Edited version of your private ruling

Authorisation Number: 1012575126160

Ruling

Question 1

Is Company A entitled to a notional deduction under section 355-205 of the Income Tax Assessment Act 1997 (ITAA 1997) for expenditure of a specific amount incurred in the 20YY year of income?

Answer

Yes.

This ruling applies for the following period:

Income tax year ended 30 June 2012.

The scheme commences on:

1 July 2011

Relevant facts and circumstances

Company A has registered R&D activities under section 27A of the Industry Research & Development Act 1986 (IR&DA 1986).

Company A is the owner of exclusive rights to develop and commercialise certain technology. It conducts the development and commercialisation of the technology by engaging skilled information technology specialists capable of developing and commercialising the technology.

To do this Company A has an agreement with Company B to conduct R&D activities on its behalf. The agreement between Company A and Company B is based upon a course of conduct over a number of years and which is partially, but not wholly, documented in a letter dated early July 20XX (Letter A). Letter A states that it is confirming a continuing arrangement and Company B shall invoice Company A annually in arrears the actual costs incurred in relation to development and managerial services. In late June 20YY Company B sent invoice #1 dated end June 20YY for a specific amount. to Company A for R&D activities it had undertaken for Company A during the income year ended 30 June 20YY. These R&D activities were those registered under section 27A of the IR&DA 1986, and were conducted solely within Australia.

In June 20YY a Director of Company A wrote to the Directors of Company B by letter advising that Company A was unable to pay the invoiced amount. The Director requested that an additional loan facility be provided to Company A by Company B so as to enable Company A to meet their obligation and settle the invoice in full.

In June 20YY a Director of Company B wrote to the Director of Company A by letter confirming that Company B would extend additional loan funds sufficient for Company A to settle the outstanding invoice on the same terms and conditions of the existing intercompany loan facility. The Director of Company B requested in the letter:

…that by way of a payment direction that rather than us advance your company the funds so that your company can pay the outstanding invoice, is that your company adjust the balance of the outstanding inter company loan facility as consideration for the settlement of the outstanding invoice #1 in full.

Accordingly the amount recorded in our general ledger as a debtor will be reallocated to the inter company loan facility. We also hereby request your company update your general ledger to reflect the payment in full of the invoice and increase in the intercompany loan facility.

The intercompany loan facility between Company A and Company B has existed since at least 1 July 2004. The balance of the intercompany loan facility has fluctuated over time as repayments have been made. The intercompany loan facility has been formalised in a document dated 30 June 20ZZ (Loan Document). The Loan Document contains clauses related to repayment, interest charges, methods of payment and what is to occur in the event of a default.

On 30 June 20YY the following journal entries were made in relation to invoice #1 dated 30 June 20YY for a specific amount being rendered to Company A by Company B:

Company B

Dr Trade Debtors $

Cr Services Income $

Company A

Dr Services Expense $

Cr Trade Creditors $

On 30 June 20YY the following journal entries were made in relation to the additional loan funds being extended by Company B to Company A for payment in full of invoice #1 dated 30 June 20YY for a specific amount.

Company B

Dr Loan Asset $

Cr Trade Debtors $

Company A

Dr Trade Creditors $

Cr Loan Liability $

Company B is an associate of Company A under section 318 of the Income Tax Assessment Act 1936 (ITAA 1936).

Relevant legislative provisions

ITAA 1936 51(1)

ITAA 1936 318

ITAA 1997 8-1

ITAA 1997 110-25(2)

ITAA 1997 110-55

ITAA 1997 355-205

ITAA 1997 355-205(1)(a)

ITAA 1997 355-205(1)(b)

ITAA 1997 355-210

Reasons for decision

Section 355-205 of the ITAA 1997 relevantly states that:

(1) An R&D entity can deduct for an income year (the present year) expenditure it incurs during that year to the extent that the expenditure:

(a) is incurred on one or more R&D activities:

(i) for which the R&D entity is registered under section 27A of the Industry Research and Development Act 1986 for an income year; and

(ii) that are activities to which section 355-210 (conditions for R&D activities) applies; and

(b) if the expenditure is incurred to the R&D entity's associate -- is paid to that associate during the present year.

