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Ruling

Subject: business related costs

Question 1

Subject to the limitations of subsection 40-880(3) of the Income Tax Assessment Act 1997, is the entity entitled to deduct the expenses incurred that are the subject of this private ruling under section 40-880 of the Income Tax Assessment Act 1997?

Answer

Yes.

Question 2

Does the Commissioner consider the following formula a fair and reasonable method for determining the extent that the relevant business was carried on by the entity for a taxable purpose for the purposes of subsection 40-880(3) of the Income Tax Assessment Act 1997 to be applied to the expenses incurred?

Answer

Yes.

Question 3

Does the Commissioner consider the following formula a fair and reasonable method for determining the extent that the relevant business was carried on by the entity for a taxable purpose for the purposes of subsection 40-880(3) of the Income Tax Assessment Act 1997 to be applied to the expenses incurred by the entity after it ceased to carry on the relevant business?

Answer

Yes.

This ruling applies for the following periods:

The year ended 30 September 2008

The year ended 30 September 2009

The year ended 30 September 2010

The year ended 30 September 2011

The scheme commences on:

1 January 2008

Relevant facts and circumstances

The taxpayer is an Australian resident for income tax purposes.

The taxpayer has historically operated several businesses, including Business A.

The taxpayer decided to ensure that its resources are dedicated to achieving growth and expansion in three of the four markets in which its businesses operated. Accordingly, the taxpayer made a decision to demerge Business A.

Business A was subsequently carried on by another entity; Entity B.

The taxpayer continued to carry on business A, B and C.

Up to the date of demerger of Business A, Business A was carried on wholly by the taxpayer for the purpose of producing income. The taxpayer derived assessable income and non-assessable, non-exempt income as a result of operating Business A.

During years to which this ruling applies, the taxpayer was not aware of any circumstances, plans or proposals for new business activities which would cause additional non-assessable non-exempt income or exempt income to be derived by Business A in the future.

The taxpayer incurred the expenditure that is the subject of this private ruling in order to facilitate the demerger of Business A from its overall business.

The expenses were incurred throughout the 2008, 2009, 2010 and 2011 income years.

The expenses incurred includes legal services and advice, accountants' services and advice, investment banking services and advice, IT consulting advice and management of the internal systems split.

The majority of this expenditure was incurred before the demerger was effected. A majority of the goods or services that were received or rendered for which these costs were incurred were received or rendered before the demerger date.

Incidental costs have been excluded from the subject of the private ruling.

The expenditure does not form part of the cost of a depreciating asset.

All costs relating to the transfer of assets (including potentially depreciating assets and land) have been excluded from the expenses.

The expenses are not deductible under another provision of the Income Tax Assessment Act 1936 or Income Tax Assessment Act 1997.

The expenses are not otherwise taken into account for working out assessable income or deductible losses of the taxpayer.

The expenses are not expenditure of a private or domestic nature.

The taxpayer did not derive exempt income or non-assessable non-exempt income as a result of undertaking the demerger of Business A.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 4-5

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Section 40-880

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

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

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

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

Income Tax Assessment Act 1997 Subsection 40-880(3)

Income Tax Assessment Act 1997 Subsection 40-880(4)

Income Tax Assessment Act 1997 Subsection 40-880(5)

Income Tax Assessment Act 1997 Paragraph 40-880(5)(d)

Income Tax Assessment Act 1997 Paragraph 40-880(5)(f)

Income Tax Assessment Act 1997 Subsection 40-880(6)

Income Tax Assessment Act 1997 Subsection 40-880(7)

Income Tax Assessment Act 1997 Subsection 40-880(8)

Income Tax Assessment Act 1997 Section 40-880(9)

Income Tax Assessment Act 1997 Subsection 40-25(7)

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Subsection 110-25(3)

Income Tax Assessment Act 1997 Section 110-35

Income Tax Assessment Act 1997 Subsection 110-35(10)

Income Tax Assessment Act 1997 Subsection 110-55(2)

Income Tax Assessment Act 1997 Section 701-1

Income Tax Assessment Act 1997 Subsection 701-1(1)

