Edited version of your written advice

Authorisation Number: 1013103977163

Date of advice: 21 October 2016

Ruling

Subject: Section 40-880 Black-hole Expenditure

Question 1

Will section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to provide a deduction for capital expenditure incurred by the taxpayer associated with the sale of its own shares?

Answer

Yes

Issue 1:

Is the expenditure capital in nature such that it can be deducted under section 40-880?

Answer

Yes

Issue 2:

Is the expenditure business related capital expenditure for the purposes of sub-section 40-880(2A)?

Answer

Yes

Issue 3

Could the expenditure be taken into account in working out the amount of a capital gain, such that paragraph 40-880(5)(f) excludes the expenditure from being deductible under section 40-880?

Answer:

No

This ruling applies for the following periods:

● Income year ended 30 June 20VV

● Income year ended 30 June 20WW

● Income year ended 30 June 20XX

● Income year ended 30 June 20YY

● Income Year ended 30 June 20ZZ

The scheme commences on:

1 July 20UU

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 taxpayer, a company incorporated in Australia operates a business in Australia for a taxable purpose.

The taxpayer required additional financing to expand its business. The shareholders of the taxpayer were unable to obtain the necessary financing on their own, and so sought out a third party who would be willing to provide the required financing.

A third party (the purchaser) capable of providing the additional financing required to expand the business, offered to provide the required financing in exchange for all the shares held by each of the shareholders.

In association with this event, each of the shareholders and the purchaser entered into an agreement in the 20VV income year under which the sale of the shares was conditional on the taxpayer incurring and paying certain costs associated with the sale of the shares (the Agreement).

On sale, the following costs were incurred, and paid for, by the taxpayer.

● Seller's Warranty and Indemnity Insurance: $XXX,XXX.XX

● Transaction Success Fee payable to a consultant: $XXX,XXX,XX

● Legal Fees: $XXX,XXX,XX

● Other Incidental Costs of sale: $XX,XXX,XX

Each of the items of expenditure were payable to third parties unrelated to the taxpayer, shareholders or the purchaser. No further agreements, including agreements to adjust the sale proceeds, nor any reimbursement, transfer of liability or loan agreements, were in place as between the taxpayer, the shareholders or the purchaser, or any of the service providers. Consequently, the shareholders and the purchaser did not incur or pay for any of the above costs associated with the sale of the shares.

Following the sale of the shares, the purchaser obtained additional financing for the taxpayer which enabled the expansion of the taxpayer's business, through the purchase of additional assets which were put to use in the operation of the taxpayer's business.

Throughout the process of the sale of the taxpayer's shares, the taxpayer's business remained unchanged and continued to be operated for the same taxable purpose.

Relevant legislative provisions

● Income Tax Assessment Act 1997 Section 40-880

● Income Tax Assessment Act 1997 Section 110-40

● Income Tax Assessment Act 1997 Section 110-45

● Income Tax Assessment Act 1997 Section 112-35

Detailed reasoning

Issue 1:

Is the expenditure capital in nature such that it can be deducted under section 40-880?

Answer

Yes

Relevantly, the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No.1) Bill 2006 (the EM) at paragraph 2.18 to 2.22 states:

2.18 The provision only applies to business capital expenditure.  What this amounts to in the context of an existing, former or prospective business is determined on a case by case basis having regard to the general principles established by the Courts.  This includes expenditure that fails the general deduction provision of section 8-1 by reason only of being capital or of a capital nature.  [Schedule 2, item 30, subsection 40-880(2)]

2.19 Expenditure on the structure by which an entity carries on (or used to or proposes to carry on) their business and on the profit yielding structure of the business would ordinarily be expected to be of a capital nature.  Capital expenditure can also relate to a business's trading operations or the entity that will carry on the business.

2.20 The structure covers the legal entity (such as a company) or the legal relationship (such as a partnership or trust) that is the entity that carries on the business for a taxable purpose and that holds the business assets.

2.21 For pre- and post-business expenditure, it may also provide a deduction for capital expenditure that falls outside the positive business limb of section 8-1.  However, the mere fact that the expenditure fails the positive business limb of section 8-1 does not necessarily bring it into this provision. 

