Private ruling: Deductibility of annuity payments and capital or revenue in nature
Ruling period: 1 July 2009 to 30 June 2014

Ruling: Q1: Are the annuity payments paid to the life tenant an expense, necessarily incurred, in carrying on the business and therefore a deductible expense according to paragraph 8-1(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997) for the rulee? | A1: No | Q2: Are the annuity payments to the life tenant, as required by the last will and testament of the deceased, revenue or capital expense in relation to the rulee? | A2: No

Relevant facts and circumstances: Prior to their death, the deceased, was in a partnership with their spouse (Partnership A). Partnership A operated a business. Partnership A utilised the property, as the land on which the business was operated. The deceased's share in the partnership assets and liabilities were bequeathed to their relative under the will. The relative has an existing partnership for income tax purposes with their spouse; Partnership B who is the rulee. Partnership B operates a business and is registered for Goods and Services Tax (GST). The applicant and his spouse own an adjoining property which they utilise to run the business. Probate of the will was granted on a certain date and executors and trustees are the spouse of the deceased and members of Solicitors firm, at date of death. According to the will, the deceased gave a property to the trustees to be held trust for their relative, so that the relative might have the exclusive use and occupation of the property, subject to them complying with certain conditions. The first condition for the relative was to pay in annuity to the spouse of the deceased (the life tenant), during spouse's lifetime, to be paid each year by quarterly payments. The annuity is to be indexed. The second condition for the relative was to pay all rates, insurances and outgoings in respect of the maintenance of the property. Another condition states that should the annuity payments fail to be made the property can be sold by the trustees and the life tenant is to receive a certain amount from the sale and the balance is to be paid to the relative. The final point in relation to the property is that if all the conditions are satisfied, then upon the death of the life tenant the property shall be transferred to the relative absolutely. Upon the deceased passing, their interest in Partnership A passed to the relative according to the will. The relative then paid the spouse of the deceased a sum in satisfaction of their interest in Partnership A. The assets from Partnership A are being transferred by way of election to the rulee who will continue to operate the business. Payment of the annuity has been made each quarter commencing at the date of death.

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

Reasons for decision: Summary: Subsection 8-1(1) of the ITAA 1997 allows a taxpayer a deduction for all losses or outgoings to the extent to which they are: (a) incurred in gaining or producing assessable income; (the first limb) or (b) necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income; (the second limb). However, subsection 8-1(2) of the ITAA 1997 excludes a loss or outgoing of a capital, private or domestic nature, or where the loss or outgoing is incurred in gaining or producing exempt income. To qualify for deductibility under section 8-1(1)(b) a loss or outgoing must be necessarily incurred "in carrying on a business for the purpose of gaining or producing" such income. The phrase "in gaining or producing" is to be read as "in the course of gaining or producing": Amalgamated Zinc (de Bavay's) Ltd v FCT (1935) 54 CLR 295. Of the phrase "in carrying on a business", Menzies J said in John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30; 7 AITR 346 at 363: The element that I think it necessary to emphasise here is that the outlay must have been incurred in the carrying on of a business, that is, it must be part of the cost of trading operations. The significance of the word "in" is that it provides a basis for delineating outlays preparatory to or beyond the scope of income earning activities even though they may be essential prerequisites to the derivation of income. To satisfy the first limb of section 8-1 of the ITAA 1997, the loss or outgoing must be relevant and incidental to the operations or activities from which the assessable income is produced: W Nevill & Co Ltd v FCT (1937) 56 CLR 290 at 305; Ronpibon Tin NL v FCT (1949) 78 CLR 47; Steele v FCT (1999) 41 ATR 139 at 151. This principle is also expressed in terms of there having to be a sufficient nexus (or connection) between the outgoing and the production of assessable income. The occasion of the loss or outgoing should be found in whatever is productive of the assessable income. In this case, the outgoing is a quarterly annuity payment that has arisen as a condition of a will. The payment of the annuity is an obligation of an individual being a relative and not the rulee. The will provides that the relative has the exclusive use and occupation of a property subject to certain conditions, of the first being to pay an annuity to the