Capital Allowances: business related costs - limitation of deduction - lease or other legal or equitable right

Does paragraph 40-880(5)(d) of the Income Tax Assessment Act 1997 (ITAA 1997), which excludes a deduction under section 40-880 for an amount of expenditure incurred to the extent that 'it is in relation to a lease or other legal or equitable right', apply so as to reduce the taxpayer's deduction under section 40-880 of the ITAA 1997 for capital expenditure it incurred both before and after the demerger date?

No. Paragraph 40-880(5)(d) of the ITAA 1997 does not apply so as to reduce the taxpayer's deduction under section 40-880 of the ITAA 1997 for capital expenditure it incurred both before and after the demerger date.

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 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.

The capital expenditure the taxpayer incurred before the demerger date was incurred 'in relation to your business' for the purpose of paragraph 40-880(2)(a) of the ITAA 1997.

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.

The taxpayer's deduction under section 40-880 of the ITAA 1997 for capital expenditure it incurred both before and after the demerger date is not limited under subsection 40-880(3) of the ITAA 1997.

Paragraph 40-880(5)(d) of the ITAA 1997 provides 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 in relation to a lease or other legal or equitable right'.

In respect of paragraph 40-880(5)(d) of the ITAA 1997, paragraph 2.68 of the Explanatory Memorandum to Tax Laws Amendment (2006 Measures No. 1) Bill 2006 ('the EM') states: This exclusion replicates that found in the repealed section 40-880, having been added in 2002 in the context of the Government's review of the treatment of expenditure incurred on leases or other legal or equitable rights. The 2005-06 Budget announced that the Government would take a case-by-case approach in relation to the taxation of rights.

Since that paragraph states that the exclusion contained in paragraph 40-880(5)(d) of the ITAA 1997 replicates that found in the repealed section 40-880 of the ITAA 1997, it is relevant to consider the repealed paragraph 40-880(3)(d) of the ITAA 1997. In discussing that exclusion, paragraph 3.67 of the Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 5) 2002 stated: The Government is reviewing the treatment of expenditure incurred in relation to leases or other legal or equitable rights as part of the consideration of the recommendations of the Review of Business Taxation. The appropriate income tax treatment of capital expenditure incurred in relation to these leases and rights will be determined as part of that review. Consequently, capital expenditure on leases or other legal or equitable rights will be excluded from deduction under section 40-880. For example, expenditure representing lease surrender payments incurred in closing down your business will not be deductible under section 40-880.

It is therefore relevant to consider what 'leases and rights' were considered in the recommendations of the Review of Business Taxation in order to determine the intended scope of the phrase 'in relation to a lease or other legal or equitable right' in paragraph 40-880(5)(d) of the ITAA 1997 and former paragraph 40-880(3)(d) of the ITAA 1997.

The proposed review of the taxation of 'leases and rights' was discussed at pages 213-280 of the Review of Business Taxation, A Platform for Consultation , Discussion Paper 2 Volume I, February 1999. Specifically, at paragraph 8.1 on page 217, the following is stated: What is a lease or right? Leases and rights are essentially arrangements for transferring some or all of the benefits of ownership of an asset from the owner to the recipient of the lease or right. The following kinds of rights contracts are covered by the discussion: • leasing and similar contracts which provide rights over physical assets, for example, leases of equipment; • contracts giving rights over intangible assets, such as spectrum licences and rights in films, patents, copyright, and industrial designs; • indefeasible rights of use over assets, such as telecommunication cables; • profits á prendre , that is, a right to take a product such as standing timber from another person's land; • contracts for services; • restrictive covenants; and • rights to receivables arising from 'rights' contracts, for example, lease receivables.

There is also a reference at paragraph 9.4 on page 233 of that document that 'service contracts that are, in substance, broadly similar to leases' were part of the review. Further, there is a reference at paragraph 10.1 on page 269 of that document to the effect that rights under franchise agreements were also part of the review.

Section 10 of the Review of Business Taxation, A Tax System Redesigned , Report, July 1999, made recommendations in relation to the taxation of leases and rights. While that report did not explain what was encompassed by the expression 'leases and rights', it can reasonably be inferred that it was referring to the sorts of 'leases and rights' outlined in the Review of Business Taxation, A Platform for Consultation , Discussion Paper 2 Volume 1, February 1999, referred to above.

On the facts, there are no leases or other legal or equitable rights of the types considered by the Review of Business Taxation (in the context of its review of the taxation of leases and rights) in relation to which the expenditure referred to in the facts could reasonably be said to have been incurred.

The Review of Business Taxation was concerned with the proper taxation treatment of 'receipts and expenditure associated with leases and rights on a consistent basis': see paragraph 8.3 on page 217. What receipts and expenditure are so associated with leases and rights as to call for consistent treatment? That depends on what the overall framework is within which treatment should be consistent.

Division 40 of the ITAA 1997 does not apply in the context of a generalised 'tax value method' treatment, and that generalised treatment was the context of the Review of Business Taxation's discussion of receipts and expenditures associated with leases and rights. In the context of the income tax law, what receipts and expenditures are so associated with leases and rights as to be within the scope of paragraph 40-880(5)(d) of the ITAA 1997 may therefore require a closer connection than the connection contemplated in the publications of the Review.

Although it could be said that the expenditure was to some extent incurred in relation to the shares held by the shareholders in the new entity that carries on the international business and that a share is a bundle of rights (albeit the bundle of rights forms one piece of property (see paragraphs 20-26 of Taxation Ruling TR 94/30 and section 1070A of the Corporations Act 2001 ), shares do not appear to be among the type of rights that the Review of Business Taxation considered in the context of its review of the taxation of leases and rights.

For the foregoing reasons, paragraph 40-880(5)(d) of the ITAA 1997 does not apply so as to reduce the taxpayer's deduction under section 40-880 in respect of capital expenditure it incurred as set out in the facts.