Edited version of private ruling

Authorisation Number: 1011708771181

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Ruling

Subject: Whether the invoice to the trust is an allowable deduction

Question 1

Is the licence fee payable to the trust an allowable deduction?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2010

The scheme commences on:

1 July 2009

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Due to personal financial circumstances, the business owner approached the principal for assistance during the 2008-09 income year.

An arrangement was entered into between the parties to conduct a business.

Prior to this time, the business owner had conducted a similar business using a related entity as the trading entity, which had been placed into administration.

The arrangement was entered into as the business owner needed time to raise working capital and another business structure in order to recommence trading.

The business owner utilised another entity in existence at the time that he owned and controlled, being the trust, to contract with the principal on the following basis.

An agreement was entered into where the trust would provide all of the supplier and customer contacts and distribution channels to operate the business in exchange for a licence fee.

An agreement was also entered into where the principal (or his related entities) would provide warehousing, office infrastructure, and working capital on a fee for service basis.

As part of this agreement, the principal provided the working capital and business structure via an entity he controlled, being the taxpayer, for which the taxpayer charged a management fee.

The business operations were managed by the business owner, and he was paid a salary from the taxpayer for the work performed.

The taxpayer recorded profits from the importing business for the period that it traded in the 2008-09 income year. The taxpayer returned this profit in its income tax return and paid the profits accordingly. However it did not distribute the remaining profits to its shareholders.

The agreements mentioned above were not exercised during the 2008-09 income year as the parties were still trying to get the importing business off the ground and to build working capital within the business.

The business remained profitable so the respective parties have exercised the various agreements as follows:

· the taxpayer has charged the management and service fees to recoup the costs for the use of the business structures, warehousing etc;

· the business owner has been paid a salary for managing the importing business

· the trust has invoiced the business the licence fee for the use of the supplier and customer contacts as well as all of the distribution channels.

The last invoice is the subject of this ruling request.

The invoice from the trust has charged a set rate of gross sales for the use of the licence.

There are no similar licences, so to ensure that the rate was commercial, the parties compared the rates charged in similar industry licensing arrangements in the wholesale sector. The average advertising spending was then aggregated and the result was an amount just below the set rate of gross sales. As this comparison still did not quite equate with what was actually provided for in this agreement, a small premium was added which resulted in the set rate of gross sales amount shown on the invoice.

Eventually the business owner managed to put together enough money to provide for another trading entity and sufficient working capital so that he could once again operate the importing business himself.

As a result, all of the arrangements listed above were terminated, and the importing business recommenced in another entity wholly owned by the business owner late in the 2009-10 income year. This included the business owner resigning as an employee of the taxpayer and the termination of the two agreements for the use of the taxpayer's business structures and the use of the importing suppliers and customers.

Further information was requested, including the invoice for the licence fee. This invoice was provided and is attached. In the end, the invoice covered the period from the start date in the 2008-09 income year up to the termination date. The invoice was based on gross sales (or total revenue as the invoice puts it. A calculation indicates that the arithmetic is correct.

The original agreement between the business owner and the principal was a verbal handshake between the two parties, so there is no written agreement formalising this original arrangement.

The business owner has stated that the amount shown on this invoice currently remains outstanding, as the parties are awaiting the decision on the private ruling request before settling.

The two parties, the business owner and the principal, are not related in any way, but have known each other as friends for some time before this arrangement took place.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 995-1

Income Tax Assessment Act 1936 Subsection 6(1)

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.

Summary

The 'licence fee' shown on the invoice will be an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for expenses incurred in earning assessable income, or necessarily incurred in carrying on a business for the purpose of earning assessable income.

However, the expenses cannot be capital, capital in nature, private or domestic in nature, or incurred to earn exempt income.

Royalty is defined in section 995-1 of the ITAA 1997 to be the same as the definition is section 6 of the Income Tax Assessment Act 1936 (ITAA 1936)

The definition of royalty in sub-section 6(1) of ITAA 1936 is quite long, but the part relevant here is an amount paid or credited, however described or computed, whether the payment is periodical or not, as consideration for either:

· the use of, or the right to use, any copyright, patent, design, model, plan, secret formula or process, trademark or other like property or right; or

· the supply of scientific, technical, industrial, or commercial knowledge or information.

In this case, the request is considering an invoice which applies for the period from the commencement of the income year to the termination date. The amount shown on the invoice is calculated at the set rate of the gross sales received during that period. On the face of it, the receipt of monies from an invoice calculated on the basis of gross sales from the business operations would constitute ordinary income, provided that everything is on a bona fide arms length basis.

In this case the invoice is a licence fee for the use of 'knowledge' held by the business owner which was in the form of contacts with overseas suppliers, Australian customers, and with the various distributers. The use of this 'knowledge' would have eliminated the usual start up problems that most new businesses have in reaching their sales targets, in that the importing business operated by the taxpayer would have been up to full speed very quickly with a full customer and supplier book from the 'knowledge' provided by the business owner via the trust. The result of the use of this information was that the business was profitable immediately, with gross sales of over $3 million dollars in that short period of time.

