Edited version of private advice

Authorisation Number: 1052071465515

Date of advice: 16 December 2022

Ruling

Subject: Recharge agreement for provision of equity interests to employees

Question 1

Can Company A claim a deduction under section 8-1 Income Tax Assessment Act 1997 (ITAA 1997) for the proposed intercompany recharge to be paid to Holding Co?

Answer

No.

Question 2

Can Company A claim a deduction under section 40-880 ITAA 1997 for the proposed intercompany recharge to be paid to Holding Co?

Answer

No.

This ruling applies for the following periods:

Income tax year ending 31 December 20XX

Income tax year ending 31 December 20XX

The scheme commences on:

When the agreement between Company A and Holding Co is executed.

Relevant facts and circumstances

Company A is an Australian resident private company that is a wholly owned subsidiary of Holding Co, a United States of America resident company listed on the New York stock exchange.

Holding Co has in place the 'Incentive Plan' (the Plan) pursuant to which it issues restricted stock units (RSUs) to its employees and employees of its subsidiaries. The rights to receive these RSUs under the Plan are referred to herein as 'Awards'.

The Plan states the purpose is to enhance the profitability and value of Holding Co for the benefit of its Stockholders to attract, retain, and reward employees with stock in Holding Co and strengthen the mutuality of interests between such individuals and the stockholders.

All Awards are granted by Holding Co. Awards are approved by the Holding Co Board of Directors (or via delegated authority by Holding Co's Chief Executive Office and head of Human Resources).

Holding Co makes the decision to provide Awards to employees of its subsidiaries including Company A. Company A does not request Holding Co to provide its employees with Awards nor is involved in determining the vesting conditions, or which employees to offer Awards to.

Each Award entitles the recipient to earn and receive one RSU in Holding Co in the future subject to the terms of the RSU Award Agreement. The Awards have a 4-year vesting period as follows:

•         25% 12 months from date of grant

•         25% 24 months from date of grant

•         25% 36 months from date of grant

•         25% 48 months from date of grant.

These Awards were first offered to employees of Company A in late 20XX and early 20XX. Since that time, Company A has increased its number of employees and further grants of Awards have been made.

For Australian taxation purposes, the Awards issued under the relevant terms of the Plan qualify for deferred taxation pursuant to Subdivision 83A-C, Division 83A of the Income Tax Assessment Act 1997 (ITAA 1997).

Company A has lodged its annual Employee Share Scheme (ESS) report with the ATO and issued ESS statements to affected employees in respect of those Awards that vested (and resulted in RSUs being issued to the employees) during the income year ended 30 June 20XX.

International Financial Reporting Standards (IFRS 2 Share-based payment) requires an entity to recognise share-based payment transactions (such as granted shares, share options, or share appreciation rights) in its financial statements, including transactions with employees or other parties to be settled in cash, other assets, or equity instruments of the entity. Specific requirements are included for equity-settled and cash-settled share-based payment transactions, as well as those where the entity or supplier has a choice of cash or equity instruments.

Examples of items included in the scope of IFRS 2 are share appreciation rights, employee share purchase plans, employee share ownership plans, share options plans and plans where the issuance of shares (or rights to shares) may depend on market or non-market related conditions.

The issuance of shares or rights to shares requires an increase in a component of equity. IFRS 2 requires the offsetting debit entry to be expensed when the payment for goods or services does not represent an asset. The expense should be recognised as the goods or services are consumed. For example, the issuance of shares or rights to shares to purchase inventory would be presented as an increase in the inventory and would be expensed only once the inventory is sold or impaired.

The issuance of shares to employees with, say, a three-year vesting period is considered related to services over the vesting period. Therefore, the fair value of the share-based payment, determined at the grant date, is expensed over the vesting period.

As a general principle, the total expense related to equity-settled share-based payments will equal the multiple of total instruments that vest and the grant-date fair value of those instruments. In short, there is a 'truing up' to reflect what happened during the vesting period.

The journal entry recording the IFRS 2 expensing requirement in its simplest form can be summarised as follows:

Debit Share option/right expense

Credit Share capital/Equity

In accordance with IFRS 2 requirements, Holding Co has recorded an expense amount in each of its reporting years during the relevant period based on the fair value of the Awards as at the grant date.

Holding Co proposes to on-charge a portion of this reported expense during the relevant period to Company A based on the proportion of Australian employee Award recipients as a percentage of the total amount of Awards issued to employees within the group.

The amount on-charged (Recharge Amount) will represent the current years reported amount plus the amount reported in the prior income year.

For financial reporting consistency, Company A has also recognised an expense in its financials for the share-based compensation expense by debiting the expense item and crediting a reserve in its balance sheet. This treatment is consistent with the requirements in Accounting Standards AASB2: Share-based Payments.

However, as yet there is no liability for it to pay an amount to Holding Co although it is intended that such an intercompany charge will be raised.

Reasons for decision

Unless otherwise stated, all legislative references are to the Income Tax Assessment Act 1997.

Question 1

Subsection 8-1(1) relevantly provides:

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 assessable income.

In other words, to be entitled to claim a deduction from your assessable income under subsection 8(1), then there must be:

• a loss or outgoing,
• which has sufficient connection

to the production of that assessable income.

Further, the amount of that deduction is only available to the extent that the loss or outgoing relates to the gaining or producing of that assessable income.

Losses or outgoings

Under the Recharge Agreement, Company A will be invoiced by Holding Co an amount equivalent to Holding Co's equity-based compensation expenses (calculated for Company A's employees) and Company A will pay this amount within 30 days of receipt of the invoice.

This criterion is therefore met.

Sufficient connection

In order for a loss or outgoing to be deductible under subsection 8-1(1) it must either be:

1. incurred in gaining or producing assessable income, or
2. necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

To claim a deduction under section 8-1 it is therefore necessary to establish some link or nexus between the loss or outgoing and the production of assessable income (in the case of the first positive limb) or the carrying on of a business for the purpose of producing assessable income (in the case of the second positive limb). The necessary link or nexus is sometimes referred to as a 'sufficient connection'.

A line of authorities indicate that, to be deductible, a loss or outgoing must be incurred 'in the course' of gaining or producing assessable income or in carrying on a business for that purpose. This requires that the loss or outgoing:

1. be 'incidental and relevant' to the taxpayer's income producing/business operations (Ronpibon Tin NL v FC of T (1949) 8 ATD 431 (1949) 78 CLR 47)
2. have the 'essential character' of an income producing/business expense (Lunney v FC of T; Hayley v FC of T (1958) 11 ATD 404 (1958) 100 CLR 478, or
3. have a 'perceived connection' with the gaining or producing of income (FC of T v Hatchett 71 ATC 4184).

In general terms, a 'sufficient connection' will exist between a loss or outgoing and the gaining or production of assessable income where the loss or outgoing is incidental and relevant to the income earning activities.

As explained in paragraph 31-360 of the CCH Federal Income Tax Reporter:

The interaction between the above tests was described by Hill J in FC of T v Firth 2002 ATC 4346 at p 4348 when he said:

The positive tests require that there be a connection between the loss or outgoing on the one hand and the assessable income or business on the other. The nature of that connection has been expressed in different ways in the cases. It is sometimes said that there must be a 'perceived connection' between the loss or outgoing and the assessable income or business: FC of T v Hatchett 71 ATC 4184 at 4187... In other cases it has been said that the expenditure must be 'incidental and relevant' to the operations or activities regularly carried on by the taxpayer for the production of income: Ronpibon Tin NL & Tongkah Compound NL v FC of T (1949) 8 ATD 431 at 435; (1949) 78 CLR 47 at 56, FC of T v Smith 81 ATC 4114 at 4117. These ways of describing the connection that is a necessary prerequisite to deductibility are but part of the process of identifying the essential character of the expenditure in order to determine whether a particular loss or outgoing is in fact incurred in gaining or producing the assessable income or in carrying on a business which more directly contributes to the gaining or production of the assessable income: Lunney v FC of T (1958) 11 ATD 404; (1957-1958) 100 CLR 478 at 413 and 499 respectively.

Remuneration paid directly to employees engaged in the business being carried on is generally deductible under section 8-1 as a necessary and unavoidable trading cost of doing business. Commuting a revenue item such as salary or wages or a bonus to a lump sum amount doesn't automatically alter its character (Pridecraft Pty Ltd v. Federal Commissioner of Taxation [2004] FCAFC 339; 2005 ATC 4001; (2004) 58 ATR 210 and Spotlight Stores Pty Ltd & Anor v. Federal Commissioner of Taxation [2004] FCA 650; 2004 ATC 4674; (2004) 55 ATR 745).

Remuneration expenses paid indirectly to employees through a third party can still retain the character of a remuneration expense (Federal Commissioner of Taxation v Foxwood (Tolga) Pty Ltd (1981) 147 CLR 278; 81 ATC 4261 (Foxwood) at 4264). However, in the absence of an obligation or liability directly to an employee, the character of the payment as remuneration can be called into question (Foxwood at 4265).

Recently, in Clough Limited v Federal Commissioner of Taxation (No 2) [2021] FCAFC 197; 2021 ATC 20-805, payments were made to employees to end their rights that had not vested under an employee share scheme.

However, the payments were made because the rights of the employees were perceived to be an impediment to the sale of all the remaining shares in the company to the majority shareholder, and the employees needed to surrender their rights before the share sale could be completed.

Despite the fact that "but for" the rights/options having been granted the amount would not be paid, the Full Federal Court nevertheless concluded that the payments did not have the requisite connection with the business. The Court considered that the character of the payment from a legal point of view was not always commensurate with the character of the payment from a practical and business point of view (at [81]), citing the decision in Foxwood as an example.

In concluding the payments didn't satisfy the first positive limb, the Court didn't deny the "but for" connection with the option scheme. However, the immediate proximate causal event requiring the payments be made to employees related to the change in control of the taxpayer from the takeover proposal.

The Court also concluded that the payments were not a working expense in the Clough business. They were not payments "by way of reward to the employees" (at 86).

Whilst the grant of Awards in Holding Co is the condition precedent to the Recharge Amount (or even a 'but for'), this does not stamp the relevant payments of the Recharge Amount with the quality of a revenue outgoing incurred in the everyday course of a business.

In order to understand whether the payment is incidental and relevant to the income earning activities of Company A, we need to consider the immediate cause or occasion for the payment. The following factors are informative:

•         Holding Co has made separate agreements with Company A employees to issue Awards to them at a future point in time if certain conditions are satisfied.

•         Company A is

o   not party to these agreements

o   does not have the power to request Holding Co to provide Awards to its employees,

o   does not have the power to request which employees to provide Awards to

o   does not have the power to determine what conditions to attach to the Awards.

It is at the absolute discretion of Holding Co whether any employee receives any Awards and under what circumstances.

•         The Recharge Amount is not paid to Holding Co because it is "out of pocket" for payments made to third parties. Holding Co will be issuing equity (RSUs) in itself and the Recharge Amounts are calculated based on the accounting treatment of share-based payments. The Recharge Amounts are an estimate of the value of the Awards granted and will be updated based on whether the RSUs are forfeited or actually provided to employees as part of their arrangement with Holding Co.

•         The Recharge Agreement is a separate arrangement to the equity arrangements in place with the employees. Any benefit derived by Company A from the equity arrangements exists regardless of the Recharge Agreement as Awards are provided at the sole discretion of Holding Co.

•         If the Recharge Agreement is terminated by either party or from failure of Company A to pay, there is no impact to the outstanding or future Awards.

Other than the liability created by the Recharge Agreement itself, there is no liability owed by Company A to its employee to which payment of the Recharge Amount relates. Company A is not a party to the Employee Share Scheme Agreement between the employee and Holding Co and the employee is not a party to the Recharge Agreement between Company A and Holding Co. The Recharge Amount is not a direct payment to an employee, and it does not discharge or satisfy a remuneration obligation or liability of Company A. The payment to Holding Co does not have the character of a reward for services.

The more immediate cause for the payment is the Recharge Agreement. The agreement was created to give effect to Holding Co's request that its subsidiaries pay a Recharge Amount based on the accounting expense in its financial reports. Company A was not party to the Recharge arrangement because it had a liability to remunerate employees but because it is in an ownership structure of a multinational group (Company A is wholly owned by Holding Co) whose parent entity has chosen to remunerate the group's staff with these Awards to align the staff interests with the stockholders' interests.

Conclusion

Therefore, the payment of the Recharge Amount is not:

a)    incurred in the course of gaining or producing assessable income, or

b)    necessarily incurred in the course of running a business.

For the reasons given above, the object of the payment was not to remunerate employees.

The better view is that the object of the payment was to retain the co-operation and goodwill of the global offshore parent of the multinational group in participating in the scheme and to facilitate the payment of money by subsidiaries to the global offshore parent.

This was the occasion or immediate cause of the payment and there is no readily apparent operational benefit to the Company A's business in making the payment.

As such, payment of the Recharge Amount is not a cost of the Company A's ordinary trading operations. It is also not the occasion for what is productive of Company A's assessable income. It does not satisfy either paragraph 8-1(1)(a) or 8-1(1)(b) and is not deductible to Company A.

Question 2

The relevant provisions of section 40-880 state:

Object

40-880(1)

The object of this section is to make certain *business capital expenditure deductible over 5 years, or immediately in the case of some start-up expenses for small businesses, if:

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

(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.

Deduction

40-880(2)

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

...

Limitations and exceptions

...

40-880(5)

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

(a) ...; or

(f) 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; or

...

40-880(6)

The exceptions in paragraphs (5)(d) and (f) do not apply to expenditure you incur to preserve (but not enhance) the value of goodwill if the expenditure you incur is in relation to a legal or equitable right and the value to you of the right is solely attributable to the effect that the right has on goodwill.

Taxable purpose' is defined in subsection 40-25(7) and includes 'the purpose of producing assessable income'.

Under subsection 40-880(2), the expenditure must be 'in relation to' the taxpayer's business i.e. Company A.

The phrase 'in relation to' is defined widely,(First Provincial Building Society v Federal Commissioner of Taxation (1995) 128 ALR 118; 95 ATC 4145; Commissioner of Taxation v Eichmann [2019] FCA 2155; BOS International (Australia) Ltd v Babcock & Brown International Pty Ltd [2011] NSWSC 1382 at [21] - [23]) and its meaning is ascertained by reference to the nature and purpose of the provision in question and the context in which it appears (PMT Partners Pty Ltd v Australian National Parks & Wildlife Service [1995] HCA 36; (1995) 184 CLR 301 at 313).

In Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues it is stated at paragraph 75 that:

The words 'in relation to', whilst positing a test that is not as strict as 'in carrying on' however indicate that the expenditure in question is sufficiently relevant to the business to impress on it the character of a business expense of that business.

As discussed above, the Recharge Amounts lack the necessary association or connection to the purpose for which the business of Company A is carried on. This is because the Recharge Amounts primarily relate to an Agreement between Holding Co and Company A rather than one involving Company A's employees/liability to provide for its employees. Since Holding Co is an entity separate to Company A and not actively involved in the business carried on by Company A, the payment lacks an association to Company A's business to be 'in relation to' it.

Section 40-880 will therefore not apply in relation to the Recharge Amounts paid by Company A to Holding Co.