Income Tax Assessment Act 1997 Subsection 995-1(1)

Commercial Arbitration Act 1985 (NT) Section 48

Corporations Act 2001 Section 1070A

Reasons for decision

Question 1

Subject to the limitations and exceptions contained in subsections 40-880(3) to 40-880(9) of the Income Tax Assessment Act 1997 (ITAA 1997), subsection 40-880(2) of the ITAA 1997 provides that you can deduct in equal proportions over a period of five income years starting in the year in which you incur it, capital expenditure you incur:

o in relation to your business;

o in relation to a business that used to be carried on;

o in relation to a business proposed to be carried on; or

o 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.

Capital expenditure

It is a requirement for the application of subsection 40-880(2) of the ITAA 1997 that the expenditure is capital in nature.

Dixon J in Sun Newspapers Ltd & Associated Newspapers Ltd v FCT (1938) 61 CLR 337 provided guidelines that have been generally adopted for distinguishing between capital and revenue expenditure. Dixon J observed that 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 difference between the outlay and returns representing profit or loss.

Dixon J identified three matters to be considered in determining the capital or revenue nature of an amount of expenditure. These were (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 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 taxpayer incurred the relevant expenditure solely to ensure that the demerger of Business A happened.

The demerger was undertaken to ensure that the taxpayer's resources are dedicated to achieving growth and expansion in its remaining market.

Expenses incurred after the demerger of Business A were incurred to ensure the businesses the taxpayer carried on following the demerger had infrastructure required to operate. It is accepted that these expenses were required to provide the taxpayer with the necessary internal infrastructure to meets its ongoing business needs following the demerger of Business A, thus representing capital expenditure.

In applying the tests outlined in the Sun Newspapers case to the relevant expenditure incurred by the taxpayer, it is apparent that the expenditure was not incurred as part of the ordinary business operations of the taxpayer. The expenditure was incurred as part of changing the structure by which the taxpayer's businesses would be carried on following the demerger of Business A.

Therefore, the expenditure, which is the subject of this private ruling, is capital expenditure for the purposes of section 40-880 of the ITAA 1997.

You incur

The facts of this ruling state that the expenses have been incurred both before and after the demerger date by the taxpayer. Therefore, it is accepted that the taxpayer incurred the expenses that are subject to this private ruling.

In relation to

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.

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.

In First Provincial Building Society Limited v. Commissioner of Taxation (1995) 56 FCR 320; 95 ATC 4145; (1995) 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 (ITAA 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.

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 incurrence of the expenditure and a particular business. In discussing the types of business capital expenditure to which subsection 40-880(2) applies, paragraphs 2.19 and 2.20 of the EM state:

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.

The statement in paragraph 2.48 of the EM that 'the business to which the expenditure relates is that most relevant to the expenditure' indicates that when there is such a connection between the incurring of the expenditure and more than one business, the expenditure is treated for the purposes of subsection 40-880(2) of the ITAA 1997 as incurred in relation to the business that is most relevant to the expenditure.

In identifying for the purposes of subsection 40-880(2) of the ITAA 1997 the business that is most relevant to the expenditure, it is necessary to look to the character of the expenditure and what it achieved rather than simply the broad intent of its incurrence.

ATO Interpretative Decision ATO ID 2007/91 considers whether expenses for legal services and advice; accountants' services and advice; and investment banking services and advice fall under the parameters set out by paragraph of 40-880(2) of the ITAA 1997 for deductibility under that section. The expenses were incurred in demerging an international business from a consolidated group. The goods and services for which the expenses were incurred were received or rendered and incurred, prior to the demerger. It was determined that the expenses came under the umbrella of paragraph 40-880(2)(a) of the ITAA 1997 as they were in relation to the business of the taxpayer that it was currently carrying on at the time the expenditure was incurred, being the international business.

