Edited version of your written advice

Authorisation Number: 1012914131189

Date of advice: 24 November 2015

Ruling

Subject : Deduction- Legal Expenses

Question 1:

Did the company commence carrying on a business?

Answer:

No

Question 2:

Are the expenses for the business and legal advice in relation to a vendor agreement and another agreement paid by you, as a director, on behalf of the company deductible to you?

Answer:

No

Question 3:

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the expenses in relation to the business and legal advice provided in relation to a vendor agreement and another agreement?

Answer:

No

Question 4:

Are you entitled to a deduction under section 40-880 of the ITAA 1997 for capital expenditure that you incurred for the business and legal advice provided in relation to a vendor agreement and another agreement?

Answer:

No (your deduction otherwise available under section 40-880 of the ITAA 1997 is prevented by subsection 35-10(2B) of the ITAA 1997)

This ruling applies for the following period:

Year ended 30 June 2015

The scheme commenced on:

1 July 2014

Relevant facts

You were a director of a company.

You and another person are the only shareholders of the company.

The company was incorporated.

You applied for an Australian Business Number.

The business was to import items from overseas for sale in Australia.

You entered into a vendor agreement to purchase the business.

As part of the purchase of the business you were required to seek approval from an overseas company.

You sought business and legal advice from a specialist in relation to vendor and other agreements.

You used your personal funds to pay for the business and legal advice in relation to the vendor and other agreements on behalf of the company.

You provided a number of business plans to the overseas company.

Funding was approved to purchase the business.

You applied for a licence as part of the company business operation

The vendor withdrew from the sale as the overseas company not approve an agreement as part of the sale.

You believe the purchase of the business would have been a profitable undertaking.

The company did not earn any income.

The company is now deregistered.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 subsection 35-10(4)

Income Tax Assessment Act 1997 subsection 35-10(4)

Income Tax Assessment Act 1997 subsection 35-10(2B)

Income Tax Assessment Act 1997 paragraph 35-10(2B)(b)

Income Tax Assessment Act 1997 subsection 35-10(2D)

Income Tax Assessment Act 1997 subsection 35-10(2E)

Income Tax Assessment Act 1997 subsection 35-10(4)

Income Tax Assessment Act 1997 subsection 35-55(2)

Income Tax Assessment Act 1997 paragraph 35-55(1)(a)

Income Tax Assessment Act 1997 paragraph 35-55(1)(b)

Reasons for decision

1. Whether the company had commenced business
In determining when a business commences, there are three indicators that must be present before it can be said that a business has commenced. These are:

• purpose, intention and decision;

• acquisition of a business structure; and

• commencement of business operations

The information which you have provided clearly indicates that the company's intended business activity is best characterised as a trading activity. The intention was to receive income from the business activity of selling motor cycles to the general public.

Purpose, intention and decision:

The chain of events leading to the commencement or start-up of a business activity often begins with a mere intention to establish the business activity. This is developed by researching the proposed business and, in some instances, by experiment. This process culminates in a final decision on whether to commence business. However, not all businesses commence in such an orderly manner.

It is clear from the information you have provided that you had shown some commitment to forming a business by seeking advice and researching company's proposed business activity.

Acquisition of a business structure:

Most business activities have a structure that provides the framework of the business. It is usually a collection of capital assets. What the particular capital assets are will depend on the particular business activity.

For a business activity to commence, an appropriate business structure should be in place. As to what this structure will consist of, and its size, this will be a question of fact and degree, and depend on the nature of the business activity.

The company had entered into a vendor agreement to purchase an existing business to items to the general public.

Commencement of business operations:

As noted by Brennan J in Inglis v Federal Commissioner of Taxation (1979) 10 ATR 493; 80 ATC 4001, the level of activity is important in deciding whether a business is being carried on. Brennan J stated at ATC 4004-4005; ATR 496-497 that:

The carrying on of a business is not a matter merely of intention. It is a matter of activity. Yet the degree of activity which is requisite to the carrying on of a business varies according to the circumstances in which the supposed business is being conducted.

For example, if a business activity is characterised as a primary production activity, involving the planting and cultivating of trees, then the planting of the trees could be seen as the commencement of that business. Alternatively, if a business activity is characterised as a trading activity, the business would generally be considered to commence once the business began selling its stock or providing services for a fee.

