Edited version of your private ruling

Authorisation Number: 1012600555215

Ruling

Subject: Settlement payment

Question 1

Are you, as trustee, entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) in respect of the settlement sum?

Answer

No.

Question 2

Are you, as trustee, entitled to a deduction under section 40-880 of the ITAA 1997 in respect of the settlement sum?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts and circumstances

The Taxpayer carried on a business.

The Taxpayer entered into a joint venture agreement with Entity X and Entity Y to establish a joint venture between Entity X and the Taxpayer.

The Taxpayer entered into a loan agreement where Entity W advanced money to the Taxpayer to finance the Taxpayer's interest in the joint venture. A Deed of Charge was also entered where the Taxpayer granted a charge over its assets in favour of Entity W as security for the loan monies.

The Taxpayer failed to pay or repay any part of the Loan and accrued interest on or before the due date for payment or repayment.

Entity W served notices ('Notices') demanding repayment of all monies owing under the Loan Deed.

Other agreements were entered into between parties related to the Taxpayer, Entity X and Entity Y in relation to the joint venture.

The Taxpayer and related entities (collectively referred to as the 'Taxpayer Parties') wished to exit and cease their involvement in the joint venture and settle all claims existing between themselves on one hand and Entity X, Entity Y and related parties (collectively referred to as the Other Parties) on the other hand. To facilitate this, the Taxpayer Parties and the Other Parties executed a Terms Sheet setting out the terms on which the Taxpayer Parties would cease their involvement in the joint venture and settle all claims existing between the Taxpayer Parties and the Other Parties.

Following the execution of the Terms Sheet, the Taxpayer Parties and the Other Parties entered into a Deed of Settlement and Release ('Settlement Deed') whereby:

(a) the Taxpayer transferred to Entity X all of its legal and beneficial interest in the joint venture in consideration for Entity X settling the principal amount of the Loan with Entity W

(b) the Taxpayer was to pay the Aggregated Settlement Sum' to the Other Parties in consideration for releasing the Taxpayer Parties from any liability or claim:

(i) for any alleged breaches of the joint venture, related agreements, Deed of Charge and Loan Deed

(ii) for any alleged failure of the Taxpayer Parties to comply with the Notices, and

(iii) from the circumstances which gave rise to the Other Parties' rights specified in paragraphs (i) and (ii) above.

A portion of the Aggregated Settlement Sum has been paid to the Other Parties by the Taxpayer who will also pay the remaining amount in the future.

There is no written agreement between the Taxpayer Parties in relation to the payment of the Aggregated Settlement Sum by the Taxpayer. It was always intended that the Taxpayer would be principally responsible for the payment of the Aggregated Settlement Sum and the remaining parties would guarantee the payment.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1
Income Tax Assessment Act 1997 Section 40-880
Income Tax Assessment Act 1997 Subsection 40-880(2)
Income Tax Assessment Act 1997 Subsection 40-880(3)
Income Tax Assessment Act 1997 Subsection 40-880(5)
Income Tax Assessment Act 1997 Section 104-5
Income Tax Assessment Act 1997 Section 108-5

Reasons for decision

Summary

It is considered that the settlement payment is a capital payment made to secure the Taxpayer's release from all future obligations and liabilities relating to the joint venture agreement. As it is a capital payment, no deduction is allowable under section 8-1 of the ITAA 1997.

However, a deduction of 20% of the settlement payment is allowable under section 40-880 of the ITAA 1997 in the 2011-12 financial year, and subsequent four years, in relation to the settlement payment.

Detailed reasoning

Settlement payment as a general deduction

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 or a provision of the taxation legislation excludes it.

In determining if expenditure is allowable, the nature of the expenditure must be considered. The nature or character of the expenditure follows the advantage that is sought or gained by incurring the expenses.

If the advantage sought is a new asset or right or an advantage with an enduring benefit, then the expenses take on the character of capital expenditure.

The courts have established guidelines for distinguishing between capital and revenue outgoings. In Sun Newspapers Ltd and Associated Newspapers Ltd v. FC of T (1936) 61 CLR 337, (1938) 45 ALR 10; (1938) 1 AITR 403; 5 ATD 87, three elements were identified as being relevant:

• the nature of the advantage sought

• the way it is to be used or enjoyed

• the means adopted to get it.

In this case, the Taxpayer (and the other members of the Taxpayer Parties) entered into the Deed of Settlement as they wished to cease their involvement in the joint venture and to settle all debts between themselves and the Other Parties.

All monies owing and liabilities under the Loan Deed were extinguished by transferring the Taxpayer's interest in the joint venture.

