Edited version of private advice

Authorisation Number: 1052302976514

Date of advice: 29 November 2024

Ruling

Subject: Retention bonuses paid to employees

Question 1

Will the Bonus Payments made under the Deferred Bonus Plan be deductible under section 8-1 ITAA 1997?

Answer

No.

Question 2

If the Bonus Payments are not deductible section 8-1 ITAA 1997, will the Bonus Payments be deductible under section 40-880 ITAA 1997?

Answer

Yes.

This private ruling applies for the following period:

Year ended 30 June 20xx

The scheme commenced on:

xx xx 20xx

Relevant facts and circumstances

Background

1. HeadCo is an Australian incorporated company that is a tax resident of Australia.

2.    On xx xx 20xx, HeadCo acquired all of the shares in Company A under a Share Sale Agreement (SSA).

3.    Company A is an Australian incorporated company that is a tax resident of Australia that was incorporated on xx xx 20xx.

4. Company A owns 100% of the shares in Company B, an Australian incorporated company that is a tax resident of Australia that was incorporated on xx xx 20xx.
5. In turn Company B owns 100% of the shares in Company C, an Australian incorporated company that is a tax resident of Australia that was incorporated on xx xx 19xx.
6. On xx xx 20xx HeadCo elected to form a tax consolidated group (the TCG) with Company A, Company B and Company C. HeadCo is the head entity of the TCG.
7. At all relevant times, Company C carried on the business of the design, manufacture and global distribution of certain products.
8. Company B also owns a number of foreign incorporated subsidiaries which operate retail outlets within their respective countries for their products. One of these is Overseas Co, which was incorporated on xx xx 20xx and carried on the business of selling their products offshore at all relevant times. Overseas Co is a 100% subsidiary of Company B.
9. Historically, the TCG has not received dividends from any foreign subsidiary and is not expected to receive any dividends in the future.
10. Shortly after it was acquired by HeadCo, Company A established a Bonus Plan (BP), which was documented by way of the Plan Rules and Offer Letters issued to certain employees.
11. Company A made offers to five members of the senior management team (the Participants) to participate in the BP.
12. The Participants comprised four Australian based employees and one overseas based employee.
13. The Participants had little involvement in the share sale transaction, with four Participants having no involvement and not being aware of the transaction until shortly before the SSA was entered into. However, one Participant was required to field due diligence questions and provide responses, but took no place in commercial negotiations nor had any involvement in the legal documentation process.

The Plan Rules

14. The BP is a bonus incentive plan which provides the Participants with the opportunity to receive bonus remuneration which is calculated with reference to the long term returns to the shareholders of HeadCo and its subsidiaries (The Group).
15. The BP is designed to produce additional rewards over and above their basic salary for meeting or exceeding the Company Targets.
16. The Bonus Payment amount for each Participant is calculated by reference to the metrics outlined in the relevant Offer Letter together with the conditions of the Participant's employment at the time a 'change in control' event occurs.
17. Change of Control means the occurrence of any single event in which securities in HeadCo are the subject to an initial public offering on a recognised stock exchange, a trade sale, or any other transaction, which results in a change in the control of more than 50% of all issued securities in HeadCo .... that the Board of directors of Company A determines, in its absolute discretion, to be a Change of Control.
18. Ordinarily, a Participant is disqualified from receiving a Bonus Payment if, prior to the Payment Date, they have provided a notice of resignation, received a notice of termination, or are made aware that they are subject to an on-going disciplinary procedure.

Bonus Plan Offer Letters

19. Offer Letters were issued to the Participants on xx xx 20xx.
20. The Participants were offered the opportunity to receive a Bonus Payment, and the amount of the Bonus Payment was dependent on a number of variables including a calculation related to a multiple of invested capital and where applicable a discount multiplier if a participant ceased employment.
21. Each Participant accepted the offer to participate in the BP

Share Sale Agreement

22. On xx xx 20xx, the Shareholders of HeadCo entered into the SSA to sell all of the ordinary shares in HeadCo to the Buyer.
23. The SSA contained a number of Conditions Precedent clauses to complete the sale and purchase of the shares (Completion).
24. The sale of HeadCo to the Buyer was completed on xx xx 20xx after the Condition Precedents were satisfied.
25. The purchase price was $xx after various adjustments.

