Edited version of your private ruling

Authorisation Number: 1012517624578

Ruling

Subject: Deduction - Repayment of performance fee

Question 1

Does the repayment of the Performance Fee in a later year of income give rise to an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

If the answer to question 1 is no, will the amount of the Performance Fee repaid in the later income year be neither assessable income nor exempt income for the year it was originally paid under section 59-30 of the ITAA 1997?

Answer

Not applicable. The amount repaid is an allowable deduction under section 8-1 of the ITAA 1997.

This ruling applies for the following periods:

Year ended 30 June 20XY

Year ended 30 June 20XZ

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The scheme that is the subject of this ruling has been ascertained from:

· private ruling application, and

· agreement

1. The rulee is a listed entity and the head entity of the tax consolidated group.

2. A member of the group, Company A is an entity that, through its staff, possesses skills in a specific industry. To exercise its skills, Company A enters into agreements with a number of entities.

3. Company A entered into an agreement with Company B. A copy of the agreement has been provided and forms part of the facts.

4. Under the agreement, Company A was to provide management services to Company B in undertaking a number of projects. For this, Company A received a base management fee and a Performance Fee calculated and payable upon the completion of each project on the basis of the outcome of that project.

5. However, under the agreement, if the Internal Rate of Return (IRR) for investors calculated at the point of the winding up of Company B did not equal or exceed the threshold IRR specified in the agreement, the Performance Fees already paid were refundable to the extent necessary to give investors the specified return, or entirely where that threshold could not be met. This requirement is described as a Performance Fee clawback under the agreement.

6. In an earlier year, Company A received a Performance Fee for completion of a project. Recognising the contingency in the true derivation of the fee, this amount was not included in the accounting income of Company A in that financial year. However in calculating the taxable income of the Head Company the whole amount was included as assessable income for that year.

7. In a later year, the various projects were nearing completion and to facilitate the eventual winding up of the business, a view was taken on whether the overall IRR had been met. Because one of the Projects had been unsuccessful, it appeared that the IRR had not been met and that the Performance Fee would need to be fully repaid. This repayment was made in this later year.

8. Under the Management Agreement the payment of the Performance Fee is defined in regard to each project undertaken by Company A. The provision for a claw back of this Performance Fee enables a refund of any fee where the required internal rate of return is not met at the end of the agreement which is at the winding up of the business.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 59-30

Reasons for decision

Question 1

Does the repayment of the Performance Fee in a later year give rise to an allowable deduction under section 8-1 of the ITAA 1997?

Detailed reasoning

Section 8-1 of the ITAA 1997 provides that you can deduct from your assessable income any loss or outgoing that is incurred in gaining or producing your assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. However, you cannot deduct a loss or outgoing to the extent that it was capital in nature, private or domestic in nature, or incurred in relation to producing exempt or non-assessable non-exempt income.

Income of Company A is earned under the agreement as a result of the receipt of Base Management Fees and Performance Fees from Company B. A Performance Fee is payable to the Company A at the end of each Project undertaken during the course of the agreement. It is calculated on completion of a subject Project and occurs when the timing and amount of the net receipts from that Project can be determined with a high level of certainty.

The amount of the Performance Fees included in the earlier income year was calculated under the agreement by the formula set out in the agreement at the conclusion of a particular Project. The Performance Fees clawback repayment amount arose as a result of another clause in the agreement which concerns the overall performance of the business venture and is calculated on the winding up of the business.

The Performance Fees clawback repayment amount does not specifically relate to any one Project, but is tied to the IRR for all of the Projects undertaken by the Company B.

Taxation Determination TD 93/149 relates to a travel agent that receives commission income from a service provider. It states that if the payment of the commission has matured into a recoverable debt, and the agent is not obliged to take any further steps in accordance with the terms of the contractual arrangements between the travel agent and the service provider before becoming entitled to the commission, this will generally indicate that the commission has been derived.

The situation described in TD 93/149 is analogous to the Performance Fee that is paid by the Company B to Company A. At the end of a Project, Company A is not obliged to take any further steps to be entitled to the Performance Fee for that Project. Accordingly, at that point in time, Company A has derived assessable income from the Performance Fee.

Further, paragraph 6 of TD 93/149 provides an example of where a travel agent is required to repay an amount of commission income:

If the travel agent is required to repay an amount of commission income to a service provider, for example in the case of a cancellation, and the amount of the repayment has been previously included in the assessable income of the travel agent, the amount repaid is considered to be a loss or outgoing incurred in gaining or producing the assessable income of the travel agent or necessarily incurred by the travel agent in carrying on business for that purpose, and therefore deductible under subsection 51(1).

A loss or outgoing that is incurred in a particular year of income is deductible under section 8-1 of the ITAA 1997 even though it relates to the assessable income of an earlier income year (AGC (Advances) Ltd v. Federal Commissioner of Taxation (1975) 132 CLR 175; (1975) 5 ATR 243; 75 ATC 4057 and Placer Pacific Management Pty Ltd v. Federal Commissioner of Taxation (1995) 31 ATR 253; (1995) 95 ATC 4459; and ATO Interpretative Decision ATO ID 2002/1091).

The terms of the agreement indicate that the Performance Fees clawback provision is a right created under the agreement to ensure that the Company B's overall investment has a required rate of return for its investors. The repayment by Company A of Performance Fees directly relates to their provision of services under the agreement.

The clawback amount is limited to the total amount of Performance Fees paid to Company A during the entire period of the agreement. There is no provision in the agreement between Company B and Company A for a claw back payment to be made where there have been no Performance Fees paid. Although not payable until the end of the agreement, the claw back is an outgoing directly related to deriving assessable income and is not considered to be a payment of a capital, private or domestic nature.

The Performance Fee received by Company A under the agreement related to the ending of a particular project in the earlier year. During the later income year various projects were nearing completion and to facilitate the winding up of the business, a calculation was made under the Performance Fee clawback provision and consequently an amount was paid back to Company B as it had not met with the IRR requirements.

Accordingly, the amount of Performance Fees repaid to Company B is deductible under section 81 of the ITAA 1997 for the later income year as it was necessarily incurred in deriving the assessable income of Company A.

Question 2

If the answer to question 1 is no, will the amount of the Performance Fee repaid in the later income year be neither assessable income nor exempt income for the earlier income year under section 59-30 of the ITAA 1997?

Detailed reasoning

Subsection 59-30(1) of ITAA 1997 provides that an amount you receive is not assessable income and is not exempt income for an income year if:

(a) you must repay it; and

(b) you repay it in a later income year; and

(c) you cannot deduct the repayment for any income year.

It does not matter if the amount is part of a larger amount or the obligation to repay existed when you received the amount or it came into existence later (subsection 59-30(2) of the ITAA 1997).

As the Performance Fee clawback amount repaid is an allowable deduction under section 8-1 of the ITAA 1997 in the later income year, section 59-30 of the ITAA 1997 will not apply due to the operation of paragraph 59-30(1)(c) of the ITAA 1997.