Whether a business is carried on or when it can be said that a business commences are always dependent on the facts of each case.

The business activity was to sell items to the general public and from the regular sales the company would have produced a revenue stream as part of its business operations. However, the sale activity did not actually commence as the company had not yet acquired the business from which it could sell its stock and earn regular income.

The company had undertaken research and provided a number of business plans as part of the requirements to purchase the business. The company also secured a loan to purchase the business and applied for a licence to operate the business.

When it was realised the overseas company would not approve one agreement as part of the sale, the vendor withdrew from the sale.

The company did not receive any income.

From the information provided the company's activities were preliminary to the carrying on of its intended business and were considered to be directed to constructing a profit-yielding structure. We consider that, up to this point, the company was still in the course of establishing a business and had not commenced income-earning operations.

2. Whether company expenses paid by a director are deductible to the director

As a general rule, an outgoing will not be deductible unless it is incurred in gaining or producing the assessable income of the taxpayer who incurs it (Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153). In that case, the expenses were not incurred by the taxpayer in earning his assessable income in his capacity as director but rather the income of the company. There is no nexus between the outgoing and the assessable income of the taxpayer in such a case as to characterise the outgoing as incidental and relevant to the gaining of assessable income of the taxpayer.

In practice, taxpayers often have to deal with groups of related companies or entities and with payments which are non-arm's length in the sense that payments are made either to or (wholly or partly) for the benefit of an associated person or entity.

Taxpayers must bear in mind that each entity is a separate legal entity and taxpayer, and that generally a loss or outgoing will not be deductible under 8-1 of the ITAA 1997 unless it is incurred in gaining or producing assessable income (or in carrying on a business for the purpose of gaining or producing such income) for the taxpayer who incurred that loss or outgoing: see Federal Commissioner of Taxation v Munro (1926) 38 CLR 153 at 170 per Knox CJ.

3. Legal expenses

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 Federal Commissioner 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.

Capital expenses

An expense will usually be capital in nature where it is incurred with the intention to create an asset or advantage of a lasting and enduring nature (British Insulated & Helsby Cables Ltd v. Atherton (1926) AC 205; (1926) 10 TC 155).

The following guidelines for determining whether a loss or outgoing is of a capital nature have been set down by the High Court in Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (Sun Newspapers case) (1938) 5 ATD 23; 5 ATD 87; 61 CLR 337: 

• the expenditure is related to the business structure itself, that is, the establishment, replacement or enlargement of the profit yielding structure rather than the money earning process, or

• the nature of the advantage has lasting and enduring benefit, or

• the payment is 'once and for all' for the future use of the asset or advantage rather than being recurrent and ongoing.

Legal expenses in relation acquisitions of a business

As noted above, expenditure made in order to establish an asset is generally considered to be of a capital nature and therefore not deductible. In your case you incurred expenses for the acquisition of a business. The legal expenses were incurred in connection with securing an enduring (lasting) benefit which was to establish ownership of the business structure and premises.

The legal expenses in question did not arise out of the day to day activities of an ongoing business activity you carried on. The character of the legal expense you incurred is such that it was incurred in seeking to acquire a capital asset that is an ongoing business and accordingly capital in nature.

In addition in the year that you incurred the expenses on behalf of the company you did not derive any salary and wages or director's fees income from the company as the company did not receive any income. The expenses were properly referrable to the company, despite the fact that you were a director of the company and at the time of payment of some of the expenses you may have had a reasonable expectation that income would be derived from the company in the future. Your legal expenses incurred in this action are therefore not deductible under section 8-1 of the ITAA 1997. Similarly the expense for the business advice sought from the specialist is not deductible under section 8-1 of the ITAA 1997 as the expense is also capital in nature.

4. Whether business advice and legal expenses in relation to the vendor and distribution agreements are deductible under section 40-880 of the ITAA 1997

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 5 income years starting in the year in which you incur it, capital expenditure you incur:

(a) in relation to your business; or

(b) in relation to a business that used to be carried on; or

(c) in relation to a business proposed to be carried on; or

(d) to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business.