The Bonus Payments

26. No Payment Date will arise until a Change of Control has occurred.
27. The Bonus Payment amounts for the Participants are contained in each Offer Letter. The amount of the bonus payments were ratcheted to the multiple of invested capital achieved (which ended up being xx times). The multiple of invested capital was calculated based on the purchase price before deducting for employee incentive amounts.
28. The multiple was calculated as follows:

Table 1: The multiple of invested capital was calculated as follows:

29. The Offer Letters to the Participants, outlined that where the targets are achieved, the Bonus Payment for the Participants would be $xx.
30. On or around xx xx 20xx, the Participants were provided with documents with respect to a proposal to co-invest in the ultimate Australian parent of the Buyer. This co-investment proposal allowed the Participants to use a portion of their after-tax Bonus Payments to subscribe for ordinary shares in Buyer HoldCo and/or a new management incentive plan.
31. On xx xx 20xx, further offer letters were issued to the Participants inviting them to subscribe for a mix of ordinary and X Class shares in Buyer HoldCo.
32. Prior to xx xx 20xx, the Participants signed and returned subscription letters to Buyer HoldCo which had the effect of:
    1. Confirming their application for ordinary and X Class shares in Buyer HoldCo for their respective consideration; and
    2. Directing Company A to pay to Buyer HoldCo on their behalf a portion of proceeds they would otherwise be entitled to receive under the BP in full and final satisfaction of their obligation to pay the Subscription Price.
33. On xx xx 20xx, on completion of the sale of the shares in HeadCo, the Participants were entitled to receive the Bonus Payments, which were calculated by reference to the growth in the equity of the HeadCo shares (a multiple of invested capital).
34. On xx xx 20xx, the Group paid $xx to the Participants..
35. For payroll administration and reporting reasons, Third Party Co (on behalf of the Group) made the Bonus Payment to the oversea based employee

Source of Funds

36. The funds used to pay the Australian Participants and Buyer HoldCo were sourced from the cash holdings of Company C, which is a member of the HeadCo tax consolidated group. The funds were not obtained through loans.
37. To pay the Bonus Payment to the oversea Participant, existing intragroup loan arrangements were utilised.
38. No other payments, aside from the Bonus Payment, before tax and other deductions of $xx, were or will be paid to any of the 5 Participants as a result of this transaction.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Subsection 40-880

Income Tax Assessment Act 1997 Subsection 40-880 (3) - (9)

Does Part IVA apply to this private ruling?

Part IVA of the Income Tax Assessment Act 1936 contains anti-avoidance rules that can apply in certain circumstances where you or another taxpayer obtains a tax benefit, imputation benefit or diverted profits tax benefit in connection with an arrangement.

If Part IVA applies, the tax benefit or imputation benefit can be cancelled (for example, by disallowing a deduction that was otherwise allowable) or you or another taxpayer could be liable to the diverted profits tax.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies, we will need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select 'Part IVA: the general anti-avoidancerule for income tax'.

Reasons for decision

Question 1

Will the Bonus Payments made under the Bonus Plan be deductible to HeadCo under section 8-1 ITAA 1997?

Summary

The Bonus Payments made under the Bonus Plan are not deductible to HeadCo under section 8-1 as they are not an outgoing that is incurred in gaining or producing your assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

Detailed reasoning

Consolidation

Consolidation: income tax consolidated groups are treated as a single entity for income tax purposes

Taxation Ruling TR 2004/11 Income tax: consolidation: the meaning and application of the single entity rule in Part 3-90 of the Income Tax Assessment Act 1997 explains what the single entity rule (SER) in section 701-1 is and how it applies to members of a consolidated group.

Section 701-1 is a key provision of the consolidation regime. It is the means by which the members of a consolidated group are treated as a single entity (being the head company) for income tax purposes.

The SER operates for the purposes set out in subsections 701-1(2) and (3) (the core purposes). These purposes are to work out the amount of the head company and subsidiary member's liability for income tax and the amount of a loss for a relevant period. They include all matters relevant and incidental to those calculations. The intended operation of the SER is to apply the income tax laws to a consolidated group as if it were a single entity.

For income tax purposes the SER deems subsidiary members to be part of the head company rather than separate entities during the period that they are members of the consolidated group. As a consequence, the SER has the effect that the actions and transactions of a subsidiary member are treated as having been undertaken by the head company.

Payments made to the Participants

On xx xx 20xx, Company A paid the Bonus Payments to the Australian Participants. For administrative purposes, Third Party Co paid the Bonus Payments to the overseas Participant on behalf of the Group. On that date Company A was a 100% subsidiary of HeadCo and HeadCo was the head entity of an income tax consolidated group.

