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Authorisation Number: 1011946189918

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Ruling

Subject: Deductions for various outgoings incurred under an arrangement.

Question

Are the outgoings under the arrangement allowable as deductions under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following periods:

The 2011 income year.

Relevant facts and circumstances

The taxpayer entered into several agreements (referred to collectively as the arrangement) with a third party for the supply of an item that it then sells to the market in order to produce assessable income.

Under the arrangement, various outgoings were payable by the taxpayer to the third party. The outgoings that were the subject of this ruling were invoiced to, and payable by, the taxpayer on a periodic basis that aligned with the periodic supply of the contracted item. If the taxpayer failed to pay the outgoings, there were contractual clauses that would lead to the counter-party having a right to terminate the arrangement, which would mean the supply of the item would cease.

The taxpayer was not required to, and did not provide, credit support in the form of a lump sum payment of an amount in respect of these outgoings. There was no other requirement for the taxpayer to dispense with its liability for these outgoings in any form other than on a periodic basis for the duration of the term of the arrangement.

Further, if the arrangement was terminated due to the failure of the third party to supply the item, the taxpayer would no longer be required to pay the various outgoings in respect of any period after the termination date. If termination arose in any other circumstances, the taxpayer would not be required to pay these outgoings in respect of any period after termination.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

General deductions are allowable under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997). Subsection 8-1(1) of the ITAA 1997 contains the positive limbs of the test for general deductions.

However, even if a loss or outgoing satisfies one of the positive limbs, a deduction is not allowed to the extent that it satisfies one of the negative limbs of the test for general deductions as contained in subsection 8-1(2) of the ITAA 1997.

The positive limbs

Subsection 8-1(1) of the ITAA 1997 relevantly provides as follows:

... You can deduct from your assessable income any loss or outgoing to the extent that:

(a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a *business for the purpose of gaining or producing your assessable income.

In order for the periodic outgoing to be deductible under subsection 8-1(1) of the ITAA 1997, they must be 'incurred' in 'gaining or producing…assessable income'. These terms are considered below.

'Incurred' in the relevant year of income

There is no statutory definition of the term 'incurred', however, the term was considered by Dixon J in New Zealand Flax Investments Ltd. v. Federal Commissioner of Taxation (1938) 61 CLR 179 at 207:

'"Incurred" does not mean only defrayed, discharged, or borne, but rather it includes encountered, run into, or fallen upon. It is unsafe to attempt exhaustive definitions of a conception intended to have such a various or multifarious application. But it does not include a loss or expenditure which is no more than impending, threatened or expected.'

Further guidance is provided in Taxation Ruling TR 94/26: Income tax: section 8-1 - meaning of 'incurred' - implications of the High Court decision in Coles Myer Finance (TR 94/26). Generally, for an outgoing to be 'incurred', TR 94/26 considers that a presently existing pecuniary liability at the end of the relevant income year is sufficient, even though there has been no actual disbursement. However, it is not sufficient that the liability to pay is pending, threatened or expected.

Whether there is a presently existing pecuniary liability is a legal question in each case. TR 94/26 further provides at paragraph 6:

Whether there is a presently existing pecuniary liability is a question which must be determined in light of the particular facts of each case, and especially by reference to the terms of the contract or arrangement under which the liability is said to arise.

Referable to the relevant income year

Paragraph 15 of TR 94/26 provides that it is not necessary, in determining whether a loss or outgoing has been incurred, "to have regard to the period to which an expense is properly referable where the liability comes into existence and is discharged in the same year".

In gaining or producing assessable income

The words 'in gaining or producing' were considered in Ronpibon Tin N.L. and Tongkah Compound N.L. v. Federal Commissioner of Taxation (1949) 78 CLR 47 (Ronpibon) at 56-58:

'The words "incurred in gaining or producing the assessable income" mean in the course of gaining or producing such income…In brief substance, to come within the initial part of the sub-section it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income…The question is how far was it incurred in the course of, how far was it incidental and relevant to, gaining or producing the assessable income.'

Thus, there needs to be a sufficient nexus between the expenditure and the production of assessable income. Further guidance is provided in Taxation Ruling TR 95/33 (TR 95/33) which refers in paragraph 24 to the following statement in the High Court decision in Fletcher & Ors. v. Federal Commissioner of Taxation (1991) 173 CLR 1:

'The question whether an outgoing was, for the purposes of s. 51(1), wholly or partly "incurred in gaining or producing the assessable income" is a question of characterisation. The relationship between the outgoing and the assessable income must be such as to impart to the outgoing the character or an outgoing of the relevant kind.'

The essential character of an expense is a question of fact to be determined by reference to all the circumstances. TR 95/33 further provides that it will not generally be necessary to have regard to the taxpayer's subjective purpose, motive or intention, where having regard to the overall objective circumstances, there is an obvious commercial connection between the loss or outgoing and the income producing activities of the taxpayer.

Conclusion

Based on the facts, the taxpayer will satisfy one of the positive limbs in subsection 8-1(1) of the ITAA 1997 in respect of its liability for the periodic outgoing.