The word 'incurred' in section 355-205 of the ITAA 1997 is not defined within the ITAA 1997. The word 'incurred' in section 355-205 of the ITAA 1997 has the same meaning as that ascribed to the word 'incurred' in section 8-1 of the ITAA 1997.

Taxation Ruling TR 97/7 Income Tax: section 8-1 - meaning of 'incurred' - timing of deductions (TR 97/7) sets out in detail the view of the Commissioner of Taxation on whether an outgoing is 'incurred' for the purposes of section 8-1 of the ITAA 1997. TR 97/7 provides that a taxpayer incurs an outgoing at the time that they owe a present money debt that they cannot escape. In incurring an outgoing a taxpayer need not actually have paid any money provided that the taxpayer is definitively committed in the year of income. A loss or outgoing may be incurred even though it remains unpaid provided that the taxpayer is 'completely subjected' to the loss or outgoing. That is, it must be a presently existing liability to pay a pecuniary sum, even though the liability may be defeasible by others and even though the amount of the liability cannot be precisely ascertained, provided it is capable of reasonable estimation. Whether there is a presently existing liability is a legal question in each case, having regard to the circumstances under which the liability is claimed to arise.

The High Court of Australia considered the meaning of 'incurred' in section 51(1) of the ITAA 1936 which was the predecessor to section 8-1 of the ITAA 1997 in a number of decisions, including: Commissioner of Taxation (Cth) v James Flood Pty Ltd (1953) 88 CLR 492, Nilsen Development Laboratories Pty Ltd v Commissioner of Taxation (Cth) (1981) 144 CLR 616 and Coles Myer Finance Ltd v Commissioner of Taxation (1993) 176 CLR 640.

The meaning of 'incurred' in section 8-1 of the ITAA 1997 has been considered in a number of decisions, including: Malouf v Federal Commissioner of Taxation (2009) 174 FCR 581, Commissioner of Taxation (Cth) v CityLink Melbourne Ltd (2006) 228 CLR 1 and Transurban City Link Ltd v Commissioner of Taxation (2004) 135 FCR 356.

The meaning of 'incurred' in the R&D context has been considered in recent times by the Administrative Appeals Tribunal in a number of decisions, including: Outbound Logistics Pty Ltd v Federal Commissioner of Taxation [2012] AATA 899, Hadrian Fraval Nominees Pty Ltd v Federal Commissioner of Taxation [2013] AATA 127, Ozone Manufacturing Pty Ltd v Federal Commissioner of Taxation [2013] AATA 420, Vision Intelligence Pty Ltd and Commissioner of Taxation [2013] AATA 527 and Desalination Technology Pty Ltd v Federal Commissioner of Taxation [2013] AATA 846.

Company A has an agreement with Company B which is based upon a course of conduct over a number of years and which is partially, but not wholly, documented in Letter A. Letter A states that Company B will invoice Company A annually in arrears the actual costs incurred by Company B in relation to development and managerial services.

Company B rendered invoice #1 dated 30 June 20YY for a specific amount on Company A for services it had performed in the year ended 30 June 20YY. The invoice has not been disputed by Company A. There is nothing in the invoice or Letter A which shows any intention that the obligation to pay the specific amount was contingent upon the occurrence of any future event.

The Commissioner considers that Company A incurred expenditure for a specified amount for the purposes of subsection 355-205(1) of the ITAA 1997 when invoice #1 dated 30 June 20YY was rendered by Company A as Company A then had a presently existing liability to pay that amount based upon the performance of the services in question, and the rendering of the invoice in conjunction with the terms of Letter A.

Whether the amount incurred by Company A was incurred on one or more R&D activities for the purposes of paragraph 355-205(1)(a) of the ITAA 1997

In order for expenditure to be incurred on one or more R&D activities for the purposes of paragraph 355-205(1)(a) of the ITAA 1997 it must satisfy the requirements of subparagraph 355-205(1)(a)(i) and subparagraph 355-205(1)(a)(ii) of the ITAA 1997 which are that:

· the expenditure must be incurred on one or more R&D activities for which the entity is registered under section 27A of the IR&DA 1986 (subparagraph 355-205(1)(a)(i) of the ITAA 1997); and

· the expenditure must be incurred on one or more R&D activities which are activities to which section 355-210 of the ITAA 1997 applies (subparagraph 355-205(1)(a)(ii) of the ITAA 1997).

