Edited version of private advice

Authorisation Number: 1051774288693

Date of advice: 11 November 2020

Ruling

Subject: Employee share scheme

Question 1

Will Company X obtain an income tax deduction, pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), in respect of a cash contribution made during an income year by Company X to the Trustee of the Trust in relation to the subscription for shares by the Trust?

Answer

Yes

Question 2

Will the contribution by Company X to the Trustee of the Trust, made at a time on or after the participants acquire the relevant employee share scheme interest, to fund the acquisition of shares be deductible to the Company X at a time determined by section 8-1 of ITAA 1997?

Answer

Yes

Question 3

Will the subscription proceeds be included in the assessable income of Company X under section 6-5 or 20-20 of the ITAA 1997 or trigger a Capital Gains Tax (CGT) event under Division 104 of the ITAA 1997?

Answer

No

Question 4

Will the Commissioner make a determination that Part IVA of the Income Tax Assessment Act  1936 (ITAA 1936) applies to deny, in any part or in full, any deduction claimed by Company X in respect of contributions made to the Trustee of the Trust for the purpose of acquiring shares to satisfy grants of employee share scheme interests under Company X's employee share schemes?

Answer

No

Relevant facts and circumstances

1.    Company X is an Australian resident. Company X is the head company of a tax consolidated group, pursuant to section 359-10 of Schedule 1 of Taxation Administrative Act 1953.

2.    Company X established a trust for the purpose of acquiring ordinary shares (Shares) to satisfy awards of options (Options) issued under Company X's employee share plan (Plan).

Employee Share Scheme (ESS)

3.    The Plan is part of Company X's remuneration strategy and aims to ensure the long-term creation of value in Company X by rewarding eligible participants (Participants) with Options that allow them to share in the growth of the business and assisting with the retention of key talent personnel.

4.    The Plan was approved by the board (Board) of Company X. The terms and conditions are set out in the employee share option plan rules (Plan Rules) and the terms on which Participants are invited to participate in the Plan are set out in the offer letter (Offer).

5.    A summary of the key terms of the Plan Rules are outlined below:

•   The Board determines the procedure for offering Options to Participants.

•   Options may be subject to vesting conditions as set out in the Offer

•   A Participant may only exercise Options once they are vested (Vested Options)

•   Options that have not vested and have not expired lapse and cease to exist either on termination of employment or expiry date of the Options.

•   Participants must not dispose of any Options or Shares unless the Board consents

•   Company X may choose to buy-back Vested Options or allocates Shares in accordance with the Plan.

6.    The Plan is an employee share scheme that falls within Division 83A of the ITAA 1997.

The Trust

7.    The Trust was established in accordance with the trust deed (Trust Deed).

8.    The Trust Deed requires the Trustee to acquire plan securities (including Options or Shares) in accordance with instructions received from Company X, provided that the Trustee receives sufficient funds.

9.    The Trustee does not have any right or interest in the Shares or Options acquired by the Trustee in accordance with the Deed.

10.  All funds received by the Trustee from Company X will constitute accretions to the corpus of the Trust.

11.  The Trustee can only transfer Options or Shares held under the Trust to a Participant when directed to do so by Company X.

Exercise of the Options

12.  The Commissioner was asked to provide a ruling on the basis of the Offers that were exercised by Participants during a particular income year.

13.  In that income year, Company X made a contribution to the Trustee of the Trust after the Shares were issued pursuant to exercise of Options by the Participants.

Relevant legislative provisions

Fringe Benefits Tax Assessment Act 1986 section 136

Income Tax Assessment Act 1936 Division 6

Income Tax Assessment Act 1936 Part IVA

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 20-20

Income Tax Assessment Act 1997 section 83A

Reasons for decision

Question 1

14.  Subsection 8-1(1) of the Income Tax Assessment Act 1997 will allow you to 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.

15.  However, pursuant to paragraph 8-1(2)(a), you cannot deduct a loss or outgoing under section 8-1 to the extent that it is a loss or outgoing of capital, or of a capital nature.

Contribution must be incurred

16.  A loss or outgoing must have been 'incurred' in a particular income year in order to be deductible under section 8-1.

17.  As a broad guide, you incur an outgoing at the time you owe a present money debt you cannot escape, irrespective of whether the debt is paid or payable immediately in the future. But this broad guide must be read subject to the propositions developed by the Courts.

18.  The Commissioner has issued Taxation Rulings which set out the ATO's view on the interpretation of the word 'incurred' in section 8-1 by setting out general rules, settled by case law, which will assist in most cases in defining whether and when a loss or outgoing has been incurred.