The contractual agreement to pay bonuses to the Participants is between Company A, a subsidiary company of HeadCo, and the Australian Participants. Under the Single Entity Rule, the actions and transactions of the subsidiary company are imputed to the head company, with those actions and transactions treated as having been undertaken by the head company. Therefore, the tax consequences for any payment to the Participants will apply to HeadCo.

Company A is treated as part of HeadCo from xx xx 20xx. Therefore, the tax consequences for any payment will apply to HeadCo under the SER.

General deductions under section 8-1

A deduction is allowed under section 8-1 for losses or outgoings to the extent that the loss or outgoing is incurred in gaining or producing assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

Subsections 8-1(1) and (2) provide:

(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.

(2) However, you cannot deduct a loss or outgoing under this section 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.

Section 8-1: Incurred

For section 8-1 to apply, it is necessary to ascertain whether an amount has been incurred. Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions provides (at paragraph 5) that, as a broad guide, you incur an outgoing at the time you owe a present money debt that you cannot escape. Additionally, Taxation Ruling TR 94/26 Income tax: subsection 51(1) - meaning of incurred - implications of the High Court decision in Coles Myer Finance provides guidance on the meaning of the term incurred. In particular, paragraph 3 states:

In most cases where a loss has not been realised or an outgoing has not been made, a presently existing pecuniary liability, at the end of the relevant income year, will be a necessary prerequisite to an expense being 'incurred' for the purposes of subsection 51(1) (Coles Myer Finance 93 ATC 4220; 25 ATR 95; Nilsen Development Laboratories Pty Ltd & Ors v. FC of T 81 ATC 4031; 11 ATR 505).

Also a loss or outgoing may be incurred for the purposes of section 8-1 even though no money has actually been paid out. In W Nevill & Company Ltd v. FC of T (1937) 56 CLR 290 at 302 it was said:

'the word used is 'incurred' and not 'made' or 'paid'. The language lends colour to the suggestion that, if a liability to pay money as an outgoing comes into existence, [the section is satisfied] even though the liability has not been actually discharged at the relevant time... it is only the incurring of the outgoing that must be actual; the section does not say in terms that there must be an actual outgoing - a payment out.'

The SSA was signed on xx xx 20xx but was subject to a condition precedent. Therefore the change of control did not occur until xx xx 20xx. As the Participants had signed offer letters that were conditional on a number of terms, including a change of control, Company A did not have an obligation to pay the Bonus Payments until the date of the change of control, being xx xx 20xx. This is the point the liability comes into 'existence'. Therefore Company A (or HeadCo under the SER) incurred a loss or outgoing in relation to the Bonus Payments during the income year ended xx xx 20xx.

Positive limbs

To be deductible under section 8-1, the positive limbs in subsection 8-1(1) require there to be a sufficient nexus between the Bonus Payments and the gaining or producing of its assessable income, or the carrying on of the business of HeadCo.

In this case, it is necessary to consider the character and the nature of the payment to establish the nexus required under section 8-1. This will also be relevant when it comes to consider the negative limbs; particularly whether the payment was capital, or of a capital nature.

Paragraph 8-1(1)(a): The first positive limb

The first positive limb of subsection 8-1(1) provides that a loss or outgoing may be deductible under paragraph 8-1(1)(a) to the extent that "it is incurred in gaining or producing your assessable income".

To satisfy that limb, Ronpibon Tin (N.L.) v Federal Commissioner of Taxation, [1945] HCA 15;(1949) 78 CLR 47 (Ronpibon Tin), provides that it is both sufficient and necessary that the 'occasion' of the loss or outgoing should be found in whatever is productive of assessable income.

In Watson as Trustee for the Murrindini Bushfire Class Action Settlement Fund v Commissioner of Taxation [2020] FCAFC 92 at [33], the full Federal Court held:

'While the connection with activities which more directly gained or produced the assessable income need not be direct (Day at [21]), the occasion of the outgoing must be found in what is productive of the assessable income; there must be a sufficient nexus between the outgoing and "the activities which more directly gain or produce the assessable income".

To identify or find the occasion of the loss or outgoing, it is necessary to examine all relevant circumstances giving rise to the outgoing. It will be relevant to ask what the outgoing was incurred to effect from a practical or business point of view (Thawley J in Clough Limited v Commissioner of Taxation [2021] FCAFC 197 (Clough Appeal)).

The principles of the positive limbs were most recently discussed in Clough Ltd v Federal Commissioner of Taxation [2021] FCA 108 (Clough) and confirmed in the subsequent Clough Appeal.

