Edited version of your private ruling

Authorisation Number: 1012500989148

Ruling

Subject: Deductibility of prepaid licence fees

Question 1

Is the Prepayment of the Licence Fee by Company B deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Will the proportion of the Prepayment of the Licence Fees that is deductible by Company B in a relevant year of income be determined in accordance with the formula in section 82KZMD of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

Yes.

This ruling applies for the following periods:

Income year ended 30 June 2013

Income year ended 30 June 2014

Income year ended 30 June 2015

Income year ended 30 June 2016

Income year ended 30 June 2017

Income year ended 30 June 2018

Income year ended 30 June 2019

Income year ended 30 June 2020

Income year ended 30 June 2021

Income year ended 30 June 2022

The scheme commences on:

Income year ended 30 June 2013.

Relevant facts and circumstances

The Applicant

1. Company A (the Applicant) is an Australian resident company and is the head company of a tax consolidated group for the purposes of Part 3-90 of the ITAA 1997.

2. Company B is a wholly-owned subsidiary of the Applicant and a member of the Applicant's income tax consolidated group.

3. The Applicant advises that the facts necessary for establishing that Company B is carrying on a business exists. Company B's business includes the provisions of the Services under the Services Agreement with Company X as discussed at paragraph 5 below.

The Services Agreement

4. Company X has entered into an agreement to construct, finance, operate and maintain a facility for the Facility Owner (the Project).

5. Company B and Company X have entered into an agreement under which Company B has agreed to provide certain services (the Services) to Company X in respect of the Project.

6. In consideration for Company B providing the Services, Company X pays Company B a monthly fee (Services Fee).

The Licence

7. The Facility Owner has also entered into an agreement (Licence Agreement) with Company B under which the Facility Owner has granted Company B a licence (the Licence) which gives Company B the right to access and use certain property (the Property) in order to comply with its obligations and liabilities under the Services Agreement.

8. The Licence is granted exclusively for the Project and for the purposes of Company B performing its obligations under the Services Agreement.

9. The Licence has been granted for a number of years which coincides with the term of the Services Agreement and the period that Company B must provide the Services to Company X.

10. The term of the Licence may be extended in accordance with the Licence Agreement.

11. The Licence Agreement sets out the circumstances in which the Licence may be terminated. The Facility Owner may at any time in its absolute and sole discretion terminate the Licence for convenience by giving notice to Company B or in the event of default by Company B. The Licence may also be terminated by either the Facility Owner or Company B if a Force Majeure Event occurs.

The Licence Fee

12. Under the Licence Agreement, Company B is required to pay an annual Licence Fee to the Facility Owner for access to and use of the Property.

13. Company B and the Facility Owner have negotiated for Company B to prepay the present value of the Licence Fees which would otherwise be payable annually for the term of the Licence prior to any extension (the Prepayment). The agreement for Company B to make the Prepayment is reflected in the Licence Agreement.

14. Company B has paid the Prepayment, which was funded out of the Applicant's existing debt facilities.

15. Under the terms of the Licence Agreement, the Prepayment of the Licence Fee is wholly or partially refundable to Company B in the event of termination. The method for calculating the refund is set out in the Licence Agreement and varies depending on the reason for the termination but is referable to the unexpired term of the Licence Agreement.

16. In the event the term of the Licence is extended, the terms and conditions of the Licence Agreement will remain unchanged, unless agreed by the parties. Additionally, if extended, it is likely that Company B will be liable to pay the annual Licence Fees during the extended term, as the period to which the Prepayment relates will have expired.

17. The Licence Agreement and the payment of the Licence Fee does not confer Company B or any of its related entities with any permanent ownership rights, or the option to acquire any permanent ownership rights, over the Property. At all times, the Property is vested in the Facility Owner and any right, title and interest held by Company B in respect of the Property (including any ancillary assets) must revert or be handed back to the Facility Owner if the Licence Agreement is terminated, including at the end of the term of the Project.

Relevant legislative provisions

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 Section 230-45.

Income Tax Assessment Act 1997 Paragraph 230-460(2)(e).

Income Tax Assessment Act 1936 Subsection 82KZL(1).

Income Tax Assessment Act 1936 Subsection 82KZL(2).

Income Tax Assessment Act 1936 Paragraph 82KZL(2)(b).

Income Tax Assessment Act 1936 Section 82KZMA.

Income Tax Assessment Act 1936 Paragraph 82KZMA(1)(a).

Income Tax Assessment Act 1936 Paragraph 82KZMA(1)(b).

