Edited version of your written advice

Authorisation Number: 1012992332457

Date of advice: 7 April 2016

Ruling

Subject: Rent roll

Question 1

Is the company entitled to an outright deduction under section 8-1 of the Income Tax Assessment 1997 (ITAA 1997) for the expenditure incurred in acquiring a rent roll?

Answer:

No

Question 2

Is the company entitled to a deduction for the decline in value of a rent roll under section 40-25 of the ITAA 1997?

Answer:

No

Question 3

Is the company entitled to a deduction over a period of five years under section 40-880 of the ITAA 1997 for the expenditure incurred in acquiring a rent roll?

Answer:

No

Question 4:

Can the company calculate its assessable income on a profit emerging basis?

Answer:

No

This ruling applies for the following periods:

Year ended 30 June 2015

Year ending 30 June 2016

Year ending 30 June 2017

Year ending 30 June 2018

Year ending 30 June 2019

The scheme commenced on:

1 July 2014

Relevant facts

The company is a licensed real estate agent.

The company's business activity is to manage rental properties.

The company earns the following income amounts by providing management services to landlords in respect of their rental properties:

• Management fees (commonly called commissions) for the ongoing management of the property, being based on a percentage of the gross weekly rental;

• Letting fees, payable where the company sources a new tenant for a vacant property;

• Re-letting fees, where a tenant renews their lease agreement with the landlord; and

• Fees from various incidental activities such as advertising, postage and sundries, end of financial year statement and re-issue statement fees.

The company has acquired several rent rolls over the years it has been operating including the rent roll acquired through the Sale of Rent Roll Agreement dated XX/XX/XXXX (Sale of Rent Roll Agreement).

The purchase price under the Sale of Rent Roll Agreement was $X,XXX,XXX including an amount for 'Other Assets' which comprised the vendor's following assets:

• the premises lease

• plant and equipment including office computers, printers, photocopier, furniture, and office fit out

• several vehicles

• telephone and facsimile numbers

• the right to redirect the vendor's emails in respect of the business property management and the rent roll.

Clause X of the Sale of Rent Roll Agreement states that the purchaser acknowledges and agrees that it is liable for the continuing employment of the employees (that have taken up offers of employment with the purchaser).

Clause X of the Sale of Rent Roll Agreement states that 'The Vendor and the Purchaser agree that the sale of business is the sale of a going concern.'

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5.

Income Tax Assessment Act 1997 section 8-1.

Income Tax Assessment Act 1997 subsection 40-30(1).

Income Tax Assessment Act 1997 subsection 40-30(2)

Income Tax Assessment Act 1997 paragraph 40-30(1)(c).

Income Tax Assessment Act 1997 section 108-5.

Income Tax Assessment Act 1997 subsection 110-25(2)

Income Tax Assessment Act 1997 section 40-880.

Income Tax Assessment Act 1997 paragraph 40-880(5)(f)

Reasons for decision

Summary

The company is not entitled to a deduction under section 8-1 of the ITAA 1997 for the cost of acquiring a rent roll as the expenditure is capital in nature. The expenditure is considered to be part of the cost of expanding a business by essentially acquiring another business or a portion of another business. A rent roll is an intangible asset but not of a kind listed in subsection 40-30(2) of the ITAA 1997 and is therefore excluded from being a depreciating asset by paragraph 40-30(1)(c) of the ITAA 1997. The expenditure is not an allowable deduction under section 40-880 of the ITAA 1997 as it could be taken into account in working out the amount of a capital gain or capital loss from a CGT event.

For a taxpayer to be entitled to use the profit emerging basis to calculate its assessable income, the gross receipts themselves must not be ordinary income, rather the receipts must consist of both a return of circulating capital and income. As expenditure on a rent roll is considered to be a cost of expanding a business by essentially purchasing another business or a portion of another business, it is not regarded as circulating capital. Also, gross management fees received from landlords are themselves ordinary income. Therefore, the company cannot use the profit emerging basis to return its assessable income.

Detailed reasoning

Section 8-1 of the ITAA 1997

Section 8-1 of the ITAA 1997 allows a deduction for any loss or outgoing incurred in gaining or producing assessable income, or that is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income except to the extent that such loss or outgoing is of a capital nature.

The classic formulation of the matters to be considered in determining whether a loss or outgoing is of a capital or revenue nature is that of Dixon J in Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403 (Sun Newspapers) where his Honour said:

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.

More recently in GP International Pipecoaters Pty Ltd v. Federal Commissioner of Taxation (1990) 170 CLR 124; 90 ATC 4413; (1990) 21 ATR 1 the High Court pointed out that the character of expenditure is ordinarily determined by reference to the nature of the asset acquired and that the character of the advantage sought by the making of the expenditure is a critical factor in determining the character of what is paid.

