Edited version of your written advice

Authorisation Number: 1051345704337

Date of advice: 6 March 2018

Ruling

Subject: Deductions - income or capital

Question 1

Is the taxpayer entitled to a deduction under section 8-1 in respect of Contract Rights Fees it paid in respect of the relevant Contracts during the income year ended 30 June 2017?

Answer

Yes

Question 2

If the answer to Question 1 is “yes”, is the taxpayer entitled to claim the deduction for the Contract Rights Fees in full in the income year ended 30 June 2017, on the basis that the Contract Rights Fees were incurred upon execution of the relevant Contracts and section 82KZMD does not apply?

Answer

No

This ruling applies for the following period:

Year ended 30 June 2017

The scheme commences on:

1 July 2016

Relevant facts and circumstances

Relevant entities

● The taxpayer is primarily concerned with the provision of products and services.

● The taxpayer also comprises various other subsidiary members undertaking activities complimentary to and/or in support of the business activities of the taxpayer.

Overview

● Over the past ten years, there has been a substantial change in the manner in which entities such as the taxpayer remain competitive, secure new business and protect existing contracts. This change has been driven by various external factors.

● In response to this change in the market, entities have become more innovative in how they target, secure and protect profitable contracts. This is particularly so in instances in which these contracts are issued via a tender process.

● This in turn has resulted in a market expectation that service providers seeking to procure and protect the larger profitable contracts will offer to pay a ‘Contract Rights Fee’ as part of the tender response (or otherwise through the negotiation process).

● The taxpayer has entered into a number of contracts, whereby it obtains the right to be the primary provider of services, including where it is required to pay Contract Rights Fees.

The Contracts

● The Contracts give the taxpayer the right to supply services to the agreed entities.

● Where any additional services are required, which are outside the scope of the Contracts, the taxpayer is required to provide the services for further agreed fees and the additional services become part of the services provided under the Contracts. However, the taxpayer is not required to provide the additional services if it is not financially viable, is technically impossible or otherwise agreed between the parties.

● The Contracts generally provide the taxpayer with an exclusivity right to provide services to the entities, in that the entities are broadly prohibited from contracting with any other party for the provision of services for the agreed term.

● However, the entities are entitled to engage other providers in limited circumstances.

Contract Rights Fees

● The taxpayer’s Contract Rights Fees vary in quantum, and may be payable upfront or in instalments over the life of the contract.

● The largest and most profitable of the taxpayer’s Contracts require the payment of Contract Rights Fees.

Specific contracts

Contract A

● The purpose of Contract A was to agree the contractual terms and conditions upon which the taxpayer would provide the agreed services to the multiple entities owned and operated by Group A. The services to be provided were stipulated in the Contract.

● Various contractual provisions stipulate the quality and standard to which the agreed services must be provided. Specific Contract clauses set out general requirements and standards to which the taxpayer must adhere (e.g. relevant policies and regulations). Furthermore, the performance of the taxpayer was to be assessed.

● The taxpayer was provided some level of exclusivity in relation to the provision of services to the relevant entities. To this end, a Clause provided that, in consideration of payment of the Contract Rights Fee, Group A agreed not to grant any other lease, licence or contractual interest to any other party to provide services similar to those provided by the taxpayer.

● Pursuant to the Contract, the initial term of the agreement was for a specified period, commencing on a specific date. The Contract provided that an initial term could be extended for two further terms, by mutual agreement, subject to payment of additional contract rights fees.

● In return for providing the agreed services, the taxpayer was contractually entitled to various income streams under Contract A.

● Importantly, the taxpayer agreed to pay to Group A a Contract Rights Fee. The Contract Rights Fee was payable in a lump sum on the date on which Contract A was executed by the parties.

Contract B

● The purpose of Contract B was to agree the contractual terms and conditions upon which the taxpayer would provide the agreed services to Group B. The services to be provided by the taxpayer are broadly as per those stipulated in Contract A (above).

● Importantly, the taxpayer agreed to pay to Group B a Contract Rights fee.

