Edited version of private advice

Authorisation Number: 1052091637728

Date of advice: 28 February 2023

Ruling

Subject: Deductibility of settlement payment

Question

Is the payment made by Company A pursuant to a Deed of Settlement deductible under section 8-1 of the Income Tax Assessment Act 1997 in relation to the year ended 31 December 20XX?

Answer

Yes.

This ruling applies for the following period:

Year ended 31 December 20XX

The scheme commences on:

1 January 20XX

Relevant facts and circumstances

Company A is an Australian proprietary company.

As part of its business operations, Company A sold trading stock to Company B.

Administrators and subsequently Liquidator was appointed to Company B. Within 6 months prior to the date of Company B's administration, Company B made payments to Company A for products supplied.

The liquidator commenced legal proceedings against Company A, the liquidator alleged that the Company A payments were unfair preference payments and voidable transactions within the meaning of sections 588 FA, 588FC and 588FE of the Corporations Act 2001 and sought orders that Company A pay to Company B an amount equivalent to the payments made plus interest and costs.

In legal proceedings, the Court held that the company B was insolvent at all times during the relation-back period.

Company A filed various defences against the payments being unfair preferences; however, if the defences were held to be ineffective, the sales would be voidable under the Corporations Act and Company A could be ordered by the court to pay the full amount of the payments to the liquidator. Company A initiated attempts to settle the matter out of court.

In order to avoid the uncertainty, inconvenience, delay and considerable expense of litigation, without any admission as to liability, the parties agreed to resolve the claims subject of the legal proceeding.

As part of the settlement of the dispute the liquidator agreed to an offer which required Company A repaying part of the original sales proceeds received from Company B as a Settlement Payment, thereby retaining the majority of its proceeds from the relevant sales.

The agreement was set out in a Settlement Deed (the Deed).

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Detailed reasoning

Subsection 8-1(1) of the ITAA 1997 provides that 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.

(collectively referred to as "the positive limbs")

However, subsection 8-1(2) of the ITAA 1997 prevents deductions for losses or outgoings 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.

(collectively referred to as "the negative limbs")

The Settlement Payment will be deductible under section 8-1 of the ITAA 1997 if either of the positive limbs in subsection 8-1(1) of the ITAA 1997 are satisfied and it does not fall within the negative limbs in subsection 8-1(2) of the ITAA 1997.

The Positive limbs

To be deductible under section 8-1 of the ITAA 1997, the positive limbs in subsection 8-1(1) of the ITAA 1997 require there to be a nexus between the payment paid by Company A under the Deed and the gaining or production of its assessable income, or the carrying on of its business for that purpose.

In determining whether a loss or outgoing is characterised as having been incurred in gaining or producing assessable income, the courts have considered whether the loss or outgoing is incidental and relevant to the operations or activities regularly carried on by the taxpayer for the production of income.

The High Court in Ronpibon Tin NL v FC of T [1949] HCA 15; (1949) 78 CLR 47 (Ronpibon) at 57 said that:

For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end. The words "incurred in gaining or producing the assessable income" mean in the course of gaining or producing such income...

Notwithstanding the differences in other respects in the present provision, the expression "incurred in gaining or producing the assessable income" has been left unchanged and bears the same meaning. In brief substance, to come within the initial part of the sub-section 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.

The loss or outgoing must be incidental and relevant in the sense of having the essential character of a business or income-producing expense. In Lunney v Commissioner of Taxation [1958] HCA 5; (1958) 100 CLR 478 at 497-499 the Court said:

Examination of [earlier] cases,... shows that the expression 'incidental and relevant' was not used in an attempt to formulate an exclusive and exhaustive test for ascertaining the extent of the operation of the section; the words were merely used in stating an attribute without which an item of expenditure cannot be regarded as deductible under the section...

In the context in which they have been used the expressions relied upon... have been intended as a reference, not necessarily to the purpose for which an item of expenditure has been incurred, but, rather, to the essential character of the expenditure itself...

For a loss or outgoing to be deductible under paragraph 8-1(1)(b) of the ITAA 1997, the loss or outgoing must be necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. Per Latham CJ, Rich, Dixon, McTiernan and Webb JJ in Ronpibon (at CLR 56):

The word 'necessarily' no doubt limits the operation of the alternative, but probably it is intended to mean no more than 'clearly appropriate or adapted for'.

Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts: FC of T v. Smith, which provides the Commissioner's view on the deductibility of interest expenses, explains at paragraph 24 that:

24. Where the taxpayer carries on a business the second limb of section 8-1 requires there to be a relevant connection between the outgoing and the business. In deciding whether the interest is 'necessarily incurred' in the sense of 'clearly appropriate' to that business (FC of T v. Snowden and Willson Pty Ltd (1958) 99 CLR 431), regard must be had to the nature of the business activity (Magna Alloys & Research Pty Ltd v. FC of T 80 ATC 4542; 11 ATR 276), the business purpose for which the outgoing was incurred (FC of T v. The Midland Railway of Western Australia Ltd (1952) 85 CLR 306), the objective circumstances surrounding the incurring of the expenditure (FC of T v. South Australia Battery Makers Pty Ltd (1978) 140 CLR 645) and the character of the expense (John Fairfax & Sons Pty Ltd v. FC of T (1959) 101 CLR 30).

Hill J summarised the principles in FC of T v Firth [2002] FCA 413 at [6] as:

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.

For the Settlement Payment to be deductible under paragraph 8-1(1)(b) of the ITAA 1997, the payment must have the essential character of a loss or outgoing incurred in carrying on a business which more directly contributes to the gaining or producing of Company A's assessable income. The costs must be clearly appropriate to that business, having regard to the nature of Company A's business activities, the business purpose for which the costs are to be incurred, and the objective circumstances surrounding the incurring of the costs.

In Commissioner of Taxation (Cth) v Murry [1998] HCA 42 at [54], Gaudron, McHugh, Gummow and Hayne JJ observed:

...A business is not a thing or things. It is a course of conduct carried on for the purposes of profit and involves notions of continuity and repetition of actions.

As part of its business operations, Company A sold trading stock to Company B. Company B is an independent enterprise which sources stock from various suppliers. Company B had paid Company A for products supplied.

Company A incurred an outgoing by paying an amount pursuant to the terms in the Deed between Company A and the liquidator. The Deed required Company A to repay part of the original sales proceeds received from Company B. Company A retained the majority of its proceeds from the relevant sales.

There must be a connection between the payment and the business operations of producing assessable income in order to satisfy the requirement that the outgoing is necessarily incurred in carrying on a business (Ronpibon Tin NL v. Federal Commissioner of Taxation (1949) 78 CLR 47 (Ronpibon Tin).

Magna Alloys & Research Pty Ltd v FC of T (1980) 11 ATR 276 ("Magna Alloys") is the leading authority with regards to the secondpositive limb of section 8-1 of the ITAA 1997. In this case, the taxpayer's company claimed a deduction for legal expenses incurred by the company in defending several of its directors against criminal prosecution for conspiracy. The Federal Court upheld an appeal by the taxpayer, allowing the deduction. It was found that the expense satisfied the positive limb of what was then subsection 51(1) of the Income Tax Assessment Act 1936 (now section 8-1 of the ITAA 1997) as it was necessarily incurred in carrying on the business. It was found it was reasonably appropriate for the interests of the taxpayer company to defend the directors and protect the reputation of the business against charges.Deane and Fisher JJ stated:

"Interests of the taxpayer were inextricably involved with those of its directors and agents, and it is plainly in the taxpayer's own interests that the directors and agents be properly represented. In these circumstances, the incurring of expenditure in providing adequate representation for the directors and agents was reasonably capable of being regarded as desirable and appropriate from the point of view of the pursuit of the business ends of the taxpayer's business".

Deane and Fisher JJ continue:

"In these circumstances, the fact that the directors may have been motivated by consideration of their own position neither negates the conclusion that the outgoings were reasonably capable of being seen as desirable and appropriate from the point of view of the pursuit of the business ends of the taxpayer's business nor prevents the conclusion that they were incurred by the directors on behalf of the taxpayer for the purpose of gaining advantages which they saw as being desirable and appropriate in that sense."

Company A filed various defences against the payment being unfair preferences; however, in the event that the defences were held to be ineffective, the sales would be voidable under the Corporations Act and Company A could be ordered by the Court to pay the full amount of the Company A payment to the liquidator.

As a result of entering the Deed and paying the Settlement Payment, Company A retained majority of its proceeds from sales and avoided the disruption to the business and management as well as the considerable costs associated with litigation.

There is a business being carried on for the purpose of gaining or producing the assessable income. The Settlement Payment was made in the context of the ongoing operation of the business by Company A in connection with the derivation of its assessable income. It was expenditure incurred with the object of "the conduct of the business on a profitable basis", and it was "incidental and relevant" to the operations or activities from which Company A's assessable income was produced. Accordingly, the payment of the Settlement Payment can be reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of that business. The payment was made to secure the retention of part of the sales proceeds from the sale of trading stock and to minimise costs, time and uncertainty relating to an action in relation to those sales proceeds.

Therefore, as there is a sufficient connection between Company A's payment of the amount pursuant to the Deed and Company A's business activities, the payment was necessarily incurred by Company A in the carrying on of its business for the purpose of gaining or producing its assessable income.

Section 8-1 positive limbs - Conclusion

As the payment was necessarily incurred in carrying on Company A's business for the purpose of gaining or producing Company A's assessable income, the payment satisfies the positive limbs of section 8-1 of the ITAA 1997.

To determine whether the payment is deductible under section 8-1 of the ITAA 1997, it must also be determined whether any of the exclusions under the negative limbs of section 8-1 of the ITAA 1997 apply.

Negative limb - Whether an outgoing or loss is capital or of a capital nature?

In determining whether the Settlement Payment is capital or revenue in nature, the test formulated by Dixon J. in Sun Newspapers Ltd & Associated Newspapers Ltd v. FC of T (1938) 5 ATD 87; (1938) 61 CLR 337 must be considered. His Honour stated, at 363:

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 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.

In the High Court decision in Hallstroms Pty Ltd v FCT (1946) 72 CLR 634, Dixon J incorporated his reasons in Sun Newspapers and elaborated upon them, stating at 648 'What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view...'

In GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124, the High Court determined at 137 that '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.'

In considering the character of the advantage sought, the High Court provided the following guidance in Federal Commissioner of Taxation v Sharpcan Pty Ltd (2019) 373 ALR 414 at 421-422:

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...Thus, an indicator that an outgoing is incurred on capital account is what it secures is necessary for the structure of the business.

However, as Dixon J explained in Sun Newspapers at 362, whilst recurrence and enduring benefit are relevant considerations, they are not determinative factors:

But the idea of recurrence and the idea of endurance or continuance over a duration of time both depend on degree and comparison...Recurrence is not a test, it is no more than a consideration the weight of which depends upon the nature of the expenditure.

Again, the lasting character of the advantage sought is not necessarily a determining factor.

Character of the advantage sought

The payment made by Company A under the Deed related to the resolution of an issue which had arisen in relation to its prior receipt of income from the sale of trading stock. the object that the expenditure was "calculated to effect from a practical and business point of view" related entirely to the ongoing business of the company.

The payment was made to secure the retention of part of the sales proceeds from the sale of trading stock and to minimise costs, time and uncertainty relating to an action in relation to those sales proceeds It is inherently connected with the ordinary trade activities of the company, which is not an affair of capital or of a capital nature.

The payment was not an outgoing of capital or of a capital nature.

The manner the expenditure was used

Company A made the decision to make the payment to avoid the uncertainty, cost, inconvenience, delay and expense of litigation and to ensure that that Company A retained an acceptable level of the amount in the dispute with the certainty that the liquidator would not make further claims against the company. Furthermore, Company A's rights as a creditor of the company B were confirmed and it was at liberty to prove in the liquidation of company B for the unpaid portion of the debt (the amount of settlement payment) and exercise its rights. Therefore, the payment arose out of the day-to-day activities of Company A's business.

The payment was not of a capital nature because it did not relate to the establishment, replacement or enlargement of Company A's profit yielding structure.

The means of payment - recurrent v. one-off lump sum payment

Finally, we need to consider the manner in which the Settlement Payment was made, and the criteria listed by Dixon J in Sun Newspapers, being recurrent and periodical as opposed to one-off lump sum.

Although the Settlement Payment was a one-off lump sum payment and will not re-occur in the future, this does not mean that it is capital in nature. Dixon J. explained in Sun Newspapers (at 362) that the actual recurrence of expenditure need not take place nor be expected as likely for such expenditure to be in the nature of revenue. It is enough that there be a potential for such an outgoing to be met by the business (Commissioner of Taxation v. Consolidated Fertilizers Ltd (1991) 22 ATR 281 at 293).

Considering the remaining criteria in subsection 8-1(2) of the ITAA 1997, the payment is also not:

•         of a private or domestic nature; or

•         incurred in relation to producing exempt or non-assessable non-exempt income; or

•         subject to another provision in ITAA the 1997 that would prevent the deduction

Accordingly, the payment meets the requirements to be an allowable deduction under subsection 8-1(1) of the ITAA 1997 and is not excluded by subsection 8-1(2) of the ITAA 1997.