Private ruling: Business capital expenditure - section 40-880 of the Income Tax Assessment Act 1997
Date of advice: 15 October 2018
Published: December 2018

Ruling: Q1: Is the expenditure which ABC incurred deductible under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes, to the extent the expenditure is not on in-house software, nor expenditure that forms part of a cost base of a CGT asset. | Q2: Is the expenditure which ABC incurred for certain legal expenses deductible under section 40-880 of the ITAA 1997? | A2: Yes, to the extent the expenditure does not form part of a cost base for a CGT asset.

Relevant facts and circumstances: The Entities CBC CBC is a company originally founded in a foreign country and is listed on a foreign stock exchange. CBC operates in the financial services arena in various countries. CBC disclosed total income in a recent Annual Report which exceeds A$25 million. ABC Pty Ltd ABC Pty Ltd (‘ABC’) was established a couple of years ago as a tax resident of Australia and is a wholly-owned subsidiary of ICI. ICI is incorporated in a foreign jurisdiction, and is in turn a wholly-owned subsidiary of CBC. ABC was established and funded by ICI as a holding structure to partner with an unrelated Australian entity, AustCo, to start up a new financial services business in Australia. AAA Pty Ltd (‘AAA’) and DBC Pty Ltd (‘DBC’) were also established as part of this process. ABC holds over 40% of each of AAA and DBC. ABC will derive assessable income from its investment in DBC through the receipt of dividends from AAA. AAA Pty Ltd (AAA) AAA is a tax resident of Australia which was established for the purpose of investing in DBC. DBC Pty Ltd (DBC) DBC is a tax resident of Australia. DBC was established to run a financial services business in Australia. DBC will derive assessable income from these activities. At the time the expenditure was incurred by ABC, DBC was not established or had not yet commenced its business. DBC could not be established until certain ‘conditions precedent’ were met. The Transactions 1) Costs incurred to establish DBC ABC incurred several costs to establish the DBC’s business. This included expenditure for the shareholders agreements. All of the costs were initially invoiced by the third-party service providers to AustCo. Some of the costs were incurred on the development of DBC’s commercial website. In accordance with the relevant shareholders agreement, AustCo then invoiced ABC for ABC’s share of the third-party fees. Apart from a statutory licence, none of this expenditure related to other licences. DBC was subsequently granted a licence to operate a financial services business. Staff from both AustCo and FinServ worked on the project on a full time basis. Each party was to fund the costs’ in accordance with its respective share. FinServ and various other providers invoiced AustCo, and then AustCo in turn invoiced ABC for its share. Each party to the shareholder agreements carried its own costs for drafting the agreements. AAA’s share of the costs were initially invoiced to AustCo which on-charged a portion of the costs to ABC. 2) Costs incurred to draft various agreements ABC incurred legal costs to draft the various agreements. The legal services were provided by a law firm. The legal costs were invoiced to ICI which in turn raised an invoice to ABC for the costs. Other Matters Licences and Intellectual Property There are no licences of intellectual property (‘IP’), however the agreements allow for a grant of non-exclusive licenses to use certain IP in carrying on the business. There is no income generated from the non-exclusive licence.

