Edited version of private advice

Authorisation Number: 1052356631211

Date of advice: 31 January 2025

Ruling

Subject: Deductions - compensation payments

Question 1

Is the Estate eligible to claim a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the monthly compensation payments to the tenant pursuant to the first Deed of Settlement, as varied?

Answer 1

Yes.

Question 2

Is the Estate eligible to claim a deduction under section 8-1 of the ITAA 1997 for the final settlement payments to the tenant pursuant to the second Deed of Settlement?

Answer 2

Yes.

This ruling applies for the following periods:

Income year ended 30 June 20XX

Income year ended 30 June 20XX

Income year ended 30 June 20XX

Relevant facts and circumstances

Individual A owned and was the lessor of the commercial property (the Property) in partnership with their late partner until their partners passing in 20XX. Upon their partner's passing Individual A continued to lease the Property under the same lease terms to the existing tenant (the Tenant), until Individual A's passing in 20XX, at which time it became an asset of the Estate.

The Estate (as landlord) continued to lease the Property under the same lease arrangement, and would do so until such time as the Estate could make arrangements to dispose of the Property (with the current lease in place).

The lease at the time had been entered into for a period of X years from 20XX, with an option to extend for a further X years. The Property was being used by the Tenant to run a business.

During the period between April 20XX and September 20XX, the Property was rented by the Estate to the Tenant on a continual basis until significant damage with the building was highlighted. A structural engineering report was obtained in September 20XX that indicated that significant works would be required to bring the Property back to a suitable condition.

During the rectification works, further issues became apparent and a dispute arose between the Estate and the Tenant in regard to:

•                     the state and condition of the Property and the obligations of the Landlord to effect repairs to the Property

•                     the obligations of the Tenant to pay rent and outgoings for the Property

•                     whether the Property was unsafe and whether the Tenant should continue to trade from the Property, and

•                     any claims from the Tenant against the Estate in respect of the state and condition of the Property.

The Estate and the Tenant attended mediation and entered into a Deed of Settlement dated XX 2021 to settle the dispute on the terms set out therein.

However, a secondary survey of the Property, obtained in or around June 20XX, indicated that the structural elements of the building were far more degraded than had been initially assessed, the outcome of which would require most of the building to be demolished and rebuilt in order to bring the building to a state where it would be able to be reoccupied.

As a consequence, the Estate and the Tenant executed a Variation of Deed of Settlement on XX 20XX whereby they agreed to amend the Deed of Settlement (i.e. update the scope and timing of works) with terms agreed that included an extension of the existing lease term for a further X years, and that the Estate pay to the tenant compensation for its inability to trade during the construction period, being an amount of $XX,XXX plus GST per month, calculated from 20XX and payable at the conclusion of each month.

The Estate considered demolishing the building and selling the block as vacant land. However, to maximise the benefit for the beneficiaries of the Estate, it was decided to undertake the demolition and rebuild.

The terms of the existing lease arrangement were reviewed by legal counsel for the Estate, and it was determined that the lease could not be legally ended, and that the Estate would be required to proceed with the lease agreement in its current form, notwithstanding the period that the Tenant would be unable to occupy the premises whilst works were undertaken.

This settlement brought forward the option for the Tenant to extend the lease for a further X years. In discussions with the Tenant regarding the fact that they would be required to vacate the premises during the initial repair works, it was the Tenant who tabled bringing forward the lease option as part of their negotiations, and it was the Tenant who strove to achieve an outcome whereby their lease would not be terminated.

It was made clear by the Tenant that they wished to reoccupy the tenancy and obtain the longest and most favourable lease terms they could, and that any agreement between the parties in respect of the period of works to be undertaken could be used as leverage by the Tenant to negotiate for more favourable lease terms. The scenarios under which the Tenant was prepared to permit the lease to be terminated and to accept a compensation payment for such termination were extremely limited.

As understood, this is because the business operated by the Tenant out of the Property was of a kind that would be difficult to relocate given the nature of the Property, size and fit out required for their operations.

