Edited version of your written advice

Authorisation Number: 1051333288222

Date of advice: 1 February 2018

Ruling

Subject: Business related costs

Question 1:

Does the payment by Company A of a proportion of xx% of the legal costs incurred by the third-party purchaser of Company C represent part of the cost base of the original disposal, being incidental costs, pursuant to Section 110-25 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

No.

Question 2:

If not, does the payment by Company A of a proportion of xx% of the legal costs incurred by the third-party purchaser of Company C represent ‘black hole expenditure’ pursuant to Section 40-880 of the ITAA 1997?

Answer:

No.

This ruling applies for the following periods

XX XX 20XX to YY YY 20YY

The scheme commences on

XX XX 20XX

RELEVANT FACTS AND CIRCUMSTANCES

1. Company W is the trustee for Company B.

2. Company D is the trustee of Company A.

3. On ZZ XX 19XX, Company W, as trustee for Company B, purchased xx% of the business, being the leasehold and business assets of, Company C. Company W later purchased xx% of the business premises on ZZ XX 19XX.

4. During the year ended ZZ YY 20YY, Company D, as trustee for Company A, purchased the remaining xx% of the business and premises of Company C.

5. On ZZ ZZ 20ZZ, Company A and Company B (as vendors) entered in an agreement to sell the business and the premises of Company C for consideration of $x to a third-party purchaser.

6. Subsequent to settlement, the third-party purchaser commenced legal action against the vendors. The purchaser made claims that the market value of the business had been overstated and made an application for damages.

7. On ZZ ZZ 20ZZ, the purchaser (as Applicant) of Company C, submitted their ‘Further Amended Statement of Claim’ with the relevant Court of Australia which outlined the following contentions:

a. the vendors had misrepresented the true amount of the expenses and liabilities of the business by approximately $xx for the year ended YY YY 20YY.

b. the purchaser relied on the representations of the financial position of Company C made by vendors in making their offer for the business

c. had the purchaser been fully aware of the true financial position of Company C, it would not have made the offer to purchase the business

d. the purchaser had suffered a financial loss due to having paid greater than the market value for the business, and

e. the purchaser was entitled to damages as a result of the misrepresentation of the expenses and liabilities.

8. On ZZ ZZ 20ZZ, the purchaser and vendors came to a settlement where, without admission of misrepresentation, the vendors agreed to pay the purchaser $XX of the settlement sum plus xx% of the Applicant’s costs to settle the dispute.

a. entities related to the business operating under the name of Company R were also respondents to the claim made by the purchaser. As part of the settlement, these parties also agreed to pay $y of the settlement sum plus yy% of the Applicant’s costs.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 110-A

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Section 110-35

Income Tax Assessment Act 1997 Subdivision 40-I

Income Tax Assessment Act 1997 Section 40-880

Anti-avoidance rules

Part IVA is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

REASONS FOR DECISION

All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.

QUESTION 1:

Summary

The payment by Company A of a proportion of xx% of the legal costs incurred by the purchaser of Company C does not represent part of the cost base of the original disposal, being incidental costs, pursuant to subsection 110-25 of the ITAA 1997.

DETAILED REASONING

CAPITAL GAINS TAX PROVISIONS

9. Subsection 102-5(1) of the ITAA 1997 provides that the assessable income of a taxpayer includes any ‘net capital gain’ made during the income year.

10. Section 102-20 provides that a taxpayer may make a capital gain or a capital loss if and only if, a capital gains tax (CGT) event happens.

CGT Event A1

11. Section 104-5 sets out a summary list of CGT events. CGT event A1 is the disposal of a CGT asset pursuant to subsection 104-10(1).

12. Subsection 104-10(5) provides that a capital gain or loss is disregarded if a taxpayer acquired an asset before 20 September 1985.

CALCULATING CAPITAL GAINS OR LOSS ARISING FROM A CGT EVENT

13. Pursuant to subsection 104-10(4), a taxpayer will make a capital gain if the capital proceeds from the disposal are more than the asset’s cost base. The capital gain is calculated by determining the capital proceeds from the disposal, less the asset’s cost base.

Cost base

14. Subdivision 110-A provides the general rules about cost base of CGT assets. Section 110-25 provides that there are five elements to an asset’s cost base which broadly, are the:

a. money paid in respect of acquiring the asset

b. incidental costs incurred (further defined in section 110-35)

c. costs of owning the CGT asset

d. capital expenditure incurred for the purpose of increasing or preserving the assets value or installing or moving the asset, and

e. capital expenditure incurred to establish, preserve or defend the title to the asset, or a right over the asset.

