Private ruling: Business capital expenditure
Date of advice: 6 November 2017
Published: April 2018
Ruling period: 1 July 20xx to 30 June 20xx
Date scheme commenced: 1 July 20xx

Ruling: Q1: Is the payment capital expenditure incurred by Company A in the 20xx income year in relation to its business for the purposes of subsection 40-880(2) of the ITAA 1997? | A1: Yes.

Relevant facts and circumstances: Company A is the head company of an income tax consolidated group. In 20xx, the Company A decided to separate one of its businesses through a demerger. A new company, Company B, was incorporated for the purposes of holding all entities and assets associated with Company A’s demerged business after the demerger. Demerger Deed In preparation for the demerger the companies entered into a Demerger Deed. The Demerger Deed provides a mechanism whereby certain historical tax costs that relate to the business of the other company prior to the demerger can be claimed from the other company. The ‘tax claim’ mechanism was triggered once the tax claim reached a minimum threshold. During the relevant income year, the net tax amount as calculated by the parties reached a balance of less than the threshold amount. Deed of Amendment The companies decided to enter into a Deed of Amendment to amend the Demerger Deed to lower the tax claim minimum threshold to $1 and to exclude certain tax costs from the definition of ‘tax claim’. The amendment of the Demerger Deed resulted in a large payment from Company A to Company B in respect of a tax claim amount that was previously under the minimum threshold required for payment. The key reason that Company A decided to amend the Demerger Deed and make the payment was to obtain certainty that Company A would not come under an obligation to pay other potentially greater amounts than the threshold amount if the dispute ensued in relation to certain tax costs that were excluded under the Deed of Amendment. The payment made by Company A constitutes the final settlement of its obligations under the Demerger Deed in respect of the existing net tax claim by Company B.

Relevant legislative provisions: Income Tax Assessment Act 1997 subsection 40-880

Reasons for decision: Summary: The payment is capital expenditure incurred by Company A in the relevant income year in relation to its business for the purposes of subsection 40-880(2) of the ITAA 1997. Subject to the limitations and exceptions contained in subsections 40-880(3) to (9) of the ITAA 1997, the Company A is entitled to claim a deduction over a period of 5 income years under subsection 40-880(2) of the ITAA 1997 in respect of the payment made to Company B in the relevant income year. | Detailed Reasoning - Detailed reasoning: According to subsection 40-880(1) of the ITAA 1997, the object of section 40-880 is to allow a deduction over 5 years for certain business capital expenditure, incurred on or after 1 July 2005, if: (a) the expenditure is not otherwise taken into account; and (b) a deduction is not denied by some other provision; and (c) the business is, was or is proposed to be carried on for a taxable purpose. Taxation 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 ) sets out the Commissioner’s views on the interpretation of the operation and scope of section 40-880 of the ITAA 1997. Paragraph 23 of TR 2011/6 states that determining the amount allowable as a deduction under section 40-880 is a multi-steps process: ● First, it is necessary to determine initial entitlement under of subsection 40-880(2); and ● Then, the limitations and exceptions in the subsequent subsections must be considered. | Detailed Reasoning - Subsection 40-880(2): Subject to the limitations and exceptions contained in subsections 40-880(3) to (9) of the ITAA 1997, subsection 40-880(2) of the ITAA 1997 provides that you can deduct, in equal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur: (a) in relation to your business; or (b) in relation to a business that used to be carried on; or (c) in relation to a business proposed to be carried on; or (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 order to determine whether Company A will be entitled to claim a deduction under section 40-880 of the ITAA 1997 in respect of the payment made to Company B in the relevant income year, it is necessary to consider whether all conditions of subsection 40-880(2) are satisfied. | Detailed Reasoning - The expenditure must be incurred on or after 1 July 2005: There is no statutory definition of the term “incurred”. As a board guide, the taxpayer incurs an outgoing at the time they owe a present money debt that they cannot avoid paying (paragraph 62 of TR 2011/6). Paragraph 63 of TR 2011/6 refers to Taxation Ruling TR 97/7 Income Tax: section 8-1 – meaning ‘incurred’ – timing of deductions which sets out the following principles developed by case law to help determine whether and when expenditure is incurred: ● a taxpayer need not actually have paid any money to have incurred expenditure provided that they are definitely committed. ● it is not sufficient if the liability is merely contingent or no more than pending threatened or expected, no matter how certain it is that the expenditure will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum; ● a taxpayer may have a presently existing liability, even though the liability may be defeasible by others or the amount of the liability cannot be precisely ascertained, provided it is capable of reasonable estimation (based on probabilities); ● whether there is a presently existing liability is a legal question in each case, having regard to the circumstances under which the liability is claimed to arise; and ● in the case of a payment made in the absence of a presently existing liability (where the money ceases to be the taxpayer’s funds) the expense is incurred when the money is paid. Under the Demerger Deed, Company A was not under any obligation to make a payment to Company B and Company B was not permitted to make any claim for payment against Company A as its net tax claim amount had not reached the threshold amount. However, the Deed of Amendment allows Company B to make a claim of its net tax amount due to the reduction of the threshold amount. Company A is required to make the payment to Company B within certain period from the date of that Deed. The Deed of Amendment created a presently existing liability in Company A. The payment constitutes full and final settlement by Company A of its obligation to Company B under the Demerger Deed. Accordingly, it is considered that the payment made by Company A to Company B during the relevant income year was incurred by Company A on or after 1 July 2005 for the purposes of section 40-880 of the ITAA 1997. | Detailed Reasoning - The expenditure must be capital in nature: The expression ‘capital expenditure’ is not a defined term. Whether expenditure is capital in nature is determined on the facts of the each particular case having regard to the principles established by the case law. Paragraph 66 of TR 2011/6 refers to the classic test for determining whether expenditure is of a capital or revenue nature which is explained in the judgment of Dixon J in Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CRL 337; (1938) 5 ATD 23; (1938) 1 AITR 403 ( Sun Newspapers ): His Honour said at 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 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 (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 character of the advantage sought provides important direction. It provides the best guidance as to the nature of the expenditure as it says the most about the essential character of the expenditure itself. This was emphasised in the decision of the High Court in G.P. International Pipecoaters v Federal Commissioner of Taxation (1990) 170 CLR 124; 90 ATC 4413; (1990) 21 ATR1 (paragraph 67 of TR 2011/6). If expenditure produces some asset or advantage of a lasting character for the benefit of the business it will be considered to be capital expenditure. As stated in Sun Newspapers at 355 per Latham J, an enduring benefit does not require that the taxpayer obtain an actual asset, it may be a benefit which endures, in the way that fixed capital endures. Menzies J in John Fairfax & Sons Pty Ltd v. Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 11 ATD 510; (1959) 7 AITR 346 concluded that a capital expense can also result in the reduction of capital. In Foley Brothers Pty Ltd v. FC of T (1965) 13 ATD 562; (1965) 9 AITR 635, outgoings incurred for the purpose of altering the organisation or structure of the profit-yielding subject (including its demise) were considered to be of a capital nature (paragraph 68 of TR 2011/6). The objectives of entering into the Demerger Deed by the parties were to facilitate the demerger and set out the transitional and ongoing relationship between the parties. Under the terms of the Demerger Deed, the parties have provided mutual indemnities with relation to certain tax claims, arisen as a result of the demerger, provided that a net tax amount reached the threshold amount. The subsequent Deed of Amendment was entered into by the parties to reduce this threshold amount. On the facts, the advantage that flows from the payment by Company A to Company B under the Deed of Amendment includes: ● The payment constitutes full and final settlement of Company A’s obligations to Company B under the relevant clause of the Demerger Deed; ● The payment provides practical certainty relating to the perceived risk that Company A may