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Ruling

Subject: Deductibility of Licence payments

Question 1

For the purpose of calculating the net income or loss of a partnership in accordance with Division 5 of the Income Tax Assessment Act 1936 (ITAA 1936), are payment obligations of the partnership granted for a project allowable deductions under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) on each relevant payment date?

Answer

Yes

This ruling applies for the following periods:

XX/XX/XXXX to XX/XX/XXX

The scheme commences on:

XX/XX/XXXX

Relevant facts and circumstances

A consortium of companies ('the Consortium') has been formed and appointed as preferred bidder for the right to design, construct, commission, maintain and provide services to an asset ('the Asset') for the State ('the Project'). The State will make payments in consideration for the above services ('the Payments').

A partnership ('the Partnership') will enter into an agreement with the State over the construction and development of the Asset.

The Project will be comprised of a design and construction phase followed by an operating phase. At the conclusion of the Project, the Partnership's rights to access the Asset under the Agreement will come to an end and the State will have unencumbered legal ownership of the Asset. The terms of the Agreement are such that the Partnership will have no underlying proprietary right to the Asset.

The Agreement

The Partnership will enter into the Agreement with the State. Under the Agreement, the State will, amongst other things:

· Procure the design, construction and commissioning of the Asset from the Partnership in exchange for a payment to be paid to the Partnership upon completion of a phase of the Project ('the Completion Payment').

· Procure the provision of services in relation to the Asset from the Partnership by providing consideration in the form of payments ('Service Payments').

Design and construction phase

The State will grant the Partnership a right to access the area necessary for the construction of the Asset for the duration of the design and construction phase.

The Partnership will subcontract the design and construction of the Asset to an unincorporated joint venture ('the D&C Subcontract').

The State will pay the Completion Payment to the Partnership at upon the completion of a phase of the Project. The Completion Payment is expected to be at least equal to the design and construction costs incurred by the Partnership under the D&C Subcontract. However, the final value of the Completion Payment will depend upon the time taken to complete the design, construction and commissioning of the Asset.

Operating Phase

Upon completion of the first stage, the State will grant the Partnership an operating phase licence ('Licence') over the Asset for the purposes for providing the services under the Agreement.

The Partnership will pay market value licence fees ('the Licence Payments') periodically in arrears over the term of the Licence from entry into the Licence as consideration for access to the Asset (in accordance with the terms of the Licence).

The Licence provides that the Partnership will not acquire permanent ownership rights over the Asset; all rights granted under the Licence will revert to the State upon expiry of the Licence and the Partnership will not have any right to remove assets fixed to the land.

Provided certain performance standards are met, the State will pay the Partnership's Service Payments for the duration of the Licence as consideration for the provision of the services in respect of the Asset.

The Partnership will subcontract, under a subcontract, the provision of services in respect of the Asset.

The Partnership will also subcontract, under a services agreement, the provision of services in respect of the Asset.

Receivables Purchase Deed

The State, the Partnership and Finance Co will enter into the Receivables Purchase Deed at Financial Close.

Under the Receivables Purchase Deed the State will assign its right, title to, and interest in all of the Licence Payments (as they fall due) at a specified point in time during the Project in consideration for the payment by Finance Co of the Receivables Purchase Payment in a lump sum payment at that time.

Over the term of the Licence, therefore, the Partnership will effectively pay the Licence Payments to Finance Co in accordance with the Receivables Purchase Deed.

The Receivables Purchase Payment will be calculated as the present value of the Licence Payments payable to the State. This will, in turn, depend on the time taken to complete the design, construction and commissioning of the Asset (eg. any delay is expected to reduce the operational term of the Project, resulting in lower Licence Payments). It is currently expected that the Receivables Purchase Payment will be approximately $X.

The Partnership will be entitled to a Receivables Refund Payment from the State in the event the Project is terminated in certain circumstances.

State Loan

The State and Finance Co will enter into the State Loan Agreement at a specified point in time during the Project.

Under the State Loan Agreement, Finance Co will advance funds to the State at specified point in time during the Project. The State Loan and the Receivables Purchase Payment will provide the State with sufficient funds to pay the Completion Payment to the Partnership. It is currently expected that Finance Co will advance $XXX to the State under the State Loan Agreement.

The State Loan will be interest bearing at a rate not less than the rate payable by Finance Co under the Syndicated Loan Facility and the State will repay the State Loan during the operating phase of the Project.

On-Lending Agreement

Finance Co and the Partnership will enter into the On-Lending Agreement at the time the State Loan Agreement is entered into.

