Edited version of your written advice

Authorisation Number: 1051191555082

Date of advice: 8 February 2018

Ruling

Subject: Lump sum payment

Question 1

Is Company A entitled to an income tax deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the lump sum payment?

Answer

No.

This ruling applies for the following period:

XXXX to XXXX

The scheme commences on:

During the income year ended XXXX.

Relevant facts and circumstances

1. Company A is an Australian resident.

2. Company A was granted a lease to use an Asset which will enable it to produce its assessable income.

3. Company A elected to pay the rent for the lease as a lump sum in advance. The lease is for an Initial Term of X years, with the option to extend the lease term further.

4. The amount of the lump sum was calculated using the net present value (NPV) of rent otherwise payable over the Initial Term.

5. The lump sum payment unconditionally and irrevocably releases Company A from any claim for further rent during the Initial Term.

6. But for Company A’s election to pay the rent as a lump sum in advance, the rent for the Initial Term would have been reviewed annually and payable by equal monthly instalments.

7. Company A is entitled to a pro-rata refund of the unused portion of the lump sum payment if, in certain circumstances, the Initial Term of the lease is terminated prior to its expiry.

8. There is no transfer or option to transfer the ownership of the Asset to Company A at the end of the lease term.

Relevant legislative provision

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Question 1

Section 8-1 of the ITAA 1997 provides:

(1) You can deduct from your assessable income any loss or outgoing to the extent that:

(a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

(2) However, you cannot deduct a loss or outgoing under this section to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature; or

(b) it is a loss or outgoing of a private or domestic nature; or

(c) it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or

(d) a provision of this Act prevents you from deducting it.

The lump sum payment will allow Company A to access the Asset to perform activities that will produce its assessable income. Accordingly, the lump sum payment is an outgoing incurred by Company A in producing its assessable income and subsection 8-1(1) of the ITAA 1997 is satisfied.

The circumstances described in paragraphs 8-1(2)(b), (c) and (d) of the ITAA 1997 do not apply in this instance. It therefore follows that the lump sum payment will be deductible to Company A under section 8-1 of the ITAA 1997 if the lump sum payment is not an outgoing of capital or of a capital nature (paragraph 8-1(2)(a) of the ITAA 1997).

The leading authority on whether or not a loss or outgoing is in the nature of capital is Sun Newspapers Ltd & Anor v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403 (Sun Newspapers). In Sun Newspapers, Dixon J said at CLR 359; ATD 93-94; AITR 410:

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

The test for identifying whether an outgoing is capital or revenue is to ask what a payment is really for, in the sense of what is it intended to effect from a practical and business point of view, and whether what is paid for is capital or revenue, in the sense described by Dixon J: AusNet Transmission Group Pty Ltd v. Federal Commissioner of Taxation (2015) 255 CLR 439, [2015] HCA 25, 99 ATR 816.

In Sun Newspapers, Dixon J outlined three matters to consider in applying this test (at CLR 363; ATD 96; AITR 413):

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.

Each matter is considered in turn below.

1. The character of the advantage sought, and in this its lasting qualities may play a part

When making a distinction between an outgoing of a capital and a revenue nature, the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor: GP International Pipecoaters Pty Ltd v. Federal Commissioner of Taxation (1990) 170 CLR 124; [1990] HCA 25; 90 ATC 4413.

In Commissioner of Taxation v. Star City (2009) 175 FCR 39; [2009] FCAFC 19; 2009 ATC 20-093, Goldberg J states at paragraph 63:

…there was an issue as to the label of “rent” which the parties had used to describe the lump sum prepayment…In those circumstances, as recognised by the Full Federal Court in City Link Melbourne Ltd v. Commissioner of Taxation (2004) 141 FCR at [46], and by the Full Federal Court in Federal Commissioner of Taxation v. Broken Hill Pty Co Ltd (2001) 179 ALR 593 at 601-602, labels are not determinative and surrounding circumstances may be resorted to determine the true characterisation of a payment in an appropriate case.

Leases are capital assets. This was recognised by Gaudron, Gummow, Kirby and Hayne JJ in Federal Commissioner of Taxation v. Montgomery (1999) 198 CLR 639; [1999] HCA 34; 42 ATR 475 where, in reference to a lease acquired by a firm of solicitors, at paragraph 91 their Honours said ‘[t]hat the lease of the premises was part of the profit-yielding structure of the firm’s business is beyond question’. However, payments under a lease are usually not made for the entirety of the lease, but for periods of use under the lease, as those periods arise or expire. As such, what is sought by any particular payment is not the lease, but instead a period of use. Therefore, the advantage sought by an ordinary rent payment is not of enduring benefit to the business, but instead the use of premises for a limited period.

The factual circumstances surrounding the lease agreement may be sufficient to displace this general proposition. Where a payment is made to secure an enduring benefit, such as the future use and enjoyment of an asset, it points towards an outgoing of a capital nature.

