Edited version of private ruling

Authorisation Number: 1011678492435

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Ruling

Subject: Deductions - deductibility of capital contributions to set up a company; expenses paid by director to acquire assets for a business; and, interest incurred on loans and legal expenses.

Question 1

Can I deduct an amount that I have paid in acquiring assets for A Co Pty Ltd (A Co) under section 8-1 of the Income Tax Assessment Act 1997?

Answer

No

Question 2

Can I deduct an amount in relation to the decline in value of assets, where I have paid the acquisition cost of those assets for A Co, under section 40-15 of the ITAA 1997?

Answer

No

Question 3

Can I deduct interest incurred on loans I have taken to acquire assets for A Co under section 8-1 of the ITAA 1997?

Answer

No

Question 4

Can I deduct interest incurred on loans I have taken to contribute capital to start up A Co under section 8-1 of the ITAA 1997?

Answer

No

Question 5

Can I deduct legal costs incurred in attempting to recover the amounts that I have contributed as capital and paid to acquire assets for A Co under section 8-1 of the ITAA 1997?

Answer

No

Question 6

Can I deduct the amount of capital I have contributed to start up A Co under section 40-880 of the ITAA 1997?

Answer

No

Question 7

Can I deduct legal costs incurred in attempting to recover the amounts that I have contributed as capital and paid to acquire assets for A Co under section 40-880 of the ITAA 1997?

Answer

No

Question 8

Can I deduct interest incurred on loans I have taken to acquire assets for A Co under section 40-880 of the ITAA 1997?

Answer

No

Question 9

Can I deduct interest incurred on loans I have taken to contribute capital to start up A Co under section 40-880 of the ITAA 1997?

Answer

No

This ruling applies for the following periods:

Year ending 30 June 2011

The scheme commenced on:

1 July 2010

Relevant facts and circumstances

You entered into a company venture with a partner. You entered a partnership agreement prior to commencing the venture.

You were a director and shareholder of A Co and expected to share in the profits of the business.

You were not an employee of A Co.

You purchased assets for A Co, which continue to be owned and held by the A Co.

You also invested capital in A Co.

You incurred interest on loans taken to purchase the assets and invest capital.

A Co purchased business cards and uniforms with logos, in addition to advertising in the Yellow Pages.

You undertook training at your own cost in order to be proficient in conducting your business activity.

You found that your business partner was not operating the business in a manner acceptable to you and could not reconcile your differences. You ceased participating in the venture. You removed yourself as a director and shareholder of A Co to protect your reputation.

You undertook legal action to attempt recovery of funds contributed for the operation of A Co and the purchase of the assets. Your legal action to date has been unsuccessful. You have ceased legal action as it is unlikely that you will succeed. You have incurred legal costs.

A Co continues to trade under the direction of your business partner, including holding and making use of those assets purchased by you.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 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 Section 40-15

Income Tax Assessment Act 1997 Section 40-25

Income Tax Assessment Act 1997 Subsection 40-25(1)

Income Tax Assessment Act 1997 Subsection 40-25(2)

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

Income Tax Assessment Act 1997 Subsection 40-25(8)

Income Tax Assessment Act 1997 Section 40-880

Income Tax Assessment Act 1997 Subsection 40-880(1)

Income Tax Assessment Act 1997 Subsection 40-880(2)

Income Tax Assessment Act 1997 Subsection 40-880(3)

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

Income Tax Assessment Act 1997 Subsection 40-880(5).

Further issues for you to consider

We have limited our ruling to the questions raised in your application. There may be related issues that you should consider including:

As you have withdrawn your association with A Co, you may be taken to have disposed of your shares in A Co. Ordinarily, disposing of shares results in a Capital Gains Tax event happening. Generally, for shares this would be CGT event A1

When calculating any capital gain or capital loss on disposal of shares, an amount you have paid in the acquisition of those shares should be taken into account within the first element of the cost base or reduced cost base.

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997, unless otherwise stated.