Under the On-Lending Agreement, Finance Co will advance funds to the Partnership from Financial Close to enable the Partnership to fund the design and construction of the Asset. It is expected that approximately $XXX will be outstanding under the On-Lending Agreement; of this, approximately $XX will be repaid by the Partnership at a specified point in time during the Project (leaving an amount outstanding which will be repaid by the Partnership during the operating phase).

Amounts lent under the On-Lending Agreement will be interest bearing at a rate not less than the rate payable by Finance Co under the Syndicated Loan Facility and repayable in accordance with a repayment schedule.

Partnership: income tax profile

The applicant states that the Partnership will be treated as a flow-through entity for income tax purposes, with the partners (ie. the Partnership Trusts) including in their taxable income their share of the net income or partnership loss of the Partnership in accordance with Division 5 of the ITAA 1936.

Furthermore, the application states that the Partnership will be treated as if it were a separate entity for the purposes of determining the net income or partnership loss (for example, its net income will be its taxable income and its partnership loss will be its tax loss calculated as if it were a separate entity).

The applicant states that the Partnership's assessable income and allowable deductions over the Project will be as follows:

Assessable income:

· Net gain arising from the design and construction of the Asset, being the Completion Payment less the payments under the D&C Contract (which is expected to be nil).

· Service Payments (as consideration for operating the Asset).

· Interest from bank deposits.

Allowable deductions (including amounts deductible over time):

· Licence Payments paid to the State under the Operating Phase Licence (as consideration for on-going access to the Asset).

· Interest to Finance Co under the On-Lending Agreement.

· Payments under the FM Subcontract.

· Payments under the services agreement.

· Various bid costs and related expenses.

· Various borrowing and other ongoing operating costs.

The applicant has stated that it is intended that over the term of the Project the assessable income of the Partnership will exceed the allowable deductions of the Partnership, producing overall net income for the Partnership.

The applicant has stated that the Partnership will not be deriving any non-assessable non-exempt income.

Finance Co: income tax profile

The applicant states that Finance Co's assessable income and allowable deductions will be as follows:

Assessable income:

Received less Receivables Purchase Payment) under the Receivables Purchase Deed

· Interest income from the Partnership under the On-Lending Agreement.

· Interest income from the State under the State Loan.

Allowable deductions

· Interest to the Lenders incurred on the Syndicated Loan Facility.

· Finance Co is not expected to make any distributions to Finance Holding Co.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5,

Income Tax Assessment Act 1997 section 8-1,

Income Tax Assessment Act 1997 paragraph 8-1(1)(a),

Income Tax Assessment Act 1997 paragraph 8-1(2)(a),

Income Tax Assessment Act 1997 paragraph 8-1(2)(b),

Income Tax Assessment Act 1997 paragraph 8-1(2)(c) and

Income Tax Assessment Act 1997 paragraph 8-1(2)(d).

Reasons for decision

Summary

The Licence Payments will be incurred in gaining or producing the Partnership's assessable income for the purpose of paragraph 8-1(1)(a) of the ITAA 1997.

The Licence Payments will not be outgoings of capital or of a capital nature for the purpose of paragraph 8-1(2)(a) of the ITAA 1997.

Therefore, the Licence Payments will be deductible to the Partnership under section 8-1 of the ITAA 1997 when they are incurred.

Detailed reasoning

Section 8-1 of the ITAA 1997

Section 8-1 of the ITAA 1997 allows a deduction for any loss or outgoing incurred in gaining or producing assessable income or that is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income except to the extent that such loss or outgoing is, inter alia, of capital or of a capital nature.

Relevantly, 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

…

Positive limb: will the Licence Payments be incurred in gaining or producing the Partnership's assessable income?

The connection between a taxpayer's outgoings and the generation of assessable income was considered in Ronpibon Tin NL and Tongkah Compound NL v FC of T (1949) 78 CLR 47. The High Court stated that:

For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end. The words "incurred in gaining or producing the assessable income" mean in the course of gaining or producing such income.

and

In brief substance, to come within the initial part of the sub-section it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income.

Under the Agreement, the Partnership must perform its obligations in respect of the Asset and provide the Services. In return for performing the Services, the Partnership will derive as income the Licence Payments from the State. The Licence Payments will be ordinary income derived by the Partnership and be included in the Partnership's assessable income under section 6-5 of the ITAA 1997.

To enable the Partnership to perform the Services the State will grant it a right to access the asset in return for the Licence Payments.

