ATO ID 2010/132: Capital allowances: business related costs - expenditure in relation to a proposed business
Date of decision: 17 June 2010
Year of income: Year ended 30 June 2010
Business line: Private Groups and High Wealth Individuals

Issue
Is the capital expenditure incurred by the taxpayer 'in relation to a business proposed to be carried on' for the purposes of paragraph 40-880(2)(c) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision
No. The capital expenditure is not incurred 'in relation to a business proposed to be carried on' for the purposes of paragraph 40-880(2)(c) of the ITAA 1997 as there is not a sufficient and relevant connection between the taxpayer's incurrence of the expenditure and the proposed business. The object of the expenditure was to discharge the taxpayer's personal contractual obligations rather than to serve a need or object of the proposed business.

Facts
The taxpayer was employed under an employment contract for a fixed term. The taxpayer terminated the contract before the end of the term so that he could commence carrying on a business. As a consequence of terminating the contract early, the taxpayer was liable to pay compensation to his employer and he incurred capital expenditure to satisfy this liability.

Reasons for decision
Summary: All legislative references are to the ITAA 1997. Subject to the limitations and exceptions contained in subsections 40-880(3) to (9), paragraphs 40-880(2)(a), (b) and (c) allow a deduction for capital expenditure you incur in relation to your business, or in relation to a business that used to be carried on or a business that is proposed to be carried on. Subsection 40-880(1) describes the object of section 40-880 to make certain business capital expenditure deductible over five years. The expression 'business capital expenditure' connotes capital expenditure that has the essential character of business expenditure. This is confirmed by paragraph 2 25 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 (EM to the Bill) which notes: 'The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business'. The words 'in relation to' indicate that the expenditure in question must be sufficiently relevant to the current, former or proposed business to impress on it the character of a business expense of that particular business. The legislation does not define the expression 'in relation to' and so it takes its ordinary meaning. The Macquarie Dictionary defines 'related' as 'associated; connected'. Accordingly, the expenditure and the business need to be associated or connected for the expenditure to be described as being 'in relation to' the business. However, although the phrase 'in relation to' uses wide words of connection, the intended width of the relationship between the two connected subjects must be considered against their legislative context. This principle of interpretation was applied by the High Court in PMT Partners Pty Ltd (In Liquidation) v. Australian National Parks & Wildlife Service (1995) 184 CLR 301. Brennan CJ, Gaudron and McHugh JJ observed, in considering the application of the Commercial Arbitration Act 1985 (NT ), at 313: Inevitably, the closeness of the relation required by the expression 'in or 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. The legislative context of section 40-880 indicates that the closeness of the association or connection must objectively support the conclusion that the expenditure is a business expense of the particular business. This is the same idea conveyed by the then Treasurer in media release no. 045 on 10 May 2005 that announced a systemic tax treatment for 'legitimate business expenses, known as blackhole expenditures.' The adjective 'legitimate' emphasises that the expenditure in question must be a genuine business expense of a particular proposed, current or former business. Whether capital expenditure is truly a business expense turns on the particular facts and circumstances and is a matter of impression and judgement. 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. The EM to the Bill at paragraph 2 26 gives the following examples of the type of expenditure that has the requisite connection with a proposed business for the purposes of paragraph 40-880(2)(c): There are various pre-business expenses that would be incurred 'in relation to' a proposed business. These include, but are not limited to, expenditures to investigate the viability of the business (eg, feasibility studies or market research), establishment costs (such as the costs of establishing the business structure), or expenses that are a necessary precedent to the business being carried on (costs of market testing or putting in a tender). These categories of expenditure demonstrate an immediate connection with the proposed business in the sense that the expenditure is directed to meeting an objective or requirement that arises out of the proposed business. Feasibility studies and market testing, for example, provide information in the context of making commercial decisions about the scope and focus of the business that is proposed. Similarly, the cost of establishing the business structure is directly related to the proposed business because it is an integral step in being able to carry on the business operations. In contrast, the expenditure to compensate for the early termination of the employment contract does not have the character of an expense that satisfies an objective or requirement of the business. Rather, the payment was made to satisfy the taxpayer's personal obligations under his employment contract. The purpose of the payment was to discharge the taxpayer from his obligation to perform the contract. The expenditure is relevantly related to the employment contract, not to the proposed business. By ending the employment relationship the taxpayer was able to carry on a business without being in breach of his contractual obligations. Although in this sense there is a connection between the expenditure and the proposed business, it is not a connection that is sufficiently close to satisfy the description of being 'in relation to' the proposed business. The necessary connection is not established merely because the payment would not have been made but for the decision to commence carrying on a business. The compensation payment cannot be characterised as expenditure that serves a need or object of the proposed business. That is, the expenditure is not an expense of the business the taxpayer proposes to carry on. It is not directed to meeting the anticipated commercial requirements of the proposed business. Rather, its purpose is to free the taxpayer from the contractual obligation that would otherwise prevent him from carrying on his own business. In the circumstances, there is not a sufficient and relevant connection between the taxpayer's incurrence of the expenditure on the compensation payment and the proposed business. Accordingly, the expenditure is not incurred in relation to the proposed business for the purposes of paragraph 40-880(2)(c). The expenditure cannot be deducted under section 40-880.

Legislative references: Income Tax Assessment Act 1997 section 40-880 subsection 40-880(1) paragraph 40-880(2)(a) paragraph 40-880(2)(b) paragraph 40-880(2)(c) subsection 40-880(3) subsection 40-880(4) subsection 40-880(5) subsection 40-880(6) subsection 40-880(7) subsection 40-880(8) subsection 40-880(9)
Case references: PMT Partners Pty Ltd (In Liquidation) v Australian National Parks & Wildlife Service (1995) 184 CLR 301
Other references: Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 The Macquarie Dictionary, 2001 , rev. 3rd edn, The Macquarie Library Pty Ltd, NSW
Subject references: Blackhole expenditure Capital Allowances CoE Capital expenditure