Edited version of private advice

Authorisation Number: 1051783834458

Date of advice: 11 December 2020

Ruling

Subject: Termination payments and franchises

Issue 1

Deductibility of Surrender Payments under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

Question 1

Are the Surrender Payments made by Entity A to Entity C in respect of Restaurant A and Entity D in respect of Restaurant B for the early termination of the respective franchise agreements allowable deductions in the year of payment under section 8-1 of the ITAA 1997?

Answer

No.

Issue 2

Deductibility of Surrender Payments under section 40-880 or section 25-100 of the ITAA 1997.

Question 2

If the answer to Question 1 is 'no', are the Surrender Payments made by Entity A to Entity C in respect of Restaurant A and Entity D in respect of Restaurant B for the early termination of the respective franchise agreements deductible over 5 years under section 25-100 of the ITAA 1997?

Answer

Yes, but only to the extent that the Surrender Payments relate to the termination of the licences granted under the Franchise Agreement to exploit the intellectual property of XX Tax Consolidated Group.

Question 3

If the answer to Question 1 is 'no' are the Surrender Payments made by Entity A to Entity C in respect of Restaurant A and Entity D respect of Restaurant B for the early termination of the respective franchise agreements deductible over 5 years under section 40-880 of the ITAA 1997?

Answer

No.

This ruling applies for the following period:

1 July 20XX to 31 June 20XX.

The scheme commences on:

12 October 20XX.

Relevant facts and circumstances

Background

Entity A carries on a food and restaurant business.

Entity A has developed unique recipes, methods and systems for producing, marketing and selling its food and related products (the System).

Entity A has applied substantial resources to developing particular systems, methods, techniques, processes, and know-how that form part of the System.

Entity B operates a number of 'corporate restaurants' whereby it incurs all expenses and derives all of the revenue in relation to those restaurants.

Entity A and Entity are both members of the same income tax consolidated group (XX Tax Consolidated Group).

Entity A has granted a number of franchises in Australia whereby the franchisee is granted the following:

(1)  An exclusive right to operate a business using the System; and

(2)  A non-exclusive license to exploit the intellectual property owned by the Franchisor (the Licences).

All of the intellectual property is held by the head company of the income tax consolidated group and is licensed to Entity A to use when granting franchises.

Relevantly, Entity entered into a franchise agreement with the following entities:

(1)  Entity C in respect of the XX restaurant on 9 November 20XX (Entity C Franchise Agreement); and

(2)  Entity D in respect of the XX restaurant on 28 February 20XX (Entity D Franchise Agreement).

(together the Franchise Agreements).

The Entity C Franchise Agreement is typical of a franchise agreement entered into by Entity A and is largely identical to the Entity D Franchise Agreement.

Termination of franchises

Entity A and Entity B have entered into deeds of surrender, release and asset purchase with the abovementioned entities to terminate the Franchise Agreements prior to the end of their initial term (Terminating Deeds).

By terminating the Franchise Agreements, the XX Tax Consolidated Group can manage the restaurants as corporate restaurants as opposed to franchises, with a view to increase profitability.

The Terminating Deeds provide that the franchisees under the Franchise Agreements will:

(1)  Surrender the existing franchise agreement and property license (under which a related entity of Entity A granted to the franchisee the right to occupy a premises); and

(2)  Sell certain assets used in the franchise business to Entity B.

Entity A has paid the franchisees an amount as consideration for the surrender of the Franchise Agreements (Surrender Payments) and Entity B has paid the franchisees an amount as consideration for the purchase of the Assets of the business (Purchase Price of Assets). (Together, the Terminating Payments).

Surrender Payments

The Surrender Payments, which are the subject of this Ruling, are payable by Entity A to the respective franchisees to compensate them for the early termination of the Franchise Agreements. The amount of the Surrender Payments is subject to negotiation with the franchisee in each individual case.

The Terminating Deeds do not identify any goodwill as being acquired from the franchisees. This is consistent with the XX Tax Consolidated Group's business model in respect of its franchisees. The XX Tax Consolidated Group has built up significant value in its brand, trademarks, goodwill, and retains all ownership of its intellectual property. Under a franchise agreement with Entity A, franchisees are only provided access to the intellectual property via a non-exclusive license.

Entity A has not provided a breakdown of the Surrender Payments to show what amount is attributable to the termination of the Licences and what value is attributable to the termination of other contractual obligations under the Franchise Agreements.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 25-110

Income Tax Assessment Act 1997 subsection 25-110(1)

Income Tax Assessment Act 1997 subsection 25-110(3)

Income Tax Assessment Act 1997 subsection 25-110(4)

Income Tax Assessment Act 1997 subsection 25-110(5)

Income Tax Assessment Act 1997 subsection 25-110(6)

Income Tax Assessment Act 1997 subsection 40-25(7)

Income Tax Assessment Act 1997 section 40-880

Income Tax Assessment Act 1997 subsection 40-880(2)

Income Tax Assessment Act 1997 subsection 40-880(3)

Income Tax Assessment Act 1997 subsection 40-880(4)

Income Tax Assessment Act 1997 subsection 40-880(5)

Income Tax Assessment Act 1997 paragraph 40-880(5)(b)

Income Tax Assessment Act 1997 subsection 40-880(6)

Income Tax Assessment Act 1997 subsection 40-880(7)

Income Tax Assessment Act 1997 subsection 40-880(8)

Income Tax Assessment Act 1997 subsection 40-880(9)

Income Tax Assessment Act 1997 subsection 108-5(1)

All legislative references in this document are made to the ITAA 1997 unless otherwise stated.

Reasons for decision

Question 1

Summary

The Surrender Payments are not allowable deductions under section 8-1.

Detailed reasoning

Section 8-1 allows an immediate deduction for expenses incurred in the course of carrying on a business provided that the expenses are not capital in nature.

Negative limbs in section 8-1

Of the four negative limbs in subsection 8-1(2), the relevant limb is whether the loss or outgoing is capital, or of a capital nature (paragraph 8-1(2)(a)).

The guidelines for distinguishing between capital and revenue were laid down in Sun Newspapers Ltd and Associated Newspapers Ltd v FC of T (1938) 61 CLR 337: (1938) 45 ALR 10; (1938) 1 AITR 403; 5 ATD 97 (Sun Newspapers).

In Sun Newspapers, Dixon J stated:

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay.

Therefore, it is important to identify the profit yielding structure of the business and to distinguish it from the process of operating the profit yielding structure.

Entity A's business

A franchise is an arrangement which allows the franchisee to use the intellectual property, goodwill and business system that is owned by the franchisor. The term "franchising" covers various forms of co-operation between different corporations.

The XX Tax Consolidated Group utilises the System it has developed in two ways. Firstly, it operates corporate restaurants whereby it sells products to customers, earning 100% of the gross revenue and incurring all expenditure in relation to those sales.

Secondly, the XX Tax Consolidated Group's other method of generating income is by Entity A granting non-exclusive licenses to franchisees to use the intellectual property of the group. Its revenue from this limb of the business is derived by receiving an upfront franchise fee payment and ongoing royalty payments, marketing contributions and advertising caps, at a percentage of the net sales of the franchise.

Profit yielding structure

In identifying the profit yielding structure established by Entity A, reference is made to the statements of Justice Dixon in Sun Newspapers:

The business structure or entity or organisation may assume any of an almost infinite variety of shapes. In a trade or pursuit where little or no plant is required, it may be represented by no more than the intangible elements constituting what is commonly called goodwill, that is, widespread or general reputation, habitual patronage by clients or customers and an organised method or serving their needs.

The Commissioner considers that a franchise is an enterprise that is within the scope of the above statement of Dixon J, in that it comprises a low proportion of physical assets and a high proportion of intangible assets, including intellectual property and goodwill.

Another relevant consideration as described in Sun Newspapers by Dixon J, is assessing the character of the expenditure:

There are, I think, three matters to be considered, (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 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.

In summarising the task of determining the revenue or capital nature of expenditure, Gageler J said in AusNet Transmission Group Pty Ltd v. Federal Commissioner of Taxation (2015) 255 CLR 439; [2015] HCA 25; 2015 ATC 20-521 (AusNet) at paragraph 74:

To characterise expenditure from a practical and business perspective is not to disregard the legal nature of any liability that is discharged by the making of that expenditure. It is not to inquire into whether the expenditure is similar or economically equivalent to expenditure that might have been incurred in some other transaction. It is to have regard to the "whole picture" of the commercial context within which the particular expenditure is made, including most importantly the commercial purpose of the taxpayer in having become subjected to any liability that is discharged by the making of that expenditure. It is, where necessary, to "make both a wide survey and an exact scrutiny of the taxpayer's activities". [footnotes omitted]

The High Court also recently considered the general principles relevant to whether expenditure is on capital or revenue account in Commissioner of Taxation v Sharpcan Pty Ltd (2019) 373 ALR 414 (Sharpcan). In Sharpcan at paragraph 18, the High Court stated:

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 to be used and whether the means of acquisition is a once-and-for-all outgoing for the acquisition of something of enduring advantage or a periodical outlay to cover the use and enjoyment of something for periods commensurate with those payments. Once identified, the advantage is to be characterised by reference 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; and between an enterprise itself and the sustained effort of those engaged in it. Thus, an indicator that an outgoing is incurred on capital account is that what it secures is necessary for the structure of the business.

Character of the advantage sought

The High Court in GP International Pipecoaters Pty Ltd v Commissioner of Taxation 1990 170 CLR 124 at 137 observed thatthe 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. The nature or character of the expenditure will therefore follow the advantage that is sought to be gained by incurring the expenditure. If the advantage to be gained is of a capital nature, then the expenditure incurred in gaining the advantage will also be of a capital nature.

In Colonial Mutual Life Assurance Society Ltd v. Federal Commissioner of Taxation (1953) 89 CLR 428; [1953] HCA 68; (1953) 5 AITR 597, Fullagar J remarked while considering the nature of the advantage sought by making the outlay:

The questions which commonly arise...are (1) What is the money really paid for? - and (2) Is what is really paid for, in truth and in substance, a capital asset?

Having regard to the character of the advantage sought, Entity A has contended that the Terminating Deeds were entered into so that the XX Tax Consolidated Group could operate the restaurants more economically as corporate restaurants rather than franchises, with a view to increasing profitability.

Clause 20.2 of the Terminating Deed states:

The parties agree that each supply under the arrangement involving the sale of the Business by the Franchisee to the Purchaser is a supply of a going concern for GST purposes.

This clause makes it clear that Entity A was to acquire a going concern by entering into the Termination Deeds.

Having regard to what Entity A acquired under the Termination Deeds, it is clear that, on completion of the agreement, Entity A was put in a position where it could continue the operation of the franchised businesses without interruption.

The Commissioner is of the view that Entity A's purpose for terminating the franchised stores was so that it could maximise profits for an indefinite period of time and gain full control of the businesses. This could be achieved by entering into the Terminating Deeds and terminating the relevant Franchise Agreements.

From a similar perspective, in determining the character of the advantage sought by the expenditure, it is necessary to examine whether the expenditure secured an enduring benefit for the business.

Entity A contends that judicial support for the Termination Payments being revenue in nature can be found in Anglo Persian Oil Co v Dale (1931) 16 TC 253 (Anglo Persian). In Anglo Persian it was unanimously held that a lump sum payment made by a company to terminate the contract to employ agents to manage the company's business in Persia was deductible.

In Anglo Persian, the company had contracts with agents for the conduct of its business in remote parts of the world. The agents were remunerated by commission at specified rates. As the business developed, the company from time to time dispensed with the services of such agents, finding itself able to carry on the business more economically directly by its own servants.

Lawrence J stated at 270 that:

The Company by cancelling the agency agreement, and itself undertaking the future management of its business in Persia, neither enlarged the area of its operations, nor improved its goodwill nor embarked upon a new enterprise; it merely effected a change in its business method and internal organisation, leaving its fixed capital untouched. (emphasis added).

Entity A has contended that in its circumstances, the advantage created by the Surrender Payments does not bring into existence an asset or an advantage of 'enduring benefit' for the business of the XX Tax Consolidated Group. This is because although the XX Tax Consolidated Group is terminating the Franchise Agreements and will operate the relevant restaurants itself, it may at any time revert to its former method of conducting the business in relation to those restaurants be re-entering into franchise agreements.

The Commissioner considers that Anglo Persian is distinguishable from Entity A's circumstances on the basis that the contractual relationship between Anglo Persian and its agents was one of agency, with Anglo Persian contracting its agents to represent it in its dealings with its customers in remote areas. In doing so, Anglo Persian retained its relationship as the principal in dealings with its customers.

This can be contrasted with Entity A's circumstances whereby it granted a non-exclusive right to enable a franchise to operate using Entity A's business system so as to service its own customers. Whilst the franchisee is required to operate its franchise under strict terms and conditions as outlined in the Franchise Agreement, this does not change the fact that the right provided by Entity A requires the franchisee to operate the business as their own and on the basis that they earn all profits and bear all of the risks which are normally associated with running a business.

From a similar perspective, it is considered the company-owned restaurants form part of the business structure the XX Tax Consolidated Group employs to earn its assessable income. Under the Terminating Deeds, the Purchase Price, which includes the Surrender Payment, secured for Entity A the particular franchised restaurant. The franchised restaurant acquired by Entity A added to the XX Tax Consolidated Group's network of corporate restaurants through which it earns profit. Once acquired, there is no fixed end date on how long Entity A can continue the operation of the business for, which points towards the enduring nature of the advantage sought by the making of the Purchase Price payments of which the Surrender Payments are a significant component.

The Commissioner considers that the character of the advantage sought in this case supports the Surrender Payments being capital in nature.

The manner in which it is to be used, relied upon or enjoyed

According to Dixon J in Sun Newspapers, when considering the manner in which the expenditure is to be enjoyed, regard must be had to the recurrent nature of the returns it produces.

From the above analysis it is evident that Entity A will acquire, upon terminating the franchise agreements, a going concern by virtue of the fact that the franchisees no longer hold the right to operate the franchise and the XX Tax Consolidated Group can operate the restaurants as its own corporate restaurants.

By terminating the Franchise Agreements Entity A was successful in acquiring a business structure that would result in increased profits as compared with receiving its income by way of royalties and other recurring payments.

Therefore it can be concluded that the manner in which the expenditure was to be used and relied upon or enjoyed was by effectively acquiring a going concern that would result in regular returns by way of sales of goods and services from the running of the particular stores as corporate restaurants.

This factor also supports the Surrender Payments being capital in nature.

The means adopted to obtain it

The final consideration as described in Sun Newspapers by Dixon J, in assessing the character of the expenditure requires analysis of the means adopted to obtain the benefit and whether this payment related to the expansion of the profit yielding structure or whether the outlay was more akin to an ordinary business expense that could be matched with regular returns.

In its application Entity A has highlighted that the recurrent or "once and for all" expenditure test suggests that if the expenditure is recurring, it is more likely to be revenue in nature. Conversely, if it is a one-off expenditure, it is more likely to be capital in nature.

Entity A argues that the Surrender Payments are of a recurring nature due to the ability of Entity to terminate franchise agreements or enter into a terminating deed with a franchisee where it considers it could operate the particular restaurant more efficiently. It advances the argument that it could later re-grant the franchise agreement or continue to operate the restaurant itself which supports the payments being recurring in nature.

The Commissioner does not agree with Entity A's contention that the Surrender Payments are of a recurring nature. On the contrary, it is considered that the preponderance of evidence suggests that the Surrender Payments were a single lump sum payment that the XX Tax Consolidated Group was obligated to pay the Franchisee under the Terminating Deeds upon completion.

The Completion Payment is relevantly defined under Clause 1 (10) of the Terminating Deed for the Entity C Franchise Agreement as the "aggregate of the Purchase Price and the Surrender Payment, less the Retention Sum."

Therefore the Completion Payment which comprises the Surrender Payment is paid as a single payment to the Franchisee upon completion.

The nature of the one-off lump sum payment under the Terminating Deeds adds weight to the conclusion that the Surrender Payments are "once and for all" payments to secure a permanent and enduring advantage and are capital in nature.

Conclusion

For the reasons outlined above, it is considered that Entity A is not entitled to claim a deduction for the Surrender Payments under section 8-1 as they are outgoings of capital or of a capital nature and therefore prevented from being deductible under the provision by virtue of paragraph 8-1(2)(a).

Issue 2

Question 1

Summary

The Surrender Payments made by Entity A are deductible over a 5-year period pursuant to section 25-110 to the extent that the payments relate to the termination of the Licences granted under the Franchise Agreements to use the intellectual property of the XX Tax Consolidated Group.

Detailed reasoning

Section 25-110

Section 25-110 provides a 5-year write-off for capital expenditure incurred to terminate a lease or licence that results in the termination of the lease or licence if the expenditure is incurred in the course of carrying on a business or in connection with ceasing to carry on a business, subject to exceptions contained in subsections 25-110(3) to 25-110(6).

Subsection 25-110(1) states:

(1) You can deduct an amount for capital expenditure you incur to terminate a lease or licence (including an authority, permit or quota) that results in the termination of the lease or licence if the expenditure is incurred:

(a) in the course of carrying on a *business; or

(b) in connection with ceasing to carry on a business.

Subsection 25-110(1) requires the following:

1. The amount is capital expenditure;

2. The amount is incurred to terminate a lease or licence;

3. The amount results in the termination of the lease or licence;

4. The amount is incurred in the course of carrying on a business, or in connection with ceasing to carry on a business.

However, there are also some types of expenditure that cannot be deducted because of the exceptions in subsections 25-110(3) to 25-110(6).

The Surrender Payments incurred by Entity A are a component of the Terminating Payments which secured the termination of the Franchise Agreements, an integral part of Entity A's business structure.

The Terminating Payments enabled Entity A to terminate pre-existing franchise agreements so that it was able to operate the franchises as their own corporate restaurants.

In that context, the payment 'goes to the character and organisation of the profit-earning business and not to be an incident in the operations by which it is carried on': refer Hallstroms Pty Ltd v FC of T (1946) 72 CLR 634; 8 ATD 190. Therefore the payment is capital in nature.

It is considered that the requirements of subsection 25-110(1) are satisfied as follows:

(a) The payments are capital in nature (see Question 1);

(b) The amounts are incurred to terminate a lease or a licence to the extent that the payments relate to the non-exclusive Licences to use the intellectual property granted under the Franchise Agreements. The Terminating Deeds bring about the termination of the Licences granted by Entity A to the franchisees under the respective Franchise Agreements;

(c) The payments were incurred by Entity A in the carrying on of a business.

The words 'to terminate a lease or a licence' in subsection 25-110(1) entail a direct link between the incurrence of the deductible expenditure and the termination of the lease or licence. In other words, deductible expenditure is that which has been incurred for the purposes of causing or inducing the termination of the lease or licence and has the consequence of having done so. The payment incurred by Entity A was for terminating all of the rights and obligations under the Franchise Agreements. So the payment to the franchisee to terminate the franchise was paid by Entity A to terminate not only the licence to use the intellectual property but also the contractual obligations under the Franchise Agreement.

In its ruling application Entity A states:

...we understand that the Surrender Payments made by Entity A to the franchisees under the Terminating Deeds should be characterised as terminating not only the Licenses but also the contractual obligations under the Franchise Agreements.

In these circumstances, it is reasonable to conclude that only part of the Surrender Payments can be said to be paid to terminate the licence to use the intellectual property. This part of the payments is eligible for deduction under section 25-110.

Based on the information supplied by Entity A, it is considered that none of the exceptions contained in subsections 25-110(3) to 25-110(6) apply in this case for the following reasons:

(1)  Entity A is terminating the licences, which are not finance leases (subsection 25-110(3));

(2)  Entity A and the franchisees dealt with each other at arm's length under the Terminating Deeds (subsection 25-110(4));

(3)  Entity A or an associate of Entity A will not enter into another lease or licence with the franchisees or an associate of the franchisees under the Franchise Agreements (subsection 25-110(5)); and

(4)  The Surrender Payments are not for the granting or receipt of another lease or licence (subsection 25-110(6)).

Section 40-880

The Franchise Agreements entered into between Entity A and the franchisees conferred contractual rights and obligations on both the franchisor and the franchisee. The Termination Payments terminated the various rights and obligations that collectively constituted what the franchisee acquired under the Franchise Agreements.

In short, a franchise may include but be wider than a licence, which would appear to be the case here. See Bob Jane T-Marts v FC of T 99 ATC 4437; FC of T v United Aircraft Corporation (1943) 68 CLR 525.

The portion of the Surrender Payments which do not relate to the Licenses granted under the Franchise Agreements and relate to the termination of the contractual rights or obligations under the Franchise Agreements needs to be considered.

Section 40-880 provides a deduction for certain business-related capital expenditure incurred on or after 1 July 2005 referred to as 'blackhole expenditure'.

Subsection 40-880(1) states in relation to the object of section 40-880:

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

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

(b) a 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.

Subsection 40-880(2) provides:

You can deduct, in equal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur:

(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 of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business.

There are various limitations and exceptions contained in subsections 40-880(3) to (9) which apply to limit or deny a deduction under section 40-880.

Paragraph 40-880(5)(d) provides that a taxpayer cannot deduct expenditure they incur to the extent that it is in relation to a lease or other legal equitable right.

Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues (TR 2011/6) contains the Commissioner's view on the application of section 40-880.

Paragraph 47 of TR 2011/6 states:

The existence of paragraphs 40-880(5)(a) and 40-880(5)(f) and section 25-110 mean that paragraph 40-880(5)(d) has limited practical application. It applies to expenditure incurred on or after 1 July 2005 that has a sufficient and relevant connection to a lease or right held by an entity other than the taxpayer. The 'rights' in question do not include all legal rights but only those similar to leases in that they give the taxpayer a right to exploit the asset with which the right is associated. In other words, the right is carved out of an asset but falls short of full ownership of the asset. Examples of such rights include profits à prendre, easements and other rights of access to land. The rights however are not limited to rights associated with land.

The contractual rights to which the Surrender Payments relate would arguably fall within the ambit of those considered in paragraph 40-880(5)(d).

Paragraph 230 of TR 2011/6 cites the following example from the explanatory memorandum to the Tax Laws Amendment (2006 Measures No 1) Bill 2006 (Cth) (the Explanatory Memorandum):

In January 2006, AORT Pty Ltd was seeking to obtain a prospecting right over a particular tract of land. It undertakes an investigation to determine if there are any other rights held over that land. The investigation finds that a farmer holds a right of access over the land, and AORT Pty Ltd agrees to pay the farmer compensation to access the land. As the taxpayer's expenditure is in relation to a right (being compensation for the right to access the land) it is not deductible under the business-related costs provision.

However, the expenses would be included in the expanded first element of cost of a depreciating asset the taxpayer starts to hold as being in relation to starting to hold that asset, being the exploration right.

On this basis, the Surrender Payments which are compensation paid to the Franchisees for the early termination of contractual rights are payments which are made in relation to a legal or equitable right and therefore not able to be deducted under section 40-880.

As the above example demonstrates paragraph 40-880(5)(d) captures capital expenditure which may be captured by other exceptions in subsection 40-880(5). Relevantly, paragraph 40-880(5)(f) provides:

You cannot deduct anything under this section for an amount of expenditure you incur to the extent that:

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;

A 'CGT asset' is broadly defined in subsection 108-5(1) as:

(a) any kind of property; or

(b) a legal or equitable right that is not property.

Subsection 40-880(6), which limits the application of the exception in paragraph 40-880(5)(f), is not considered to apply here. This is because any goodwill is understood to be owned by the XX Tax Consolidated Group.

At paragraph 48 TR 2011/6 states:

In most cases, capital proceeds and cost base (or reduced cost base) are taken into account in working out the amount of a capital or capital loss from a CGT event. Therefore, capital expenditure which reduces capital proceeds from a CGT event or forms part of the cost base (or reduced cost base) of a CGT asset could be taken into account in working out the amount of a capital gain or capital loss from a CGT event for the purposes of paragraph 40-880(5)(f).

Relatedly, paragraph 50 of TR 2011/6 states:

In the context of section 40-880 the words of paragraph 40-880(5)(f) do not require that the capital expenditure be actually taken into account in working out a capital gain or capital loss, or that the capital gain or capital loss worked out be actually taken into account in working out the net capital gain included in the taxpayer's assessable income - that is a separate process. If the words were interpreted otherwise expenditure which should receive CGT treatment could inappropriately become a revenue deduction.

The application of section 40-880 was recently considered in Origin Energy Pty Ltd v FC of T [2020] FCA 409. At paragraph 189 Thawley J quotes the Explanatory Memorandum and cites the following example in relation to 40-880(5)(f):

Example 2.13

On 1 May 2006, Chooks Pty Ltd, a restaurateur, enters into a franchise agreement under which it pays $100,000 for the right to use the franchisee's name. Therefore, Chooks has acquired a CGT asset, that is, the right, with a cost base of $100,000. The cost will ultimately be recognised at the time of a subsequent CGT event, for example, were Chooks to dispose of the right.

It is considered that the termination of any contractual rights or obligations for which consideration is paid by Entity A in the form of the Surrender Payments to the respective franchisees would be similar in nature to those in the aforementioned example.

On this basis the portion of the Surrender Payments which do not relate to the termination of the Licenses (but relate to other contractual rights or obligations under the Franchise Agreements) could be taken into account in working out the amount of a capital gain or capital loss, and therefore is not deductible under section 40-880.

Conclusion

The expenditure incurred by Entity A is deductible under section 25-110 to the extent that the Surrender Payments relate to the termination of the Licences granted under the Franchise Agreements. Any remaining portions of the Surrender Payments relating to the termination of contractual rights or obligations under the Franchise Agreements are unable to be deducted under section 40-880 by virtue of paragraphs 40-880(5)(d) and (f).