In this case, from a practical and business point of view, the expenditure on a acquiring rent roll:

• significantly increased the number of the property management contracts already held by the company resulting in an enlargement of the profit yielding structure of the business

• removed a competitor from the company's market resulting in an increased market share

• was made in a lump sum to secure the use of additional property management contracts to be held by the company.

Taking into consideration all the factors above, the outgoing made by the company in acquiring a rent roll, is considered to be capital in nature.

There are no taxation rulings or determinations which deal with property management contracts specifically. However, the above view is consistent with that expressed in Taxation Ruling TR 2000/1 which deals with the tax consequences of the acquisition and disposal of insurance registers. The registers are a record of the rights of an insurance agent to future income from renewals and also provide a record of policyholders that an agent has an exclusive right to deal with on behalf of an insurance company. Consequently, there are similarities to property management contracts acquired by the company.

Paragraph 13 of TR 2000/1 states:

Expenditure incurred by an agent acquiring an insurance register would be of a capital nature ... irrespective of the legal form of the transaction and consequently not allowable as a deduction under section 8-1 of the Act.

Further, at paragraph 85, in considering the capital-revenue distinction the Ruling has regard to the judgment of Latham J in Sun Newspapers where his Honour said at 355:

It is true that the payments did not result in obtaining a new capital asset of a material nature, but they did obtain a very real benefit or advantage for the companies, namely, the exclusion of what might have been serious competition.

You have referred to the judgments in National Australia Bank v. Federal Commissioner of Taxation (1997) 80 FCR 352; 97 ATC 5153; (1997) 37 ATR 378 (NAB's case) and Tyco Australia Pty Ltd v. F C of T 2007 ATC 4799 (Tyco's case) to support your contention that the expenditure incurred to acquire the rent rolls are part of the company's development activities which are directed towards increasing sales and market share.

In NAB's case the bank was required to pay a lump sum (but further amounts were payable if loan quotas were exceeded) to the Commonwealth in order to have the exclusive right to make advances to Australian Defence Force personnel for a 15 year period. The Full Federal Court held that the payment was of a revenue nature as it did not enlarge the framework within which the Bank carried on its activities. Rather, it was incurred as part of the process by which the Bank operated to obtain regular returns by means of regular outlay. The Full Court determined that the payment was in the nature of a marketing expense and had a revenue rather than capital aspect.

In Tyco's case, it was held that the advantages sought by each payment was the winning of a customer to be retained for future revenue for services to be provided. Each payment was made to secure an incremental accretion to the customer base of the taxpayer and the expenditure was incurred in the ordinary business activity of winning customers.

At paragraph 55 of 2007 ATC 4811 it is stated:

The substantive commercial effect, it was submitted, was that the Authorised Dealers, through themselves and their own commission agents, operated as a marketing sales force for ADT (that is, the business run by TAPL) in order to obtain customers and revenue stream from customers to be passed over to TAPL. 

At paragraph 81 of 2007 ATC 4814 it is stated:

This was not the purchasing or creation of a business structure. It was, to paraphrase and elaborate upon the words of Dixon J in Sun Newspapers 61 CLR at 360, the building of the extent of the profit-yielding subject (being the customer base of TAPL) as the product of the course of operations, by the incremental winning of customers by the chosen method of organising and remunerating an independent, but controlled, sales force.

We have given consideration to your arguments outlined in NAB's case and Tyco's case; however, by contrast, the expenditure outlaid by the company on each rent roll served to enlarge its operations by increasing its market share and removing competitors from the company's market. Further, the expenditure was not in the nature of marketing as determined in NAB's and Tyco's cases as a rent roll by its very nature is an asset containing a list of property management contracts held by a previous competitor. In L D Nathan & Co Ltd v. IRC (NZ) (1970) ATR 810 and Commissioner of Inland Revenue v. L. D. Nathan & Co. Ltd. (1971) 2 ATR 503, [1972] NZLR 209 (Court of appeal (NZ)), the taxpayer purchased the business of a competitor and sought to claim a deduction in respect of identified amounts paid under the purchase agreement for the list of their competitor's customers. The New Zealand Court of Appeal, relying on the authority of the Australian cases, Sun Newspapers and BP Australia, held that the cost was capital in nature.

Further the expenditure outlaid for a rent roll is not as a result of the process by which the company obtains its regular returns such as commissions, letting and re-letting fees and fees for marketing expenses such as advertising and other sundry fees. The company obtains its regular returns by providing management services and costs incurred in providing these services such as employee wages are the expenses of a revenue nature that are deductible under section 8-1 of the ITAA 1997. Expenditure on a rent roll is a cost of expanding the business rather than a cost of undertaking its day to day business activities of providing management services.

In determining whether an item of expenditure falls to be capital or revenue no one single factor is determinative. After examining all the relevant factors it is considered that the expenditure in acquiring a rent roll is capital in nature and not deductible under section 8-1 on the ITAA 1997.

