Private ruling: Whether payments are deductible under either section 8-1 or section 40-880
Date of advice: 15 September 2016
Published: November 2016
Ruling period: Year ending 30 June 2017 | Year ending 30 June 2018 | Year ending 30 June 2019 | Year ending 30 June 2020 | Year ending 30 June 2021
Date scheme commenced: 1 July 2016

Ruling: Q1: Is the entity entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) in relation to the buy-back payment? | A1: No. | Q2: If the buy-back payment is considered capital, is the entity entitled to claim a deduction under section 40-880 of the ITAA 1997 for the buy-back payment? | A2: No. | Q3: Will the entity be entitled to a deduction under section 8-1 of the ITAA 1997 in relation to the termination of services payment that will be payable if the services agreement is terminated during the service term? | A3: No. | Q4: If the termination of services payment is considered capital, will the entity be entitled to claim a deduction under section 40-880 of the ITAA 1997 for the termination of services payment? | A4: No.

Relevant facts and circumstances: The entity entered into an agreement with another entity (W) to give up the right to part of its income for services W would provide over a number of years. W and the entity have now entered into a buy-back agreement. The buy-back provides for the entity to buy-back the right to part of its income granted to W. Specifically, in consideration of the revenue buy back the entity agreed to: • Pay W a lump sum amount (the buy-back payment); and • Enter into an arrangement (services agreement) for a shorter period (service term). The buy-back agreement also contained a termination of services agreement which provides for the situation whereby the entity terminates the service agreement during the service term. Should such a termination occur the entity would be liable to pay a make a termination of services payment to W.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 8-1 | Income Tax Assessment Act 1997 Section 104-25 | Income Tax Assessment Act 1997 Section 108-5 | Income Tax Assessment Act 1997 Subsection 110-35(11) | Income Tax Assessment Act 1997 Section 40-880

Reasons for decision: Summary: All the legislative references that follow are to the Income Tax Assessment Act 1997 . Section 8-1 Section 8-1 allows a deduction for losses and outgoings to the extent that they: • are incurred in gaining or producing assessable income; or • are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, no deduction is allowed for losses or outgoings to the extent that they are of a capital, private or domestic nature, or are incurred in relation to gaining or producing exempt income. In this case it is clear that the buy-back payment was incurred in earning the entity's assessable income. However, it must also be determined whether or not that expenditure is excluded from deductibility on the basis that it is of a capital nature. The decision in Sun Newspapers and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403) is a leading authority on the distinction between revenue and capital expenditure. The test laid down in this case involves the consideration of three matters: • the character of the advantage sought by the outgoing • the manner in which the advantage is to be used, relied upon or enjoyed by the taxpayer, and • the means adopted to obtain the advantage, such as by recurring payments. In relation to the first two matters it is necessary to examine whether the expenditure secures an enduring benefit for the business ( British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205). The buy-back payment gives rise to an advantage which is that the entity no longer has the obligation to pay to W a percentage of its revenue for the term of the original agreement. This advantage has a lasting and enduring character. The third matter involves a consideration of whether the outlay is a periodic one covering the use of the asset or advantage during each period or whether the outlay is calculated as a single final provision for the future use or enjoyment of the asset or advantage. The buy-back payment is a one off type expenditure and therefore does not represent recurrent expenditure for the entity's business. The buy-back payment is considered to be capital in nature as it secures an enduring benefit; affects the entire profit making structure of the business; and is a one off type payment rather than a recurrent payment. Consequently a deduction is not allowable under section 8-1 for the buy-back payment. Section 40-880 Section 40-880 allows for a five year write-off for black-hole business capital costs provided the expenditure is not otherwise taken into account, a deduction is not denied by some other provision and the business was carried on for a taxable purpose. However, there are some limitations and exceptions. You cannot deduct an amount of expenditure you incur to the extent that it could, apart from this section, be taken into account in working out the amount of a capital gain or capital loss from a CGT event. In this case, the CGT exclusion requires consideration. Section 108-5 in part states a CGT asset is any kind of property or a legal or equitable right that is not property. Note 1 to section 108-5 specifically states that an example of a CGT asset is 'a right to enforce a contractual obligation'. Section 104-25 discusses the cancellation, surrender and similar endings of an intangible CGT asset (CGT event C2). Subsection 104-25(1) states CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset: (a) Being redeemed or cancelled; or (b) Being released, discharged or satisfied; or (c) Expiring; or (d) Being abandoned, surrendered or forfeited; or (e) If the asset is an option - being exercised; or (f) If the asset is a convertible asset - being converted. Subsection 104-25(2) states the time of the event is when you enter into the contract that results in the asset ending or if there is no contract, when the asset ends. Termination or other similar fees incurred as a direct result of your ownership of a CGT asset ending are incidental costs included in the CGT asset's cost base (subsection 110-35(11)). Under the original agreement the entity had to pay a percentage of its revenue to W but also had the right to receive services from W. By terminating the deed the entity gave up its right to enforce the contractual obligation on W to provide the entity with services and consequently CGT event C2 happened. The buy-back payment is a cost incurred by the entity in terminating its right to enforce contractual obligations under the original agreement and is therefore included in the cost base of the CGT asset. The entity received no capital proceeds and therefore has made a capital loss. As the buy-back payment is taken into account in working out a capital gain or a capital loss from a CGT event, a deduction is not allowable under section 40-880. Termination of services payment It is considered that the character of the termination of services payment is essentially the same as that of the buy-back payment. Consequently all of the above reasoning with respect to the buy-back payment applies equally to the termination of services payment. Therefore, a deduction is not allowable under section 8-1 or 40-880 with respect to the termination of services payment but it is included in the cost base when calculating the capital loss that will occur if the entity terminates the service agreement within the service term.