Edited version of your private ruling

Authorisation Number: 1012575298530

Ruling

Subject: Deductibility of incentives

Question 1

Are cash incentive payments and expenditure on property incentives incurred by the taxpayer deductible pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Are the cash incentive payments and expenditure on property incentives deductible in full in the year in which the expenditure is incurred?

Answer

Yes

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

Year ended 30 June 2015

Year ended 30 June 2016

The scheme commences on:

1 January 2011

Relevant facts and circumstances

1) The taxpayer conducts a venue management business in which it provides services to clubs and hotels to assist them in operating their venues. In return for the services provided the taxpayer charges a fee.

2) In order to provide security to the taxpayer, it ordinarily seeks to lock clients into long term service contracts, normally in the order of 10 years (venue management contracts).

3) In consideration of this, the taxpayer will often agree to provide incentives to its clients (arms length parties) to induce them to enter into the venue management contracts.

4) The taxpayer provides cash incentives either by making cash payments to the client (not a reduction in the fee payable under the arrangement) or cash payments to third parties on behalf of the client, for example for capital works (collectively the Cash Incentives). The Cash Incentives are not loaned to the client and are not required to be paid back to the taxpayer. The Cash Incentives may become payable during the term of the venue management contract upon the client incurring relevant expenditure (e.g. carrying out capital works) and invoicing the taxpayer.

5) The taxpayer also provides actual goods or services including fit outs (e.g. painting, carpeting, room design, renovations) and marketing and branding services including logo design, signage design, and marketing plans (collectively the Property Incentives). Title to the Property Incentives passes to the client and is not retained by the taxpayer.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for Decision

Note: Footnote references are displayed at end of document.

Question 1

Summary

The Cash Incentives and expenditure on Property Incentives are deductible as they are outgoings incurred in gaining or producing the taxpayer's assessable income and they are not excluded from being deductible pursuant to subsection 8-1(2) of the ITAA 1997.

Detailed Reasoning

1. Subsection 8-1(1) of the ITAA 1997 allows a deduction for any loss or outgoing to the extent that:

a. it is incurred in gaining or producing assessable income; or

b. it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

2. However, subsection 8-1(2) of the ITAA 1997 provides that a loss or outgoing is not deductible to the extent that:

c. it is capital or of a capital nature;

d. it is of a private or domestic nature;

e. it is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income; or

f. a provision of the ITAA 1997 or Income Tax Assessment Act 1936 (ITAA 1936) prevents its deduction.

Positive limbs

3. For the relevant expenses to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of your assessable income. The words "incurred in gaining or producing the assessable income" mean in the course of gaining or producing such income. The occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if no assessable income is produced, what would have been expected to produce assessable income: Ronpibon Tin NL v FC of T (1949) 78 CLR 47.

Application to the taxpayer's circumstances

4. When the taxpayer provides cash or expends money to provide the Property Incentives to venue operators, there is an outgoing. The incentives are provided to the venue operators as inducements to enter into a contract for the provision of venue management services so that the taxpayer may enjoy the receipt of revenue in the form of fees in respect of the provision of those services. The occasion for the outgoing is incidental or relevant to the production of assessable income.

5. It is noted that on certain occasions the taxpayer may provide services at no charge and in such cases no loss or outgoing arises in respect of revenue forgone.

Negative Limbs

6. The payment of Cash Incentives or expenditure on Property Incentives is not of a private or domestic nature or incurred in relation to gaining or producing exempt income or non-assessable non-exempt income.

First negative limb - Capital v revenue expenditure

7. The guidelines for distinguishing between capital and revenue outgoings were laid down in Sun Newspapers Ltd and Associated Newspapers Ltd v. FC of T (1938) 5 ATD 87; (1938) 61 CLR 337 (Sun Newspapers). In that case, Dixon J stated that the distinction between expenditure 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". After discussing this distinction and the difficulties inherent in applying the distinction in a practical sense, his Honour said:

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.

8. In GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124; 90 ATC 4413; (1990) 21 ATR 1 the High Court pointed out that the character of expenditure is ordinarily determined by reference to the nature of the asset acquired and that the character of the advantage sought by the making of the expenditure is the chief, if not critical, factor in determining the character of what is paid.

9. In Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634 Dixon J stated:

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.

10. In BP Australia v Federal Commissioner of Taxation (1965)112 CLR 386; (1965) 9 AITR 615 (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 tie but the orders that would flow from it and that the payment of the sums became part of the regular conduct of the business. The Privy Council noted at page 399 that:

"To find whether expenditure is of a recurrent nature one must take a broad view of the general operation under which the expenditure was incurred. Here it was made to meet a continuous demand in the trade. Prima facie matters connected with the ever recurring question of marketing and customers, though not themselves recurrent in an identical form share the same quality of recurrence possessed by matters "connected with the ever-recurring question of personnel ".

