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

Was the capital expenditure the taxpayer incurred after the demerger date 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. All the capital expenditure the taxpayer incurred after the demerger date 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 on goods and services provided and received before the demerger and a business the taxpayer used to carry on.

The taxpayer is an Australian resident company that carries on several industry related businesses solely for a taxable purpose. All but one of the taxpayer's businesses were carried on domestically - the other business was carried on internationally. The taxpayer's Board of Directors decided to demerge the international business from the domestic businesses to, amongst other things, better focus the core activities and growth opportunities of the respective businesses. The demerger had the effect of splitting the shareholder's investment in the taxpayer into two separate investments. The taxpayer continued to carry on the domestic businesses while a new entity carried on the international business.

The process to demerge the international business from the domestic businesses included: • a capital reduction of the taxpayer • a Scheme of Arrangement to apply the taxpayer's capital reduction amount on behalf of its shareholders as consideration for the issue of shares to those shareholders in the entity that would carry on the international business • a reconstitution of the Boards of the taxpayer and the new entity, and • listing both the taxpayer and the new entity on the Australian Stock Exchange (ASX).

The capital expenditure the taxpayer incurred on or after 1 July 2005 on effecting the demerger ('the demerger costs') comprised fees for: • legal services and advice • accountants services and advice, and • investment banking services and advice.

The taxpayer incurred the demerger costs solely to ensure that the demerger of the international business happened.

The capital expenditure the taxpayer incurred on effecting the demerger of the international business was incurred both before and after the demerger date. The capital expenditure incurred after the demerger date was for goods and services provided and received prior to the demerger date.

Subject to the limitations and exceptions contained in subsections 40-880(3) to 40-880(9) of the ITAA 1997, subsection 40-880(2) of the ITAA 1997 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 (b) in relation to a business that used to be carried on (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) of the ITAA 1997, 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. 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) of the ITAA 1997 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: 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. 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) of the ITAA 1997. 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) of the ITAA 1997 as incurred in relation to the business that is most relevant to the expenditure.

In identifying for the purposes of subsection 40-880(2) of the ITAA 1997 the business that is most relevant to the expenditure, it is necessary to look to the character of the expenditure and what it achieved rather than simply the broad intent of its incurrence. The broad intent in this case was the taxpayers' Board's thinking as to benefits intended or expected to flow to the taxpayer that directed their decision towards the object of demerging the international business.

The capital expenditure the taxpayer incurred after the demerger was legal fees, accountant's fees and investment banker's fees which related to goods and services rendered pre-demerger. For this expenditure the taxpayer was provided with a variety of services and advice to effect the Scheme of Arrangement (an integral part of ensuring the demerger of the international business would happen) and the other inextricably linked activities which would ensure that the demerger of the international business would occur. The character of this expenditure is as part of changing the structure by which the international business would be carried on through its demerger from the taxpayer. Accordingly, the business that is most relevant to the expenditure is the international business.

In the circumstances, there is a sufficient and relevant connection between the taxpayer's incurrence of the capital expenditure on legal, accountant's and investment banker's fees and the international business, and that business is the most relevant to that expenditure.

Accordingly, paragraph 40-880(2)(b) of the ITAA 1997 applies to the capital expenditure the taxpayer incurred after the demerger date for goods and services provided and received before the demerger date as it is capital expenditure the taxpayer incurred in relation to a business (the international business) that it used to carry on prior to the demerger date.