Private ruling: Deductibility of option cancellation payment

Ruling: Q1: Are option cancellation payments made to employee option holders deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997). | A1: No

Relevant facts and circumstances: The company was listed on the Australian Stock Exchange (ASX). The company remunerated its employees, including executives and managers, through various means including granting shares and options in the company as well as making cash payments in the form of salary and wages. The applicant advised that the employee option scheme operated as follows: · there was no 'formal' employee share scheme such as a share trust; · options were granted at no cost to the employee as part of the employee's contract of employment; · generally, there were vesting conditions applied to the options (usually related to length of service); · options had varying exercise prices (generally related to when the options were granted); · once the vesting conditions were satisfied, the employee made the choice whether to exercise the options or allow them to lapse; and · if the employee chose to exercise the options, the employee paid the exercise price to the company and received the equivalent number of ordinary shares in the company. Options were held by employees, associates of employees and non-employees. Options were not listed on the ASX. The company's Board recommended an acquisition following a planned demerger. A copy of the demerger scheme booklet and the option cancellation deed was supplied by the applicant.

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

Reasons for decision: Summary: Section 8-1 of the ITAA 1997 is the general deduction provision. It states: 8-1(1) 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. 8-1(2) 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; or (c) it is incurred in relation to gaining or producing your *exempt income or your *non-assessable non-exempt income; or (d) a provision of this Act prevents you from deducting it. Subsection 8-1(1) of the ITAA 1997 contains the positive limbs of the provision. Subsection 8-1(2) of the ITAA 1997 contains the negative limbs of the provision. Subsection 8-1(2) of the ITAA 1997 containing the negative limbs is the area of the provision that is relevant to this ruling, in particular paragraph 8-1(2)(a) of the ITAA 1997. As stated, a distinction is made for the purposes of section 8-1 of the ITAA 1997 between a capital outgoing and a revenue outgoing. A capital outgoing is an outgoing which forms part of, or is inherently linked to the structure of the business, whereas a revenue outgoing is associated with the income producing activities of the business. The leading authority on the distinction between a capital outgoing and a revenue outgoing is Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; 1 AITR 353; 5 ATD 87 ( Sun Newspapers ). Dixon J in Sun Newspapers laid down guidelines for distinguishing between capital and revenue expenditure and observed at 410 that: The distinction between expenditure and outgoings on revenue account and on 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. In expanding upon this concept, Dixon J at 413 referred to three matters to be considered: There are, I think three matters to be considered: (1) the character of the advantage sought, and in this its lasting qualities may play a part; (2) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part; and (3) the means adopted to obtain it; that is by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment. In this case, the company incurred the relevant expenditure solely to ensure that the demerger of its subsidiary happened, with the implementation of the scheme of arrangement being one of the steps in ensuring the demerger happened. There were stated advantages to shareholders in implementing the demerger scheme. In applying Dixon J's tests in the Sun Newspapers case to the relevant expenditure incurred by the company, it is apparent that the expenditure (being the option cancellation payment) was not incurred as part of the ordinary business operations of the company. The expenditure was incurred as part of changing the structure by which the international and early stage assets would be owned and operated separate to the local assets. The option cancellation payment was a large, once and for all sum. The decision to make the option cancellation payment could not be made without the approval of shareholders. It provided a benefit of an enduring nature and altered the profit-yielding structure of the company's business. The applicant argued that the original provision of the options was for remuneration for employee services and a substitute for the payment of salary and wages. This implies that when the company granted the options to its employees, it incurred a loss or outgoing. Taxation Ruling TR 2008/5 provides at paragraph 2 that when a company issues shares as consideration for services, the issue of its shares is neither a loss nor an outgoing of the company and so not deductible under section 8-1 of the ITAA 1997. This statement can be applied equally to the granting of options. The applicant argues that the expenditure was not incurred once and for all, it was incurred for services rendered during a certain period and the applicant had to continue to remunerate employees to obtain their future services. The option cancellation payment was only made after a resolution put to shareholders was carried by poll. The resolution was put to shareholders so that one of the conditions necessary to effect the demerger of a subsidiary from the company was satisfied. It was a once and for all payment which had nothing to do with the remuneration of employees and everything to do with the restructure of the company. The option cancellation payment was made to all option holders which included employees, associates of employees and non-employees . Regardless, employee share schemes commonly allow for the grant of share options to employees. Typically these are call options. A call option over a share gives the holder the right, but not the obligation, to obtain a share in a specified company at a predetermined date or during a predetermined period (the maturity date or exercise period) and at a predetermined amount (the exercise price). Normally, under employee share schemes the terms of the option are governed by a contract between the parties conferring the relevant right on the employee. The copies of employment contracts that the company provided state the terms of the options to be granted. Additionally, the demerger scheme booklet and the option cancellation deed both provide that all unvested options will vest, after which time the option holder has a specified period of time to exercise the options should they choose to do so. The terms of the contract conferring the right on the employee have been met, that is, the employee was able to exercise their options should they choose to do so. In the application, the applicant argued that the 'advantage sought by … was to substitute the means by which it remunerated certain employees so that those employees would not be disadvantaged as the options they held would no longer be exercisable.' Clearly, this is not the case. The employee option holders were able to exercise the options they held if they chose to do so. The advantage gained by making the payment was to the company's shareholders who benefited from the demerger scheme and subsequent acquisition scheme. In summary: · the advantage gained by making the option cancellation payment was to the company's shareholders who, by resolving to agree to the options condition, were able to effect the demerger of a subsidiary from the company which in turn enabled the acquisition of the company to take place, resulting in shareholders receiving a premium for their shares; · the option cancellation payment was a large, once and for all sum; and · the option cancellation payment enabled the demerger of a subsidiary from the company and the subsequent acquisition of the company by another entity which both provided a benefit of an enduring nature in the formation of a separate entity and significantly changed the profit yielding structure of the original company . Accordingly, given the facts in this instance and following the principles espoused in the Sun Newspapers case, the option cancellation payment made by the company to its employee option holders is capital in nature and not deductible to the company under paragraph 8-1(1)(b) of the ITAA 1997.

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