Edited version of private advice

Authorisation Number: 1051522059077

Date of advice: 30 May 2019

Ruling

Subject: Deductibility of incentive payment

Question 1

Is the VEP2 incentive payment tax deductible under section 8-1 of the Income Tax Assessment Act 1997?

Answer

Yes

Question 2

Is the VEP2 incentive payment tax deductible under section 40-880 of the Income Tax Assessment Act 1997?

Answer

No

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commences on:

1July 20XX

Relevant facts and circumstances

A Pty Ltd was the head company of an income tax consolidated group (A Pty Ltd Tax Group). The consolidated group included B Pty Ltd.

Authorised representatives of B Pty Ltd operated their own businesses and contracted with B Pty Ltd to use its services.

Under deed and acceptance by participants, A Pty Ltd commenced a Virtual Equity Plan (VEP1) with selected authorised representatives of B Pty Ltd (Participants). The plan was to provide a reward structure for Participants based on the Participants' contribution to the profits of B Pty Ltd.

The VEP1 ceased operating without a payout event happening.

A new arrangement (VEP2) was entered into with previous VEP1 Participants which provided them with the same value as the ceased VEP1.

The amount payable under the VEP2 was only payable to participants upon the occurrence of specified events.

A Pty Ltd shares were purchased by a member of the tax consolidated group with C Pty Ltd as the head entity (C Pty Ltd Tax Group) and consequently A Pty Ltd and its subsidiaries became members of the C Pty Ltd Tax Group in the income year ended 30 June 2018.

The share sale activated the reward payments under the GPP rules.

Under the rules there was no legal obligation for the A Pty Ltd Tax Group to make the payment.

Under the share sale agreement the purchaser agreed to make the payments to the VEP2 participants.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 40-880

Reasons for decision

Question 1

Is the VEP2 incentive payment tax deductible under section 8-1 of the Income Tax Assessment Act 1997?

Summary

The payment in satisfaction of the VEP2 under the share purchase agreement is deductible under section 8-1 of the ITAA 1997 as it is necessarily incurred in carrying on the business of the tax consolidated group.

Detailed reasoning

Deductibility of losses or outgoings

The general deduction provision, section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) relevantly provides:

8-1(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.

8-1(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.

Section 8-1 of the ITAA 1997 allows a deduction for losses or outgoings to the extent that they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for that purpose. However, to the extent that the losses or outgoings are of a capital, private or domestic nature, or relate to gaining or producing exempt income or non-assessable non-exempt income, they will not be deductible. In addition, losses or outgoings will not be deductible under section 8-1 of the ITAA 1997 to the extent that another provision prevents a taxpayer from deducting them. Whilst in many cases losses and outgoings can factually satisfy both positive limbs, a loss or outgoing need only satisfy one of these limbs to be claimed as a general deduction pursuant to subsection 8-1(1) of the ITAA 1997.

Loss or outgoing

The term 'outgoing' is generally taken to encompass all types of expenditure and suggests a movement of resources from a taxpayer (e.g. a payment), while the term loss ensures that losses where no payment is involved (e.g. theft) and involuntary payments are potentially covered.

Losses or outgoings are incurred in gaining or producing assessable income where they are 'incidental and relevant to that end' (Ronpibon Tin NL v. FCT [1949] HCA 15 78 CLR 47). Where a taxpayer is carrying on a business for the purpose of gaining or producing assessable income, voluntary expenditure incurred for business needs may be deductible. It is the taxpayer who decides whether the expenditure 'is dictated by the business ends to which it is directed' (Federal Commissioner of Taxation v. Snowden & Willson Pty Ltd [1958] HCA 23; (1958) 99 CLR 431 at 437).