The reconstruction of the Property was completed by the Estate, and the Estate informed the Tenant that:

•                     the Property was ready for occupation by the Tenant;

•                     the lease would commence from 20XX; and

•                     the monthly compensation of $XX,XXX will no longer be paid.

However, further disputes arose between the Estate and the Tenant around that time in relation to particular assertions made by the Tenant, namely that:

•                     the Property was not ready for occupation;

•                     a substantial number of the Tenant's fittings and chattels had been stolen or were missing or damaged;

•                     various Tenant fixtures and fittings needed to be installed or replaced by the Estate;

•                     the Tenant was not required in the circumstances to go into possession of the Property and pay rent and outgoings;

•                     the Estate was required to continue to make the monthly compensation payments; and

•                     the term of the lease should be extended for another X years.

Following a further mediation process, these latest disputes were settled by another Deed of Settlement entered into by the parties on XX 20XX, with terms agreed as follows:

•                     the Tenant move into and take possession of the Property by no later than 20XX and commence trading as soon as possible thereafter;

•                     the Tenant commence payment of rent by 20XX;

•                     the lease would be further varied by adding another option term of X years which, if exercised by the Tenant, would lapse on 20XX; and

•                     the Estate will pay the Tenant $XX,XXX (inclusive of GST) in full and final satisfaction of the disputes as follows:

­        $XX,XXX on or before XX 20XX; and

­        $XX,XXX on or before XX 20XX.

The only revision of the lease terms through this second (and final) Deed of Settlement was an adjustment to the monthly lease payment to account for increases to CPI since the last review of the market value rental, and the addition of a further X-year lease option in recognition of the fact that the Property was unable to be occupied for more than X years of the previous X-year lease term. This further option was granted at the behest of the Tenant.

The costs to reconstruct the Property were significant and exceeded original estimates considerably. It was further understood and accepted by the Executors that the full cost of completing the rectification works, at a time when COVID lockdowns and delays, building supply shortages and cost blowouts were impacting on this process, would be significant and that, in addition to previous costs relating to the acquisition and maintenance of the Property, would far exceed the realisable value of the Property upon sale. The Executors did not anticipate realising a profit from this undertaking, which has since been confirmed by the subsequent realisation of a capital loss from the sale of the Property under the instruction of the beneficiaries of the Estate.

Pursuant to terms of the first settlement, as varied, the Estate made XX monthly compensation payments to the Tenant during the 20XX income year, and a further X payments during the 20XX income year.

Pursuant to the terms of the second settlement, the Estate made X compensation payments of $XX,XXX to the Tenant, one each during the 20XX and 20XX income year.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 8-1(1)

Income Tax Assessment Act 1997 paragraph 8-1(1)(a)

Income Tax Assessment Act 1997 subsection 8-1(2)

Income Tax Assessment Act 1997 paragraph 8-1(2)(a)

Income Tax Assessment Act 1997 paragraph 8-1(2)(b)

Income Tax Assessment Act 1997 paragraph 8-1(2)(c)

Income Tax Assessment Act 1997 paragraph 8-1(2)(d)

Income Tax Assessment Act 1997 section 27-5

Further issues for you to consider

When claiming a deduction, you cannot claim the GST component of your expenses as a deduction if you can claim it as a GST credit on your business activity statement.

The extent to which the compensation payments are deductible under section 8-1 of the ITAA 1997 is subject to section 27-5 of the ITAA 1997 which denies a deduction for a loss or outgoing to the extent that it includes an amount relating to a GST credit to which the Estate is entitled.

Reasons for decision

All subsequent legislative references are to the ITAA 1997.

Questions 1 and 2

Summary

The compensation payments made by the Estate to the Tenant pursuant to the terms of the first Deed of Settlement, as varied, and the second Deed of Settlement are deductible under section 8-1.

Detailed reasoning

Section 8-1 contains the general rules for deductibility. It consists of both positive limbs (those provisions which set out the criteria necessary for a loss or outgoing to be deductible) and negative limbs (those provisions which set out exclusions from deductibility).

