outlay is a periodical payment covering the use of the asset or advantage during each period, or whether the outlay is calculated as a single final provision for the future use or enjoyment of the asset or advantage.

When the matters stated by Dixon J in Sun Newspapers are considered, the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid. The nature or character of the expenditure will therefore follow the advantage that is sought to be gained by incurring the expenditure. If the advantage to be gained is of a capital nature, then the expenditure incurred in gaining the advantage will also be of a capital nature.

Dixon J in Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 8 ATD 190; (1946) 3 AITR 436 stated that the nature or character of the expense follows the advantage which is sought to be gained by incurring the expenses.

The character of the advantage sought provides important direction. It provides the best guidance as to the nature of the expenditure because it says the most about the essential character of the expenditure itself. The decision of the High Court in G P International Pipecoaters Pty Ltd v. Commissioner of Taxation (1990) 170 CLR 124 at 137; (1990) 90 ATC 4413 at 4419; (1990) 21 ATR 1 at 7 emphasised this, stating:

The character of expenditure is ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure, for the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid: Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 61 C.L.R 337, at p.363.

Generally, if an outgoing is incurred to strengthen and preserve a company's profit-yielding subject, the outgoing is on capital account. This test considers whether the expenditure relates to the structure within which the profits are earned or whether it relates to part of the money-earning process.

In Sun Newspapers, Dixon J said at 61 CLR 360:

As general conceptions it may not be difficult to distinguish between the profit-yielding subject and the process of operating it. In the same way expenditure and outlay upon establishing, replacing and enlarging the profit-yielding subject may in a general way appear to be of a nature entirely different from the continual flow of working expenses which are or ought to be supplied continually out of the returns or revenue.

Application to the taxpayer's circumstances

The payment made by the franchisee to the franchisor was for the fee applicable to providing consent to a dealing in the shares of the franchisee.

To determine the deductibility under section 8-1 of the ITAA 1997 of the payment it is necessary to determine the true character of the payment. That is, it is necessary to clarify what the fee actually represents. The connection between the purpose of the payment of the fee and the activities by which the assessable income of the taxpayer is produced is of particular importance.

The taxpayer is a company conducting a franchise business. Under the terms of the Franchise Agreement, the taxpayer (the franchisee) cannot permit any dealing in its shares without the prior written consent of the franchisor.

As a consequence of a recent sale in the franchisee's shares, the taxpayer was required to pay a fee to the franchisor pursuant to the grant of consent to deal in the shares. This payment represented a percentage of the increase in value of the franchise business as determined by valuation.

As a result of obtaining consent to deal in the shares and the subsequent payment of the related fee, the taxpayer has been able to continue operating as a franchisee and performing its obligations under the Franchise Agreement.

It is considered that under the terms of the Franchise Agreement, the fee applicable to the grant of consent by the franchisor to a dealing in the shares of the franchisee represents consideration for the right to continue operating as a franchisee despite a change in the share ownership of the franchisee.

The payment of the fee is not a part of the money-earning process of the franchisee and does not constitute a continuing expense in the carrying on of a business. Rather, as it is attached to the right to carry on the franchise business, it relates to the income earning environment within which the taxpayer operates.

The expenditure was incurred by the taxpayer in obtaining a consent that has allowed the taxpayer to continue to meet its obligations under the existing Franchise Agreement. As such, the payment of the fee has given rise to an advantage which has a lasting and enduring character and has secured an enduring benefit for the taxpayer's business. The 'enduring benefit' in this case is eligibility to continue carrying on the business under the existing Franchise Agreement.

Accordingly, it is concluded that the payment that was made to the franchisor in accordance with the Franchise Agreement, triggered by the sale of shares in the franchisee company, cannot be claimed as a deduction under section 8-1 of the ITAA 1997 as the payment is an outgoing of a capital nature.

