Edited version of your written advice

Authorisation Number: 1051413632397

Date of advice: 16 August 2018

Ruling

Subject: Deductibility of exclusivity fee

Question

Is the outgoing described as an ‘Exclusivity Fee’, paid by a wholly owned subsidiary of the taxpayer deductible in accordance with section 8-1 of the Income Tax Assessment Act 1997 (‘ITAA 1997’)?

Answer

No.

This ruling applies for the following period:

Income year ended 30 June 2015

The scheme commences on:

1 July 2014

Relevant facts and circumstances

1. The taxpayer is a company incorporated in Australia.

2. During the year ended 30 June 2015, the taxpayer was the head company of a tax consolidated group (‘the taxpayer’s tax consolidated group’).

3. A subsidiary member of the taxpayer’s tax consolidated group provides a service within Australia (‘the Company’).

4. The Company entered into an Initial Agreement with another entity (Entity X) for the exclusive use of an item owned by Entity X (‘2011 Agreement’).

5. The Initial Agreement granted the Company a non-exclusive, non-transferrable licence to use the item within Australia for the term of the agreement.

6. The Initial Agreement provided the term of the contract for a set period, with automatic renewal for successive periods.

7. The Initial Agreement provided that Entity X retained all intellectual property rights in the item, service and contract material.

8. The Initial Agreement generally provided that a proportionate split of any fees or premium payable by the Company’s customers for access or usage of the item was to be shared whereby a percentage was payable to Entity X and a percentage was payable to the Company.

9. A few variations were made to the Initial Agreement but a notable one was when the Initial Agreement was varied such that Entity X agreed not to licence the use of the item to any other party in Australia that was not currently using the item without written consent from the Company.

10. Some years later, the Company entered into a Subsequent Agreement.

11. The Initial Agreement was terminated on the Effective Date of the Subsequent Agreement.

12. Under the Subsequent Agreement, Entity X and the Company entered into an arrangement pursuant to which Entity X provides the Company with exclusive access to the Item in Australia.

13. The Subsequent Agreement states the term of the agreement continues in perpetuity until it is terminated. The Subsequent Agreement can be terminated by the Company at any time or by Entity X if the Company breaches certain material conditions of the Subsequent Agreement.

14. From the Effective Date, the item was fully integrated into the Company’s business.

15. As a result of the Subsequent Agreement, all customers of the item in its Australian application migrated to the Company from Entity X.

Employment offers

16. The Subsequent Agreement obliged the Company to make employment offers to Entity X’s employees.

17. Several employment offers were made to, and accepted by, employees from Entity X. The employees joined the Company from Entity X to ensure the Company had the necessary expertise to operate the item. This also prevented those employees from being made redundant within Entity X.

18. The employment offers were made in order to integrate Entity X’s functions into the Company. The Company would ultimately be the sole marketer of the item in Australia instead of Entity X, given that Entity X would no longer have a market facing presence in Australia.

19. Under the Subsequent Agreement, the Company provides training and first level support for the item.

Rights to the item

20. The Subsequent Agreement provides that the Company was granted exclusive rights of use for the item within Australia. Entity X undertook not to licence the item to any other person in Australia.

21. The Subsequent Agreement provides that Entity X retains all Intellectual Property Rights in the item.

Consideration under the Subsequent Agreement

22. The Subsequent Agreement provides that a non-refundable Exclusivity Fee must be paid to Entity X on the Effective date.

23. If the Company earns in excess of a set amount for any calendar year, the Company is liable to pay to Entity X a percentage of all net Revenue in excess of the set amount.

Pricing/determining the Exclusivity Fee and its value in perpetuity

24. The Exclusivity Fee took into account the financial modelling, which included the following considerations and assumptions:

a. a business case and benefits case of return on investment based on a 5 year period;

b. anticipated future sales of products through the use of the item;

c. growth of the use of the item and the increase of the number of customers using it within Australia;

d. increase in revenue for the Company as revenue would no longer be shared with Entity X;

e. reduction in costs incurred by the Company under the Initial Agreement;

f. expected benefits for the Company from obtaining exclusive rights; and

g. opportunity costs and risks associated with Entity X exiting the Australian market.

25. The Company charges and bills customers for use of the item.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Application of the single entity rule in section 701-1

The consolidation provisions of the ITAA 1997 allow certain groups of entities to be treated as a single entity for income tax purposes. Under the single entity rule (SER) in section 701-1 the subsidiary members of a consolidated group are taken to be parts of the head company. As a consequence the subsidiary members cease to be recognised as separate entities during the period they are members of the consolidated group with the head company of the group being the only entity recognised for income tax purposes.

