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Ruling

Subject: Deductibility of outgoing

Question 1

Is the taxpayer entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (the ITAA 1997) for an amount paid under an agreement?

Answer

No

This ruling applies for the following period:

1 July 2010 to 30 June 2011

The scheme commenced on:

December 2010

Relevant facts and circumstances:

The taxpayer paid an amount under an agreement. A related agreement sets out the circumstances in which the taxpayer is entitled to receive compensation in respect of the payment. The agreement and related agreement refer to the amount paid representing a prepayment of operating expenses.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1936 Section 82KZMD

Reasons for decision

Section 8-1 of the ITAA 1997

Section 8-1 of the ITAA 1997 states:

8-1 General deductions

(1) You can deduct from your assessable income any loss or outgoing to the extent that:

(a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a *business for the purpose of gaining or producing your assessable income.

(2) However, you cannot deduct a loss or outgoing under this section to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature; or

(b) it is a loss or outgoing of a private or domestic nature; or

(c) it is incurred in relation to gaining or producing your *exempt income or your *non-assessable non-exempt income; or

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

(3) A loss or outgoing that you can deduct under this section is called a general deduction.

The taxpayer's contentions

The taxpayer contends that the amount paid under the agreement represents a prepayment of operating expenses. As these are part of the process of operating the profit yielding structure of the taxpayer, the taxpayer contends that the amount paid under the agreement is of a revenue nature.

Outgoings of capital or of a capital nature

There is no statutory definition of 'capital'. However there is a significant body of case law which has considered this expression in the context of section 8-1 of the ITAA 1997 and its predecessor section 51(1) of the Income Tax Assessment Act 1936. Ultimately whether a loss or outgoing is capital or revenue in nature is determined by the facts of each particular case having regard to the principles established by the case law.

In Sun Newspapers Ltd v FC of T (1938) 61 CLR 337 (Sun Newspapers), 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.

In Sun Newspapers Dixon J also formulated the 'classic test' for determining whether expenditure is of a capital or revenue nature:

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.

In respect of the first matter, it has been said that "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" (GP International Pipecoaters Pty Ltd v FC of T (1990) 170 CLR 124 at 137; Commissioner of Taxation v Citylink Melbourne Limited [2006] HCA 35 at paragraph 148).

Later in Hallstroms Pty Ltd v FC of T (1946) 72 CLR 634 (Hallstroms), Dixon J said 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 Tyco Australia Pty Ltd v FC of T 2007 ATC 4799 the principles set out by Dixon J in Sun Newspapers and Hallstroms were considered by Allsop J, who said at page 4807:

…it is important to appreciate the content of the approach of Dixon J in Sun Newspapers 61 CLR 337 and Hallstroms Case 72 CLR 634. It is not, as some of the respondent's submissions in this case seemed to state, that one "looks through" the legal or strict juridicial form of a transaction if "good cause" for so doing is shown. The analysis, that is the ascertainment of the character of the expenditure and what it is calculated to effect, is made from a practical and business point of view, though, of course, as part of that analysis, it is essential to understand the proper legal characterisation of what has occurred: Commissioner of Taxation of the Commonwealth of Australia v South Australian Battery Makers Pty Limited (1978) 140 CLR 645 at 657-60 and 661-662.

At 4809, Allsop J also said:

The mere identification of the correct description of the legal rights obtained or transferred by any transaction is generally too narrow a focus for the answering of the question. This is especially so once it is recognised that almost every commercial arrangement based on contract can be analysed jurisprudentially from the perspective of buying and selling rights or choses in action. Such rights are merely the legal or juridicial building blocks of relationships built from business and practical activity. The enquiry as to whether an outgoing is on capital or revenue account looks to the business and practical effects and advantages sought in the whole context: Commissioner of Taxation of the Commonwealth of Australia v Raymor (NSW) Pty Limited 90 ATC 4461; (1990) 24 FCR 90 at 99 and National Australia Bank 80 FCR at 363-364.

In Colonial Mutual Life Assurance Society Ltd v FCT (1953) 89 CLR 428 at 454, Fullager J said:

The questions which commonly arise in this type of case are: (1) What is the money really paid for? and (2) Is what it is really paid for, in truth and substance, a capital asset?

FCT v Star City [2009] FCAFC 19 is authority for the proposition that in determining the true character of an outgoing one is not limited to a consideration of the terms of the contractual documents which gave rise to the payment of the outgoing. The determination of that characterisation is ultimately to be undertaken from a practical and business point of view. That point of view is not confined to the words of the document pursuant to which the payment is made.

As stated by Goldberg J at paragraph 63:

In the present case there was no issue that any of the transaction documents was a sham. But there was an issue as to the label of "rent" which the parties had used to describe the lump sum prepayment… In those circumstances, as recognised by the Full Federal Court in City Link Melbourne Ltd v Commissioner of Taxation (2004) 141 FCR 69 at [46], and by the Full Federal Court in Federal Commissioner of Taxation v Broken Hill Pty Co Ltd (2001) 179 ALR 593 at 601-602, labels are not determinative and surrounding circumstances may be resorted to determine the true characterisation of a payment in an appropriate case…

Conclusion

In our view, the payment was made to obtain a capital asset. This is supported by the terms of the agreement under which the payment was made and the terms of the related agreement under which compensation is payable, as well as the surrounding circumstances.

Applying the principles formulated by Dixon J in Sun Newspapers:

The payment was made in two large instalments. These are non-recurring payments. The advantage sought by the payment is commonly regarded as a capital asset. The capital asset significantly added to the taxpayer's business. The capital asset will endure for the benefit of the taxpayer for a significant period.

The payment made by the taxpayer is a capital outgoing and is not deductible under section 8-1 of the ITAA 1997.