Relevant legislative provisions: Income Tax Assessment Act 1997 subsection 40-25(7) | Income Tax Assessment Act 1997 subsection 40-880(1) | Income Tax Assessment Act 1997 subsection 40-880(2) | Income Tax Assessment Act 1997 paragraph 40-880(2)(c) | Income Tax Assessment Act 1997 subsection 40-880(2A) | Income Tax Assessment Act 1997 subsection 40-880(4) | Income Tax Assessment Act 1997 paragraph 40-880(4)(a) | Income Tax Assessment Act 1997 subsection 40-880(5) | Income Tax Assessment Act 1997 paragraph 40-880(5)(a) | Income Tax Assessment Act 1997 paragraph 40-880(5)(b) | Income Tax Assessment Act 1997 paragraph 40-880(5)(c) | Income Tax Assessment Act 1997 paragraph 40-880(5)(d) | Income Tax Assessment Act 1997 paragraph 40-880(5)(e) | Income Tax Assessment Act 1997 paragraph 40-880(5)(f) | Income Tax Assessment Act 1997 paragraph 40-880(5)(g) | Income Tax Assessment Act 1997 paragraph 40-880(5)(h) | Income Tax Assessment Act 1997 paragraph 40-880(5)(i) | Income Tax Assessment Act 1997 paragraph 40-880(5)(j) | Income Tax Assessment Act 1997 subsection 40-880(6) | Income Tax Assessment Act 1997 subsection 40-880(7) | Income Tax Assessment Act 1997 subsection 40-880(8) | Income Tax Assessment Act 1997 subsection 40-880(9) | Tax Laws Amendment (2006 Measures No.1) Act 2006 section 3 and Schedule 2 item 51(1)

Reasons for decision: Summary: To the extent the expenditure is not on in-house software or expenditure that forms part of a cost base for a CGT asset, ABC is entitled to deductions under section 40-880 for business capital expenditure. The requirements in subsections 40-880(2) and (4) were satisfied, and the requirements of subsections 40-880(5) to 40-880(9) do not apply. The expenditure is deductible under section 40-880 in equal proportions over a period of five (5) income years starting in the year of income in which ABC incurred the expenditure. | Detailed Reasoning - Detailed reasoning: Subsection 40-880(2) Subsection 40-880(2) states 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: … (c) in relation to a business proposed to be carried on; or … In ABC’s circumstances, paragraph 40-880(2)(c) is relevant, as the expenditure ABC incurred was in relation to the financial services business which at the time was proposed to be carried on by DBC. Subsection 40-880(2A) Deduction Subsection 40-880(2A) provides that you can deduct the entire amount of the capital expenditure in the income year in which you incur it if: (a) the expenditure is incurred in relation to a business that is proposed to be carried on; and (b) the expenditure is incurred: (i) in obtaining advice or services relating to the proposed structure, or proposed operation of the business; or (ii) in payment to an *Australian government agency of fees, taxes or charges relating to establishing the business or its operating structure; and (c) you are a *small business entity for the income year, or both of the following apply: (i) you are not carrying on a *business in the income year; (ii) you are not *connected with, or an *affiliate of, another entity that carries on a business in the income year and that is not a small business entity for the income year. ABC incurred the expenditure in relation to the financial services business that was proposed to be carried on by DBC. The expenditure was incurred for a business that was proposed to be carried on and included obtaining legal advice and other services relating to the proposed structure and the proposed operation of the business. Therefore the requirements of paragraph 40-880(2A)(a) and subparagraph 40-880(2A)(b)(i) are satisfied. Meaning of small business entity Turning to paragraph 40-880(2A)(c), subsection 995-1(1) states that the term ‘small business entity’ has the meaning given by section 328-110. Subsection 328-110(1) states you are a small business entity for an income year (the current year) if: You are a small business entity for an income year (the current year ) if: (a) you carry on a *business in the current year; and (b) one or both of the following applies: (i) you carried on a business in the income year (the previous year ) before the current year and your *aggregated turnover for the previous year was less than $10 million; (ii) your aggregated turnover for the current year is likely to be less than $10 million. Meaning of aggregated turnover Subsection 328-115(1) provides that your aggregated turnover for an income year is the sum of the relevant annual turnovers (as set out in subsection 328-115 (2)) excluding any amounts covered by subsection 328-115 (3). Subsection 328-115(2) provides that the: … relevant annual turnovers are: (a) your *annual turnover for the income year; and (b) the annual turnover for the income year of any entity (a relevant entity ) that is *connected with you at any time during the income year; and (c) the annual turnover for the income year of any entity (a relevant entity ) that is an *affiliate of