Therefore there is a definite link between the use of this information and the amount of sales generated by the importing business operated by the taxpayer. It would not be surprising if the gross sales would have been reduced by a lot more than the set rate being charged under this invoice, if this 'knowledge' was not made available to the taxpayer.

The mere fact that the payment will be a single receipt payable at the end of the period does not affect whether the amount is considered to be a deduction.

The issue is whether the payment could be considered to be capital, or capital in nature. In Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; 5 ATD 87, the High Court considered the difference between expenses and capital outgoings. One test is whether there is an enduring benefit to the taxpayer as a result of incurring the loss or outgoing.

In this case, the expense only relates to the period of time that the importing business was being conducted, so there is no enduring benefit for the incurring of the expense. Also the expense was calculated as a set percentage of gross sales, so it would only relate to the period in question, in a manner similar to rental. Therefore the expense is not capital or capital in nature.

The next issue to consider is whether the expense was incurred in earning assessable income, or necessarily incurred in carrying on of a business. The invoice relates to the particular business being carried on by the taxpayer. The reason for the expenditure was to gain access the 'knowledge' relating to the business, which included suppliers and customers. As the particular business was a new business for the taxpayer, getting access to this sort of information would make a large difference to the amount of gross sales revenue that would be achieved. It therefore follows that the expense is relevant to the business operations, or to the earning of assessable income.

Therefore the deduction for the use of the knowledge would be an allowable deduction to the taxpayer.

The next issue is the payment. The invoice was dated late in the 2009-10 income year, and all of the 'knowledge' was provided before the invoice was prepared.

When the loss or outgoing becomes an allowable deduction is considered in Taxation Ruling TR 97/7. Broadly, you incur an outgoing at the time you owe a present money debt that you cannot escape. Therefore, the deduction would be allowable when the invoice has been served and the entity has a definite liability to pay the amount. In this case the invoice is dated late in the 2009-10 income year, and would have been served on that date as well, as for most of the year, the two parties were working together.

The relevant amount on the invoice does not need to have actually been paid to be an allowable deduction. herefore the fact that the amount has not actually been paid to date does not affect whether the amount is an allowable deduction in the relevant year, or not.

Therefore, in the absence of information to the contrary, the taxpayer had a liability to pay that amount as at 30 June 2010, and so would be entitled to a deduction for that amount for the 2009-10 income year.

The last item to consider is the relationship between the parties. The two people, the business owner and the principal were friends prior to the agreement being made, but are not related to each other. The agreement itself has been made on a commercial footing. The question is whether the various contracts have been made on an arms length basis. If there is any doubt, then Taxation Ruling TR 95/33 requires that the intention and purpose of the transactions be considered.

The basic reasoning was that an entity related to the business owner was operating the business, but it managed to get into difficulties, which resulted in the entity that was being used to operate the business being placed into administration.

This left the business owner with a problem with the importing business as the entity no longer existed and he didn't have a lot of money at that time. The principal agreed to assist as he had some spare capacity in his own business operations and a handshake deal was done to incorporate the importing business into one of his entities. The taxpayer was the entity chosen by the principal with that task.

The operations were on the basis that principal would be compensated fully for the additional expenses that the taxpayer or any other related entity was to provide to operate the importing business. An agreement was drawn up to satisfy this requirement. The second part was that the business owner would be employed by the taxpayer to manage the business, and was paid a salary for the services rendered. There are no issues with these agreements, provided that the rates were commercially realistic.

The third agreement was the one which is the subject of the ruling. To assist in making the business profitable, the business owner was required to make available all of the 'knowledge' or know how that had been picked up over the years, so that the business would operate the same way that it had previously. Part of that was by becoming an employee to manage the business operations. The remaining information, being the suppliers, customers, and the supply chain information, would allow the new business to run profitably without the usual start up problems that a wholesale business would encounter.

An agreement was made on the basis that the 'knowledge' would be made available to the taxpayer on a percentage of gross income basis, in that case at a set rate of gross. The question is whether it is considered that this agreement was commercially realistic. There was no direct comparison available. herefore, information was provided in relation to similar wholesale operations which came out at just below the set rate, but with slightly different things being provided.

As a result of that information, it is considered that the set rate percentage was made using a commercially realistic methodology. Therefore there is no reason to consider that there are any issues in relation to the purpose or intention of the transaction. Therefore the method of calculation of this invoice will be accepted as valid.

The last issue is whether the use of the trust to supply this 'knowledge' is acceptable. The 'knowledge' itself would be an intangible asset of some variety as its use would have some value to the taxpayer. The issue is who owns this 'knowledge'. If it is actually owned by the trust, it would be capable of earning income from the use of this 'knowledge'.

Previously it would have been an intangible asset used by the related entity as it was previously carrying on the business prior to it having gone into administration.

As this was the case, there is no specific reason why it could not have been transferred from the previous company to the trust when the administration commenced to allow it to profit from the use of the information.

If that was not the case, then it would have been as an asset of the business owner himself. In order for the trust to declare the income, the asset would need to be transferred to the trust.