As Company A has registered R&D activities under section 27A of the IR&DA 1986 and invoice #1 dated 30 June 20YY in the amount of $2,000,000 was for the conduct of those R&D activities by Company B the expenditure incurred by Company A was incurred in the 2012 year of income on one or more R&D activities and therefore satisfies the requirements of subparagraph 355-205(1)(a)(i) of the ITAA 1997.

As the R&D activities which gave rise to invoice #1 dated 30 June 2012 in the amount of $2,000,000 were conducted for Company A by Company B solely within Australia the R&D activities are covered by section 355-210 of the ITAA 1997 and therefore satisfy the requirements of paragraph 355-205(1)(b) of the ITAA 1997.

Whether the amount incurred by Company A was expenditure which was incurred to an associate and paid to that associate during the present year for the purposes of paragraph 355-205(1)(b) of the ITAA 1997

The word 'associate' as used in paragraph 355-205(1)(b) of the ITAA 1997 is defined in section 995-1 of the ITAA 1997 as having the same meaning given by section 318 of the ITAA 1936. Company B is an associate of Company A.

The explanatory memorandum to the Tax Laws Amendment (Research and Development) Bill 2010 (EM) provides the following explanation concerning the meaning of 'paid' for the purposes of paragraph 355-205(1)(b) of the ITAA 1997:

Expenditure incurred to an associate

3.77 If the R&D entity incurs an amount of expenditure to an associate and pays the amount in the same year, that amount is deductible in that year (assuming other conditions are satisfied). Payment has its general legal meaning in the income tax law, which includes constructive payment. Therefore, in working out whether an R&D entity has paid an amount to another entity, and when the payment is made, the amount is taken to be paid to the other entity when the R&D entity applies or deals with the amount in any way on the other's behalf, or as the other directs. [Schedule 1, item 1, section 355-205] [Emphasis added]

The meaning of 'paid' therefore takes its general legal meaning which includes constructive payment.

The ordinary meaning of 'paid' was considered by the Federal Court of Australia in ABB Australia Pty Ltd and Another v Federal Commissioner of Taxation (2007) 162 FCR 189 (ABB). In ABB Lindgren J said at page 226 that:

It is said that in order for payment to occur, there must be a monetary obligation, the offer of an act by the debtor in discharge of it, and an acceptance of that offer by the creditor; see Proctor C, Mann on the Legal Aspect of Money (6th ed, Oxford University Press, 2005) at [7.04]; Brindle M and Cox R (eds), The Law of Bank Payments (3rd ed, Sweet & Maxwell, 2004) at [1-002] ff, and cases referred to in those works, including Libyan Arab Foreign Bank v Bankers Trust Company [1989] QB 728 at 764 per Staughton J; Goode RM, Payment Obligations in Commercial and Financial Transactions (London, Sweet & Maxwell, 1983) p 11 ff; and Derham SR, The Law of Set-Off (3rd ed, Oxford University Press, 2003) at [16.01] and fn 2. These conditions are satisfied in the present case. ABB Australia had a monetary obligation to ABB Zurich; these companies were in agreement that that monetary obligation should be discharged by ABB Australia's paying the amount to BAL.

In East Finchley Pty Ltd v Commissioner of Taxation (1989) 90 ALR 457 (East Finchley) an issue to be considered was whether a payment had been made by a set-off arrangement. Hill J observed at page 470 that:

…I can see no reason why the combination of the two letters should not in any event have constituted a sufficient demand for payment to bring about a situation that there was an obligation in equity by force of the trust deed to pay to the beneficiaries and an obligation by virtue of the loan agreement between the trustee and beneficiaries in law to pay by way of loan the moneys to the trustee by the beneficiaries so that the principle in Spargo's case brought about the result that there was in law a payment.

The Loan Document which exists between Company A and Company B formalises an intercompany loan facility which has existed for a long period of time between Company A and Company B.

Company A contends that invoice #1 dated 30 June 20YY for a specific amount was paid through a set-off arrangement when it requested and was to be provided with additional loan funds from Company B under the Loan Document and was directed by Company B to make journal entries adjusting the balance of the outstanding intercompany loan facility as consideration for settlement of the outstanding invoice in full. On the facts available there is nothing to suggest that Company B did not have the capacity to actually lend loan funds to Company A.