Income Tax Assessment Act 1936 Subsection 82KZMA(2).

Income Tax Assessment Act 1936 Subparagraph 82KZMA(2)(a)(i).

Income Tax Assessment Act 1936 Subsection 82KZMA(3).

Income Tax Assessment Act 1936 Subparagraph 82KZMA(3)(a)(i).

Income Tax Assessment Act 1936 Subparagraph 82KZMA(3)(b).

Income Tax Assessment Act 1936 Subparagraph 82KZMA(3)(c).

Income Tax Assessment Act 1936 Subsection 82KZMA(4).

Income Tax Assessment Act 1936 Subsection 82KZMA(5).

Income Tax Assessment Act 1936 Section 82KZMD.

Reasons for decision

Section 8-1 of the ITAA 1997 provides:

(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 ...

The positive limb: will the Licence Fees be incurred in gaining or producing Company B'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, at 56-57:

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…

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 Services Agreement, Company B must provide the Services to Company X. In return for performing the Services, Company B will derive as income the monthly Services Fee from Company X. These amounts will be required to be included in Company B's assessable income.

To enable Company B to perform the Services, the Facility Owner has granted Company B the Licence which gives Company B the right to access and use the Property in order to comply with obligations and liabilities under the Services Agreement. In consideration for the grant of the Licence, Company B is required to pay the Facility Owner an annual Licence Fee. However, following negotiations with the Facility Owner, Company B has agreed to pay the Prepayment.

Without the Licence and the payment of the Licence Fee, Company B would not be able to produce its assessable income. The Licence and the Licence Fee payments allow Company B access to and use of the Property to enable it to provide the Services which produces its assessable income i.e. the monthly Services Fees.

Accordingly, the Licence Fee is an outgoing incurred by Company B in gaining or producing its assessable income for the purpose of paragraph 8-1(1)(a) of the ITAA 1997.

The negative limb: will the Licence Fees be outgoings of capital, or of a capital nature?

Pursuant to paragraph 8-1(2)(a) of the ITAA 1997, an outgoing is not deductible under section 8-1 to the extent that it is an outgoing of capital, or of a capital nature.

The leading Australian authority on whether or not a loss or outgoing is of a capital nature is Sun Newspapers Ltd & Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers). In Sun Newspapers, Dixon J held that the critical distinction between outgoings on capital account and those on revenue account lay in the distinction between the 'profit yielding structure' and the process by which the profit yielding structure operates to derive profits. He said, at CLR 359:

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss.

Dixon J stated that there are three matters to consider when deciding whether an outgoing is on capital or revenue account (at CLR 363):

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.

The enquiry must be made from a practical and business point of view. In Hallstroms Pty Ltd v. Federal Commissioner of Taxations (1946) 72 CLR 634, Dixon J observed, at 648, that:

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.

Labels used by the parties to describe a payment are not determinative, and the surrounding circumstances may be taken into account to determine the true characterisation of a payment: see Goldberg J in FCT v. Star City Pty Limited [2009] FCAFC 19.

The importance of the 'character of the advantage sought' test was restated by the High Court in Commissioner of Taxation v. Citylink Melbourne Limited (2006) 228 CLR 1 (Citylink). Crennan J (with whom Gleeson CJ, Callinan and Heydon JJ agreed) said, at 43:

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.

In determining the character of the advantage sought by the expenditure, it is necessary to examine whether the expenditure secures an enduring benefit. 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.

In this case, the advantage secured by Company B from the payment of the Licence Fee is the right to access and use the Property to enable it to provide the Services to Company X. The advantage obtained by Company B does not have any lasting quality or enduring benefit beyond the period to which the Prepayment relates. In the event the term of the Licence is extended, it is likely that Company B will be liable again to pay the annual Licence Fees as the period to which the Prepayment relates will have expired.

The payment of the Licence Fee does not confer Company B with any permanent ownership rights, nor any option to acquire any permanent ownership rights, over the Property or to the land on which the Property is located. At all times, the Property is vested in the Facility Owner and any right, title or interest granted to or held by Company B in respect of the Property (including in ancillary assets) must revert or be handed back to the Facility Owner if the Licence Agreement is terminated, including at the end of the term of the Project. The Licence Fees are not instalments paid on the purchase price of a capital asset; they are fees in respect of the use of the Property, from which Company B is able to derive its income, but which are ultimately "surrendered back" to the Facility Owner.

Whilst Company B has prepaid, as a lump sum, the present value of the total annual Licence Fees otherwise payable over the term of the Licence, the Prepayment secures the same principal advantages for Company B as a periodic annual payment would have, being the right to access and use the Property over the term of the Licence to enable it to perform the Services and produce its assessable income.

