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Ruling

Subject: Apportionment of professional fees - CGT cost base - deductibility of capital expenditure

Issue 1:

Apportionment of professional advisor fees

Question 1:

Is it reasonable to apportion professional advisor fees paid by the trust in relation to a particular transaction in line with the final split of the cash flows arising under the transaction which in this case is a split between a partial share sale and an injection of new equity?

Answer:

Yes

Issue 2:

CGT cost base

Question 1:

Is the portion of the professional advisor fees incurred by the trust in respect of the partial realisation of the shares in the business eligible to be included in the cost base of the shares sold in the calculation of the capital gain for the CGT event?

Answer:

Yes

Issue 3:

Deductibility of capital expenditure

Question 1:

Is the portion of the professional fees incurred by the trust to procure an investor's injection of new share equity eligible to be deducted over five years as business capital expenditure under section 40-880 of the Income Tax Assessment Act 1997?

Answer:

Yes

This ruling applies for the following period

1 July 2010 to 30 June 2015

The scheme commenced on

1 July 2010

Relevant facts

S is the corporate trustee of the trust. M and A are eligible beneficiaries of the trust. M and A are also the directors and joint shareholders of S. The trust came into existence in 1999. S carries on a business of investing in, funding and actively managing its interest in the business and in real property. All activities undertaken by S that are referred to in this private ruling request were undertaken in its capacity as corporate trustee of the trust.

The business was formerly a wholly owned subsidiary of S and was established in 1991, the founding members being M and A. The managing director of the business is M. The business has a board comprised of a number of executive and independent non executive directors.

The business is a holding company of the main operating entities comprising the group, being:

· Pty Ltd ("O")

· P Pty Ltd ("P")

· W Pty Ltd ("W")

The group is in the business of building (customised or portable units) for rent or sale. Sales or rental agreements will often be associated with a service contract, through which the entities also derive income.

In 2008, S as trustee of the trust began considering plans to expand the operations of the business. To realise this however, the group required access to funding and/or support of a partner. Commercially, there were a number of options available to them such as going into a partnership or joint venture arrangement, borrowing funds or issuing shares.

In this regard, S trustee of the trust engaged professional services consultants to assist with or facilitate the transaction. This included canvassing all possible options to expand the business, identifying preferred investors, representing the trust in negotiations and finalising the transaction. The terms of their respective engagements were that these consultants would be remunerated by way of a monthly fee and a success fee based upon a successful sale or placement of an equity interest.

During the year ended 2011, the trust incurred and paid success fees to professional service firms and transaction advisory consultants ("the success fees").

The scope of the services provided by these advisers specifically included:

· Advising on options available for expanding the business, consideration of funding, partner support and refining the strategic objectives

· Identification and pursuit of a cornerstone investor to realise the objectives of expanding the business and future profitability

· Assisting to position the company during negotiations to maximise value

· Assistance in the protection of the shareholder's interests during negotiation through protection mechanisms

· Assistance in the design and implementation of a process for the transaction to increase the likelihood of a successful outcome

· Assistance in identifying solutions to resolve any deal issues which arise during the process

· Assistance with establishing a due diligence data room

· Assistance with the management of the due diligence process, including assistance with responses to queries raised

· Assistance with the appointment of other professionals such as lawyers and tax advisers as required

· Reviewing the draft sale agreement prepared by lawyers to advise on whether it meets any financial and strategic objectives

· Advice and assistance with negotiating the terms of the proposed transaction

· Working with the legal adviser to negotiate the final offer price and terms of agreement and coordinate the finalisation and execution of the sale and purchase agreement, and

· Assistance in negotiating the terms of the transaction

It was not clear at the time the professional advisers were engaged what form the transaction would ultimately take.

The transaction in its final form, after exploring a number of alternatives, involved the sale by the trust of some of its shares in the business to an investor, the receipt of a pre-sale dividend and also the issue of new shares in the business to the same investor.

The engagement letters of the professional advisers did not specify the extent to which services were provided in relation to the raising of equity and/or sale of shares. The invoices to S as trustee of the trust for the success fees did not show a split between the fees for the raising of equity and the fees in relation to the sale of shares.

The transactions comprising the pre-sale dividend, sale of shares and issue of new equity to the investor were completed in 2011.

