Private ruling: Income tax deduction of legal and transactional costs
Date of advice: 1 December 2016
Published: May 2017
Ruling period: 1 July 201X to 30 June 201Y
Date scheme commenced: 1 July 201X

Ruling: Q1: Will the Relevant Expenses be deductible to the Taxpayer under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes.

Relevant facts and circumstances: The Taxpayer is the holding company and head company of a tax consolidated group. The group manufactures, sells and distributes its products into Australian and foreign markets. Management of the Taxpayer formed the view that the Taxpayer had reached a position where the Taxpayer would be better placed under new ownership, in particular a multi-national enterprise. The Taxpayer appointed a service provider to provide the Taxpayer with financial advice and assistance, which included evaluating potential acquirers. The Acquirer made a non-binding offer to acquire 100% of shares in the Taxpayer. Other non-solicited offers were also received by the shareholders to acquire 100% of the group. The Taxpayer also appointed a law firm to act as legal and tax advisers with respect to this sale process. A share sale agreement between the shareholders and the Acquirer was executed. The Taxpayer has incurred various transaction costs in connection with the sale to the Acquirer ('Relevant Expenses'). These expenses were provided in the Taxpayer's application for the private binding ruling. The Taxpayer's understanding is that the Acquirer intends to continue to operate the business of the Taxpayer in substantially the same manner in which it is currently operated by the management team, with no change to the current business plan and strategy as devised by the management team. The Taxpayer further understands that the Acquirer has no intention to transfer any current business or make any material changes to the business arrangements within the group. The Taxpayer does not derive any non-assessable non-exempt income or any exempt income in connection with its business.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 40-880.

