Edited version of private advice

Authorisation Number: 1012682705560

Ruling

Subject: Deductible expenses

Question 1

Are the franchise renewal fees eligible to be deducted over the life of the service period (the renewal period) on the basis that they would be otherwise deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

Yes

Question 2

Are the legal fees incurred in reviewing the franchise renewal agreement eligible to be deducted under section 8-1 of the ITAA 1997?

Answer:

Yes

This ruling applies for the following period(s)

Year ended 30 June 2014

The scheme commences on

1 July 2013

Relevant facts and circumstances

You entered into a franchise agreement with a bank to operate a branch.

The agreement was that on payment of an amount, you were permitted to commence operations. You paid the original establishment fee to secure the right to use the bank's systems and intellectual property.

Options for renewal (the franchise renewal fees) were $XXX per five years with the option renewal giving the franchisee (you) the right to keep operating and earning revenue.

You incurred legal expenses in reviewing the franchise renewal agreement.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1936 Subdivision H of Division 3 of Part III

Reasons for decision

Deductible expenses

Section 8-1 of the Income Tax Assessment Act 1997 (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.

The issue of whether a loss our outgoing is on capital or revenue account has been considered by the courts in various cases, most notably in Sun Newspapers Ltd. and Associated Newspapers Ltd. v. F.C. of T. (1938) 61 CLR 337 at p. 363, where Dixon J made the following statement:

"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."

Franchise renewal fees

In applying Sun Newspapers Ltd v FC of T principles to your situation, the first consideration is the character of the advantage sought, which incorporated the length of the period for which the rights under the franchise agreement were secured upon the renewal, and the second consideration is the manner in which the advantage was to be enjoyed. Given that five years is considered to be a relatively short period for the purposes of the character of the advantage sought test, and that at the end of the five years you would have nothing and any renewal would involve recurrence of outgoings, it follows that the renewal fees would not be on capital account.

This treatment of the franchise renewal fees is in line with the ATO view as explained in the Decision Impact Statement on Inglewood & Districts Community Enterprises Ltd v FC of T [2011] AATA 607 where it was found that the franchise renewal fees under a community bank model were of a revenue nature.

Accordingly, the franchise renewal fees would be eligible to be deducted over the life of the service period (renewal period), pursuant to Subdivision H of Division 3 of Part III of the Income Tax Assessment Act 1936 (ITAA 1936), on the basis that it would be otherwise deductible under section 8-1 of ITAA 1997.

Legal fees

In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. FC of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

As the advantage sought in incurring the legal expenses was in relation to the review of the franchise renewal agreement of which the franchise renewal fees themselves have been found to be on revenue account, it follows that the legal expenses incurred will also be on revenue account.

Accordingly, the legal fees incurred on the review of the franchise renewal agreement will be deductible under section 8-1 of the ITAA 1997.