Private ruling: Blackhole expenditure
Published: March 2014
Ruling period: Year ended 30 June 2014
Date scheme commenced: 1 July 2013

Ruling: Q1: Is expenditure incurred in the drafting of both a shareholders agreement and services agreement preliminary business capital expenditure and deductible for tax purposes over five years under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes

Relevant facts and circumstances: You incurred legal fees in drafting both a shareholders agreement and services agreement between you (the company) and your new shareholders. The agreements set out how you conduct business and your dealings with your shareholders.

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

Reasons for decision: Summary: Subsection 40-880(1) of the ITAA 1997 provides a deduction over five years for certain business capital expenditure that are incurred on or after 1 July 2005 if: (a) the expenditure is not otherwise taken into account; and (b) a deduction is not denied by some other provision, and (c) the business is, was or is proposed to be carried on for a taxable purpose. Subsection 40-880(2) of the ITAA 1997 states: 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. Loss or outgoing of capital or of a capital nature In relation to the issue of determining whether expenditure is of a revenue or capital nature, the decision of the High Court of Australia in Sun Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 ( Sun Newspapers ) is the leading authority. In Sun Newspapers , Dixon J stated that there are three matters to be considered when deciding whether expenditure incurred is revenue or capital. They are: i) the character of the advantage sought by the outgoing; ii) the manner in which the advantage is to be used, relied upon or enjoyed by the taxpayer; and iii) the means adopted to obtain the advantage, such as by recurring payments. The character of the advantage sought provides the best guidance as to the nature of the expenditure because it says the most about the essential character of the expenditure itself. The decision of the High Court in G P International Pipecoaters Pty Ltd v Commissioner of Taxation (1990) 170 CLR 124 at 137 emphasised this stating: The character of expenditure is ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure. For 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: Sun Newspapers Ltd. and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 at 363… The advantage that the company sought in making the payment was to discharge their obligation for legal expenses incurred in drafting their shareholders agreement and services agreement. The payment was made in respect of their business structure and how they conduct their business. The payment therefore is capital in nature and cannot be deducted under section 8-1 of the ITAA 1997 on this basis and that it was not necessarily incurred in carrying on the business for the purpose of producing assessable income. It is necessary to consider the legislative context of subsection 40-880(2) of the ITAA 1997 in order to determine whether there is a sufficient and relevant connection between the incurrence of the expenditure and a particular business. In discussing the types of business capital expenditure to which subsection 40-880(2) applies, paragraphs 2.19 and 2.20 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 (EM) state: 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 [emphasis added]. 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 (or used to or proposes to carry 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) of the ITAA 1997. 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 expression 'in relation to' denotes the proximity required between the expenditure on the one hand and the former, current or proposed business on the other. Establishing that the expenditure is in relation to the relevant business is the threshold step in determining whether the expenditure can be deducted under one of these paragraphs. At paragraph 76 of Taxation Ruling TR 2011/6 it notes that: The legislation does not define the expression 'in relation to' and so it takes its ordinary meaning. The Macquarie Dictionary Pty Ltd, NSW, defines 'related' as 'associated; connected'. Accordingly, the expenditure and the business need to be associated or connected for the expenditure to be described as 'in relation to' the business. 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. In considering the phrase 'in relation to' contained within subsection 40-880(2) of the ITAA 1997, paragraph 2.25 of the EM 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 use of the expression 'in relation to' in subsection 40-880(2) of the ITAA 1997 rather than 'in carrying on' or the preposition 'on' to qualify the closeness of the required connection indicates that Parliament intended there to be greater latitude in the connection that needs to exist. The phrase 'in relation to' was considered 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. In paragraphs 78 and 79 of TR 2011/6 it is concluded that: The legislative context of 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 genuine business expense of a particular business. …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. By making the payment for the legal fees, the company has incurred an expense, on the drafting of the two agreements, to satisfy the need of their business to advise new shareholders of their rights and obligations. Since the scope of subsection 40-880 (2) of the ITAA 1997 is broad, it could therefore be said that the capital expenditure was incurred in relation to the company's business. Subsections 40-880(3) and 40-880(4) of the ITAA 1997 both contain a 'taxable purpose test' which applies to the expenditure identified in subsection 40-880(2) by reference to the extent to which it relates to carrying on a business for a taxable purpose. Taxable purpose is defined in section 40-25 of the ITAA 1997 and as is relevant means at paragraph 40-25(7)(a) 'the purpose of producing assessable income'. The company has continued to operate its business. Therefore, the business was and is carried on for a taxable purpose. The ways in which expenditure can be otherwise taken into account as listed in subsections 40-880(5) to (8) of the ITAA 1997 have been taken into account and are discussed below. In relation to subsection 40-880(5) of the ITAA 1997, we have considered each paragraph: (a) the expenditure does not form part of a depreciating asset that the company used to hold; (b) we have established that the amount cannot be deducted under another provision of the ITAA 1997; (c) the amount paid does not form part of the cost of land; (d) it is not in relation to a lease or other legal or equitable right. Leases and rights are essentially arrangements for transferring some or all of the benefits of ownership of an asset from the owner to the recipient of the lease or right. This has not happened by the payment of the amount by the company for legal expenses; (e) apart from section 40-880 of the ITAA 1997 the amount would not be taken into account in working out the taxpayer's assessable income or loss; (f) the payment will not be taken into account in working out the amount of a capital gain or a capital loss; (g) there is no provision that would make the amount non-deductible if it was not capital; (h) no provision of the ITAA 1997 other than this section prevents the expenditure being taken into account as described in paragraphs (a) to (f) for a reason other than the expenditure being of a capital nature; (i) the expenditure is not domestic or private in nature; and (j) it was not incurred in gaining or producing exempt income or non-assessable non-exempt income. Subsections 40-880(6) to (8) of the ITAA 1997 are not applicable. Subsection 40-880(9) is also not applicable as the expenditure was not a return on or of equity or debt interest to another entity. Conclusion Legal expenditure incurred by the company on the preparation of a draft shareholders agreement and services agreement relates to outlining both the structure and the business of a company. Both the shareholders agreement and the services agreement seek to define the manner in which the legal entity is owned and to its trading operations. In such circumstances, there is a sufficient and relevant connection between a company's incurrence of such expenditure and the structure of the company and its business. Accordingly, the capital expenditure on the legal fees by the company for drafting a shareholders agreement and services agreement is capital expenditure incurred in relation to a business for the purposes of paragraph 40-880(2)(a) of the ITAA 1997. To conclude, you may deduct your legal expenses incurred in the preparation of your draft shareholders agreement and services agreement over five years under section 40-880 of the ITAA 1997. You can deduct 20% of the expenditure in the year you incurred the expenditure and in each of the following four years.