Thawley, J in the Clough Appeal noted that:

(a)    the payments were not incurred in gaining or producing assessable income on the basis that the occasion of them lay in the takeover and not in gaining or producing assessable income.

(b)    the payments were not connected with considerations of business operations, efficiency or expediency. The payments were predominantly connected with facilitating a change in the underlying shareholding of the company and that in the absence of the change in control, no expenditure would have been incurred by Clough.

(c)    the takeover was the proximate causal event requiring that the payments be made and the payments would not have been made but for the takeover.

The occasion is not limited to the immediate causes for the payment, although contemporaneous events will be directly relevant and significant, and may in some circumstances, be decisive. While questions of causation (would a payment have been made were it not for the existence of a particular circumstance?) and purpose are relevant, it is necessary to identify and understand the characterisation question having regard to all relevant circumstances. (Thawley J in Clough) And, after determining this, whether the outgoing is 'incidental and relevant' to the activity or occasion must be considered. (Watson as Trustee for the Murrindini Bushfire Class Action Settlement Fund v Commissioner of Taxation [2020] FCAFC 92).

In addition, IT 2656 Income Tax: Deductibility of Takeover Defence Costs notes that costs incurred to prevent a takeover:

•         aren't deductible under the first positive limb because they aren't incidental and relevant to producing income [paragraphs 12-13]

•         are unlikely to be deductible under the second limb because they are concerned with share ownership, not a working expense incurred in carrying on the company's business [paragraphs 14, 16]

•         are likely to be capital because they are relevant to business structure or ownership of the company [paragraphs 26-27].

The same considerations apply to employment costs. While most payments made to staff would be deductible as having an ordinary trading character, this always depends on the circumstances.

Paragraph 8-1(1)(b) - Second positive limb

The second positive limb of subsection 8-1(1) provides that a loss or outgoing may be deductible under paragraph 8-1(1)(b) to the extent they were "necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income".

It has been observed that the second positive limb adds little in practice to the first positive limb (Ronpibon Tin). An outgoing will be "necessarily incurred in carrying on a business" if it is:

(a)    "clearly appropriate" or "adapted" for the carrying on of the business; and

(b)    "reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business". (Spriggs v Commissioner of Taxation [2009] HCA 22; (2009) 239 CLR 1)

The Commissioner considered what was meant by the second positive limb in Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 (TR 2011/6):

"73. In contrast, for expenditure to be deducted under the second positive limb of section 8-1, it must be incurred in carrying on a business. To satisfy this requirement, the outgoing must have the character of a working or operating expense of the entity's business or be an essential part of the cost of its business operations. In John Fairfax & Sons Pty Ltd v. FC of T (1958 9) 101 CLR 30 Menzies J stated at page 49:

...there must, if an outgoing is going to fall within its terms, be found (i) that it was necessarily incurred in carrying on a business; and (ii) that the carrying on of the business was for the purpose of gaining assessable income. The element that I think is necessary to emphasise here is that the outlay must have been incurred in the carrying on of a business, that is, it must be part of the cost of trading operations. [emphasis added]

74. The test under the second positive limb of section 8-1 is therefore a more demanding test requiring a more immediate or direct link between the expenditure and the process of operating the business than a connection that qualifies the expenditure as being 'in relation to' a business."

Factors considered in characterising the Bonus Payments

In characterising the Bonus Payments the following is considered relevant (although not exclusively):

(a)    The Participants entitlement to the Bonus Payments are contingent on a change of control, including the sale of more than 50% of the issued securities in HeadCo.

(b)    The Participants entitlement to the Bonus Payment is impacted if they do not remain employed.

(c)    The Participants all held key senior management roles.

(d)    On xx xx 20xx, the offers for Bonus Payments were made to the Participants.

(e)    All Participants accepted the Offer Letters.

(f)     On xx xx 20xx, the SSA was signed for the sale of the shares in HeadCo to the Buyer.

(g)    On xx xx 20xx, the SSA was completed and the Participants became entitled to their Bonus Payments.

(h)    All of the Participants were long term employees of the Group.

(i)      The quantum of the Bonus Payments paid to the Participants was calculated by reference to the growth in the ordinary equity value of HeadCo from the date of Completion until the date of the change of control.

(j)      Each Participant is remunerated by way of an annual salary.

(k)    One participant was required to field due diligence questions and provide responses. However, they did not take part in any commercial negotiations nor did they have any involvement in the legal documentation process.

(l)      The other Participants had minimal involvement with the negotiation of the SSA.

(m)   The BP is designed to produce additional rewards over and above their basic salary for meeting or exceeding the Company Targets.

