Edited version of your private ruling

Authorisation Number: 1012489975113

Ruling

Subject: Deductibility of payments under section 8-1 ITAA 1997

Question 1

Is the payment made by the taxpayer to the entity A deductible under section 8-1 of the Income Tax Assessment Act 1997?

Answer

No

Question 2

Is the payment required to be made by the taxpayer to entity B deductible under section 8-1 of the Income Tax Assessment Act 1997?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

The scheme commences on:

16 October 2011

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.

Company A carried on a business (the Business). It agreed to sell the Business to an entity (the Buyer)

The company had several shareholders who held shares with the same rights, entitlements and obligations.

Those shareholders were:

· the taxpayer (a trust)

· Trust A

· Trust B

Company A's directors were Person TP, a trustee of the taxpayer and Person A, a trustee of Trust A.

The Contract of sale contained a number of special conditions the failure to satisfy these special conditions would have triggered the following clause of the Contract of sale:

· the party who would have benefitted from a particular special condition had to give notice to the other party if the special condition is not satisfied

· the parties had to then negotiate in good faith to amend the Contract of sale if acceptable to both parties (to address the non-satisfaction of the special condition)

· if the parties were unable to agree the amendments to the Contract of sale the Contract of sale ends.

Person A was not satisfied with the payments to be made to the Trust A under the Contract of sale and various other terms contained in the Contract of sale.

Accordingly, Person A advised Person TP that unless Person TP:

· agreed to certain terms and conditions and

· executed an agreement setting out these terms and conditions

Person A would not comply with the special conditions of the Contract of sale, therefore the sale could not settle.

Accordingly Person TP agreed to the terms and conditions stipulated by Person A and executed a Settlement agreement which set out the terms and conditions. The Settlement agreement between the company, Person TP and Person A was executed on in late 20XX.

The sale of business under Contract of sale settled on soon after on a date all parties agreed to.

Pursuant to the Settlement agreement if certain conditions were met after a particular period Person TP was required to pay Person A amount one.

Pursuant to the Settlement agreement if certain conditions were met for a particular period Person TP was required to pay Person B amount two.

Whilst not specified in the wording of the clauses in the Settlement agreement the parties intended that:

· these payments be made by Person TP in their capacity as trustee of the taxpayer and

· these payments made to Person A and Person B in their capacity as trustees of their respective trusts.

In mid 20YY TP (as trustee of the taxpayer) paid amount one to Person A (being the payment due to the Trust A).

Person TP (as trustee of the taxpayer) will pay amount two to the Trust B.

Relevant legislative provisions

Income Tax Assessment Act 1997 8-1.

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.

Issue 1

Question 1

Summary

The payment made by the taxpayer to Trust A is not deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except where they are of a capital, private or domestic nature, or relate to the earning of exempt income.

In relation to the first positive limb in paragraph 8-1(1)(a) of the ITAA 1997, the courts have held that the phrase "incurred in gaining or producing assessable income" means incurred "in the course of" gaining or producing assessable income (Amalgamated Zinc (De Bavay's) Ltd v. Federal Commissioner of Taxation (1935) 54 CLR 295; Ronpibon Tin NL v. Federal Commissioner of Taxation (1949) 78 CLR 47 (Ronpibon Tin); Federal Commissioner of Taxation v. Payne (2001) 202 CLR 93 (Payne); Federal Commissioner of Taxation v. Day (2008) 236 CLR 163).

In Ronpibon Tin, the High Court explained (at 57):

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.

The essential question, rephrased by the High Court in Payne (at 100), is: "is the occasion of the outgoing found in whatever is productive of actual or expected income?"

The Settlement agreement between the company, Person TP and Person A provided terms under which they agreed to complete the settlement of the sale of the Business. Person TP as trustee for the taxpayer incurred amount two when the relevant conditions in the Settlement agreement were met.

By agreeing to pay the amount in accordance with the terms in the Settlement agreement, the taxpayer ensured that Person A would cooperate in meeting the conditions of the Contract of sale. The proceeds from the sale of the Business would then become dividends to the shareholders after deducting the costs and expenses of settlement of the sale.

The payment is most directly attributable to the sale of the Business. Person A agreed to fulfil the special conditions in the Contract of sale partly because of this payment.

At 202 CLR 102 of Payne Gummow, Kirby, Hayne JJ note the following:

As Dixon CJ pointed out, the question in Lunney was how an undisputed principle was to be applied. The principle which had to be applied in that case, and must be applied in this, is one which limits the allowance of a deduction for outgoings to those outgoings that are incurred in the course of deriving assessable income. It is a principle which excludes outgoings which, although incurred for the purpose of deriving assessable income, are not incurred in the course of doing so. Distinguishing between those two kinds of outgoing may well invite some criticism, but if it does, the criticism is directed at the legislation, not at the way in which the legislation has been interpreted.