● In all other material aspects, Contract B is in the same format and contains the same contractual terms and conditions as Contract A, albeit in relation to a different entity. This includes the agreed services, the quality and standard requirements, the initial term of the arrangement and possible extension periods, and the income streams receivable by the taxpayer.

Additional information

● There are multiple Contracts (including the two referred to above) covering many entities, to which the taxpayer is a party, that continue to apply as at the date of this ruling.

● The Contracts are of a similar nature to the two contracts noted above. Various terms may differ slightly, such as initial terms and extension periods, exact services to be provided, the nature of the services to be provided and the basis for remuneration. However, the Contracts are broadly consistent in nature and operation.

● Notwithstanding the above, there are differences across the Contracts in the quantum and payment terms of the Contract Right Fees. With respect to the payment terms associated with the Contract Rights Fees, these may be payable in a lump sum (e.g. Contract A and Contract B), periodically over the life of the Contracts, or as a combination of an initial sum and subsequent periodic payments.

● Importantly, if a Contract is terminated, the counterparty to the Contract is not required to refund any contract rights fees already received from the taxpayer. Furthermore, any portion of a Contract Rights Fee not yet paid as at the termination date (i.e. future instalments not yet due) are generally still required to be paid by the taxpayer notwithstanding the termination.

Relevant legislative provisions

Section 8-1 of the Income Tax Assessment Act 1997

Section 82KZL of the Income Tax Assessment Act 1936

Section 82KZMA of the Income Tax Assessment Act 1936

Section 82KZMD of the Income Tax Assessment Act 1936

Reasons for decision

Question 1

Summary

The Contract Rights Fee payments made by the taxpayer as detailed in Contract A and Contract B are outgoings incurred in the normal course of business and are deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income or a provision of the taxation legislation excludes it.

The Commissioner accepts that the Contract Rights Fees paid by the taxpayer were incurred to gain or produce assessable income. However, the issue to be determined is whether the Contract Rights Fees paid are losses or outgoings of a capital nature or a revenue nature.

Sun Newspapers Limited and Associated Newspapers Limited v Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers) established three matters to take into consideration when making the distinction between capital and revenue:

(a) The character of the advantage sought, and in this its lasting qualities may play a part;

(b) The manner in which it is 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.

Subsequent to Sun Newspapers, two other cases applied the factors outlined by Dixon J; namely the BP Australia Ltd v Commissioner of Taxation of the Commonwealth of Australia (1965) 112 CLR 286 (BP Australia case) and National Australia Bank v Federal Commissioner of Taxation (1997) 97 ATC 5153 (NAB case).

The BP Australia case considered the nature of payments made by the taxpayer, in the business of distributing and selling petrol, to service station owners, who in return undertook to deal exclusively for a certain period in the brands of petrol approved by the taxpayer. The payments made were upfront and the amounts paid were determined by the intensity of the competition for securing the site and obtaining re-selling outlets.

The Privy Council held that the payments were revenue in nature. The Privy Council noted that the taxpayer was not achieving a monopoly nor buying off competition, that the advantage sought was to promote sales and obtain orders for petrol by up-to-date marketing methods and that the object was not to tie the service station owners (retailers), but the orders that would flow from the tie. The payments to the retailers were part of the regular conduct of business.

In the NAB case, the taxpayer paid the Commonwealth an upfront lump sum for an exclusive right to provide loans to defence force personnel for 15 years under the Commonwealth’s subsidised home loan scheme. The amount paid was calculated based on the expected profits from the fully subsidised part of new loans, the unsubsidised part of new loans and other products, such as personal loans and credit cards that the taxpayer could expect to sell to new customers under the scheme.

The Full Federal Court held that the upfront payment was revenue in nature and deductible. The Court noted the similarities to the BP Australia case and that the advantage sought by the taxpayer was the expansion of its customer base and the earning of income from loans and that the right obtained was not in the nature of a monopoly, nor comparable to the acquisition of goodwill. The fact that it was a one off payment was not conclusive as to whether the payment was capital in nature. Rather, the Court noted that the payment was in the nature of a marketing expense which pointed to it being revenue, rather than capital, in nature.

The factors consider in Sun Newspapers, BP and NAB are a useful basis for determining whether the expenditure incurred by the taxpayer is capital or revenue in nature.