As the Court explained in Re Magna Alloys & Research Pty Ltd v. Commissioner of Taxation of the Commonwealth of Australia [1980] FCA 150; (1980) 49 FLR 183 the outgoings can be voluntary:

The requirement that the claimed outgoing be 'necessarily' incurred in carrying on the relevant business does not, in the context, mean that the outgoing must be either 'unavoidable' or 'essentially necessary'. Nor does the word 'necessarily' import a requisite of logical necessity. What is required is that the relevant expenditure be appropriate and adapted for the ends of the business carried on for the purpose of earning assessable income... For practical purposes and within the limits of reasonable human conduct, it is for the man who is carrying on the business to be the judge of what outgoings are necessarily to be incurred.

Incurred

There is no statutory definition of the term 'incurred'. Generally, a deduction is allowable because a liability arises necessitating the payment of an expense.

Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions sets out the Commissioners view on the meaning of incurred under section 8-1 of the ITAA 1997, having regard to case law on the predecessor to section 8-1 of the ITAA 1997, i.e. section 51(1) of the Income Tax Assessment Act 1936 (ITAA 1936).

The Ruling provides a summary of the principles that can be derived from case law on the meaning of 'incurred' for the purposes of section 8-1 of the ITAA 1997.

Paragraph 6 of Taxation Ruling TR 97/7 outlines the general rules which help to define whether and when a loss or outgoing has been incurred:

(a) a taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitely committed in the year of income. Accordingly, a loss or outgoing may be incurred within section 8-1 even though it remains unpaid, provided the taxpayer is 'completely subjected' to the loss or outgoing. That is, subject to the principles set out below it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum;

(b) a taxpayer may have a presently existing liability, even though the liability may be defeasible by others;

(c) a taxpayer may have a presently existing liability, even though the amount of the liability cannot be precisely ascertained, provided it can be reasonably estimated;

(d) whether there is a presently existing liability is a legal question in each case, having regard to the circumstances under which the liability is claimed to arise;

(e) in the case of a payment made in the absence of a presently existing liability (where the money ceases to be the taxpayer's funds) the expense is incurred when the money is paid.

A taxpayer must be completely subjected or definitively committed to the liability

Paragraph 16 of TR 97/7 provides:

A loss or outgoing may be incurred for the purposes of section 8-1 even though no money has actually been paid out. In W Nevill & Company Ltd v. FC of T (1937) 56 CLR 290 at 302 it was said:

'the word used is 'incurred' and not 'made' or 'paid'. The language lends colour to the suggestion that, if a liability to pay money as an outgoing comes into existence, [the section is satisfied] even though the liability has not been actually discharged at the relevant time ... it is only the incurring of the outgoing that must be actual; the section does not say in terms that there must be an actual outgoing - a payment out.'

(See also New Zealand Flax Investments Ltd v. FC of T (1938) 61 CLR 179 at 207 (New Zealand Flax); FC of T v. James Flood Pty Ltd (1953) 88 CLR 492 at 506 (James Flood); Nilsen Development Laboratories Pty Ltd & Ors v. FC of T (1981) 144 CLR 616 at 624 (Nilsen Development Laboratories); FC of T v. Firstenberg 76 ATC 4141 at 4148; (1976) 6 ATR 297 at 305.)

FC of T v James Flood Pty Ltd (1953) 88 CLR 492 provides that in order for a loss or outgoing to be incurred under section 8-1 of the ITAA 1997, the taxpayer must have completely subjected or definitively committed itself to the liability and not be dependent on the occurrence of a future event.

According to the case of Nilsen Development Laboratories Pty Ltd & Ors v FC of T (1981) 33 ALR 161, a taxpayer is definitively committed to a loss or outgoing where they have a presently existing liability.

Subparagraph 6(d) of TR 97/7 provides that determining whether the taxpayer has a presently existing liability is a legal question in each case, having regard to the circumstances under which the liability is claimed or arises.

For a loss or outgoing to be incurred for the purposes of section 8-1 of the ITAA 1997, it must therefore be a liability in the sense of an existing obligation to pay an amount, rather than a probable future payment.

Taxation Ruling TR 94/26 Income tax: subsection 51(1) - meaning of incurred - implications of the High Court decision in Coles Myer Finance also provides the Commissioner's views on the meaning of 'incurred' and states at paragraph 6 that:

Whether there is a presently existing pecuniary liability is a question which must be determined in light of the particular facts of each case, and especially by reference to the terms of the contract or arrangement under which the liability is said to arise.

