Edited version of your private ruling

Authorisation Number: 1012495238587

Ruling

Subject: Income Tax: deductions - capital v revenue

Question 1

Is the taxpayers liability that arose in the 20XX income year in obtaining the right to hold an entitlement an outgoing that is "incurred" under either limb of Section 8-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Is the outgoing incurred on an entitlement an outgoing of capital nature?

Answer

Yes

Question 3

Is the outgoing incurred in acquiring that entitlement fully deductible in a single income tax year, and if so, which year?

Answer

No

Question 4

Does the 'properly referable' test and/or the prepayment rules in Sections 82KZL-82KZO of the Income Tax Assessment Act 1936 (ITAA 1936) apply such that each quarterly instalment is deductible over the course of the quarter that it relates to, resulting in instalments which fall due on dd/mm of the relevant income years and that are required to maintain the right to continue holding the entitlement for the three months following each payment, being deductible via apportionment over the eligible service period for that instalment?

Answer

No

Question 5

Is the taxpayer required to apportion the final quarterly instalment over a three month period, or over the remainder or the 10 year licence period (i.e. 1 March 2017 to 15 August 2022)?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ending 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

Year ending 30 June 2017

The scheme commences on:

1 June 2009

Relevant facts and circumstances

The taxpayer operates a property which requires a licence and provides a number of different services.

All of these services have been offered by the business for a number of years. One of the activities requires the taxpayer to own a number of entitlements.

The entitlements were previously owned by another entity and sub-licensed by the taxpayer. In recent times new State regulatory rules have operated to allow the entitlements to be owned by the taxpayer.

The entitlements are issued for a period of x years and may be extended for up to two further years.

The taxpayer paid a non refundable bond in order to participate in the process to obtain the entitlements.

The taxpayer was successful in the process and became liable for the whole of the price of the entitlements acquired

The taxpayer is paying the purchase price of the entitlements by instalments.

In this ruling the phrase 'outgoing' means the total value of the purchase price of the entitlements acquired by the taxpayer through the process inclusive of the bond which was applied towards the purchase price. It also means an instalment or instalments of the purchase price (as the context requires).

There is State legislation which governs the criteria to obtain, the purchase and the management of the entitlements. This includes the ability to transfer the entitlements and the process that will happen if the taxpayer/owner forfeits the entitlements.

Relevant legislative provisions

Income Tax Assessment Act 1997

Section 8-1

Income Tax Assessment Act 1936

Subdivision H

Section 82KZL

Section 82KZMA

Section 82KZMD

Reasons for decision

Question 1

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 the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

More specifically subsection 8-1(1) of the ITAA 1997 states:

8-1(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.

TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions sets out the Commissioner's view of the meaning of the term 'incurred'. As a broad guide, you incur an outgoing at the time you owe a present money debt that you cannot escape (paragraph 5 TR 97/7).

The term 'incurred in gaining or producing your assessable income', is to be read as meaning 'incurred in the course of gaining or producing your assessable income'. In Amalgamated Zinc (De Bavay's) Ltd v FC of T (1935) 54 CLR 295 at p 303, Dixon J said:

"The expression 'in gaining or producing' has the force of 'in the course of gaining or producing' and looks rather to the scope of the operations or activities and the relevance thereto of the expenditure than to purpose in itself."

The courts have held that for there to be a deduction under section 8-1 there must be a sufficient connection between the loss or outgoing and the production of assessable income. The loss or outgoing must be incidental and relevant to the earning of assessable income (Ronpibon Tin NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431; (1949) 4 AITR 236).

In this case it is considered that in the year in which the taxpayer obtained the entitlements they had a present money debt pertaining to the acquisition of the entitlements, which is an outgoing incidental and relevant to the taxpayer producing assessable income though the provision of specific services to its clients.

Accordingly, the taxpayer's liability that arose in obtaining the entitlements is an outgoing that is incurred for the purposes of section 8-1(1) of the ITAA 1997.

It is noted that TR 97/7 sets out that for the purpose of section 8-1 of the ITAA 1997 it is sometimes not enough that a loss or outgoing has been incurred and it must also be properly referable to the year of income in which the deduction is sought.

Consideration of whether the outgoing is properly referable to the relevant income year is not needed in this case due to the characterisation of nature of the outgoing, as explained in the answer to question 2 below.

Question 2

The first negative limb of section 8-1 of the ITAA 1997 denies a deduction for a loss or outgoing incurred where it is a loss or outgoing of capital, or of a capital nature (see paragraph 8-1(2)(a)).