yours at any time during the income year. Meaning of connected with an entity Subsection 328-125(1) states that an entity is connected with another entity if: (a) either entity controls the other entity in a way described in this section; or (b) both entities are controlled in a way described in this section by the same third entity. ‘Control’ is defined in subsection 328-125(2) and includes: ● owning interests in another entity which carry a right to receive at least 40% of dividend or capital distributions, or ● owning equity interests in a company that carry a right to exercise at least 40% of the voting power in the company. ABC is controlled by CBC as CBC wholly-owns ABC. Therefore, paragraph 328-125(1)(a) operates such that the annual turnover of CBC is taken into account in the calculation of CBC’s relevant annual turnover; paragraph 328-115(2)(b). As the annual turnover of CBC exceeds $25 million, neither subparagraph 328-110(1)(b)(i) nor and subparagraph 328-110(1)(b)(ii) are satisfied, and accordingly ABC is not a small business entity under subsection 328-110(1). As ABC is not a small business entity under subsection 328-110(1), the requirements of paragraph 40-880(2A)(c) are not satisfied, and ABC is ineligible to deduct the capital expenditure entirely in the income year in which ABC incurred the expenditure. Subsection 40-880(3) - taxable purpose requirement Subsection 40-880(3) states 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 relevant business is or was proposed to be carried on by DBC. Therefore, subsection 40-880(3) is not relevant in the circumstances of ABC’s expenditure in this matter. Subsection 40-880(4) Subsection 40-880(4) states that: You can only deduct the expenditure, for a *business that another entity used to carry on or proposes to carry on, to the extent that: (a) the business was carried on or is proposed to be carried on for a *taxable purpose; and (b) the expenditure is in connection with: (i) your deriving assessable income from the business; and (ii) the business that was carried on or is proposed to be carried on. Subsection 995-1(1) states that ‘taxable purpose’ has the meaning given by section 40-25. Section 40-25 Taxable purpose - meaning. Relevantly, paragraph 40-25(7)(a) provides that a ‘taxable purpose’ is: (a) the *purpose of producing assessable income; or … ABC will derive assessable income from its investment in DBC through the receipt of dividends from AAA on equity interests owned in DBC which will in turn fund dividends to its shareholders including ABC. Therefore, the requirement of paragraph 40-25(7)(a) is satisfied. In ABC’s circumstances, as the business of DBC was proposed to be carried for a taxable purpose, the paragraph 40-880(4)(a) requirement is satisfied. Further, the expenditure is in connection with ABC deriving assessable income by way of dividends which will flow indirectly from DBC’s proposed business. Therefore the paragraph 40-880(4)(b) requirement is satisfied. Accordingly, ABC satisfies the requirements of subsection 40-880(4). Subsection 40-880(5) Subsection 40-880(5) provides that: You cannot deduct anything under this section for an amount of expenditure you incur to the extent that: (a) it forms part of the *cost of a *depreciating asset that you *hold, used to hold or will hold; or (b) you can deduct an amount for it under a provision of this Act other than this section; or (c) it forms part of the cost of land; or (d) it is in relation to a lease or other legal or equitable right; or (e) it would, apart from this section, be taken into account in working out: (i) a profit that is included in your assessable income (for example, under section 6-5 or 15-15 ); or (ii) a loss that you can deduct (for example, under section 8-1 or 25-40 ); or (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; or (g) a provision of this Act other than this section would expressly make the expenditure non-deductible if it were not of a capital nature; or (h) a provision of this Act other than this section expressly 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; or (i) it is expenditure of a private or domestic nature; or (j) it is incurred in relation to gaining or producing *exempt income or *non-assessable non-exempt income. The expenditure is not on ‘one item’, but rather is the total of various expenditures for various items. For subsection 40-880(5), it is important to consider the expenditure for each item. Subsection 40-880(5) ensures that section 40-880 operates as a provision of last resort. Where expenditure on an item is deductible under another provision of Australian Income Tax legislation, forms part of the cost of a depreciating asset, forms part of the cost base of a CGT asset, and so on, the expenditure on that item will not be deductible under section 40-880 in accordance with subsection 40-880(5). As DBC had not commenced business when ABC incurred the items of expenditure, the items