2.22 Taxpayers can deduct the following specific types of capital expenditure: 

● expenditure to establish your business structure;

● expenditure to convert your business structure to a different structure;

● expenditure to raise equity for your business;

● expenditure to defend your business against a takeover;

● costs to your business of unsuccessfully attempting a takeover; and

● costs to stop carrying on your business,

Example 8 of Taxation Ruling (TR) 2011/6 directly contemplates the sale of shares to a new shareholder, as being on capital account to which section 40-880 may apply.

As the expenditure was incurred and paid for by the taxpayer, in respect of its profit yielding structure as opposed to its business operations, it is reasonable to conclude that the expenditure is capital in nature.

Issue 2:

Is the expenditure business related capital expenditure for the purposes of sub-section 40-880(2A)?

Answer

Yes

In order to be deductible, the expenditure must also serve an 'objective of the business', reflected in paragraph 84 of Taxation Ruling (TR) 2011/6 which states relevantly:

“expenditure relating to the ownership of the entity carrying on the business is not business related capital expenditure unless it can be demonstrated that the change of ownership serves an objective of the business.”

As the facts demonstrate that the expenditure was incurred to enable additional financing to be obtained for the future growth of the taxpayer's business, the expenditure meets the requirement of serving an objective of the business.

Consequently, it is reasonable to conclude that the expenditure relates its business related capital expenditure on the basis that the taxpayer was unable to obtain sufficient financing to expand its business, and incurred and paid for the relevant expenditure so as to enable additional financing to be obtained. The expenditure may therefore be deductible pursuant to s40-880(2A)(b)(i).

Issue 3

Could the expenditure be taken into account in working out the amount of a capital gain, such that paragraph 40-880(5)(f) excludes the expenditure from being deductible under section 40-880?

Answer:

No

Paragraph 40-880(5)(f) states:

You cannot deduct anything under this section for an amount of expenditure you incur to the extent that:

(f) it could, apart from this section, be taken into account in working out the amount of a *capital gain or *capital loss from a *CGT event;

On sale of the taxpayer's shares, the following costs were incurred and paid for, by the taxpayer.

● Seller's Warranty and Indemnity Insurance: $XXX,XXX.XX

● Transaction Success Fee payable to a consultant: $XXX,XXX.XX

● Legal Fees: $XXX,XXX.XX

● Other Incidental Costs of sale: $XX,XXX.XX

Section 40-880(5)(f) provides that no amount is deductible where it could be taken into account in working out a capital gain or loss from a CGT event. Accordingly, expenditure included in the cost base (Subdivision 110-A) and reduced cost base (Subdivision 110-B) cannot be deducted under section 40-880 because such expenditure is taken into account in working out a capital gain or capital loss.

Similarly, expenditure that has been or can be deductible under another provision, is excluded from any element of the cost base when working out a capital gain or loss pursuant to sub-section 110-40(2) and sub-section 110-45(2) of the ITAA 1997. This includes recouped expenditure, which is also excluded from the cost base of an asset, except to the extent that the recoupment is included in assessable income: see sub-section 110-40(3) and sub-section 110-45(3). Further, inclusion of expenditure in a taxpayers cost base calculation, may be altered where the liability is assumed by a separate taxpayer pursuant to section 112-35 of the ITAA 1997.

The above provisions ensure that when taxpayers calculate their net capital gain, only that expenditure which has been incurred by the taxpayer may be included in the cost base, excluding amounts which have been previously deducted under a separate provision.

In the present case, the facts demonstrate that only the taxpayer paid for and incurred the relevant expenditure, and as such, the expenditure is not included in the cost base calculation for either the shareholder's or the purchaser.

As it is only necessary that the expenditure "could" be taken into account in determining the amount of a capital gain or loss, paragraph 40-880(5)(f) may be interpreted as having a broad application.

Relevantly TR 2011/6 states at para 48-50:

48. In most cases, capital proceeds and cost base (or reduced cost base) are taken into account in working out the amount of a capital gain or capital loss from a CGT event. Therefore, capital expenditure which reduces capital proceeds from a CGT event or forms part of the cost base (or reduced cost base) of a CGT asset could be taken into account in working out the amount of a capital gain or capital loss from a CGT event for the purposes of paragraph 40-880(5)(f).

