Edited version of private ruling

Authorisation Number: 1011760545492

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Ruling

Subject: Income Tax Deductions

Issue 1

Question 1

Is the lump sum payment to be made by Company A to Company B deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

If Company A's lump sum payment is deductible under section 8-1 of the ITAA 1997, will the deduction be incurred in the year when the payment is made?

Answer

Yes

This ruling applies for the following period<s>:

Income year ended 30 June 2013

The scheme commences on:

1 July 2012

Issue 2

Question 1

If Company A's lump sum payment is not deductible under section 8-1 of the ITAA 1997, will the payment form part of the capital gains tax cost base of a capital gains tax asset?

Answer

Not applicable

This ruling applies for the following period:

Income year ended 30 June 2013

The scheme commences on:

1 July 2012

Issue 3

Question 1

If Company A's lump sum payment is not deductible under section 8-1 of the ITAA 1997, and does not form part of the capital gains tax cost base of a capital gains tax asset, can the payment be deducted over 5 years under section 40-880 of the ITAA 1997?

Answer

Not applicable

This ruling applies for the following period<s>:

Income year ended 30 June 2013

The scheme commences on:

1 July 2012

Relevant facts and circumstances

General background

Company A is a management company managing equity portfolios and balanced portfolios.

Advance funds

Company A currently provides investment management services to a number of funds.

Company C currently provides other services to the Funds and charges fees to the funds accordingly.

Proposed transactions

Company C entered into a non-binding agreement with Company A where Company A will provide services to the funds. These services are currently provided to the Funds by Company C.

Company A will be entitled to additional fees from the Funds for providing these additional services. After a transitional period, a binding agreement will be entered into.

Under the proposal, Company A will be required to pay Company C a lump sum as consideration for the appointment of Company A to provide these additional services to the Funds.

The Payment amount is calculated as the present value of additional income expected to be earned by Company A from the provision of the additional services after allowing for expected costs in providing the same services.

Other relevant facts

The additional services to be provided by Company A are an expansion of Company A's existing business (and not a significant change or a new business).

The relative costs incurred in providing the additional services are expected to be higher than the relative costs incurred with respect to the current services provided by Company A. As such, the additional net revenue stream to Company A will constitute an accretion/addition to its existing fee base.

Company A's long standing operating framework will not change as a result of taking on the responsibility for the additional services.

There will be no change in Company A's funds under management as Company A is already the investment manager for the Funds.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1,

Income Tax Assessment Act 1997 section 8-5,

Income Tax Assessment Act 1997 section 25-10,

Income Tax Assessment Act 1997 section 40-25 and

Income Tax Assessment Act 1997 section 40-880.

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if Company A or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement Company A asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If Company A want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Issue 1 Question 1

Summary

The payment to be made by Company A to Company C will be deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

The general provision that determines deductibility of expenses is section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997). Under section 8-1, 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 (first limb) or it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income (second limb). However, you cannot deduct a loss or outgoing that is capital or of a capital, private or domestic nature or it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income or if a provision of the Act prevents you from deducting it.

Other provisions in the ITAA 1997 contain specific deductions which are made allowable by section 8-5 of the ITAA 1997. Examples of specific deductions include repairs under section 25-10 of the ITAA 1997 and deductions for the decline in value of depreciating assets under section 40-25 of the ITAA 1997.

The expression "capital expenditure" is not a defined term. The distinction between expenses of a capital and revenue nature is often a fine one and as such has given rise to a voluminous body of case law.

The "recurrent" and "once and for all" expenditure test suggests that if expenditure is recurring, it is more likely to be revenue in nature. If it is a one-off expenditure, it is more likely to be capital in nature. In Vallambrosa Rubber Co Ltd v Farmer (1910) 5 TC 529, Lord Dunedin said (at p 536):

"I do not say that this consideration is absolutely final or determinative; but in a rough way I think it is not a bad criterion of what is capital expenditure as against what is income expenditure to say that capital expenditure is a thing that is going to be spent once and for all, and income expenditure is a thing that is going to recur every year".

Whether expenditure is capital in nature is determined on the facts of each particular case having regard to the principles established by case law. The general rule is that the nature of the loss or outgoing is determined by the underlying issue to which the loss or outgoing relates. The classic tests for determining whether expenditure is of a capital or revenue nature is explained in the following passage of Dixon J in Sun Newspapers Ltd. and Associated Newspapers Ltd. v Federal Commissioner of Taxation (1938) 61 CLR 337 (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 …"

The character of the advantage sought provides important direction. It provides the 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.

Generally, expenditure that is incurred in establishing, replacing and enlarging the profit-yielding subject itself (i.e. the business) will be characterised as capital in nature, and can be contrasted with the continual flow of working expenses which are or ought to be supplied continually out of the returns or revenue. That is, the distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay.