19.  Paragraph 21 of Taxation Ruling TR 97/7 Income Tax: section 8-1 - meaning of 'incurred - timing of deductions (TR 97/7) provides that:

Generally, a deduction is allowable because a liability arises necessitating the payment of an expense. However, some payments are not necessitated by a presently existing liability, and they are incurred only upon payment. Examples of such expenses include gifts, insurance premiums, licence renewals and motor vehicle registration fees - these payments are at the discretion of the taxpayer, if the taxpayer wants those benefits.

20.  Further, paragraph 4 of Taxation Ruling TR 94/26 Income Tax: subsection 51(1) - meaning of incurred - implications of the High Court decision in Coles Myer Finance (TR 94/26) provides:

A presently existing liability of the type discussed in paragraph 3 above is not necessary where the taxpayer makes a purely voluntary payment or a prepayment. One example of a purely voluntary payment is where an employer voluntarily pays a Christmas bonus to employees. Such a payment may be deductible even though there is no legal obligation to make the payments.

21.  Following the ATO's views on the interpretation of section 8-1, outlined in the extracted paragraphs from TR 97/7 and TR 94/26 above, it is the Commissioner's view that Company X made a voluntary payment and the amount was incurred upon payment.

22.  The amount incurred was irretrievable and non-refundable as it has been entirely expensed by the Trustee for the purposes of acquiring Shares to satisfy the Options that were exercised during that particular Income Year. The Shares have been allocated to the Participants.

23.  Further, there was no mechanism for allocated Shares to be forfeited by Company X under the Plan Rules or the Trust Deed. The only way the Shares may be returned to Company X is through buy-back in accordance with the Plan Rules.

24.  Accordingly, the amount of contribution paid by Company X to the Trust has been incurred for the purposes of subsection 8-1(1) of the ITAA 1997.

Sufficient Nexus

25.  To claim a deduction under section 8-1, it is also necessary to establish a nexus or link between the loss or outgoing and the production of assessable income or the carrying on of a business for the purpose of gaining of producing assessable income.

•         Was the loss or outgoing incurred in gaining or producing assessable income under paragraph 8-1(1)(a)?

26.  Determining whether particular expenditure has been incurred in gaining or producing assessable income is a question of fact according (see Ronpibon Tin NL and Tongkah Compound NL v FC of T (1949) 78 CLR 47).

27.  The term 'incurred in gaining or producing assessable income' means incurred 'in the course of gaining or producing assessable income (see Commissioner of Taxation v Payne [2001] HCA 3).

28.  The expression 'incurred in gaining or producing assessable income' should be given a very wide application (Commissioner of Taxation v Day [2008] HCA 53), noting that it will not be enough to show some general link or causal connection between the expenditure and the production of income.

29.  For an expense to be incurred in gaining or producing assessable income it is both sufficient and necessary that the occasion of the expense should be found in whatever is productive of assessable income. To determine what is productive of a taxpayer's assessable income, consideration should be given to the scope of the taxpayer's income producing activities.

30.  It follows that to determine whether the outgoing, being the cash contribution made to the Trustee of the Trust during that particular income year, is incurred in gaining or producing the assessable income of Company X, the occasion of the outgoing should be found in whatever is productive of assessable income. This requires consideration of the scope of the particular activities undertaken by Company X for the purpose of gaining or producing assessable income.

31.  Company X carries on a business that produces assessable income in Australia.

32.  It is considered that the Trust and the Plan are being operated to remunerate its employees as a component of Company X's business. This is consistent with the Plan being part of Company X's remuneration strategy which aims to ensure the long-term creation of value in Company X.

33.  The Commissioner accepts that the contribution to the Trust was made to enable Company X to meet its obligations arising from the grant of Options under the Plan. The contribution, used by the Trust to acquire the Shares and deliver the Shares to Participants, forms part of the overall remuneration costs of Company X such that there is a sufficient connection between the occasion of the outgoing and the production of income from the activities of the business carried out by Company X.

34.  Looking at the evidence, facts and circumstances, and in particular the business conducted by Company X and the need to attract, retain and reward talented employees, it is the Commissioner's view that the provision of benefits to Participants as part of a broader remuneration plan is intrinsically, and therefore, necessarily connected to the carrying on of the business. The provision of benefits to Participants is reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business. As such, it is an outgoing incurred in the course of gaining or producing the assessable income which will satisfy the requirements of paragraph 8-1(1)(a).

