Edited version of your private ruling

Authorisation Number: 1012170157736

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Ruling

Subject: Income Tax - Deductions - Other employee related expenses

Question 1

Can the Company claim a deduction for redundancy payments made to unrelated staff in terms of section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

If a deduction can be claimed in terms of section 8-1 of the ITAA 1997 can the Company carry forward any losses in terms of Division 36 of the ITAA 1997 caused by the redundancy payments made to staff?

Answer

No

Question 3

If a deduction cannot be claimed in terms of section 8-1 of the ITAA 1997 for redundancy payments made to staff, can the Company deduct the amount pursuant to section 25-50 of the ITAA 1997?

Answer

No

Question 4

If a deduction for redundancy payments made to staff is allowed in terms of section 26-55 of the ITAA 1997 and carry forward losses arise, does section 26-55 of the ITAA 1997 apply to limit the deduction available to the Company?

Answer

No

Question 5

Can a deduction be allowed in terms of section 8-1 of the ITAA 1997 for an incentive redundancy payment paid to staff who remained with the business until it was sold?

Answer

Yes

This ruling applies for the following period

1 July 2010 to 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The Company conducted a business prior to 2011.

The staff was notified that the business was to be shut down or sold and 'all of the employees of the business will be made redundant'.

The employees had a pre-existing legal entitlement to redundancy.

The redundancy aspect of the payments to employees is a legal obligation imposed and calculated under the relevant Award.

The staff was advised in advance of their entitlements including: long service leave, annual leave and redundancy payments.

The employers advised the employees that 'If you work up until your redundancy date you will be granted two additional weeks' pay in your redundancy package. The primary purpose of this additional payment was provided as an incentive for staff to remain in employment, rather than quit, so that the business had staff for its ongoing trade. The payment was not made in recognition or reward for past services, but was awarded for continued service until the cessation of business.

The business was sold to purchasers who intended to carry on a similar business.

After the sale, all staff was offered employment by the Purchaser. It was made clear however that this would be employment on different terms and under different conditions, and in some cases substantially different conditions. Most employees took up the offer.

No ownership interests in the Company have been traded. The same owners remain. The Continuity of Ownership test is satisfied

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 25-50

Income Tax Assessment Act 1997 section 26-55

Income Tax Assessment Act 1997 Division 36

Reasons for decision

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Question 1

Summary

A deduction is not allowable in terms of section 8-1 of the ITAA 1997 as the expenditure is not considered to be incurred in carrying on a business and is considered to be capital in nature.

Detailed reasoning

In order to consider the issue, two questions need to be answered in determining whether the expense is deductible under section 8-1 of the ITAA 1997. The first is whether the expense has the essential character of expenditure which is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income in terms of subsection 8-1(1) of the ITAA 1997 with emphasis on the words 'in carrying on a business'. The second question considers whether the exclusory provisions of subsection 8-1(2) of the ITAA 1997 apply. This ruling has considered both limbs of the section.

The expenditure is a necessary expense and the taxpayers have been carrying on a business. These facts are not in dispute.

Taxation Ruling TR 95/33 at paragraph 11 states:

Where, having regard to the overall objective circumstances, there is an obvious commercial connection between the loss or outgoing and the carrying on of the taxpayers' business, it will not be generally necessary to have regard to the taxpayer's subjective purpose, motive or intention.

There is an obvious commercial connection between the redundancy payment made to the employees of a business and the business which was carried on it is therefore unnecessary to consider the subjective purpose, motive or intention of the payment.

What must be examined is the relationship between the expenditure incurred and whether it was incurred in carrying on the business for the purpose of gaining or producing assessable income. This matter was discussed in Telecasters North Queensland Limited v. Federal Commissioner of Taxation: 89 ATC 4501 (1989) 20 ATR 637 where it was found that:

The retiring allowances paid to C and S were not incidental and relevant to gaining or producing assessable income and were thus not deductible under the first limb of sec. 51(1). Ronpibon Tin N.L. v. F.C. of T. (1949) 78 C.L.R. 47 applied.

For a payment to be deductible under the second limb of sec. 51(1) there must be a connection between the purpose of the payment and the production of income. A retiring allowance primarily paid as a reward for past services does not have the requisite connection.

There must be a clear connection between the outgoing and the assessable income being derived. Payments made to employees who provide services to the business during the operation of a business are clearly related to the carrying on of that business. However a payment made to employees who have become superfluous to a company at the closure of a business cannot be seen as an ongoing expense attributable to the efforts of the business to derive assessable income.

This is supported by Union Trustee Co Ltd V FCT (1935) 53 CLR 263, where Rich J said:

It is not enough that it was made in the course of business. It must appear that it is an outgoing incurred for the production of assessable income. There must be a connection between the purpose of the payment and the further pursuit of gain, the production of income.