ATO Interpretative Decision ATO ID 2007/92 considers whether expenses for legal services and advice; accountants services and advice; and investment banking services and advice falls under the parameters set out by paragraph of 40-880(2) of the ITAA 1997 for deductibility under that section. The expenses were incurred in demerging an international business from a consolidated group. The goods and services for which the expenses were incurred were received or rendered prior to the demerger, but incurred after the demerger. It was determined that the expenses came under the umbrella of paragraph 40-880(2)(b) of the ITAA 1997 as they were in relation to a business that the taxpayer used to carry on before the demerger, being the international business.

The capital expenditure the taxpayer incurred includes legal services and advice, accountants' services and advice, investment banking services and advice, IT consulting advice and management of the internal systems split. For this expenditure the taxpayer was provided with a variety of products, services and advice to effect the key steps involved in the demerger of Business A and the other inextricably linked activities which would ensure that the demerger of Business A would occur and the taxpayer's remaining businesses would be able to operate as required following the demerger of Business A. The character of this expenditure is as part of changing the structure by which the Business A would be carried on by the taxpayer, enabling its demerger. We consider that the relevant business for the expenses in relation to the application of section 40-880 of the ITAA 1997 is the business of Business A.

In the circumstances, there is a sufficient and relevant connection between the taxpayer's incurrence of the expenses that are the subject of this ruling and Business A, and that business is the most relevant to that expenditure.

More particularly, paragraph 40-880(2)(a) applies to the capital expenditure that is the subject of this ruling and that the taxpayer incurred before the demerger of Business A as it is capital expenditure incurred in relation to Business A the taxpayer carried on prior to the demerger in accordance with ATO ID 2007/91.

Paragraph 40-880(2)(b) applies to the capital expenditure that is the subject of this ruling that the taxpayer incurred after the demerger as it is capital expenditure which relates to goods and services received and rendered, as it is capital expenditure that the taxpayer incurred in relation to a business (Business A) that it used to carry on before the demerger in accordance with ATO ID 2007/92.

Limitation and exclusions

Section 40-880 of the ITAA 1997 also provides a number of limitations and exclusions that prevent some expenditure from being deductible under that section. The taxable purpose limitation provided by subsection 40-880(3) of the ITAA 1997 is considered by question 2 and question 3 of this private ruling.

Subsection 40-880(4) of the ITAA 1997 considers taxable purpose in determining the extent that an entity can deduct the expenditure, where the relevant business is a business that another entity used to carry on or proposes to carry on.

Subsection 40-880(5) provides that an entity cannot deduct expenditure under section 40-880 to the extent that:

The expenditure forms part of the cost of a depreciating asset that you hold, used to hold or will hold;

· you can deduct an amount for the expenditure under another provision of the ITAA 1936 or ITAA 1997;

· the expenditure forms part of the cost of land;

· the expenditure is in relation to a lease or other legal or equitable right;

· the expenditure would, apart from section 40-880, be taken into account in working out a profit that is included in the entities assessable income or a loss that the entity can deduct;

· the expenditure could, apart from section 40-880, be taken into account in working out the amount of a capital gain or capital loss from a CGT event;

· a provision of the ITAA 1936 or ITAA 1997 other than section 40-880 would expressly make the expenditure non-deductible if it were not of a capital nature;

· a provision of the ITAA 1936 or ITAA 1997 other than section 40-880 expressly prevents the expenditure being taken into account as described in paragraphs (a) to (f) for a reason other than the expenditure being of a capital nature;

· the expenditure is of a private or domestic nature; or

· the expenditure is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income.

Subsection 40-880(6) states that the exceptions in paragraphs 40-880(5)(d) and (f) do not apply to expenditure the entity incurred to preserve (but not enhance) the value of goodwill if the expenditure is in relation to a legal or equitable right and the value to the entity of the right is solely attributable to the effect that the right has on goodwill.

Subsection 40-880(7) states that an entity cannot deduct an amount under paragraph 40-880(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.

Subsection 40-880(8) denies a deduction under section 40-880 for an amount of expenditure that was excluded from the cost of a depreciating asset or the cost base or reduced cost base of a CGT asset because of a market value substitution rule.