Question 2

Summary

The payment made to the franchisor in accordance with the Franchise Agreement, triggered by the sale of shares in the franchisee company, forms part of the cost base of the franchise business for capital gains tax purposes and should be included in the fourth element of the cost base of the Franchise business under subsection 110-25(5) of the ITAA 1997.

Detailed reasoning

A capital gains tax (CGT) asset is any kind of property, or a legal or equitable right that is not property: section 108-5 of the ITAA 1997.

Section 110-25 of the ITAA 1997 provides the general rules about the cost base of a CGT asset. Subsection 110-25(1) of the ITAA 1997 provides that the cost base of a CGT asset consists of 5 elements:

· the first element is the cost of acquisition: subsection 110-25(2) of the ITAA 1997;

· the second element is the incidental costs incurred in relation to the asset: subsection 110-25(3) of the ITAA 1997;

· the third element is the cost of ownership of the asset: subsection 110-25(4) of the ITAA 1997;

· the fourth element is capital expenditure incurred, the purpose or the expected effect of which is to increase or preserve the assets' value: subsection 110-25(5) of the ITAA 1997;

· the fifth element is capital expenditure incurred to establish, preserve or defend title to the asset, or a right over the asset: subsection 110-25(6) of the ITAA 1997.

Application to taxpayer's circumstances

The rights acquired by the franchisee under the Franchise Agreement, that is the rights to carry on a franchise business, constitute a CGT asset in accordance with section 108-5 of the ITAA 1997.

As established above, the payment made to the franchisor in accordance with the Franchise Agreement, triggered by the sale of shares in the franchisee company, is an outgoing of a capital nature. As the expenditure has enabled the taxpayer to continue to meet its obligations under the existing Franchise Agreement it is attached to the right to carry on the franchise business. Accordingly, the fee forms part of the cost base of the CGT asset being the rights acquired under the Franchise Agreement.

As the payment that was made to the franchisor in accordance with the Franchise Agreement, triggered by the sale of shares in the franchisee company, has allowed the taxpayer to preserve the environment within which they derive their income, and therefore the value of their franchise business, the fee should be included in the fourth element of the cost base under subsection 110-25(5) of the ITAA 1997.

Question 3

Summary

The payment made to the franchisor in accordance with the Franchise Agreement, triggered by the sale of shares in the franchisee company, is not deductible over five years under section 40-880 of the ITAA 1997.

Detailed reasoning

Section 40-880 of the ITAA 1997 provides a deduction over five years for certain capital expenditure incurred by a taxpayer in relation to a past, present or prospective business if the expenditure is not already taken into account or not denied a deduction elsewhere in the income tax law.

Subsection 40-880(2) of the ITAA 1997 provides that the expenditure must be incurred by the taxpayer:

(a) in relation to their existing business

(b) in relation to their or another entity's business that used to be carried on; or

(c) in relation to their or another entity's business proposed to be carried on, or

(d) as a shareholder, beneficiary or partner to liquidate or deregister a company or to wind up a trust or partnership provided that the company, trust or partnership carried on a business.

Subsection 40-880(5) of the ITAA 1997 provides the circumstances in which a deduction is not available under section 40-880 of the ITAA 1997. Specifically, paragraph 40-880(5)(f) of the ITAA 1997 provides that no amount is deductible where it could be taken into account in working out a capital gain or loss from a CGT event.

Application to taxpayer's circumstances

As it has been established that the payment made to the franchisor in accordance with the Franchise Agreement, triggered by the sale of shares in the franchisee company, forms part of the cost base of a CGT asset, it will be taken into account in working out a capital gain or capital loss from a CGT event happening to that asset. As such, the limitation listed in paragraph 40-880(5)(f) of the ITAA 1997 applies so as to exclude a deduction under section 40-880 of the ITAA 1997.

Accordingly, the payment that was made to the franchisor in accordance with the Franchise Agreement, triggered by the sale of shares in the franchisee company, is not deductible over five years under section 40-880 of the ITAA 1997.