Application of the positive limbs to the Bonus Payments

Analysis of the positive limbs

Section 8-1(1) requires a nexus between the outgoing and the gaining or producing of assessable income or the carrying on of a business for the purpose of gaining or producing assessable income.

Remunerating employees is usually an ordinary business expense. However, that is not the case where the payment is attributable to motives other than the profitable conduct of a company's affairs. (see, for example, Robert G Nall Limited v Federal Commissioner of Taxation (1937) 57 CLR 695). Where a payment is directly concerned with the ownership of a company, it may take on a different character.

The BP's purpose is a bonus incentive plan, to provide certain eligible employees (the Participants) with the opportunity to receive bonus remuneration on a change of control. The bonus payments are calculated by reference to the long term returns of the shareholders of the Group.

The Participant's entitlement to the Bonus Payments is formulated such that they relate to a change of control event which in the present circumstances is the sale of HeadCo's shares. The BP rules states that 'No Payment Date will arise until a Change of Control has occurred, therefore the Bonus Payments would not have been paid unless a change of control event as defined in the BP rules occurs. The Bonus Payments are considered to be formulated to incentivise the Participants to work towards a change of control which in this case is the sale of the Group, via the sale of the ordinary shares of HeadCo. This is an unusual event outside the ordinary course of running a business it is more probably characterised as expenditure related to the business entity, structure, or organisation set up or established for the earning of profit.

Therefore, although the Bonus Payments have a connection to the business of the Group, they were not incurred in the pursuit of its business ends. To be deductible, an outlay must be part of the cost of trading operations to produce income. It must have the character of a working expense. (John Fairfax & Sons Pty Ltd v Federal Commissioner of Taxation (1959) 101 CLR 30 per Menzies J) The Bonus Payments were not in the nature of a working expense in the carrying on of HeadCo's business being the design, manufacture and global distribution of their products. They were instead concerned with the ownership of HeadCo and the sale of the Group's business. Working towards achieving a sale is an unusual event outside the ordinary course of operating a business.

It is acknowledged that the Participants (in light of their roles within the Group) are involved in maximising the value of the business and a consequence of this is the maximisation of the share value for the company's shareholders.

However, the first positive limb does not enquire whether the functions of the Participants are for the gaining or producing of assessable income. The enquiry is whether the loss or outgoing has the requisite nexus with assessable income. Thus, the application of the first positive limb is whether the occasion of the Bonuses Payments is found in whatever is productive of the gaining or producing of assessable income.

Expenditure which is concerned with the takeover of a taxpayer is not relevant or incidental to gaining or producing of assessable income. (Federal Commissioner of Taxation v The Swan Brewery Company Limited [1991] FCA 360) Where costs are concerned with the ownership of shares in a company, an insufficient connection exists between the expenditure and the carrying on of the company's business to accept that the costs have the character of a working expense of the business or form part of its income-producing operations. (IT 2656 at [16])

The conclusion to be drawn from the discussion above is that the Bonus Payments are inextricably linked to the sale of the Group's business. The occasion for these bonuses is found in a change of control event which is concerned with ownership of the Group and the pursuit of long term returns for the shareholders. In the present circumstances the change of control event manifested itself, via the sale of HeadCo's shares.

Application of the negative limbs to the retention bonuses

Paragraph 8-1(2)(a) - the first negative limb

The Bonus Payments are not deductible as they are "a loss or outgoing of capital, or of a capital nature" within the meaning of paragraph 8-1(2)(a).

The decision of the High Court of Australia in Sun Newspaper Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 23; (1938) 1 AITR 403 (Sun Newspapers) is the leading authority on the distinction between revenue and capital expenditure. The general rule is found in the frequently quoted statement of Dixon J as he then was at 359-360 where he said:

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity structure or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss...As general conceptions it may not be difficult to distinguish between the profit yielding subject and the process of operating it. In the same way expenditure and outlay upon establishing, replacing and enlarging the profit-yielding subject may in a general way appear to be of a nature entirely different from the continual flow of working expenses which are or ought to be supplied continually out of the returns or revenue.

The classic formulation of the matters to be considered in determining whether a loss or outgoing is of a capital or revenue nature is explained by the following passage from Sun Newspapers:

"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 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..." (per Dixon J)

The character of the advantage sought provides important direction. It provides the best guidance as to the nature of the expenditure (Paragraph 67 of TR 2011/6 adopting the emphasis in GP International Pipecoaters v Federal Commissioner of Taxation (1990) 170 CLR 124; 90 ATC 4413; (1990) 21 ATR 1). If the expenditure produces some asset or advantage of a lasting character for the business, it will be considered to be capital expenditure.