The positive limbs in subsection 8-1(1) state:

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

The negative limbs in subsection 8-1(2) state that 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 (the ITAA 1997) prevents you from deducting it.

To be deductible under section 8-1, the compensation payments must satisfy one of the positive limbs and not be excluded by any of the negative limbs.

Paragraph 8-1(1)(a)

Paragraph 8-1(1)(a) requires a sufficient connection between the expenditure and the gaining or producing of assessable income.

In order for expenditure to be an allowable deduction under this provision it must be incidental and relevant to the production of the taxpayer's assessable income. The High Court in Ronpibon Tin NL v Federal Commissioner of Taxation [1949] HCA 15; (1949) 78 CLR 47 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" means in the course of gaining or producing such income.

... 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 purpose of the payments made by the Estate to the Tenant pursuant to the terms of the first Deed of Settlement, as varied, was to compensate the Tenant for its inability to trade during the construction period. The purpose of the payments made by the Estate to the Tenant pursuant to the terms of the second Deed of Settlement was to compensate the Tenant in full and final satisfaction of the disputes between the parties at the time (for e.g. the need for particular fixtures and fittings of the Tenant to be installed or replaced).

The expenditure enabled the disputes between the parties to be settled, ensured that the Estate maintained good relations with its existing Tenant, ensured that the Tenant would retake possession of the Property and resume paying rental income to the Estate, and was incurred by the Estate as a direct consequence of being the landlord of the Property.

Therefore, the payments made by the Estate to the Tenant under both Deeds of Settlement are considered to have been incidental and relevant to the derivation of the Estate's assessable rental income and incurred in gaining or producing that income.

Where there is sufficient nexus to satisfy either of the positive limbs, it is then necessary to determine whether the expenditure will be excluded under any of the negative limbs[1].

Paragraph 8-1(2)(a)

Losses or outgoings of capital or of a capital nature are not deductible from assessable income under paragraph 8-1(2)(a). There is no statutory definition of 'capital' or 'capital nature'.

The leading Australian case on whether expenditure is considered 'capital' or 'revenue' is Sun Newspapers Limited v. FCT (1938) 61 CLR 337 (Sun Newspapers).

In Sun Newspapers Dixon J proposed a test that focuses on the taxpayer's profit-yielding structure. His Honour said (at 359):

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.

Critically, Dixon J stated that the following 3 factors need 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 regard or outlay to cover its use or enjoyment for periods commensurate with the payment or making a final provision or payment so as to secure future use or enjoyment.

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 that what it secures is necessary for the structure of the business.

Outgoings to secure or to enhance a structural asset (whether tangible or intangible) are of a capital nature, whereas expenditure on a revenue asset (for e.g. trading stock) is on revenue account.

In Herald & Weekly Times Ltd v FC of T (1932) 48 CLR 113 (the Herald & Weekly Times case) the taxpayer, the proprietor and publisher of an evening newspaper, claimed deductions for damages paid in respect of a defamatory matter published by the newspaper and the costs in connection with a related libel action. The High Court allowed the deductions as publishing the newspaper was both the source of income and the cause of the liability.

The principles established in the Herald & Weekly Times Case were applied in Case C12 (1952) 3 TBRD 100. In that case the trustees of a deceased estate let a city property to a number of tenants. A tenant's injured employee claimed damages against the trustees in respect of injuries they sustained on the rental premises. The Board, in allowing the trustees a deduction for the amount that they paid to settle the claim, stated that:

[the trustees] became liable... because they had let rooms to tenants...It was in the capacity of landlord that the outgoing was incurred...the expense incurred resulted from a risk which, to a landlord, is ever present...the expense claimed as a deduction was one which arose out of the letting of the building to tenants for the purpose of producing assessable income, and that it can properly be regarded as having been incurred 'in the course of' gaining or producing that assessable income...I cannot see that the outgoing produced "an enduring benefit" of any sort. I can see no justification...for capitalising the expense. It seems to me to be one which should properly be set against revenue account.

