Edited version of private advice

Authorisation Number: 1052063148847

Date of advice: 13 February 2023

Ruling

Subject: Deductibility of expenses - principle of mutuality

Question 1

Is the methodology for allocating expense between company Y (Y) and company X (X) acceptable for the purposes of:

•         X claiming a deduction for salary and wages incurred in generating the Service Fee under section 8-1 of the If the Income Tax Assessment Act 1997 (ITAA 1997)

•         Y claiming a deduction for the Service Fee paid under section 8-1 of the ITAA 1997?

Answer

Yes.

Question 2

In the event Y and X were to form a tax consolidated group, would the methodology for allocating expense continue to be appropriate for the above purposes?

Answer

Yes.

This ruling applies for the following periods:

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

X, Y and Z operate together as XYZ Group

X is an incorporated entity that is a mutual organisation. X owns all ownership interests in Y and Y owns all ownership interests in Z.

X is not exempt from tax, however on certain receipts X collects from members (eg membership fees), the receipts are treated as non-assessable mutual income due to the application of the 'principle of mutuality'.

Expenditure incurred in generating mutual receipts is not an allowable deduction for X.

X's taxable income (eg investment income) is taxed at the corporate tax rate.

Y earns insurance premium income from X members and non-member policy holders as well as income generated from investment assets that it holds.

All of Y's income is taxed at the corporate rate, and the mutuality principle does not apply to any of Y's income.

Employees

X employs all staff of the XYZ Group.

Y has no employees of its own, other than its Managing Director who is also an employee of X. Y pays directors fees in respect of its board members.

A significant portion of X's salary and on-cost expenditure spend is incurred in respect of services performed in supporting Y's activities as a general insurer.

Staff costs incurred by X on behalf of Y are reimbursed by way of a management fee between the two entities. Y incurs the management fee expense, and X recognises an equivalent income amount in its stand-alone accounts.

XYZ Group revenue

The main sources of revenue for XYZ Group are:

•         fees paid by members to X for general membership services

•         insurance premiums on policies provided by Y

•         investment income (e.g. dividends and interest).

Insurance premiums charged by Y are independently actuarially determined.

Service Fee

The Service Fee is a reimbursement of finance and administration costs incurred by X on behalf of Y, as well as other amounts included under the 'consolidated operating expenses'. These costs include staff costs and other overheads.

To the extent that X incurs expenses that relate to the activities of Y, the correct commercial outcomes for both entities are obtained by way of a 'cost recovery' arrangement i.e. by X "on-charging" costs initially incurred by it to Y.

The XYZ Group, applies this method because the costs were originally incurred for the purpose of managing the insurance business.

For accounting purposes, "on-charging" is achieved by way of the Service Fee, which is payable by Y to X. There is no mark-up on this fee. Costs incurred by X are reimbursed by Y at cost, to the extent that they relate to Y's activities.

From a tax perspective, this results in an amount of income earned by X (Service Fee income) and an equal and offsetting expense amount to Y.

Calculation of Service Fee

As the Service Fee is recovered at cost, it is necessary to identify which specific costs incurred by X actually relate to the Y business.

The amount of the Service Fee is determined with reference to an "expense allocation" method.

Expense allocation methodology

The costs giving rise to the Service Fee are drawn largely from the consolidated operating expenses. In particular, the finance and administration expenses.

The costs fit broadly into two categories:

•         staff costs (salary and wages and on-costs)

•         other operating expenses.

Approach for allocation of staff expenses

The XYZ Group is a financial services and member organisation. Therefore, a significant proportion of the overall operating expenses of the group are salaries and wages and on-costs.

In respect of labour costs incurred by X, the majority of these labour costs relate to services provided by Y, and that activities and services undertaken by X require minimal resources and expenditure.

Although X provides a number of services, the nature of these services and the frequency with which members access these services mean that the provision of the services is not labour or resource-intensive, whereas the services provided by Y are relatively labour and resource-intensive.

The apportionment of expenses not directly attributed to a particular source of income is heavily weighted towards Y, rather than X.

Salary and wages of operating departments

Of the total salaries and wages expenses incurred at the group level, approximately 48% are incurred by the operating departments.

In determining how to allocate actual costs to Y by way of the Service Fee, the XYZ employs an allocation methodology based on the proportion of effort applied to each of the responsibilities by time and process analysis. This analysis will be undertaken annually to determine the correct proportion of expenses to apportion between the responsibilities of the departments and between the entities with respect to each department.

Salary and wages of non-operating departments

The CEO and Corporate Services Department provides managerial, financial and administrative support to both X and Y.

The expenses of these non-operating departments are allocated to Y (by way of the Management Fee) in a manner that is consistent with the allocation at the operating department level.

Non Staff Related Expenses

Non staff related expenses incurred by X that relate, in part or in full for the activities of Y, are analysed to determine the appropriate allocation percentage.

Expenses incurred by either X or Y that relate entirely to the activities of their own business but do not impact on the determination of the Service Fee.

Where no obvious direct-link occurs, expenses will be allocated between X and Y by applying the same percentage allocation that the staff related costs are split between the two entities (as above).

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 8-2

Income Tax Assessment Act 1997 subsection 703-15(2)

Income Tax Assessment Act 1997 section 703-20

Reasons for decision

Question 1

Summary

The methodology for allocating expenses between Y and X is acceptable for the purpose of Y claiming a deduction for the Service Fee under section 8-1 of the ITAA 1997[1], as it reasonably and accurately reflects Y and X's revenue and expenses.

The information provided by the applicants supports the view that a greater proportion of expenditure is incurred by Y, rather than X. However, the exact proportion allocated to Y or X will need to be determined each accounting period, based on the extent of the actual activities undertaken by each entity.

Detailed reasoning

In accordance with section 8-1 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.

However, section 8-2 provides that you cannot deduct a loss or outgoing 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.

Expenses incurred in deriving mutual receipts are not deductible under subsection 8-1(1), because they are not incurred in gaining or producing assessable income, and they are not incurred in carrying on a business for the purpose of gaining or producing assessable income.

More explicitly, mutual receipts are not income according to ordinary concepts, and as such, they are not caught under section 6-5 as 'ordinary income'. Because mutual receipts are not considered ordinary income, they are excluded from the positive limbs of section 8-1, and deductions against mutual receipts are not allowed.

Based on the facts, it is proposed that the expenses incurred will be apportioned between X and Y in the following way:

• Expenses that can be specifically identified as being incurred by X or Y, then it is appropriate to allocate the expenses directly to that specific entity, or section within the entity, that has incurred the expense
• Labour costs incurred by X are allocated 95% to Y and the remainder (5%) to X
• Expenses not directly attributed to a particular source of income apportioned towards Y, rather than X.

When expenses cannot be identified as specifically relating to mutual or non-mutual receipts then a method of apportionment between X and Y needs to be determined.

Taxation Determination TD 93/194 Income tax: how should a licensed club apportion expenses when calculating its taxable income? (TD 93/194) examines the apportionment of expenses between mutual and non-mutual activities of a licensed club.

Paragraph 2 and 3 of TD 93/194 sets out the acceptable methodologies for allocating expenditure between mutual and non-mutual receipts, including a discussion on the 'reasonable basis method', as discussed below:

Clubs may, for the purposes of calculating taxable income, adopt an alternative technique where there is a reasonable basis to do so (e.g. better recording system of member/non-member spending) and provided it reasonably and accurately reflects the club's income for the year in question.

Although TD 93/194 relates specifically to clubs, the principles set out in the ruling are also relevant to other taxpayers.

Case law: the apportionment principle

The method of apportioning income has been discussed in a number of cases, with most relying on the basis that non-member receipts as a portion of total income are used to apportion deductions.

In Case K16 78 ATC 154 different methods of apportionment were applied in respect of general operating and interest outgoings incurred by a credit union, which had derived both non-assessable and assessable income. The method of apportionment was found to be acceptable, but it was also found that, in arriving at a fair method of apportionment, the Commissioner should not necessarily apply a single method of apportionment.

Case W45 89 ATC 435 explained that a method of apportionment based on a percentage of member floor space to total floor space of an exhibition was found to be an acceptable method.

The Commissioner's method of apportioning expenditure was upheld in Adelaide Racing Club Incorporated v Federal Commissioner of Taxation (1964) 13 ATD 361. The racing club derived revenue from various sources, including member subscriptions, entrance charges paid by non-members, nomination and acceptance fees from members and non-members which wished to race their horses, lump sum payments by caterers, and fees paid by broadcasting stations. A portion of the club's revenue also came directly or indirectly from members who attended its race meetings.

The Commissioner accepted revenue from members as non-assessable, and made a dissection of the club's expenditure, treating certain items as applicable to revenue from members, and certain items as directly applicable to income from non-members. The remainder of the expenditure and depreciation, which was deductible, was calculated in accordance with the following formula:

In upholding the Commissioner's apportionment, Owen J said that, in such a case, the Commissioner was faced with a difficult problem under the general deduction provision to determine the extent to which outgoings were incurred in gaining or producing assessable income.

His honour explained that, although the method adopted by the Commissioner was subjected to considerable criticism, and various alternative bases had been suggested by Counsel for the club, he believed that they were at least equally open to criticism and produced varying results. Therefore, his Honour was not satisfied that the procedure adopted by the Commissioner was wrong. Anderson J stated [at 4165]:

Where a particular cost covers more than one activity, an allocation must be made. If, finally, some residuum of a particular item is left, which does not admit of precise allocation to any activity, it must between the various activities on a basis which is equitable.

It is accepted that a single method of apportionment will not automatically apply in each case.

It has been submitted that it is arbitrary to apportion the expenses of the XYZ Group simply on the basis of the non-mutual income 'as a percentage of' total income, given that a detailed analysis of each class of expenditure can be performed.

The analysis performed by the XYZ Group classifies each class of expense into one of the three categories outlined in TD 93/194 (paragraph 2), being:

a)    Non-allowable expenses- those expenses relating specifically to members;

b)    Wholly allowable expenses- including those expenses relating specifically to assessable income (e.g. investment expenses); and

c)    Partially allowable expenses- those expenses that cannot be identified as being wholly allowable or non-allowable.

Where the expenditure falls into the third category, the XYZ Group apportions this expenditure based on the apportionment methods outlined above

Conclusion

The allocation of expenditure between X and Y is a question of appropriately allocating expenditure between mutual and non-mutual receipts or activities.

X provides a number of services to members, the nature of these services, and the frequency with which members access these services, means that the provision of the services is not as labour or resource-intensive. Therefore, the apportionment of expenses not directly attributed to a particular source of income is heavily weighted towards Y, rather than X.

In accordance with the above, the methodology for allocating expenses is acceptable in the circumstances, as it reasonably and accurately reflects Y and X's revenue and expenses and provides an accurate reflection of the allocation between mutual and non-mutual income.

Question 2

Summary

The XYZ Group is not currently a consolidated group for taxation purposes. However, if the group were to consolidate, the methodology for allocating expenses between Y and X would continue to be appropriate.

As explained in Question 1, the allocation process is essentially that of allocating expenditure between mutual-and non-mutual receipts or activities. This process would, in substance, remain the same if Y and X were to consolidate.

Detailed reasoning

Based on the information provided Y and X, X is eligible to be the head company of a tax consolidated group in accordance with subsection 703-15(2), as all the requirements of item 1 in the table are satisfied.

Entities that are specifically excluded from being a member of a consolidated or consolidatable group, because of income tax treatment requirements, are outlined in section 703-20. Entities that are subject to the principle of mutuality are not included on this list.

ATO Interpretive Decision ATO ID 2006/325 Income Tax Consolidated Group: mutuality principle explains that, where the principle of mutuality applies to the head company of a consolidated group, insurance premiums received by an insurance company that is a member of the group, but not of itself a mutual entity, are not mutual receipts.

For taxation purposes, transactions between members of a consolidated group are ignored. Therefore, if the XYZ Group were to consolidate, for taxation purposes, it is accepted that:

• fees incurred by Y from X would not be a deduction
• fees received by X from Y would not be assessable income
• the tax treatment of expenditure incurred outside the consolidated group would retain its character and still need to be allocated between the mutual and non-mutual receipts of the group.

Consolidation would not change the character of receipts and expenditure incurred by entities that are not part of the tax consolidated group:

• Mutual receipts and expenditure would retain their character as mutual receipts and expenditure.
• Non-mutual receipts and expenditure would retain their character as non-mutual receipts and expenditure.

As such, the allocation between mutual and non-mutual expenditure currently undertaken to allocate expenditure between X and Y would, in substance, remain the same if a consolidated group were formed.

Conclusion

If the XYZ Group consolidates for taxation purposes, the principle of mutuality will continue to apply to the mutual receipts and expenditure of the group.

In determining whether staff, or other costs, incurred by X are attributable to the generation of mutual income from members, or the generation of assessable income from sources other than members (for instance, insurance premiums) will be a question of fact, to be determined by the members of the group (as explained in Question 1 of this private ruling).

Therefore, in accordance with the above, the allocation of expenses between X and Y will continue to be appropriate if they tax consolidate. However, the expenses incurred by the consolidated group will still need to be analysed to determine the mutual and non-mutual receipts, as discussed at Question 1 of the private ruling.

[1] All legislative references in this document are to the Income Tax Assessment Act 1997.