The factors laid out by Dixon J in Sun Newspapers are not exhaustive and none of the elements are decisive in themselves. Characterisation of the expenditure is not to be decided by any rigid test or description, it has to be derived from many aspects of the whole set of circumstances. It is a common sense appreciation of all the guiding features which must provide the ultimate answer: BP at 389.

(a) The character of the advantage sought

As outlined above, it is accepted that it is essential to consider the character of the advantage sought in making the expenditure. This requires an examination of all the relevant facts and circumstances to determine the characterisation of the expenditure. The character of the advantage is to be ascertained by asking what the expenditure is calculated to effect from a practical and business point of view: Hallstroms Pty Ltd v. FCT (1946) 72 CLR 634 at 648 (Hallstroms).

To determine the effect from a practical and business point of view, the purpose or the chief object for making the outgoing should be considered: Sun Newspapers at CLR 363. However, where there is voluntary payment or the objective purpose for expending an amount is unclear, the subjective purpose is relevant in drawing a conclusion on what the purpose of the expenditure was to effect.

Therefore, both direct and indirect objective may be taken into account in determining whether an outgoing is deductible: Magna Alloys & Research Pty Ltd v. FCT (1980) 33 ALR 213 at 235.

In Jupiters Limited v DFC of T (2002) ATC 4022 it was held that “special rent” payments were capital. Dowsett J stated at 4040 that:

It seems that the applicant expected to enjoy de facto exclusivity after the expiry of the ten year period, no doubt because its established position would make it difficult for a competitor to establish itself, given the perceived limit to the size of the market. The second relevant aspect, which really reflects the first, is the applicant’s initial intention to treat the special rental for accounting purposes as being properly amortised over the full seventy-five year period of the lease, coupled with the actual treatment of that part which was paid in advance as a security deposit. This treatment suggests a belief that the exclusivity period would be of long-term benefit in the applicant’s business. The exclusivity arrangements were not, in any sense, to be acquired or consumed on an annual basis over the ten year term. Strategic decisions were no doubt made, taking account of the certainty that there would be competition for ten years and the expectation that there would be none for some time thereafter.

In Tyco Australia Pty Ltd v FCT 2007 ATC 4801 (‘Tyco case’), the taxpayer was an electronic security monitoring company that derived income from security monitoring services. The taxpayer engaged contractors to secure customers and enter into alarm monitoring contracts directly with customers. At dispute was the nature of lump sum payments made by the taxpayer to contractors for the novation of the alarm monitoring contracts from the contractors to the taxpayer. Whilst Allsop J accepted that the payments led to an acquisition of rights by the taxpayer, Allsop J held that the advantage sought by each payment was the winning of a customer to be retained for future revenue for services to be provided. This was on the basis that 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 81 of the Tyco case Allsop J 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 or organising and remunerating an independent, but controlled, sales force…’

In the present circumstances, the character of the advantage sought by the payment of the Contract Rights fees is not of a permanent or enduring nature. Rather, the term of the Contracts is for a specific period and only secures the right to provide certain services within that period. In addition, although under the Contracts the entity and the taxpayer must use best endeavours to assist others to use the services provided by the taxpayer, it is noted that others retain the right to use the product and services of their choice and are not obligated to use the products and services recommended by the taxpayer.

Similar to the BP Australia, NAB and Tyco cases discussed above, the advantage sought by the incurrence of the Contract Rights Fees is essentially access to and delivery of services to customers and the consequential income.

As in the BP Australia case, the Contract Rights Fees are part of the regular conduct of the business and are a commercial and efficient means of acquiring new customers and retaining existing customers. The Contract Rights Fee payments in respect of Contract A and Contract B were made for the securing of the contract to provide services. The nature of the expenditure incurred by the taxpayer can be characterised as marketing costs.

The Contract Rights Fees paid by the taxpayer form an essential part of the cost of the business operations of services and has the character of working expense, being revenue rather than capital in nature.

(b) The manner in which it is used

The second test under the Sun Newspapers approach to determining whether an outgoing is revenue or capital in nature looks at the manner in which the benefit obtained is to be used, relied upon or enjoyed.

