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Was the taxpayer's capital expenditure incurred 'in relation to your business' for the purposes of paragraph 40-880(2)(a) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes. The taxpayer's capital expenditure was incurred 'in relation to your business' for the purposes of paragraph 40-880(2)(a) of the ITAA 1997 because there was a sufficient and relevant connection between the taxpayer's incurrence of the expenditure and the taxpayer's business.

The taxpayer conducts a business on a purpose designed site. They carry on the business wholly for a taxable purpose.

A necessary part of the taxpayer's business is the maintenance of a licence from a government authority to carry on that business. In order for the taxpayer to maintain the necessary licence from the government authority, they must comply with a condition that they provide the government authority with a financial assurance in respect of the licence. The financial assurance is intended to provide a guarantee that, amongst other things, certain remedial costs in respect of the taxpayer's business are not borne by the community.

The taxpayer sought to satisfy their obligation to provide a financial assurance by incorporating a company (the company) into which the taxpayer subscribed capital to establish a pool of funds. The subscription of capital occurred by the taxpayer subscribing for shares in the company upon its establishment and then on a quarterly basis until the fund reached (and maintained) the maximum amount required by the government authority.

The shares do not grant any rights to the taxpayer to receive dividends, appoint a director, vote at meetings of the company or receive a return of funds they have paid to the company for the shares. The shares may, however, be transferred for valuable consideration as part of a sale of the taxpayer's business. The taxpayer also subscribed a separate nominal amount for one voting share, the cost of which is excluded from the expenditure under consideration.

The taxpayer is expected to fund any remedial action from their own resources and not from the financial assurance fund. That is, the company will not use the money in the fund to carry out remedial action on behalf of the taxpayer as a matter of course. This is only done in circumstances where the taxpayer fails to carry out that action themselves. In this respect, the company has the ability to undertake the remedial work itself (or assume responsibility for the work being done). The government authority is also able to claim against the fund for reimbursement if the government authority is required to undertake remedial action.

The share subscription is capital expenditure incurred on or after 1 July 2005.

All references to legislation in this Interpretative Decision are to the ITAA 1997 unless otherwise stated.

Subject to the limitations and exceptions contained in subsections 40-880(3) to 40-880(9), subsection 40-880(2) provides that you can deduct, in equal proportions over a period of five 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.

As the taxpayer carries on a business and incurred the expenditure under consideration here, it is necessary to consider whether paragraph 40-880(2)(a) is satisfied.

In considering the phrase 'in relation to' contained within subsection 40-880(2), paragraph 2.25 of the Explanatory Memorandum to Tax Laws Amendment (2006 Measures No. 1) Bill 2006 (the EM) states: The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business. The concept used to establish this character or requisite relationship between the expenditure incurred by the taxpayer and the business carried on (current, past or prospective) is 'in relation to'. The connector 'in relation to' allows the appropriate latitude to enable the deductibility of qualifying capital expenditure incurred before the business commences or after it has ceased.

The phrase 'in relation to' was considered by the High Court in PMT Partners Pty Ltd (In Liquidation) v. Australian National Parks & Wildlife Service (1995) 184 CLR 301. Brennan CJ, Gaudron and McHugh JJ observed, in considering the application of the Commercial Arbitration Act 1985 (NT), at 313: Inevitably, the closeness of the relation required by the expression 'in or in relation to' in s 48 of the Act, indeed, in any instrument - must be ascertained by reference to the nature and purpose of the provision in question and the context in which it appears.

In that case, Toohey and Gummow JJ also observed: It is apparent that the words 'in or in relation to' are particularly wide. ... Cases concerning the interpretation of this phrase in other statutory contexts are of limited assistance. However, the cases do show that the words are prima facie broad and designed to catch things which have sufficient nexus to the subject. The question of sufficiency of nexus is, of course, dependent on the statutory context. (at 330) ... The connection which is required by the phrase 'in relation to' is a question of degree. There must be some "association" which is "relevant" or "appropriate". The question of the relevance or appropriateness of the connection is a question which cannot be divorced from the particular statutory context. (at 331)

In First Provincial Building Society Limited v. Commissioner of Taxation (1995) 56 FCR 320; 95 ATC 4145; (1995) 30 ATR 207, Hill J considered the phrase 'in relation to' within the context of paragraph 26(g) of the Income Tax Assessment Act 1936. He considered the words 'in relation to' in that context included a relationship that may either be direct or indirect, provided that the relationship consisted of a real connection, but that a merely remote relationship is insufficient.

It is therefore necessary to consider the legislative context of subsection 40-880(2) in order to determine whether there is a sufficient and relevant connection between the incurrence of the expenditure and a particular business. In discussing the types of business capital expenditure to which subsection 40-880(2) applies, paragraphs 2.19 and 2.20 of the EM state: 2.19 Expenditure on the structure by which an entity carries on (or used to or proposes to carry on) their business and on the profit yielding structure of the business would ordinarily be expected to be of a capital nature. Capital expenditure can also relate to a business's trading operations or the entity that will carry on the business. 2.20 The structure covers the legal entity (such as a company) or the legal relationship (such as a partnership or trust) that is the entity that carries on the business for a taxable purpose and that holds the business assets.

These paragraphs indicate that capital expenditure incurred on the structure by which an entity carries on, or used to or proposes to carry on their business, on the profit yielding structure of the business, or relating to the business's trading operations, are capable of being described as capital expenditure incurred 'in relation to' that business for the purposes of subsection 40-880(2). Whether such capital expenditure is incurred 'in relation to' the particular business will depend on whether there is a sufficient and relevant connection between the incurring of the expenditure and that business on the facts of the particular case.

In the present case, a necessary part of the taxpayer's business is the maintenance of a licence from the government authority to carry on that business. In order for the taxpayer to maintain the necessary licence from the government authority, they must comply with a condition that they provide the authority with a financial assurance in respect of the licence. The taxpayer sought to satisfy their obligation to provide a financial assurance by incorporating a company into which the taxpayer subscribed capital to establish a pool of funds. The subscription of capital occurred by the taxpayer subscribing for shares in the company upon its establishment and then on a quarterly basis until the fund reached (and maintained) the maximum amount required by the government authority.

The incurrence of capital expenditure by the taxpayer in subscribing for shares in the company is an integral step in the process of establishing a pool of funds which will be used to provide the government authority with the necessary financial assurance. The provision of a financial assurance by the taxpayer to the government authority is a condition of the taxpayer maintaining the necessary licence from the authority for the taxpayer to carry on their business.

In these circumstances, there is a sufficient and relevant connection between the taxpayer's incurrence of the expenditure in subscribing for shares in the company and the taxpayer's business. Accordingly, the capital expenditure the taxpayer incurred in subscribing for shares is capital expenditure the taxpayer incurred in relation to their business for the purposes of paragraph 40-880(2)(a).

However, subsections 40-880(3) - 40-880(9) set out further limitations and exceptions to the amount that can be deducted under section 40-880. In this case paragraph 40-880(5)(f) applied to the taxpayer's share subscription expenditure to exclude any deduction under section 40-880 for that expenditure. The expenditure was included in the first element of the CGT cost base of the shares.