'Enduring' does not in this context mean permanent in the sense of perpetual. (Commissioner of Taxes v Nchanga Consolidated Copper Mines Ltd [1964] AC 948) An enduring benefit does not require that the taxpayer obtain an actual asset, it may be a benefit which endures, in the way that fixed capital endures (Sun Newspapers and paragraph 68 of TR 2011/6). Nettle J observed in AusNet Transmission Group Pty Ltd v Commissioner of Taxation [2015] HCA 25 at [141] that:

"the fact that the result or purpose of expenditure is the acquisition of some right or advantage of a lasting character for the benefit of the profit-yielding subject is a necessary but not sufficient indication that the expenditure is incurred on capital account."

In the Clough Appeal, Thawley J, at 18 observed that:

'... 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 ... 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. (emphasis added)'

Each of the circumstances listed above under the heading Factors considered in characterising the Bonus Payments bear relevance in characterising the Bonus Payments.

Application of paragraph 8-1(2)(a) - the first negative limb to the Bonus Payments

The Bonus Payment was paid once and occurred only on completion of the sale of the HeadCo's shares. The obligation to pay the Bonus Payment is borne by Company A pursuant to an agreement between itself and the Participants.

On completion of the sale of the shares in HeadCo, the Participants were paid a Bonus Payment, which was calculated by reference to the growth in the equity of the HeadCo shares. The multiple of invested capital determined the quantum of the Bonus Payments. The Bonus Payments were not reduced, as none of the Participants had left their employment.

The Bonus Payment is linked to the sale of shares in HeadCo rather than related to the ongoing trading operations of the business. The sale of shares secured a lasting change for the Group, and this represents an enduring advantage.

In Foley Brothers Pty Ltd it was stated that outgoings incurred for the purpose of altering the organisation or structure of the profit-yielding subject (including its demise) were considered to be of a capital nature.

There is also a more general lasting advantage in securing a new shareholder, which is related to the continuity of that business. Costs spent in securing a more eager shareholder may be paid on capital account. There is no inflexible principle that an amount of expenditure which remunerates employees cannot be an item of capital expenditure.

In AusNet (supra) at [15], the majority noted that a "recurrent payment" might tend to indicate that expenditure is of a revenue nature, whilst a "once and for all payment" might tend to indicate that it is a capital outlay. The Bonus Payments flow from a single transaction. The Bonus Payments are calculated by reference to shareholder returns which tends to indicate that they were paid on capital account.

The character of the advantage sought

Sun Newspapers highlights the distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity structure or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss.

The Participants became entitled to receive the Bonus Payment at the time a Change of Control occurred, provided they met certain eligibility requirements. The quantum of the Bonus Payment is dependent on meeting the relevant Company Targets, relating to the long term growth in the ordinary equity of HeadCo (as set by the Board), however the Bonus Payment can be reduced by a discount if the Participant leaves their employment.

The Bonus Payments were incurred under an agreement (offer letter) relating to a change of control via ultimately the sale of shares held in HeadCo. The character of the advantage sought by incurring the Bonus Payments is concerned with ownership of the Group and the pursuit of long term returns for the existing shareholders and therefore relates to 'the business entity structure or organization set up or established for the earning of profit and not the process by which such an organization operates to obtain regular returns by means of regular outlay'. The advantage sought was of an enduring benefit to the Group.

The manner in which the advantage is to be used, relied upon or enjoyed

The second test in Sun Newspapers requires an examination of the manner in which the benefit obtained is to be used, relied upon or enjoyed.

It is likely that all business expenditure is made with the intention of securing some commercial advantage. It is necessary to establish the effect of the expenditure and how long the effect is likely to endure. Where the expenditure results in an intangible benefit or advantage, it is necessary to establish whether the asset is sufficiently substantial and has substantial enduring benefit to count as capital.

Where a loss or outgoing gives rise to a benefit of an enduring nature, the loss or outgoing is more likely to be capital in nature. The test arose to prominence in British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 where it was held that an employer contribution to establish a staff pension fund was capital in nature on the basis that it brought into existence an asset of 'enduring benefit'. Viscount Cave LC stated at 192 that:

When an expenditure is made, not only once and for all, but with a view to bring into existence an asset or advantage for the enduring benefit of a trade, l think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

It is noted that the term 'enduring' does not mean that the asset or advantage should last forever. This was supported in Commissioner of Taxes v. Nchanga Consolidated Cooper Mines Ltd [1964] 1 All ER 208 in which it was stated that 'permanent' does not mean 'perpetual'.

