Private ruling: Obtaining a deduction and input tax credits for blackhole expenditure
Date of advice: 3 October 2018
Published: November 2018
Ruling period: Year ended 30 June 201D | Year ended 30 June 201E
Date scheme commenced: 1 July 201C

Ruling: Q1: Are the Advisor Costs incurred by the X Co and Y Co in the years 30 June 201D and 30 June 201E deductible over five years under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes | Q2: Are X Co and Y Co entitled to claim input tax credits on the acquisitions comprising the Advisor Costs? | A2: Yes

Relevant facts and circumstances: Y Co was incorporated in 201B and is a manufacturer and supplier of food items in the Australian and Country A market places. Y Co is registered for goods and services tax (GST) effective since incorporation. X Co was incorporated in 200A and is a supplier of drink items in the Australian and Country A market places. X Co is registered for GST effective since incorporation. X Co and Y Co, whilst having an element of shareholder commonality, are treated and run as separate businesses and did not share a common parent entity until a transaction discussed below took place. X Co and Y Co (collectively, the Taxpayers or the Business), have experienced strong growth since their inception. As a result of this growth, unsolicited approaches were made to the shareholders of Y Co in 201C from investors acknowledging the strong business and growth potential. The directors of the Taxpayers made the decision to engage a strategic advisor in late 201C. The brief given to the strategic advisor was that an independent strategic review of the Taxpayers’ was needed to assist the directors to determine what direction they should take the Business in. The Taxpayers signed an engagement letter with the strategic advisor in late 201C. Following this review, the Taxpayers considered the options presented to them, being: ● sell all ownership interests in the Business to the highest bidder ● solicit offers from investors who would partner with the Business ● maintain the status quo and continue to grow taking on new funding options The directors of the Taxpayers decided that selling the Business was not their preferred option. As a result of the strategic review and the view of the directors, it was decided that a private equity investor would provide the best partner for growth for the Business. The directors therefore decided in late 201C to find a strategic partner to help grow the Business, which was Phase II of the strategic advisor engagement. The investor ultimately chosen was BOB Private Equity (BOB). The transaction with BOB (the Transaction) involved selling a portion of the original shareholders’ ownership interest in the Business. The Transaction was implemented by way of 100% of the shares in each of X Co and Y Co being acquired under a share purchase agreement for a combination of cash and scrip consideration. The original shareholders of the Business now hold a portion of the equity on issue in the ultimate holding company which indirectly acquired all of the shares in X Co and Y Co. The Taxpayers signed an engagement letter with a professional services firm in early 201D to assist the Taxpayers with the proposed sale of the shares in the Business. The Taxpayers also signed an engagement letter with a law firm in early 201D for legal services in connection with the restructure of the Business and the sale of the shares. The Taxpayers incurred various transaction costs (Advisor Costs). The Advisor Costs are summarised as follows: Service provider X Co Y Co Net fee GST Description of services Strategic advisor $$$$ $$$$ $$$$ $$$$ ● Perform strategic review of the Business – including analysing stand alone and combined business, preparing indicative valuation of X Co, Y Co and the combined business, compiling a list of potential investors/buyers, presentation of strategic review to the shareholders ● Undertaking the investment or sale process – including preparation of the Information Memorandum, initiating contact with potential investors/buyers, negotiate non-disclosure agreements with potential investors/buyers, marketing, investor/bidder selection, liaise with legal and tax advisers Law firm $$$$ $$$$ $$$$ $$$$ ● Legal services in relation to the restructure of the Business Professional services firm $$$$ $$$$ $$$$ $$$$ ● Perform financial and tax due diligence with respect to the disposal of X Co and Y Co. All income derived by the Business is assessable in Australia. The Taxpayers do not derive any exempt or non-assessable non-exempt income.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 40-880. | Income Tax Assessment Act 1997 subsection 40-880(2) | Income Tax Assessment Act 1997 paragraph 40-880(2)(a) | Income Tax Assessment Act 1997 subsection 40-880(3) | Income Tax Assessment Act 1997 subsection 40-25(7) | Income Tax Assessment Act 1997 subsection 995-1(1) | A New Tax System (Goods and Services Tax) Act 1999 section 11-5 | A New Tax System (Goods and Services Tax) Act 1999 section 11-15 | A New Tax System (Goods and Services Tax) Act 1999 section 11-20