Relevant legislative provisions

Income tax Assessment Act 1997 section 8-1

Income tax Assessment Act 1997 subsection 8-1(2)

Income tax Assessment Act 1997 section 40-880

Income tax Assessment Act 1997 subsection 40-880(2)

Income tax Assessment Act 1997 subsection 40-880(3)

Income tax Assessment Act 1997 subsection 40-880(4)

Income tax Assessment Act 1997 paragraph 40-880(4)(a)

Income tax Assessment Act 1997 subsection 40-880(5)

Income tax Assessment Act 1997 section 40-880(5)(f)

Income tax Assessment Act 1997 section 104-10

Income tax Assessment Act 1997 section 110-25

Income tax Assessment Act 1997 section 110-55

Income tax Assessment Act 1997 subsection 110-55(2)

Income tax Assessment Act 1997 subsection 110-25(2)

Income tax Assessment Act 1997 subsection 110-25(3)

Income tax Assessment Act 1997 subsection 110-35(1)

Income tax Assessment Act 1997 subsection 110-35(2)

Income tax Assessment Act 1997 subsection 110-35(11)

Income tax Assessment Act 1997 subsection 112-30(1A)

Income tax Assessment Act 1997 section 116-20

Income tax Assessment Act 1997 subsection 995-1(1)

Issue 1:

Question 1:

Summary

It is reasonable to apportion professional advisor fees paid in relation to a particular transaction in line with the final split of the cash flows arising under the transaction which in this case is a split between a partial share sale and an injection of new equity.

Detailed reasoning

Revenue v capital

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) states that you can deduct from your assessable income any loss or outgoing to the extent that it is incurred in gaining or producing assessable income, or is necessarily incurred in carrying on a business for that purpose. However, you cannot deduct a loss or outgoing that is of a capital, private or domestic nature (subsection 8-1(2) of the ITAA 1997).

"Capital expenditure" is not a defined term. Whether expenditure is capital in nature is determined on the facts of each particular case having regard to the principles established by case law. An expenditure that fails the positive limbs of section 8-1 of the ITAA 1997 does not necessarily mean that it will be capital expenditure.

The classic test for determining whether expenditure is of a capital or revenue nature is explained in the judgment of Dixon J in Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 23; (1938)1 AITR 403 (Sun Newspapers) where he state that:

· 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 outlay...

The character of the advantage sought provides an important direction and the best guidance as to the nature of the expenditure as it says the most about the essential character of the expenditure itself. This was emphasised in the decision of the High Court in G.P. International Pipecoaters v. Federal Commissioner of Taxation (1990) 170 CLR 124; 90 ATC 4413; (1990) 21 ATR 1.

If the expenditure produces some asset or advantage of a lasting character for the benefit of the business it will be considered to be capital expenditure. As stated in Sun Newspapers at 355 per Latham J, an enduring benefit does not require that the taxpayer obtain an actual asset, it may be a benefit which endures, in the way that fixed capital endures. In Foley Brothers Pty Ltd v. FC of T (1965) 13 ATD 562; (1965) 9 AITR 635, outgoings incurred for the purpose of altering the organisation or structure of the profit-yielding subject (including its demise) were considered to be of a capital nature.

In your case, S as trustee of the trust engaged consultants to advice on its expansion of the business which required the group access to funding and/or support of a partner. In this regard the trust incurred and paid a success fee which is a one-off fee to professional service firms and transaction advisory consultants specifically for the purposes of facilitating this transaction. Based on the case law decisions, mentioned above, and the nature of the expense, the costs incurred by the trust can be characterised as costs of a capital nature. This is because the expenditure is incurred in establishing, replacing and enlarging your profit-yielding (i.e. business) structure which is characterised as a capital expense in nature. Further, the consideration for the outlay is a one-off payment rather than a periodic payment for the advantage sought.

The capital costs incurred by the trust for this transaction can be divided into:

· a sale of some shares by the trust in the business to the an investor and the receipt of a pre-sale dividend;

· the issue of new shares in the business to the investor.

With regard to apportioning the capital costs, the use of the expression "to the extent that" in section 8-1 and section 40-880 of the ITAA 1997 indicates that apportionment may be required. Apportionment is a question of fact and involves a determination of the proportion of the expenditure that is attributable to deductible purposes.

In Taxation Ruling TR 2011/6 Income Tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues, paragraph 24 states that subsections 40-880(3), 40-880(4) and 40-880(5) indicates that an apportionment may be required when applying those subsections. In contrast however, subsection 40-880(2) does not contain the expression "to the extent that". In the absence of the expression "to the extent that" in subsection 40-880(2), the Commissioner is of the view that it does not prevent an apportionment of expenditure on a single thing or service which serves more than one purpose or object. This is equally so whether the thing or service serves distinct and separate purposes or objects, or whether the thing or service serves two or more purposes or objects indifferently.

The basis for any such apportionment must be fair and reasonable in all circumstances: Ronpibon Tin NL Ltd v FC of T (1949) 8 ATD 431; (1949) 78 CLR 47 at p 437; p 59.

Based on the facts of your case, the Commissioner is of the view that it will be reasonable for you to apportion the professional advisor's fees. The approach to the apportionment as set out by you in your application for private ruling will be accepted as it is fair and reasonable.

