Edited version of your written advice

Authorisation Number: 1013000707669

Date of advice: 20 April 2016

Ruling

Subject: Income tax - Deductions - Business and professional expenses - Capital vs revenue expenditure

Question 1

Are payments made for the termination of franchises properly and correctly claimed as allowable deductions in the year of payment under section 8-1 of the Income Tax Assessment Act 1997?

Answer

No

Question 2

If not, are the payments deductible over 5 years under either section 40-880 or section 25-110 of the Income Tax Assessment Act 1997?

Answer

Yes

This ruling applies for the following periods:

01 July 20VV to 30 June 20XX

01 July 20YY to 30 June 20ZZ

The scheme commences on:

01 July 20VV

01 July 20YY

Relevant facts and circumstances

• The Taxpayer carries on a retail sale and franchise business.

• It operates corporate stores whereby it incurs all expenses and derives all revenue in relation to that store.

• The Taxpayer has also granted franchises in Australia, whereby the franchisee is granted a non-exclusive licence to establish and operate one business name using the Taxpayer's trademarks, image, system, and other intellectual property.

• The agreement is entered into for an initial period as specified in the agreement. The Taxpayer receives an initial franchise fee at the outset of the agreement which is recognised over the term of the franchise agreement. It also receives recurring royalties and advertising fees, at a percentage of gross revenue of the franchisee store. The franchisee has a right of renewal subject to certain conditions.

• Suitable premises for the franchisee are located by the Taxpayer. Franchisee stores are selected in locations that are seen as complimentary to the overall business and not in competition with other stores. The franchise agreement allows the franchisee to select a store location subject to the approval of the Taxpayer, but in practice this does not tend to occur.

• The Taxpayer enters into a head lease in relation to the premises and grants an occupancy right to the franchisee by way of an outlet licence. This in effect creates an agreement between the taxpayer and the franchisee which mirrors the Taxpayer's obligations to the landlord under the head lease and under which the franchisee indemnifies the Taxpayer against any liabilities resulting from breaches of the terms outlet licence by the franchisee, including resulting claims against the Taxpayer by the landlord. Typically the outlet licence would be for the same term as the franchise agreement.

• It is noted that under a typical franchise agreement, the franchisee agrees that any goodwill and other rights or interests arising from the franchisee's use of the business name, belong to the Taxpayer. At the end of the franchise, the franchisee is not entitled to receive any payment or compensation from the Taxpayer for any goodwill in connection with the business name, or any reputation developed by the franchisee in connection with the business or the premises.

• Further, other intangible assets, including customer information, and intellectual property, remain the sole property of the Taxpayer under the terms of the franchise agreement. In any case, it is considered that any intellectual property relating to the Taxpayer business is connected to its existing brand and is unlikely to be generated by individual franchisee stores.

• The Taxpayer has entered into a number of agreements to terminate existing franchises located in large retail complexes for the 20WW and 20XX financial years.

• The Taxpayer anticipates entering into further termination agreements of existing franchises for future periods from the 20AA financial year through to the 20ZZ financial year.

• To terminate existing franchise agreements, the Taxpayer would enter into a deed of surrender to end the franchise agreement, referred to as "franchise termination agreements" before the end of its initial term.

• The Termination Agreements provide for two events to take place:

• The surrender of the existing franchise agreements and outlet licences (under which the franchisee effectively sub-leases the premises from the Taxpayer); and

• The sale of the assets of the franchise business to the Taxpayer.

• The amount payable by the Taxpayer to the franchisee is made up of the following:

• The stock value - an amount allocated to stock based on its invoice cost, which per the franchise termination agreement is additional to the payment specified;

• The "balance" - a fixed amount specified in the agreement.

• The "balance" of the payment is not explained in the Termination Agreements however it is payment for the acquisition of assets of the business including plant and equipment and business records. Plant and equipment includes assets such as the shop fit out, computers, printers etc.

• The remainder of the payment after deducting the market value of assets acquired is a fee payable for the termination of the existing franchise agreement. The amount of this payment is subject to negotiation with the franchisee in each individual case.