Reasons for decision: Detailed Reasoning - Issue 1: Blackhole expenditure | Summary: A deduction is allowable over five years under section 40-880 for the Advisor Costs incurred by the Taxpayers. | Detailed Reasoning - Detailed reasoning: 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 judgment on whether an outgoing is capital or capital in nature is Dixon J’s judgment 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 Advisor Costs were incurred by the Taxpayers to facilitate a strategic review of the Business and the ultimate restructure of the Business. These expenses relate to the Taxpayers’ business structure or the ownership of that structure and were not incurred as part of the Taxpayers’ normal business operations or the continuous process by which the Taxpayers derive their income. Therefore, the Advisor Costs are capital expenses. | Detailed Reasoning - In relation to your business: Subject to the limitations and exceptions contained in subsections 40-880(3) to (9), subsection 40-880(2) provides that you can deduct, in equal proportions over a period of five income years starting in the year in which you incur it, capital expenditure you incur: (a) in relation to your business (b) in relation to a business that used to be carried on (c) in relation to a business proposed to be carried on (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. In identifying, for the purposes of subsection 40-880(2), the business that is most relevant to the expenditure, Tax Ruling TR 2011/6 Income tax: business related capital expenditure – section 40-880 of the Income Tax Assessment Act 1997 core issues (TR 2011/6) provides that it is necessary to look at the Taxpayers’ overall business rather than a particular undertaking or enterprise within the overall business. In this case, the manufacture and supply of food and drink items are considered the relevant businesses for the purposes of subsection 40-880(2). The relevant provision in this case is paragraph 40-880(2)(a) as the Taxpayers carried on their respective businesses at the time they incurred the expenditure. For a deduction to be allowable under paragraph 40-880(2)(a) you must incur capital expenditure ‘in relation to’ your business. ATO Interpretative Decision ATO ID 2007/109 Income Tax Capital Allowances: business related costs – in relation to your business (ATO ID 2007/109) notes that there needs to be a sufficient and relevant connection between the taxpayer’s incurrence of the expenditure and the taxpayer’s 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 & 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 Taxpayers’ 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, is 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 Taxpayers incurred capital expenditure in engaging advisors to undertake a strategic review of the Business to determine the future direction of the Business. The strategic review of the Business by the strategic advisor involved financial and operational analysis of the Business. The ultimate decision by the directors of the Taxpayers was to find a strategic partner to help grow the business. The investor was chosen for its business acumen, expertise in relevant subject matters and the access to capital. The decision to bring on an investor meant that there would be structural changes to the Business. Under the restructure, the Taxpayers now share a common parent entity. The Taxpayers engaged legal advisors and other professional advisors to assist in connection with the restructure. The financial and legal advisers performed a variety of legal, accounting and other professional services in relation to the restructure, including drafting and reviewing contracts and conducting financial and tax due diligence. On the facts of this case, capital expenditure on Advisor Costs was incurred on the changing structure by which the Business will be carried on and on the profit yielding structure of the Business. The purpose of the Transaction was to realise the strong growth potential of the Business. Accordingly, the Advisor Costs have a sufficient and relevant connection with the Taxpayers’ business for the purposes of paragraph 40-880(2)(a). Any deduction the Taxpayers are 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 Taxpayers’ carry on is carried on for a taxable purpose. The definition of ‘taxable purpose’ is provided in subsection 40-25(7) of the ITAA 1997 to include the purpose of producing assessable income. The term ‘purpose of producing assessable income’ is further defined in subsection 995-1(1) of the ITAA 1997 as being either: ● for the purpose of gaining or producing assessable income ● 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. Paragraph 27 of TR 2011/6 notes that if the expenditure relates to the whole of the business but part of the business is carried on to derive exempt income or non-assessable non-exempt income then to that extent the expenditure will not be deductible. All income derived by the Taxpayers is assessable. The Taxpayers do not derive any exempt income or any non-assessable non-exempt income. Considering all the facts, at the time the Taxpayers incurred the Advisor Costs, the Taxpayers were carrying on their business for a taxable purpose. As such, subsection 40-880(3) will not apply to limit the Taxpayers’ 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 Advisor Costs incurred by the Taxpayers under section 40-880. Therefore, the Taxpayers are entitled to deduct the Advisor Costs in equal proportions over five income years from the time the expenses were incurred pursuant to subsection 40-880(2). | Detailed Reasoning - Issue 2: GST – input tax credits | Summary: The Taxpayers are entitled to input tax credits on acquisitions comprising the Advisor Costs. | Detailed Reasoning - Detailed reasoning: Section 11-20 of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act) provides that you are entitled to the input tax credit for any creditable acquisition that you make. The requirements for a creditable acquisition are set out in section 11-5 of the GST Act and provide that you make a creditable acquisition if all of the below are satisfied: (a) you acquire anything solely or partly for a creditable purpose (b) the supply of the thing to you is a taxable supply (c) you provide, or are liable to provide, consideration for the supply (d) you are registered, or required to be registered. Section 11-15 of the GST Act provides that you acquire a thing for a creditable purpose to the extent that you acquire it in carrying on your enterprise. However, you do not acquire a thing for a creditable purpose to the extent that the acquisition relates to making supplies that would be input taxed or the acquisition is of a private or domestic nature. Goods and Services Tax Ruling GSTR 2008/1 Goods and services tax: when do you acquire anything or import goods solely or partly for a creditable purpose? (GSTR 2008/1) provides guidance on the creditable acquisition requirement. On the facts: ● the Taxpayers were carrying on an enterprise when the supplies of advisory services were acquired ● the Taxpayers acquired these supplies of advisory services in carrying on their enterprise, that is, to secure a benefit or advantage in continuing the Business’ enterprise ● the acquisition does not relate to making supplies that would be input taxed nor that are of a private or domestic nature ● the supplies made to the Taxpayers were taxable supplies for which they were liable to pay consideration and for which they did make payment ● the Taxpayers were registered for GST when the acquisitions were made. As the Taxpayers have met all of the requirements under section 11-5 of the GST Act for a creditable acquisition, they are entitled to input tax credits for the GST included in the price of the Advisor Costs.