11. The decision of the Privy Council overturned the decision of the High Court in BP Australia Ltd v Federal Commissioner of Taxation (1964) 110 CLR 387 where, in their dissenting judgments:

Kitto J stated:

But a promise by a service station operator not to deal with oil companies other than the appellant or its allies was only the negative side of the substantial positive advantage which it was the purpose and practical effect of the agreement to produce, namely the advantage of a practical certainty that the whole of the custom of the service station, for motor spirit, would be given to the appellant or its allies for the agreed period; and what the appellant really paid its money for was that positive advantage. The purpose was not to create a situation in which to set about selling motor spirit; it was to secure the particular sales which would be necessary for the satisfaction of the service station's requirements of the period. The payment of the money was analogous to expenditure in sending a commercial traveller on his rounds to secure orders; it was part and parcel of the business of effecting sales. [at pg 413]

…What matters is that the change in the organization of the wholesale trade in motor spirit from the old system of multiple pump service stations to the new "solo" system meant inevitably that every oil company, if it wanted to sell motor spirit to service stations in the future, had to accept the necessity of spending money, not at the beginning once and for all, but at the beginning and from time to time, to ensure that it would receive from as many service stations as possible the whole of their orders for limited periods. [at p415]

… In the view I take of the case, the advantage was not the acquisition of a new market, not a new framework within which to carry on trade for the future, not an extension of the appellant's selling organization to include a regiment of resellers. It was not such an exclusion of competition as adds to goodwill a negative right and thus increases the value of goodwill. It consisted simply of the practical assurance of receiving bundles of orders for motor spirit, the circumstances being such that for the foreseeable future it would be only by getting similar bundles of orders that such a trade as the appellant's could be carried on. [at pg 416]

Dixon CJ stated:

I do not think it was acquiring a capital asset or doing any more than so conducting its business on revenue account as to increase it and make as certain as it could that its business was continuing and also would continue, if possible, to expand. For my part I cannot think that all the course adopted changed the character of the transactions of the company from those of a continual attempt to establish its product in a consumers' market and to meet all the obstacles which arose in a long and rather troubled period to obtaining a reputation for its product. There appears to me to be no specific expenditure in increasing its plant, machinery or any other element in the profit-earning instrument under its control. I do not see any sufficient ground of a distinct or specific nature for saying that the expenditure was of a capital nature. [at p410]

12. In National Australia Bank v. Federal Commissioner of Taxation (1997) 80 FCR 352; 97 ATC 5153; (1997) 37 ATR 378 (National Australia Bank), the bank purchased from the Commonwealth government the exclusive right to provide Commonwealth subsidised loans to Australian Defence Force personnel for a period of 15 years for $42 million dollars and annual amounts thereafter if the scheme was successful. The Full Federal Court held that the case was not unlike the case of BP Australia and considered that the payment was made "in order to secure the practical certainty that most of those ADF personnel who qualified for a subsidy and wanted a home loan would become customers of the Bank'. The payment was made for the purpose of attracting an additional class of borrower to whom the bank could sell its product. By granting loans to the ADF personnel the bank also expected to gain revenue from other products provided to the home loan customers. The Full Federal Court found that the payment was made as part of a marketing strategy implemented in the course of conducting the bank's business of selling home loans and other products which generated its interest income.

13. In Tyco Australia Pty Ltd v FC of T 2007 ATC 4799 (Tyco) the taxpayer (an electronic security monitoring company) in the relevant income years, derived income in the form of fees paid by home owners and small businesses for security monitoring services. The taxpayer engaged contractors (Authorised Dealers under a programme established by the taxpayer) to secure customers and to enter into alarm monitoring contracts directly with those customers. The taxpayer then paid the Authorised Dealers a lump sum 'assignment fee' for the novation of each contract. The assignment fee changed over the relevant periods. Under the first two versions of the contract the fee was based on a multiple of the monthly fee payable by the customer and under the third version it was a flat fee. Under the first two versions, the assignment fee represented most, if not all, of the total of the fees payable under the life of the contract. It was noted that the contract would only be profitable to Tyco Australia Pty Ltd if the customers would continue with the contracts after the initial term expired.

14. The issue in Tyco was whether the payments made by the taxpayer to the authorised dealers were of a capital nature and therefore not deductible under section 8-1 of the ITAA 1997. Allsop J held that the payments were on revenue account and therefore deductible under section 8-1 of the ITAA 1997.

