Edited version of private advice

Authorisation Number: 1052193280530

Date of advice: 16 November 2023

Ruling

Subject: Assessable income

Question

Is Company A able to deduct the proposed payments of $xxxxxx to B and $xxxxxx to C under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)[1]?

Answer

No.

This private ruling applies for the following period:

10 March XXXX to 30 June XXXX

The scheme commenced on:

10 March XXXX

Relevant facts and circumstances

1.    Person B and Person C are spouses.

2.    Company A is a registered tax agent. On XXXX, Company A started the Accounting Services franchise, an accounting and tax franchise business.

3.    Person C was appointed Director of Company A on XXXX. They became the Managing Director of the company in XXXX. Their duties mainly constitute providing franchise technical support, delivering franchise workshops, preparing, and lodging tax returns for clients and employees, supervising tax agent for non-tax agents' franchisees, practice operations and efficiencies.

4.    In XXXX, Person B joined Company A as a Franchise Development Manager. Their duties mainly constitute franchise recruitment, intellectual property development, quality and performance management and marketing facilitation.

5.    On XXXX, Person B became a Director of Company A.

6.    Person C currently holds xxxx% beneficial interest in the company, with Person B holding the remaining xxxx% beneficial interest.

7.    Person C and Person B are Company A's only employees.

8.    As part of person C's and Person B's employment packages, Company A prepares their income tax returns and lodges them with the ATO.

9.    Company A prepared the XXXX and XXXX income tax returns of Person B and Person C. Person C was the responsible tax agent of Company A who lodged B's and their own individual income tax returns.

Audit of Person C's and Person B's tax affairs

10.  Person B's and Person C's tax affairs for the years ended 30 June XXXX and 30 June XXXX (the audit period) were audited by the Commissioner.

11.  At audit, the Commissioner found that Person B and Person C each failed to include $xxxxx in their assessable income.

12.  Additionally, the Commissioner found that Person C failed to take the basic minimum steps expected of an agent with his standing in his profession and with his level of expertise and education. The Commissioner determined that the blameworthy act of the tax agent caused the assessable income to be underreported and the tax liability significantly understated resulting in 50% penalty imposed for recklessness on Person B and Person C.

13.  As a result of these audits, amended assessments were issued such that the following additional tax (Additional Primary Tax Liabilities) was payable:

a.    $xxxx by Person C, and

b.    $xxxx by Person B.

14.  Also, the following penalties (Penalty Liabilities) were imposed by the Commissioner:

c.     $xxxx to Person C

d.    $xxxx to Person B which later was reduced to $xxxx on 24 March XXXX by the ATO.

Proposed payments to Person C and Person B:

15.  Company A proposes to pay a total of $xxxx, which comprises the Additional Primary Tax Liabilities and Penalties Liabilities, in the year ending 30 June XXXX. The purpose of the proposed payments is to:

a.    ensure both individual's continual employment with the company

b.    help avoid damage to the business from a negligent claim enforced by Courts and

c.     avoid potential legal action being taken by Person B and Person C, which will ensure the negligent act is kept private and confidential

16.  Company A has held professional indemnity insurance policy since XXXX. As both Person B and Person A are related parties (both being its employees, shareholders and Directors), the company cannot make any compensation claim for negligence as per the policy.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

These reasons for decision accompany the Notice of private ruling for Company A.

Question

Is Company A able to deduct the proposed payments of $xxxx to Person B and $xxxx to Person C under section 8-1?

Answer

No.

Summary

The proposed payments are not losses or outgoings incurred in gaining or producing income by Company A and are not deductible under section 8-1.

Detailed reasoning

Requirement of sufficient connection between loss or outgoing expenses and income producing activity to claim tax deductions

17.  Section 8-1 allows a deduction to an entity for all the losses or outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are capital or of a capital nature, private or domestic nature, or relate to the earning of exempt income or non-assessable non-exempt income, or specifically prevented from being deductible by another provision.