• Assets under the termination agreement are referred to as stock, business records, goodwill of the business, plant and equipment.

• The Termination Agreement also imposes restrictions on the Franchise, including:

• A confidentiality clause such that the Franchisee must not disclose the terms of the termination agreement on the basis that it could harm the business interests of the Taxpayer and

• A restraint of trade clause which requires that the Franchisee must not operate or be involved in supplying similar goods or services within the restrain area.

• A clause whereby the franchisee agrees that all the goodwill and other rights and interest arising from the Franchisee's use of business names, the trade marks, the image and the system belong to the Taxpayer or a related entity of the Taxpayer.

• An intellectual property clause whereby the franchisee acknowledges that all customer information is and remains the sole property of the Taxpayer.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Section 25-110.

Income Tax Assessment Act 1997 Section 40-880.

Income Tax Assessment Act 1997 Section 40-880(2).

Income Tax Assessment Act 1997 Section 40-880(2)(a).

Income Tax Assessment Act 1997 Section 40-880(2)(b).

Income Tax Assessment Act 1997 Section 40-880(2)(c).

Income Tax Assessment Act 1997 Section 40-880(2)(d).

Income Tax Assessment Act 1997 Section 40-880(5)(b).

Reasons for decision

Question 1

Summary

The termination payments made by the Taxpayer are not deductible under section 8-1 of the ITAA 1997 as they are capital in nature.

Detailed reasoning

Section 8-1 of the ITAA 1997 allows an immediate deduction for expenses incurred in the carrying on of a business provided that the expenses are not capital in nature.

The guidelines for distinguishing between capital and revenue were laid down in Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337: (1938) 45 ALR 10; (1938) 1 AITR 403; 5 ATD 97 (Sun Newspapers).

In Sun Newspapers, Dixon J stated:

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay.

Another relevant consideration as described in Sun Newspapers by Dixon J, is assessing the character of the expenditure:

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 outlay to cover its use or enjoyment for periods commensurate with the payment by making a final provision or payment so as to secure future use or enjoyment. (Emphasis added).

These reasons for decision will first consider what constitutes the Taxpayer's business and its profit yielding structure. It will then consider the character of the expenditure in terms of the above factors.

What is the Taxpayer's Business?

A Franchise is an arrangement which allows the franchisee to use the intellectual property, goodwill and business system that is owned by the Franchisor. The term, "franchising" covers various forms of co-operation between different corporations. (Halsbury's Laws of Australia).

The Taxpayer utilises the business system it has developed in two ways. Firstly it operates corporate stores whereby it sells products and services to customers, earning 100% of the gross revenue and incurring all expenditure in relation to these sales.

The Taxpayer's other method of generating income is from granting non-exclusive licenses to franchisees to use the intellectual property, goodwill and business system that the Taxpayer has developed. Its revenue from this part of the business is derived by receiving an upfront franchise payment and ongoing royalty payments.

What is the Taxpayer's Business profit yielding structure?

In identifying the structure established by the Taxpayer for the earning of profit, reference is made to the statements of Dixon J in Sun Newspapers[3]:

The business structure or entity or organisation may assume any of an almost infinite variety of shapes. In a trade or pursuit where little or no plant is required, it may be represented by no more than the intangible elements constituting what is commonly called goodwill, that is, widespread or general reputation, habitual patronage by clients or customers and an organised method of serving their needs.

It is considered that a franchise is an enterprise that is within the scope of the above statement of Dixon J, in that it comprises a low proportion of physical assets and a high proportion of intangible assets, including goodwill.

Goodwill

The High Court of Australia stated in Commissioner of Taxation (Cth) v Murry [1998] HCA 42 that the attraction of custom still remains central to the legal concept of goodwill, and further that:

• For legal purposes, goodwill is the attractive force that brings in custom and adds to the value of the business. It may be site, personality, service, price or habit that obtains custom: paragraph [13].

• The goodwill of a business is the product of combining and using the tangible, intangible and human assets of a business for such purposes and in such ways that custom is drawn to it: paragraph [24].

• It may be site, personality, service, price or habit that obtains custom: paragraph [67].

• Goodwill is a quality or attribute that derives, among other things, from using or applying other assets of a business, for example, use of a trade mark or a particular site, or from selling at competitive prices: paragraph [24].

• It is more accurate to refer to goodwill as having sources than it is to refer to it as being composed of elements: paragraph [24].

• Many of the sources of goodwill are not themselves property. Nor are they assets for accounting purposes. Examples include manufacturing and distribution techniques, the efficient use of the assets of a business, superior management practices and good industrial relations: paragraph [25].

• Other examples are location of the business, a lack of competition resulting from an enforceable restrictive covenant, and statutory monopolies in respect of products of a business such as patents or trademarks: paragraph [26].

• Expenditures such as advertising and promotional expenses are also sources of goodwill: paragraph [27].

The commissioner considers that the Taxpayer's business structure relies on the intellectual property it has developed which is the main component that makes up the goodwill of the Taxpayer.

The Commissioner acknowledges that the franchise agreements result in the franchisee not owning the Goodwill of the business, however what the Franchisee does acquire is a non-exclusive licence to operate a certain store and utilise the Taxpayer's goodwill it has developed, provided the Franchisee complies with the terms and conditions of the Franchise Agreement.

Therefore whilst it is considered that no goodwill belongs to the franchisee, whilst a franchise agreement is in place, the Taxpayer effectively gives up its right to operate a store in the area using the Franchise system that the Taxpayer has developed. When the Taxpayer makes a payment to terminate a franchise, it is effectively cancelling the licence so that the full use of the goodwill relating to the particular store reverts back to the Taxpayer.

It is considered the fact that the Taxpayer has control over the premises by way of being a head lessee does not have an effect on whether goodwill is acquired or not. Furthermore, the fact that the Taxpayer has entered into a tenancy arrangement for the lease of the premises does not support the argument that it is simply reorganising the way it operates its business, or that they are not acquiring a new business in its entirety.

Operation of Corporate Stores

It is considered that the corporate stores from which the Taxpayer operates itself, form part of the Taxpayer's profit yielding structure.

Granting and termination of a Franchise

The granting of the non-exclusive licence to the Franchisee allows the franchisee to operate its own business subject to the terms and conditions in the Franchise Agreement for the franchise term. The relevant clauses which support that the franchisee operates its own business include:

• Business means the business to be conducted by the Franchisee as a Franchise pursuant to this Agreement;

• Customer means a customer of the Business; and

• The Franchisee and the Guarantor (if any) each acknowledge that:

The Taxpayer does not guarantee any return on investment or profit
to the Franchisee;

The success of the Business depends upon the Franchisee's own effort and the Franchisee assumes responsibility for the success or failure of the Business.

From the above terms and conditions it is evident that the granting of the Franchise results in the Taxpayer disposing of part of its profit yielding structure by issuing the non-exclusive license to operate its business in a certain location.

It is considered that by terminating a franchise the Taxpayer is agreeing to accept the surrender of the Franchise (a non-exclusive licence) such that it will be able to operate the particular store itself.

Character of the advantage sought

In relation to the character of the advantage sought by the expenditure it is necessary to examine whether the expenditure secures an enduring benefit for the business. This test was outlined in British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 (British Insulated) at 213 - 214 by Viscount Cave where he stated: 

"But when an 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 a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital. "

As stated by Dixon J in Sun Newspapers, the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid. The nature or character of the expenditure will therefore follow the advantage that is sought to be gained by incurring the expenditure. If the advantage to be gained is of a capital nature, then the expenditure incurred in gaining the advantage will also be of a capital nature.

It is considered the commercial reality of the transactions against the requirements of the contractual terms such that neither is the sole deciding factor but a factor to be considered. As such, the Commissioner has focussed on what the Taxpayer received in return for the expenditure, in accordance with the comments of Windeyer J in BP Australia Ltd v Federal Commissioner of Taxation [1965] ALR 381 [8]:

Regard ought therefore to be had to what it was sought to acquire and to the relation of that to the taxpayers undertaking or business. These, rather than the form of the transaction or the mechanics of the acquisition, are what appear to me to be deciding factors. In other words, it is what the particular taxpayer got for his money, rather than how he got it that is important.

In considering the nature of the advantage sought, the Taxpayer states that:

The Taxpayer is not seeking to terminate all of its franchise agreements, but has identified selected stores where it considers that it can generate more revenue by managing those locations as corporate stores as opposed to franchises. Typically, the Taxpayer is better positioned to operate stores which are located in large retail complexes.

From the above statement it is clear that the nature of the advantage sought is to terminate the franchise agreement so that they can operate in locations (large retail complexes) where they consider they can maximise profits.

Further, the following reasons indicate that the purchase of the Franchise does have an enduring benefit:

1) The one off termination allowed the Taxpayer to operate the store as a corporate store for an indefinite period of time. Had the Taxpayer not paid the termination fee, The Franchisee could have been granted a franchise renewal (for minimal cost) for a further 3 terms of 5 years in duration; and

2) There is no evidence to support that after termination of the franchised stores, the stores were or would have been re-franchised to another Franchisee.

Further evidence to support the fact that the character of the advantage sought was to acquire a going concern and operate it as part of its corporate stores can be found in the Termination Agreement at clause 18.2 which states:

The parties agree that each supply under the arrangement involving the sale of the Business by the Franchisee to the Taxpayer is a supply of a going concern for GST purposes.

The above supports the conclusion that the nature of the advantage sought was for the Taxpayer to acquire a going concern, which it considered would be more profitable then by allowing the Franchisee to operate the store.

From the above evidence, it is considered that the Taxpayer's main purpose for terminating the franchised stores was so that it could maximise profits for an indefinite period of time and that it could do this by terminating the franchised store.

It is considered that granting of a franchise would result in Taxpayer reducing its profit yielding structure and the subsequent termination would result in the expansion of its profit yielding structure.

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

According to Dixon J in Sun Newspapers, when considering the manner in which the expenditure is to be enjoyed, regard must be had to the recurrent nature of the returns it produces.

From the above analysis it is evident that what the Taxpayer acquired, upon terminating the Franchise Agreement, was a going concern by virtue of the fact that the Franchisee no longer held the license to operate the Franchise and that now the Taxpayer could operate the store as its own corporate store.

By terminating the Franchise the Taxpayer was successful in acquiring a business structure that would result in increased profits as compared with receiving its income by way of royalties.

Therefore it can be concluded that the manner in which the expenditure was to be used and relied upon or enjoyed was by effectively acquiring a going concern that would result in regular returns in the way of sales of goods and services from the running of the particular store.

The means adopted to obtain it

The final consideration as described in Sun Newspapers by Dixon J, in assessing the character of the expenditure, is to look at the means adopted to obtain the benefit and whether this payment related to the expansion of the profit yielding structure or whether the outlay was more akin to an ordinary business expense that could be matched with regular returns.

In Labrilda Pty Ltd v. Deputy Commissioner of Taxation [1996] ATC 4303, the taxpayer paid an up-front accreditation fee for participation in the Team Pak Program conducted by the principal, Mobil Oil. Under that program Mobil granted the right to the taxpayer to carry on its service station business using the "Mobil System". The specific program was designed to provide its participants with necessary training, marketing advice, advertising, promotion and other such assistance in setting up the business.

 The majority in that case concluded that the taxpayer's expenses in relation to the above were of capital nature and not deductible as outgoings incurred in carrying on of the business. The expenses were more concerned with the business structure and characterised as expenditure which established the profit-yielding structure of the taxpayer's business.

It is considered that the payment of a lump sum clearly relates to the termination of the Franchise Agreement, which enables the Taxpayer to expand its profit yielding structure to an area where it does not have the right to operate a Taxpayer store. You have also stated that "Taxpayer considers that it can manage stores more profitably as corporate stores." Furthermore, whilst not determinative, the fact that the payment is made as a lump sum indicates that the payment was made as a "once and for all" payment for more of a capital purpose.

Conclusion

From analysing the above factors it is considered that the payment to terminate a franchise is not deductible under section 8-1 of the ITAA 1997 on the basis that the character of the expenditure is capital in nature.

Question 2

Summary

The termination payments made by the Taxpayer are deductible over a 5 year period pursuant to section 25-110 of the ITAA 1997 to the extent that the payment relates to the termination of the licence to use intellectual property.

Detailed reasoning

Subject to the limitations and exceptions contained in subsections 40-880(3) to (9), subsection 40-880(2) 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.

Paragraph 40-880(5)(b) provides that you cannot deduct anything under section 40-880 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 section 40-880. In this case it is necessary to consider sections 8-1 and 25-110 of the ITAA 1997.

As the expenditure incurred by the Taxpayer is capital expenditure (see question 1), the expenditure is not deductible under section 8-1 of the ITAA 1997.

As the capital expenditure was incurred to terminate a non-exclusive licence, the expenditure is deductible under section 25-110 of the ITAA 1997.

Section 25-110

Section 25-110 of the ITAA 1997 provides a 5-year write-off for capital expenditure incurred to terminate a lease or licence that results in the termination of the lease or licence if the expenditure is incurred in the course of carrying on a business or in connection with ceasing to carry on a business, subject to exceptions contained in subsections 25-110(3) to 25-110(6) of the ITAA 1997. 

The payment of the termination fee incurred by the Taxpayer secured the termination of the franchise agreement and the termination was an integral part of the Taxpayer's business structure.

The payment enabled the Taxpayer to terminate a pre-existing franchise agreement so that it was able to operate the franchise as one of its own corporate stores.

In that context, the payment 'goes to the character and organisation of the profit-earning business and not to be an incident in the operations by which it is carried on': refer Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634; 8 ATD 190. This makes the payment an affair of capital. 

The franchise agreement entered into between the Taxpayer and the Franchisee conferred contractual rights and obligations on both the franchisor and the franchisee. The nature of a franchise prescribes that the payment terminated the various rights and obligations that collectively constitute what the franchisee acquired under the franchise agreement. This includes the right to use the intellectual property in operating the franchise during the term of the agreement, and the contractual right to use the services of the franchisor for purposes advertising and marketing of their products, management assistance and training.

In short, a franchise may include but be wider than a licence, which would appear to be the case here. See Bob Jane T-Marts v Federal Commissioner of Taxation 99 ATC 4437; the definition of 'franchise agreement' in Trade Practices (Industry Codes Franchising) Regulations 1998 Reg 3; Federal Commissioner of Taxation v United Aircraft Corporation (1943) 68 CLR 525.

The words 'to terminate a lease or a licence' in subsection 25-110(1) of the ITAA 1997 entail a direct link between the incurrence of the deductible expenditure and the termination of the lease or licence. In other words, deductible expenditure is that which has been incurred for the purposes of causing or inducing the termination of the lease or licence and has the consequence of having done so. The payment incurred by the Taxpayer was for terminating all of the rights and obligations under the franchise agreement. So the payment to the Franchisee to terminate the franchise was paid by the Taxpayer to terminate not only the licence to use the intellectual property but also the contractual obligations under the Franchise Agreement. 

In these circumstances, it is reasonable to infer that only that part of the payment of that can be said to be paid 'to' terminate the licence to use the intellectual property and result in its termination is eligible for deduction under section 25-110 of the ITAA 1997. Apportionment of the payment would therefore be required.

In making this apportionment of the payment, the method used must be reasonable and what is reasonable will often depend on the particular circumstances. In any case however, the remainder of what it not deductible under section 25-110 will be deductible under section 40-880.  

Based on the information supplied by the Applicant, it is considered that none of the exceptions contained in subsections 25-110(3) to 25-110(6) of the ITAA 1997 applies in this case.