The Settlement Sum was paid to the Other parties as consideration for being released from all claims and liabilities in relation to the various agreements entered into between the Other parties and the Taxpayer Parties.

The advantage obtained from the payment of the settlement sum was the release from the joint venture. This is a capital advantage as the parties did not have any further involvement or liability in relation to the joint venture. It protects the Taxpayer's business structure and operations as they have the freedom to conduct their business without regard to future liabilities under the joint venture.

As being released from all existing and future joint venture related liabilities is capital in nature, the settlement sum is also capital in nature. Therefore, no deduction is allowable under section 8-1 of the ITAA 1997 for the settlement sum.

Settlement payment as a deduction under section 40-880 of the ITAA 1997

Subsection 40-880(2) of the ITAA 1997 provides that you can deduct, in equal proportions over a period of five income years, starting in the year in which you incur it, capital expenditure you incur:

(a) in relation to your business, or

(b) in relation to a business that used to be carried on, or

(c) in relation to a business proposed to be carried on, or

(d) to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business.

This deduction is subject to the limitations and exceptions contained in subsections 40-880(3) to (9) of the ITAA 1997.

On the facts of this case there is no issue of capital expenditure the Taxpayer incurred being incurred in relation to a business that used to be carried on or a business proposed to be carried on. Further, there is no issue of paragraph 40-880(2)(d) applying to the facts. Accordingly, this Ruling considers whether paragraph 40-880(2)(a) is satisfied.

Capital expenditure in relation to your business

In considering the phrase 'in relation to' contained within subsection 40-880(2) of the ITAA 1997, paragraph 2.25 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 ('the EM') states:

The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business. The concept used to establish this character or requisite relationship between the expenditure incurred by the taxpayer and the business carried on (current, past or prospective) is 'in relation to'. The connector 'in relation to' allows the appropriate latitude to enable the deductibility of qualifying expenditure incurred before the business commences or after it has ceased.

The phrase 'in relation to' was considered by the High Court in PMT Partners Pty Ltd (In Liquidation) v. Australian National Parks & Wildlife Service (1995) 184 CLR 301. Brennan CJ, Gaudron and McHugh JJ observed, in considering the application of the Commercial Arbitration Act 1985 (NT), at 313:

Inevitably, the closeness of the relation required by the expression "in or in relation to" in s 48 of the Act - indeed, in any instrument - must be ascertained by reference to the nature and purpose of the provision in question and the context in which it appears.

In that case, Toohey and Gummow JJ also observed, at 331:

It is apparent that the words "in or in relation to" are particularly wide. … Cases concerning the interpretation of this phrase in other statutory contexts are of limited assistance. However, the cases do show the words are prima facie broad and designed to catch things which have sufficient nexus to the subject. The question of sufficiency of nexus is, of course, dependent on the statutory context. …

The connection with is required by the phrase "in relation to" is a question of degree. There must be some "associations" which is "relevant" or "appropriate". The question of relevance or appropriateness of the connection is a question which cannot be divorced from the particular statutory context.

In First Provincial Building Society Limited v. FC of T 95 ATC 4145; 30 ATR 207, Hill J. considered the phrase 'in relation to' within the contexts of paragraph 26(g) of the Income Tax Assessment Act 1936. He considered the words 'in relation to' in that context included a relationship that may either be direct or indirect, provided that the relationship consisted of a real connection, but that a merely remote relationship is insufficient (at ATC 4155; ATR 218).

It is therefore necessary to consider the legislative context of subsection 40-880(2) of the ITAA 1997 in order to determine whether there is a sufficient and relevant connection between the expenditure incurred and the taxpayer's business. In discussing the types of business capital expenditure to which subsection 40-880(2) of the ITAA 1997 applies, the EM states:

2.19 Expenditure on the structure by which an entity carries on (or used to or proposes to carry on) their business and on the profit yielding structure of the business would ordinarily be expected to be of a capital nature. Capital expenditure can also relate to a business's trading operations or the entity that will carry on the business.

2.20 The structure covers the legal entity (such as a company) or the legal relationship (such as a partnership or trust) that is the entity that carries on the business for a taxable purpose and that holds the business assets.

These paragraphs indicate that capital expenditure incurred on the structure by which an entity carries on (or used to or proposes to carry on) their business, on the profit yielding structure of the business, or relating to the business's trading operations, are capable of being described as capital expenditure incurred in relation to that business for the purposes of subsection 40-880(2) of the ITAA 1997. Whether such capital expenditure is incurred in relation to the particular business will depend on whether there is a sufficient and relevant connection between the incurring of the expenditure and that business on the facts of the particular case.