The income of the taxpayer is by way of dividends from the Company. The taxpayer's outgoing will result in the Company having funds with which to pay dividends to the taxpayer. It could be said that the advantage conferred by the payment was necessary for, but not in the regular income earning activities of the taxpayer.

It was therefore incurred functionally 'too soon' to be deductible even though it may not have been incurred temporally 'too soon'. An outgoing may be temporally 'too soon' where there is a significant delay between the incurring of the outgoing and the actual or projected receipt of income.

A further consideration in relation to the deductibility of the payment is whether it is capital in nature. Under paragraph 8-1(2)(a) of the ITAA 1997 you cannot deduct a loss or outgoing under section 8-1 to the extent that it is a loss or outgoing of capital or of a capital nature.

The nature or character of expenditure follows 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 expenses incurred in gaining the advantage will also be of a capital nature.

The guidelines for distinguishing between capital and revenue outgoings were laid down in the High Court case of Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; 5 ATD 87 (Sun Newspapers Case). It was pointed out that expenditure in establishing, replacing and enlarging the profit-yielding structure itself is capital and is to be contrasted with working or operating expenses. The test laid down in the Sun Newspapers Case involved three elements, although none is in itself decisive:

· the nature of the advantage sought

· the way it is to be used or enjoyed and

· the means adopted to get it.

The courts have held, in the absence of special circumstances that expenditure is capital in nature where it is made with a view to bringing into existence an asset or an advantage (tangible or intangible) for the enduring benefit of the business (British Insulated & Helsby Cables v. Atherton (1926) AC 205).

Also, outgoings incurred in the preservation of an existing capital asset have been held to be capital in nature (John Fairfax & Sons Pty Ltd v. Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 7 AITR 346; (1959) 11 ATD 510). 

The third element involves a consideration of whether the outlay is a periodic one covering the use of the asset or advantage during each period, or whether the outlay is calculated as a single final provision for the future use or enjoyment of the asset or advantage.

In Case 48/97 97 ATC 500; 37 ATR 1208, the applicant was a majority shareholder of two private companies, V and B, and had borrowed funds from a bank to discharge one of the company's indebtedness to the bank. The applicant argued that the purpose of the loan was to allow the company to continue in business, become profitable and then pay dividends to him.

After having concluded that the interest expense was not sufficiently connected to the applicant's income producing activities the Tribunal also noted that:

…if it can be said that the 1989 loan was incurred with the object of ensuring the derivation of future dividends from V, thus benefitting the taxpayer, the loan is better characterised as being of a capital nature. Insofar as the loan allowed V to continue trading, it could be characterised as expenditure to safeguard the dividend-paying capacity of a company, and hence the value of the Applicant's share investment in that company. Such expenditure is concerned with the protection of the source of supply, rather than with the derivation of the dividends as such, and is therefore of a capital nature…

In ATO ID 2007/136 a taxpayer's legal expenses incurred in seeking to stop a further share issue by the company in which the taxpayer owned shares is considered are considered to be capital in nature. This is because the advantage sought to be obtained by pursuing the legal action was to preserve the taxpayer's existing equity interest in the company, being the taxpayer's existing proportion of the company's issued shares and the enduring benefit that attaches to that equity interest.

The one-off payment incurred by the taxpayer ensured that the company was able to sell the business with the consequence the proceeds from the sale would be paid to the taxpayer as dividends. The payment helped ensure that the taxpayer's source of income was protected. Therefore it is considered capital in nature.

Since the payment was incurred functionally 'too soon' and is capital in nature, the payment made by the taxpayer to the Trust A is not deductible under section 8-1 of the ITAA 1997.

Question 2

Summary

The payment required to be made by the taxpayer to the Trust B is not deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

In order to be deductible under section 8-1 of the ITAA 1997, a loss or outgoing must have been 'incurred' in that year. Based on various decisions of the courts, an expense may still be incurred where there has not been an actual payment made.

In Taxation Ruling TR 94/26 Income tax: subsection 51(1) - meaning of incurred - implications of the High Court decision in Coles Myer Finance, paragraph 3 states:

In most cases where a loss has not been realised or an outgoing not been made, a presently existing pecuniary liability, at the end of the relevant income year, will be a necessary prerequisite to an expense being incurred…In this respect it is not sufficient that the liability to pay is pending, threatened or expected, no matter how certain it is in the year of income that the outgoing will occur in a future year.

Whether there is a presently existing pecuniary liability is a question which must be determined in the light of particular facts, especially by reference to the terms of the contract or arrangement under which the liability is said to arise.

Based on the relevant clause in the Settlement agreement the taxpayer will pay the Trust B amount two if certain conditions were met for a particular period. That period has not yet ended.

Since the conditions have not yet been fully met, the taxpayer has only a pending or expected liability. Consequently, it cannot be said that the taxpayer has incurred the outgoing as yet.

Once the liability has been incurred however, for the reasons outlined in relation to question one, the outgoing will not be deductible under section 8-1 of the ITAA 1997.