of expenditure were incurred ‘at a point too soon’ to enable ABC a general deduction for the items of expenditure under section 8-1. The items of expenditure are also not deductible under another specific deduction provision (other than section 40-880), and do not obtain tax recognition elsewhere in Australian income tax legislation, with exceptions for the extent that the items are for the commercial website (discussed below). In ABC’s circumstances, some of the costs incurred to establish DBC were incurred on the development of DBC’s commercial website. Paragraph 52 of Taxation Ruling TR 2016/3 Income tax: deductibility of expenditure on a commercial website (‘TR 2016/3’) sets out the Commissioner’s view that section 40-880 will generally not apply to allow deductions for capital expenditure on commercial websites as it is usually ‘in-house software’ and, if not, is likely to be part of the cost base of a CGT asset. Accordingly, to the extent that part of the costs incurred to establish DBC is expenditure on ‘in-house software’ or is included in the cost base of a CGT asset, the subsection 40-880(5) requirement applies to deny the deduction under section 40-880 for that item. This does not operate to limit or deny ABC’s entitlement to a deduction for the remaining part of the expenditure incurred to establish DBC under section 40-880. Subsections 40-880(6), 40-880(8) and 40-880(9) are not relevant to ABC’s circumstances. Subsection 40-880(7) Subsection 40-880(7) states that you cannot deduct an amount under paragraph 40-880(2)(c): … in relation to a *business proposed to be carried on unless, having regard to any relevant circumstances, it is reasonable to conclude that the business is proposed to be carried on within a reasonable time. In ABC’s circumstances, the Commissioner accepts that the business which DBC proposed to carry on commenced within a reasonable time. Accordingly, ABC satisfies the requirements of subsection 40-880(7). | Summary: To the extent the expenditure does not form part of a cost base of a CGT asset, ABC is entitled to deductions for the legal expenses under section 40-880 as business capital expenditure. The requirements in subsections 40-880(2) and (4) were satisfied, and the requirements of subsections 40-880(5) to 40-880(9) do not apply. The expenditure is deductible under section 40-880 in equal proportions over a period of five (5) income years starting in the year of income ABC incurred the expenditure. | Detailed Reasoning - Detailed reasoning: Subsection 40-880(2) Subsection 40-880(2) states 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: | Detailed Reasoning - …: (c) in relation to a business proposed to be carried on; or … In ABC’s circumstances, paragraph 40-880(2)(c) is relevant, as the expenditure ABC incurred was in relation to the financial services business which at the time was proposed to be carried on by DBC. Subsection 40-880(2A) For the same reasons as set out in the Detailed reasoning for subsection 40-880(2A) in Question 1 above, ABC is ineligible to deduct the capital expenditure entirely in the income year in which ABC incurred it. Subsection 40-880(3) - taxable purpose requirement For the same reasons as set out in the Detailed reasoning for subsection 40-880(3) in Question 1 above, subsection 40-880(3) is not relevant in the circumstances of ABC’s expenditure in this matter. Subsection 40-880(4) For the same reasons as set out in the Detailed reasoning for subsection 40-880(4) in Question 1 above, ABC satisfies the requirements of this subsection. Subsection 40-880(5) Subsection 40-880(5) is quoted in full in the Detailed reasoning for this subsection in Question 1 above. Most of the analysis in the Detailed reasoning for this subsection in Question 1 above is relevant for the various items of expenditure making up the legal expenses (with the exception of the discussion on items of expenditure on the commercial website). To the extent that an item of the legal costs is expenditure that is included in, or forms part of, the cost base of a CGT asset, the subsection 40-880(5) requirement applies to deny the deduction under section 40-880 for that item. In particular, to the extent the item of expenditure is for drafting clauses in the shareholder agreements and / or for granting the non-exclusive licence, that extent forms part of the cost base of a CGT asset (being the non-exclusive licence), This does not operate to limit or deny ABC’s entitlement to a deduction for the remaining part of the expenditure under section 40-880. Subsections 40-880(6), 40-880(8) and 40-880(9) are not relevant to ABC’s circumstances. Subsection 40-880(7) For the same reasons as set out in the Detailed reasoning for subsection 40-880(7) in Question 1 above, ABC satisfies the requirements of this subsection.

Reasons for decision: All legislative references are to the Income Tax Assessment Act 1997 (ITAA1997) unless otherwise specified.