Edited version of your written advice

Authorisation Number: 1012706244535

Ruling

Subject: Deduction for contract termination fee

Question 1

Is the fee paid by the Company G to terminate certain contracts deductible under section 8-1 of the Income Tax Assessment Act 1997 ('ITAA 1997')?

Answer

Yes

Relevant facts and circumstances

Company G is the head company of an income tax consolidated group.

Company G as part of a joint venture arrangement, entered into a long term contract where it agreed to supply certain goods to Entity J for prices specified in the contract. Entity J is not related to Company G and is not part of the joint venture.

Company G makes losses in fulfilling its supply obligations under the contract. The contract has a number of years to run.

Company G will pay a fee to Entity J to terminate the supply contract. The amount of the fee was determined by way of negotiation process with Entity J. 

Company G determined an acceptable termination fee which was premised on achieving an acceptable net present value (NPV) benefit from making the payment. The fee was calculated to reflect an NPV assessment of no longer making losses pursuant to the contract and of the opportunity costs of achieving sales profitably at current market prices, including when the fee is taken into account.

The entire fee is payable in a lump sum payment. Upon payment of the fee, Company G's obligation to make supplies to Entity J will cease immediately. The fee is not a compensation payment or a penalty payment made for a breach of contract. 

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

All legislative references are to provisions of the Income Tax Assessment Act 1997 unless specified otherwise.

Section 8-1 provides that:

8-1(1) You can deduct from your assessable income any loss or outgoing to the extent that:

(a) it is incurred in gaining or producing your assessable income; or

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

8-1(2) However, you cannot deduct a loss or outgoing under this section to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature; or

(b) it is a loss or outgoing of a private or domestic nature; or

(c) it is incurred in relation to gaining or producing your *exempt income or your *non-assessable non-exempt income; or …

For an outgoing to be deductible under section 8-1, it is necessary to establish that it is relevantly connected with the income producing or business activities of the taxpayer, and that it is not of capital or of a capital nature.

Section 15AC of the Acts Interpretation Act 1901 also provides that where:

(a) an Act has expressed an idea in a particular form of words; and

(b) a later Act appears to have expressed the same idea in a different form of words for the purpose of using a clearer style;

the ideas shall not be taken to be different merely because different forms of words were used.

Therefore, cases considering the application or otherwise of former section 51(1) of the Income Tax Assessment Act 1936 (ITAA 1936) are directly relevant to the application or otherwise of section 8-1.

Positive limbs

The Commissioner considers that the fee paid by Company G to Entity J is relevantly connected with the income producing or business activities of Company G.

Company G is in the business of making certain supplies. Company G as part of a joint venture arrangement makes certain supplies to various customers in various markets.

The Commissioner accepts that the fee payable in the circumstances of Company G will be paid to terminate an 'onerous' contract.

Conclusion for positive limbs

The fee paid by Company G to terminate its supply obligations under the contract is an outgoing incurred in gaining or producing Company G's assessable income for the purposes of subsection 8-1(1).

Negative limbs

The fee paid by Company G is not an outgoing of a private or domestic nature, nor is it incurred in gaining or producing exempt income or non-assessable, non-exempt income.

It is therefore necessary to consider if the payment is an 'outgoing of capital, or of a capital nature'.

'outgoing of capital, or of a capital nature'

A loss or outgoing that satisfies one of the positive limbs of subsection 8-1(1) is not deductible if the loss or outgoing is of 'capital, or of a capital nature'.

The tests set out in Sun Newspapers Ltd & Associated Newspapers Ltd v FC of T (1938-1939) 61 CLR 337 established whether the loss or outgoing relates to the taxpayer's 'profit yielding structure' (sometimes also referred to as the 'business entity' test).

Dixon J stated at 363:

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 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.

Dixon J concluded that the outgoings were on capital account for reasons including that the outgoings were of a large sum, were incurred to remove competition, and that the chief object of making the outgoings was strengthening and preserving the taxpayer's existing business organisation, and to acquire an asset.

Payment for cancellation or breach of agreement

In Foley Brothers Pty Ltd v FC of T (1965) 13 ATD 562 the taxpayer company entered into a 20-year agreement containing an undertaking not to reduce the scope or extent of its trading activities. It breached this undertaking when financial difficulties forced it to undergo a major rationalisation and organisation of its activities. As a result of the breach the other party to the agreement commenced legal proceedings. The proceedings were settled on the basis that the taxpayer pay a certain sum in return for the agreement being rescinded, thereby leaving the taxpayer free to carry out its reorganisation. In the end, six of the seven branches and almost all capital assets were disposed of. Kitto, Taylor and Menzies JJ. of the High Court of Australia took the view that the freedom acquired to carry out the reorganisation was an enduring benefit and not merely a freedom to make day-to-day decisions in the course of carrying on income producing activities.

In deciding Foley Brothers, Kitto, Taylor and Menzies JJ. stated at 563:

lt was a freedom, not to make decisions, or even to carry decisions into effect, as part of the process of producing income within that structure, but to make changes in the structure of the income-producing organisation. ... It is a fundamental error to treat a freedom to dispense with whole branches of a widespread enterprise as if it were only a freedom to move the goods in a shop from one counter to another. The true contrast is between altering the framework within which income producing activities are for the future to be carried on and taking a step as part of those activities within the framework.

Payment for cancellation of onerous service agreements

In W Nevill & Co Ltd v FC of T (1937) 56 CLR 290 (Nevill's Case), a sum paid in consideration of cancellation of an onerous service agreements was held to be deductible.

In Nevill's Case, the company was carrying on business with a single managing director, however the board of directors decided to introduce a system of joint management, and an additional managing director was appointed.

The joint directorship later proved unsatisfactory. A payment for a sum of £2,500 was made to one of two joint managing directors, Mr King, in consideration of his agreeing to the rescission of a contract entitling him to retain that office for another four years or more at a salary of £1,500. The company's purpose in effecting the transaction was to save the salary and at the same time to put an end to joint control.

In deciding whether the expenditure in question represented a loss or outgoing of capital, Latham C.J. stated at 300:

No asset was acquired by the expenditure of the sum of £2,500. The agreement between the company and King for the employment of King was not something affecting the whole structure of the company's business. Its cancellation cannot be regarded as involving the acquisition of a capital asset. The cancelled agreement was an agreement for the employment of a servant made in the ordinary course of the company's business. I am unable to discern any reason which would justify the conclusion that the £2,500 was a capital expenditure.

Further, in deciding whether the outgoing in question was actually incurred in gaining or producing Latham C.J. also stated at 300-301:

The payments in question were actually made bona fide in the course of business in the interests of the efficiency of the business. …The facts stated in this case show that the expenditure was actually incurred in gaining or producing the assessable income of the year in question. The expenditure was made for the purpose of increasing the efficiency of the company and therefore increasing its income producing capacity. It was not a capital expenditure, it was, in my opinion, an expenditure incurred in the course of gaining or producing assessable income…

While Nevill's Case considered provisions of the Income Tax Assessment Act 1922-1932 which are similar to former section 51(1) of the ITAA 1936 and section 8-1, those provisions differed due to the absence of the words or a similar idea of 'extent to which' and instead there was a concept of 'money not wholly or exclusively laid out or expended for the production of assessable income.' Nevertheless, the parts of the provisions considered in Nevill's Case are broadly similar to the relevant parts of former section 51(1) of the ITAA 1936 and section 8-1.

In Metals Exploration Ltd. v. Federal Commissioner of Taxation 1986 17 ATR 786 the lump sums paid for release of certain loan obligations which have been described as onerous were not losses or outgoings of a capital nature.

The taxpayer company was engaged in a joint venture in nickel mining. The company exercised a half share in the venture through a wholly owned subsidiary, as did its associate company. Finance for the project was structured so that liability for loan repayment vested with the subsidiary companies. At issue was the exception to this arrangement which was the funding obtained from two merchant banks under Put agreements. Under these agreements, the merchant banks could require the companies to lend them the money outstanding from their subsidiaries, at an interest rate of one-eighth of a per cent lower than the rate they were receiving from the subsidiaries.

After some time had elapsed, the taxpayer company wished to avoid the possibility of the merchant banks exercising their right to such loans. Accordingly, it negotiated a figure of $475,000 at which to buy out of the agreements. This figure was claimed as a deduction under section 51(1) of the ITAA 1936 during the 1978 tax year.

Murphy J of the Supreme Court of Victoria allowed the appeal in favour of the taxpayer for the following reasons at 790-793:

… the original Put agreements were in my opinion entered upon by the taxpayer in the course of its business, and that it did so for the purpose of gaining or producing income. .. any resultant outgoing or loss was incurred in gaining or producing assessable income or attempting to do so.

… the taxpayer negotiated the cancellation of the Put agreements in order to avoid the risks of an annual recurrent drain on its income, likely to be occasioned by having to meet an outgoing approximately equal to the amount by which interest calculated on the sum owing by its subsidiary at relevant market rates exceeded eight per cent … had the Put agreements remained in force, the taxpayer would have been likely to sustain an assessable income loss of the "interest differential". … the differential payment of interest would … have amounted to an allowable deduction from assessable income.

… the taxpayer was able to pay the negotiated sums to cancel the Put agreements out of its operating profits. It did not borrow nor realise a capital asset for this purpose.

No asset or advantage for the enduring benefit of the taxpayer's business was created by the transaction: … [Nevill's Case … at 299-301].

… the dominant feature of the payment of the lump sums in the present case … was to eliminate the contractual obligation to incur a recurrent liability to pay interest which could not be recouped, and the payment of which interest itself would have been an allowable deduction on revenue account to the taxpayer. The lump sum payment was from a practical and business point of view calculated to effect a beneficial resolution of this threatened recurrent drain on assessable income. This was the occasion which called for the expenditure.

Application to the circumstances of Company G

Having regard to the cases above and guidelines for distinguishing between capital and revenue outgoings, the fee paid is characterised as set out below:

Character of the advantage sought

The advantage obtained by the fee paid is to relieve Company G from making supplies to Entity J at a loss pursuant to the contract.

If Company G were not to exit the contract, Company G would continue to make losses in fulfilling its contractual obligations to Entity J.

Further, the payment was not a compensation or penalty payment made as a result of a breach of contract. 

Finally, the termination of the contract did not enlarge (or reduce) the business operation, nor created a new enterprise, of Company G.

The manner in which it is to be used, relied upon or enjoyed

When Company G paid the fee, Company G was instead enabled to make the supplies that it would have otherwise made to Entity J more profitably.

Accordingly, Company G improved the amount of sales income within its existing business structure.

The means adopted to obtain it

Company G will make a single payment of the fee to Entity J in order to terminate the contracts.

Nevertheless, the payment is calculated to reflect a net present value assessment of no longer making losses pursuant to the contractual obligations and of the opportunity costs of achieving sales profitably at current market prices, including when the fee is taken into account.

Further, Nevill's Case supports the conclusion that as the expenditure is not for acquisition of a capital asset or directed towards the profit-yielding structure of Company G, the expenditure is on 'revenue account'. The expenditure is directed at exiting a loss-making contract which is a part of the trading activities of Company G, rather than one which enlarges, reduces or otherwise forms part of the structure or assets through which Company G carries on business.