•         Was the loss or outgoing necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income under paragraph 8-1(1)(b)?

35.  Paragraph 8-1(1)(b) requires the loss or outgoing to be necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

36.  In Magna Alloys & Research Pty Ltd v FC of T(1980) 11 ATR 276, the Full Federal Court stated that an outgoing is necessarily incurred in carrying on a business where, viewed objectively, it is reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business being carried on for the purpose of earning assessable income.

37.  The same reasoning applied above to a consideration of the application of paragraph 8-1(1)(a) can be applied here.

38.  The Commissioner accepts that the contribution to the Trustee of the Trust was made to enable Company X to meet its obligations arising from the grant of Options under the Plan. The contribution forms part of the overall remuneration costs of Company X such that there is a sufficient connection between the occasion of the outgoing and the production of income from the activities of the business.

39.  The provision of benefits to Participants is reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business.

40.  Looking at the evidence, facts and circumstances, and in particular the relevant activities of the Company X's group overall, the business conducted by Company X and the need to attract, retain and reward talented employees, it is the Commissioner's view that the provision of benefits to Participants as part of a broader remuneration plan is intrinsically, and therefore, necessarily connected to the carrying on of the business.

41.  As such, it is an outgoing necessarily incurred in the course of gaining or producing the assessable income by means of carrying on the business which will satisfy the requirements of paragraph 8-1(1)(b).

Not capital or of a capital nature

42.  Even if subsection 8-1(1) is satisfied, a deduction will not be allowed if the contribution satisfies paragraph 8-1(2)(a) - losses or outgoings of capital or of a capital nature are not deductible. As such, the contribution will not be deductible under section 8-1 to the extent it secures a capital advantage for Company X.

43.  In Sun Newspapers Ltd v Commissioner of Taxation [1938] HCA 73; (1938) 61 CLR 337 at 363, Dixon J said that in determining whether a payment was on capital or revenue account three matters are to be considered - whether an outgoing is capital or revenue can generally be determined by examining the character of the advantage sought, the manner in which it is to be used, relied upon or enjoyed and the means adopted to obtain it.

44.  The general principles relevant to whether expenditure is on capital or revenue account have been recently considered by the High Court in AusNet Transmission Group Pty Ltd v Commissioner of Taxation (AusNet) (2015) 255 CLR 439 and Commissioner of Taxation v Sharpcan Pty Ltd (Sharpcan) (2019) 373 ALR 414. In Sharpcan, the High Court stated (some citations omitted):

Authority is clear that the test of whether an outgoing is incurred on revenue account or capital account primarily depends on what the outgoing is calculated to effect from a practical and business point of view. Identification of the advantage sought to be obtained ordinarily involves consideration of the manner in which it is used and whether the means of acquisition is a once-and-for-all outgoing for the acquisition of something of enduring nature or a periodical outlay to cover the use and enjoyment of something for periods commensurate with those payments. (emphasis added)

45.  In AusNet, the majority emphasised the importance of the 'advantage sought by the taxpayer in making the payments' at 23, quoting Gibbs ACJ in Commissioner of Taxation v South Australian Battery Makers Pty Ltd ((1978) 140 CLR 645 at 655). Also, in GP International Pipecoaters Pty Ltd v Commissioner of Taxation (1990) 170 CLR 124, the court found at 137 that the primary question is the character of the advantage sought by the taxpayer in incurring the expenditure.

•         The character of the advantage being sought

46.  The nature of the advantage being sought is determined objectively (see Mussalli v Commissioner of Taxation [2020] FCA 544 at [42] per Jagot J).

47.  As noted above, the Trust and the Plan are being operated to remunerate Participants as a component of Company X's business. This is consistent with the Plan being part of Company X's' remuneration strategy which aims to ensure the long-term creation of value in Company X.

48.  Here, the contribution to the Trustee of the Trust was made to enable Company X to meet its obligations arising from the grant of Options under the Plan. Therefore, the contribution, used by the Trustee of the Trust to acquire the Shares and deliver the Shares to Participants, should form part of the overall remuneration costs of Company X.

49.  The purpose of the contribution to the Trustee of the Trust was to provide an incentive to Participants, to reward them and make them more contented and ready to remain in the service of Company X. They were regarded by Company X as rewards to Participants for the profits they helped to make. The contribution was intimately connected with the day-to-day operation of Company X's business as the goodwill of Participants was something which might fluctuate from day to day.

