Edited version of your written advice

Authorisation Number: 1012789472079

Ruling

Subject: Deductibility of Franchise Termination payments

This ruling applies to:

'A' Pty Ltd.

Questions:

1) Can the payments made by the Franchisor for the termination of the franchises be claimed as allowable deductions in the year of payment under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer :

No

2) If not, are the payments deductible over five years under section 25-110 or section 40- 880 of the ITAA 1997?

Answer :

Yes: under section 25-110 of the ITAA 1997

This ruling applies for the following periods:

In respect of the payments made for these stores:

• Store X: From 1 July 2009 to 30 June 20ZZ

• Store Y : From 1 July 20YY to 30 June 20AA

• Store Z: From 1 July 20ZZ to 30 June 20BB

The scheme commenced on:

1 July 20XX for the payments made in respect of the X store, on 1 July 20YY in respect of the Y store and on 1 July 20ZZ in respect of the Z store.

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The applicant is a well-established Franchisor comprising of stores Australia wide of which some are franchised. The group carries on the business of retail sale of certain products and maintenance services. The franchisees operate under exclusive licences granted by the franchisor which entitle them to operate in a designated geographical territory, using trademarks, logos, systems and other intellectual property of the franchisor.

The Franchise agreements of the stores have been terminated in 20WW and 20XX prior to the end of their initial terms by the franchisor, by payment of a termination fee to each franchisee.

The applicant has applied to the Commissioner seeking clarification on whether the termination payments can be claimed as a deduction under section 8-1 of the ITAA 1997, or alternatively whether they are deductible over 5 years under section 25-110 or section 40-880 of the ITAA 1997.

Facts provided by the applicant:

• The franchisor operates a number of 'corporate stores' whereby the group incurs all expenses and derives all revenue from each store.

• The franchisees are granted exclusive licences to operate in a designated territory.

• The franchisees are required to operate the businesses by using the franchisor's trademarks, images, systems and other intellectual property.

• It is stated in the franchise agreement that any goodwill and other rights or interests arising from the franchisee's use of the business name, will belong to the franchisor.

• The franchise agreement also states that the franchisee is not entitled to receive any payment or compensation from the franchisor for any goodwill in connection with the business name or any reputation developed by the franchisee.

• The franchise agreements which are the subject of this ruling have been terminated as follows:

Franchised store Date of termination Payment per contract Termination Payment

a) X July 20XX $ - PPE* $

b) Y March 20YY $- PPE $ $

c) Z November 20YY $- PPE $ $

*Property, Plant & Equipment

• The terminations were effected by two main transactions which transpired between each franchisee and the franchisor:

• The transfer, surrender and release of the existing franchise agreement from the outgoing franchisee to the franchisor, and

• The sale of the assets of the franchise business to the franchisor

• The 'Termination fee' paid by the franchisor to the departing franchisee purportedly consisted of one or more of the following components:

• The stock value - a value agreed on by both parties or determined by an independent stock taker;

• Assets - a fixed amount specified in the agreement for all unencumbered plant, property & equipment;

• 'Goodwill'- a fixed amount specified in the agreement.

• The Termination statements also stated that 'Goodwill' is the fee payable for the termination of the existing franchise agreement's 'franchise termination fee'. The franchise termination fee is subject to negotiation with the franchisee in each individual case.

• The applicant made submissions in support of the application for the Private ruling, stating that 'even if any goodwill arose specifically in relation to the franchisee, any such goodwill is attributable to the franchisor', and added 'the allocation of payment to goodwill in the franchise contract is therefore incorrect'. The submission also stated that the 'allocation of payment to assets is therefore limited to the tangible assets acquired from franchisees, being stock, plant and equipment and business records'.

• The applicant has also submitted that on this basis the franchisee was not expected to own or develop any significant intellectual property. Even if goodwill were to arise in franchised stores, the franchise agreement sets out that:

'The Franchisee acknowledges that one of the reasons the Franchisor signed this agreement with the Franchisee was the reasonable expectation on the part of the Franchisor that its goodwill will increase in value as a result of the Franchisee'.

• Copies of the relevant income statements submitted by the applicant, indicate that deductions for depreciation expenses of all fixed assets, plant and equipment have previously been claimed.