18.  Paragraph 6 of Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions (TR 97/7) states that the word 'incurred' has been interpreted by the courts as a definite liability or commitment whether paid in the current income year (no timing issue) or to be paid in a future income year.

19.  Therefore, to be eligible for a deduction pursuant to section 8-1, it is necessary for the expense to be incurred in gaining or producing assessable income.

20.  If an expense is 'incidental and relevant' to a taxpayer's income producing activities, it is likely to be considered sufficiently connected with the derivation of assessable income and therefore will be an allowable deduction under section 8-1 (Ronpibon Tin NL & Tongkah Compound NL v. Federal Commissioner of Taxation)[2].

Characterisation of compensation payments

21.  The term 'compensation' is not defined in ITAA 1997; therefore, the term takes on its ordinary meaning. The Macquarie Dictionary defines the term as 'something given or received as an equivalent for services, debt, loss, suffering, etc'.

22.  Taxation Ruling 95/35 Income tax: capital gains: treatment of compensation receipts (TR 95/35) provides guidance on the meaning of the term. Paragraph 3 of TR 95/35 states that, for the purposes of the ruling:

a compensation receipt, or compensation, includes any amount (whether money or other property) received by a taxpayer in respect of a right to seek compensation or a cause of action, or any proceeding instituted by the taxpayer in respect of that right or cause of action, whether or not:

•                     in relation to any underlying asset;

•                     arising out of Court proceedings; or

•                     made up of dissected amounts.

23.  As per paragraph 3 of TR 95/35 'The right to seek compensation is the right of action arising at law or in equity and vesting in the taxpayer on the occurrence of any breach of contract, personal injury or other compensable damage or injury. A right to seek compensation is an asset for the purposes of Part IIIA. The right to seek compensation is acquired at the time of the compensable wrong or injury, and includes all of the rights arising during the process of pursuing the compensation claim. The right to seek compensation is disposed of when it is satisfied, surrendered, released or discharged.'

24.  The character of a compensation payment is determined from the purpose for which it is being disbursed. Paragraph 188 of TR 95/35 states that an undissected lumpsum payment received by a taxpayer would be considered as income or capital depending upon the circumstances and the underpinning reason for which the payment has been made (FC of T v. Slaven (Slaven's, case))[3]. This premise was relied upon and applied in Slaven's case where the payment was made to compensate for loss or impairment of the taxpayer's earning capacity following a motor vehicle accident where character of the receipt became a determining factor for it to be considered as income or capital which in that case was considered as capital. The court while concluding stated that 'It is the character of the receipt in the hands of the taxpayer as recipient that must be determined'.

Application to your circumstances:

25.  In order for the proposed payments to be deductible pursuant to section 8-1, Company A must demonstrate that the proposed payments will be necessarily incurred in gaining or producing assessable income.

Proposed payment of Additional Primary Tax Liabilities

26.  Company A states that $xxxx and $xxxx of the $xxxxx it proposes to pay to Person C and Person B, respectively, relates to additional amount of tax payable by them as a result of the Commissioner increasing their assessable income for the audit period. The company claims that these payments are compensation and will be made to:

a.    ensure both individual's continual employment with the company

b.    help avoid damage to the business from a negligent claim enforced by Courts, and

c.     avoid potential legal action being taken by Person B and Person C, which will ensure the negligent act is kept private and confidential.

28.  However, it is not accepted that Person C and Person B suffered any loss in relation to these amounts and therefore had any right to seek compensation in relation to them. As per paragraph 113 of TR95/35, 'A right to seek compensation is not granted by a person in the same way as an allotment of shares or a grant by a company to a shareholder of rights to subscribe for shares. The right to seek compensation only vests in the plaintiff on, and springs from, the breach of duty or injury. It is not acquired or obtained from another person.' Therefore, regardless of the fact that Company A had incorrectly prepared their income tax returns, Person C and Person B both had an obligation to include the additional income from the share buy-backs in their assessments. This obligation did not arise due to the action of Company A. Had their assessments been correctly prepared and lodged in the first instance, their tax liabilities would have included the Additional Primary Tax Liabilities. As such, Person C and Person B have not suffered any loss from the incorrect lodgement of their income tax returns, these liabilities existed regardless of the incorrect preparation of their income tax returns. Consequently, Person C and Person B do not hold a right to be compensated by Company A in relation to these amounts.