Additional cases have considered the manner used test. Dixon J noted in Hallstroms at 646-647:

As a prefatory remark it may be useful to recall the general consideration that the contrast between the two forms of expenditure corresponds to the distinction between the acquisition of the means of production and the use of them; between establishing or extending a business organisation and carrying on the business; between the implements employed in work and the regular performance of the work in which they are employed; between an enterprise itself and the sustained effort of those engaged in it.

In this case, the Contract Rights Fees incurred were costs as part of a normal business practice and usual industry procedure. The manner used in the provision of the contract rights fee is consistent with normal industry practices, to enable the taxpayer to obtain the services contract, which they were successful in obtaining.

In respect of the manner in which the advantage is to be used, relied upon or enjoyed, there is no change in the ‘profit-yielding structure’ of the taxpayer within the test in Sun Newspapers.

As in the NAB case there is no alteration of the framework within which the taxpayer is carrying on its ordinary income-producing activities. Rather, the Contract Rights Fee is incurred as part of the business model or process in which the taxpayer operates to seek to obtain regular income.

As in the Tyco case, the Contract Rights Fees do not result in the purchase or creation of a business structure. Instead, the Contract Rights Fees are paid in the expectation that the amount will be recouped out of the income streams derived from the provision of services.

(c) The means adopted to obtain the advantage

The third test under Sun Newspapers approach to determine whether an outgoing is revenue or capital in nature looks at the means adopted to obtain the benefit. For instance, 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.

The Contract Rights Fees involve an upfront payment and in some cases further instalments over time on each anniversary of the commencement within the term of the underlying Contract. However, even where the Contract Rights Fee involves only one upfront payment, as noted above, a one-off payment is not of itself sufficient to indicate that a payment is capital in nature.

In this case, the Contract Rights Fee paid by the taxpayer does not secure an ongoing benefit because the agreement of a specified period does not result in an ongoing advantage to the taxpayer at the expiration of the contract, even though there is the ability to extend the contract.

Accordingly, the fact that some Contract Rights Fees are paid in a lump sum upfront does not alter the character of the advantage sought nor the manner in which it is used, and that these factors are indicative of the Contract Rights Fees being revenue, not capital, in nature.

The Contract Rights Fee payments made by the taxpayer as detailed in the Contract A and Contract B are outgoings incurred in the normal course of business and are deductible under section 8-1 of the ITAA 1997.

Question 2

Summary

Where expenditure qualifies for a deduction under section 8-1 of the ITAA 1997, the deduction is generally allowable in full in the year in which the expenditure is incurred. However, the timing of deductions for certain types of expenditure is subject to the advance payment rules in sections 82KZL to 82KZO of the ITAA 1936.

For the reasons set out below, the taxpayer is not entitled to claim a deduction for the Contract Rights Fees in full in the income year ended 30 June 2017 as Subsection 83KZMA(3) has not been met.

Detailed reasoning

The prepayment rules contained in Subdivision H of Division 3 of Part III of the ITAA 1936 operate to spread over more than one income year, a deduction for prepaid expenditure that would otherwise be immediately deductible, in full.

For our purposes, section 82KZMD is the relevant operative provision. Section 82KZMA of the ITAA 1936 outlines the criteria that must be satisfied before section 82KZMD will apply to a relevant expenditure. Where section 82KZMD applies, the relevant expenditure is deductible in part only in income years that are covered by the eligible service period.

The relevant criteria that must be satisfied for section 82KZMD of the ITAA 1936 as set out in section 82KZMA, are as follows:

a. The taxpayer incurs an amount of expenditure in the year of income (82KZMA(1));

b. The taxpayer could otherwise deduct the expenditure under 8-1 (82KZMA(1)(a)(i));

c. The taxpayer carries on a business (82KZMA(2)(a));

d. The relevant expenditure is incurred in carrying on a business (82KZMA(3)(a)(i));

e. The expenditure must be incurred under an agreement* (82KZMA(3)(b));

f. The expenditure must be incurred in return for the doing of a thing under the agreement (82KZMA(3)(c)); and

g. The thing to be done under the agreement is not to be wholly done within the expenditure year (82KZMA(3)(c)).

