Deductions and expenses: premium included as part of the purchase price - capital or revenue expense

Is a premium paid as a component of the purchase price of part of another entity's business an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No. The premium paid is not an allowable deduction under section 8-1 of the ITAA 1997 as it is an outgoing of capital, or of a capital nature.

The taxpayer carried on the business of marketing financial products. Its business included the indirect making of loans through brokers and advisers who acted as intermediaries between the taxpayer and its customers.

The taxpayer, in looking to develop a direct clientele relationship model, acquired the direct lending loan book of another entity. Under the transaction, all assets and liabilities in respect of that loan book became the property of the taxpayer. The taxpayer also acquired the direct lending staff of the vendor.

Whilst the taxpayer acquired the customer relationships and loan documentation in respect of the vendor's direct lending business, it was restricted from offering any of its other products to those customers.

The purchase price paid by the taxpayer to the vendor for the loan book comprised the face value of outstanding loans as at the purchase date together with the premium. The premium component has been treated as goodwill in the taxpayer's books of account.

As a result of the acquisition, the taxpayer's overall lending market share increased by approximately 2%.

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, or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, no deduction is allowed where the outgoings are of capital, or of a capital nature.

In Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403 Dixon J referred to what are now considered guidelines in determining whether a loss or outgoing is of a capital or revenue nature: There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

In BP Australia Ltd v. Federal Commissioner of Taxation (1965) 112 CLR 386; (1965) 14 ATD 1; (1965) 9 AITR 615 (BP Australia) rival companies began offering direct financial inducements to retailers to join their solo site plans. BP was forced to follow suit and lump sum payments were offered to retailers who would tie themselves to BP products for periods of not less than three years. The Privy Council held that the real object of the outgoing was not the tied network but the orders that would flow from it. The tie agreements were a temporary solution that were of a recurrent nature. The advantage sought was the promotion of sales by up to date marketing methods which had become necessary. The expenditure was held to be deductible and not capital, or of a capital nature.

In National Australia Bank v. Federal Commissioner of Taxation (1997) 80 FCR 352; 37 ATR 378; 97 ATC 5153 (NAB) the bank made a lump sum payment to the Commonwealth in order to secure for 15 years the exclusive right to make advances to defence force personnel. The Full Federal Court found that there were features present which diluted the significance of the lump sum payment. The bank wanted to make periodic payments and the agreement contemplated that an initial payment would be followed by 16 annual payments. The payment was held to be of a revenue nature as it did not enlarge the framework within which the bank carried on its activities. Rather, it was incurred as part of the process by which the bank operated to obtain regular returns by means of regular outlay. Furthermore, the payment was found to be in the nature of a marketing expense and had a revenue flavour.

Unlike the situation in BP Australia and NAB, it could not be said that the advantage sought in this instance was in the nature of marketing. Payment of the premium enabled the taxpayer to gain an enduring advantage through the enlargement of its business framework. Rather than maintain the taxpayer's existing position, the expenditure enabled it to establish a new market through the acquisition of an existing customer base.

In Federal Commissioner of Taxation v. Email Ltd [1999] FCA 1177; 99 ATC 4868; 42 ATR 698, the Full Federal Court said that where expenditure is made to acquire an asset, the nature of what is acquired will cast light on whether the outgoing is of a capital or revenue nature. In the present instance, from a practical and business point of view, the expenditure: • enabled the taxpayer to fast track its entry into a new market • enabled the acquisition of all the assets and liabilities of a part of the vendor's business which had the effect of enlarging the taxpayer's business framework and its profit yielding structure, and • was made as part of a single lump sum to secure the use and enjoyment of the business acquired, including its existing customer relationships and loan documentation.

Having regard to the whole set of circumstances, it is considered that the outgoing is of capital or of a capital nature. The premium was paid as part of the purchase price of an asset of an enduring nature and is not deductible under section 8-1 of the ITAA 1997.