Reasons for decision

These reasons for decision accompany the Notice of private ruling for 'A' PTY LTD.

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Summary

The applicant is a well-established Franchisor of products and maintenance services which consists stores Australia wide of which some stores are franchised.

The Franchise agreements of the X,Y and Z Stores have been terminated by the Franchisor in 20XX and 20YY prior to the end of their initial 20 year terms, by the payment of a termination fee to each franchisee.

Details of the Termination fees paid are as follows:

Franchised store Date of termination Payment per contract Termination Payment

a) X 1 July 20XX $ - PPE* $

b) Y 5 March 20YY $- PPE $ $

c) Z 1 November 20YY $- PPE $ $

*Property, Plant & Equipment

The franchisor has applied to the Commissioner seeking clarification on whether the termination payments can be claimed as a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), or alternatively whether they are deductible over 5 years under section 25-110 or section 40-880 of the ITAA 1997.

Detailed reasoning

1) Can the payments made by the Franchisor for the termination of the following franchises be claimed as allowable deductions in the year of payment under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

• X

• Y

• Z

Information provided by the applicant:

Correspondence from the applicant including:

• Application for a Private Ruling including attachments.

• Submission in response to ATO's request for further information.

• Confirmation by the tax agent that all three payments were made in respect of 'terminations' and not in respect of a 'surrender or release' as mentioned in the details of termination of the.

The applicant is a well-established franchisor which operates an Australia wide network of stores marketing products and maintenance services of which some stores are franchised.

The franchisor has granted licences to selected franchisees to operate under their registered trademark by using the group's logos, systems and products and benefit from the group's advertising and marketing activities in relation to the operation of the stores under their control. The right to operate stores is limited to designated geographical territories which are specified on the map provided in the agreement and contract entered into by the franchisees. The franchisees are granted exclusive licences to operate the stores for an initial term of 20 years under strict conditions and guidelines as set out in the Agreement and contract of sale.

The applicant has submitted that the franchisor has built up significant value in its brand name, trademarks and goodwill, and will retain all ownership of its intellectual property. It has also submitted that the original franchise agreement stated that all goodwill will remain with the franchisor, on the termination of a franchisee. On this basis the franchisees were not expected to develop any significant intellectual property.

The agreements of the three terminated stores specifically stated that:

"The Franchisee acknowledges that one of the reasons the Franchisor signed this agreement with the Franchisee was the reasonable expectation on the part of the Franchisor that its goodwill will increase in value as a result of the Franchisee".

The Termination Fee in respect of the three stores being ruled on consisted of the following:

Two main transactions involving:

• The transfer of the existing franchise agreement back to the franchisor.

• The sale of the assets of the franchised business back to the franchisor.

The amount payable by the franchisor to the outgoing franchisee was made up of the following:

• The stock value - a value agreed by both parties or as determined by an independent stock taker.

• PPE - a fixed amount in the agreement for all unencumbered plant, property & equipment

• 'Goodwill' - a fixed amount specified in the agreement.

However, in respect of each agreement the applicant has submitted that 'the allocation of the payment to goodwill in the franchise contract of sale is therefore incorrect'. The applicant has also submitted that 'the allocation of payment to assets is therefore limited to the tangible assets acquired from franchisees, being stock, plant, equipment and business records'.

Copies of the relevant income statements submitted by the applicant indicate that deductions for depreciation expenses of all fixed assets, plant and equipment have previously been claimed. Therefore, it is the remaining written down values of the assets that will constitute the value of the assets included in the Termination fees paid.

Reasons for decision:

In considering whether Termination fees paid to the outgoing franchisees qualify for a deduction under section 8-1 of the ITAA 1997, it must be determined whether the outgoings are of a capital or revenue nature.

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, or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, no deduction is allowed under subsection 8-1(2) of the ITAA 1997 for expenses to the extent that they are of capital or of a capital nature, or is of a private or domestic nature.

The courts have differentiated between the two types of expenses when determining deductibility. The first being deductible revenue or income related expenses and secondly expenses referrable to capital account that will not qualify for deductions under section 8-1 of the ITAA 1997.