In the circumstances of this case, VEP2 provides an incentive to authorised representatives for the purpose of producing assessable income of C Pty Ltd. The VEP2 is designed to increase the profits of the group. The outgoing is incidental and relevant to gaining or producing assessable income. The taxpayer's outgoing is 'dictated by the business ends to which it is directed' and is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

When the shares of A Pty Ltd and its subsidiaries are purchased and included in C Pty Ltd Tax Group, a contractual obligation to make the payments under the VEP2 is made. The fact that the books of account record the VEP2 amounts payable to the participants as a liability does not necessarily mean that the outgoing has been incurred at that point in time for the purposes of section 8-1 of the ITAA 1997.

Consequently, it is at the time of execution of the share purchase agreement that the C Pty Ltd Tax Group member has a legal obligation to pay the VEP2 amount and is considered to be completely subjected or definitely committed to the liability at that time.

Negative limb - capital or revenue?

Subsection 8-1(2) of the ITAA 1997 prevents a general deduction for a loss or outgoing being claimed under subsection 8-1(1) to the extent that the relevant loss or outgoing is:

·         a loss or outgoing of capital, or of a capital nature,

·         a loss or outgoing of a private or a domestic nature,

·         incurred in gaining or producing exempt income, or

·         prevented from being deductible under a specific provision of the ITAA 1997 or the Income Tax Assessment Act 1936 (ITAA 1936).

These four exceptions are commonly referred to as the negative limbs of section 8-1 of the ITAA 1997.

Provided, therefore, that none of the negative limbs apply in the circumstances, C Pty Ltd Tax Group will be entitled to a deduction for the outgoings it incurs for the VEP2 pursuant to paragraph 8-1(1)(b).

In Hallstroms Pty Ltd v. Federal Commissioner of Taxation(1946) 72 CLR 634, Dixon J, in considering the capital revenue distinction, referred at 647 to the general consideration that:

... the contrast between [expenditure on capital or revenue account] 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 context, Viscount Cave in British Insulated and Helsby Cables Ltd v. Atherton (1926) AC 205 at pages 213-214 also stated:

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 a 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 VEP2 scheme provides an incentive for participants to increase the income or financial gain of the company. The VEP2 scheme expense has been incurred to increase the revenue of the company. The expense is not incurred to enhance or improve the business structure/operations through which C Pty Ltd Tax Group carries on its business. Nothing in the facts suggests that the outgoing is private or domestic in nature, or is incurred in gaining or producing exempt income, or is otherwise prevented from being deductible under a specific provision of the ITAA 1997 or the ITAA 1936.

Accordingly, for the reasons set out above, the VEP2 expense is incurred by C Pty Ltd Tax Group and is an allowable deduction to the C Pty Ltd Tax Group under section 8-1 of the ITAA 1997.

Question 2

Is the VEP2 incentive payment tax deductible under section 40-880 of the ITAA1997?

Summary

The payment in satisfaction of the VEP2 amount as described is not deductible under section 40-880 of the ITAA 1997 as it is not a capital expense.

Detailed reasoning

The object of section 40-880 is to make certain business capital expenditure deductible over 5 years if:

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

b)    the deduction is not denied by some other provision; and

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

There are however some limitations and exceptions to the deductibility of these costs.

Subsection 40-880(5) of the ITAA 1997 states that you cannot deduct anything under section 40-880 for an amount of expenditure incurred to the extent that it:

·         forms part of the cost of a depreciating asset (paragraph 40-880(5)(a) of the ITAA 1997)

·         is taken into account in working out the amount of a capital gain or capital loss from a CGT event (paragraph 40-880(5)(f) of the ITAA 1997).

The expenditure must be capital in nature

For the reasons set out above, the VEP2 expense is not a capital expenditure. Consequently, section 40-880 of the ITAA 1997 has no application to the VEP2 expense.