Edited version of private advice

Authorisation Number: 1012623563219

Ruling

Subject: franchise costs

Question 1

Is the amount paid to the franchisor to be included in the cost base and not deducible under section 8-1, section 40-880 or Division 40 of the Income Tax Assessment Act 1997?

Answer

Yes

Question 2

Is the amount paid to the franchisor for an initial training course to be included in the cost base and not deducible under section 8-1, section 40-880 or Division 40 of the Income Tax Assessment Act 1997?

Answer

Yes

This ruling applies for the following periods

Year ending 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

Year ending 30 June 2017

The scheme commenced on

1 July 2013

Relevant facts

The entity paid various amounts to the franchisor.

An associated individual also completed a training package before being accepted by the franchisor to purchase the franchise, then after he sought taxation and legal advice, the entity was raised.

Only then did the entity enter into the franchise agreement with the franchisor.

The entity obtained an ABN and was registered for GST.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Section 40-880

Income Tax Assessment Act 1997 Division 108

Income Tax Assessment Act 1997 Section 110-25

Reasons for decision

Question 1

Revenue or Capital

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows you to claim a deduction for a loss or outgoing that is incurred in gaining or producing your assessable income, or necessarily incurred in carrying on a business to gain or produce assessable income. These deductions are limited by the exclusion of losses or outgoings that are capital, private or domestic in nature.

Generally, the costs connected with an acquisition, establishment, enlargement of a business or the acquisitions of fix capital assets are not deductible. The costs of acquiring a business would not be considered as a cost of carrying on a business for the purpose of gaining assessable income, unless it is an operating expense.

In John Fairfax & Sons Pty Ltd v Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 7 AITR 346; (1959) 11 ATD 510 it was noted that:

To make a payment to acquire or to defend the acquisition of a favourable position from which to earn income or to enter into arrangements that will yield income is not in general an outlay incurred either in gaining or in carrying on business for the purpose of gaining assessable income, such a payment in the case of a trading company occurs at a stage too remote from the receipt of income to be so regarded. To be deductible an outlay must be part of the cost of trading operations to produce income, i.e., it must have the character of a working expense.

The decision in Associated Newspapers Ltd and Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87 provides guidelines for distinguishing between capital and revenue expenditure. This case considered the issue of whether expenditure in establishing, replacing and enlarging the profit-yielding structure itself was capital. The test laid down in this case involved three elements:

• the nature of the advantage sought

• the way it is to be used or enjoyed

• the means adopted to get it.

In regard to the first two elements, the courts have held that, in the absence of special circumstances, expenditure is capital in nature where it is made with the view to bringing into existence an asset or an advantage for the enduring benefit of the trade or business.

This principle was followed in United Energy Limited v. Federal Commissioner of Taxation (1997) 78 FCR 169; 97 ATC 4796; (1997) 37 ATR 1, where the Full Federal Court held that franchise fees charged by the Victorian government in respect of electricity distribution companies, were not deductible. The Court said that the essential character of the advantage gained by the franchise fee was immunity from competition for a specified period from other distribution companies for customers in the licence area. The immunity was of enduring benefit to the taxpayer and the fee was therefore of a capital nature.

The third element involves consideration of the way the outlay is made, that is, is it a periodical payment covering the use of the asset or advantage, or a single and final payment made for the future enjoyment of the asset.

In Labrilda Pty Ltd v. Deputy Federal Commissioner of Taxation (1996) 65 FCR 119; (1996) 96 ATC 4303; (1996) 32 ATR 206, the taxpayer paid an up-front accreditation fee for participation in the Team Pak Program conducted by the principal, Mobil Oil. Under that program Mobil granted the right to the taxpayer to carry on its service station business using the 'Mobil System'. The specific program was designed to provide its participants with necessary training, marketing advice, advertising, promotion and other such assistance in setting up the business.

The majority in that case concluded that the taxpayer's expenses in relation to the above were of capital nature and not deductible as outgoings incurred in carrying on of the business. The expenses were more concerned with the business structure and characterised as expenditure which established the profit-yielding subject of the taxpayer's business.

In this case the various payments are not regarded as operating or working expenses of the business. The essential character of the advantage gained by the entity was the right to operate using the franchisor's trade mark and systems. These are of enduring benefit to the entity and therefore the expenses are considered capital in nature and are not deductible under section 8-1 of the ITAA 1997.

Cost Base

Section 110-25 of the ITAA 1997 discusses general rules about the cost base.