The relevant issue here is whether the lump sum to be paid by Company A to Company C is deductible under section 8-1 of the ITAA 1997. As stated earlier, a loss or outgoing is deductible for income tax purposes pursuant to section 8-1 of the ITAA 1997 to the extent that:

· it is incurred in gaining or producing assessable income (first limb); or

· it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income (the second limb); and

· it is not capital or of a capital nature.

The relevant test in establishing whether the expenditure was incurred for the purpose of gaining or producing assessable income is usually an objective test. The taxpayer's subjective purpose in incurring a loss or outgoing is normally irrelevant in the case of a voluntary loss or outgoing, particularly where the outgoing gives rise to the receipt of a larger amount of assessable income.

In this case, the expenses to be incurred by Company A to acquire the additional services from Company C have been made with the objective of making a profit by providing the additional services to the Funds. Therefore, Company A will either make a profit or loss in relation to providing these additional services.

In the case of BP Australia Limited v Federal Commissioner of Taxation (1965) 14 ATD 1, BP made payments to service station owners to ensure that petrol retailers exclusively sold its products (and the products of certain other petrol wholesalers) at their service stations. Agreements were entered into with the service station owners whereby BP, in consideration for the owners selling during a certain period only brands of petrol approved by it, promised to pay them lump sums. The Commissioner disallowed a claim for a deduction of the lump sum amounts on the basis that they were capital in nature.

The Commissioner's assessment was confirmed by the High Court, with Kitto J dissenting. However, on appeal, the Privy Council held that the payments were made on revenue account and were therefore deductible. The Privy Council considered that the payments made by BP were essentially payments made to customers for the purpose of securing orders for a quantity of goods, and therefore represented part of the cost of selling the goods.

Lord Pearce made a number of useful comments in this judgment. Lord Pearce discussed the dissenting judgment of Kitto J:

"... the advantage was not the acquisition of a new market, not a new framework within which to carry on trade for the future, not an extension of the appellant's selling organisation to include a regiment of resellers. It was not such an exclusion of competition as adds to goodwill a negative right and thus increases the value of goodwill..."

These comments have significant application to Company A. The lump sum payment to be made by Company A to Company C to acquire the provision of additional services is not a payment that augments the goodwill or any other enduring asset of the business of Company A. The lump sum payment to be made by Company A is for the provision of providing additional services to the Funds. Further, the nature of the payment is not considered as an expansion of the operative framework of Company A. The payment for the additional services to be provided by Company A is merely an expansion of Company A's existing business and there is not a significant change to the business or a new business.

In National Australia Bank Limited v FC of T (1997) ATC 5153, the Bank paid $42 million to the Commonwealth for the exclusive right to make subsidised home loans to Australian Defence Force personnel for a period of 15 years. The Commissioner disallowed a claim for deduction of the lump sum payment made to the Commonwealth on the basis that it was capital in nature. At first instance the Federal Court agreed with the Commissioner's decision. However, on appeal to the Full Federal Court it was held that the payment was of a revenue nature and was therefore deductible.

The Full Federal Court's decision was based on the view that the advantage sought by the Bank in making the payment was the expansion of its home loan customer base and the earning of income from the loans. The right obtained was not in the nature of a monopoly nor was it comparable to the acquisition of goodwill.

The Full Federal Court noted that the $42 million payment did not enlarge the framework within which the Bank carried on its activities, but rather was incurred as part of the process by which the Bank operated to obtain regular returns by means of regular outlay, the difference between the outlay and the returns representing profit or loss. As such, the payment was in the nature of a marketing expense, which pointed to it having a revenue rather than a capital aspect.

The Full Federal Court also stated:

"And in Foley Brothers Pty Ltd v FC of T (1965) 13 ATD 562 at 563 Kitto, Taylor and Menzies JJ said the, 'true contrast is between altering the framework within which income-producing activities are for the future to be carried on and the taking of a step as part of those activities within the framework'".

Company A will be making a lump sum payment to Company C to acquire the provision of providing additional services to the Funds. The lump sum payment to be made to Company C will not enlarge the framework within which Company A carried on its ordinary activities. It will be incurred as part of the process by which Company A operates to obtain regular returns by means of regular outlay. The difference between the outlay and the returns thus representing the profit or loss. The payment to be made by Company A to Company C is made as part of Company A's ordinary trading or income earning activities in the expectation that the amount would be recouped out of profits made from providing the additional services to the Funds.

In view if the above, the lump sum payment amount to be made by Company A to Company C will be deductible under section 8-1 of the ITAA 1997.

Issue 1 Question 2

Summary

If Company A's payment is deductible under section 8-1 of the ITAA 1997, the deduction will be incurred when the payment is made.

Detailed reasoning

For a loss or outgoing to be deductible under section 8-1 of the ITAA 1997, it must generally have been "incurred" in that year. In general terms, an outgoing is incurred at the time a taxpayer owes a present money debt that the taxpayer cannot escape. There is no exhaustive definition of the term "incurred" but the courts have developed a series of guidelines that can be used in assisting to determine whether an item has been incurred in a current year.