On the facts of this case the relevant paragraph to consider is paragraph 40-880(2)(c) of the ITAA 1997 because all expenditure was incurred prior to the commencement of the business.

Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues is the Commissioner's view of identifying the key issues which need to be resolved to establish entitlement to a deduction under the provision.

Noted at paragraph 10 of the TR 2011/6 it states:

The business in relation to which the taxpayer incurs the expenditure is not limited to the taxpayer's existing business. The expenditure may relate to a former or proposed business, or to the liquidation, deregistration or winding up of a company, partnership or trust that carried on a business and of which the taxpayer was a member, a partner or a beneficiary.

In considering the term 'proposed to be' for the purposes of paragraph 40-880(2)(c) of the ITAA 1997, the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 (EM) states at, paragraphs 2.31 to 2.33 of the EM state:

2.31. For a business to be proposed to be carried on for the purposes of this provision, the taxpayer needs to be able to demonstrate a commitment of some substance to commence the business, and sufficient identity about the business that is proposed to be carried on. The deductibility of expenses in advance of the business being carried on will rest on the facts of each case, but this commitment and identity must be tangible; that is, there would need to be some evidence that would enable an objective assessment of the existence of that commitment and identity.

2.32. Further guidance as to the level of commitment required to deduct pre-business expenditure is provided by subsection 40-880(7). In essence, this requires that, having regard to relevant circumstances, it must be reasonable to conclude that the commitment exists. One of these circumstances is that the business be proposed to be carried on within a reasonable time. This may vary according to the industry or the nature of the business and would recognise the long lead times that may be involved. [Schedule 2, item 30, paragraph 40-880(2)(c), subsection 40-880(7)].

2.33. Such commitment could be shown by, but is not limited to, at least some of the following:

• a business plan;

• the establishment of a business premises;

• research into the likely markets or profitability of the business; and

• capital investment in assets of the business.

Eligibility for deduction under section 40-880 of the ITAA 1997 is established as at the time when the expenditure is incurred: see paragraph 2.40 of the EM. Therefore, at the time you incurred the expenditure, you need to demonstrate, for the purposes of paragraph 40-880(2)(c) of the ITAA 1997, a commitment of some substance to commence the business and sufficient identity about the business to be carried on by the company.

A review of the information provided indicates soon after the company's incorporation, the company entered into an agreement to purchase an existing business from the vendor. The company provided a number of business plans, sought legal and business advice in relation to the proposed business, sought and was approved finance to purchase the existing business and secure a licence and ABN. This demonstrates a commitment of some substance to commence the business, and sufficient identity about the business proposed to be carried on. Furthermore, given the close proximity in time from when the capital expenditure on company's business and legal fees were incurred and when the above activities were conducted, it is reasonable to conclude that this commitment existed at the time you incurred the expenditure.

Further, in all the circumstances, we consider that there is a sufficient and relevant connection between your incurrence of the capital expenditure on company's business and legal expenses and the business proposed to be carried on by the company.

Accordingly, we consider that the capital expenditure incurred on the company business and legal fees is capital expenditure you incurred in relation to a business proposed to be carried on for the purposes of paragraph 40-880(2)(c) of the ITAA 1997. This view is not negated by the fact that the company's business did not commence.

The capital expenditure that is the subject of this ruling is incurred in relation to a business proposed to be carried on by an entity (the company) other than the entity which incurred the expenditure (you). Therefore, any deduction to you under section 40-880 is subject to the limitations set out in subsection 40-880(4), rather than the limitation set out in subsection 40-880(3) of the ITAA 1997.

Limitations under subsection 40-880(4) of the ITAA 1997

Subsection 40-880(4) of the ITAA 1997 provides that 'you can only deduct the expenditure, for a business that another entity used to carry on or proposes to carry on, to the extent that:

(a) the business was carried on or is proposed to be carried on for a taxable purpose; and

(b) the expenditure is in connection with:

(i) your deriving assessable income from the business; and

(ii) the business that was carried on or is proposed to be carried on.'

The relevant business for the purposes of the application of subsection 40-880(4) of the ITAA 1997 - the proposed business of the company - was proposed to be carried on wholly for a taxable purpose.