Capital allowances

Under Division 40 of the ITAA 1997, deductions are available for the decline in value of depreciating assets, to the extent that the asset is used for a taxable purpose.

A depreciating asset is defined in subsection 40-30(1) of the ITAA 1997 to be an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used but excludes land, trading stock and intangible assets except for those listed in subsection 40-30(2) of the ITAA 1997. The list includes items of intellectual property, in-house software and certain other intangible assets.

From the information provided a rent roll is not of a kind listed in subsection 40-30(2) of the ITAA 1997, but is an intangible asset and it is excluded from being a depreciating asset by paragraph 40-30(1)(c) of the ITAA 1997.

Capital gains tax

Section 108-5 of the ITAA 1997 states that CGT assets are any kind of property, or a legal or equitable right that is not property. Therefore, the costs incurred to acquire a rent roll can be included as part of the cost of a CGT asset under subsection 110-25(2) of the ITAA 1997.

Section 40-880 of the ITAA 1997

Subject to the limitations and exceptions contained in subsections 40-880(3) to 40-880(9) of the ITAA 1997, a taxpayer can deduct in equal proportions over a period of five income years under section 40-880 of the ITAA 1997, capital expenditure incurred in relation to their business which is carried on for a taxable purpose.

However, subsection 40-880(5) of the ITAA 1997 sets out that you cannot deduct anything under section 40-880 of the ITAA 1997 for an amount of expenditure incurred to the extent that it:

• forms part of the cost of a depreciating asset (paragraphs 40-880(5)(a) of the ITAA 1997)

• could be taken into account in working out the amount of a capital gain or capital loss from a CGT event (paragraph 40-880(5)(f) of the ITAA 1997).

As noted above, the expenditure for the acquisition of a rent roll does not form part of the cost of a depreciating asset. However, the expenditure could be taken into account in working out the amount of a capital gain or capital loss from a CGT event. Therefore, you are not entitled to a deduction under section 40-880 of the ITAA 1997 in relation to the cost of a rent roll.

Profit emerging basis

Section 6-5 of the ITAA 1997 provides, in brief, that an Australian resident must include in assessable income the ordinary income it derives from all sources. Ordinary income is income according to ordinary concepts.

In Federal Commissioner of Taxation v. Stone [2005] HCA 21 (2005) 222 CLR 289 (2005) 2005 ATC 4234; (2005) 59 ATR 50, the majority judgment of the High Court considered the meaning of the phrase 'income according to ordinary concepts'. The court referred to the judgment in Scott v. Commissioner of Taxation (NSW) (1935) 3 ATD 142 at 144-145, where it was considered that in determining how much of a receipt should be treated as income, regard must be had to the ordinary concepts and usages of mankind.

Ordinarily for tax purposes, a receipt of money is either income or capital which in the context of carrying on a business is divided into fixed and circulating capital.

A taxpayer may be entitled to use the profit emerging basis, a form of net profit basis, to calculate its assessable income if its gross receipts consist of both a return of circulating capital and income.

For example, a taxpayer who carries on a business of debt acquisition and recovery acquires debts as a business deal with the object of outlaying capital in the hope of getting back the outlay and more, that is, a profit. The money outlaid is thus circulating capital and its return would normally constitute a mixture of circulating capital and profit, or if a loss results, just circulating capital.

In Federal Commissioner of Taxation v. Cititbank Limited & Ors (1993) 44 FCR 434; (1993) 93 ATC 4691; (1993) 26 ATR 423 (Citibank), it was held that a necessary requirement to be entitled to use the profit emerging basis is that the gross amounts received were not themselves income according to ordinary concepts.

In this case, it is considered that expenditure on a rent roll is a cost of expanding a business by essentially purchasing another business or a portion of another business and therefore is not regarded as circulating capital. Rather the expenditure is increasing the fixed capital of the business.

Also, the gross receipts of the company are fees paid by landlords for management services provided by the company which are income according to ordinary concepts. Consequently, the requirement set out in Citibank in order to be able to use the profit emerging basis is not met.

You have referred to Citibank and XCO Pty. Ltd. v. Federal Commissioner of Taxation (1971) 124 CLR 343 (1971) 2 ATR 353 (1971) 45 ALJR 461 (XCO's case) in support of your contention that the company is entitled to use the profit emerging basis. In Citibank, the taxpayer was involved in providing finance through finance leases and the payments the taxpayer received consisted of an interest component and a principal repayment component. In XCO's case the taxpayer acquired a debt at a discount and the amount received by the taxpayer consisted of a return of capital and income. Unlike the management services fees received by the company which are themselves, ordinary income, the gross amounts received by the taxpayers in Citibank and XCO's case clearly consisted of both a return of circulating capital and income.

As the fees received by the company are income according to ordinary concepts rather than consisting of both a return of circulating capital and income, the company is not entitled to use the profit emerging basis to determine its assessable income.