29.  Therefore, the proposed payment of $xxxx to Person C and $xxxx to Person B do not have the nature of compensating them for a loss they incurred due to the actions of Company A. Rather, these proposed payments are more accurately characterised as payments of the individuals' tax liabilities by the company on their behalf. As such, the amounts are not necessarily incurred in the gaining or producing of income by Company A. Section 8-1 is not satisfied and Company A is not eligible to deduct the Additional Primary Tax Liabilities.

Proposed payment of Penalty Liabilities:

30.  As explained above in relation to the proposed payment of the Additional Primary Tax Liabilities, for Company A to be eligible to deduct the proposed payments of the Penalty Liabilities, the company needs to demonstrate that these proposed expenses will necessarily be incurred to gain or produce assessable income.

31.  The Penalty Liabilities arose because of Person B and Person C making false or misleading statements in their income tax returns.

32.  The purpose of the proposed payments of the Penalty Liability amounts by Company A are said to ensure Person C and Person B's continual employment with the company, help avoid damage to the business from a negligent claim enforced by Courts and avoid potential legal action being taken by Person C and Person B which will ensure the negligent act is kept private and confidential.

33.  It is not accepted that Person C and Person B, as directors and shareholders of the company, would be able to take legal action against Company A for their actions as employees.

34.  Nor it is accepted that the proposed payment of the Penalty Liability amounts will ensure the individuals continued employment with the company. That is, it is not accepted that Person C and Person B's employment with the company is at risk due to the fact that the Penalty Liabilities were imposed as a result of the incorrect lodgement of their income tax returns by Person C. Person C was the individual that lodged the income tax returns. He had full knowledge of the information contained therein. As such, it is not accepted that his employment with the company, nor that of his spouse, is at risk due to his behaviour.

35.  Moreover, Person C and Person B are the sole Directors, and the only two employees, of the company. Person C holds xxx% and Person B holds xxx% of the shares in Company A. Due to this, they both have a vested interest to protect the company's reputation and performance. Their resignation from Company A would not aid their personal interest, which is closely tied to the performance in the company.

36.  Even if Person C and Person B have the ability to take legal action against Company A, which is not accepted, not only would this damage the reputation of the company, but such legal action would also damage their personal interests through diminished dividends caused by potential damage to the company's reputation and revenue. It is therefore not accepted that it is likely that the individuals would commence legal action and that the payment of the Penalty Liabilities is necessary to mitigate any potential harm to the business' reputation from such legal action.

37.  Paragraph 113 of TR95/35 states that 'The right to seek compensation only vests in the plaintiff on, and springs from, the breach of duty or injury. It is not acquired or obtained from another person.' Person C and Person B do not have a right to seek compensation from Company A for effectively the actions of Person C and the Penalty Liabilities that arose.

38.  Therefore, the proposed Penalty payments cannot be characterised as compensation. Rather, these proposed payments are more accurately characterised as payments of the individuals' Penalty by the company on their behalf. As such, these proposed Penalty amounts will not necessarily be incurred in gaining or producing assessable income for Company A; therefore, are not deductible under section 8-1.

[1] All future legislative references are to the Income Tax Assessment Act 1997, unless otherwise stated.

[2] Ronpibon Tin NL & Tongkah Compound NL v. Federal Commissioner of Taxation [1949] HCA 15; (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431.

[3] Federal Commissioner of Taxation v. Slaven 84 ATC 4077; (1984) 15 ATR 242 (Slaven's case).