Issue 2:

Question 1:

Summary

The portion of the professional advisor fees incurred by the trust in respect of the partial realisation of the shares in the business is eligible to be included in the cost base of the shares sold in the calculation of the capital gain for the CGT event.

Detailed reasoning

As discussed above, it will be reasonable for you to apportion your professional advisor's fees and adopt the approach to apportionment as set out in your application for private ruling.

A CGT event A1 (Section 104-10 of the ITAA 1997) will happen on the disposal of some of your shares in the business to the investor. The amount of a capital gain or loss arising from a CGT event is worked out by referring to the provisions dealing with the relevant CGT event. CGT event A1 happens when a taxpayer disposes of a CGT asset. The capital gain will be the capital proceeds from the CGT event less the asset's cost base. The capital loss will be the reduced cost base of the asset less the capital proceeds from the CGT event.

The cost base of a CGT asset has five elements (section 110-25 of the ITAA 1997). The reduced cost base of a CGT asset also has five elements (section 110-55 of the ITAA 1997) and all the elements are the same as the cost base except the third element (subsection 110-55(2) of the ITAA 1997) The cost base is used in the calculation of a capital gain from the happening of a CGT event and the reduced cost base is used in the calculation of a capital gain made from the happening of a CGT event.

The first element (subsection 110-25(2) of the ITAA 1997) refers to the acquisition cost which refers to the total of the money paid or required to be paid and the market value of any other property given or required to be given in acquiring the CGT asset. The second element refers to incidental cost which consists of various incidental costs incurred by the taxpayer. These incidental costs are included in both the cost base and reduced cost base of a CGT asset as the second element of the cost base pursuant to subsections 110-25(3) and 110-55(2) of the ITAA 1997. Incidental costs you incurred are defined in subsection 110-35(1) of the ITAA 1997 as costs you have incurred:

(a) to acquire a CGT asset, or

(b) that relate to a CGT event.

There are 10 categories of incidental costs (subsections 110-35(2)-110-35(11) of the ITAA 1997). The ninth incidental cost is an exception to the rule that the cost must have been incurred by you. This cost is incurred by the head company if you are part of a consolidated group or a MEC group. Note: the cost of any professional advice that you obtain about the operation of tax laws can only be included as an incidental cost if the advice was provided by a registered tax advisor (subsection 110-35(2) of the ITAA 1997).

As you have disposed of some of the shares in the business to the investor, the disposal of these shares (being a CGT asset) triggered CGT event A1. The expense incurred by you that relates to the disposal of the CGT asset i.e. the portion of the expense that will relate to the CGT asset, can be apportioned to the CGT asset. Subsection 112-30(1A) of the ITAA 1997 states that if you incur expenditure and only part of it relates to another element of the cost base or reduced cost base of a CGT asset, that element includes that part of the expenditure that is reasonably attributable to that element. Subsection 112-30(1A) of the ITAA 1997 allows you to apportion part of the expenditure incurred under one transaction that relates to another element of the cost base or reduced cost base of a CGT asset. Therefore, the portion of the expense of professional fees incurred by you that relates to the disposal of the shares by you in the business can be included in the cost base, or reduced cost base, of the CGT asset (i.e. shares) for the purpose of calculating any capital gain or loss made on the disposal of your shares in the business as a result of CGT event A1 happening..

Pre-sale dividend

In Taxation Ruling TR 2010/4 Income tax: capital gains: when a dividend will be included in the capital proceeds from a disposal of shares that happens under a contract or a scheme of arrangement, the Commissioner states in paragraph 9 that a dividend declared or paid by a company (target company) to a shareholder who has disposed of shares in that company (the vendor shareholder) under a contract of sale or a scheme of arrangement will be treated as capital proceeds of the vendor shareholder in relation to the disposal of the shares if the vendor shareholder has bargained for the receipt of the dividend (whether or not in addition to other consideration) in return for giving up the shares.

Section 116-20 of the ITAA 1997 states that capital proceeds from a CGT event includes money or market value of any other property you have received or are entitled to receive, in respect of the event happening.

You have negotiated with the investor to partially realise its interests in the business through the combination of payment of the pre-sale dividend and consideration for the transfer of shares. It has been agreed that the investor would be funding the dividend payment through the injection of additional equity to ensure that the business has sufficient funds to pay this dividend.

In view of the above, the dividend would therefore be treated as part of the capital proceeds received that resulted from the partial sale of shares. Therefore the portion of the professional advisor fees incurred by you that relate to the pre-sale dividend on the disposal of the shares by you in the business can be included in the cost base of the CGT asset disposed.