In the case of Buckley & Young Ltd. v. Commissioner of Inland Revenue 78 ATC 6019 Woodhouse J stated:

A payment made as a matter of commercial necessity or expediency to secure the removal of an unsatisfactory director or employee is referable only to the current business operations of the taxpayer in gaining its assessable income and that also stamps it with the character of a revenue and not a capital disbursement.

This case clearly distinguishes payments made for the removal of an individual in 'current (ongoing) business operations' and the redundancy of an entire workforce as an integral component of winding up a business.

In the case known as the Federal Commissioner of Taxation v. Foxwood (Tolga) Pty Ltd (1981) 147 CLR 278; 11 ATR 859; (1981) 81 ATC 4261 (Foxwood Tolga) the vendor of a business agreed as part of a sales agreement to pay the purchaser an amount based on the calculated value of accrued long service leave entitlements for employees upon sale of the business. No employees were entitled to receive the payments at that time and the payment was solely made as part of the sale of the business. A deduction was not allowed to the vendor as the vendor did not have an obligation to pay the employees an amount with respect to their long service leave entitlement and the business being carried on. The payment was considered incidental and relevant to the sale of the business. The accrued entitlements were long service leave provision amounts recorded on capital account which were being transferred to the purchaser.

The distinction between the Foxwood Tolga case and this case is that the employees have an ongoing entitlement to accrue and receive payment for long service leave which continued despite the sale of the business, therefore the payment between the vendor and purchaser became part of the negotiated price of selling the business. In the Company case the obligation to pay the employee's redundancy payments only arises on the termination of the business. Although it is an obligation directly payable to the employees it also falls within the expenditure incurred to close a business rather than to carry on a business.

Having regard to the whole set of circumstances, it is considered that the amounts expended on redundancy payments which arose as an obligation of winding up a business are not expenses incurred in carrying on a business.

The courts have differentiated between two types of expenses when determining deductibility. The first being deductible revenue or income related expenses and secondly expenses referrable to capital account that will not qualify for deductions under paragraph 8-1(2)(a) of the ITAA 1997.

The decision of the High Court in Sun Newspapers Ltd & Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337 (1938) 5 ATD 23 ; (1938) 1 AITR 403 (Sun Newspapers) is the leading authority on the distinction between revenue and capital expenditure. The general rule is found at 359 where Dixon J said:

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….

As general conceptions, it may not be difficult to distinguish between the profit yielding subject and the process of operating it. In the same way expenditure and outlay upon establishing, replacing and enlarging the profit-yielding subject may in a general way appear to be of a nature entirely different from the continual flow of working expenses which are or ought to be supplied continually out of the returns or revenue.

In the Sun Newspapers case, Dixon J stated three matters to be considered when deciding whether expenditure incurred is revenue or capital in nature. These are:

· the character of the advantage sought by the outgoing;

· the manner in which the advantage is to be used, relied upon or enjoyed by the taxpayer; and

· the means adopted to obtain the advantage, such as by recurring payments.

The character of the advantage sought provides important direction. It provides the best guidance as to the nature of the expenditure because it says the most about the essential character of the expenditure itself. The decision of the High Court in G P International Pipecoaters Pty Ltd v. Commissioner of Taxation (1990) 170 CLR 124 at 137; (1990) 90 ATC 4413 at 4419; (1990) 21 ATR 1 at 7 emphasised this, stating:

The character of expenditure is ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure, for the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid: Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 61 C.L.R 337, at p.363

The payment made to employees whose services were to be terminated at the conclusion of a business was the discharging of a legally enforceable liability.

In relation to the character of the advantage sought by the expenditure it is necessary to examine whether the expenditure secures an enduring benefit for the business. This test was outlined in British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 at 213 - 214 by Viscount Cave where he stated:

But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

As noted above, when the matters stated by Dixon J in the Sun Newspapers Case are considered, the character of the advantage sought by the making of the expenditure is the chief, if not the critical factor in determining the character of what is paid. The nature or character of the expenditure will therefore follow the advantage that is sought to be gained by incurring the expenditure. If the advantage to be gained is of a capital nature, then the expenditure incurred in gaining the advantage will also be of a capital nature.

The redundancy payment made has an enduring effect in that the employees of the business are permanently terminated.

A comparison has been drawn between the employee's responsibility to pay long service leave and redundancy payments as an accrued expense.

In accordance with the Long Service Leave Act 1955: (LSL Act)

Except as otherwise provided in this Act, every worker shall be entitled to long service leave on ordinary pay in respect of the service of the worker with an employer. Service with the employer before the commencement of this Act as well as service with the employer after such commencement shall be taken into account for the purposes of this section.