There is no statutory definition of 'capital' or 'capital nature'.

The judgment of Dixon J in Sun Newspapers Ltd v. FC of T (1938) 61 CLR 337 (the Sun Newspapers Case ) is a leading exposition of the matters examined in order to differentiate whether an amount is capital or revenue in nature.

Accordingly the following indicators, consistent with the matters raised by Dixon J, in the Sun Newspapers Case point towards an expense being capital in nature:

· The expenditure is related to the business structure itself. This includes the establishment, replacement or enlargement of the profit yielding structure of business rather than the money earning process.

· The nature of the asset has lasting and enduring benefit to the business.

· The payment is made 'once and for all' being a single final provision for the future use or enjoyment of the asset or advantage rather than on a regular basis, such as weekly, monthly or yearly or for a specific period.'

It must be borne in mind that the statements made by Dixon J are not exhaustive or ultimately definitive of the relevant matters to be considered in each case. For example, the absence of recurrence of a payment suggests that an outgoing is capital in nature, but it is not conclusive (National Australia Bank v. Federal Commissioner of Taxation (1997) 80 FCR 352; 97 ATC 5153; (1997) 37 ATR 378 )

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

The term enduring was referred to by Rich J at page 547 in Herring v. FCT (1946) 72 CLR 543, who stated that 'by enduring it is not meant that the asset or advantage should last forever. It is a matter of degree and only one element to be considered.'

The full Federal Court in Jupiters Ltd v Deputy Commissioner of Taxation [2002] FCAFC 206, 2002 ATC 4566 (Jupiters) held that the advantage sought by payment of 'special rental' under an agreement between the taxpayer and the Queensland Government was an asset of a capital nature. In the Jupiters case the full Federal Court adopted the following approach (at 2002 ATC 4571):

In the leading case of Colonial Mutual Life Assurance Society Ltd v FC of T (1953) 10 ATD 274 at 283; (1953) 89 CLR 428 at 454 Fullagar J (with whom Kitto and Taylor JJ agreed) said (emphasis in original):

``... 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 in substance, a capital asset?''

Their honours went on to say (at 2002 ATC 4572):

The nature of the asset acquired (see GP International Pipecoaters Pty Ltd v FC of T 90 ATC 4413 at 4419; (1989-1990) 170 CLR 124 at 137) was exclusivity and freedom from competition within 60 kilometres of the Complex. That advantage was of a lasting or enduring quality. In itself ten years is a substantial period but, as his Honour pointed out, for practical purposes the advantage obtained would extend well beyond that, as was recognised by Jupiters' own accounting treatment. Although there were default provisions applicable to both parties, it would be unreal to see Jupiters as buying a year's exclusivity as it made the Special Rental payments year by year.

In this case the taxpayer directly acquired the entitlements which replaced the entitlements it sub-licensed from another unrelated entity. The entitlements are legal rights which fall within the definition of a 'CGT asset' in section 108-5 of the ITAA 1997.

It is considered that the outgoing was incurred to acquire the entitlement assets because of the enduring benefit the entitlements have to the taxpayer's business. The enduring benefits include:

· The term of the entitlements;

· Without the entitlements the taxpayer cannot provide specific services to its clients;

· The conditions imposed on the entitlements include regional and municipal limits on the numbers of entitlements, giving the holder a level of exclusivity

· The taxpayer may transfer entitlements in accordance with the provisions of the State Act;

· If the taxpayer defaults in making its instalment of purchase price payments, the proceeds arising from the allocation of a entitlement forfeited (less any State-owned amounts) must be paid to the operator who forfeited that entitlement

Even though there are default provisions in the agreement and the State Act which may result in a forfeiture of entitlement(s) if an instalment is not paid, it is considered unreal that the taxpayer is only buying the benefit of the entitlements for a period shorter than the entire 10 year term (see Jupiter above).

The taxpayer expects that the allocation process is to occur each x years so that they will be able to hold a successive series of entitlements such that they can continue to operate the specific aspect of their existing business. In these circumstances, the enduring benefit of the entitlements extends past the initial term.

The taxpayer may pay the purchase price upfront or choose to pay it by interest free instalments. It is considered that taxpayer's election to pay the purchase price of the entitlements by quarterly instalments does not change the character of the outgoing from capital to revenue in nature.

