Edited version of private advice

Authorisation Number: 1012622611585

Ruling

Subject: Franchise buy back for resale

Questions & Answers:

Will your proposed expenditure on the back buy of one of your franchises, for the purpose of resale in the future, be treated as a revenue expense?

Yes.

2. Will the above mentioned proposed expenditure be deductible in the income year when the franchise is resold (rather than in the income year when the expenditure is incurred)?

Yes.

This ruling applies for the following periods:

Year ending 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

The scheme commences on:

1 July 2013

Relevant facts and circumstances

You are a franchise company that occasionally sells franchises (which you treat as revenue) and derives income regular income from franchise royalties. You propose (under a first right of purchase) to repurchase an existing outlet (as a going concern), improve the business and then resell it at some time in the future. You have not repurchased one of your franchises before.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

A business of franchising is carried on by granting to others the right to use, within a specified territory, the 'intellectual property' that enables use of a brand name and the business format that delivers the franchisee its custom. The nature of the assets utilised are all the 'intellectual property' rights held, maintained and developed to licence for a fee the brand name and associated business format.

There are at least three ways a disposal of assets can be treated for taxation purposes:

1. As a capital gains and losses from the mere realisation of a capital asset under Part 3-1 and Part 3-3 of the ITAA 1997. This includes possible small business relief under Division 152 for a small business entity.

2. On revenue account from carrying on a business of buying and selling trading stock.

3. On revenue account as a result of an 'isolated commercial transaction' entered into by a non-business taxpayer or by a business taxpayer outside the ordinary course of their business (as provided for in Taxation Ruling TR 92/3).

In summary, the term 'mere realisation of a capital asset' has been described as "liquidating or realising the old assets" (Commissioner of Taxes v Melbourne Trust Limited [1914] AC 1001); whereas the term 'business' encompasses trade engaged in on a regular or continuous basis; whereas the term 'isolated (one-off) commercial transaction' does not amount to a business but has the characteristics of a business deal, comprising of the acquisition of a new asset and its development and sale.

Taxation Ruling TR 92/3 is about the character of isolated commercial translations. Paragraph 9 explains if a transaction involves the sale of property, it is usually necessary that the taxpayer has the purpose of profit-making at the time of acquiring the property. Paragraph 49(g) further explains:

…if the property has no use other than as the subject of trade, the conclusion that the property was acquired for the purpose of trade and, therefore, that the transaction was commercial in nature, would be readily drawn.

An example of an isolated commercial transaction is found in Taxation Determination TD 2010/21, which is about profits on sale in relation to a leveraged buyout (LBO). An LBO involves: (i) the acquisition of interests in a target entity; (ii) the holding of those interests for a period during which operational improvements are usually made to improve the earnings and value of the target entity; and (iii) the acquisition of those interests with the intention of resale at a profit and the subsequent realisation of a profit. The example, in paragraph 6 of TD 2010/21, is as follows:

Offshore Co is a Cayman Islands entity. Its equity is primarily owned indirectly by non-Cayman Islands resident investors. Offshore Co acquires an Australian public company in a LBO with the intention of restructuring its activities and re-floating the company on the Australian Securities Exchange within a three year time frame. It will have low or negative returns until the realisation of the investment because of interest costs and management expenses. Offshore Co's profit from this arrangement arises from carrying out a commercial transaction entered into for the purpose of profit-making by sale rather than from a mere realisation of assets. Consequently, the profit constitutes income according to ordinary concepts for the purposes of section 6-5 (see Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income). The characterisation of this gain as constituting ordinary income…

Importantly, for an isolated commercial transaction, outgoings are only deductible on completion of the transaction, which is when the final profit or loss is calculated for income tax purposes (refer to Commercial and General Acceptance Ltd v . FC of T 77 ATC 4375; (1977) 7 ATR 716).

Therefore, similar to the trading stock of a business, the deductions claimable on an isolated commercial transaction will not fully crystallise until the completion of the transaction, i.e., when the asset is sold.

(Note: The trading stock rules are found in Division 70 of the ITAA 1997, where section 70-15 provides, in general, a deduction can be claimed when an item becomes part of the trading stock on hand of a business. However, because section 70-45 requires a business to value each item of trading stock on hand at the end of an income year - which becomes assessable income as closing stock - the deduction claimed does not fully crystallise until the disposal of that item.)

In your case, your proposed repurchase, restructure and resale of a franchise appears to be an isolated commercial transaction since: (i) it is not the kind of transaction you perform on a regular or continuous basis in the carrying on of a business; and (ii) it is not a capital gains tax transaction because you have the intention of resale at the time of purchase (rather than the intention to purchase and carrying a business with the franchise for an undefined period).

Since the proposed transaction would be an isolated commercial transaction, it will fall on revenue account and the cost of the purchase cannot be claimed until your resale of the franchise is completed.