The LSL Act then goes on to explain the process of accruing a record of the employee's entitlement and outlines the circumstances under which an employee has access to that leave entitlement and the non-exhaustive list includes:

· taking the leave provided the employee and employer have mutually agreed to an appropriate time;

· where the worker dies

· on the termination of the worker

The fact that 'every worker' shall be entitled to long service leave means that the accrual of a liability for long service leave is necessary for businesses with employees and the payment of long service leave will generally be considered a cost incurred in carrying on a business dependant upon the circumstances which trigger the payment of the long service leave.

In accordance with the Fair Work Act 2009 a redundancy is a genuine redundancy if:

· the employer no longer needs the person's job to be done by anyone because of changes in the operational requirements of the business, and

· the employer followed any consultation requirements in the modern award, enterprise agreement or other industrial instrument that applies.

In the Company's situation the change to the 'operational requirements' of the business is that the business is no longer being carried on. The only circumstance under which an employee is entitled to receive a redundancy is when the employer no longer needs the person's job. While it is possible for a business to make some positions redundant during the ordinary course of carrying on their business the redundancy in this case was not utilised to improve or restructure a business which will continue to be carried on. The redundancy expense was not an accrued expense in the nature of long service leave incurred in the carrying on of the business but was an expense incurred in terminating the business. A redundancy is not an event which crystallises an accruing payment obligation because a business is not conducted with the expectation that a redundancy will always be payable.

Some payments made to employees in the course of employment are not deductible as incurred in carrying on a business. As discussed in Goodman Fielder Wattie Ltd v. Federal Commissioner of Taxation (1991) 29 FCR 376; 91 ATC 4438; (1991) 22 ATR 26 it was found by Hill J that expenditure is deductible as revenue in nature when it 'can be seen to be clearly part of the recurring outgoings of the company on its business activities'. Where payments are made to employees engaged wholly in affairs of capital the expense is properly characterised as capital in nature. In the payment of redundancies where there is no ongoing engagement of employees in the business of gaining or producing assessable income, it is clear that the payments made are properly characterised as capital in nature.

In this respect we consider that it is appropriate to have regard to the service provided by the employee for the payment which has been made. The redundancy payment is calculated with reference to the period of an employee's service but is not considered to be an expense accrued during that period of service. The payment has been made for the termination of the employee's services making the payment related to closing the business and a capital expense.

The fact that the payment for redundancy is a legally enforceable expense is not indicative of the deductible nature of the payment as outlined in Commissioner of Taxation v. Star City Pty Ltd (2009) 175 FCR 39; 2009 ATC 20-093; (2009) 72 ATR 431 (Star City), where Jessup J stated:

…Merely to look at the legal rights and obligations which existed as between the payer and the payee (ie the employer and the employee) would be of no assistance in the task of characterisation.

The expense incurred is a payment made 'of an enduring nature' being the closure of the business operations at the specified location. The advantage to be enjoyed by the business on payment of the redundancy is the legal and equitable conclusion of the company's business in relation to its employee obligations

There is an important difference between operating a business and expanding or closing a business. In Hallstroms Pty Ltd (1946) 72 CLR 634, Dixon J referred at 647 to the general consideration that:

…the contrast between [expenditure on capital or revenue account] corresponds to the distinction between the acquisition of the means of production and the use of them; between establishing or extending a business organisation and carrying on the business; between the implements employed in work and the regular performance of the work in which they are employed; between an enterprise itself and the sustained effort of those engaged in it.

Many judgments in relation to the deductibility of expenditure refer to the statement by Viscount Cave in British Insulated and Helsby Cables Ltd v. Atherton (1926) AC 205 at pp 213-214:

But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is a very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

Redundancy payments made to employees upon the sale of a business are an expense incurred without an expectation of repetition. The closure of a business and the expenses incurred in implementing that closure including a 'one off' payment for employees no longer engaged in the business which used to be carried on cannot be seen as an ongoing expense attributable to the efforts of the business to derive assessable income. The redundancy payment is an expense of a capital nature incurred to conclude the income producing activities of the business.

Question 2

Summary

Because a deduction is not allowable in terms of section 8-1 of the ITAA 1997 no loss is available to be carried forward.

Question 3

Summary

A deduction is not allowable in terms of section 25-50 of the ITAA 1997 because the payments made on the termination of the employee's employment cannot be considered to be payments of 'pensions, gratuities or retiring allowances'.

Detailed reasoning

Subsection 25-50(1) of the ITAA 1997 allows a deduction for the payment of a pension, gratuity or retiring allowance that you make to an employee, a former employee or a dependant of an employee or former employee where the payment is made in good faith in consideration of the past services of the employee, or former employee, in any business that you carried on for the purpose of gaining or producing assessable income.

For section 25-50 of the ITAA 1997 to apply the redundancy payments must be considered to be either a 'pension, gratuity or retiring allowance'. These words are not defined in the legislation and therefore take on their ordinary meaning.

