Capital Allowances: business related costs - in relation to a business that used to be carried on

Was the capital expenditure incurred by the taxpayer incurred 'in relation to a business that used to be carried on' for the purpose of paragraph 40-880(2)(b) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes. The capital expenditure the taxpayer incurred was incurred 'in relation to a business that used to be carried on' for the purpose of paragraph 40-880(2)(b) of the ITAA 1997, because there was a sufficient and relevant connection between the taxpayer's incurrence of the expenditure and a business that used to be carried on, and that business is the most relevant to the expenditure.

The taxpayer is a company that carries on business entirely for a taxable purpose.

The taxpayer incurred, after 30 June 2005, capital expenditure to settle certain legal proceedings brought against it by the liquidator of another company (the company in liquidation). It was alleged that the taxpayer had wrongfully received money that belonged to the company in liquidation arising from that company's business activities and that deprivation of that money led to an inability of the company in liquidation to pay its trade debts.

All legislative references in this Interpretative Decision are to the ITAA 1997 unless otherwise noted.

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 5 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.

In considering the phrase 'in relation to' contained within subsection 40-880(2), paragraph 2.25 of the Explanatory Memorandum to the 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. FC of T 95 ATC 4145; 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 (at ATC 4155; ATR 218).

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, the EM states: 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.

The statement in paragraph 2.48 of the EM - '[t]he business to which the expenditure relates is that most relevant to the expenditure' - indicates that when there is such a connection between the incurring of the expenditure and more than one business, the expenditure is treated for the purposes of subsection 40-880(2) as incurred in relation to the business that is most relevant to the expenditure.

In identifying for the purposes of subsection 40-880(2) the business that is most relevant to the expenditure, it is necessary to look to the character of the expenditure rather than simply the broad intent of its incurrence. The broad intent in this case was the taxpayer's Director's thinking as to benefits intended or expected to flow to the taxpayer that directed their decision towards the object of settling the legal action.

The taxpayer incurred capital expenditure to settle the legal proceedings against it. The plaintiff's claims against the taxpayer were that the taxpayer had wrongfully received money that belonged to the company in liquidation arising from that company's business activities and that deprivation of that money led to an inability of the company in liquidation to pay its trade debts. The capital expenditure bears the character of expenditure incurred in relation to the trading operations of the company in liquidation. It is considered that the business that is most relevant to the capital expenditure is the business that used to be carried on by the company in liquidation.

In the circumstances, there is a sufficient and relevant connection between the taxpayer's incurrence of the capital expenditure and the business that used to be carried on by the company in liquidation, and that business is the most relevant to that expenditure.

Accordingly, the capital expenditure was incurred in relation to the business that used to be carried on by the company in liquidation and falls within the ambit of paragraph 40-880(2)(b).