Having regard to the whole picture, the Prepayment of the Licence Fee would not appear to detract from the fact that the Licence Agreement refers to an annual Licence Fee being payable over the term of the Licence. By making the Prepayment, Company B has simply relieved itself of the responsibility to make regular annual Licence Fee payments. This is supported by the fact that, in the event the Licence Agreement is terminated early, a portion of the Prepayment relating to the unexpired term of the Licence will be refundable to Company B. The Prepayment is a substitution for a continuous demand for the Licence Fees.

Accordingly, it is considered that the Prepayment of the Licence Fees is not an outgoing that is capital or of a capital nature.

Application of Division 230 of the ITAA 1997

For completeness, it is considered that Division 230 of the ITAA 1997 will not apply to the Prepayment as the Licence Agreement will not constitute a 'financial arrangement' as defined by section 230-45 of the ITAA 1997. Under the Licence Agreement, the Facility Owner has granted Company B a licence to access and use Property for the purposes of enabling Company B to meet its obligations under the Services Agreement and to provide the Services. In exchange, Company B has paid the Prepayment to the Facility Owner. The rights received by Company B are not cash settlable and are not insignificant compared to the cash settlable obligation to pay the Prepayment of the Licence Fee.

Further, even if the rights and obligations under the Licence Agreement did constitute a financial arrangement under section 230-45 of the ITAA 1997 to which Division 230 of the ITAA 1997 may apply, paragraph 230-460(2)(e) of the ITAA 1997 which applies to a right or obligation arising under a licence to use real property, goods or a personal chattel (other than money or a money equivalent), or intellectual property would operate to exclude the financial arrangement from being subject to the application of Division 230.

Question 2

Summary

The Prepayment of the Licence Fees will be deductible in accordance with the formula in section 82KZMD of the ITAA 1936.

Detailed reasoning

Where expenditure qualifies for deduction under section 8-1 of the ITAA 1997, the deduction is generally allowable in full in the year in which the expenditure is incurred. However, the timing of deductions for certain types of expenditure is subject to the advance payment rules in sections 82KZL to 82KZO of the ITAA 1936.

Subsection 82KZMA(1) of the ITAA 1936 provides:

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

(a) apart from those sections, the taxpayer could deduct the expenditure under section 73B, 73BA, 73BH, 73QA, 73QB or former section 73Y of this Act or section 8-1 of the Income Tax Assessment Act 1997 for the expenditure year; and

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

The requirement in paragraph 82KZMA(1)(a) of the ITAA 1936

For the reasons given above in response to Question 1, the Prepayment of the Licence Fees will be deductible under section 8-1 of the ITAA 1997 when the Prepayment is made.

Paragraph 82KZMA(1)(a) of the ITAA 1936 is satisfied because the Prepayment could otherwise be deducted when the Prepayment is made under section 8-1 of the ITAA 1997.

The requirements in paragraph 82KZMA(1)(b) of the ITAA 1936

The requirement in subsection 82KZMA(2) of the ITAA 1936

In order to satisfy the requirements of sub-paragraph 82KZMA(2)(a)(i) of the ITAA 1936, Company B must carry on a business. As stated at paragraph 5 above, the Applicant has advised that the facts necessary for establishing that Company B is carrying on a business exists. Therefore, Company B will meet the requirement in subsection 82KZMA(2) of the ITAA 1936.

The requirement in subsection 82KZMA(3) of the ITAA 1936

Subsection 82KZMA(3) of the ITAA 1936 requires the Prepayment to be:

· incurred in carrying on a business (subparagraph 82KZMA(3)(a)(i) of the ITAA 1936), and

· incurred under an agreement (paragraph 82KZMA(3)(b) of the ITAA 1936), and

· incurred in return for the doing of a thing under the agreement that is not to be wholly done within the expenditure year (paragraph 82KZMA(3)(c) of the ITAA 1936).

For the reasons discussed above in relation to the requirement in subsection 82KZMA(2), Company B is considered to be carrying on a business. As also stated in paragraph 3 above, Company B's business includes the provision of the Services. The Licence Fee was necessarily incurred by Company B to enable it to perform the Services. Therefore, the Prepayment will be incurred by Company B in carrying on a business and will be incurred under an agreement, being the Licence Agreement. As a result, subparagraph 82KZMA(3)(a)(i) of the ITAA 1936 and paragraph 82KZMA(3)(b) of the ITAA 1936 will be met.