The franchisor has made Termination payments to the three outgoing franchisees as lump sum payments for ending the franchisee's licence prior to their initial term granted in the franchise agreement.

The critical factor in determining the essential character of an outgoing 'is the character of the advantage sought by the making of the expenditure' (Sun Newpapers Ltd v. FC of T (1938) 61 CLR 337 at 363 per Dixon J). At 355 per Latham J, stated that:

an enduring benefit does not require that the taxpayer obtain an actual asset, it may be a benefit which endures, .…..

If expenditure produces some asset or advantage of a lasting character for the benefit of the business it will be considered to be capital expenditure.

This view was previously enunciated by Viscount Cave L.C. in

British Insulated and Helsby Cables v. Atherton (1926) 10 T.C. 155 at 192:

" … when expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such expenditure as properly attributable not to revenue but to capital."

You have explained in your submission that the franchisor adopted this approach to terminate licences and manage them as corporate stores with a view to 'generating and growing more revenue', 'with a view to increasing the Group's profitability' and to 'protect relationships with its broader network of franchisees'.

You submitted that granting payment at termination was made 'on commercial terms as it could otherwise earn an unwanted reputation with existing and potential future franchisees which could make future negotiations difficult when entering into new franchise arrangements'.

Although the franchisor's outgoing has not been incurred with the aim of 'obtaining an actual asset' as outlined by Latham J in Sun Newpapers Ltd case, his view confirmed that:

If expenditure produces some asset or advantage of a lasting character for the benefit of the business it will be considered to be capital expenditure.

As concluded in the above opinions, we consider that the franchisor's expenditure has been made for the purpose of obtaining 'an advantage of a lasting character' and 'for the enduring benefit of trade' and is therefore a loss of Capital or of a capital nature and is therefore not deductible under section 8-1 of ITAA 1997.

Therefore no deduction is allowable in terms of section 8-1 of the ITAA 1997 in respect of the termination payments made by the franchisor to the three outgoing franchisees of the following stores:

• X

• Y and

• Z

2) If not, are the Termination payments (made by the franchisor) deductible over five years under section 25-110 or section 40-880 of the ITAA 1997?

As concluded above we consider the Termination payments made by the franchisor to the outgoing franchisees to be Capital expenditure or to be of a capital nature.

Subsection 25-110(1) of the ITAA 1997 provides that you can deduct an amount for capital expenditure you incur to terminate a lease or licence that results in the termination of the lease or licence, if the expenditure is incurred:

a) in the course of carrying on a business; or

b) in connection with ceasing to carry on a business.

We consider that the Termination fees paid by the franchisor fall within paragraph 25-110(1)(b) as the payments were made in respect of ceasing the franchisee's stores, which had been operated under a licence from the franchisor.

Subsection 25-110(2) of the ITAA 1997 provides that the amount you can deduct is 20% of the expenditure:

a) for the income year in which the lease or licence is terminated; and

b) for each of the next 4 income years .

Therefore a deduction is allowable in terms of section 25-110 of the ITAA 1997 in respect of the termination payments made by the franchisor to the three outgoing franchisees of the following stores:

• X

• Y and

• Z

The deduction may be claimed under subsection 25-110(2) of the ITAA 1997,for 20% of the Termination fee of each store from the income year in which the licence was terminated, and 20% of the expenditure for each of the next 4 income years.

A deduction of more than 20% of each amount of expenditure may not be claimed by the franchisor in any particular income year.

Section 40-880 of the ITAA 1997:

Section 40-880 of the ITAA 1997 does not apply to the 'Termination payments' made by the franchisor. Given that the Commissioner considers that the amounts are deductible under section 25-110 of the ITAA 1997, the outgoings are not deductible under section 40-880 of the ITAA 1997 by virtue of paragraph 40-880(5)(b), which provides that you cannot deduct anything under this section for an amount of expenditure you incur to the extent that 'you can deduct an amount for it under a provision of this Act other than this section [ie:40-880]

Relevant legislative provisions

Income Tax Assessment Act 1997:

Section 8-1

Section 40-880

Subsection 25-110(1)

Subsection 25-110(2)

Reasons for decision