In this case, there is a sufficient and relevant connection between the Taxpayers' incurrence of the capital expenditure on the settlement payment and the business the Taxpayer carries on. Accordingly, the expenditure the Taxpayer incurred on the settlement payment is capital expenditure the Taxpayer incurred in relation to its business for the purposes of paragraph
40-880(2)(a) of the ITAA 1997.

Subsections 40-880(3) to (9) of the ITAA 1997 set out limitations and exclusions to deductibility under section 40-880 of the ITAA 1997. As the Taxpayer's business is carried on wholly for a taxable purpose subsection 40-880(3) of the ITAA 1997 does not apply to limit the amount the Taxpayer can deduct under section 40-880 of the ITAA 1997 for this expenditure. On the facts of this case, only paragraphs 40-880(5)(b) and (f) of the ITAA 1997 need to considered.

Paragraph 40-880(5)(b) of the ITAA 1997 provides that you cannot deduct anything under section 40-880 of the ITAA 1997 for an amount of expenditure you incur to the extent that you can deduct an amount for it under a provision of 'this Act' other than section 40-880 of the ITAA 1997. In this case it is necessary to consider section 8-1 of the ITAA 1997.

As discussed above, the expenditure incurred by the Taxpayer is capital expenditure and is not deductible under section 8-1 of the ITAA 1997. Therefore, paragraph 40-880(5)(b) of the ITAA 1997 will not apply to deny a deduction under section 40-880 of the ITAA 1997.

Paragraph 40-880(5)(f) of the ITAA 1997 provides that you cannot deduct anything under section 40-880 of the ITAA 1997 for an amount of expenditure you incur to the extent that it could, apart from this section, be taken into account in working out the amount of a capital gain or loss from a capital gains tax (CGT) event.

Capital proceeds and cost base or reduced cost base are taken into account in working out a capital gain or loss from a CGT event. Section 104-5 of the ITAA 1997 lists the CGT events.

Section 108-5 of the ITAA 1997 defines a CGT asset as any kind of property, or a legal or equitable right that is not property. Examples of CGT assets include: land and buildings, shares in a company and units in a unit trust, options, debts owed to the taxpayer, a right to enforce a contractual obligation, foreign currency, securities, industrial plant and equipment, any kind of chose in action whether legal or equitable, easements, profits prendre, rent charges, reversions, life interest, and interests in remainder.

In this case, the settlement payment does not form part of the capital proceeds and/or the cost base or reduced cost base of a CGT asset. Therefore, paragraph 40-880(5)(f) of the ITAA 1997 does not apply to reduce the Taxpayer's deduction under section 40-880 of the ITAA 1997.

Accordingly, the Taxpayer can deduct its capital expenditure on the settlement payment over five years under section 40-880 of the ITAA 1997. The Taxpayer can deduct 20% of the capital expenditure in the income year it incurred the expenditure and in each of the following four years.

Amount incurred in the 2011-12 financial year

Under the Settlement Deed the Taxpayer is required to pay an Aggregated Settlement Sum over a number of financial years.

As the full amount was not paid in a single financial year, it needs to be determined how much of the payment has been 'incurred' for section 40-880 of the ITAA 1997 purposes.

The term 'incurred' is not defined within the income tax legislation. Taxation Ruling TR 97/7 sets out the Commissioner's view on the meaning of 'incurred' for the purposes of section 8-1 of the ITAA 1997 in determining the timing of deductions for taxpayers returning income on a receipts basis. Although TR 97/7 specifically discusses section 8-1 of the ITAA 1997, the principles it contains can also be applied to section 40-880 of the ITAA 1997. The ruling provides that:

• a loss or outgoing may be incurred even though a payment has not been made

• the liability must be 'more than impending, threatened or expected' and not contingent

• a taxpayer can be completely subjected to a liability even though it is defeasible by others as long as the taxpayer is definitely committed to the outgoing, and

• it is necessary to determine the year of income to which the loss or outgoing is properly referable, at lease in relation to cases involving financing transactions and liabilities which accrue either daily or periodically.

In this case, the Taxpayer's liability under the Settlement Deed is more than impending, threatened or expected and is not contingent upon another event occurring. The liability is defined and known with certainty.

It is accepted that the Taxpayer incurred a liability in the 2011-12 financial year even though the full amount was not paid to the Other Parties during that year.

Thus, section 40-880 of the ITAA 1997 allows the Taxpayer to claim a deduction equal to 20% of the Aggregated Settlement Sum in the 2011-12 financial year, and subsequent four years, in relation to the settlement payment.