Edited version of private advice

Authorisation Number: 1051931778732

Date of advice: 8 December 2021

Ruling

Subject: General deductions

Question

Is the payment of the Purchase Price made by Company X to Company Y pursuant to the agreement deductible to Company Z under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes. The Purchase Price is deductible to Company Z as the head company of an income tax consolidated group of which Company X is a subsidiary member and is made up of the Completion Payment which is deductible in the income year ending 30 June 20YY and the Deferred Payment (if any) which is deductible in the income year ending 30 June 20ZZ.

Relevant facts and circumstances

Company Z's business activities

Company Z is the head company of an income tax consolidated group of which Company X is a subsidiary member.

Company Z offers service products through various brands to consumers and commercial customers.

Company Y's business activities

Company Y is a service provider that is removing certain service products from its business offering.

Company Y's gross sales is a small fraction of Company Z's gross sales.

Overview of transaction

Various agreements were entered into to give effect to Company Y's transition out of selling certain service products (the Transaction Agreements).

Under the Transaction Agreements, Company X acquired the Assets from Company Y for a Purchase Price that was made up of a Completion Payment and a Deferred Payment (if any).

The Assets are made up of certain rights that provide Company X with the ability to contact and offer various service products to customers who were previously offered service products by Company Y.

The Completion Payment was made on the date of completion, being XX June 20YY.

The Deferred Payment (if any) will be calculated based on the number of clients retained by Company X as a result of using the Assets as at XX June 20ZZ and will be paid on XX August 20ZZ.

If certain service product retention thresholds are met, a Deferred Payment will be made. If the service product retention thresholds are not met, a Deferred Payment will not be made.

Other key parts of the Transaction Agreements are set out below:

(a)       Company Y was the owner of the Assets,

(b)       Company Y would stop offering certain service products, and

(c)       Company Y would refer customers to Company X.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 701-1

Reasons for decision

Deductibility under section 8-1

Section 8-1 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.

(3) A loss or outgoing that you can deduct under this section is called a general deduction.

The positive limbs

Under subsection 8-1(1) a deduction is allowed for a loss or outgoing to the extent it has been incurred in gaining or producing assessable income (first positive limb) or it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income (second positive limb).

Incurred

The Commissioner's view of the meaning of 'incurred' for the purposes of section 8-1 is set out in Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions.

Broadly, an outgoing is incurred at the time that you owe a presently existing liability that cannot be escaped. However, a presently existing liability does not exist if the liability is no more than pending, threatened or expected, or contingent on future events.

A number of authorities are provided in TR 97/7 which is reproduced (in part) below:

6. The courts have been reluctant to attempt an exhaustive definition of a term such as 'incurred'. The following propositions do not purport to do this, they help to outline the scope of the definition. The following general rules, settled by case law, assist in most cases in defining 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 definitively 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 is capable of reasonable estimation (based on probabilities);

(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.

...

16. 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.)

17. This proposition was recently confirmed by the High Court in FC of T v. Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52 (Energy Resources) when, quoting from James Flood, it said (ATC at 4539; ATR at 56):

'Section 51(1) "has been interpreted to cover outgoings to which the taxpayer is definitively committed in the year of income although there has been no actual disbursement".'

18. The liability must be 'more than impending, threatened or expected' - refer New Zealand Flax (CLR at 207). '[W]hat is clearly necessary is that there should be a presently existing liability' - Nilsen Development Laboratories (CLR at 624). It is not a presently existing liability if it is contingent - refer James Flood (CLR at 506); Nilsen Development Laboratories (CLR at 207); Marbren Pty Ltd v. FC of T 84 ATC 4783 at 4788-4789; (1984) 15 ATR 1145 at 1152.

19. A taxpayer can be completely subjected to a liability even though it is defeasible by others - refer Commonwealth Aluminium Corporation Ltd (77 ATC 4151 at 4161; (1977) 7 ATR 376 at 386).

20. But, it is to be emphasised that the taxpayer must be definitively committed to the outgoing, even though it may be defeasible. A taxpayer who takes goods on approval for example could not be said to be definitively committed to their purchase.

Accordingly, where the liability is impending, threatened or expected, or is contingent on some future event, then it is not a presently existing liability and the loss or outgoing has not been incurred.

The Purchase Price is made up of a Completion Payment and a Deferred Payment (if any).

The Completion Payment was paid on the date of completion, being XX June 20YY. Accordingly, the Completion Payment was incurred in the income year ending 30 June 20YY either because a presently existing liability existed in that income year, or otherwise because the payment was made in that income year.

Company X will commence contacting clients and offering service products from XX November 20YY.

Accordingly, it cannot be said that Company X met the relevant retained service product thresholds and that a presently existing liability to make a Deferred Payment exists in the income year ending 30 June 20YY.

It can be expected that Company X will know whether a Deferred Payment is required to be made on XX June 20ZZ. Alternatively, even if the calculation is carried out after that date, it will be conducted based on retained clients that existed on XX June 20ZZ.

Therefore, the conditions required to make a Deferred Payment will either be satisfied or failed on XX June 20ZZ. This means that the loss or outgoing will actually be incurred in the income year ending 30 June 20ZZ because that is when the presently existing liability arises.

Accordingly, if the relevant thresholds are met and a Deferred Payment is required to be made, the Deferred Payment will be incurred in the income year ending 30 June 20ZZ.

Gaining or producing assessable income

For an outgoing to be deductible under the first limb of section 8-1, the relationship between the outgoing and Company Z's assessable income must be such as to impart to the outgoing the character of an outgoing incurred in gaining or producing assessable income. According to decisions of the courts, an outgoing is not characterised as having been incurred in gaining or producing assessable income unless it is 'incidental and relevant to that end': Ronpibon Tin NL & Tongkah Compound NL v. FC of T (1949) 78 CLR 47 at 56; 8 ATD 431 at 436. It has also been said by the courts that the test of deductibility under the first limb of the section is that:

it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income. ( Ronpibon Tin case 78 CLR at 57; 8 ATD at 436).

For an outgoing to be deductible under the second limb of section 8-1, it must have the character of a working or operating expense of IAG's business or be an essential part of the cost of its business operations.

In the Ronpibon Tin case, the High Court said (78 CLR at 56; 8 ATD at 435):

The word "business" is defined by subsection 6(1) to include profession, trade, employment, vocation or calling, but not occupation as an employee. The alternative in subsection 51(1) therefore covers a wide description of activities. But in actual working it can add but little to the operation of the leading words, "losses or outgoings to the extent to which they are incurred in gaining or producing the assessable income". No doubt the expression "in carrying on a business for the purpose of gaining or producing" lays down a test that is different from that implied by the words "in gaining or producing". But these latter words have a very wide operation and will cover almost all the ground occupied by the alternative.

Company X entered certain agreements to acquire the Assets. The Assets acquired by Company X effectively increases the customer base of Company Z.

Company Z already provides the types of service products to its own customers that the Assets allow it to provide to a new set of customers. This is seen as merely an increase in Company Z's customer base in order to generate additional income from its various brands.

Therefore, the Completion Payment and the Deferred Payment (if any) have the requisite connection to the production of assessable income for Company Z by increasing Company Z's customer base.

The negative limbs

A loss or outgoing is deductible if it meets the either of the positive limbs contained in subsection 8-1(1), but is not be deductible if it meets any of the negative limbs contained in subsection 8-1(2).

Loss or outgoing of capital, or of a capital nature (subparagraph 8-1(2)(a))

A loss or outgoing of capital, or of a capital nature, will not be deductible under section 8-1.

Extensive common law authority exists to guide the interpretation of what is or isn't capital expenditure.

The starting point is usually the following principles drawn from Dixon J's judgment in the case of Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers):

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.

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 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.

More recently the High Court considered the capital/revenue dichotomy in the case of FC of T v Sharpcan Pty Ltd (2019) ATC 20-715; [2019] HCA 336 (Sharpcan) and summarised the principles as follows:

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 character of the advantage sought provides the best guidance as to the nature of the expenditure because it says the most about the essential character of the expenditure itself. The decision of the High Court in GP International Pipecoaters Pty Ltd v Commissioner of Taxation (19920) 170 CLR 124 at 137 provides:

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 CLR 337 at 363...

The character of the advantage sought is to be determined from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process (Hallstroms Pty Ltd v FC of T (1946) 8 ATD 190 at 195; (1946) 72 CLR 634 at 648, per Dixon J).

The 'character of the advantage' means the character of the advantage sought by the taxpayer for himself by making the outgoings (Federal Commissioner of Taxation v South Australia Battery Makers 78 ATC 4412 at 4418).

Where what is sought to be obtained is not an asset, but a practical though intangible business advantage, then that too must be analysed to determine its nature, as, for example, whether it is an enduring advantage for the benefit of the business (South Australian Battery Makers 78 ATC 4412 at p 4421).

Further, in Sharpcan the High Court set out a counterfactual test to assist with determining the character of the advantage sought. This test compares the expected structure of the business after the outgoing with the expected structure of the business but for the outgoing.

In Tyco Australia Pty Ltd v FC of T (2007) ATC 4799; [2007] FCA 1055 (Tyco) the taxpayer was in effect acquiring customer service agreements from an authorised dealer of Tyco alarm systems which increased Tyco's customer base.

41. As these passages reveal, the regular payment of sums to secure customers, to add incrementally to a customer base and thus to expand a business and to obtain revenue from such customers is easily able to be seen to be on revenue account.

75. It is uncontroversial that the payment of the Assignment Fees led to an acquisition of rights by TAPL by assignment and novation. Those rights can be seen to be assets purchased by TAPL. The price of the assignment of the assets was, under first two versions of the Authorised Dealer Agreement, equivalent to almost all of the revenue stream inherent within the term of the rights assigned, and, under the third version, about two thirds of all the revenue stream within the term of the rights assigned. Thus, TAPL could be said to have been buying bundles of rights so that it might profit from the acquisition of the person with whom the assigned contract is made, as a customer, beyond the three year term. Mr Brown said as much.

76. This does not make this an affair of capital. The asset or the so-called accretion to structure was, in practical and business terms (and in legal terms), the winning of a customer. That a very attractive (to the Authorised Dealer) Assignment Fee was set reflected the anticipation not of the value of the contract rights themselves that were assigned, but rather the future value of the connection with the customer and the future revenue stream once the customer was won. The advantage sought by each payment was the winning of a customer, so that he, she or it might be retained and exploited (using that word in a neutral sense) for future revenue for services to be provided.

77. ... By the winning of customer by customer (in significant numbers) TAPL built up its customer base and its hoped for future revenue. It is important to recognise that each Assignment Fee was payable in respect of each Customer Service Agreement assigned and novated. Each assignment and novation and each passing of a customer to TAPL was an incremental accretion to the customer base of TAPL. This distinguishes the payments (as a collection of individual payments) from the purchase of a book of business as was involved in the Honeywell transaction.

78. ... It highlights that the advantage sought was the winning of the individual customer and the hoped-for future revenue after the initial three year period which might be brought about once the connection was made. Looked at in this way, the expenditure of money was in the ordinary business activity of winning customers.

79. When one steps back from each individual assignment and places the AD Program in its context, it amounts to one business method of seeking out, contracting and profiting from additional customers. It could have been done by many methods, including employees, commission agents or, as here, independent contractors, going out to obtain customers. The instrument used (whether employee, agent or independent contractor) would need to be remunerated. The method of remuneration does not affect the character of the advantage sought: the incremental addition to the customer base of TAPL and the future obtaining of revenue therefrom.

80. ... The characterisation of what TAPL was getting by making the payments of the Assignment Fees is assisted by understanding other equivalent ways of obtaining the same advantage. The same advantage could have been obtained by use of employees (as had been done) or by the use of commission agents. In each case, a relationship between TAPL and the customer could have been brought about.

81. This was not the purchasing or creation of a business structure. It was, to paraphrase and elaborate upon the words of Dixon J in Sun Newspapers 61 CLR at 360, the building of the extent of the profit-yielding subject (being the customer base of TAPL) as the product of the course of operations, by the incremental winning of customers by the chosen method of organising and remunerating an independent, but controlled, sales force.

83. As to the second and third aspects of the advantage referred to by Dixon J in Sun Newspapers 61 CLR at 363, being the manner in which the advantage sought was to be used in the business and the means adopted to obtain the advantage, these considerations are bound up with what I have already said. The advantage obtained was the addition of each customer to the business of TAPL. This was to be used in the continuous and recurrent task of providing services during, and hopefully after, the contract period. The means adopted to obtain the advantage was the payment of each Assignment Fee as the cost of acquiring each customer to whom the services would be provided and from whom revenue would be extracted. This was an incremental recurrent activity brought about by the activity of the group of people charged with the responsibility of finding individual customers for TAPL.

The main purpose for Company X to enter the agreements was to acquire the Assets. Other rights acquired by Company X are incidental to and supportive of Company X's acquisition of the Assets.

The substance of the Assets is that they allow Company Z the opportunity to increase its customer base by providing the ability to offer service products to customers that formerly obtained service products from Company Y.

Company X's circumstances are similar in many ways to Tyco. The analysis is particularly similar with respect to the advantage sought being the winning of a customer so that Company Z may profit from that customer in future.

Company Z has extended its customer base rather than acquiring an asset that changes or improves the business structure.

Company Z's business structure after the expenditure and acquisition of the Assets is the same as it would have been but for the expenditure. Company Z already offered similar service products through its various brands, and but for the expenditure Company Z would have continued to offer those service products. The expenditure merely granted Company Z access to more potential customers.

The fact that Company X has made a one-off payment does not necessarily preclude the advantage from being characterised as revenue in nature.

Therefore, the character of the advantage sought indicates that the Purchase Price is revenue in nature.

Manner in which the advantage is to be used

Where expenditure is made to secure an asset or an advantage of an enduring kind, the loss or outgoing is more likely to be capital in nature. This test was outlined in British Insulated and Helsby Cables Ltd v Atherton [1926] AC 205 at 213-214 by Viscount Cave where he stated:

But when expenditure is made, not only once and for all, but with a view to bring into existence an asset or an advantage for the enduring benefit of 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.

A benefit need not be permanent or everlasting in order to be enduring. Latham CJ in Sun Newspapers provided (at 355):

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.

Certain rights acquired as part of the Assets will expire after 35 days if the client has failed to purchase a service product from Company Z. On the other hand, if the client does purchase a service product from Company Z then it is not clear how long the benefit will endure.

Even if a client purchases a service product, that client may choose to not purchase again in future, or even to cancel the service product early. This could happen if the client finds a competing provider that better suits their needs.

On balance, it does not appear that Company Z acquired an enduring benefit.

As discussed above, the advantage sought is the acquisition of additional customers which expands the customer base of Company Z. This advantage is intended to be used to generate further profits from the customers through the issue of new service products.

Because the service products are of a type that Company Z already issues, it cannot be said that the acquisition of the new customers is an enhancement of the business structure.

Accordingly, the advantage is simply being used to increase profits from an already existing business structure which indicates that the Purchase Price is revenue in nature.

Means adopted to obtain the advantage

The means adopted to obtain the advantage is the third criteria set out in Sun Newspapers and generally relates to whether the payment in return for the advantage is recurrent or a one-off final payment.

Ordinarily, a recurring payment would be more akin to a revenue expense and a one-off final payment is more likely to be capital.

However, the frequency of payment is not itself a determinative factor and a one-off payment will not always be capital in nature (NAB v FCT (1997) 80 FCR 352).

Company X has paid the Completion Payment which is a one-off lump sum amount and may pay a Deferred Payment if certain conditions are met which would also be a one-off payment of a lump sum amount.

The Purchase Price, made up of the Completion Payment and the Deferred Payment (if any), is not a payment that expands the profit making structure of Company Z's business, nor does it provide an enduring advantage for Company Z.

Because of this, the fact that the payments may be considered one-off lump sums is not enough to stamp the expenditure as capital in nature.

Conclusion

The Completion Payment was incurred by Company X in the year ending 30 June 20YY whilst the Deferred Payment (if any) will be incurred in the year ending 30 June 20ZZ.

Both parts of the Purchase Price have the necessary connection to Company Z's income producing activities.

The advantage sought by Company Z is merely an increase in its customer base for a business that it already provides. It is not an enhancement to the business structure or the creation of a new business, nor does the expenditure provide an enduring benefit.

For these reasons, the Purchase Price is deductible under section 8-1. The Completion Payment is deductible in the year ending 30 June 20YY and the Deferred Payment (if any) will be deductible in the year ending 30 June 20ZZ.

Because Company X is a subsidiary member of an income tax consolidated group of which Company Z is the head company, the Purchase Price will be deductible for Company Z pursuant to the single entity rule contained in section 701-1 of the ITAA 1997.