Deductions: initial management fee - when incurred

Is the taxpayer, a participant in an investment project, entitled in the 2002 income year to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the cost of the initial management fee levied by the project manager?

Yes. The taxpayer, a participant in an investment project, is entitled in the 2002 income year to a deduction under section 8-1 of the ITAA 1997 for the cost of the initial management fee levied by the project manager.

The taxpayer received from an investment project manager an 'Information Memorandum' inviting them to apply for participation in a particular project.

The 'Information Memorandum' contained the application form and highly detailed terms and conditions of participation, which included the following: • The project manager had absolute discretion to accept or reject the taxpayer's application. If accepted, the taxpayer would immediately have project holdings allocated to them. • Post-acceptance, a Management Agreement was to be signed and executed in order to formalise the terms of project management, which included liability to a set amount representing an initial management fee. The Management Agreement would have as its commencement date the date of acceptance of the taxpayer into the project. • In signing and executing the application form, if accepted into the project, the taxpayer would make the irrevocable appointment of the project manager as their Power of Attorney for the duration of the project. The Power of Attorney extended to an authority on the project manager's part to sign and execute the Management Agreement on the taxpayer's behalf. • Under the Power of Attorney, the taxpayer agreed to be bound by anything done by the holder of the Power of Attorney. • The entire amount of the initial management fee, a cheque for which was to be forwarded with the application, was to be held by the project manager as application monies to be refunded in the event that the taxpayer's application was unsuccessful. • There was no condition that the finalisation of the agreement or acceptance of the taxpayer into the project would be 'subject' to the subsequent signing of the Management Agreement. • It was noted that there was no right on behalf of the taxpayer to withdraw from the project once accepted. • There was no minimum subscription required for the project.

On 25 June 2002, the taxpayer signed, executed and delivered to the project manager the application form.

The project manager accepted the taxpayer's application on 27 June 2002. Prior to 30 June, a substantial deposit was paid, and the borrowed balance was transferred to the project manager.

In early July 2002, the project manager signed and executed the Management Agreement on behalf of the taxpayer. A copy of the executed agreement, along with a formal notice of acceptance into the project, was delivered to the taxpayer several days later.

The taxpayer's circumstances are such that they satisfy the conditions for entitlement to a deduction under section 8-1 of the ITAA 1997 for the initial management fee, as set out in a Tax Office Product Ruling relating to the investment project. The Product Ruling states that the expenditure is deductible in full for the income year in which it is incurred.

Section 8-1 of the ITAA 1997 allows a general deduction for losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

It is accepted that there is a sufficient connection between the cost of the initial management fee and the taxpayer's income producing activities and that there are no exclusionary clauses that would deny a deduction, the sole question to be addressed is that of when the expenditure was incurred.

Taxation Ruling TR 97/7 sets out the Tax Office view of the meaning of 'incurred'. Broadly, an outgoing is incurred at the time that a present money debt is owed and cannot be escaped. Importantly, a taxpayer need not have actually paid any money to have incurred such an outgoing, providing they are definitively committed to it in the year of income. That is, it must be a 'presently existing liability to pay a pecuniary sum'. 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.

An application of the principles of contract law to the taxpayer's circumstances determines the point at which the agreement between the taxpayer and the project manager was concluded, giving rise to a binding contract which in turn evidences a presently existing liability.

The application to participate in the investment project may be described as an offer, on the part of the taxpayer, that the project manager was free to accept or reject. With the offer accepted, the salient question is that of whether or not the subsequent signing and execution of the Management Agreement was a condition of the agreement, that is, a requirement that a specific event take place before the contract could be considered binding.

A High Court case that considered such questions is Godecke v. Kirwan (1973) 129 CLR 629 ( Godecke's Case ), where Walsh J discussed the following distinction between binding and non-binding contracts made by Parker J in Von Hatzfeldt-Wildenburg v. Alexander [1912] 1 Ch. 284: it is a question of construction whether the execution of the further contract is a condition or term of the bargain or whether it is a mere expression of the desire of the parties as to the manner in which the transaction already agreed to will in fact go through.

Walsh J noted that there were many cases that developed this concept beyond the stark choice between these two alternatives, in that the execution of the further contract may be neither a mere expression of desire nor a condition of the agreement, but rather: It may be a term of a concluded agreement and may place upon the parties an obligation, capable of being specifically enforced by the court, to sign a further contract in accordance with the agreement which they have already made.

In light of this, Walsh J concluded that, based on a construction of the Offer and Acceptance, Godecke and Kirwan: did intend to make a bargain to take effect immediately and did not intend that each of them should be at liberty to withdraw at any time until a further contract was signed.

It was seen that there was no intention to make the execution of the formal contract a condition of a binding contract coming into force.

The relevant factors that led to this conclusion were: • there was the immediate payment of a substantial deposit, • the initial documentation at no point used the term 'subject to' the signing of a further contract, and • the negotiations were not in the form of informal documents such as telegrams or letters but rather were couched in 'detailed terms and conditions of the sale and purchase'.

As may be seen, the taxpayer's negotiations with the project manager in this case are comparable to those that took place between Godecke and Kirwan in that they feature the aforementioned factors and, additionally, the following indicators of an inescapable agreement: • in granting Power of Attorney to the project manager, the taxpayer irrevocably relinquished control over when or whether the Management Agreement was to be signed and executed, • the taxpayer was to be bound by any action of the project manager as the holder of Power of Attorney, • upon acceptance but prior to the signing and execution of the Management Agreement, the taxpayer was allocated their holdings in the investment project, and • no right for the taxpayer to withdraw from the project was provided for in the terms and conditions of the agreement.

It is considered that upon acceptance of the taxpayer into the investment project, the taxpayer and the project manager had finalised the terms of their agreement and intended to be immediately bound to carrying them out, even though the terms regarding project management were to be restated in a separate form which did not alter their effect. The arrangement is considered to have given rise to a binding contract, and in turn a presently existing liability to pay the initial management fee, that took effect in the 2002 income year - the income period in which the taxpayer was accepted into the project.

Accordingly, the taxpayer is entitled in the 2002 income year to a deduction under section 8-1 of the ITAA 1997 for the cost of the initial management fee levied by the project manager. Note: Taxation Ruling TR 2000/8, which contains statements to the effect that potentially deductible expenditure in the form of an initial management fee is considered incurred only when the relevant management agreement is executed, was not intended to cover factual situations such as that described in this decision.

As can be seen from the discussion in Godecke's Case, matters of interpretation of agreements depend on a construction of the terms and nature of those agreements and are matters of fact.

Arrangements where agreements are executed in a year subsequent to entry into a project will remain subject to additional scrutiny as to when relevant amounts are incurred.

For the avoidance of doubt, agreements should be executed in the year of entry into a project, particularly in cases where minimum subscription is an issue. In this regard see the decision of the Federal Court in Spangaro v. Corporate Investment Australia Funds Management Ltd [2003] FCA 1025 ; (2003) 54 ATR 241 where a subsequent finding that minimum subscription had not in fact been achieved resulted in a finding that there was no valid contract in place between the parties.