Edited version of private ruling

Authorisation Number: 1011811173459

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Ruling

Subject: travel, accommodation and legal expenses

Question 1

Is the trust entitled to a deduction for travel and accommodation expenses under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Is the trust entitled to a deduction for legal expenses under section 40-880 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2010

The scheme commenced on

1 July 2009

Relevant facts and circumstances

The trust holds the shareholding in a company.

The company entered into a franchise agreement.

Prior to the company entering into the agreement the trust incurred travel and occasional accommodation expenses in reviewing various businesses operating under the same franchise.

The trust also incurred legal expenses in reviewing the franchise agreement prior to the agreement being signed.

Relevant legislative provisions

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

Income Tax Assessment Act 1997 Paragraph 40-880(2)(c).

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

The trust is entitled to a deduction for travel, accommodation and legal expenses under paragraph 40-880(2)(c) of the ITAA 1997 as there was sufficient commitment to the business at the time the expenses were incurred.

Detailed explanation

Section 40-880 of the ITAA 1997 is a provision of last resort. Capital expenditure is only deductible under section 40-880 of the ITAA 1997 if it is not already recognised elsewhere in the income tax law.

It is therefore first necessary to consider whether a deduction is allowable under section 8-1 of the ITAA 1997

As a general, rule a loss or outgoing is not deductible under section 8-1 of the ITAA 1997 unless it is incurred in gaining or producing the assessable income of the person who incurs it, see FC of T v. Munro (1926) 38 CLR 153 at p 170 per Knox CJ.

In Little v. FC of T 2006 ATC 2488 (Little's case) the taxpayer had been interested in purchasing a Hose Doctor franchise. As a condition of entry into the franchise agreement, the taxpayer caused a private company to be incorporated with himself as the sole director. The taxpayer also leased a new truck in his own name, ceased his employment and commenced conducting the business under the franchise agreement. The taxpayer's claim for expenses relating to the truck was disallowed as the taxpayer conducted no business at all; the business was conducted by the company. Accordingly, the expenses were not incidental and relevant to deriving the taxpayer's income and they were not deductible

The trust's situation is comparable to that of Little's case. The trust did not conduct the business to which the expenses related to; the business is conducted by the company. The legal expenses in relation to the review of the franchise document and establishment deed could only be incidental to the business of the company; they were not incurred in the earning of the assessable income of the trust. The travel and accommodation expenses in researching the franchise were also unrelated to the earning of the assessable income of the trust. Furthermore the travel, accommodation and legal expenses were incurred at a point too soon. These expenses are also considered to be related to the establishment of the profit yielding structure of the proposed business and are therefore capital in nature.

As such the trust not entitled to a deduction for these expenses under section 8-1 of the ITAA 1997.

40-880 of the ITAA 1997

Section 40-880 of the ITAA 1997 potentially applies to the expenditure the subject of this ruling because the expenditure was incurred on or after 1 July 2005: see section 3 and Schedule 2 Item 51(1) of the Tax Laws Amendment (2006 Measures No.1) Act 2006.

Subject to the limitations and exceptions contained in subsections 40-880(3) to (9) of the ITAA 1997, subsection 40-880(2) of the ITAA 1997 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.

On the facts of this case the relevant paragraph to consider is paragraph 40-880(2)(c) of the ITAA 1997 because the expenditure was incurred prior to the commencement of the business.

In considering the phrase 'in relation to' contained within subsection 40-880(2) of the ITAA 1997, paragraph 2.25 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 ('the EM') states:

The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business. The concept used to establish this character or requisite relationship between the expenditure incurred by the taxpayer and the business carried on (current, past or prospective) is 'in relation to'. The connector 'in relation to' allows the appropriate latitude to enable the deductibility of qualifying capital expenditure incurred before the business commences or after it has ceased.