The compensation payments made by the Estate under both Deeds of Settlement are not considered to be capital in nature. Reasons for this include:

•                     In making the payments, the Estate did no more than was required to return all parties to their original positions; the benefit sought to be obtained from the payments was to not disturb the existing lease arrangements with the Tenant, but there was no discernible enduring benefit or advantage to be gained by the Estate from retaining the Tenant.

•                     In all exchanges, it was the Tenant who refused any course of action other than to remain in the Property and to maximise the term of their lease within the legal bounds of the lease arrangement; no amount of payments made by the Estate was in consideration for the addition of a further option to the lease and no benefit was sought by the Estate to enhance the value of the Property via the retention of the Tenant or any extension of their lease term. On the contrary, it is recognised that it was possible that the Estate could have obtained better lease terms at a more competitive rental by a new tenant upon the reconstruction of the property, and/or to alter the fit-out of the Property to be less tenant-specific, thereby widening the options for future tenancies and better rental yields.

•                     To end the lease in contravention of its terms would have resulted in a capital compensation to the Tenant for failing to adhere to the terms; thus continuing the lease with altered terms during a period when the building was unable to be safely occupied was within the ordinary course of a commercial rental arrangement, and not capital in nature.

•                     The reconstruction was a mere replacement of the existing structure, completed to the same dimensions, fit out and completed with contemporaneous materials of a kind that would represent a direct replacement of the structure prior to its demolition, and no more; no capital profit was anticipated and nor was it the intention to construct with a view to making a capital profit on eventual sale (as evidenced by the loss that was ultimately incurred on disposal).

•                     Had the structural defects in the building not occurred, the relationship between the Estate (as landlord) and the Tenant would have carried on in the normal course of business with no view to making improvements or modifications to the Property, and to have disposed of the Property and realised the assets of the Estate in accordance with Individual A's Will and the wishes of the beneficiaries; as such, no enduring benefit or advantage was sought by the Estate in dealing with the Tenant during the period of administration.

Accordingly, the deductibility of the compensation payments incurred by the Estate are not excluded by any of the negative limbs.

Timing of deductions

There is no statutory definition of the term 'incurred'. As a broad guide, Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions (TR 97/7) confirms (at paragraph 5) that you incur an outgoing at the time you owe a present money debt that you cannot escape, subject to the propositions developed by the courts which help to outline the scope of the definition of incurred, as listed in paragraph 6 of TR 97/7:

(a)           a taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitively committed in the year of income. Accordingly, a loss or outgoing may be incurred within section 8-1 even though it remains unpaid, provided the taxpayer is 'completely subjected' to the loss or outgoing. That is, subject to the principles set out below, it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum;

(b)           a taxpayer may have a presently existing liability, even though the liability may be defeasible by others;

(c)           a taxpayer may have a presently existing liability, even though the amount of the liability cannot be precisely ascertained, provided it is capable of reasonable estimation (based on probabilities);

(d)           whether there is a presently existing liability is a legal question in each case, having regard to the circumstances under which the liability is claimed to arise;

(e)           in the case of a payment made in the absence of a presently existing liability (where the money ceases to be the taxpayer's funds) the expense is incurred when the money is paid.

The compensation payments to the Tenant pursuant to terms of the first Deed of Settlement, as varied, were subject to the Tenant's inability to trade and, for the purposes of section 8-1, were incurred by the Estate at the time they were paid (across the 20XX and 20XX income years).

The compensation payments to the Tenant pursuant to terms of the second Deed of Settlement were not contingent in any way and represented a presently existing liability to which the Estate was definitively committed at the time the Deed was executed on XX 20XX. Therefore, for the purposes of section 8-1, these compensation payments were incurred by the Estate in the 20XX income year.

[1] The exclusions under paragraphs 8-1(2)(b), (c) and (d) are not relevant to these circumstances and are not addressed in this ruling.