Private ruling: Deductibility of annuity payments
Date of advice: 12 February 2016
Published: April 2016
Ruling period: Year ended 30 June 2016
Date scheme commenced: 1 July 2015

Ruling: Q1: Are you entitled to a deduction for annuity payments made to Person X? | A1: No.

Relevant facts and circumstances: Person X, your parent, currently owns land ('the Properties') in their own right. You have worked fulltime on the Properties for a number of years. The properties have a registered mortgage to the bank and a second mortgage to Person Y. During the 2015-16 financial year, you and Person X have farmed the properties as a partnership. Prior to that date, Person X farmed the properties in partnership with Person Y, and then as a sole trader during the 2014-15 financial year. The partnership profits are used to service the bank debt and Person Y's mortgage with any surplus profits being shared equally between you and Person X. The structure of the partnership will allow a wage to be paid to you for the work you perform. Person X will obtain a further property from Person Y and expects to inherit an additional property from Person Z. You and Person X will enter into a deed ('the Deed'). Under the Deed, Person X will • transfer their existing properties, other than 'Property U' into your name • transfer the property they obtains from Person Y into your name after Person X have become the registered proprietor • if Person X inherits the property from Person Z, they will transfer that property into your name once they have become the registered proprietor, and • will transfer an interest in remainder for Property U subject to their life. In the event that Person X surrenders their life interest in the property to purchase alternative accommodation, you will make a payment to them. In exchange for the transfer: • you will pay Person X an annuity of $XX per year, with a percentage increase per year allowing for inflation, paid monthly in arrears • you will assume liability for and indemnify Person X against any liability for the bank's mortgage and the second mortgage to Person Y The Deed provides for the base rate of the annuity to be varied to a lower amount if the annuity is an allowable deduction for taxation purposes. If you fail to make the annuity payments, you will become liable to make a lump sum payment required to cover the agreed cost of living for Person X's lifetime. A third mortgage is to be registered against the properties from you to Person X. If a prior mortgagee refuses consent to registration of the mortgage to Person X, you agree to the lodgement of a caveat against the titles of the Properties to protect Person X's interest. If you sell the properties and discharge the mortgage, you must provide Person X with a mortgage of an alternative property, with no less equity than the mortgage has at the time of discharge. If you fail to pay a monthly instalment of the annuity within one month of the due date, Person X may terminate the annuity by notice to you. This will allow Person X to exercise their power of sale under the mortgage. The annuity is to cover your Person X's living costs until their death and will begin when all proposed documents are signed.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 8-1