Without access to the asset and the payment of the Licence Payments, the Partnership cannot conduct its business and will not be able to provide the Services that will produce its assessable income. The Licence and the Licence Payments are integral to the production of the Partnership's ordinary income in that they allow the Partnership to operate the asset and provide the services in order to derive assessable income.

The occasion of the payment of the Licence Payments will be found in what will be productive of the Partnership's assessable income. Each Licence Payment will be an outgoing incurred by the Partnership in gaining or producing its assessable income for the purpose of paragraph 8-1(1)(a) of the ITAA 1997.

Negative limb: will the Licence Payments be general deductions?

On that facts, paragraphs 8-1(2)(b) to (d) of the ITAA 1997 do not apply to prevent the Partnership from deducting the Licence Payments as a general deduction. Accordingly, it is only necessary to consider the application of paragraph 8-1(2)(a) of the ITAA 1997.

Will the Licence Payments be outgoings of capital or of a capital nature?

In determining whether a loss or outgoing is of a capital or revenue nature, Dixon J in Sun Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87 stated:

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 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.

Character of the advantage sought

Dixon J applied the principles in Sun Newspapers' Case and stated in Hallstroms Pty Ltd v FC of T (1946) 72 CLR 634:

…the contrast between the two forms of expenditure 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.

Dixon J at 648:

What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.

In FC of T v CityLink Melbourne Limited 2006 ATC 4404 the High Court stated at 4427 that:

The characterisation of an outgoing depends on what it is calculated to effect to be judged from a practical and business point of view…The character of the advantage sought by the making of the expenditure is critical.

Enduring benefit for the business

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.

Relevantly, in FC of T v CityLink Melbourne Limited 2006 ATC 4404 Crennan J noted, at paragraph 154:

The concession fees are only payable during the term of the concession period. The respondent does not acquire permanent ownership rights over the roads or lands used. All rights granted under the Concession Deed revert to the State at the expiry of the concession period. Unlike periodic instalments paid on the purchase price of a capital asset, the concession fees are periodic licence fees in respect of the Link infrastructure assets, from which the respondent derives its income, but which are ultimately "surrendered back" to the State. Accordingly, they are on revenue account.

Similarly, the taxpayer does not acquire permanent ownership rights over the premises. All rights under the Agreement revert to the State at the expiry of the agreement. Accordingly, this factor supports the view that the Licence Payments are on revenue account.

Advantage sought

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. The Licence Payments will be payable on a recurring and periodic basis (periodically in arrears), be uniform and be referable only to the granting of access to the Asset for periods commensurate with the payments.

In terms of the character of the advantage which is sought by the Partnership the periodic payment of the Licence Payments over the course of the term of the Agreement will allow the Partnership to:

· Operate and manage the Asset.

· Profit from the operation and management of the Asset.

The Licence Payments accrue day-by-day and the payment of each Licence Payment reflects a periodic outlay for use of the Asset for that period of time covered by the particular Licence Payment.

The Licence Payments do not have lasting qualities and are not of enduring benefit; they do not have a 'once and for all' nature and do not form part of the profit yielding structure of the Partnership. The Licence Payments contributed by the State are relied upon or enjoyed on a periodic and recurrent basis. Finally, the means adopted to obtain the services, facilities and entitlements (for example. payment of concession fees) is a periodic reward or outlay for the use of the Project for periods commensurate with the payment. In summary, the Licence Payments are outgoings expended were part of the money earning process. Accordingly, it must also follow that the Licence Payments are revenue, on revenue account, rather than outgoings on capital.

Furthermore, the Licence Payments the Partnership incurs are, from a practical and business point of view, expenditure calculated to effect the Partnership's provision of its services to fulfil its obligations under the Agreement to design, construct and commission the Project. Each Licence Payment will secure for the Partnership the right to access and use the asset to provide the Services for the period to which the Licence Payment relates.

The character of the advantage sought by the Partnership is the fulfilment of its obligations to deliver the Services to the State under the Agreement, allowing derivation of its ordinary business income. Each Licence Payment will be a recurring expense of the Partnership and will represent an outgoing in the ordinary course of carrying on the Partnership's business rather than an outgoing to establish its business organisation or structure. This advantage will not have any lasting quality or enduring benefit beyond the period to which the Licence Payment relates. Each Licence Payment will be a recurring expense of the Partnership. Each Licence Payment will be on revenue account, or of a revenue nature.

Accordingly, the Licence Payments will be deductible to the Partnership under section 8-1 of the ITAA 1997 when they are incurred.