Subsection 110-25(1) of the ITAA 1997 states the cost base of a CGT asset consists of 5 elements.

Subsection 110-25(2) of the ITAA 1997 states the first element is the total of:

(a) the money you paid, or are required to pay, in respect of acquiring it

(b) the market value of any property you gave, or are required to give, in respect of acquiring it (worked out at the time of acquisition).

In your case the various fees are capital in nature. They are considered to be included in the first element of the cost base as the money paid in respect of acquiring the right to operate the franchise. The entity can include the full amount paid in the cost base.

Section 40-880 Business related costs

The object of this section is to make certain business capital expenditure deductible over 5 years if:

(a) the expenditure is not otherwise taken into account

(b) a deduction is not denied by some other provision

(c) the business is, was or is proposed to be carried on for a taxable purpose.

There are however some limitations and exceptions to the deductibility of these costs.

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

In your case the various fees form part of the cost base therefore they will be taken into account when working out an amount of a capital gain or capital loss from a CGT event therefore the various fees cannot be deducted under section 40-880 of the ITAA 1997.

Depreciating assets

Division 40 of the ITAA 1997 discusses rules about deductibility of capital expenditure.

Subsection 40-30(1) of the ITAA 1997 states a depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used except:

(a) land

(b) an item of trading stock

(c) an intangible asset, unless it is mentioned in subsection (2).

Subsection 40-30(2) of the ITAA 1997 states the following are intangible assets if they are not trading stock:

(a) mining, quarrying or prospecting rights

(b) mining, quarrying or prospecting information

(c) items of intellectual property

(d) in-house software

(e) IRUs;

(f) Spectrum licences

(g) Data transmitter licences

(h) Telecommunications site access rights.

Division 108 of the ITAA 1997 covers CGT assets.

Subsection 108-5(1) of the ITAA 1997 states a CGT asset is:

(a) any kind of property

(b) a legal or equitable right that is not property

In your case the various expenses you have incurred are considered part of an intangible asset and are not expected to decline in value over time therefore the expenses are capital assets and not depreciating assets which would be covered under Division 40 of the ITAA 1997.

Conclusion

The various payments are not regarded as operating or working expenses of the business. They are considered capital in nature and therefore not deductible under section 8-1 of the ITAA 1997.

The various fees are considered a first element of the cost base and are therefore not deductible under section 40-880 of the ITAA 1997.

The entity purchased the right to establish a franchise. This right is considered an intangible asset and is not expected to decline in value over time and is also considered an intangible asset and forms part of the structure of the business therefore all expenses are capital assets and not depreciating assets which would be covered under Division 40 of the ITAA 1997.

Question 2

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.

Taxation Ruling TR 98/9 discusses the circumstances under which self-education expenses are allowable as a deduction. Self-education expenses are deductible where they have a relevant connection to the taxpayer's current income earning activities.

TR 98/9 provides that a deduction is allowable for self-education expenses if a taxpayer's current income-earning activities are based on the exercise of a skill or some specific knowledge and the subject of the self-education enables the taxpayer to maintain or improve that skill or knowledge (Federal Commissioner of Taxation v. Finn (1961) 106 CLR 60, (1961) 12 ATD 348).

Similarly, if the study of a subject of self-education objectively leads to, or is likely to lead to an increase in a taxpayer's income from his or her current income earning activities in the future, a deduction is allowable.

However, no deduction is allowable for self-education expenses if the study is designed to enable a taxpayer to open up a new income-earning activity, whether in business or in the taxpayer's current employment. Such expenses of self-education are incurred at a point too soon to be regarded as incurred in gaining or producing assessable income (see Federal Commissioner of Taxation v. Maddalena (1971) 45 ALJR 426; (1971) 2 ATR 541; 71 ATC 4161; TR 98/9).

In your case, you undertook a specific franchisor training course prior to purchasing the franchise. It is considered that the course you undertook is a prerequisite to a new income-earning activity as an operator of a franchise. The franchise business had not commenced when the training course was undertaken.

The entity is not entitled to claim a deduction for self-education expenses under section 8-1 of the ITAA 1997 because the expenses were incurred at a point too soon to be regarded as incurred in gaining or producing assessable income and are capital in nature.

The cost of the course should be added to the cost base. The cost of the course is not deductible under section 40-880 or Division 40 of the ITAA 1997 for the same reasons as outlined in question 1.