15. With regards to the second element of incidental costs, section 110-35 describes ten categories of ‘incidental costs’ that could be incurred to acquire or in relation to a CGT event. In summary, these are:

a. remuneration for the services of a surveyor, valuer, auctioneer, accountant, broker, agent, consultant or legal adviser

b. the cost of transfer

c. stamp duty or other similar duty

d. advertising costs to find a buyer or seller

e. costs associated with a valuation or apportionment for the purposes of Part 3-1 or 3-3

f. search fees relating to the CGT asset

g. cost of a conveyancing kit

h. borrowing expenses

i. specified costs incurred by members of consolidated groups, and

j. termination or similar fees incurred as a direct result of ownership of the CGT asset ending.

APPLICATION TO YOUR CIRCUMSTANCES

16. Together with Company B, you entered into an agreement to sell the business and premises of Company C for consideration of $xx to a third-party purchaser. As this represents the disposal of a CGT asset, pursuant to subsection 104-10(1), CGT event A1 occurred.

17. In order to calculate the capital gain you made from the sale pursuant to subsection 104-10(4), it is necessary to establish the cost base of the business.

18. Given that you acquired 50% of the business in 20XX, you acquired it after 20 YY 19YY. It is therefore, a post-CGT asset and any proceeds received in relation to its disposal are regarded pursuant to subsection 104-(5).

19. On 27 XX 20XX, you entered into a settlement agreement to resolve the dispute with the third-party purchaser such that you, and Company B, agreed to pay $xx of the settlement sum to the purchaser, together with xx% of the third-party purchaser’s legal costs.

a. The Commissioner has already ruled that the payment of $xx to the third-party purchaser satisfies modification rule 4 of section 116-50.

20. Although remuneration for services of a legal advisor may be considered an incidental cost pursuant to subsection 110-35(2), the cost must be incurred to either acquire a CGT asset or in relation to a CGT event to satisfy subsection 110-35(1) and form part of the cost base of the CGT asset.

21. In your case, you did not engage the legal advisor and the legal costs were not incurred by you to acquire the CGT asset and paragraph 110-35(1)(a) is therefore not satisfied. Rather, you are compensating the third-party purchaser for the remuneration which they paid to the legal advisor for the services which they provided.

22. The payment of a proportion of xx% of the third-party purchaser of Company C’s legal costs was incurred by you as a result of you entering into a settlement of the legal action taken against you. The legal costs are based on remuneration provided by the third-party purchaser to their own legal advisor and can therefore only be considered remuneration for services from the perspective of the third-party purchaser, not yourself. Therefore, although you are compensating the third-party purchaser for their legal costs, they are not in relation to the CGT event, being the disposal of the business and paragraph 110-35(1)(b) is also not satisfied.

23. As the legal costs are not an incidental costs, they do not form part of the cost base of the CGT asset and subsection 110-25 is not satisfied.

QUESTION 2:

Summary

The payment by Company A of a proportion of xx% of the legal costs incurred by the third-party purchaser of Company C does not represent ‘black hole expenditure’ pursuant to section 40-880 of the ITAA 1997.

DETAILED REASONING

BUSINESS RELATED COSTS (‘BLACK HOLE’ EXPENDITURE)

24. Broadly, subsection 40-880(1) allows for certain business capital expenditure to be deductible over five years if:

a. the expenditure is not otherwise taken into account; and

b. a deduction in relation to the expenditure is not denied by some another provision; and

c. the business is, was or is intended to be carried on for a taxable purpose.

25. Subsection 40-880(2) provides that capital expenditure incurred can be deducted in equal proportions over a period of five income years, starting in the year in which it was incurred;

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, wind up a company or wind up a trust, that carried on a business.

26. The phrase “in relation to” employed in subsection 40-880(2) is not defined in the legislation and so takes its ordinary meaning. Paragraph 2.25 of the EM states:

The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business. The concept used to establish this character or requisite relationship between the expenditure incurred by the taxpayer and the business carried on (current, past or prospective) is 'in relation to'. The connector 'in relation to' allows the appropriate latitude to enable the deductibility of qualifying capital expenditure incurred before the business commences or after it has ceased.

27. The phrase “in relation to” was considered by the High Court in PMT Partners Pty Ltd (In Liquidation) v. Australian National Parks and Wildlife Service (1995) 184 CLR 301. Brennan CJ, Gaudron and McHugh JJ observed, in considering the application of the Commercial Arbitration Act 1985 (NT) at 313:

Inevitably, the closeness of the relation required by the expression 'in or in relation to' in s 48 of the Act - indeed, in any instrument - must be ascertained by reference to the nature and purpose of the provision in question and the context in which it appears.