Question 1

Detailed reasoning

General discussion of the law

Section 8-1 provides for general deductions. Subsection 8-1(1) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income. Subsection 8-1(2) sets out that you cannot deduct a loss or outgoing where that loss or outgoing is of a capital, private or domestic nature, or relate to the earning of exempt income.

Taxation Ruling 97/7 discusses the meaning of 'incurred' as a result of various court cases and its application in section 8-1 of the ITAA 1997. In particular, to clarify when a deduction is said to have been 'incurred'.

TR 97/7 sets out that an amount may be considered to be 'incurred' even though it may not have been paid within the income year to which it relates.

Further, the courts have considered the meaning of 'incurred in gaining or producing assessable income'. In Ronpibon Tin NL Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; 56 ALR 785; 8 ATD 431 (Ronpibon Tin case) the High Court stated that:

For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing assessable it must be incidental and relevant to that end. The words "incurred in gaining or producing the assessable income" mean in the course of gaining or producing such income.

Alternatively, in British Insulated & Helsby Cables v. Atherton (Inspector of Taxes) (1926) AC 205 (British Insulated case) it was demonstrated that expenditure which is made once and for all to obtain an enduring advantage will ordinarily have the character of capital.

Whether company expenses paid by a director/employee can be deductible to the director/employee

ATO Interpretive decision ATO ID 2002/341 discusses the deductibility of expenses incurred by a director on behalf of their employer, where the director is also a shareholder and employee. ATO ID 2002/341 states that such expenditure is not deductible by the director as that expenditure relates to the generation of the employer's assessable income.

ATO ID 2002/341 discussed that an outgoing will not be deductible unless it is incurred in gaining or producing the assessable income of the taxpayer who incurs it, as demonstrated in Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153. In that case, the expenses were not incurred by the taxpayer in earning his assessable income in his capacity as director but rather the income of the company. There is no nexus between the outgoing and the assessable income of the taxpayer in such a case as to characterise the outgoing as incidental and relevant to the gaining of assessable income of the taxpayer.

There have been a number of cases in which it has been held that expenses incurred by an individual taxpayer, on behalf of a company of which the taxpayer was a shareholder and/or director, are not deductible. Examples of these cases are discussed in the following paragraphs.

In Case U134 87 ATC 780; AAT Case 92 (1987) 18 ATR 3646 the taxpayer was a shareholder and director of a family company who paid some of the company's expenses but was not reimbursed by the company for these expenses. The taxpayer did not receive any directors fees from the company in the relevant income year. The Administrative Appeals Tribunal held that the expenses were not deductible as the taxpayer incurred the expenses in his capacity as a director but did not derive any assessable income in that capacity.

In Case 26/94 94 ATC 258; (1994) 28 ATR 1133, the taxpayer was a shareholder and director of a family company. He borrowed money which he on-lent to the company. At that time the company had no capacity to borrow in its own name. Interest on the money would only be paid when the company was in a profit earning position.

The taxpayer claimed the interest and other costs relating to the borrowings as a deduction under subsection 51(1) of the ITAA 1936. He submitted that he had lent the money to the company to shore up its debts and ensure its future profitability which would enable him to derive assessable dividends in future.

The Administrative Appeals Tribunal held that the expenses were not deductible for the following reasons:

The primary purpose of the taxpayer in borrowing the money was to temporarily assist the company to avoid liquidation by providing a short-term rescue package.

One of the taxpayer's objectives in lending the money to the company was to ensure its profitability so as to derive future dividends from the company. However, the connection between the lending and the future dividends was too remote.

Application of the law

Your expenditure to acquire assets for A Co is considered to be of a capital nature, subsection 8-1(2) acts to deny a deduction for expenditure of that nature.

Further, you undertook the acquisition of assets and paid for certain CGT assets on behalf of A Co. You state that you expected to share in the profits of A Co, however you have not derived assessable income, and have no prospect of deriving assessable income from this venture in the future. You also state that you are not an employee of A Co. In your case there is no nexus between your expenditure to acquire those assets and the derivation of your assessable income.

Therefore, you can not deduct an amount that you have paid in acquiring assets for A Co under section 8-1.

Question 2

Detailed reasoning

Depreciating assets

The object of section 40-15 is to:

· to allow you to deduct the cost of a depreciating asset; and

· to spread the deduction over a period that reflects the time for which the asset can be used to obtain benefits; and

· to provide deductions for certain other capital expenditure that is not otherwise deductible.

Section 40-25 provides that when deducting an amount for depreciating assets, you can deduct the decline in value. Subsection 40-25(1) states that:

You can deduct an amount equal to the decline in value for an income year (as worked out under this Division) of a depreciating asset that you held for any time during the year.

Generally, only one taxpayer can deduct amounts for a depreciating asset.

However subsection 40-25(2) states that you must reduce your deduction by the part of the asset's decline in value that is attributable to your use of the asset, or your having it installed ready for use, for a purpose other than a taxable purpose.

Subsection 40-25(7) sets out the meaning of 'taxable purpose' and states that, subject to subsection (8), a taxable purpose includes 'the purpose of producing assessable income'.

Application of the law

You acquired assets in your capacity as director of A Co and those assets were to be owned and held by A Co for the purpose of deriving A Co's assessable income. A Co continues to trade and continues to use those assets within its business for the purpose of deriving assessable income.

It is considered that your expenditure to acquire CGT assets relates to the derivation of A Co's assessable income, where A Co may be entitled to claim a deduction under an appropriate provision. Only one taxpayer can deduct amounts for a depreciating asset.

Therefore, you can not deduct an amount in relation to the decline in value of assets, where you have paid the acquisition cost of those assets for A Co, under section 40-25 of the ITAA 1997.

Question 3

Detailed reasoning

There is no nexus between the interest expense incurred on your loans and the derivation of assessable income.

Therefore, you can not deduct interest incurred on loans taken to acquire assets for A Co under section 8-1.

Question 4

Detailed reasoning

There is no nexus between the interest expense incurred on your loans and the derivation of assessable income.

Therefore, you can not deduct interest incurred on loans taken to contribute capital to start up A Co under section 8-1.

Question 5

Detailed reasoning

General discussion of the law

ATO Interpretive Decision ATO ID 2003/484 discusses legal expenses incurred in defending against a claim for damages. Although differing from your circumstances, the same principles can be applied.

In particular, ATO ID 2003/484 discusses that the purpose for which the legal expenses were incurred must be examined to determine whether those expenses are of a capital or revenue nature. Further, that there must be a connection between the legal expenses and the generation of assessable income. ATO ID 2003/484 draws upon certain case law, some of which is discussed in the following paragraphs.

In Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) ALR 434; (1946) 8 ATD 190 it was indicated that in determining whether a deduction for legal expenses is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered.

The principles within Magna Alloys & Research Pty Ltd v. Federal Commissioner of Taxation (Cth) (1980) 49 FLR 183; 33 ALR 213; 11 ATR 276; 80 ATC 4542; (Magna Alloys case) indicate that the nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. For example, if the advantage to be gained is of a capital nature, then the legal expenses incurred in gaining the advantage are also of a capital nature and not deductible.

Legal expenses are generally deductible if the legal action:

· arose out of, or concerned the day to day income producing activities of the taxpayer, as was proposed in Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169

· is not undertaken to protect the taxpayer's profit yielding subject

· has more than a peripheral connection to the taxpayer's business, as discussed in Magna Alloys case and Putnin v. Commissioner of Taxation (1991) 27 FCR 508: 91 ATC 4097; (1991) 21 ATR 1245).

Application of the law

There is no nexus between the interest expense incurred on your loans and the derivation of assessable income.

Following the principles of Magna Alloys case, your legal expenses are considered to be of a capital nature. Therefore, subsection 8-1(2) acts to deny a deduction for those expenses.

You can not deduct legal costs incurred in attempting to recover the amounts that you have contributed as capital and paid to acquire assets for A Co under section 8-1 of the ITAA 1997.

Question 6

Detailed reasoning

Section 40-880 applies to make certain business capital expenditure deductible over time. Subsection 40-880(1) sets out the object of this section is to make certain business capital expenditure deductible over 5 years if:

· the expenditure is not otherwise taken into account; and

· a deduction is not denied by some other provision; and

· the business is, was or is proposed to be carried on for a taxable purpose.

Subsection 40-880(2) provides that you can deduct, in equal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur:

· in relation to your business; or

· in relation to a business that used to be carried on; or

· in relation to a business proposed to be carried on; or

· 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.

However there are limitations and exceptions to the operation of section 40-880. These include:

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 40-880(4) provides that you can only deduct the expenditure, for a business that another entity used to carry on or proposes to carry on, to the extent that:

· the business was carried on or is proposed to be carried on for a taxable purpose; and

· the expenditure is in connection with:

· your deriving assessable income from the business; and

· the business that was carried on or is proposed to be carried on.

Further, subsection 40-880(5) provides that you cannot deduct anything under section 40-880 for an amount of expenditure you incur to the extent that:

· it forms part of the cost of a depreciating asset that you hold, used to hold or will hold; or

· you can deduct an amount for it under a provision of this Act other than this section; or

· it forms part of the cost of land; or

· it is in relation to a lease or other legal or equitable right; or

· it would, apart from this section, be taken into account in working out:

· a profit that is included in your assessable income (for example, under section 6-5 or 15-15); or

· a loss that you can deduct (for example, under section 8-1 or 25-40); or

· it could, apart from this section, be taken into account in working out the amount of a capital gain or capital loss from a CGT event; or

· a provision of this Act other than this section would expressly make the expenditure non-deductible if it were not of a capital nature; or

· a provision of this Act other than this section expressly prevents the expenditure being taken into account as described in paragraphs (a) to (f) for a reason other than the expenditure being of a capital nature; or

· it is expenditure of a private or domestic nature; or

· it is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income.

The explanatory memorandum for Tax Laws Amendment (2006 Measures No. 1) Bill 2006; Tax Laws Amendment (2006 Measures No. 1) Act 2006 provides guidance as to the intent of amendments made to section 40-880 and how the provision should operate.

Paragraph 2.10 of the memorandum states that:

A key principle in determining the deductibility of business capital expenditure is the relationship between the expenditure and the business. This nexus will be a question of fact and in determining the relationship of the expenditure to the business, the former business or the prospective business, and when the expenditure is incurred, are necessarily considered.

Paragraph 2.11 states that where the expenditure is incurred in relation to a business being carried on, or incurred in relation to a business that was formerly carried on, the relationship can be ascertained by considering the business that was actually carried on.

Paragraph 2.13 sets out that in keeping with general income tax principles, the deduction is available to the taxpayer who incurs the qualifying expenditure. Generally, the taxpayer incurring the expenditure is the same taxpayer that is carrying on, or used to carry on the business. In some circumstances a taxpayer will incur expenditure in relation to a business that was formerly carried on by another entity. Specific rules apply in these circumstances to ensure that the taxpayer who incurs the expenditure is entitled to the deduction.

Paragraph 2.14 highlights that, even where an amount is deductible under section 40-880, the non-commercial loss provisions may also prevent individuals, either alone or in partnership, from deducting pre- and post-business expenditures from other assessable income.

In relation to capital expenditure, paragraph 2.18 states that the provision only applies to business capital expenditure. What this amounts to in the context of an existing, former or prospective business is determined on a case by case basis having regard to the general principles established by the Courts. This includes expenditure that fails the general deduction provision of section 8-1 by reason only of being capital or of a capital nature.

In paragraph 2.19 it is states that 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. Paragraph 2.20 includes that 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.