Section 40-880(9) denies a deduction under section 40-880 for an amount of expenditure incurred in returning an amount an entity received. A deduction is also denied to the extent that, for another entity, the amount represents a return on or of an equity interest, or a debt interest that is an obligation of the entity incurring the expenditure.

Based on the facts, it is considered that none of the limitations and exclusions provided by section 40-880 of the ITAA 1997 act to prevent the taxpayer deducting the expenses under section 40-880 of the ITAA 1997.

The expenses that were incurred prior to the demerger satisfy the requirements of paragraph 40-880(2)(a) of the ITAA 1997. The expenses that were incurred after the demerger satisfy the requirements of paragraph 40-880(2)(b) of the ITAA 1997. Subject to the limitations of subsection 40-880(3) of the ITAA 1997, none of the limitations or exclusions provided by section 40-880 act to prevent the taxpayer from deducting the expenses. Therefore, subject to the effects of subsection 40-880(3) of the ITAA 1997, the taxpayer is entitled to deduct the expenses under section 40-880 of the ITAA 1997.

Question 2

Given that capital expenditure that is the subject of this private ruling was incurred by the taxpayer in relation to a business (being Business A the taxpayer carried on) that before the demerger the taxpayer was carrying on at the time the expenditure was incurred, any deduction to the taxpayer under paragraph 40-880(2)(a) of the ITAA 1997 is subject to the limitations set out in subsection 40-880(3) of the ITAA 1997.

Subsection 40-880(3) of the ITAA 1997 provides that you can only deduct expenditure for a business that you carry on to the extent that the business is carried on for a taxable purpose. The relevant business here is the Business A to which paragraph 40-880(2)(a) of the ITAA 1997.

The EM states at paragraphs 2.46 and 2.47:

The definition of 'taxable purpose' is provided by subsection 40-25(7) of the ITAA 1997 and covers various purposes, including the purpose of producing assessable income. The term purpose of producing assessable income is further defined in subsection 995-1(1) of the ITAA 1997 as being something done:

· for the purpose of gaining or producing assessable income; or

· in carrying on a business for the purpose of gaining or producing assessable income.

A taxpayer whose business is not carried on for a taxable purpose cannot deduct expenditure to that extent. This limitation is not an annual test: that is, it is not to limit deductions to only the income years in which the business is carried on for a taxable purpose. The test as to the taxable purpose of the business is applied - as at the time the expenditure is incurred - to the taxable purpose of the business by reference to all known and predictable facts in all years.

The application of subsection 40-880(3) of the ITAA 1997 requires that the taxpayer determine, as at the time the capital expenditure was incurred, the extent to which the taxpayer's business will be carried on for a taxable purpose.

Draft Taxation Ruling TR 2010/D7 provides the Commissioner's preliminary view on the application of section 40-880 of the ITAA 1997. Whilst it is recognised that the draft ruling has not been issued, and when issued will apply to arrangements begun to be carried out from 8 December 2010, it is considered that the draft ruling provides the strongest indication as to the methodology the Commissioner will accept in determining the taxable purpose of a relevant business.

Paragraphs 23 to 30 of TR 2010/D7 provide that in the absence of a prescribed methodology the Commissioner will accept an apportionment of taxable purpose that is made on a fair and reasonable basis. Generally, the extent to which a business is carried on for a taxable purpose is determined by comparing the amount of any exempt income and non-assessable non-exempt income the business has derived, or will derive, with total income (that is, assessable income plus exempt income plus non-assessable non-exempt income). This percentage is then applied to the amount of expenditure to reduce the deduction.

The taxable purpose of the business is tested as at the time the expenditure is incurred. Where expenditure is incurred for an existing business, the test takes into account all known and predictable facts about the taxable purpose of the business in future years, not just in the year the expenditure is incurred or the years for which a deduction under section 40-880 is sought.

As previously determined the relevant business in determining the deductibility of the demerger costs incurred before the demerger is the Business A carried on by the taxpayer. Therefore, the taxable purpose of that business needs to be determined at the time the expenses were incurred.