The meaning and application of the SER is explained in Taxation Ruling TR 2004/11 Income tax: consolidation: the meaning and application of the single entity rule in Part 3-90 of the Income Tax Assessment Act 1997. As a consequence, the actions and transactions of the subsidiary members of the taxpayer’s tax consolidated group are treated for income tax purposes as having been undertaken by the taxpayer as the Australian head company of the taxpayer’s income tax consolidated group.

Section 8-1

Section 8-1 of the ITAA 1997 allows a deduction for 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.

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 Commissioner accepts that the Exclusivity Fee paid by the Company was incurred to gain or produce assessable income. Accordingly, the issue to be determined is whether the Exclusivity Fee paid is a loss or outgoing of a capital nature or a revenue nature.

There is no statutory definition of 'capital' or 'capital nature'. 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). The judgment of Dixon J in Sun Newspapers at CLR 359; ATD 93-94; AITR 410 provides that:

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).

In Sun Newspapers at 363, Dixon J outlined three matters to consider 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 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.

1. The character of the advantage sought

The character of the advantage sought provides guidance as to the nature of the expenditure. In GP International Pipecoaters Pty Ltd v. Federal Commissioner of Taxation (1990) 170 CLR 124 at 137; 90 ATC 4413 at 4419; (1990) 21 ATR 1 at 7, the High Court made the following statement:

The character of expenditure is ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure, for 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: Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 61 C.L.R 337, at p.363....

The exclusive right to use the item in Australia is an important part of the collection of rights the Company obtained under the Subsequent Agreement. Pursuant to the Subsequent Agreement, the Company was granted exclusive use of the item in Australia and Entity X undertook not to licence the item to any other entity in Australia for the duration of the Subsequent Agreement.

The character of the advantage sought from paying the Exclusivity Fee can be summarised as acquiring the exclusive rights of the item within Australia. The term of this right is perpetual and:

1. prevents any other party (i.e. competitors) from using the item in Australia, unless the Company consents to the use;

2. reduces administrative costs in relation to pricing which were payable to Entity X under the Initial Agreement;

3. allows the Company to obtain a greater market share in its business by solely gaining the Australian client base of the item; and

4. provides the Company with the rights to current and future revenues produced by the item within Australia.

The right to use the item amounts to the acquisition of an asset or an advantage, which, consistent with the decision of British Insulated & Helsby Cables v. Atherton (1926) AC 205, is likely to be capital in nature.

In consideration of the character of the advantage sought, the Company acquired an asset under the Subsequent Agreement, being the exclusive right to use the item within Australia, and the Exclusivity Fee formed part of the cost of that acquisition.

All business expenditure is likely to be made with the intention of securing some commercial advantage. It is necessary to establish is the effect of the expenditure and how long it will likely endure. In the case of British Insulated & Helsby Cables v. Atherton (1926) AC 205 at 547, Viscount Cave LC said:

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.

The term 'enduring' was referred to by Rich J in Herring v. FCT (1946) 72 CLR 543, who stated that 'by enduring it is not meant that the asset or advantage should last forever. It is a matter of degree…’. However, in considering whether the character of the advantage sought has an enduring benefit, the benefit does not have to be everlasting. This approach was confirmed by Latham CJ in Sun Newspapers at 355 where he said:

It is true that the payments did not result in obtaining a new capital asset of a material nature, but they did obtain a very real benefit or advantage for the companies, namely, the exclusion of what might have been serious competition. When the words "permanent" or "enduring" are used in this connection it is not meant that the advantage which will be obtained will last forever. The distinction which is drawn is that between more or less recurrent expenses involved in running a business and an expenditure for the benefit of the business as a whole.

In his leading judgment in BP Australia Ltd v Commissioner of Taxation (1965) 112 CLR 386 (‘BP’) [1966] AC 224 at 267, Lord Pearce commented that “The longer the duration of the agreements, the greater the indication that a structural solution was being sought”. In BP, the average term of the multiple agreements was 5 years, which was said not to point towards either revenue or capital. However, “had they been for 20 years, that fact would have pointed to a non-recurring payment of a capital nature.”

The Subsequent Agreement does not contain an end date, meaning the exclusive use of the item in Australia for which The Company paid the Exclusivity Fee continues in perpetuity. The Company can terminate the Subsequent Agreement at any time, however, this right does not change the agreed term.