“agreement” is a defined term under sub section 82KZL(1) and means any “agreement, arrangement, understanding or scheme, whether formal or informal, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings”. Agreement as defined is therefore very broad.

h. The expenditure is not “excluded expenditure” (as defined in subsection 82KZL(1)).

Relevantly, excluded expenditure means an amount of expenditure “under a contract of service”.

If section 82KZMA is satisfied, section 82KZMD will operate to spread a deduction for the expenditure in accordance with the subsection 82KZMD(2), determined by the eligible service period. The pro-rata deduction is determined by dividing the ‘period in year’ over ‘eligible service period’.

“eligible service period” is defined in subsection 82KZL(1) to mean –

“in relation to an amount of expenditure incurred under an agreement, means the period from the beginning of :

(a) the day, or the first day, on which the thing to be done under the agreement in return for the amount of expenditure is required, or permitted, as the case may be, to commence being done; or

(b) if the expenditure is incurred on a later day - the day on which the expenditure is incurred;

until the end of:

(c) the day, or the last day, on which the thing to be done under the agreement in return for the amount of expenditure is required, or permitted, as the case may be, to cease being done; or

(d) if that day or last day ends more than 10 years after the beginning of the period - 10 years after the beginning of the period.

Application of sections 82KZMA and 82KZMD to the Contract Rights Fees paid by AHP

Considering the requirements of section 82KZMA, it is considered that the Contract Rights Fees paid by the taxpayer in respect of Contract A and Contract B are -

a. expenditure incurred by the taxpayer at the time it is paid under the relevant contract;

b. deductible to the taxpayer at the time it is paid under section 8-1;

c. paid at a time when the taxpayer is carrying on a business; and

d. incurred in relation to the carrying on of that business.

e. The expenditure is incurred under an agreement, being the specific contract.

Is the expenditure incurred in return for the doing of a thing under the agreement? If so, what is the “thing to be done”?

The ‘doing of a thing’ can include ‘unbilled work already done and the work yet to be done’. Taxation Determination TD 2010/14 provides that if the ‘doing of the thing under the agreement’ is not actually done, that is outside the control of the taxpayer, the prepayment provisions still apply. Whether the thing is done is determined by reference to when a thing is to be done and not by reference to when it is actually done.

Further, the “thing to be done” or the “doing of a thing” for the purposes of the prepayment rules is intentionally broad. The expression is not defined in the subdivision. Taxation Ruling 99/11 Income tax: basis of assessment of interest paid in advance and received in advance by financial institutions (TR 99/11) states at paragraph 12 (in respect of the use of similar wording in 82KZM) that “it is of broad application and embraces the provision or continued provision of financial benefits”.

It is considered that the expenditure (Contract Rights Fee) is incurred in return for the doing of a thing under the agreement. The thing to be done is the rights granted to the taxpayer to supply products and services over more than one income year, and beyond the income year in which the Contract Rights Fees is paid. The Contracts allow the taxpayer to have the right to provide products and services to the entity from which it derives assessable income. It also provides that the entity not pursue services from competing suppliers.

The Contract Rights Fees are not ‘excluded expenditure’ (subsection 82KZMA(4) of the ITAA 1936), as that term is defined in subsection 82KZL(1) of the ITAA 1936, as the amount of the payment is not less than $1,000, it is not required to be paid by law, or by an order of the court, of the Commonwealth, a State or a Territory. It is not a payment under a contract of service, it is not a payment of a capital, private or domestic nature and nor does it come within paragraphs (e) or (f) of ‘excluded expenditure’ as defined in subsection 82KZL(1).

The Contract Rights Fees are not made to meet a ‘pre-RBT obligation’ (subsection 82KZMA(5) of the ITAA 1936) as that term is defined in subsection 82KZL(1) of the ITAA 1936.

As a result, the portion of the Contract Rights Fees that is deductible in each year of income that contains all or part of the ‘eligible service period’ (as defined in subsection 82KZL(1) of the ITAA 1936) is calculated using the formula contained in subsection 82KZMD(2) of the ITAA 1936.