In BP Australia Ltd v. Federal Commissioner of Taxation (1965) 112 CLR 386; 14 ATD 1; [1965] 3 All ER 209 (BP Australia), the Privy Council gave consideration to the length of the agreement as an indicator of the nature of the payment and said at CLR 399-400; ATD 9; All ER 220:

What additional indication is given by the actual length of the agreements? That must be a question of degree. Had the agreements been only for two or three year periods that fact would have pointed to recurrent revenue expenditure. Had they been for twenty years, that fact would have pointed to a non-recurring payment of a capital nature. Length of time, though theoretically not a deciding factor, does in practice shed a light on the nature of the advantage sought. The longer the duration of the agreements, the greater the indication that a structural solution was being sought.

In this case, the lump sum payment is not made with respect to any particular period, but is instead the entire sum paid for a lease. The lease is for an Initial Term of X years, with the option to extend the lease term further. The advantage sought by Company A is of an enduring kind, as although it will not be able to enjoy the right to the Asset forever, it will have the advantage of the use and enjoyment of the Asset for an extensive period of time. It therefore adds to the profit yielding subject of the business. Dixon J made the following comments regarding expenses of this kind in Sun Newspapers at CLR 360, ATD 94, AITR 411:

In the same way expenditure and outlay upon establishing, replacing and enlarging the profit-yielding subject may in a general way appear to be of a nature entirely different from the continual flow of working expenses which are or ought to be supplied continually out of the returns or revenue. The latter can be considered, estimated and determined only in relation to a period or interval of time, the former as at a point of time.

Therefore, it is considered that the character of the advantage sought points towards the lump sum payment being capital or of a capital nature.

2. 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

In this case, by entering into a long term lease and paying the rent for the Initial Term as a lump sum in advance, Company A has been able to secure the benefit of future access to the Asset for a significant period at a predetermined cost. This provides Company A with an advantage which is similar to the outright ownership of the Asset. The manner in which the lease is to be used is therefore consistent with the payment of rent being capital or of a capital nature.

3. 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

Generally, a once and for all lump sum payment is indicative of a capital expenditure while recurrent payments are indicative of revenue expenditure.

In Federal Commissioner of Taxation v. Creer (1986) 11 FCR 52; [1986] FCA 140; 86 ATC 4318, the Federal Court referred to the distinction between a capitalised sum paid for a lease and an outgoing of rent which accrues ‘de die in diem’ for the use of premises. At paragraph 31, Fisher J said:

The test adopted by Dixon J. in Sun Newspapers supra is equally helpful, namely to determine whether the amount is a "capitalized sum payable by instalments" or "rent accruing de die in diem for the use of the thing". The word "capitalized" has dictionary meanings which are presently apt, namely "converted into capital" or "computed present value of income".

Fisher J’s reference to an obligation accruing ‘de die in diem’ does not indicate that the obligation should be calculated by reference to periods, but that some obligation should actually accrue periodically. His Honour further said that only where obligations to pay arose ‘de die in diem’ in respect of a lease could there be any rule that the outgoing was necessarily on revenue account.

In this case, Company A has made a lump sum payment in advance for the Initial Term. The amount of the lump sum was calculated using the NPV of rent otherwise payable over the Initial Term. The lump sum payment unconditionally and irrevocably releases Company A from any claim for further rent during the Initial Term. Accordingly, no further obligation to pay rent is accruing ‘de die in diem’. Company A has therefore made a final payment to secure the future use and enjoyment of the Asset and the payment is capital or of a capital nature.

The payment made by Company A is comparable to that made by the taxpayer in Clarke v. Federal Commissioner of Taxation (1932) 48 CLR 56, [1932] HCA 46, 2 ATD 121. There a taxpayer acquired a ten year lease of a hotel, for which he paid £12,000 at the commencement of the lease, and £42 per week thereafter. The taxpayer was also required to accept a tie to the brewers who owned the hotel in order to obtain the lease, diminishing the lease’s value to the taxpayer. The up-front payment was accepted by the High Court to be a prepayment of rent. However, they still found that it was capital in nature. They said, at CLR 74; ATD 125:

[The upfront payment] represented the present price of the future enjoyment of an interest in land of long duration. It is quite true that the premium is an anticipated rent. That means, however, that what otherwise might have been part of the rent reserved has been capitalised. No doubt it is capital expenditure in the acquisition of an asset of a diminishing or wasting nature and therefore required in a proper account a provision for depreciation. But the annual loss which would so be provided for out of revenue would none the less be a loss of capital.

While Company A is entitled to a pro-rata refund of the unused portion of the prepaid rent, the circumstances in which Company A will be entitled to the refund are limited. The fact that in certain limited circumstances the lump sum paid by Company A can be refunded does not detract from the characterisation of the payment as capital or of a capital nature.

Conclusion

Accordingly, in consideration of the factors above, Company A is not entitled to an income tax deduction under section 8-1 of the ITAA 1997 for the lump sum payment as the payment is capital or of a capital nature.