HeadCo incurred the various Bonus Payments under an agreement whereby the Participants became entitled to receive the Bonus Payment at the time a Change of Control occurred, provided they met certain eligibility requirements. The quantum of the Bonus Payment is dependent on meeting the relevant Company Targets, relating to the long term growth in the ordinary equity of HeadCo (as set by the Board), The payments are concerned with ownership of the Group (structural change) which renders a significant enduring benefit related to a change of ownership.

The means adopted to obtain it

The third test in Sun Newspapers is the means adopted to obtain the benefit.

There is a distinction between operating a business and expanding a business. In Hallstroms Pty Ltd v. Federal Commissioner of Taxation(1946) 72 CLR 634, Dixon J as he then was referred at 647 to the general consideration that:

... the contrast between [expenditure on capital or revenue account] corresponds to the distinction between the acquisition of the means of production and the use of them; between establishing or extending a business organisation and carrying on the business; between the implements employed in work and the regular performance of the work in which they are employed; between an enterprise itself and the sustained effort of those engaged in it.

Many judgments in relation to the deductibility of expenditure refer to the statement by Viscount Cave in British Insulated and Helsby Cables Ltd v. Atherton (1926) AC 205 at pages 213-214:

But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is a very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

In present circumstances, the Bonus Payments are not a recurrent business expense but amount to one-off payments under an agreement (offer letter) relating to a change of control via ultimately the sale of shares held in HeadCo. The Bonus Payments is concerned with ownership of the Group and the pursuit of long term returns for the shareholders.

In current circumstances, as discussed above, the Bonus Payments are not deductible as they are "a loss or outgoing of capital, or of a capital nature" within the meaning of paragraph 8-1(2)(a).

Paragraphs 8-1(2)(b), (c) & (d) - the second, third, and fourth negative limbs

These paragraphs do not exclude a deduction.

Question 2

If the Bonus Payments are not deductible section 8-1 ITAA 1997, will the Bonus Payments be deductible under section 40-880 ITAA 1997?

Summary

The Bonus Payments paid to each Participant are capital expenditure which is deductible over a period of 5 income years, starting in the year in which the expenditure is incurred.

Detailed reasoning

Application of section 40-880

Capital expenditure is deductible in equal proportions over a period of 5 income years starting in the year in which the expenditure is incurred, if the requirements of subsection 40-880(2) are satisfied. The provision relevantly provides:

"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

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

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

(d)  ..."

As noted above the Bonus Payments were incurred during the income year ended xx xx 20xx

Subsection 40-880(3) further requires that the relevant business be carried on for a taxable purpose. Having satisfied the requirements of subsection 40-880(2), the capital expenditure is nevertheless precluded from deduction if subsection 40-880(5) applies to the expenditure. Paragraph 40-880(5)(f) is the relevant provision for the purposes of this analysis:

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

(a)  ...

(b)  ...

(c)   ...

(d)  ...

(e)  ...

(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".

The Commissioner's views on the operation and scope of section 40-880 are set out in TR 2011/6.

Section 40-880 applies to capital expenditure which is business related. Therefore, revenue expenditure and non-business expenditures are excluded from the operation of section 40-880. As discussed in the paragraphs above, the Bonus Payments are characterised as capital or capital in nature.

The relevant business

In identifying, for the purposes of subsection 40-880(2), the business that is most relevant to the expenditure, TR 2011/6 provides that it is necessary to look at the Taxpayers' overall business rather than a particular undertaking or enterprise within the overall business. In this regard, TR 2011/6 at paragraph 28 explains that if a company carries on a manufacturing business in Australia and is also the holding company of a number of overseas subsidiaries, for the purposes of subsection 40-880(2), the company's overall business is both a holding company and a manufacturer (TR 2011/6 paragraph 30).

In this case, the relevant businesses for the purposes of subsection 40-880(2) is a holding company for a number of overseas subsidiaries and the design, manufacture and global distribution of certain products.

The relevant provision in this case is paragraph 40-880(2)(a) as the taxpayer carried on the respective businesses at the time they incurred the expenditure.