The Macquarie Multimedia Dictionary version 5.0.0 dated 01/10/01 defines a pension as a fixed periodical payment made in consideration of past services, injury or loss sustained, merit, poverty, etc or an allowance or annuity.

The meaning of the term 'pension' was also considered by Hill J. in the Federal Court in Tubemakers of Aust Ltd v. FC of T 93 ATC 4207; (1993) 25 ATR 183. His Honour concluded that the essential characteristic of a pension is only that there be periodical payments.

The payment made to the employees was not periodical in nature therefore it does not comply with the definition of a 'pension'.

A gratuity is defined in the Macquarie Multimedia Dictionary version 5.0.0 dated 01/10/01as a gift, usually of money, over and above payment due for service or tip that which is given without claim or demand

The redundancy payments made to the employees were part of a legally enforceable entitlement owed to the employees at the time of the termination of their work contracts therefore the payments do not comply with the definition of a gratuity.

The Macquarie Multimedia Dictionary version 5.0.0 dated 01/10/01 defines 'retire' as 'to withdraw, go away, or remove oneself'. Ordinarily 'retiring' in relation to employment is understood to mean removing oneself from the workforce and not returning, or at best significantly reducing ones involvement.

Where the staff employed by a business have had their employment terminated as the result of the closure of that business the employees receive a redundancy payment in recognition of the cessation of employment at that business and not in recognition of 'removing oneself from the workforce'. It is indicated in the facts that most staff took up further employment with the new business owners therefore there is no question that the payment was made for their retirement.

Because the redundancy payment does not comply with the definitions which apply to the legislation governing payments made for 'pensions, gratuities or retiring allowances' no deduction is claimable in terms of section 25-50 of the ITAA 1997.

Question 4

Summary

A deduction is not allowable in terms of section 25-50 of the ITAA 1997 therefore the limit on deductions imposed by section 26-55 of the ITAA 1997 does not apply.

Question 5

Summary

A deduction is allowable in terms of section 8-1 of the ITAA 1997 because the payment was made as an incentive to allow the business to continue trading until the time of closure.

Detailed reasoning

The company can deduct a loss or outgoing under section 8-1 of the ITAA 1997 if they satisfy either of the following positive limbs in subsection 8-1(1) of the ITAA 1997 if they:

· incur the loss or outgoing in gaining or producing your assessable income, or

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

Losses or outgoings will not however be deductible if they are capital, private or domestic in nature, or are incurred in relation to exempt or non-assessable non-exempt income in accordance with subsection 8-1(2) of the ITAA 1997.

The employers advised the employees who were to be made redundant that there would be an incentive payment of an extra two weeks made as part of their redundancy package if the employees continued to work for the company until the cessation of trade.

The purpose of the payment was to enable the business to trade efficiently until the closure of the business by the current owners.

The incentive payments paid to employees who were being made redundant form part of the overall remuneration costs of the employer incurred in the ordinary course of carrying on its business. The extra expense has been incurred in order to carry on the business, accordingly, there is a sufficient nexus between these outgoing (which is the incentive payment) and the derivation of assessable income, for the payment be deductible under paragraph 8-1(1)(b) of the ITAA 1997.

The incentive payment has been considered necessary by the employer and in Magna Alloys and Research Pty Ltd v. FC of T 80 ATC 4542; 11 ATR 276. Deane and Fisher JJ commented upon the relevance of subjective purpose. At 80 ATC 4559; 11 ATR 295, their Honours said:

the statement of Fullagar J in FC of T v. Snowden & Willson Pty Ltd ... that "within the limits of reasonable human conduct the man who is carrying on the business must be the judge of what is 'necessary' ". The controlling factor is that, viewed objectively, the outgoing must, in the circumstances, be reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business being carried on for the purpose of earning assessable income.

Expenses that are 'incidental and relevant' to the taxpayer's income earning activities are considered to be sufficiently connected with the derivation of assessable income and therefore will be an allowable deduction under section 8-1 of the ITAA 1997 Ronpibon Tin NL & Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).

Therefore, providing that the expense can be objectively viewed as a necessary or natural consequence of the taxpayer's income earning activities, the expense will be 'incidental and relevant' to the income earning activities of the taxpayer.

The payments relate directly or indirectly to services provided to the employer, and constitute part of the overall remuneration costs of the employer incurred in the ordinary course of carrying on its business until its cessation. There is therefore a sufficient nexus between these outgoings and the derivation of assessable income, for the payment to be deductible under paragraph 8-1(1)(b) of the ITAA 1997.

Furthermore this payment is neither capital, private or domestic in nature, nor does it relate to exempt or non-assessable non-exempt income. The expenditure was incurred in carrying on the business for the purpose of gaining or producing assessable income, and not incurred in closing the business.

Further issues for you to consider

Capital expenditure incurred 'in relation to your business' may be considered under the provisions of section 40-880 of the ITAA 1997. This matter has not been addressed in this ruling.