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Ruling

Subject: Deductibility of costs incurred under a deed of settlement

Question

Can the company claim an amount paid as part of a deed of settlement as a deduction?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

The scheme commenced on:

1 July 2008

Relevant facts and circumstances

The company purchased three blocks of land with the intention of future development, had plans drawn up and were granted development approval, building approval and operational works approval by the relevant local government body before a developer was appointed under a project deed to manage the project.

As part of the project deed it was agreed that A, B and C would be appointed directors of the company and the company's sole director and shareholder would simultaneously resign as a director.

Under the project deed the developer was to take all necessary steps to enable the company to:

(a) obtain the finance required to complete the project;

(b) engage a builder to construct the building;

(c) engage all requisite consultants to facilitate the completion of the project;

(d) obtain final Council approvals and the registration of the Survey Plan;

(e) offer the units for sale at their market price;

(f) complete the project.

In order to secure the finance the company had to grant a first registered Bill of Mortgage over the land and a fixed and floating charge over all its assets and undertakings in favour of the financier and if required A, B and C would give personal guarantees. The mortgage facility was provided by a lender.

The project development deed further provided that the developer shall lend a sum to the company and the sole shareholder to enable them to comply with a clause of the deed requiring them to repay all loans and advances owing by the company. Under the deed the developer will indemnify the company for all interest paid or payable in connection with the finance raised for the construction and completion of the project.

The project deed further provided that the developer will be paid a project management fee.

Following a dispute between the sole shareholder on the one hand and A, B and C on the other, in relation to the project, a deed of settlement was executed to resolve the matter. The parties to this deed were the company, the sole shareholder, A, B and C, the developer and the lender.

The settlement deed provides as background, among other matters, that the dispute arose between the sole shareholder and A, B and C as to the proper expenditure in relation to the project.

Under this deed it was agreed that upon or after completion:

· The company would provide the developer with the title to two of the unsold units in the project;

· The sole shareholder would pay the developer a sum less mortgage release fees owing to the lender;

· One half of the bank accounts to be retained by the company;

· The company would be released and discharged from its liability under a mortgage owing to the lender;

· A, B and C would acknowledge and agree that the sole shareholder is again the sole director of the company;

· A, B and C would release and discharge the sole shareholder from any claim which any of them may have had against him:

o arising from their removal or purported removal as directors of company; and

o in respect of any loss, damage or liabilities they incur, or could incur, as a result of the sole shareholder acting as director of the company during the dispute.

· The developer, A, B and C and the sole shareholder agree that, on completion, the project deed is at an end and each party releases and discharges each other party from any continuing obligations under the project deed and in respect of any or all claims which they have, or could have, arising out of, or in connection with the project deed.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that you can deduct from your assessable income any loss or outgoing that is incurred in gaining or producing your assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. However you cannot deduct a loss or outgoing that is of a capital, private or domestic nature.

For a loss to be incurred in gaining or producing the assessable income "it is both sufficient and necessary that the occasion of the loss ... be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income" (Ronpibon Tin N.L. and Tongkah Compound N.L. v. FC of T (1949) 78 CLR 47 at 57; Fletcher & Ors v. FC of T 91 ATC 4950 at 4957; (1991) 22 ATR 613 at 622).

The liability to pay a sum to the developer arose from a dispute over costs incurred in the development of a building site and includes a sum owed by the sole shareholder in his personal capacity. There is no doubt that a calculation of the amount due to the developer was calculated by reference to the profit that was expected to emerge from the venture. However it is important to note that this calculation was not based on actual profit but on the expected profit that would have been derived if the project had been completed.

The guidelines for distinguishing between capital and revenue outgoings were laid down in Sun Newspapers Ltd and Associated Newspapers Ltd v FC of T (1938) 61 CLR 337: (1938) 45 ALR 10; (1938) 1 AITR 403; 5 ATD 87 (the Sun Newspapers case) . It was pointed out that expenditure in establishing, replacing and enlarging the profit-yielding structure is capital and is to be contrasted with working or operating expenses. The test laid down in the Sun Newspapers case involved three elements, although none is in itself decisive:

-         the nature of the advantage sought;

-         the way it is to be used or enjoyed; and

-         the means adopted to get it.

As regards the first two elements, the lasting or recurrent character of the advantage and the expenditure is important. Thus the courts have held that, in the absence of special circumstances, expenditure is capital in nature where it is made with a view to bringing into existence an asset or an advantage (tangible or intangible) for the enduring benefit of the business (British Insulated and Helsby Cables v Atherton (1926) AC 205). In addition it is the nature of the advantage sought by the taxpayer that is relevant.

In your case the company has made a one off payment to release and discharge it from its obligations under the project deed entered into with the developer. This payment is considered to be a capital outlay as the purpose of the payment was to finalise a dispute over the management of a property development and enabled the company to remove a business associate from its activities.

Although the settlement sum was calculated by reference to the way in which the project deed set out the calculation of management fees which were due to be paid to the developer, the actual payment was not a management fee.

The project deed provided that the developer would be paid a project management fee from the sale of the units. We consider this to mean that the management fee only becomes payable when each unit is actually sold and the sale is completed. At the time of the settlement there were some units under contract but not completed and further units unsold. The calculation of the settlement sum has been based on these units.

The sum paid to the developer, in the case of the unsold units, is based on an estimated sale price as it was impossible to know at the time what those units would actually fetch. In the case of the units under contract, it appears that the management fee would not become payable until the sale is finalised in each case. As such there was no liability to pay a management fee at this time under the project deed.

The fact that the settlement sum was calculated by using the formula applicable to the management fee does not necessarily make it a management fee. In our view the settlement sum is a payment to enable the company to be released and discharged from its obligations under the project agreement and is therefore capital in nature.