Reasons for decision: Summary: Subsection 8-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) states you can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; or (b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. Subsection 8-1(2) of the ITAA 1997 provides, however, you cannot deduct a loss or outgoing under this section to the extent that: (a) it is a loss or outgoing of capital, or of a capital nature; or (b) it is a loss or outgoing of a private or domestic nature. Deductions allowed under section 8-1 of the ITAA 1997 are referred to as 'general deductions'. Paragraph 8-1(1) of the ITAA 1997 is referred to as the 'first limb' and requires an expense to be incurred in gaining or producing your assessable income. Deductions under this limb are available to all taxpayers. The term 'second limb' refers to paragraph 8-1(1) of the ITAA 1997 and relates to when an expense is necessarily incurred in carrying on a business for the purposes of gaining or producing your assessable income. By its very wording, deductions under the second limb are only available to taxpayers carrying on a business. Subsection 8-1(2) of the ITAA 1997 is referred to as the 'negative limb' and provides categories of outgoings that are not deductible. Under the negative limb, outgoings of capital, of a capital nature or of a private or domestic nature are not deductible. The negative limb is only examined if an outgoing meets the requirements for deductibility under either the first or second limbs of subsection 8-1(1) of the ITAA 1997. You and Person X operate a partnership on land owned by Person X. You propose to enter an agreement whereby Person X will transfer the land to you in exchange for an annuity to be paid to their for the rest of their life. You will assume responsibility for the mortgages on the land. You earned your assessable income from working for Person X on the property and, since 1 July 2015, from profits from the partnership business carried out on the property as well as a wage paid by the partnership. Your assessable income is from the partnership activities which are carried out on the land owned by Person X. After the transfer of the land into your name, you and Person X will continue to operate the partnership activities on the same land. There is no difference to the manner in which you earn your assessable income - both before and after the transfer - it is considered that the annuity is not an outgoing which has been incurred in earning your assessable income. You earn the same income irrespective of who owns the land. Similarly the annuity will not be an expense necessarily incurred in carrying on a business. The business is currently being carried on without the payment of the annuity. Also, there is provision for you to sell the property. In the event of that occurring, you are required to provide Person X with a mortgage of an alternative property but there is no requirement that that property be used for farming or partnership activities. It is considered that the annuity payments are private and domestic in nature. The purpose of the payments is to cover Person X's living costs until their death. They are to be paid irrespective of the property the mortgage is secured over or how that property is to be used. Whilst it is intended that the mortgage will be secured over the property the partnership uses to carry on its business activities, and earn assessable income for both you and Person X, the annuity payments are essentially private expenses. You have likened your situation to that in Egerton-Warburton v. Deputy Federal Commissioner of Taxation (1934) 51 CLR 568 ( 'Egerton-Warburton' ). That case involved a parent and two sons. The parent owned land he used for farming and orcharding. He entered into agreement with his two sons to sell them the land, stock, chattels and effects on a walk-in walk-out basis following consideration: • an annuity to the parent during his life • after his death an annuity to his widow • after the death of the parent and his widow, a sum of £10,000 to his three daughters and the children of a deceased daughter. The husband and his wife retained the right to use and occupy a dwelling-house on the land. A mortgage was executed over the land to secure the payment of the annuity and the £10,000. After the transfer of the land, the sons commenced a farming and orcharding business on the land. If the sons defaulted on the payment of the annuity, the parent was entitled to take possession of the land, to receive the rents thereof, and to assume and continue the management thereof to the exclusion of the sons. The Court held that the annuity payment was revenue in nature and deductible to the sons. Their Justices stated: We do not think the annual payments made by the sons are outgoings of their capital. The payments may properly be considered as made by them on revenue account. But it is another thing to hold that the sums paid are expended wholly or exclusively for the production of assessable income. The contention that they are so expended is founded upon the circumstances that the annuity is charged upon the land used to earn the assessable income, that the charge was incurred as a condition attending the acquisition of the land, and that various provisions of the charge resulted in its being virtually compulsory to use the land for farming or orcharding. Any default in the payment of the annuity or in the observance of the conditions of the charge would entitle the parent to enter into possession of the land, to receive the rents thereof, and to assume and continue the management thereof to the exclusion of the sons. These circumstances are relied upon as showing that the annuity is a charge incurred in order to enable the sons to obtain possession of the land for the purpose of earning assessable income therefrom, and paid in order to enable them to retain such possession for that purpose. … In the present case, the obligation to pay the annuity is not attached to the land by the general law, but by the convention of the parties. It is a condition of the acquisition of the land upon which the business is carried on. The nature of the business demands the use of the land, but payment of an annuity is not a necessary incident of carrying on the business. Without the land, however, the taxpayers could not carry on the business, and to acquire the land they found it the land they found it necessary to submit to the liability to pay the annuity. Your situation differs from that in Egerton-Warburton as: • you and Person X are already conducting a business activity on the land prior to the transfer whereas the sons could not commence their business activities on the land until after the transfer occurred • there is no requirement for you to use the land for specific purposes. You have the option to sell the land provided you secure a mortgage in favour of Person X over another property with the same value as the land sold. There is no requirement that the replacement property is used for business or income producing purposes • Person X is entitled to sell the property if you fail to make the annuity payments whereas in Egerton-Warbuton the parent was able to take control of the land and the business if the sons failed to make annuity payments or did not use the land for farming and orcharding. No deduction is allowable for annuity payments made to Person X as they are of a private and domestic nature.