The phrase 'in relation to' was considered by the High Court in PMT Partners Pty Ltd (In Liquidation) v. Australian National Parks & Wildlife Service (1995) 184 CLR 301. Brennan CJ, Gaudron and McHugh JJ observed, in considering the application of the Commercial Arbitration Act 1985 (NT), at 313:

Inevitably, the closeness of the relation required by the expression 'in or in relation to' in s 48 of the Act, indeed, in any instrument - must be ascertained by reference to the nature and purpose of the provision in question and the context in which it appears.

In that case Toohey and Gummow JJ also observed:

It is apparent that the words 'in or in relation to' are particularly wide. … Cases concerning the interpretation of this phrase in other statutory contexts are of limited assistance. However, the cases do show that the words are prima facie broad and designed to catch things which have sufficient nexus to the subject. The question of sufficiency of nexus is, of course, dependent on the statutory context. (at 330) …

The connection which is required by the phrase 'in relation to' is a question of degree. There must be some "association" which is "relevant" or "appropriate". The question of the relevance or appropriateness of the connection is a question which cannot be divorced from the particular statutory context. (at 331)

In First Provincial Building Society Limited v. FC of T 95 ATC 4145; 30 ATR 207, Hill J considered the phrase 'in relation to' within the context of paragraph 26(g) of the Income Tax Assessment Act 1936. He considered the words 'in relation to' in that context included a relationship that may either be direct or indirect, provided that the relationship consisted of a real connection, but that a merely remote relationship is insufficient (at ATC 4155; ATR 218).

It is therefore necessary to consider the legislative context of subsection 40-880(2) of the ITAA 1997 in order to determine whether there is a sufficient and relevant connection between the expenditure incurred and a particular business. In discussing the types of business capital expenditure to which subsection 40-880(2) of the ITAA 1997 applies, the EM states:

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. Capital expenditure can also relate to a business's trading operations or the entity that will carry on the business.

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.

These paragraphs indicate that capital expenditure incurred on the structure by which an entity carries on, or used to or proposes to carry on their business, on the profit yielding structure of the business, or relating to the business's trading operations, are capable of being described as capital expenditure incurred 'in relation to' that business for the purposes of subsection 40-880(2) of the ITAA 1997. Whether such capital expenditure is incurred 'in relation to' the particular business will depend on whether there is a sufficient and relevant connection between the incurring of the expenditure and that business on the facts of the particular case.

In this case, the capital expenditure you incurred was for travel to various locations to talk to managers and staff of various businesses operating under the same franchise. As this expenditure was incurred to assess the franchise you were considering entering into, it follows that the character of the expenditure is capable of being in relation to a business in the sense of establishing a profit yielding structure for a business proposed to be carried on.

Was that capital expenditure incurred in relation to a business 'proposed to be' carried on by the company for the purposes of paragraph 40-880(2)(c) of the ITAA 1997? In considering the term 'proposed to be', paragraphs 2.31 to 2.33 of the EM state:

2.31. For a business to be proposed to be carried on for the purposes of this provision, the taxpayer needs to be able to demonstrate a commitment of some substance to commence the business, and sufficient identity about the business that is proposed to be carried on. The deductibility of expenses in advance of the business being carried on will rest on the facts of each case, but this commitment and identity must be tangible; that is, there would need to be some evidence that would enable an objective assessment of the existence of that commitment and identity.

2.32. Further guidance as to the level of commitment required to deduct pre-business expenditure is provided by subsection 40-880(7). In essence, this requires that, having regard to relevant circumstances, it must be reasonable to conclude that the commitment exists. One of these circumstances is that the business be proposed to be carried on within a reasonable time. This may vary according to the industry or the nature of the business and would recognise the long lead times that may be involved. [Schedule 2, item 30, paragraph 40-880(2)(c), subsection 40-880(7)].

2.33. Such commitment could be shown by, but is not limited to, at least some of the following:

· a business plan;

· the establishment of a business premises;

· research into the likely markets or profitability of the business; and

· capital investment in assets of the business.

Eligibility for deduction under section 40-880 of the ITAA 1997 is established as at the time when the expenditure is incurred: see paragraph 2.40 of the EM. Therefore, at the time you incurred the expenditure, you need to demonstrate, for the purposes of paragraph 40-880(2)(c) of the ITAA 1997 , a commitment of some substance to commence the business and sufficient identity about the business proposed to be carried on.

