Capital allowances: business related costs - limitation of deduction - business of another entity

Is the taxpayer's deduction under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997) for capital expenditure they incurred in relation to a business proposed to be carried on limited by subsection 40-880(4) of the ITAA 1997?

Yes. The taxpayer's deduction under section 40-880 of the ITAA 1997 for capital expenditure they incurred in relation to a business proposed to be carried on is limited by subsection 40-880(4) of the ITAA 1997 because the business was proposed to be carried on by another entity for other than a taxable purpose and the capital expenditure is not to any extent in connection with the taxpayer deriving assessable income from that business.

The taxpayer is an Australian resident company that carries on its business solely for a taxable purpose. As part of their growth strategies for the taxpayer, the taxpayer's Board of Directors decided to insert an overseas resident holding company above the taxpayer to hold 100% of the taxpayer's issued shares and seek to have shares in the overseas holding company listed on an overseas stock exchange. This process was colloquially referred to as the overseas 'listing strategy'. The Board considered that the overseas listing strategy would, for example, provide access to a larger pool of equity capital which, ultimately, could be used to acquire assets for the taxpayer and to grow the business of the taxpayer.

The proposed steps to insert the overseas holding company above the taxpayer involved: • incorporating the overseas resident holding company; and • by a proposed Scheme of Arrangement, having all the issued shares in the taxpayer held by the overseas holding company and issuing shares in the overseas holding company to the taxpayer's existing shareholders.

The taxpayer incurred capital expenditure on legal, accounting and independent expert fees on or after 1 July 2005. For this expenditure, the taxpayer was provided with services and advice to assist in progressing and executing the overseas listing strategy. In particular, the services and advice were directed to developing and implementing the steps necessary to insert the overseas holding company above the taxpayer (including the proposed Scheme of Arrangement) and list the company on that overseas stock exchange.

The proposed business of the overseas holding company was not proposed to be carried on for a taxable purpose to any extent. The business that is most relevant to the taxpayer's capital expenditure is the business proposed to be carried on by the overseas holding company. The taxpayer's capital expenditure is incurred in relation to that business.

Subsection 40-880(4) of the ITAA 1997 provides that you can only deduct the expenditure, for a business that another entity used to carry on or proposes to carry on, to the extent that: (a) the business was carried on or is proposed to be carried on for a taxable purpose; and (b) the expenditure is in connection with: (i) your deriving assessable income from the business; and (ii) the business that was carried on or is proposed to be carried on.

The relevant business for the purposes of the application of subsection 40-880(4) of the ITAA 1997 (the business proposed to be carried on by the overseas holding company) was not proposed to be carried on for a taxable purpose to any extent. Furthermore, the capital expenditure the taxpayer incurred is not to any extent in connection with the taxpayer deriving assessable income from the proposed business of the overseas holding company for the purpose of subparagraph 40-880(4)(b)(i) of the ITAA 1997. Relevantly, the Explanatory Memorandum to the Tax Laws Amendment (2006 Measure No 1) Bill 2006 states at paragraphs 2.54 and 2.55: The expenditure must be in connection with the taxpayer deriving their assessable income from the business. [ Schedule 2, item 30, paragraph 40-880(4)(b) ] This is to provide a proxy for the relationship between the taxpayer and 'their' (ie, the taxpayer) business, where the taxpayer that incurs the expenditure is not the same as the taxpayer that carries on the business. Deriving assessable income refers to the entitlement to a share in the profits from the business. The way in which the profit is derived can be direct or indirect. The expenditure also needs to be 'in connection with' the business that was carried on or is proposed to be carried on.

In this case, the proposed business was the business of the overseas holding company, which would hold 100% of the shares in the taxpayer. As such, the taxpayer would not be in a position to derive assessable income, being an entitlement to a share in the profits (derived either directly or indirectly) from the overseas holding company's business. It is the taxpayer's shareholders, who were to become shareholders in the overseas holding company under the proposed Scheme of Arrangement, who were to be in such a position rather than the taxpayer.

Accordingly, there is a 100% limitation imposed by both paragraphs 40-880(4)(a) and 40-880(b) of the ITAA 1997 on deductibility by the taxpayer of the capital expenditure it incurred. In other words, the taxpayer cannot deduct any amount under section 40-880 of the ITAA 1997 for the capital expenditure it incurred.