2.23 In addition, shareholders, beneficiaries of trusts and partners can deduct liquidation and deregistration costs where the company, trust or partnership carried on a business. This specific addition to the general principles of deductibility that relate expenditure to a business (past, prospective or current) is to continue, and expand, deductibility for expenditure incurred in the closing-down phase of a business. Shareholders can only deduct their own expenses, and are not entitled to a share in those that the company has incurred. [Schedule 2, item 30, paragraph 40-880(2 )( d)]

The term 'In relation to' is discussed in paragraph 2.25 and states that 'The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business'. Where paragraph 2.26 states that various pre-business expenses that would be incurred 'in relation to' a proposed business, which includes, establishment costs (such as the costs of establishing the business structure).

However 2.27 sets out that post-business expenses incurred 'in relation to' a past business include capital expenses incurred for the purpose of ceasing to carry on the business as well as expenses that were incurred as a consequence of the business ceasing.

The term 'Used to be' is discussed in paragraphs 2.28 and 2.29. These state that a business that 'used to be' carried on by a taxpayer would be a business that either the taxpayer had permanently ceased to carry on themselves or that the taxpayer was permanently no longer relevantly associated with.

Further, the effect of the requirement for permanence is to ensure the application of the provision to genuine post-business expenses - that is, the taxpayer would have permanently severed their ties with the business or the business no longer operates. If the relationship with the business still exists, even if in abeyance, then the expenditure is not post-business expenditure, and therefore can only be deductible as expenditure in relation to 'your' (ie, the taxpayer) business for the purposes of paragraph 40-880(2)(a).

Application of the law

Given the facts described within your application, it is clear that A Co (a separate legal entity) was carrying on a business. In addition, it is considered that A Co carried on a business for a taxable purpose.

Further, for the purposes of section 40-880 the business being carried on was, and continues to be, that of A Co.

Although you have withdrawn your association with A Co, your expenditure has not contributed to the winding up of A Co such that it can be considered a 'business that another entity used to carry on' for the purpose of subsection 40-880(4).

Following the principle in Case 26/94, nexus between the interest expense incurred on your loans and the derivation of assessable income is too remote.

Therefore, you can not deduct the amount of capital you have contributed to start up A Co under section 40-880 of the ITAA 1997.

Question 7

Detailed reasoning

Given the facts described within your application, it is clear that A Co was carrying on a business. In addition, it is considered that A Co carried on a business for a taxable purpose.

Further, for the purposes of section 40-880 the business being carried on was, and continues to be, that of A Co.

There is no nexus between the interest expense incurred on your loans and the derivation of assessable income.

Therefore you can not deduct legal costs incurred in attempting to recover the amounts that you have contributed as capital and paid to acquire assets for A Co under section 40-880 of the ITAA 1997.

Question 8

Detailed reasoning

Given the facts described within your application, it is clear that A Co was carrying on a business. In addition, it is considered that A Co carried on a business for a taxable purpose.

Further, for the purposes of section 40-880 the business being carried on was, and continues to be, that of A Co.

Although you have withdrawn your association with A Co, your expenditure has not contributed to the winding up of A Co such that it can be considered a 'business that another entity used to carry on' for the purpose of subsection 40-880(4).

Following the principle in Case 26/94, nexus between the interest expense incurred on your loans and the derivation of assessable income is too remote.

You can not deduct interest incurred on loans you have taken to acquire assets for A Co under section 40-880 of the ITAA 1997.

Question 9

Detailed reasoning

Given the facts described within your application, it is clear that A Co was carrying on a business. In addition, it is considered that A Co carried on a business for a taxable purpose.

Further, for the purposes of section 40-880 the business being carried on was, and continues to be, that of A Co.

Although you have withdrawn your association with A Co, your expenditure has not contributed to the winding up of A Co such that it can be considered a 'business that another entity used to carry on' for the purpose of subsection 40-880(4).

Following the principle in Case 26/94, nexus between the interest expense incurred on your loans and the derivation of assessable income is too remote.

Therefore you can not deduct interest incurred on loans you have taken to contribute capital to start up A Co under section 40-880 of the ITAA 1997.