50.  As a result, the advantage sought by Company X in making the contribution to the Trust in the particular income year was enabling the management and conduct of the company's business to be carried on more efficiently by Participants who were rewarded and ready to remain in the service of the company. In other words, the advantage sought by the contribution was to effectively substitute ongoing expenditure (e.g. cash salary and bonus payments) with Shares so as to obtain the loyalty and trust of Company X's employees.

51.  Once the advantage that is being sought has been identified, it is to be characterised. In this case, having regard to the particular character of Company X, its business and of the relation to that business of Participants who are rewarded and contented, it is considered that the contribution to the Trustee of the Trust:

•         ought to be regarded as being expenditure incurred for the regular performance of the work in which the Participants are employed, and

•         is intrinsically connected to the carrying on of the business.

52.  Noting the comments of the High Court in Sharpcan at paragraph 59 above, this is what the contribution to the Trust is calculated to effect from a practical and business point of view.

53.  In this case, during the income year, Company X made a voluntary contribution to the Trustee of the Trust to satisfy its obligation under the Plan. The contribution was immediately paid by the Trustee of the Trust to Company A after the Trustee received, as subscription price of the Shares. The purpose of that contribution made to the Trustee of the Trust was transient, in that it was designed to secure the trust and confidence of Participants. Further, the contribution did not form a permanent nucleus of the Trust, but rather was permanently and entirely dissipated in remunerating the employees through the provision of the Shares.

54.  Therefore, it is the Commissioner's view that the contribution made by Company X to the Trustee of the Trust is not capital or of a capital nature.

55.  Accordingly, the cash contribution made by Company X to the Trustee of the Trust during a particular Income Year is deductible under section 8-1.

Question 2

56.  The contribution was made after the acquisition of the Options.

57.  The amount is, therefore, deductible under section 8-1 in the income year in which the contribution was made.

Question 3

Section 6-5

58.  Section 6-5 of ITAA 1997 provides that a taxpayer's assessable income includes income according to ordinary concepts.

59.  The House of Lords explained the principles in Lowry (Inspector of Taxes) v Consolidated African Selection Trust Ltd (1940) 23 TC 259 (Lowry) where shares to employees were issued at discount. As expressed by Viscount Maugham at page 285:

The issue of shares by a company, whether at par or over, does not affect the profits or gains of the company for the purposes of Income Tax.

60.  The Commissioner made similar observation in Taxation Ruling TR 2002/14 Income tax: taxation of retirement village operators (TR 2002/14) that the money received in relation to the shares issued by a company are regarded as capital receipts.

61.  The subscription price paid by Company X for acquisition of Shares is proceeds by Company X for issuing of equity in itself. It is a receipt of a capital nature and is not income accordance to ordinary concepts.

Section 20-20

62.  Section 20-20 of ITAA 1997 is about assessable recoupment.

63.  Subsection 20-20(2) provides that assessable recoupment includes an amount received as recoupment of a loss or outgoing by way of insurance or indemnity. The amount is assessable income if the loss or outgoing could be deducted in the current year or an earlier income year.

64.  Subsection 20-20(3) provides that a recoupment of a loss or outgoing, in any other circumstances except by way of insurance or indemnity, is an assessable recoupment if such loss or outgoing is deductible because of a provision listed in section 20-30 of the ITAA 1997.

65.  The Commissioner does not consider that the contribution in this case falls within any of the descriptions of assessable recoupment in section 20-20. The amount received by Company X from the Trust is a capital payment to Company X for issuing Shares in itself.

Capital Gain

66.  There is no CGT event applicable to Company X upon issuing of Shares in itself. Accordingly, no amounts will be assessable as a capital gain to Company X.

Question 4

67.  Part IVA of the ITAA 1936 is a general anti-avoidance provision which gives the Commissioner the power to cancel a 'tax benefit' that has been obtained, or would, but for section 177F, be obtained, by a taxpayer in connection with a scheme to which Part IVA applies.

68.  The Commissioner generally accepts that a general deduction may be available where an employer provides money or other property to an employee share trust where the conditions of Division 83A of ITAA 1997 are met.

69.  In this case, the scheme does not contain the elements of artificiality or unnecessary complexity and the commercial drivers sufficiently explain the entry into the use of the EST arrangement.

70.  Therefore, having regard to the eight factors set out in subsection 177D(2) of the ITAA 1936, the Commissioner has concluded that the scheme is not being entered into or carried out for the dominant purpose of enabling Company X or any other entity to obtain a tax benefit.