Regard has been made to Federal Commissioner of Taxation v South Australian Battery Makers Pty Ltd 8 ATR 879 (Battery Makers). In Battery Makers, the taxpayer claimed a deduction for full amounts paid under an agreement which also included an option to purchase the leased property. It was held by the Full High Court that the character of the advantage sought by the taxpayer in paying the outgoings that was relevant. It was held that the outgoings were genuinely made in payment of rent and the only advantage to the taxpayer was the right to occupy the premises for the period of the lease.

Unlike the Battery Makers case, the advantage sought by the taxpayer in this case is an enduring benefit arising for the acquisition of entitlement assets for a specific term. The election by the taxpayer to pay the purchase price by instalments rather than by an upfront amount is not considered to be akin to rent paid.

Regard has also been had to the judgments in BP Australia Ltd v. Federal Commissioner of Taxation (1965) 112 CLR 386; (1965) 14 ATD 1; (1965) 9 AITR 615 ( BP Australia ) and National Australia Bank v. Federal Commissioner of Taxation (1997) 80 FCR 352; 97 ATC 5153; (1997) 37 ATR 378 ( NAB ).

In BP Australia the company claimed deductions for amounts paid as trade ties to service station proprietors so that those proprietors would deal exclusively in its products for a fixed period. The payments were calculated by reference to expected sales by the service stations. The Privy Council held that the real object of the outgoing was not the tied network but the orders that would flow from it. The tie agreements were a temporary solution that were of a recurrent nature. The advantage sought was the promotion of sales by up to date marketing methods which had become necessary and the expenditure was therefore deductible as being on revenue, rather than capital, account.

In NAB the bank was required to pay a lump sum (but further amounts were payable if loan quotas were exceeded) to the Commonwealth in order to have the exclusive right to make advances to Australian Defence Force personnel for a 15 year period. The Full Federal Court held that the payment was of a revenue nature as it did not enlarge the framework within which the Bank carried on its activities. Rather, it was incurred as part of the process by which the Bank operated to obtain regular returns by means of regular outlay. The Full Court determined that the payment was in the nature of a marketing expense and had a revenue rather than capital aspect.

Unlike the BP Australia and NAB cases, it could not be said the advantage sought by the taxpayer in this instance was in the nature of marketing. The outgoing incurred by the taxpayer served to advantage that part of its business structure required for the provision of specific services to clients, and not the process by which it operated to obtain regular returns by regular outlay.

It is considered that the outgoing incurred on an entitlement is an outgoing of capital nature.

Question 3

The reasoning supporting question 3 is limited to a consideration of general deductibility under section 8-1 of the ITAA 1997.

The answer and reasoning to question 1 sets out that the outgoing was incurred in the 20XX income year. However, the answer and reasoning to question 2 also sets out that the outgoing incurred is capital in nature.

The first negative limb of section 8-1 of the ITAA 1997 denies a deduction for a loss or outgoing incurred where it is a loss or outgoing of capital, or of a capital nature (see paragraph 8-1(2)(a)).

Accordingly, notwithstanding the outgoing being incurred in the 20XX income year, it is precluded from deduction under section 8-1 because paragraph 8-1(2)(a) is satisfied.

Question 4

Subsection 82KZMA of the ITAA 1936 states:

Section 82KZMD sets the amount and timing of deductions for expenditure that a taxpayer incurs in a year of income (the expenditure year), if:

(b) the requirements in subsections (2), (3), (4) and (5) are met.

For the reasons set out in question 3, the taxpayer cannot deduct the outgoing under section 8-1 of the ITAA 1997.

Subsection 82KZMA(4) of the ITAA 1936 prescribes that the expenditure must not be 'excluded expenditure'.

Subsection 82KZL(1) of the ITAA 1936 lists what the term 'excluded expenditure' means. Relevant to this case paragraph (d) of the definition of 'excluded expenditure' states:

(d) to the extent that it is of a capital nature and cannot be deducted under:

(i) section 355-205 (R&D expenditure); or

(ii) section 355-480 (earlier year associate R&D expenditure);

of the Income Tax Assessment Act 1997;

This case does not involve R&D expenditure under Division 355 of the ITAA 1997 and therefore the outgoing cannot be deducted under either section 255-205 or 355-480 of the ITAA 1997.

As set out in detail in the reasoning to question 2 the outgoing is of a capital nature. In these circumstances the outgoing meets the definition of 'excluded expenditure' under subsection 82KZL(1).

Accordingly, subsection 82KZMA(4) is satisfied and therefore, section 82KZMD does not apply to set the amount and timing of deductions.

Question 5

For the reasons set out in question 4, subdivision H of the ITAA 1936 does not apply and section 82KZMD does not apply to set the amount and timing of deductions.