49. Where the expenditure is not reflected in the net capital gain included in the taxpayer's assessable income for the income year in which the CGT event happened because, for example, the amendment period under section 170 of the ITAA 1936 has expired without the expenditure actually having been taken into account, this does not mean that the expenditure could not be taken into account.

50. In the context of section 40-880 the words of paragraph 40-880(5)(f) do not require that the capital expenditure be actually taken into account in working out a capital gain or capital loss, or that the capital gain or capital loss worked out be actually taken into account in working out the net capital gain included in the taxpayer's assessable income - that is a separate process. If the words were interpreted otherwise expenditure which should receive CGT treatment could inappropriately become a revenue deduction.

The Explanatory memorandum to the Taxation Laws Amendment (2006 Measures No.1) Bill 2006 (para 2.73) makes it clear that where a capital gain or capital loss worked out is to be disregarded or reduced, an amount is still "taken into account in working out the amount of a capital gain or capital loss". The EM states:

2.73 Where an amount can be taken into account in working out a capital gain or loss from a CGT event, it is not deductible.  A capital gain or loss that has not yet been realised or where the capital gain or loss is disregarded (e.g. because it is a pre-CGT asset) or reduced is excluded from deduction under section 40-880 by paragraph 40-880(5)(f).  An amount is not taken into account in working out a capital gain or loss if the expenditure cannot be included in the cost base or reduced cost base of the asset (e.g. expenses related to the sale of a CGT asset that falls through).  In relation to non-residents, this provision excludes a capital gain or loss from an asset that does not have the necessary connection with Australia or any other kind of capital gain or loss that an Australian resident can make but a non-resident cannot.  This exclusion has been transferred from the repealed section 40-880 with minor modification to reflect the broader application of the law.  [Schedule 2, item 30, paragraph 40-880(5)( f )]

In Inglewood and Districts Community Enterprises Ltd v FC of T 2011 ATC at 10-202, the taxpayer operated a corporate franchise of the Bendigo Bank, using the name, logo and various systems of the Bendigo Bank. Under the franchise agreement the taxpayer paid franchise establishment fees and renewal fees, and contended that the former were not part of the cost base of any asset. The taxpayer submitted that the franchise establishment fee, although capital in nature, was for services rendered prior to carrying on any business rather than being a payment to secure an enduring benefit.

The AAT rejected this argument, citing Colonial Mutual Life Assurance Society Ltd, at 451 and 454 per Fullagar J, with whom Kitto and Taylor JJ agreed, stating that:

15. Whatever motivated the calculation of the amount, the test that applies is what the payment in fact secured. The fact that the amount of a payment obligation might be measured or calculated by reference to another factor, e.g. a revenue receipt or the quantum of work done, is not determinative.

In the present case, the taxpayer paid for and incurred certain costs associated with the sale of its own shares which, but for the agreement, would have been paid for and incurred by either of the shareholder's or the purchaser. In such instances, it may be appropriate for the expenditure to be accounted for (as contemplated by para 48 of TR 2011/6) as an amount which reduces capital proceeds, and which therefore 'could' be taken into account in working out a capital gain or loss.

It follows that, to the extent that any of the expenditure is taken into account by the shareholders in calculating their respective capital gains on sale of the shares, the amount attributed to that calculation from the costs identified above, would not be deductible by the taxpayer under s 40-880 of the ITAA 1997. For the same reason, to the extent that any of the expenditure is taken into account by the purchaser in calculating a capital gain regarding the sale of the shares, a deduction will not be available to the taxpayer for the same amount under section 40-880.

In the present circumstances however, the agreement to which the ruling relates was concluded on the basis that, in order to enable the sale of the shares, the taxpayer would incur and pay for the relevant expenditure. There was no guarantee that the expenditure would secure any additional benefit.

Since neither the shareholder's nor purchaser can incorporate any of the expenditure into the calculation of a capital gain or loss, paragraph 40-880(5)(f) will not prevent the taxpayer from deducting the expenditure pursuant to section 40-880.

This is subject to any subsequent assumption of liability by either of the shareholder's or the purchaser pursuant to section 112-35 of the ITAA 1997. Where either of the shareholder's or the purchaser assume any part of the liability for the above detailed costs, the taxpayer will not be able to claim a deduction in respect of that part of the expenditure under section 40-880.