The negative limbs

A loss or outgoing will not be deductible if it satisfies one of the negative limbs contained in subsection 8-1(2) of the ITAA 1997. Subsection 8-1(2) of the ITAA 1997 relevantly provides as follows:

However, you cannot deduct a loss or outgoing under this section to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature; or

(b) it is a loss or outgoing of a private or domestic nature; or

(c) it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or

(d) a provision of this Act prevents you from deducting it.

In the present case, the relevant issue is whether the periodic outgoing is characterised as a loss or outgoing of capital or of a capital nature. If the answer is in the affirmative then the periodic outgoing will not be an allowable deduction under paragraph 8-1(2)(a) of the ITAA 1997.

The determination of whether a loss or outgoing is of a capital nature is subject of a considerable body of case law. That case law relies upon the classic statement by Dixon J of Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers) at page 363 (for example, refer to Macquarie Finance Ltd. v. Federal Commissioner of Taxation (2005) 146 FCR 77 at 54 to 55):

'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 by making a final provision or payment so as to secure future use or enjoyment.'

The three matters in Sun Newspapers will be considered below.

Character of the advantage sought

In relation to the first factor, the following cases provide guidance as to whether the periodic outgoing secures an advantage that is properly characterised as an enduring benefit, or otherwise of a capital nature.

In Federal Commissioner of Taxation v. Citylink Melbourne Ltd. (2006) 228 CLR 1, the majority of the High Court reinforced the statements of Dixon J in Hallstroms Pty. Ltd. v. Federal Commissioner of Taxation (1946) 72 CLR 634 (at 43):

'The characterisation of an outgoing depends on what it 'is calculated to effect', to be judged from 'a practical and business point of view'. The character of the advantage sought by the making of the expenditure is critical.'

In B.P. Australia Ltd. v. Federal Commissioner of Taxation (1966) 112 CLR 386 (B.P. Australia), Lord Pearce stated at 397:

'The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other.'

It is the "character of the advantage sought by the taxpayer for himself by making the outgoings" that is relevant (Federal Commissioner of Taxation v. South Australian Battery Makers Pty. Ltd. (1978) 140 CLR 645 at 885).

The taxpayer will satisfy this factor in relation to the periodic outgoings.

The manner in which the advantage is to be used, relied upon or enjoyed

In Sun Newspapers Dixon J indicated that recurrence may play a part in relation to this factor. His Honour said (at 362):

'…"the real test is between expenditure which is made to meet a continuous demand, as opposed to an expenditure which is made once for all" (per Rowlatt J., Ounsworth v. Vickers Ltd. (2)). By this I understand that the expenditure is to be considered of a revenue nature if its purpose brings it within the very wide class of things which in the aggregate form the constant demand which must be answered out of the returns of a trade or its circulating capital and that actual recurrence of the specific thing need not take place or be expected as likely…Recurrence is not a test, it is no more than a consideration the weight of which depend upon the nature of the expenditure.'

Recurrent expenditure in this context refers to expenditure incurred as part of the constant demand of the business which has to be met out of the returns of trade or circulating capital. In Federal Commissioner of Taxation v. Email Ltd. (1999) 42 ATR 698 at 39, Hill, Drummond and Sackville JJ stated that:

'By recurrent expenditure it is not meant expenditure which may be incurred more than once, even if incurred on a number of occasions. Expenditure as we have already stated may still be capital, albeit that it is repeated. Recurrent expenditure is rather expenditure which is part of the constant demand which must be answered out of the returns of a trade or its circulating capital: Sun Newspapers at 362. Rates, rent, interest, even premiums of insurance of capital assets ( Australian National Hotels Ltd v. FC of T (1988) 88 ATC 4627, notwithstanding that the proceeds of the insurance would themselves be capital, are examples of recurrent expenditure ordinarily on revenue account if incurred in the course of a taxpayers business. Whether the expenditure is, in the sense used, recurrent, will depend more upon the nature of the expenditure than the number of times it is repeated.'

In B.P. Australia, Lord Pearce concluded that certain payments secured a benefit that was "to be used in the continuous and recurrent struggle to get orders and sell petrol" (at 405). In relation to the relevant distinction between fixed capital and circulating capital, Lord Pearce said at 398:

'Fixed capital is prima facie that on which you look to get a return by your trading operations. Circulating capital is that which comes back in your trading operations. The sums in question were sums which had to come back penny by penny with every order during the period in order to reimburse and justify the particular outlay…This however is merely one indication…'

The taxpayer will satisfy this factor in relation to the periodic outgoings.

The means adopted to obtain it

The last factor looks at the means adopted to obtain the advantage.

Dixon J in Sun Newspapers at 361 said:

'In the attempt, by no means successful, to find some test or standard by the application of which expenditure or outgoings may be referred to capital account or to revenue account the courts have relied to some extent upon the difference between an outlay which is recurrent, repeated or continual and that which is final or made once for all, and to a still greater extent upon a distinction to be discovered in the nature of the asset or advantage obtained by the outlay.'

The taxpayer will satisfy this factor in relation to the periodic outgoings.

Conclusion

Consideration of each of the factors in Sun Newspapers produces the conclusion that the periodic outgoings incurred by the taxpayer under the arrangement are not outgoings of a capital nature, and are therefore deductible to the taxpayer under section 8-1 of the ITAA 1997.