The character of the advantage of the Exclusivity Fee secures an enduring benefit for the business because the term of the Subsequent Agreement continues in perpetuity. The enduring benefit obtained from paying the Exclusivity Fee includes:

1. the right to use the item to the exclusion of all others in Australia;

2. the employment of several Entity X employees;

3. being the sole marketer of the item within Australia whereby Entity X would no longer have a market facing presence in Australia;

4. the acquisition of the customer base of Entity X’s customers within Australia;

5. the integration of the item into the Company’s business;

6. control over the pricing of its services; and

7. the right to bill customers for using the item.

Therefore, the Company has brought into existence an asset or an advantage for the enduring benefit of its trade which, according to the case of British Insulated & Helsby Cables v. Atherton (1926) AC 205, should be treated as attributable to capital.

2. The manner in which the advantage is to be used, relied upon or enjoyed

In National Australia Bank v. Federal Commissioner of Taxation (1997) 80 FCR 352; 97 ATC 5153; (1997) 37 ATR 378 (‘NAB’), the Full Federal Court considered National Australia Bank was entitled to a deduction under subsection 51(1) of the Income Tax Assessment Act 1936 in respect of the sum of $42 million which it paid to the Commonwealth for an exclusive right to participate as the lender under the scheme of housing loan assistance to members of the Australian Defence Force in respect of their home loans for a period of 15 years. The Court held that the payment was of a revenue nature as it did not enlarge the framework within which the National Australia Bank carried on its activities. Rather, it was incurred as part of the process by which the National Australia Bank operated to obtain regular returns by means of regular outlay. The Court determined that the payment was in the nature of a marketing expense and had a revenue rather than capital nature.

In BP, the company claimed deductions for amounts paid to service station proprietors so that those proprietors would deal exclusively in its products for a fixed period. The average length of these agreements was five years, although in some cases they did extend to fifteen years. The Privy Council held that the real object of the outgoing was not the agreements to deal with the proprietors but the orders that would flow from those recurrent agreements. The advantage sought was the promotion of sales by up to date marketing methods which had become necessary and the expenditure was therefore deductible as being on revenue, rather than capital, account.

The purpose behind BP Australia’s payment was characterised as being able to obtain a customer’s business as a result of making a “marketing” payment. Lord Pearce highlights that issues of marketing are part of the “continuous demands of trade”. This “continuous” nature of marketing means that associated expenses are generally recurrent in nature and therefore more likely to be revenue rather than capital in nature.

In both BP and NAB, the payments were held to be on revenue account as the character of the advantage sought was not to secure an asset, but to allow the business to carry on as they had in previous years. As such, the advantage sought was compared to a marketing expense. The expense was said to be part of the process by which the companies operated to obtain regular returns by means of regular outlay and therefore not a payment to enlarge the framework within which the companies carried on their activities.

In the present case, when the Company entered into the Subsequent Agreement, it was doing more than allowing the business to carry on as it had under the Initial Agreement. The entering into of the Subsequent Agreement was more than a pricing structure change. Rather, a lump sum payment was payable to secure exclusive rights to the item within Australia.

Pursuant to the Subsequent Agreement, the Company acquired an asset and a greater advantage in its line of business because:

1. The Subsequent Agreement enabled the Company to become wholly responsible for the marketing and sales of the item. This was to the extent that several Entity X employees transferred to the Company and Entity X would no longer have marketing responsibilities for the item;

2. The restrictive covenant allowed only the Company to use with unfettered freedom the item to provide information services to customers in Australia. That is, no other competitor can obtain any rights for the use of the item within Australia unless with the Company’s permission;

3. The Company became responsible for pricing the use of the item and billing customers for the use of the item directly which allowed the Company to build and expand their profit making structure;

4. The item provides a key channel to market the Company’s products and services; and

5. The Company acquired a competitive edge for the provision of products and services in Australia in its line of business. The customer base of the Company grew through the acquisition of the rights to the item and enhanced the Company’s competitiveness in its market.

The advantage that is sought to be gained by the incurring of the Exclusivity Fee is the Company’s ability to be the exclusive provider of the item within Australia whereby the Company would be the face of the item. This is a resource that has provided the Company a commercial advantage against (potential) direct competitors and enabled them to expand their customer base.

Unlike the BP and NAB cases, it cannot be said that the advantage sought by the Company in this instance was in the nature of marketing because it was incurred to gain the exclusive rights to the item within Australia and was not a regular outlay to obtain regular returns. Neither was the Exclusivity Fee paid to secure customer orders.

