Income tax: are support payments made by a parent entity to its subsidiary deductible under section 8-1 or section 40-880 of the Income Tax Assessment Act 1997?

No. Support payments are capital in nature for the purposes of paragraph 8-1(2)(a) of the Income Tax Assessment Act 1997 . [1]

Furthermore, such payments are included in the cost base and reduced cost base of the parent's investment in the subsidiary and are therefore not deductible under section 40-880.

For the purposes of this draft Determination, a support payment is a payment, howsoever described, made by a parent entity to a subsidiary in circumstances where the payment is objectively made because of the fact that all or a part of the subsidiary: • has made a loss or losses • is not, in the opinion of the parent entity or as agreed between the parent entity and one or more other parties (such as the subsidiary and/or a third party), sufficiently profitable (such as may be the case if the profit of the subsidiary is less than an agreed benchmark) • would likely have made a loss or losses, or not have been sufficiently profitable in the sense used above, were it not for that payment but does not include a payment by the parent entity by way of a genuine loan to the subsidiary.

For the purposes of this draft Determination a subsidiary entity of an entity (which for the purposes of this draft Determination is called a parent entity ) is an entity that would be a 'subsidiary' of that parent entity for the purposes of section 46 of the Corporations Act 2001 (CA 2001) if it is assumed that both entities are bodies corporate for the purposes of that Act. However, an entity is not a subsidiary entity of a parent entity where both entities are part of the same consolidated group or MEC group.

For the purposes of applying this test to an entity other than a body corporate: • references to control of the composition of the board are taken to be references to the ability to control decision-making in relation to the entity; and • references to issued share capital are taken to be references to the membership interests in the entity within the meaning of section 960-135.

For the purposes of this draft Determination, an investment by a parent entity in a subsidiary includes both a direct investment as well as an indirect investment held via an interest in one or more entities interposed between the parent and the subsidiary.

Parent Co is a resident company which establishes Sub Co, a wholly-owned subsidiary. Sub Co is established in order to commence a business in a foreign jurisdiction. Parent Co enters into a contract with Sub Co. Under this contract : • Parent Co grants Sub Co a licence to use Parent Co's trademarks and business systems • Parent Co undertakes to provide Sub Co with a ' business support service', whereby it will implement and manage Sub Co's business strategy • Sub Co undertakes to pay Parent Co a ' licence and service fee' in each financial year in which Sub Co makes a profit, calculated by reference to several factors, including the level of profit made • Parent Co undertakes to make a payment described as a ' market support payment' to Sub Co in each financial year in which Sub Co makes a loss, equal to the amount of that loss • The parties acknowledge that the level of the licence and service fee has been calculated taking into account Parent Co's commitment to make the market support payment • The market support payment is expressed to be consideration for Sub Co agreeing to follow the instructions of Parent Co in relation to the use of Parent Co's trademarks, business systems and business support service .

Sub Co makes a loss of $ 1 million in its first year of operation. Parent Co pays Sub Co a $ 1 million market support payment .

While the payment may satisfy the positive limb in subsection 8-1(1 ), it is not deductible because it is of a capital nature for the purposes of paragraph 8-1(2 )( a ). Notwithstanding its stated purpose, the payment is objectively made because Sub Co made a loss, and its effect is to maintain the capital value of Parent Co's investment in Sub Co. The payment is not deductible under section 40-880 but is included in the cost bases and reduced cost bases of Parent Co's shares in Sub Co .

Continuing on from Example 1, Sub Co has been operating profitably for a number of years. However, due to difficult trading conditions in its market, Sub Co makes a loss of $ 1 million. Parent Co pays Sub Co $ 1 million under the terms of the contract .

The payment is not deductible under section 8-1 as it is a loss or outgoing of a capital nature. The payment is objectively made because Sub Co made a loss, and its effect is to maintain the capital value of Parent Co's shares in Sub Co, notwithstanding that the payment is made several years after those shares were acquired. The payment is not deductible under section 40-880 but is included in the cost bases and reduced cost bases of the shares in Sub Co .

Continuing on from Example 1, assume that the ' market support payment' is instead defined in the contract to be a reimbursement of a portion of Sub Co's advertising and promotional expenditure. The amount of reimbursement is calculated to enable Sub Co to achieve an arm's length return from its core operations in accordance with an economist's report. Further assume that this payment is made periodically .

The payment is not deductible under section 8-1 as it is a loss or outgoing of a capital nature. While the payment is not defined by direct reference to the losses or profits of Sub Co, it is objectively made to ensure that Sub Co is sufficiently profitable and its effect is to maintain the capital value of Parent Co's investment in Sub Co. The payment is not deductible under section 40-880 but is included in the cost bases and reduced cost bases of the shares in Sub Co .

It is proposed that when the final Determination is issued, it will apply both before and after its date of issue. However the Determination will not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of issue of the Determination (see paragraphs 75 and 76 of TR 2006/10).

This draft Determination identifies parent-subsidiary relationships by reference to the CA 2001. Section 46 of the CA 2001 provides : A body corporate (in this section called the first body) is a subsidiary of another body corporate if, and only if: (a) the other body: (i) controls the composition of the first body's board; or (ii) is in a position to cast, or control the casting of, more than one-half of the maximum number of votes that might be cast at a general meeting of the first body; or (iii) holds more than one-half of the issued share capital of the first body (excluding any part of that issued share capital that carries no right to participate beyond a specified amount in a distribution of either profits or capital); or (b) the first body is a subsidiary of a subsidiary of the other body.