15. After referring to BP Australia and the Privy Council's approval of the above quoted passages of Dixon CJ and Kitto J in their dissenting judgments in the High Court, Allsop J stated:

As these passages reveal, the regular payment of sums to secure customers, to add incrementally to a customer base and thus to expand a business and to obtain revenue from such customers is easily able to be seen to be on revenue account.

16. Although the rights under the contracts could be seen to be assets purchased by the taxpayer, and the amount paid for each contract represented almost the whole of the contracted revenue stream, his Honour held that this did not make the matter an affair of capital. It was held that the advantage sought by each payment was the winning of a customer to be retained for future revenue for services to be provided. Each payment was made to secure an incremental accretion to the customer base of the taxpayer and the expenditure was incurred in the ordinary business activity of winning customers.¹

17. Allsop J at paragraph 78 described the case as:

an illustration, perhaps, of the fineness of the judgment that needs to be made (the "basal difficulty" as Dixon J called it in Sun Newspapers 61 CLR at 360) in characterising the method used to increase the extent, condition or efficiency of the profit-yielding subject when that can be seen to be effected by the course of operations. This is especially so in a business whose structure and value is based on the attachment and goodwill of customers for the provision of services or the supply of goods.

18. Further, Allsop J stated at paragraph 81:

This was not the purchasing or creation of a business structure. It was, to paraphrase and elaborate upon the words of Dixon J in Sun Newspapers 61 CLR at 360, the building of the extent of the profit-yielding subject (being the customer base of TAPL) as the product of the course of operations, by the incremental winning of customers by the chosen method of organising and remunerating an independent, but controlled, sales force.

19. Allsop J also held that the accounting treatment (the booking of the payments as assets to be amortised against the profit and loss account) could not be determinative of the issue and, in the circumstances of the case, it was of little assistance in characterising the payments as capital or revenue.²

20. In Taxation Ruling No. IT 2631 Income Tax: Lease Incentives paragraph 38 provides:

The provision of lease incentives will usually give rise to an allowable deduction to the lessor under section 51(1). This would follow from the characterisation of the outgoing as having been incurred for the purpose of gaining or producing assessable income. However, that conclusion may not be appropriate where the true purpose of providing the incentive was not to induce the entering into of the lease, and it might therefore be appropriate to apply Part IVA. Examples might include the purposes of benefiting an associate or shifting income to an associate with carry forward losses. Such cases will depend on their facts including the degree of association between the parties, their relative financial positions and whether the incentive can be characterised as being at arm's length. The general conclusion expressed above would not be appropriate if the landlord retained ownership of the fit-out (refer to paragraph 26). In that case the expenditure is capital in nature and therefore not an allowable deduction under subsection 51(1). Depreciation would be allowable in respect of plant or articles.

Application to the taxpayer's circumstances

21. From a practical and business point of view, the advantage sought by the payment of the Cash Incentives and expenditure on the Property Incentives is the incremental addition to the customer base of the taxpayer and the earning of revenue from the customer relationship.

22. The circumstances are similar to the cases of BP Australia, National Australia Bank and Tyco. Following the approach of Allsop J (paraphrasing the words of Dixon J In Sun Newspapers), in making the payments the taxpayer is building the extent of the profit-yielding subject (being its customer base) as the product of the course of operations, by the incremental winning of customers by the chosen method of providing cash and property incentives and earning revenue from the customer relationship over the length of the contracts and perhaps into the future. There are also similarities with lease incentives which are generally treated as being deductible (paragraph 38 of IT 2631).

23. Although a lump sum cash incentive or expenditure on fitting out in a venue may be provided at the beginning of a particular customer relationship it cannot be said that the expenditure is not regular or recurrent. As held by the Privy Council in BP Australia, to find whether expenditure is recurrent one needs to take a "broad view of the general operation under which the expenditure was incurred" and "Prima facie matters connected with the ever recurring question of marketing and customers, though not themselves recurrent in an identical form, share the same quality of recurrence possessed by matters "connected with the ever-recurring question of personnel ".

24. The taxpayer provides cash and property incentives per its negotiations with prospective clients. These may be provided for a number of customers and at various times during the customer relationship. As and when venue management contracts expire the question will arise as to how the taxpayer will retain its customers. The provision of the incentives is expenditure of a recurrent nature. As in BP Australia, the length of the agreements itself does not indicate either a capital or revenue expenditure.

Fourth Negative Limb - a provision of the Act denies deduction

25. Subdivision H of Division 3 of Part III of the ITAA 1936 modifies the operation of section 8-1 of the ITAA 1997 (the general deductions provision) in relation to the timing of deductions for certain expenditure incurred in advance.