During the years to which this ruling applies the taxpayer was not aware of any circumstances, plans or proposals for new business activities that would cause additional exempt or non-assessable non-exempt income to be derived by Business A. As such, it is considered that the taxable purpose of Business A at the time the expenses were incurred for the purposes of paragraph 40-880(2)(a) of the ITAA 1997 will be determined by comparing the amount of any exempt income and non-assessable non-exempt income Business A derived in the year that the expenditure was incurred, with total income that Business A derived in that same year.

As such, it is accepted that the extent that Business A was carried on for a taxable purpose for the purposes of subsection 40-880(3) in relation to expenses incurred before the demerger is reflected by the following formula:

Question 3

Given that capital expenditure that is the subject of this question was incurred by the taxpayer in relation to a business (Business A the taxpayer used to carry on) that after the demerger the taxpayer used to carry on at the time the expenditure was incurred, any deduction for the taxpayer under paragraph 40-880(2)(b) is subject to the limitations set out in subsection 40-880(3).

Subsection 40-880(3) of the ITAA 1997 provides that you can only deduct the expenditure for a business that you used to carry on to the extent that the business was carried on for a taxable purpose.

The EM states at paragraphs 2.46 and 2.47:

The definition of 'taxable purpose' is provided by subsection 40-25(7) of the ITAA 1997 and covers various purposes, including the purpose of producing assessable income. The term purpose of producing assessable income is further defined in subsection 995-1(1) of the ITAA 1997 as being something done:

· for the purpose of gaining or producing assessable income; or

· in carrying on a business for the purpose of gaining or producing assessable income.

A taxpayer whose business is not carried on for a taxable purpose cannot deduct expenditure to that extent. This limitation is not an annual test: that is, it is not to limit deductions to only the income years in which the business is carried on for a taxable purpose. The test as to the taxable purpose of the business is applied - as at the time the expenditure is incurred - to the taxable purpose of the business by reference to all known and predictable facts in all years.

The application of subsection 40-880(3) of the ITAA 1997 requires that the taxpayer determine, as at the time the capital expenditure was incurred, the extent to which the taxpayer's business was carried on for a taxable purpose.

Draft Taxation Ruling TR 2010/D7 provides the Commissioner's preliminary view on the application of section 40-880 of the ITAA 1997. Whilst it is recognised that the draft ruling has not been issued, and when issued will apply to arrangements begun to be carried out from 8 December 2010, it is considered that the draft ruling provides the strongest indication as to what methodology the Commissioner will accept in determining the taxable purpose of the relevant business at the time the relevant expenditure is incurred.

Paragraphs 23 to 30 of TR 2010/D7 provide that in the absence of a prescribed methodology the Commissioner will accept an apportionment of taxable purpose that is made on a fair and reasonable basis. Generally, the extent to which a business was carried on for a taxable purpose is determined by comparing the amount of any exempt income and non-assessable non-exempt income the business had derived with total income (that is, assessable income plus exempt income plus non-assessable non-exempt income). This percentage is then applied to the amount of expenditure to reduce the deduction.

The taxable purpose test for a business that used to be carried on is applied to the period which reasonably reflects the taxable purpose of the former business. Generally, the Commissioner will accept that a period of five years before the taxpayer permanently ceased operating the business will give a reasonable reflection of the taxable purpose.

As previously determined, the relevant business for determining the deductibility of the expenses incurred after the demerger is Business A that used to be carried by the taxpayer. Therefore, the taxable purpose of that business needs to be determined at the time the expenses were incurred.

During the five years before the demerger date, the taxpayer derived assessable income, exempt income and non-assessable non-exempt income as a result of carrying on Business A. As such, it is considered that the taxable purpose of Business A at the time the expenses were incurred, where they were incurred after the demerger, will be reflected by comparing the amount of any exempt income and non-assessable non-exempt income Business A derived in the five years preceding the demerger with total income that Business A derived during that period.

As such, it is accepted that the extent that Business A was carried on for a taxable purpose for the purposes of subsection 40-880(3) in relation to expenses incurred after the demerger is reflected by the following formula: