Edited version of private advice

Authorisation Number: 1052164725562

Date of advice: 4 September 2023

Ruling

Subject: Deduction under section 40-880

Question

Will the cash payments made by Company A be deductible under Section 40-880 of the ITAA 1997 for certain income years?

Answer

Yes

This ruling applies for the following:

Income tax years from XX 20XX to XX 20XX

Relevant facts and circumstances

1.     Company A (the "Company") was the head company of an income tax consolidated group.

2.     The shareholders of the Company entered a share sale agreement with a third party (the "Buyer") for it to acquire 100% interest in the Company. The takeover aligned with the Company's strategy.

3.     Before the acquisition, the Company had an employee share scheme (the "Plan") with the purpose of assisting in the reward, retention and motivation of eligible employees and aligning the interest of employees with the interest of the Company's shareholders.

4.     The Company has in the past issued options, pursuant to the Plan, to certain employees. Each option represented a right to receive one ordinary share in the Company on the exercise of the option, subject to achievement of certain vesting conditions as set out in the specific offer. Options would automatically vest immediately prior to a change of control event.

5.     The takeover by the Buyer was conditional upon the cancellation of all of the options granted to the employees. To facilitate the sale of shares in the Company, the Company entered into a cancellation agreement (Cancellation Deed) with each of the option holders in respect of their options.

6.     The Cancellation Deed provided that, at the time of completion of the sale, all of the options would be irrevocably and unconditionally cancelled and ceased to be exercisable, together with all rights and entitlements attaching to the Options. In exchange, the Company would pay the option holder the amount of consideration equal to total option value.

7.     The cancellation payment was funded from Buyer by way of an interest-bearing loan to the Company prior to the acquisition. The loan was provided conditionally upon the Company becoming a subsidiary of the Buyers after the sale.

8.     The loan was recognised as a liability in the accounts of the Company for accounting purposes. The loan was later used to reduce the total consideration payable for the acquisition of the shares in the Company.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 40-880

Reasons for decision

9.     One of the objects of section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997) is to make certain business capital expenditure deductible over five years if the expenditure is incurred for a taxable purpose, provided the deduction is not denied by other provisions.

10.  Subsection 40-880(2) provides that:

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;

(b) in relation to a business that used to be carried on; or

(c) in relation to a business proposed to be carried on...

11.  However, this deduction is limited by subsections 40-880(3), (4) and (5) as follows:

(3)          You can only deduct the expenditure, for a business that you carry on, used to carry on or propose to carry on, to the extent that the business is carried on, was carried on or is proposed to be carried on for a taxable purpose.

(4)          You can only deduct the expenditure, for a business that another entity used to carry on or proposes to carry on, to the extent that:

(a) the business was carried on or is proposed to be carried on for taxable purpose; and

(b) the expenditure is in connection with:

(i)            your deriving assessable income from the business; and

(ii)           the business that was carried on or is proposed to be carried on.

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

(a) it forms part of the cost of a depreciating asset that you hold, used to hold or will hold; or

(b) you can deduct an amount for it under a provision of this Act other than this section; or

(c) it forms part of the cost of land; or

(d) it is in relation to a lease or other legal or equitable right; or

(e) it would, apart from this section, be taken into account in working out:

(i)    a profit that is included in your assessable income (for example, under section 6-5 or 15-15); or

(ii)           a loss that you can deduct (for example, under section 8-1 or 25-40); 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

(g) a provision of this Act other than this section would expressly make the expenditure non-deductible if it were not of a capital nature; or

(h) a provision of this Act other than this section expressly prevents the expenditure being taken into account as described in paragraphs (a) to (f) for a reason other than the expenditure being of a capital nature; or

(i) it is expenditure of a private or domestic nature; or

(j) it is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income.

Meaning of 'incurred"

12.  There is no statutory definition of the term 'incurred'. However, the principles established by case law regarding the meaning of the word 'incurred' in section 8-1 of ITAA 1997 also apply to section 40-880.

13.  The Commissioner's view in TR 97/7 Income Tax: section 8-1 - meaning of 'incurred' -timing of deductions is that a taxpayer incurs expenditure if they owe a presently existing liability, having regard to the terms of the contract and other arrangement giving rise to that liability. In addition, the taxpayer must be definitively committed to the outgoing, even though it may be defeasible by others.

14.  The Cancellation Deed gave rise to a presently existing liability on the part of the Company to pay a present money debt in exchange for the options held by the option holders to be irrevocably and unconditionally cancelled and ceasing to be exercisable. Accordingly, the amount was incurred by the Company at the time of completion of the sale.

"Capital Expenditure"

15.  The expression "capital expenditure" is also not a defined term. Whether expenditure is capital in nature is determined on the facts of each particular case having regard to the principles established by case law.

16.  The generally-recognised test for considering whether expenditure is on capital or revenue account is from the judgment of Dixon J in Sun Newspapers Limited v Federal Commissioner of Taxation [1938] HCA 73 (Sun Newspapers). Dixon J outlined the following 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.

17.  The advantage which was sought by making the cancellation payment was to bring the options and rights attached to the options to an end permanently. The object in making the payment was to complete the sale of all the shares in the Company to the Buyer. In other words, the bringing of the options to an end had an effect on the capital structure of the Company by the removal of the options as securities on issue, which cleared the way for the Buyer to acquire 100% interest in the Company. The options were cancelled by the Company in performance of its obligations under the sale and pursuant to the arrangement as agreed between the Company and the option holders under the Cancellation Deed. The payment was a one-off payment to secure an enduring benefit of the business through reorganisation of its capital structure.

18.  This is consistent with the judgement handed down by the Full Federal Count in Clough Ltd v FC of T 2021 ATC 20-805 (Clough). The Court in Clough unanimously held that the payments made for cancellation of certain options and performance rights held by employees in the context of a corporate takeover by a major shareholder were capital expenditure in nature. Thawley J at [18] noted:

...in a practical business sense, the payments are better characterised as payments made pursuant to an agreement to secure a change in control rather than as meeting employee entitlements on a change of control. The payments were made to effect a reorganisation of the capital structure of Clough, through a takeover by Murray & Roberts and the delisting of Clough from the ASX. The bringing to an end of the various rights of the employees under the employee schemes was necessary to secure the reorganisation of the company's capital structure for the enduring advantage of the business... the occasion of the outgoings lay in the takeover and the object behind making the payments was the bringing to an end of the employees ' rights, at the one time, to facilitate the takeover by Murray & Roberts and the delisting of Clough.

19.  The cancellation payment made by the Company should, therefore, be considered as to have been incurred on capital account.

"In relation to the Business"

20.  Paragraphs 40-880(2)(a) to 40-880(2)(c) allow a taxpayer to deduct capital expenditure they incur if it is 'in relation to' a business.

21.  According to TR 2011/6, the term 'in relation to' denotes proximity between the expenditure and the business, as guided in the following paragraphs:

72. The use of the expression 'in relation to' in subsection 40-880(2) rather than 'in carrying on' or the preposition 'on' to qualify the closeness of the required connection indicates that Parliament intended there to be greater latitude in the connection that needs to exist.

... ...

79. Determining whether the expenditure has the character of a business expense can be approached by asking what the expenditure is for, in the sense of identifying the need or object that the expenditure serves. If the facts show that the expenditure satisfies the ends of the relevant business then it will have the character of a business expense.

22.  In this regard, the nexus requirement of section 40-880 is broader than that found in section 8-1. There needs to be an association or connection between the expenditure and the relevant business that the occasion of the outgoing can be explained by reference to the business. In the present case, the cancellation payment was made for the transfer of the Company's business from exiting shareholders to a new and interested owner (the Buyer). The occasion of the expenditure was to cancel the options held by the option holders for the purpose of securing and facilitating the acquisition by the Buyers. This not only ensures a continuity in the existence and operation of the Company and thereby the continuity of the business, but also promotes long-term growth of the business. Whilst the cancellation payment was not incurred by the Company in the ordinary scope of carrying on its business, the payment to the option holders was nevertheless made 'in relation to' the Company's business and was therefore a business-related expense.

23.  Furthermore, the change of ownership serves the objectives of the business as it allowed the Company to be wholly owned by a leader in the industry and aligned with the Company's strategy.

24.  For completeness, the Commissioner considered none of the limitations and exceptions in subsections 40-880(3), (4) and (5) apply to deny the deduction allowed under subsection 40-880(2).

Conclusion

25.  Accordingly, the cash payments made by the Company under the Cancellation Deed should be deductible under Section 40-880 of the ITAA 1997 over five years from the income year it was incurred.