Private ruling: Deductibility of an advance against royalty payments
Published: October 2014

Ruling: Q3: Does subsection 82KZMD(2) of the Income Tax Assessment Act 1936 (ITAA 1936), which governs the period of deductibility of certain advance expenditure, apply to the non-refundable and non-returnable Advance payable by Company A? | A1: No. Subsection 82KZMD(2) of the ITAA 1936 does not apply to determine the period of deductibility of the non-refundable and non-returnable Advance payable by Company A.


Relevant legislative provisions: Section 8-1: Income Tax Assessment Act 1997 | Subsection 26-25(1): Income Tax Assessment Act 1997 | Subsection 82KZL(2): Income Tax Assessment Act 1936 | Subsection 82KZMA(1): Income Tax Assessment Act 1936 | Subsection 82KZMD(2): Income Tax Assessment Act 1936 | Subparagraph 128B(2B)(b)(i): Income Tax Assessment Act 1936 Subsection 128B(5A): Income Tax Assessment Act 1936 | Royalties Article of the Country B Convention

Reasons for decision: Detailed Reasoning - Deductibility of payments under the Agreement: Section 8-1 of the ITAA 1997 provides: | Detailed Reasoning - Positive Limb`: (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. | Detailed Reasoning - Negative Limb: (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 ... | Detailed Reasoning - Positive Limb: The connection between a taxpayer's outgoings and the generation of assessable income was considered in Ronpibon Tin NL and Tongkah Compound NL v. FC of T (1949) 78 CLR 47. The High Court stated, at 56-57: For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end. The words "incurred in gaining or producing the assessable income" mean in the course of gaining or producing such income… In brief substance, to come within the initial part of the sub-section it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income. | Detailed Reasoning - Subsection 8-1(1) of the ITAA 1997: Payments made by Company A under the Agreement in the nature of Royalties or Guaranteed Minimum Royalties or the Advance, allow Company A access to, and the use of the Licensed Property. Company A derives its assessable income, among others, from the sale of the Licensed Articles. Accordingly, Company A incurs payments under the Agreement for the use of the Licensed Property to derive a portion of its assessable income for the relevant year. Therefore, in the first instance, payments made under the Agreement, whether they are Royalties, Guaranteed Minimum Royalties or the Advance, are outgoings incurred by Company A in the course of gaining or producing part of its assessable income. Consequently, the payments satisfy paragraph 8-1(1)(a) of the ITAA 1997 so that they are deductible for the purposes of the positive limb of subsection 8-1(1) of the ITAA 1997. | Detailed Reasoning - Negative Limb: Capital losses or outgoings and losses and outgoings of a capital nature, even though they are incurred in the course of producing assessable income, are not deductible under section 8-1 of the ITAA 1997. This requirement involves among others, the consideration of whether the outgoing is on revenue account. Recurrent payments where the outgoing is a periodic one covering the use of an asset or advantage during each period is generally considered to be on revenue account. Taxation Ruling TR 98/15 dealing with the deductibility of lease payments provides at paragraph 12 that, ' recurrent rental payments to secure the hire of an income producing asset are usually of a revenue nature. One-off payments to secure the use of an asset for an extended period of time or to reduce subsequent payments may be of a capital nature'. Ultimately, deductibility of an outgoing, whether of a revenue or capital nature, will be determined by reference to the legal obligations or rights under which it was paid, i.e., by reference to the agreement that operated to create the obligation to pay. In Hallstroms Pty. Ltd. v. F.C. of T (1946) 72 C.L.R. 634, at page 647, Dixon J. said- `The claim is to deduct legal expenses, and legal expenses, we may assume, take the quality of an outgoing of a capital nature or of an outgoing on account of revenue from the cause or the purpose of incurring the expenditure. We are, therefore, remitted to a consideration of the object in view when the legal proceedings were undertaken, or of the situation which impelled the taxpayer to undertake them.'' | Detailed Reasoning - Subsection 8-1(2) of the ITAA 1997: Royalties and Guaranteed Minimum Royalties Payment of Royalties and Guaranteed Minimum Royalties by Company A under the Agreement are made at the end of each quarter of a contract year for the use of the Licensed Property during the quarter. As explained previously, Company A derives a portion of its assessable income from the sale of Licensed Articles which embody the Licensed Property. Accordingly, Royalties and Guaranteed Minimum Royalties paid by Company A under the Agreement are on revenue account so that they are not precluded from deductibility pursuant to paragraph 8-1(2)(a) of the ITAA 1997. Further, they are not outgoings of a private and domestic nature for the purposes of paragraph 8-1(2)(b) of the ITAA 1997. Consequently, Royalties and Guaranteed Minimum Royalties paid by Company A under the Agreement with Company B are deductible under section 8-1 of the ITAA 1997. | Detailed Reasoning - Advance: The Advance is a single lump sum paid by Company A on commencement of the Agreement as an advance against payment of Royalties, including Guaranteed Minimum Royalties under the Agreement. Further, the payment of the Advance shall be credited and applied against Company A's' obligations to pay Royalties, including Guaranteed Minimum Royalties to Company B under the Agreement at any time during the term of the licence. The fact that the Advance is a lump-sum payment that is made in advance of the use of the Licensed Property under the Agreement, should not of itself cause the Advance to be considered capital in nature. This is supported by the decision of the Full Federal Court in the case of National Australia Bank Limited v FC of T [1997] 97 ATC 5153; [1997] 37 ATR 378; [1997] 151 ALR 225, where a lump sum payment by the taxpayer to the Commonwealth Government was held to be deductible as a revenue outgoing. In that case, the taxpayer made an up-front payment of $42 million for the exclusive right to make loans to defence force personnel, under a contract for a period of 15 years. It was held that the fact that the $42 million was a one-off payment was not decisive against it being on revenue account since : a) the character of the advantage sought by the Bank did not alter because commercial realities made a lump sum, rather than periodic payments, unavoidable; and b) if the Scheme had been successful and the Bank had made successive payments under the relevant clause, those payments would have been on revenue account. More importantly, it was also held that, 'given that the $42 million and the recurrent payments are payable for the same advantage, it would be curious if the former were to be characterised as a payment of capital when it was computed on the basis of the number of expected loans'. In the present circumstances, as the Advance is capable of reducing subsequent payments of Royalties or Guaranteed Minimum Royalties under the Agreement it is considered that the Advance is made for the same purpose and for the same advantage as the periodic Royalty or Guaranteed Minimum Royalty payments, i.e., to obtain the right to use the Licensed Property in respect of the Licensed Articles. Company A derives assessable income from the sale of the Licensed Articles. The payment of the Advance does not in any way alter the character of the advantage sought by Company A under the Agreement, which is to gain access to the use of the Licensed Property. Therefore, it is considered that the Advance is incurred in the course of gaining the assessable income of Company A and it is not an outgoing of a capital, private or domestic nature. In conclusion the Advance paid by Company A at the commencement of the Agreement with Company B is a deductible outgoing for the purposes of section 8-1 of the ITAA 1997. | Detailed Reasoning - Deductibility subject to subsection 26-25(1) of the ITAA 1997: Under subsection 26-25(1) of the ITAA 1997, a deduction is disallowed for a royalty in respect of which an amount is required to be withheld under section 12-280 of the Taxation Administration Act 1953 (TAA 1953) if the withholding tax has not been remitted to the Commissioner. Subsection 26-25(1) of the ITAA 1997 specifically provides that : You cannot deduct under this Act a royalty if: (a) Subdivision 12-F (including s.12-280) in Schedule 1 to the Taxation Administration Act 1953 requires you to withhold an amount from the interest or royalty; and (b) either: (i) you fail to withhold the amount; or (ii) after withholding the amount, you fail to comply with section 16-70 (i.e. to remit the amount withheld to the Commissioner) in relation to that amount. Subparagraph 26-25(1)(b)(ii) of the ITAA 1997 refers to subsection 16-70(1) of Subdivision 16-B of the ITAA97, which provides that: An entity that withholds an amount under Division 12 (including s.12-280 of the TAA53) must pay the amount to the Commissioner in accordance with this Subdivision. Thus, under subsection 26-25(1) of the ITAA 1997, a deduction is disallowed for a royalty if withholding tax is required to be withheld on the royalty under section 12-280 of the TAA 1953 and the amount withheld has not been remitted to the Commissioner in accordance with the payment provisions set out in Subdivision 16-B of the ITAA 1997. This is regardless of whether a deduction is otherwise allowed under section.8-1 of the ITAA 1997. | Detailed Reasoning - Are payments made by Company A to Company B under the Agreement 'royalties' for the purposes of that term?: The definition of 'royalty' or 'royalties' in subsection 6(1) of the ITAA 1936 includes payments for 'the use of, or right to use, any copyright patent, design or model, plan, trademark, secret formula or process, or other like property or right'. The definition of royalty in section 995-1 of the ITAA 1997 takes its meaning from the definition in the ITAA 1936. In determining whether a payment, made by an Australian payer to a resident of a country that has a tax treaty with Australia, is a royalty, the terms of the relevant tax treaty must be considered. The relevant tax treaty in the present circumstances is the Country B Convention. The Royalty Article of the Country B Convention defines royalties, among others, as payments or credits to the extent to which they are made as consideration for the use of or the right to use any copyright, patent, design or model, plan, secret formula or process, trademark, or other like property or right. Taxation Ruling TR 2008/7 Income tax: royalty withholding tax and the assignment of copyright sets out the Commissioner's view on the definition of royalties under Australia's tax treaties and therefore applies to non-residents who derive royalty income, among others, under the circumstances described under subsection 128B(2B) of the ITAA 1936 (discussed further in this report). TR 2008/7 provides at paragraph 30 that payments determined by reference to the use of copyright and made periodically would constitute royalties. At paragraph 114, the ruling further states that, under the standard tax treaty definition, it is not necessary for a payment to be calculated based on the degree of use of the copyright to be considered a royalty. Thus, where a payment is in substance for the use of, or right to use that copyright, even if the right is not exercised, it can still be considered a royalty. Periodic payments of Royalties by Company A under the Agreement are determined by reference to the use of the Licensed Property. Periodic payments of Guaranteed Minimum Royalties, and the Advance are in substance payments for the right to use the Licensed Property. Consequently, Royalties, Guaranteed Minimum Royalties and the Advance constitute 'royalties' for the purposes of the definition of that term in the Royalty Article of the Country B Convention. | Detailed Reasoning - Foreign resident withholding: A person is liable under subsection 128B(5A) of the ITAA 1936 to pay withholding tax if they derive income that consists of a royalty and the requirements of subsections 128B(2B) or (2C) of the ITAA 1936 are satisfied in relation to that income. Subparagraph 128B(2B)(b)(i) of the ITAA 1936 applies to income that consists of a royalty derived by a non-resident that is paid by a resident and is not an outgoing wholly incurred by the payer in carrying on business in a foreign country at or through a permanent establishment (PE) in that country. Subdivision 12-F of Schedule 1 to the TAA 1953 provides the administrative procedures for collecting withholding tax. Section 12-280 of Schedule 1 requires an entity to withhold an amount from a royalty it pays to an entity if: • that receiving entity has an address outside Australia on record with the payer, relevant to the royalty transaction; or, • the payer is authorised to pay the royalty to a place outside Australia. Company B is a Country B resident for income tax purposes and does not carry on its business through a permanent establishment (PE) in Australia. The payment by Company A, a resident, of royalties in the form of Royalties, Guaranteed Minimum Royalties and the Advance to Company B are not outgoings incurred by Company A in carrying on business in a foreign country at or through a PE in that country. Accordingly, subparagraph 128B(2B)(b)(i) of the ITAA 1936 applies to the royalty payments made by Company A so that Company B is liable to pay withholding tax on the royalties, pursuant to subsection 128B(5A) of the ITAA 1936. The Royalty Article of the Country B Convention prescribes the maximum tax that can applied to the gross amount of the royalties in Australia. As Company A has withheld the prescribed amount of tax in respect of the Advance payment, subsection 26-25(1) of the ITAA 1997 does not apply to preclude a deduction otherwise available for the Advance payment under section 8-1 of the ITAA 1997. If Company A complies with its withholding tax obligations on payment of any of Royalties or Guaranteed Minimum Royalties to Company B, subsection 26-25(1) of the ITAA 1997 will not apply to deny a deduction under section 8-1 of the ITAA 1997 in respect of such Royalties and Guaranteed Minimum Royalties paid. | Detailed Reasoning - Timing of deductibility of the Advance: Where expenditure qualifies for deduction under section 8-1 of the ITAA 1997, the deduction is generally allowable in full in the year in which the expenditure is incurred. However, the timing of deductions for certain types of expenditure is subject to the advance payment rules in sections 82KZL to 82KZO of the ITAA 1936. Subsection 82KZMA(1) of the ITAA 1936 provides: Section 82KZMD sets out the amount and timing of deductions for expenditure that a taxpayer incurs in a year of income (the expenditure year ), if: (a) part from those sections, the taxpayer could deduct the expenditure for the expenditure year under: (i) section 8-1; or (ii) ... of the Income Tax Assessment Act 1997; and (b) the requirements in subsections (2), (3), (4) and (5) are met. As determined previously in response to Questions 1 and 2, the Advance will be deductible under section 8-1 of the ITAA 1997 when the Advance is paid, satisfying paragraph 82KZMA(1)(a) of the ITAA 1936. | Detailed Reasoning - The requirement in subsection 82KZMA(2) of the ITAA 1936: (a) The taxpayer must: (iii) carry on a business; or (iv) ... and (b) If the taxpayer is a small business entity for the expenditure year, must, before lodging its return of income for that year or within such further time as the Commissioner allows, choose to apply section 82KZMD to the expenditure. As determined previously, Company A is considered to be carrying on a business and therefore the requirement in paragraph 82KZMA(2)(a) of the ITAA 1936 is satisfied. Further, Company A is not a small business entity as it will not satisfy the $2million aggregated turnover requirement for the purposes of section 328-110 of the ITAA 1997. Accordingly the requirement in paragraph 82KZMA(2)(b) is also satisfied. Consequently the requirement in subsection 82KZMA(2) is satisfied. | Detailed Reasoning - The requirements in subsection 82KZMA(3) of the ITAA 1936: The expenditure must be: (a) Either: (v) incurred in carrying on a business; or (vi) ....; and (b) incurred under an agreement (see sub section 82KZL(1); and (c) incurred in return for the doing of a thing under the agreement that is not to be wholly done within the expenditure year. Company A is in the business of selling trading stock through its stores in Australia. Therefore, the Advance payable by Company A will meet the requirement of paragraph 82KZMA(3)(a) of the ITAA 1936. The Advance is incurred under the Agreement between Company A and company B for the purposes of subsection 82KZL(1) of the ITAA 1936. Therefore, the condition in paragraph 82KZMA(3)(b) of the ITAA 1936 is satisfied. Paragraph 82KZMA(3)(c) of the ITAA 1936 requires the Advance to be 'incurred in return for the doing of a thing under the agreement that is not to be wholly done within the expenditure year'. Subsection 82KZL(2) of the ITAA 1936 relevantly states: Without otherwise limiting the generality of references in this Subdivision to expenditure being incurred under an agreement in return for the doing of a thing under the agreement: (a) … (b) where expenditure incurred under an agreement consists of a payment of rent, a lease payment or a payment of a similar kind, the expenditure shall, for the purposes of this Subdivision, be taken to be incurred in return for the making available or continued making available, as the case requires, of the thing rented or leased, or other thing of a similar kind, under the agreement during the period to which the payment relates; and (c) … Paragraph 14 of Taxation Ruling IT 2646 Income Tax: Television Program Licences provides guidance on the phrase 'payment of a similar kind'. It states: The expression "payments of a similar kind" in paragraph 82KZL(2)(b) is considered to refer to payments: a. the nature of which is similar to the nature of rent and lease payments; and b. the object or benefit sought by the payments is similar to the object or benefit sought by a payment of rent or a lease payment. Rent has been defined as 'the consideration payable under [a] lease for the right of use and occupation of the leased premises during the term of the lease' ( Commissioner of Taxation v. Krakos Investments Pty Ltd (1995) 61 FCR 489; [1995] FCA 1767; 96 ATC 4063; (1995) 32 ATR 7, per Hill J at paragraph 60). Further, 'an inherent feature of rent is that it typically involves a (generally regular) periodical payment' and 'rent is fundamentally the consideration for the right to use property' ( Federal Commissioner of Taxation v. CityLink Melbourne Ltd (2006) 228 CLR 1; [2006] HCA 35; 2006 ATC 4404; (2006) 62 ATR 648, per Kirby J at paragraph 43 and 45). However, IT 2646 states that, in relation to program licences: the "thing" to be done is the granting of the right to use the program and this "thing" is done only once (usually at the commencement for the agreement), expenditure incurred to acquire program licenses would not, of itself, fall within section 82KZM. The Advance is not a payment of a similar kind to a rent or a lease payment. Rather, the "thing" to be done under the agreement between Company A and Company B is the granting of the right to use the trademarks, much like the granting of rights to use program licenses. This "thing" is done only once, at the commencement of the agreement. As a result, paragraph 82KZMA(3)(c) of the ITAA 1936 will not be met. Overall, subsection 82KZMA(3) is not satisfied. As subsection 82KZMA(3) is not satisfied, subsection 82KZMA(1)(b) of the ITAA 1936, which requires that the conditions in each one of 82KZMA(2), 82KZMA(3), 82KZMA(4) and 82KZMA(5) be satisfied, is not satisfied. In summary, the Advance does not satisfy subsection 82KZMA(1) of the ITAA 1936. | Detailed Reasoning - Conclusion: As the requirement in subsection 82KZMA(1) of the ITAA 1936 has not been satisfied, section 82KZMD of the ITAA 1936 will not apply to set out the amount and timing of deductions for the Advance payment that Company A has incurred in the income year ending 30 June 2015. Consequently, the Advance payment is deductible under section 8-1 of the ITAA 1997 in the year that it is paid, being the income year ended 30 June 2015.

Question 1: Are amounts of Royalties and Guarantee Minimum Royalties payable by Company A under the Licence Agreement with Company B deductible outgoings in respect of Company A for the purposes of section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)? | Yes. Amounts of Royalties and Guaranteed Minimum Royalties payable by Company A under the Licence Agreement with Company B are deductible outgoings in respect of Company A for the purposes of section 8-1 of the ITAA 1997 unless precluded by subsection 26-25(1) of the ITAA 1997. | Question 2: Is the amount of the non-refundable and non-returnable Advance payable by Company A as an advance against payment of royalties under the Licence Agreement with Company B a deductible outgoing in respect of Company A for the purposes of section 8-1 of the ITAA 1997? | Yes. The non-refundable and non-returnable Advance payable by Company A as an advance against payment of royalties under the Licence Agreement with Company B is a deductible outgoing in respect of Company A under section 8-1 of the ITAA 1997 unless precluded by subsection 26-25(1) of the ITAA 1997. | Relevant facts: Company A ('the Licensee') entered into a Licence Agreement ('Agreement') with Company B ('the Licensor'), a Country B resident for income tax purposes. Company B has its principal office in Country B. Under the Agreement, Company A has an exclusive right to use, display and embody certain licensed trademarks owned by Company B (Licensed Property) in connection with certain products produced and sold by Company A ('Licensed Articles'). | Company B does not have an office or a place of fixed business in Australia. | The terms and conditions of the Agreement provide that: | • .The Licensor grants to the Licensee the exclusive, non-transferable, non-assignable right to use certain trademarks owned by the Licensor, in respect of the Licensed Articles. | • .The Licensee shall pay the Licensor at the end of each income year comprising the term of the Agreement, the greater of, an amount of Royalty calculated as a percentage of the sale of the Licensed Articles, and an amount of Guaranteed Minimum Royalties specified in the Agreement. | • On entering into the Agreement, the Licensee shall pay the Licensor an amount of Advance as specified in the Agreement. The Advance shall be non-refundable and non-returnable, but will at all times be recoupable, against the Licensee's obligations to pay Guaranteed Minimum Royalties and/or Royalties to the Licensor under the Agreement. | Royalties are payable by Company A to the overseas account of Company B. | The outgoing for royalties is not incurred in full or in part in the carrying on of a business by Company A in a country outside Australia or through a permanent establishment in a country outside Australia. | Company A has an annual turnover in excess of $2 million in respect of the income years ended 30 June 2011, 30 June 2012 and 30 June 2013.