In your case as you are a shareholder of the company, which proposed to carry on a business wholly for a taxable purpose, you would have been in a position to derive assessable income from the business through your entitlement as shareholder to any dividend paid by the company from profits from the company's business. There is nothing to suggest that the company intended never to distribute any profits from the company's business to you.

As the character of the capital expenditure incurred by you is as part of establishing the company's business structure that expenditure is in connection with the business proposed to be carried on by the company.

Accordingly, subsection 40-880(4) of the ITAA 1997 does not apply to limit the amount you can deduct under section 40-880 for the company legal expenses you incurred.

However, subsections 40-880(5) to (9) of the ITAA 1997 set out further limitations and exclusions to deductibility under section 40-880 of the ITAA 1997. On the facts of this case, only subsection 40-880(7) of the ITAA 1997 need be considered.

Limitations under subsection 40-880(7) of the ITAA 1997

Subsection 40-880(7) of the ITAA 1997 provides 'you cannot deduct an amount under paragraph (2)(c) in relation to a business proposed to be carried on unless, having regard to any relevant circumstances, it is reasonable to conclude that the business is proposed to be carried on within a reasonable time'.

As discussed above, given the activities undertaken within close proximity in time were directed towards commencement of the company's business, it is reasonable to conclude that the proposed business of the company was to be commenced within a reasonable time after the incurrence of the expenditure on the company business advice and legal expenses. Accordingly subsection 40-880(7) of the ITAA 1997 does not limit to any extent the deduction for that expenditure.

Conclusion

Subject to the application of Division 35 of the ITAA 1997, you can deduct 100 per cent of the company's expenses in relation to business and legal advice provided in regards to the vendor and distribution agreements the you incurred that are the subject of this ruling over 5 years (starting in the year in which you incurred that expenditure) under section 40-880 of the ITAA 1997.

Division 35 of the ITAA 1997

The rules in Division 35 of the ITAA 1997 prevent individuals from deducting pre- and post-business capital expenditure in relation to non-commercial activities unless certain exceptions apply.

Subsection 35-10(2B) of the ITAA 1997, specifically at paragraph 35-10(2B)(b) of the ITAA 1997, provides that an individual taxpayer cannot deduct an amount under section 40-880 of the ITAA 1997 for expenditure in relation to a business activity another entity, other than an individual (either alone or in partnership), proposes to carry on, for an income year before the one in which the business activity starts to be carried on.

In such a case, the commencement of section 40-880 (ITAA 1997) deductions are deferred until the income year in which the business activity starts to be carried on by the other entity: subsection 35-10(2D) of the ITAA 1997.

Under subsection 35-10(4) of the ITAA 1997 the rule in subsection 35-10(2B) of the ITAA 1997 does not apply if the business activity is a primary production or professional arts business and the taxpayer's assessable income (from other sources that do not relate to the business activity) for the income year in which the relevant expenditure is incurred is less than $40,000.

Under subsection 35-55(2) of the ITAA 1997 the Commissioner has a discretion to allow a taxpayer to deduct pre-business expenditure under section 40-880 of the ITAA 1997 if he is satisfied that it would be unreasonable to prevent a deduction for the expenditure because special circumstances prevented the business activity from starting. 'Special circumstances' are those outside the control of the operators of the business activity, including drought, flood, bushfire or some other natural disaster: paragraph 35-55(1)(a) of the ITAA 1997 .

In this case, you (as an individual taxpayer) are seeking a deduction under section 40-880 (ITAA 1997) for expenditure in relation to a business activity proposed to be carried on by the company (another entity) - in an income year before the one in which the business activity started to be carried on. Therefore, paragraph 35-10(2B)(b) of the ITAA 1997 is applicable.

As the business activity in this case is not a primary production or professional arts business and no special circumstances appear to have prevented the business from starting, the exception in subsection 35-10(4) of the ITAA 1997 does not apply and the Commissioner's discretion in subsection 35-55(2) of the ITAA 1997 will not be exercised.

Your deduction under section 40-880 of the ITAA 1997 is prevented by subsection 35-10(2B) of the ITAA 1997. However, if the business activity proposed to be carried on by the company starts to be carried on at a later time, you may be able to claim the deduction in a future income year.