At the time that you first incurred the capital expenditure you had identified the specific franchise you wished to enter into and had established the company structure with which to operate the franchise under.

These factors demonstrate a commitment of some substance to commence to carry on a business and sufficient identity about the business proposed to be carried on, as at the time that the expenditure was incurred. In these circumstances, we consider that there is a sufficient and relevant connection between the business that was proposed to be carried on and the travel and accommodation expenses you incurred researching the franchise and the legal expenses in reviewing the related documentation. Accordingly, a business was proposed to be carried on for the purposes of paragraph 40-880(2)(c) of the ITAA 1997 at the time you incurred the capital expenditure.

Limitations under subsection 40-880(4) of the ITAA 1997

The capital expenditure that is the subject of this ruling is incurred in relation to a business proposed to be carried on by an entity (the company) other than the entity which incurred the expenditure (you). Therefore, any deduction to you under section 40-880 is subject to the limitations set out in subsection 40-880(4) of the ITAA 1997, rather than the limitation set out in subsection 40-880(3) of the ITAA 1997.

With respect to whether the capital expenditure that you incurred is in connection with deriving assessable income from the proposed business of the company for the purpose of subparagraph 40-880(4)(b)(i) of the ITAA 1997, the EM relevantly states:

2.54 The expenditure must be in connection with the taxpayer deriving their assessable income from the business. [Schedule 2, item 30, paragraph 40-880(4)(b)]

2.55 This is to provide a proxy for the relationship between the taxpayer and 'their' (ie, the taxpayer) business, where the taxpayer that incurs the expenditure is not the same as the taxpayer that carries on the business. Deriving assessable income refers to the entitlement to a share in the profits from the business. The way in which the profit is derived can be direct or indirect. The expenditure also needs to be 'in connection with' the business that was carried on or is proposed to be carried on.

As you were a shareholder of the company, which was to carry on a business wholly for a taxable purpose, you would be in a position to derive assessable income from the business through your entitlement to your share of any dividends paid by the company out of profits from the business. There is nothing to suggest that the company intended never to distribute any profits from the company's business to you.

As the character of the capital expenditure incurred by you is as part of establishing the profit yielding structure of the business of the company that was formed by you, that expenditure is in connection with the business that was proposed to be carried on by the company.

Accordingly, subsection 40-880(4) of the ITAA 1997 does not apply to limit the amount you can deduct under section 40-880 of the ITAA 1997 for the travel, accommodation and legal expenditure that you incurred.

However, subsections 40-880(5) to (9) of the ITAA 1997 set out further limitations and exclusions to deductibility under section 40-880 of the ITAA 1997. On the facts of this case, only subsection 40-880(7) of the ITAA 1997 need be considered.

Limitations under subsection 40-880(7) of the ITAA 1997

Subsection 40-880(7) of the ITAA 1997 provides:

you cannot deduct an amount under paragraph (2)(c) in relation to a business proposed to be carried on unless, having regard to any relevant circumstances, it is reasonable to conclude that the business is proposed to be carried on within a reasonable time.

In this case it was intended that a franchise business be purchased which was to be carried on by the company after acquisition. Based on the information provided it is clear that it was intended that the franchise agreement was to be entered into once due diligence had been completed. It is reasonable to conclude that the proposed business of the company was to be carried on within a reasonable time after the incurrence of the expenditure. Accordingly, subsection 40-880(7) of the ITAA 1997 does not limit to any extent the deduction for that expenditure.

Conclusion

In your circumstances paragraph 40-880(2)(c) of the ITAA 1997 applies and is not limited by the operation of either subsection 40-880(4) or (7) of the ITAA 1997. Therefore, you can deduct 100 per cent of the capital expenditure that you incurred that is the subject of this ruling over 5 years (starting in the year you incurred that expenditure) under section 40-880 of the ITAA 1997.