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Does paragraph 40-880(5)(j) of the Income Tax Assessment Act 1997 (ITAA 1997) apply to capital expenditure the taxpayer incurs to raise capital for the acquisition of the shares in an offshore company?

Yes. Paragraph 40-880(5)(j) of the ITAA 1997 does apply to capital expenditure the taxpayer incurs to raise capital for the acquisition of the shares in an offshore company as there is a sufficient and relevant connection between the acquisition of the shares and the gaining or producing of non-assessable non-exempt income.

The taxpayer is an Australian resident company that is the head company of a tax consolidated group. The taxpayer also acts as the holding company for the taxpayer's wider group of entities (the Group) that includes Australian and offshore entities. The taxpayer's activities as a holding company constitute the carrying on of a business.

As part of the taxpayer's business of investing in, funding and managing its subsidiaries as a holding company, the taxpayer, through an offshore member of the Group that it wholly owns, acquired another offshore company by acquiring all its shares.

The acquisition funds were specifically raised from a particular rights issue and share placement in the taxpayer. The taxpayer incurred costs in raising these funds. These capital raising costs are capital expenditure incurred in relation to the taxpayer's business as a holding company under paragraph 40-880(2)(a) of the ITAA 1997.

The acquisition of the shares in the offshore company is expected to result in considerable revenue growth for the Group - primarily from future growth offshore. The taxpayer does not expect significant revenue growth in Australia. The taxpayer's core products in Australia have experienced revenue decreases. The taxpayer expects Group cost savings to arise from the acquisition of the offshore company. However, the taxpayer expects the cost savings in Australia will be small compared to the expected global savings.

The taxpayer derives assessable income in the form of management fees from its subsidiaries.

At the time the capital raising costs were incurred, the taxpayer had stated no current or future plans to extract any dividends from any of its offshore subsidiaries. However, if dividends were derived by the taxpayer from its offshore subsidiaries, they would be non-assessable non-exempt income under section 23AJ of the Income Tax Assessment Act 1936 (ITAA 1936).

Paragraph 40-880(5)(j) of the ITAA 1997 states that you cannot deduct anything under section 40-880 of the ITAA 1997 for an amount of expenditure you incur to the extent that it is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income.

The phrase 'in relation to' is also used in subsection 40-880(2) of the ITAA 1997. The Tax Office considers that the nature and extent of the connection required by the phrase 'in relation to' in the context of paragraph 40-880(5)(j) of the ITAA 1997 is the same as that required for the phrase in subsection 40-880(2) of the ITAA 1997. In considering the phrase 'in relation to' contained within subsection 40-880(2) of the ITAA 1997, 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 ITAA 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.

As such, whether capital expenditure is incurred to any extent 'in relation to' the gaining or producing of exempt income or non-assessable non-exempt income will depend on whether there is a sufficient and relevant connection between the incurrence of the expenditure and the gaining or producing of exempt income or non-assessable non-exempt income on the facts of the particular case.

In this case, the taxpayer's capital expenditure was incurred to raise capital. The object of that capital raising was targeted and specific: that is, a rights issue and share placement to provide the funds to purchase the shares in the offshore company. In determining the extent to which the taxpayer's capital expenditure was incurred in relation to gaining or producing exempt or non-assessable non-exempt income, it is appropriate in these circumstances to consider the taxpayer's particular use of the capital that it has specifically raised. In this case, the taxpayer raised the capital specifically to fund the acquisition of the shares in the offshore company.

There is no real relationship between the acquisition of the shares in the offshore company and revenue growth to the taxpayer as revenue growth in Australia is not expected to be significant. In fact, the taxpayer has experienced decreases in revenue from its core products in Australia. Therefore, the acquisition of the shares in the offshore company was not in relation to revenue growth opportunities for the taxpayer.

Similarly, there is no real relationship between the acquisition of the shares in the offshore company and cost savings to the taxpayer as the expected cost savings for the taxpayer as a result of the acquisition of the offshore company are small compared to the expected global savings. Therefore, the acquisition of the shares in the offshore company was not in relation to the cost savings for the taxpayer.

While the taxpayer may derive assessable income from the offshore company from management fees, the holding of shares in a company does not, in itself, entitle a shareholder to management fees. Therefore, there is no real relationship between the acquisition of the shares in the offshore company and the derivation of any assessable income in the form of management fees by the taxpayer from the offshore company.

As such, the only income the taxpayer can possibly derive from the acquisition of the shares in the offshore company is dividends. Any revenue growth or cost savings in respect of the taxpayer's offshore subsidiary would only increase the subsidiary's potential to pay dividends to the taxpayer. As such, there is a real connection, albeit an indirect one, between the holding of the shares in the offshore company and the receipt of dividends by the taxpayer. Any such dividends received by the taxpayer, however, would be non-assessable non-exempt income under section 23AJ of the ITAA 1936.

As there is a sufficient and relevant connection between the acquisition of the shares in the offshore company and the gaining or producing of non-assessable non-exempt income, the capital raising costs were incurred wholly in relation to the gaining or producing of non-assessable non-exempt income.

Paragraph 40-880(5)(j) of the ITAA 1997 will apply to exclude any deduction under section 40-880 of the ITAA 1997 in respect of the capital raising costs that it has incurred.