The Commissioner has considered the application of the doctrine of set-off in GST Determination 2004/4 (GSTD 2004/4) and Taxation Determination 2005/52 (TD 2005/52).

In GSTD 2004/4 paragraphs 25-28 concern lines of credit and overdrafts, paragraph 27 relevantly provides:

On closer examination there is a set-off in this situation. The supplier agrees that, instead of accepting payment directly from the recipient, the supplier will lend the required amount, or arrange for the required amount to be lent, to the recipient. Rather than go through the formality of then advancing those loan moneys to the recipient only to have the recipient immediately return the amount by way of payment for the supply, the parties simply set off the obligation to advance the loan moneys to the recipient against the recipient's obligation to pay for the supply. In this way the recipient's obligation to pay for the supply under a contract of sale is discharged and replaced with an obligation to repay the money lent (together with any interest that will accrue on the money lent) under the loan contract.

In TD 2005/52 at paragraph 2 the Commissioner stated that '…[a] set-off occurs if there are presently due mutual liabilities of sums certain owing between the same parties which they agree to set-off in equal amounts against each other.' The Commissioner summarised the relevant authorities:

3. The doctrine of set-off was considered in re Harmony and Montague Tin and Copper Mining Company (1873) 8 LR Ch App 407 (known commonly as Spargo's Case) where Mellish LJ said at 414:

Nothing is clearer than that if parties account with each other, and sums are stated to be due on one side, and sums to an equal amount due on the other side on that account, and those accounts are settled by both parties, it is exactly the same thing as if the sums due on both sides had been paid. Indeed, it is a general rule of law, that in every case where a transaction resolves itself into paying money by A. to B., and then handing it back again by B. to A., if the parties meet together and agree to set one demand against the other, they need not go through the form and ceremony of handing the money backwards and forwards.

4. In FC of T v. Steeves Agnew & Co (Vic) Pty Ltd (1951) 82 CLR 408 Dixon J in approving the doctrine of set-off established in Spargo's Case said at 420:

If cross-liabilities in sums certain of equal amounts immediately payable are mutually extinguished by an agreed set-off, that amounts to payment for most common-law and statutory purposes.

5. The doctrine of set-off also includes a set-off of equal amounts where unequal sums are owed by the parties if payment of the residue is effected by other means: FC of T v. Steeves Agnew & Co (Vic) Pty Ltd (1951) 82 CLR 408 per Dixon J at 421.

The Commissioner accepted at paragraph 6 of TD 2005/52 that an amount set-off in respect of the acquisition of an asset would constitute money paid in respect of the acquisition of the asset for the purposes of the first element of the cost base for the purposes of subsection 110-25(2) of the ITAA 1997 and the reduced cost base in section 110-55 of the ITAA 1997.

The Commissioner accepts that in the circumstances of this private ruling there are two presently existing mutual liabilities of sums certain, specifically:

· the liability of Company A to pay invoice #1 dated 30 June 20YY for a specific amount rendered by Company B because of a history of conduct between the parties and the terms of Letter A; and

· the liability of Company B to pay loan funds for a specific amount to Company A under the terms of the Loan Document.

In particular, on the facts to which this private ruling relates there is no basis on which to conclude that both liabilities have not been properly created.

The Commissioner also accepts that the two presently existing mutual liabilities of sums certain have been legitimately set-off by the letters dated 30 June 20YY.

Given the above, the expenditure incurred by Company A to its associate Company B as a result of invoice #1 dated 30 June 20YY, for a specific amount, was paid in the 20YY year of income for the purposes of paragraph 355-205(1)(b) of the ITAA 1997.

Conclusion

Company A is entitled to a notional deduction under section 355-205 of the ITAA 1997 for the expenditure which it incurred and paid to its associate Company B in the 20YY year of income in relation to invoice #1 dated 30 June 20YY.

Note: As mentioned above, this private ruling is based on the facts stated in the description of the scheme ruled on. If the circumstances of a particular arrangement are materially different from these facts, especially in relation to the form and substance of the loan agreement between the parties, a private ruling based on those facts may provide a different result.