Paragraph 82KZMA(3)(c) of the ITAA 1936 also requires the Prepayment to be 'incurred in return for the doing of a thing under the agreement that is not to be wholly done within the expenditure year'.

Subsection 82KZL(2) of the ITAA 1936 relevantly states:

Without otherwise limiting the generality of references in this Subdivision to expenditure being incurred under an agreement in return for the doing of a thing under the agreement:

(a) …

(b) where expenditure incurred under an agreement consists of a payment of rent, a lease payment or a payment of a similar kind, the expenditure shall, for the purposes of this Subdivision, be taken to be incurred in return for the making available or continued making available, as the case requires, of the thing rented or leased, or other thing of a similar kind, under the agreement during the period to which the payment relates; and

(c) …

Paragraph 14 of Taxation Ruling IT 2646 Income Tax: Television Program Licences provides guidance on the phrase 'payment of a similar kind'. It states:

The expression "payments of a similar kind" in paragraph 82KZL(2)(b) is considered to refer to payments:

a). the nature of which is similar to the nature of rent and lease payments; and

b) the object or benefit sought by the payments is similar to the object or benefit sought by a payment of rent or a lease payment.

Rent has been defined as 'the consideration payable under [a] lease for the right of use and occupation of the leased premises during the term of the lease' (FC of T v. Krakos Investments Pty Ltd (1995) 61 FCR 489, per Hill J at 503). Further, 'an inherent feature of rent is that it typically involves a (generally regular) periodical payment' and 'rent is fundamentally the consideration for the right to use property' (Commissioner of Taxation v. Citylink Melbourne Limited (2006) 228 CLR 1, per Kirby J at 19).

The Licence Fee in this case is not payable under a lease and the Licence will not give Company B an interest in the Property or a right to exclusive possession of the Property. The Prepayment of the Licence Fee is a lump sum payment paid by Company B in substitution for periodical annual payments in consideration for the right to access and use the Property for the term of the Licence. As a result, the Licence Fees (and consequently the Prepayment) is considered to be similar to rent and the advantage secured by the Prepayment of the Licence Fees will be similar to the advantage secured by the payment of rent.

The Prepayment of the Licence Fees will be a payment of a similar kind to the payment of rent for the purpose of paragraph 82KZL(2)(b) of the ITAA 1936. Accordingly, the Prepayment will be taken to be incurred in return for the Facility Owner making available the Property for Company B to access and use for the purposes of providing the Services during the period to which the Prepayment relates. As a result, paragraph 82KZMA(3)(c) of the ITAA 1936 will be met.

The requirement in subsection 82KZMA(4) of the ITAA 1936

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

'Excluded expenditure' is defined in subsection 82KZL(1) of the ITAA 1936. The amount of the Prepayment will not be less than $1,000, it will not be required to be incurred by a law, or by an order of a Court, of the Commonwealth, a State or Territory. It will not be a payment under a contract of service, it will not be a payment of a capital, private or domestic nature and it will not come within paragraphs (e) or (f) of 'excluded expenditure' as defined in subsection 82KZL(1) of the ITAA 1936.

The Prepayment does not fall within any of the limbs of the exhaustive definition of 'excluded expenditure' as defined in subsection 82KZL(1) of the ITAA 1936. As a result, the requirement in subsection 82KZMA(4) of the ITAA 1936 will be met.

The requirement in subsection 82KZMA(5) of the ITAA 1936

Subsection 82KZMA(5) of the ITAA 1936 requires that the Prepayment 'must not meet a pre-RBT obligation'.

A 'pre-RBT obligation' is defined in subsection 82KZL(1) of the ITAA 1936 as:

pre-RBT obligation means a contractual obligation that:

(a) exists under an agreement at or before 11.45 am (by legal time in the Australian Capital Territory) on 21 September 1999; and

(b) requires the payment of an amount for the doing of a thing under the agreement; and

(c) requires the payment to be made before the doing of a thing; and

(d) cannot be escaped by unilateral action by the party bound by the obligation to make the payment.

The Prepayment is not capable of meeting a pre-RBT obligation because the obligation to make the Prepayment did not exist under an agreement at or before 11.45 am on 21 September 1999. As a result, the requirement in subsection 82KZMA(5) of the ITAA 1936 will be met.

Accordingly, the requirements in paragraph 82KZMA(1)(b) of the ITAA 1936 are satisfied and section 82KZMD of the ITAA 1936 will apply to determine the portion of the Prepayment of the Licence Fees that is deductible by Company B in a relevant year of income.