spouse of the deceased during their lifetime. The important point is that the paying of the annuity by the relative has an enduring benefit in providing them with the exclusive use and occupation of the property until the life tenant's death. Upon their death the property will be transferred to relative absolutely. The obligation of the annuity payments has only arisen as the result of the will and is not an obligation that is part of the cost of trading operations of the business of the rulee. The annuity payments are the responsibility of the relative as directed by the will, and not that of the rulee. The question in FCT v Green (1950) 81 CLR 313; 4 AITR 471 concerned outgoings in relation to wages, audit fees and travel expenses by a taxpayer with diverse income producing activities. In disallowing the appeal the High Court made a clear distinction between expenses necessarily incurred if income is to be earned but which are nevertheless not incurred in the course of deriving income (at AITR 478): It is not enough, in order to establish a right to a deduction, to show that it was proper or reasonable for the taxpayer to make the expenditure which he claims as a deduction. For example, it is perfectly reasonable and proper for a taxpayer to incur living expenses ... It is true that such expenses are necessarily incurred if any income is to be earned or otherwise derived, but such expenses would be incurred whether income was earned or otherwise derived or not. It is recognised that the rulee has stated that the payment of the annuity by the relative provides them access to the land to enable the business to continue. However, as in the above case, there is a clear distinction between expenses necessarily incurred if income is to be earned but which are not incurred in the course of deriving the income. An enduring benefit of the annuity payment is the ongoing access to the property which is necessary if any income is to be earned for the business from this property; however, the expense is not necessarily incurred as part of the trading operations as it is an expense of the relative. Accordingly, as the annuity expense has not been necessarily incurred in the carrying on of a business it is not deductible under paragraph 8-1(1)(b) of the ITAA 1997 for the rulee. As the annuity payments are not an expense of the rulee they are not on capital or revenue account in relation to that entity. They are, however, an expense of the relative and following is a discussion of whether the expense is capital or revenue in nature. The first negative limb of section 8-1 of the ITAA 1997 denies a deduction for a loss or outgoing that has been incurred where it is a loss or outgoing of capital or of a capital nature: section 8-1(2)(a) of the ITAA 1997. There is no statutory criterion for determining whether a loss or outgoing is of capital or of a capital nature in ITAA 1997. The concept of "capital" is normally contrasted with that of "revenue". It is said that no deduction is allowed if a particular loss or outgoing is "on capital account'' but a deduction is allowed if the loss or outgoing is "on revenue account''. Various attempts by the courts to formulate distinguishing features, or reasons for finding that a particular item of expenditure falls into one category or the other, have given rise to substantial difficulties. The dividing line between capital and revenue expenditure is in some instances so thin that, in IR Commrs v British Salmson Aero Engines Ltd (1938) 22 TC 29, Sir Wilfrid Greene said that "in many cases it is almost true to say that the spin of a coin would decide the matter almost as satisfactorily as an attempt to find reasons". Other judges have not, however, been prepared to go as far as that. For example, Dixon J in Hallstroms Pty Ltd v FC of T (1946) 8 ATD 190 at p 194; (1946) 72 CLR 634 at p 645 said: I am not prepared to concede that the distinction between an expenditure on account of revenue and an outgoing of a capital nature is so indefinite and uncertain as to remove the matter from the operation of reason and place it exclusively within that of chance or that the discrimen is so unascertainable that it must be placed in the category of an unformulated question of fact. The truth is that, in excluding as deductions losses and outgoings of capital or of a capital nature, the income tax law took for its purposes a very general conception of accountancy, perhaps of economics, and left the particular application to be worked out, a thing which it thus becomes the business of the courts of law to do. The courts have formulated the following indicia to determine whether a loss or outgoing is capital or revenue in nature. (1) The "profit yielding structure'' ( Sun Newspapers Ltd & Associated Newspapers Ltd v FC of T (1938) 61 CLR 337; 5 ATD 87. (2) Recurrent and "once and for all'' expenditure. (3) Enduring benefit. (4) Fixed or circulating capital. (5) Requirement of an "economic sense''. None of the above indicia provides an exhaustive test but, taken together, they represent the comprehensive approach that courts, especially in later cases, have applied to difficult cases. In BP Australia Ltd v