28. In that case, Toohey and Gummow JJ also observed at 330:

It is apparent that the words 'in or in relation to' are particularly wide. Cases concerning the interpretation of this phrase in other statutory contexts are of limited assistance. However, the cases do show that the words are prima facie broad and designed to catch things which have sufficient nexus to the subject. The question of sufficiency of nexus is, of course, dependent on the statutory context.

29. and at 331:

The connection which is required by the phrase 'in relation to' is a question of degree. There must be some "association" which is "relevant" or "appropriate". The question of the relevance or appropriateness of the connection is a question which cannot be divorced from the particular statutory context.

30. In First Provincial Building Society Limited v. Commissioner of Taxation (1995) 56 FCR 320; 95 ACT 4145; (1995) 30 ART 207, Hill J considered the phrase 'in relation to' within the context of paragraph 26(g) of the Income Tax Assessment Act 1936. He considered the words 'in relation to' in that context included a relationship that may either be direct or indirect, provided that the relationship consisted of a real connection, but that a merely remote relationship is insufficient (ATC 4155; ATR 218).

31. It is therefore necessary to consider the legislative context of subsection 40-880(2) in order to determine whether there is a relevant and appropriate association between the incurrence of the expenditure and a particular business. Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues outlines, at paragraphs 15-17, the circumstances in which certain capital expenditure would be considered to be 'in relation to' a business, as follows:

15. The expression 'in relation to' denotes the proximity required between the expenditure on the one hand and the former, current or proposed business on the other. For capital expenditure to be 'in relation to' a business, there must be a sufficient and relevant connection between the expenditure and the business.

16. The closeness of the association or connection must objectively support the conclusion that the capital expenditure is a business expense of the particular business.

17. Whether capital expenditure is truly business expenditure is determined by the facts. If the facts show that the expenditure satisfies the ends of the relevant business, it will have the character of business expenditure.

32. Paragraphs 69-92 of TR 2011/6 provide further explanation as to the Commissioner's view in respect of the term 'in relation to a business'. At paragraphs 72-75, the Commissioner states that the use of the expression 'in relation to' in subsection 40-880(2), in contrast to the term 'in carrying on' used in section 8-1, indicates that the test for the purposes of section 40-880 is not as demanding or strict as that in section 8-1. However, the words 'in relation to' still require a sufficiently relevant connection between the business and the expenditure.

33 At paragraphs 82-84 of TR 2011/6, the Commissioner contrasts expenditure incurred in establishing a business with expenditure relating to the ownership of a business. These paragraphs relevantly state:

82. In many cases, the description of what the expenditure is for will be enough to demonstrate the relationship with the former, proposed or existing business. The connection will be readily evident. For example, capital expenditure incurred to establish the structure (that is, the entity) that is to carry on a proposed business has a clear connection with that proposed business.

83. There is an immediate connection between expenditure of this type and the relevant business because establishing the structure by which the business will be owned and operated is an essential prerequisite to the conduct of the business itself. The occasion of the outgoing can only be explained by reference to the business.

84. In contrast, 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.

34. Subsection 40-880(2A) provides that you can deduct the capital expenditure in the income year in which you incur it, if:

a. The expenditure is incurred in relation to a business that is proposed to be carried on; and

b. The expenditure is incurred:

i. In obtaining advice or services relating to the proposed structure, or proposed operation of the business; or

ii. In payment to an Australian government agency of fees, taxes or charges relating to establishing the business or its operating structure; and

c. You are a small business entity for the income year, or both of the following apply:

i. You are not carrying on a business in the income year;

ii. You are not connected with, or an affiliate of, another entity that carries on a business in the income year and that is not a small business entity for the income year.

35. Subsection 40-880(3) provides that you can only deduct the expenditure for a business that you carry on, used to carry on, or propose to carry on, to the extent that the business is carried on, was carried on, or is proposed to be carried on for a taxable purpose.

36. Subsection 40-880(4) 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.

37. Subsection 40-880(5) provides that you cannot deduct anything under this section for an amount of expenditure you incur to the extent that:

a. It forms part of the cost of a depreciating asset that you hold, used to hold or will hold; or

b. You can deduct an amount for it under a provision of this Act other than this section; or

c. It forms part of the cost of land; or

d. It is in relation to a lease or other legal or equitable right; or

e. It would, apart from this section, be taken into account in working out:

i. A profit that is included in your assessable income; or

ii. A loss that you can deduct; or

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; or

g. A provision of this Act other than this section would expressly make the expenditure non-deductible if it were not of a capital nature; or

h. A provision of this Act other than this section expressly prevents the expenditure being taken into account as described in paragraphs (a) to (f) for a reason other than the expenditure being of a capital nature; or

i. It is expenditure of a private or domestic nature; or

j. It is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income.