Further, this portion of the incidental costs that are a capital expense and that relate to the professional advisor's fees will not qualify for a deduction under the "blackhole" expenditure rules in section 40-880 of the ITAA 1997. This is because paragraph 40-880(5)(f) of the ITAA 1997 states that you cannot deduct anything under this section for an amount of expenditure you incur to the extent that it could, apart from this section, be taken into account in working out the amount of a capital gain or capital loss from a CGT event.

Issue 3:

Question 1:

Summary

The portion of the professional fees incurred to procure an investor's injection of new share equity is eligible to be deducted over five years as business capital expenditure under section 40-880 of the Income Tax Assessment Act 1997?

Detailed reasoning

As discussed above, the professional advisor's fees you incurred is apportioned into two categories. The second category refers to the professional fees you incurred in procuring the injection of new share equity.

Section 40-880 of the ITAA 1997 states that the object of the section is to make certain business capital expenditure deductible over 5 years if:

· the expenditure is not otherwise taken into account; and

· a deduction is not denied by some other provision; and

· the business is, or was proposed to be carried on for a taxable purpose.

Therefore, the capital expenditure you incur that is not otherwise deductible under any other provisions of the ITAA 1997 is deductible over a period of five years provided the deduction is not denied by some other provision. This is referred to as the "blackhole" expenses.

Taxation Ruling TR 2011/6 states that:

· the deduction under this provision is of a last resort i.e. if no other provision allows or denies;

· the expenditure must be a capital expenditure which is business related;

· must be incurred on or after 1 July 2005;

· if it relates to an existing business then only the entity that incurs the expenditure is entitle to a deduction if they are carrying on that business;

· the expenditure may relate to a former or proposed business, or to the liquidation, deregistration or winding up of a company, partnership or trust that carried on a business and of which the taxpayer was a member, a partner or a beneficiary;

· must relate to a business to the extent to which that business is carried on for a "taxable purpose";

· eligibility for a deduction is determined, once and for all, as at the time the expenditure is incurred;

· expenditure is allowed as a straight-line write-off over five years;

· a deduction of more than one fifth of the expenditure cannot be claimed in any particular income year;

· only the entity that incurs the expenditure qualifies for the deduction;

· once eligibility is established a number of limitations and exceptions may apply to limit the amount deductible or to deny a deduction.

As discussed and concluded earlier, the one-off success fees paid by you to professional service firms and transaction advisory consultants for the purposes of facilitating this transaction is a capital expenditure and not deductible under section 8-1 of the ITAAA 1997.

The expenditure is:

· incurred by you on or after 1 July 2005;

· the expenditure is capital in nature;

· the capital expenditure incurred by you is related to your business;

· the capital expenditure relates to your current business.

Subsections 40-880(3) and 40-880(4) then applies to limit the deductibility of the capital expenditure to the extent that it relates to that business being carried on for a taxable purpose. Taxable purpose is defined in subsection 40-25(7) of the ITAA 1997 to mean:

· the purpose of producing assessable income; or

· the purpose of exploration or prospecting; or

· the purpose of mining site rehabilitation; or

· environmental protection activities.

However, section 40-880 is only concerned with "the purpose of producing assessable income". This 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.

Paragraph 156 of TR 2011/6 states that the capital expenditure incurred by you is deductible only to the extent that it relates to so much of your business that is, was or will be carried on for a taxable purpose. Therefore, if your capital expenditure relates to the whole of a business and only some of which is, was or will be, carried on for a taxable purpose, the deduction for the capital expenditure under section 40-880(2) will therefore be limited accordingly by the application of subsection 40-880(3) or paragraph 40-880(4)(a) of the ITAA 1997.

Paragraph 157 of TR 2011/6 states that the taxable purpose of the business is tested at the time the expenditure is incurred. You must therefore consider your current and proposed business plans and how they will affect the taxable purpose of the business in the year in which the expenditure is incurred.

Example 18 in TR 2011/6 refers to Company X carrying on the business of investing in, funding and managing its subsidiaries as a holding company and the holding of shares in subsidiaries is a significant and strategic part of the company's overall business activities. The company receives some interest and fee income from its subsidiaries which is assessable income. Company X incurred capital expenditure to raise equity for the business. From all known and predictable facts in future years as at the time the expenditure was incurred, the company did not expect a declaration of dividend in its favour from any of the subsidiaries. Therefore, the part of the company's business activities that relate to the holding of shares in subsidiaries is not carried on for the purpose of gaining or producing assessable income and is considered not carried on for a taxable purpose. The business activities that related to the holding of shares in the subsidiaries account for 75% of the overall business activities of the company. Therefore, the extent to which the company's business is carried on for a taxable purpose is 25%.

As the capital expenditure incurred by you was incurred 100% for a taxable purpose and satisfies the conditions of section 40-880 of the ITAA 1997, you are therefore entitle to deduct the capital expenditure under this provision as a business capital expenditure over a period of five years.