Barwick CJ in the Full High Court decision of Nilsen Development Laboratories Pty Ltd & Ors v FC of T 81 ATC 4031 stated:

"[T]here can be no warrant for treating a liability which has not 'come home' in the year of income, in the sense of a pecuniary obligation which has become due, as having been incurred in that year."

Therefore, an outgoing not representing a pecuniary liability of the year of income will not be incurred,

"no matter how certain it is in the year of income that that loss or expenditure will occur in the future" per Barwick CJ at p 4035.

Gibbs J further state (at p 4037):

"[W]hat is clearly necessary is that there should be a presently existing liability."

In addition for a loss or outgoing to be incurred and be deductible in a particular year under section 8-1 of the ITAA 1997, the loss or outgoing must also be "properly referable" to the year of income in question to be deductible in that year.

In Coles Myer Finance Ltd v FC of T 93 ATC 4214 (Coles Myer Finance), the High Court stated that, to be an allowable deduction under Section 8-1 of the ITAA 1997, in a particular income year:

"[I]t is not enough (however) to establish the existence of a loss or outgoing actually incurred. It must be a loss or outgoing of a revenue character and it must be 'properly referable' to the year of income in question."

Therefore, Coles Myer Finance case established that:

1. the taxpayer must establish that a loss or outgoing is "incurred" i.e. a presently-existing liability

2. it then necessary for the taxpayer to establish that the loss or outgoing was "properly referable" to the year of income in question

The Commissioner subsequently issued Taxation Ruling TR 94/26 following the High Court decision in Coles Myer Finance where the Commissioners sets out his views on the timing of certain revenue expenses. In Taxation Ruling TR 94/26 Income tax: subsection 51(1) - meaning of incurred - implications of the High Court decision in Coles Myer Finance (Note: The ruling sets out the Commissioner's views on the interpretation of section 8-1 of the ITAA 1997 Act (formerly subsection 51(1) of the ITAA 1936 Act) the Commissioner states that he courts have provided little guidance as to the meaning of "properly referable".

The Commissioner therefore regarded "properly referable" as being concerned with the period of time during which the benefit from incurring the loss or outgoing is put to "profitable advantage", i.e., the period during which the benefit obtained from the liability is used in the taxpayer's assessable income producing activity. Generally, this will be the period in which the goods or services to be provided as a result of the liability are in fact provided. However, if the liability is discharged prior to the provision of the last of the goods or services then the period of profitable advantage will end with the discharge of the liability.

In Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of "incurred" - timing of deductions, the Commissioner notes that it is sometimes not enough that a loss or outgoing has been incurred. At least in relation to financing transactions and liabilities which accrue daily or periodically, the outgoing must also be "properly referable" to the year of income in which the deduction is sought. This notion has its origins in the decision of the High Court in Coles Myer Finance at 4222.

In this instance, the relevant issue is; when is the payment or outgoing in relation to the additional services acquired by Company A from Company C incurred for the purposes of Section 8-1 of the ITAA 1997.

The relevant proposed transaction arrangements that are to be entered into between Company A and Company C have been agreed between the parties and final agreements are intended to be executed before year ended 30 June 2013. The lump sum payment to be made to Company C is expected to be made in full before 30 June 2013.

In view of the above, Company A will be incurring the expenditure during the year ended 30 June 2013 and it will be payable in the year ending 30 June 2013 when the final agreements are executed between the parties. Therefore, the payment to be made by Company A will be incurred during the year ended 30 June 2013. Applying the Commissioners view in Taxation Ruling TR 94/26 Income tax: subsection 51(1) - meaning of incurred - implications of the High Court decision in Coles Myer Finance, the liability will be discharged prior to the provision of the last of the goods or services. In the circumstances, the period of "profitable advantage" will end with the discharge of the liability. Therefore, the lump sum amount to be made by Company A to Company C as consideration for the appointment of Company A to provide the additional services to the Funds will be deductible in the year ending 30 June 2013 when the payment is made.

Issue 2 Question 1

Summary

As the Commissioner has ruled in Issue 1 Question 1 that the payment is deductible under section 8-1 of the ITAA 1997, this question is therefore not applicable.

Detailed reasoning

As the Commissioner has ruled in Issue 1 Question 1 that the payment is deductible under section 8-1 of the ITAA 1997, this question is therefore not applicable.

Issue 3 Question 1

Summary

As the Commissioner has ruled in Issue 1 Question 1 that the payment is deductible under section 8-1 of the ITAA 1997, this question is therefore not applicable.

Detailed reasoning

As the Commissioner has ruled in Issue 1 Question 1 that the payment is deductible under section 8-1 of the ITAA 1997, this question is therefore not applicable.