FC of T (1965) 14 ATD 1; (1965) 112 CLR 386, Lord Pearce (delivering the judgment of the Privy Council) said (at ATD p 7; CLR p 397) that the solution to the problem "has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other''. His Lordship then quoted from Dixon J's judgment in Hallstroms Pty Ltd v FC of T (1946) 8 ATD 190 at p 196; (1946) 72 CLR 634 at p 648, where his Honour said that the answer to the income/capital question "depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process''. The questions that commonly arise when considering whether an item of expenditure is capital were stated by Fullagar J in Colonial Mutual Life Assurance Society Ltd v FC of T (1953) 10 ATD 274; (1953) 89 CLR 428, at ATD p 283; CLR p 454 (Colonial), as follows. (1) What is the expenditure or loss really for? (2) Is the expenditure really for, in truth and in substance, a capital asset? The above approach was endorsed and adopted by the Full Federal Court in Jupiters Ltd v DFC of T 2002 ATC 4566. In this case, we will examine firstly the first three relevant indicia as formulated by the courts before considering finally the questions as stated by Fullagar J in Colonial . | Detailed Reasoning - Profit Yielding Structure: The leading Australian test of whether a loss or outgoing is of a capital nature is whether it relates to the taxpayer's "profit yielding structure'' (sometimes also referred to as the "business entity'' test). This test, which requires an enquiry as to whether the expenditure relates to the structure within which the profits are earned or whether it relates to part of the money-earning process, derives from remarks of Dixon J in Sun Newspapers Ltd & Associated Newspapers Ltd v FC of T (1938) 61 CLR 337; 5 ATD 87. It has been consistently followed by Australian courts. In that case, Sun Newspapers Ltd published an evening newspaper in Sydney called The Sun which was sold at a penny halfpenny per copy. The optionees of a competing evening newspaper proposed to replace that newspaper with another newspaper to be sold at one penny per copy. To prevent the publication of the proposed newspaper, an agreement was entered into whereby Associated Newspaper Ltd, a company which held nearly all the shares in Sun Newspapers Ltd, agreed to pay £86,500 to those interested in the production of the new newspaper for their interest in the competing newspaper and in consideration for them not becoming associated for a period of three years with the publication of any other newspaper in Sydney or within 300 miles thereof. It was held that the moneys so paid were in the nature of capital. In relation to the concept of capital losses and outgoings Dixon J observed that the; distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss. (61 CLR at p 359. Emphasis added). Elaborating upon this concept his Honour then said (61 CLR at pp 359-360): The business structure or entity or organization may assume any of an almost infinite variety of shapes and it may be difficult to comprehend under one description all the forms in which it may be manifested ... But in spite of the entirely different forms, material and immaterial, in which it may be expressed, such sources of income contain or consist in what has been called a `profit-yielding subject' ... As general conceptions it may not be difficult to distinguish between the profit-yielding subject and the process of operating it. In the same way expenditure and outlay upon establishing, replacing and enlarging the profit-yielding subject may in a general way appear to be of a nature entirely different from the continual flow of working expenses which are or ought to be supplied continually out of the returns or revenue. In applying the test Dixon J referred to three matters which were to be examined. He said (at p 363): There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) 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. The features of the Sun Newspapers case which led Dixon J to the conclusion that the outgoings were on capital account included the fact that the outgoings were of a large sum, that they were incurred to remove competition, and that the chief object of making the outgoings was to strengthen and preserve the taxpayer's existing business organisation and to acquire an asset. Dixon J was to reaffirm his approach in Hallstroms Pty Ltd v FC of T (1946) 72 CLR 634 at p 646, and again in John Fairfax & Sons Pty Ltd v FC of T (1959) 101 CLR 30. In the former case he also said (at 72 CLR pp 646-647): ... it may be useful to recall the general consideration that the contrast between the two forms of expenditure corresponds to the distinction between the acquisition of the means of production and the use of them; between establishing or extending a business organization and carrying on the business; between the implements employed in work and the regular performance of the work in which they are employed; between an enterprise itself and the sustained effort of those engaged in it. In this case, the outgoings are of a large amount, however, the will prescribes that the amount be paid in the form of an annuity as recurrent payments. They are incurred to secure the