have to pay other potentially greater amounts if certain tax costs were included in the relevant definition of ‘tax claim’; and ● Company B agrees to amend the relevant clause of the Demerger Deed to allow Company A to make a tax claim in the future if Company A’s tax amount reaches the new agreed minimum threshold. Therefore, the payment provides an enduring benefit from the finalisation of the obligations of Company A under the Demerger Deed. Accordingly, it is reasonable to conclude that the payment incurred by Company A, is expenditure of capital nature for the purposes of section 40-880 of the ITAA 1997. | Detailed Reasoning - The capital expenditure must be business related: Subject to the specified limitations and exceptions, paragraphs 40-880(2)(a) to (c) of the ITAA 1997 allow a taxpayer to deduct capital expenditure if it is incurred in ‘relation to’ a business: (a) currently carried on by them; (b) formerly carried on by them or by another entity; or (c) proposed to be carried on by them or by another entity. The expression ‘in relation to’ denotes the proximity required between the expenditure on the one hand and the former, current or proposed business on the other. For capital expenditure to be ‘in relation to’ a business there must be a sufficient and relevant connection between the expenditure and the business. Whether capital expenditure is truly business expenditure is determined by the facts. Determining whether the expenditure has the character of a business, expense can be approached by asking what the expenditure is for, in the sense of identifying the need or object that the expenditure serves. If the facts show that the expenditure satisfies the ends of the relevant business, it will have the character of business expenditure (paragraph 79 of TR 2011/6). | Detailed Reasoning - The relevant business: The term ‘business’, is defined in subsection 995-1(1) of the ITAA 1997 as any profession, trade, employment, vocation or calling, but does not include occupation as an employee. The nature and scope of a business for the purposes of section 40-880 of the ITAA 1997 is a question of fact in each case. The reference in paragraph 40-880(2)(a) of the ITAA 1997 to ‘your business’ is a reference to the taxpayer’s overall business rather than a particular undertaking or enterprise within the overall business. Where the taxpayer is the head company of a consolidated group, ‘your business’ refers to the overall business of the head company (paragraph 72 of TR 2011/6). In contrast, paragraphs 40-880(2)(b) to (c) of the ITAA 1997, which concern a former business and a proposed business, could refer to an overall business or a business activity which is an element or aspect of the taxpayer’s overall business. This is also the case with the head company of a consolidated group (paragraph 73 of TR 2011/6). In this case, what needs to be considered is whether the payment was incurred in relation to the current business being carried on by Company A or the former business that used to be carried on by Company A prior to the demerger. Paragraph 40-880(2)(a) of the ITAA 1997 gives an entitlement to a deduction for capital expenditure the taxpayer incurs in relation to their business. The expenditure must relate to an existing business that the taxpayer is carrying on at the time they incur the expenditure (paragraph 98 of TR 2011/6). Under this paragraph, only the taxpayer carrying on the business, and no other taxpayer, is entitled to a deduction (paragraph 99 of TR 2011/6). Under the Demerger Deed, Company A was not under any obligation to make a payment to Company B and Company B was not permitted to make any claim for payment against Company A because the net tax amount had not reached the threshold amount. However, under the Deed of Amendment, Company B was entitled to make a net tax claim against Company A as the threshold amount was reduced to $1. The payment constitutes full and final settlement by Company A of its obligation under the Demerger Deed. This removed the perceived risk that Company A may have to pay potentially greater amounts to Company B. Accordingly, the payment is considered to be incurred by Company A in relation to its current business as there is a sufficient and relevant connection between the payment and the current business of Company A for the purposes of paragraph 40-880(2)(a) of the ITAA 1997. | Detailed Reasoning - Conclusion: Subject to the limitations and exceptions contained in section 40-880 of the ITAA 1997, Company A is entitled to deduct the capital expenditure, in respect of the payment incurred in relation to its current business, in equal proportions over a period of 5 income years starting in the relevant income year in accordance with subsection 40-880(2) of the ITAA 1997.