38. Subsection 40-880(6) provides that the exceptions in paragraphs 5(d) and (f) do not apply to expenditure you incur to preserve (but not enhance) the value of goodwill if the expenditure you incur is in relation to a legal or equitable right and the value to you of the right is solely attributable to the effect that the right has on goodwill.

39. Subsection 40-880(7) provides that 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.

40. Subsection 40-880(8) provides that you cannot deduct anything under this section for an amount of expenditure that, because of a market value substitution rule, was excluded from the cost of a depreciating asset or the cost base or reduced cost base of a CGT asset.

41. Subsection 40-880(9) provides that you cannot deduct anything under this section for an amount of expenditure you incur:

a. By way of returning an amount you have received (except to the extent that the amount was included in your assessable income or taken into account in working out an amount so included); or

b. To the extent that, for another entity, the amount is a return on or of:

i. An equity interest; or

ii. A debt interest that is an obligation of yours.

APPLICATION TO YOUR CIRCUMSTANCES

42. Together with Company B, you entered into an agreement to pay xx% of the third-party purchaser’s legal costs, in addition to the $xx of the settlement sum to the third-party purchaser, in order to resolve the dispute between yourselves.

43. Essentially, as the vendors, yourself and Company B have nothing tangible to show for the expenditure covering xx% of the third-party purchaser’s legal costs, other than the cessation of legal action against yourselves.

44. That expenditure did not result in the acquisition of a capital asset, and neither does the expenditure form part of the cost base of the business that was disposed.

45. As the expenditure which covers a proportion of xx% of the legal costs incurred by the third-party purchaser of Company C has not otherwise been taken into account, consideration must be given, in particular, to whether the expenditure may be deductible over a period of five years pursuant to subsection 40-880(2).

46. Specifically, the term ‘in relation to’ must be considered if subsection 40-880(2) is to provide a deduction for the expenditure which covers a proportion of xx% of the legal costs incurred by the third-party purchaser.

47. In the case PMT Partners Pty Ltd (In Liquidation) v. Australian National Parks and Wildlife Service (1995) 184 CLR 301, Toohey and Gummow JJ observed that the words ‘in relation to’ are designed to catch things which have “sufficient nexus to the subject”. The question of sufficiency of nexus is, of course, dependant on the statutory context.

48. As the vendors, yourself and Company B have nothing tangible to show for the expenditure covering xx% of the third-party purchaser’s legal costs, other than the cessation of legal action against yourselves. There is inadequate nexus between the expenditure and your business that was carried on. The expenditure merely covers a third-party’s legal costs.

49. In First Provincial Building Society Limited v. Commissioner of Taxation (1995) 56 FCR 320; 95 ACT 4145; (1995) 30 ART 207, Hill J considered the phrase 'in relation to' within the context of paragraph 26(g) of the Income Tax Assessment Act 1936. He considered the words 'in relation to' in that context included a relationship that may either be direct or indirect, provided that the relationship consisted of a real connection, but that a merely remote relationship is insufficient (ATC 4155; ATR 218). In this instance, the remote relationship between the expenditure and the business that was carried on by the vendors is insufficient.

50. It is therefore necessary to consider the legislative context of subsection 40-880(2) in order to determine whether there is a relevant and appropriate association between the expenditure and the particular business. TR 2011/6 outlines circumstances in which certain capital expenditure would be considered to be ‘in relation to’ a business, and these circumstances are not satisfied:

a. There is neither sufficient nor relevant connection between the expenditure and the business;

b. The connection does not objectively support the conclusion that the capital expenditure is a business expense of the particular business;

c. The facts do not show that the expenditure satisfies the ends of the relevant business, and so it does not have the character of business expenditure.

51. As detailed earlier, TR 2011/6 clearly states that 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. There is no evidence (nor can it be imputed based upon the facts) to support the view that the change of ownership served an objective of the business. Even had that been the case, the connection of the actual expenditure (i.e. reimbursing a third-party purchaser’s legal costs) to the transfer of ownership is sufficiently remote to be considered negligible. Therefore, the reimbursement of a third party purchaser’s legal costs is not in relation to the business.

52. Accordingly, a deduction under section 40-880 over five years is not appropriate for the amount paid to cover xx% of the third-party purchaser’s legal costs.

ATO view documents

Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues