Edited version of your written advice

Authorisation Number: 1012712030061

Ruling

Subject: Franchise fee

Question 1

Is the initial franchise fee an allowable deduction?

Answer

No.

Question 2

Does the franchise fee form part of the cost base for capital gains tax purposes?

Answer

Yes.

Question 3

Is the contract payment an allowable deduction?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2014

The scheme commenced on

1 July 2013

Relevant facts

The arrangement that is the subject of the private ruling is described below. This description is based on the following documents. These documents form part of, and are to be read with, this description. The relevant documents are:

• your application for a private ruling

• franchise agreement extract

• additional information received and

• tax invoices.

You purchased a franchise business.

You paid an initial franchise fee.

For every contract you receive from the franchisor, you are required to pay a contract fee to the franchisor. You subsequently incurred contract fees.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Section 40-880

Reasons for decision

Initial franchise fee

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for any loss or outgoing to the extent that it is incurred in gaining or producing assessable income or it is necessarily incurred in carrying on a business for the purposes of gaining or producing assessable income. However, no deduction is available for outgoings of a capital, private or domestic nature.

An initial franchise fee is generally charged for the right to market or sell a product or service. Generally costs connected with an acquisition, set-up, establishment, enlargement of a business, or with the acquisition of fixed capital assets are capital in nature and 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. To be deductible an outlay must be part of the cost of trading operations to produce income, that is, it must have the character of a working expense.

The decision in Sun Newspapers Ltd and Associated Newspapers Ltd v. FC of T (1938) 5 ATD 87 provides guidelines for distinguishing between capital expenditure 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 the following three elements, although none is in itself decisive:

(1) the nature of the advantage sought;

(2) the way it is to be used or enjoyed; and

(3) 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 (tangible or intangible) for the enduring benefit of the trade or business.

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 your case you paid an initial franchise fee for a franchise business. This fee relates to the acquisition and establishment of the business. It is not regarded as an operating or working expense of the business. The rights obtained in relation to this fee have an enduring benefit and are regarded as being capital in nature. Therefore no deduction is allowable under section 8-1 of the ITAA 1997.

Contract fee

Expenses that are 'incidental and relevant' to income earning activities are considered to be sufficiently connected with the derivation of assessable income and therefore will be an allowable deduction under section 8-1 of the ITAA 1997 (Ronpibon Tin NL & Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; [1949] HCA 15; (1949) 4 AITR 236; (1949) 8 ATD 431).

In your case, you incur costs in obtaining contracts. The contract fee is regarded as a necessary or natural consequence of your income earning activities and is 'incidental and relevant' to your income earning activities of the business. That is the cost arises as a consequence of the day to day activities of your business and is regarded as an operating expense incurred in carrying on the business.

The payment is not concerned with the business structure and is not a loss or outgoing of a capital nature. Accordingly, a deduction is allowable under section 8-1 of the ITAA 1997.

Capital gains tax (CGT)

Section 108-5 of the ITAA 1997 provides that a CGT asset is any kind of property, or a legal or equitable right that is not property.

The rights under the franchise agreement is a CGT asset under paragraph 108-5(1)(b) of the ITAA 1997. The franchise fee is paid in respect of acquiring a right and is included in the first element of the cost base under paragraph 110-25(2)(a) of the ITAA 1997.

The franchise fee should therefore be included as part of the CGT cost base of your CGT asset, being the rights pertaining to the franchise.

Please note that a capital loss cannot be deducted from your assessable income, but it can reduce a capital gain in the current income year or a later income year.

Section 40-880 of the Income Tax Assessment Act 1997

Business capital expenditure that is not otherwise deductible may be deductible over five years under section 40-880 of the ITAA 1997 provided the deduction is not denied by some other provision.

Section 40-880 of the ITAA 1997 potentially applies to the initial franchise fee.

Subject to the limitations and exceptions contained in subsections 40-880(3) to (9) 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 in relation to your business.

In your case, the capital expenditure in question is the payment of a franchise fee. This expenditure was incurred as an integral part of the acquisition of the legal rights necessary to allow you to conduct the franchise business. The character of the expenditure is therefore as an essential part of establishing the profit yielding structure of your business.

As there is a close and relevant connection between the franchise fee and your business, the expenditure in question was capital expenditure incurred in relation to your business for the purposes of subsection 40-880(2) of the ITAA 1997.

However, any deduction under subsection 40-880(2) of the ITAA 1997 is subject to the limitations and exceptions contained in subsections 40-880(3) to 40–880(9) of the ITAA 1997.

Subsection 40-880(5) of the ITAA 1997

On the facts of your case, paragraph 40–880(5)(f) of the ITAA 1997 needs to be considered.

Paragraph 40-880(5)(f) of the ITAA 1997 provides that a deduction is not allowed under section 40–880 of the ITAA 1997 for an amount of expenditure incurred to the extent that it could be taken into account in working out the amount of capital gain or capital loss from a CGT event.

As outlined above, the initial franchise fee is expenditure that is included in the first element of the cost base and reduced cost base of the CGT asset, that is, your franchise rights under the Franchise Agreement. As this amount is taken into account in working out the amount of a capital gain or capital loss from a CGT event affecting your franchise right, no part of that expenditure is deductible under section 40-880 of the ITAA 1997.

Subsection 40-880(6) of the ITAA 1997

Subsection 40-880(6) of the ITAA 1997 provides that the exception in subsection 40-880(5)(f) of the ITAA 1997 does not apply to expenditure that is incurred to preserve (but not enhance) the value of goodwill if the expenditure is incurred in relation to a legal or equitable right and the value to the taxpayer of the right in question is solely attributable to the effect that the right has on goodwill. In other words, the right in question can have no value to the taxpayer other than its effect on goodwill and that effect can only be to preserve the value of existing goodwill.

In your case the expenditure was incurred for the acquisition of the franchise rights under the Franchise Agreement. The rights that you acquired as a result of the expenditure on the franchise fee have value beyond the value that may be attributable to any effect on any goodwill.

Accordingly, the rights that you acquired as a consequence of the payment of the franchise fee do not have a value that is solely attributable to the effect they have on any goodwill. Consequently, subsection 40-880(6) of the ITAA 1997 does not apply to prevent paragraph 40-880(5)(f) of the ITAA 1997 from applying to this expenditure.

Conclusion

As the franchise fee is included in the cost base of the CGT asset, the exclusion in paragraph 40-880(5)(f) of the ITAA 1997 applies. That is, your franchise fee expenditure is not deductible under section 40-880 of the ITAA 1997.