26. Generally, a prepaid expense is deductible over the eligible service period (a maximum period of 10 years) rather than being immediately deductible. However, is come cases a prepaid expense may be immediately deductible.

27. For the operation of section 8-1 of the ITAA 1997 to be modified, inter alia, the expenditure in question must be incurred under an agreement and in return for the doing of a thing under the agreement that is not to be wholly done within the expenditure year.³

Application to your circumstances

28. The payment of Cash Incentives or expenditure in respect of Property Incentives under a venue management contract is incurred under an agreement but it is not in return for the doing of a thing under the agreement that is not wholly done within the expenditure year. The taxpayer agrees to provide the Cash Incentives and Property Incentives to induce the client to enter into the contract so that it can earn the fees for the contracted term. The incentives are not provided in return for the doing of any further things under the agreement by the client after the time that the outgoing is incurred.

Question 2

Summary

The Cash Incentives and expenditure on Property Incentives is deductible in full in the year in which the expenditure is incurred. There is no apportionment required to pro-rate the costs over the life of the venue management contract.

Detailed Reasoning

29. To qualify for deduction under section 8-1 of the ITAA 1997, a loss or outgoing must have been incurred. In working out your taxable income for the income year you add up all your assessable income and deductions for the income year and subtract the later from the former.

30. Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of "incurred" - timing of deductions sets out the view of the Australian Taxation Office on whether the word incurred has the same meaning for taxpayers who return income on a receipts and those who do so on an accruals basis.

31. TR 97/7 explains that in some cases a loss or outgoing although incurred also needs to be properly referrable to the year of income in which the deduction is sought: Coles Myer Finance Pty Ltd v FC of T 93 ATC 4214 (Coles Myer Finance).

32. The joint judgment of the High Court in Coles Myer Finance stated (93 ATC at 4222):

'The relevance of the present existence of a legal liability on the part of the taxpayer to meet the bills and notes at a future date is that it establishes that the taxpayer has "incurred" in the year of income an obligation to pay an amount which gives rise to a net loss or outgoing, being the recurrent cost of acquiring working or circulating capital. But there remains the question: how much of that net loss or outgoing is referable to the year of income'.

33. At paragraph 15 of TR 97/7 it is recognised that the question of timing will often not arise when a liability is incurred and discharged in the same income year. However a concern may arise where taxpayers have undischarged liabilities at year end.

34. Taxation Ruling TR 94/26 Income tax: subsection 51(1) - meaning of incurred - implications of the High Court decision in Coles Myer Finance, explains that there are certain cases where the following three criteria must be satisfied: (a) there is a presently existing liability; (b) the loss or outgoing is of a revenue character; and (c) all or part of the loss or outgoing is properly referrable to the particular year in question⁴. TR 94/6 gives the following examples of transactions that will require a determination of the year of income to which the loss or outgoing is properly referrable⁵:

· financing transactions,

· transactions where a liability is accruing daily or periodically, and

· claims of an insurer not yet notified or notified but not paid.⁶

35. TR 94/26 clarifies that Coles Myer Finance does not introduce into the law any principle of specifically matching expenses to income derived in a particular year.⁷

36. Taxation Ruling TR 94/25 Income tax: implications of the decision in Coles Myer Finance Ltd v. FC of T for the timing of deductions for prepaid expenses also explains that Coles Myer Finance did not alter the position for prepayments which were considered fully deductible in the year that they were paid. In that ruling it is recognised that the Court in Coles Myer Finance was concerned with the situation where the legal liability to pay is incurred in a particular year but the amount is not payable until a subsequent year of income.⁸

Application to your circumstances

37. The payment of the Cash Incentives and expenditure on Property Incentives will be deductible in full in the year that they are incurred. There is no timing difference between incurring the liability and its deductibility. No apportionment is required to pro-rate the costs over the life of the venue management contract.

¹ Tyco Australia Pty Ltd v FC of T 2007 ATC 4799 at paragraph 75 - 79

² Ibid at paragraph 82

³ In the taxpayer's circumstances (carrying on a business and not being a small business taxpayer) the relevant provision is subsection 82KZMA(3) of the ITAA 1936

⁴ Taxation Ruling TR 94/26 Income tax: subsection 51(1) - meaning of incurred - implications of the High Court decision in Coles Myer Finance Paragraph 7

⁵ Paragraph 8 of TR 94/26

⁶ TR 94/26 refers to the case of Australian and New Zealand Banking Group Limited v Federal Commissioner of Taxation 94 ATC 4026

⁷ TR 94/26 Paragraph 16 and paragraphs 35 - 42

⁸ TR 94/25 Paragraph 10