relative's right under the will to occupy the land and the chief object of making the outgoings is to preserve their entitlement to receive the asset absolutely on the passing of the life tenant. | Detailed Reasoning - Recurrent and "once and for all" expenditure: Although expressed as a test for capital expenditure, the recurrence of the expenditure is generally only one of the factors weighed when determining whether expenditure is capital in nature. For example, recurrence of a payment does not mean it is necessarily of revenue and not of a capital nature. As stated by Northrop, French and Sundberg JJ at p 5163 in National Australia Bank Limited v FC of T 97 ATC 5153, "The absence of recurrence suggests that an outgoing is of a capital nature. But it is not conclusive ...". The following case illustrates this point. A vendor sold land to the taxpayer in consideration of a promise by the taxpayer to pay to the vendor, for a period of 50 years, an amount equal to 90% of all rents, as and when received, from lessees or tenants of shops and a basement in a building to be erected on the site. Although the payments to the vendor were recurrent, they were characterised as instalments of a capital purchase price, and the taxpayer was denied a deduction ( Colonial Mutual Life Assurance Society Ltd v FC of T (Colonial) (1953) 89 CLR 428). In the current situation, the expenditure is recurrent as in the above case; the outgoing is capital in nature as it preserves the relative's access to the property until the death of the life tenant, and to receive the capital asset absolutely upon this event taking place. | Detailed Reasoning - Enduring Benefit Test: The enduring benefit test suggests that if a loss or outgoing gives rise to a benefit of an enduring nature, the loss or outgoing is more likely to be capital in nature. The test arose to prominence in British Insulated & Helsby Cables Ltd v Atherton (1926) AC 205; 10 TC 15. In that case, the taxpayer contributed £31,784 to establish a pension fund for its staff. The House of Lords was required to determine whether the payment was deductible to the taxpayer company. The payment was held to be capital in nature on the basis that it brought into existence an asset of "enduring benefit". Viscount Cave LC made his classic statement as to the characteristics of capital expenditure when he said (at p 192): When an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital. By "enduring" it is not meant that the asset or advantage should last forever. It is a matter of degree, and only one element to be considered ( Herring v FC of T (1946) 72 CLR 543 per Rich J at p 547). "Asset or advantage" is widely construed. It is not necessary for the asset or advantage to have a tangible existence, i.e. be capable of appearing in a balance sheet. In Foley Brothers Pty Ltd v FC of T (1965) 13 ATD 562 the taxpayer made a payment (which was held to be of a capital nature) to gain release from a contract standing in the way of a major reorganisation and reduction in the taxpayer's business operations. See also Van den Berghs Ltd v Clark (1935) 19 TC 390. In this case, the enduring benefit of the expenditure for the relative is the right to receive the property absolutely under the will upon the death of the life tenant. The benefit therefore is lasting longer than expenditure period and the payment of the annuity can be therefore distinguished from that of rent. What is the expenditure or loss really for? In this case, the outgoing is a quarterly annuity payable by the relative that has arisen as a condition of a will. The will provides that the relative has the exclusive use and occupation of a property subject to certain conditions, of the first being to pay an annuity to the spouse of the deceased during their lifetime. The important point is that the paying of the annuity by the relative has an enduring benefit in providing them with the exclusive use and occupation of the property until the life tenant's death. Upon her death the property will be transferred to the relative absolutely. In addition, if the annuity payments fail to be made according to the will, the trustees are directed to sell the property, paying a lump sum to the life tenant and the residual amount to the relative. The relative would therefore loose access and occupation of the property and the ability to acquire the capital asset. Therefore the expenditure is really for two reasons, one it provides relative with exclusive use and occupation of the property while the life tenant is alive, and secondly it ensures that upon the death of the life tenant, they will be transferred the farming property absolutely. | Detailed Reasoning - Conclusion: The expenditure is therefore not on capital or revenue account for the rulee as it is not a payment obligation of the rulee. The annuity payment is the responsibility of the relative. Accordingly, the true nature of the expenditure is capital as it is preserving the relative's right to the capital asset. As the expense is an expense of the individual and not the rulee; it is neither on capital or revenue account for the rulee.

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