Therefore, the Exclusivity Fee is not simply a marketing expense or an expense that allowed the Company to continue to allow its customers to use the item to generate revenue.

Based on the above considerations, the Exclusivity Fee is correctly characterised as enlarging the profit-yielding structure of the Company’s business rather than being a working expense. As pointed out in the Sun Newspapers case, expenditure incurred by a business that establishes or enlarges the profit yielding structure of the business is considered to be capital in nature.

It was material in the cases of NAB and BP that the fees were based on expected income over the term that the fees related to. In both cases the taxpayer expected to fully recoup the fee. Therefore the fee could properly be said to relate to the character of the advantage sought, being the income derived over the term the fee related to.

The court in NAB referred to the observations of Lord Denning MR in Murray v Imperial Chemical Industries Ltd [1967] Ch 1038. The question there was whether a lump sum paid in exchange for covenants not to compete was a capital or income receipt. At 1052 Lord Denning said:

Each case must depend on its own circumstances. But it seems to me fairly clear that if, and in so far as, a man disposes of patent rights outright (for example, by an assignment of his patent, or by the grant of an exclusive licence) and receives in return royalties calculated by reference to the actual user, the royalties are clearly revenue receipts. If, and in so far as, he disposes of them for annual payments over the period, which can fairly be regarded as compensation for the user during that period, then those also are revenue receipts.... If, and in so far as, he disposes of the patent rights outright for a lump sum, which is arrived at by reference to some anticipated quantum of user, it will normally be income in the hands of the recipient... But if, and in so far as, he disposes of them outright for a lump sum which has no reference to anticipated user, it will normally be capital...''

Unlike in NAB, the financial modelling provided does not evidence that the Exclusivity Fee was derived as the present value of the anticipated profit stream to be earned by the making of the payment. Rather, the modelling demonstrates that the Company would earn profits and returns on its investment at levels acceptable to it, over and above the amount paid for the Exclusivity Fee, after taking account of the net impact of the increased profit-earning capacity generated by the Company having the exclusive use and provision of the item in Australia.

3. The means adopted to obtain it

The third element refers to the method of payment including whether the payment is regular or one-off.

The NAB case provides that the absence of recurrence of a payment suggests that an outgoing is capital in nature, but it is not conclusive. As pointed out by Dixon J in the Sun Newspapers case at 362:

Recurrence is not a test, it is not more than a consideration the weight of which depends upon the nature of the expenditure

In Colonial Mutual Life Assurance Society Ltd v Federal Commissioner of Taxation [1953] 89 CLR 428, the consideration payable for the purchase of land was the agreement to make payments over a 50 year period based on a percentage of the rents received in relation to the land, were held to be on capital account. Fullagar J made the following comments in his judgment:

The payments are also outgoings within the second limb because they are in this sense appropriate or adapted for producing assessable income. But all this could be said of many payments which are clearly of a capital nature. It could be said of all instalments of purchase money paid for the purchase of a fixed capital asset which the purchaser acquired and used to produce assessable income.

Furthermore, as noted by Hill J in the Pine Creek Goldfields Ltd v FC of T (1999) 99 ATC 4382 in relation to the third element:

The third matter often points neither in the one direction or the other, that is the means adopted to obtain the benefit or advantage, particularly the method of payment.

In NAB, the significance of the payment being a non-recurring lump sum was diluted by the fact that the Bank wanted to make periodic payments and the Commonwealth insisted on a lump sum payment in advance; the agreement contemplated 16 annual payments in addition to the initial lump sum payment, and had the 16 annual payments been made, they would have been on revenue account.

There was no option for the Company to pay the Exclusivity Fee via periodic instalments or a lump sum payment. It was a one off fee to acquire the exclusive rights to the item within Australia in perpetuity. Furthermore, no further expenditure or recurring expenditure is to be incurred by the Company in relation to the continued holding and enjoyment of the privileges and rights conferred by the Exclusivity Fee.

Therefore, the Exclusivity Fee, being a once and for all lump sum payment for the rights obtained as a result of making that payment weighs towards the Exclusivity Fee being in the nature of a capital outgoing.

Conclusion

In determining whether an item of expenditure is capital or revenue, no one single factor is determinative. Rather, all relevant factors must be considered collectively.

After examining all the relevant factors and your circumstances, it is considered that the Exclusivity Fee is capital or of a capital nature. Accordingly, paragraph 8-1(2)(a) of the ITAA 1997 is engaged and the taxpayer is precluded from an income tax deduction under section 8-1 of the ITAA 1997 for the payment of the Exclusivity Fee by the Company.