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Is a compensation payment made to a former director of a trustee company deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No. The payment is not deductible under section 8-1 of the ITAA 1997 as it is of a capital nature.

The taxpayer is a corporate trustee. The trustee carries on a business. The beneficiaries of the trust are also directors of the trustee company. A new director joined the company and became a shareholder. The new director contributed capital to the trust. After a short period, however, conflict developed between the new and existing directors. It was decided to terminate the new director's services. The director demanded to be paid a large amount of money as compensation for the dismissal and for the capital that had been contributed. If the demands were not met legal action would be taken for compensation for unfair dismissal.

The trust agreed to pay the amount demanded. The majority of the payment was for the director not to take any legal action and the remainder was a return of capital.

Whether expenditure is deductible or not falls for consideration under section 8-1 of the ITAA 1997. An exclusion exists, however, in paragraph 8-1(2)(a) for a loss or outgoing of capital or of a capital nature.

The guidelines for distinguishing between capital and revenue outgoings were laid down in Sun Newspapers Ltd and Associated Newspapers Ltd v. FC of T (1938) 61 CLR 337; (1938) 45 ALR 10; (1938) 1 AITR 403; 5 ATD 87 (the Sun Newspapers Case). It was pointed out that expenditure in establishing, replacing and enlarging the profit-yielding structure itself is capital and is to be contrasted with working or operating expenses. The test laid down in the Sun Newspapers Case involved three elements, although none is in itself decisive: • the nature of the advantage sought; • the way it is to be used or enjoyed; and • the means adopted to get it.

As regards the first two elements, the lasting or recurrent character of the advantage and the expenditure is important. Thus the courts have held, in the absence of special circumstances, that expenditure is capital in nature where it is made with a view to bringing into existence an asset or an advantage (tangible or intangible) for the enduring benefit of the business ( British Insulated & Helsby Cables v. Atherton (1926) AC 205). In addition, it is the nature of the advantage sought by the taxpayer that is relevant.

The third element 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 payment was made to the director to guarantee that no further legal action would be taken. The payment was not made to compensate for lost income that resulted from the dismissal.

The payment was made to secure the enduring benefit of no legal action being taken against the trust. The outgoing was capital in nature and, therefore, not deductible under paragraph 8-1(2)(a).