Reasons for decision: Summary: Section 40-880 of the ITAA 1997 applies to certain business expenditure of a capital nature incurred on or after 1 July 2005. | Detailed Reasoning - Capital business expenditure: The leading judgement on whether an outgoing is capital or capital in nature is Dixon J's judgement in Sun Newspapers Ltd v FC of T (1936) 61 CLR 337. In that case, Dixon J held that: 'The distinction between expenditure and outgoings on revenue account and capital account corresponds with the distinction between the business entity, structure, or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss.' The Relevant Expenses which were incurred by the Taxpayer to facilitate the acquisition of shares in the Taxpayer by the Acquirer go towards the Taxpayer's business structure or towards the ownership of the business structure. Therefore they are capital expenses. Moreover, the expenses were not incurred as part of the Taxpayer's normal business operations or the continuous process by which the Taxpayer derives its income. | Detailed Reasoning - In relation to your business: Subject to the limitations and exceptions contained in subsection 40-880(3) to (9), subsection 40-880(2) provides that you can deduct, in equal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur: (a) in relation to your business, 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) to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business. The Relevant Expenses, the subject of this ruling, relates to the acquisition of the Taxpayer, which undertakes a range of activities. These activities form the combined business of the Taxpayer group and are considered the relevant business for the purposes of section 40-880. The Taxpayer group continued to carry on its activities and business throughout the transaction. Accordingly, paragraph 40-880(2)(b) does not apply as the capital expenditure was not incurred in relation to a business that used to be carried on. It was stated that the Acquirer intends to continue the business of the Taxpayer and not make any major changes to that business and to continue in accordance with the Taxpayer's existing strategy. As no new business was proposed to be carried on by the Taxpayer, paragraph 40-880(2)(c) has no application. Further, paragraph 40-880(2)(d) does not apply on the facts. The relevant paragraph to be considered is 40-880(2)(a). For a deduction to be allowable under paragraph 40-880(2)(a) you must incur capital expenditure 'in relation to' your business. In interpreting the phrase 'in relation to' in paragraph 40-880(2)(a) and subsection 40-880(2) generally, paragraph 2.25 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 states: 'The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business. The concept used to establish this character or requisite relationship between the expenditure incurred by the taxpayer and the business carried on (current, past or prospective) is 'in relation to'. The connector 'in relation to' allows the appropriate latitude to enable the deductibility of qualifying capital expenditure incurred before the business commences or after it has ceased.' The phrase 'in relation to' was considered by the High Court in PMT Partners Pty Ltd (In Liquidation) v Australian National Parks and 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.' In that case, Toohey and Gummow JJ also observed: 'It is apparent that the words 'in or in relation to' are particularly wide. … Cases concerning the interpretation of this phrase in other statutory contexts are of limited assistance. However, the cases do show that the words are prima facie broad and designed to catch things which have sufficient nexus to the subject. The question of sufficiency of nexus is, of course, dependent on the statutory context… The connection which is required by the phrase 'in relation to' is a question of degree. There must be some "association" which is "relevant" or "appropriate". The question of the relevance or appropriateness of the connection is a question which cannot be divorced from the particular statutory context.' In First Provincial Building Society Limited v FC of T 95 ATC 4145; 30 ATR 207, Hill J considered the phrase 'in relation to' within the context of paragraph 26(g) of the Income Tax Assessment Act 1936 . He considered the words 'in relation to' in that context included a relationship that may either be direct or indirect, provided that the relationship consisted of a real connection, but that a merely remote relationship is insufficient. It is therefore necessary to consider the phrase 'in relation to' in the context of paragraph 40-880(2)(a) in order to determine whether there is a sufficient and relevant connection between the expenditure incurred and the Taxpayer'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 Measures No. 1) Bill 2006 states: 2.19. Expenditure on the structure by which an entity carries on (or used to or proposes to carry on) their business and on the profit yielding structure of the business would ordinarily be expected to be of a capital nature. Capital expenditure can also relate to a business's trading operations or the entity that will carry on the business. 2.20. The structure covers the legal entity (such as a company) or the legal relationship (such as a partnership or trust) that is the entity that carries on the business for a taxable purpose and that holds the business assets. These paragraphs indicate that capital expenditure incurred on the structure by which an entity carries on their business, on the profit yielding structure of the business, or relating to the business's trading operations, are capable of being described as capital expenditure incurred 'in relation to' that business for the purposes of subsection 40-880(2). Whether such capital expenditure is incurred 'in relation to' the particular business will depend on whether there is a sufficient and relevant connection between the incurring of the expenditure and that business on the facts of the particular case. The Taxpayer incurred capital expenditure in engaging professional and legal advisers to perform a variety of legal and other professional services. For this expenditure, the Taxpayer was provided with services and advice in respect of evaluation of the Acquirer and other potential acquirers' takeover bids and performing its statutory and fiduciary obligations arising from the takeover offer. In addition the Taxpayer also provided information to the Acquirer to allow a due diligence to be carried out. These were all activities which formed part of the process of the takeover bid by the Acquirer of the Taxpayer. The evaluation of the takeover bid required incurring expenditure in order to adequately consider the bid. The evaluation also involved an examination of how the proposal would affect the structure by which the Taxpayer carried on its business. A successful takeover bid would see all shares in the Taxpayer acquired by the Acquirer. Such a change to the holding of the Taxpayer would represent a change to the structure by which the Taxpayer's business would be carried on. On the facts of this case there is a sufficient and relevant connection between the Taxpayer's business and the incurrence of capital expenditure on legal and other professional advice. Accordingly, the Relevant Expenses the Taxpayer incurred is capital expenditure incurred in relation to its business for the purposes of paragraph 40-880(2)(a). As the Relevant Expenses that is the subject of this Ruling was incurred by the Taxpayer in relation to its business, any deduction the Taxpayer is entitled to under section 40-880 is subject to the limitations set out in subsection 40-880(3). | Detailed Reasoning - 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 Taxpayer carries on is carried on for a taxable purpose. The term 'purpose of producing assessable income' is further defined in subsection 995-1(1) of the ITAA 1997 as being: ● for the purpose of gaining or producing assessable income; or ● 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. The Taxpayer does not derive any exempt income or any non-assessable non-exempt income. Considering all the facts, at the time the Taxpayer incurred the Relevant Expenses, the Taxpayer was carrying on its business for a taxable purposes. As such subsection 40-880(3) will not apply to limit the taxpayer's deduction under section 40-880. | Detailed Reasoning - 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 Relevant Expenses incurred by the Taxpayer under section 40-880. Therefore, the Taxpayer is entitled to deduct the Relevant Expenses that it incurred in relation to the acquisition by the Acquirer in equal proportions over 5 income years from the time the expense was incurred pursuant to subsection 40-880(2).