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Ruling

Subject: Deductibility of Contract Fees

Question 1

Is the contract fee deductible pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Is $xx of the contract fee subject to section 82KZMA of the Income Tax Assessment Act 1936 (ITAA 1936) and therefore deductible over the "eligible service period" as defined in section 82KZL of the ITAA 1936?

Answer

Yes

Question 3

Is the annual payment of $xx deductible as incurred under section 8-1 of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods:

Income tax year ended 30 June 2008 through to the Income Tax year ended 30 June 2013

The scheme commences on:

30 June 2008.

Relevant facts and circumstances

Background

Entities in the industry have, by necessity, become more innovative in how they target and secure and protect profitable contracts. For example, there is now an overall market expectation that a fee may need to be offered as part of a tender response.

Contract Fee

The key components of this contract can be summarised as follows:

· The Agreement was entered into on 30 June 2008

· "Fee" means the fee that the taxpayer pays for the right to be the exclusive provider of goods and services for 5 years

· Notwithstanding the Fee and other provisions of the Agreement, a right exists to acquire the service and product from a provider of choice.

· An extension of the term past the initial term requires the payment of an additional Fee

· Fee

(a) X agrees to pay to W the Fee as follows:

(1) $x on execution of the agreement

(2) $x on each anniversary of the date of this agreement during the Initial Term

(b) Should this agreement be terminated, X will not be required to pay any balance of the Contract Rights Fee owing as at the date of termination.

Purpose of Payment

· X offered the Fee as part of its tender response to W to ensure it remained commercially competitive against its other rivals in the tender process.

· In the absence of the Fee, the response of X would not have been considered eligible by W as the existence of a Fee was minimum requirement of the tender response.

· More broadly, while the offering of a Fee is not compulsory in all cases, it is common in the industry to be included.

· In determining whether to include a Fee in their response to the W proposal (including how much to offer), X completed internal calculations to ascertain the maximum amount that could be paid and still be within acceptable commercial ratios, including Return on Equity investment criteria.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1,

Income Tax Assessment Act 1997 Division 230,

Income Tax Assessment Act 1936 Section 82KZL and

Income Tax Assessment Act 1936 Section 82KZMA.

Reasons for decision

Issue 1 Question 1

Summary

The Contract Fee is deductible pursuant to section 8-1 of the ITAA 1997.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)

Section 8-1 of the ITAA 1997 allows a general deduction for losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, no deduction is allowed where the outgoings are of capital, or of a capital nature.

Section 8-1 of the ITAA 1997 states:

(1) 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.

(2) 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

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

Summary

By applying the factors established in Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403 (Sun Newspapers), BP Australia Ltd v. Federal Commissioner of Taxation (1965) 112 CLR 386; (1965) 14 ATD 1; (1965) 9 AITR 615 (BP) and National Australia Bank v. Federal Commissioner of Taxation (1997) 80 FCR 352; 37 ATR 378; 97 ATC 5153 (NAB), FCT Email 99 ATC 4868; GP International Pipecoaters Pty Ltd v. FCT (1990) 170 CLR 124 at 137; 21 ATR 1 at 7; 90 ATC 4413 at 4419; Hallstroms Pty Ltd v. FCT (1946) 72 CLR 634 at 648 (Hallstroms); Magna Alloys & Research Pty Ltd v. FCT (1980) 33 ALR 213 at 235; Jupiters Limited v DFC of T 2002 ATC 4022 and Tyco Australia Pty Ltd v FC of T [2007] FCA 1055; the contract fee payments were made for the securing of the contract. The nature of the expenditure incurred by the taxpayer can be characterised as marketing costs.

The contracts fee paid by the taxpayer form an essential part of the cost of the business operations and has the character of working expense.

Therefore, the taxpayer's expenditure is of a revenue nature in the context of existing business as the expenditure incurred in NAB.

Manner used, relied upon or enjoyed

The second test under Sun Newspapers approach to determining whether an outgoing is revenue or capital in nature looks at the manner in which the benefit obtained is to be used, relied upon or enjoyed.

In this case, the contract rights fees were costs as part of normal business practice and usual industry procedures. The contract fees were given to help secure the contract. The manner used in the provision of the contract rights fee is consistent with normal industry practices, to enable the taxpayer to obtain the pharmaceutical services contract, which they were successful in obtaining.

Further, the manner test used in this expenditure is of a revenue nature that is to increase sale of products and services. This was similar to NAB's strategy which was to target various segments of the home loan customer market.