Whether the expenses were incurred in relation to the relevant business

Subsection 40-880(2) requires that the capital expenditure be incurred "in relation to" the business. The connection required under this provision is a less demanding one than that required under section 8-1. However, the expenditure must still be sufficiently relevant to the business to impress on it the character of a business expense of that business (Paragraph 75 of TR 2011/6). That is, the expenditure must be a genuine business expense of a particular business (Paragraph 78 of TR 2011/6). The following serves as a useful guide in determining whether there is a genuine business expense:

"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." (Paragraph 79 of TR 2011/6)

In the High Court decision of Perlman v Perlman (1984) 155 CLR 474 at 489, Justice Mason stated:

... the expression "in relation to" is one of wide and general import and should not be read down in the

absence of some compelling reason for so doing.

In considering the phrase "in relation to" in the context of the Commercial Arbitration Act 1985 (NT), the High Court stated in PMT Partners Pty Ltd (In Liquidation) v Australian National Parks & Wildlife Service (1995) 184 CLR 301 at 313:

Inevitably, the closeness of the relation required by the expression 'in relation to' in s 48 of the Act,

indeed, in any instrument - must be ascertained by reference to the nature and purpose of the provision in question and the context in which it appears.

It is therefore necessary to consider the legislative context of subsection 40-880(2) in order to determine whether there is a sufficient and relevant connection between the incurrence of the expenditure and HeadCo's business. In discussing the types of business capital expenditure to which subsection 40-880(2) applies, the Explanatory Memorandum to the Tax Laws Amendment (2006 Measure No.1) Bill 2006 states:

2.58 The character of the expenditure must be that connected with the business itself (eg, pertaining

to the business structure, or its operations).

2.59 Put another way, the taxpayer would expect a return on that expenditure in the form of profits

from the business. The expenditure need not of itself be directly productive of the taxpayer's assessable

income.

2.60 The taxpayer does not need to be actually deriving income from the activity at the time the

expenditure is incurred to qualify for the deduction.

As outlined above, HeadCo incurred the various Bonus Payments under an agreement whereby the Participants became entitled to receive the Bonus Payment at the time a Change of Control occurred, provided they met certain eligibility requirements. The quantum of the Bonus Payment is dependent on meeting the relevant Company Targets, relating to the long term growth in the ordinary equity of HeadCo (as set by the Board), The payments are concerned with ownership of the Group (structural change) which renders a significant enduring benefit related to a change of ownership. Whilst the Bonus Payments are not considered to be a cost of the company's trading operations, these payments are nevertheless capital expenditure connected with the business itself (eg, pertaining to the business structure).

Taxable purpose

Subsection 40-880(3) provides that 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.

The business referred to in this subsection is the business to which the relevant paragraph in subsection 40-880(2) applies. In this case paragraph 40-880(2)(a) applies and therefore the issue is the extent to which the business that the Taxpayers' carry on is carried on for a taxable purpose.

The definition of 'taxable purpose' is provided in subsection 40-25(7) of the ITAA 1997 to include the purpose of producing assessable income.

The term 'purpose of producing assessable income' is further defined in subsection 995-1(1) of the ITAA 1997 as being either:

•         for the purpose of gaining or producing assessable income

•         in carrying on a business for the purpose of gaining or producing assessable income.

The Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 further explains:

2.47 A taxpayer whose business is not carried on for a taxable purpose cannot deduct expenditure to that extent. This limitation is not an annual test: that is, it is not to limit deductions to only the income years in which the business is carried on for a taxable purpose. The test as to the taxable purpose of the business is applied - as at the time the expenditure is incurred - to the taxable purpose of the business by reference to all known and predictable facts in all years.

The application of subsection 40-880(3) requires that you determine, as at the time the capital expenditure was incurred, the extent to which your business will be carried on for a taxable purpose by reference to all known and predictable facts in all years.

Paragraph 27 of TR 2011/6 notes that if the expenditure relates to the whole of the business but part of the business is carried on to derive exempt income or non-assessable non-exempt income then to that extent the expenditure will not be deductible.

All income derived by the HeadCo is assessable. HeadCo has not and is not expected to derive any exempt income or any non-assessable non-exempt income. Considering all the facts, at the time HeadCo incurred the Bonus Payments, HeadCo was carrying on its business for a taxable purpose. As such, subsection 40-880(3) will not apply to limit the Taxpayers' deduction under section 40-880.

Other limitations

Subsections 40-880(5) to (9) set out other limitations and exclusions to claiming a deduction under section 40-880. On the facts of this case, subsections 40-880(5) to (9) do not apply to limit or exclude deductibility of the Bonus Payments incurred by HeadCo under section 40-880.

Therefore, HeadCo is entitled to deduct the Bonus Payments in equal proportions over five income years from the time the expenses were incurred pursuant to subsection 40-880(2).