Means adopted to obtain

The third test under Sun Newspapers approach to determine whether an outgoing is revenue or capital in nature looks at the means adopted to obtain the benefit. For instance, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

In this case, the contract fee paid by the taxpayer does not secure an ongoing benefit because the agreement of 5 years does not result in an ongoing advantage to the taxpayer at the expiration of the contract.

Summary

The contract rights fee was not incurred to secure an enduring benefit or advantage, nor would they contribute to any specifically identifiable goodwill intangible.

Therefore, the expenditure incurred is not of a capital nature

Monopoly, buying competitors

Another element considered in BP and NAB was the effect of the steps taken and whether a monopoly was achieved. It was held in BP that the steps taken by BP achieved no monopoly nor buying off competition nor obtaining any substantial area for its own domain: BP at CLR 395.

In this case, the taxpayer does not have a monopoly on the provision of services as other competitors can and do provide the same or similar service and would also pay a contract rights fee as an inducement to obtain the contract to supply the same services.

Summary

The steps taken by the taxpayer achieved no monopoly nor buying off competition nor obtaining any substantial area for its own domain.

Recurrent nature and circulating capital

Further, the taxpayer paid the contract fee to secure the flow of revenue from the tender. The contract rights fee paid by the taxpayer were expected to generate future sales in terms of goods sold under the contract. The taxpayer paid the contracts fees to secure work from them in the normal course of their business.

Conclusion

The contract fee payments made by the taxpayer are outgoings incurred in the normal course of business and are deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

Issue 2 Question 1

Summary

$x of the contract fee is subject to section 82KZMA of the ITAA 1936 and is therefore deductible over the "eligible service period" as defined in section 82KZL.

Detailed reasoning

Where expenditure qualifies for deduction under section 8-1 of the ITAA 1997, the deduction is generally allowable in full in the year the expenditure is incurred. However, the timing of deductions for certain types of expenditure is subject to the advance payment rules in sections 82KZL to 82KZO of the ITAA 1936.

Subsection 82KZMA(1) of the ITAA 1936 provides:

Section 82KZMD sets the amount and timing of deductions for expenditure that a taxpayer incurs in a year of income (the expenditure year), if:

(a) apart from those sections, the taxpayer could deduct the expenditure under section 73B, 73BA, 73BH, 73QA, 73QB or former section 73Y of this Act or section 8-1 of the Income Tax Assessment Act 1997 for the expenditure year; and

(b) the requirements in subsections (2), (3), (4) and (5) are met.

In this case, paragraphs 82KZMA(1)(a) and (b) of the ITAA 1936 is satisfied, being an expenditure that could otherwise be deducted in the relevant expenditure year under section 8-1 of the ITAA 1997.

Further, all of the requirements of paragraphs 82 KZMA(2), (3), (4) and (5) are met.

As a result, the portion of the $x that is deductible in each year of income that contains all or part of the 'eligible service period' (as defined in subsection 82KZL(1) of the ITAA 1936) is calculated using the formula contained in subsection 82KZMD(2) of the ITAA 1936.

Issue 2 Question 2

Summary

The annual payment of $x is deductible as incurred under section 8-1.

Detailed reasoning

Under the Agreement, the $x is incurred on each anniversary date of the agreement during the Initial Term.

As discussed at Question 1 above, where expenditure qualifies for deduction under section 8-1 of the ITAA 1997, the deduction is generally allowable in full in the year the expenditure is incurred. However, the timing of deductions for certain types of expenditure is subject to the advance payment rules in sections 82KZL to 82KZO of the ITAA 1936.

Subsection 82KZMA(1) of the ITAA 1936 provides:

Section 82KZMD sets the amount and timing of deductions for expenditure that a taxpayer incurs in a year of income (the expenditure year), if:

(a) apart from those sections, the taxpayer could deduct the expenditure under section 73B, 73BA, 73BH, 73QA, 73QB or former section 73Y of this Act or section 8-1 of the Income Tax Assessment Act 1997 for the expenditure year; and

(b) the requirements in subsections (2), (3), (4) and (5) are met.

82KZMA(3) is not met as the $x is not incurred in return for the doing of a thing under the agreement that is not to be wholly done within the expenditure year (paragraph 82KZMA(3)(c) of the ITAA 1936).

Therefore, the $x is deductible in each income year that is incurred.