For the purposes of applying this test to an entity other than a body corporate, it is to be assumed that the entity is a body corporate. For this purpose, references to control of the board are taken to be references to the ability to control decision-making in relation to the entity; and references to share capital are taken to be references to interests which would be membership interests in the entity for the purposes of sections 960-130 and 960-135.

Support payments as defined in paragraph 3 of this draft Determination are typically designed to provide financial assistance to a subsidiary in a start-up period or in times of adverse business conditions or financial stress. Financial support may be required where a subsidiary experiences difficulties entering a new market, as a result of market downturns or for other reasons.

A support payment arrangement is commonly described as a means of reflecting the risk a subsidiary is exposed to when it is compelled, requested or otherwise decides to operate in a new market or continue in an existing market. The subsidiary may be using the intellectual property, systems or business strategies of its parent entity.

Whether a payment is a support payment is determined by reference to its true character, rather than the label or words used to describe it. In determining whether a payment by a parent to a subsidiary is a support payment it is necessary to consider whether the payment is, in substance, made by reference to the losses or profits of the subsidiary.

This draft Determination considers whether support payments are deductible.

Section 8-1 relevantly provides: 8-1(1) You can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; or (b) it is necessarily incurred in carrying on a *business for the purpose of gaining or producing your assessable income. 8-1(2) However, you cannot deduct a loss or outgoing under this section to the extent that: (a) it is a loss or outgoing 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 ( Sun Newspapers ), the taxpayer was denied a deduction for an amount paid to prevent a rival publisher from producing a newspaper in the area for a period of three years. The expenditure was held to be capital in nature. In coming to his decision Dixon J made a distinction between capital expenditure, being the amount used for establishing, replacing and enlarging the business entity, structure or the profit yielding subject, and revenue expenditure being the working expenses incurred in carrying on a business.

Dixon J stated in Sun Newspapers , at CLR 359; ATD 93-94; AITR 410, that: The distinction between expenditure and outgoing on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlays. The difference between the outlay and returns representing profit or loss.

Dixon J outlined a number of factors which may assist in making the revenue/capital distinction at CLR 363; ATD 96; AITR 413: 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.

The character of the advantage sought will generally provide the most useful guidance in determining the character of a loss or outgoing: Federal Commissioner of Taxation v. Email Ltd [1999] FCA 1177; 99 ATC 4868; (1999) 42 ATR 698 ( Email ).

Where a payment is made in order to discharge a pre-existing obligation, the advantage sought is characterised by reference to the obligation rather than the payment. In Email the Full Federal Court considered the character of payments made pursuant to an indemnity which was connected to the sale of shares in a related company. The Court noted: [2] ... it is common ground that it is the character of the advantage which the indemnity was calculated to effect, not directly the character of the payments themselves which must fall for consideration.

The labels used by the parties are not determinative of the character of the payment. [3] That is, the legal effect of the arrangement must be determined by a proper reading of the contract taken as a whole, rather than by reference to particular labels or descriptions adopted or asserted by the parties. [4]

The advantage sought by a support payment is the maintenance or enhancement of the capital value of a parent's investment in a subsidiary.

A support payment is, or has substantially the effect of, a non-scrip capital contribution to the subsidiary. [5] It increases the value of the parent's investment in the subsidiary, even though the subsidiary does not issue additional membership interests.

The character of this advantage is structural and enduring. Support payments are used to establish or maintain the business entity, structure or organisation through which profits are generated. They are made for the benefit of the income producing unit within which production is carried on, rather than for the production of the income itself.

The character of the advantage obtained by a support payment arrangement reflects the terms upon which such payments are required. A support payment is required when a subsidiary suffers losses or makes insufficient profits; rather than when, for instance, the subsidiary supplies an asset or service to its parent. Payments that are calculated with reference to the losses or profits of a subsidiary are objectively to be regarded as having the purpose of maintaining the subsidiary's capital structure. In terms of Dixon J's analysis in Sun Newspapers , such payments cannot therefore be regarded as part of the process by which such an organisation operates to obtain regular returns by means of regular outlays.

For the reasons explained in paragraph 27, a payment which is calculated by reference to the losses or profits of another entity cannot be considered as an outgoing on revenue account merely by reference to the description of the payment in a contract. Payments calculated by reference to the profit or losses of another entity would include cases where the payments are said to be a reimbursement of business expenses (such as marketing expenses) of that other entity, payable only if a certain revenue or profitability level is not achieved by that entity.

Further, the distinction between revenue and capital expenditure depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights. [6] From a practical and business point of view, the purpose and effect of a support payment from the parent entity's perspective is to maintain or increase the capital value of its investment in a subsidiary.

Bell & Moir Corporation Pty Ltd v. Federal Commissioner of Taxation [1999] FCA 1009; 99 ATC 4738; (1999) 42 ATR 421 ( Bell & Moir ) illustrates that the character of the advantage sought by payments - what they were calculated to effect from a practical and business point of view - is to be determined from the payer's perspective. There Hely J considered a situation where a shareholder in a company provided a guarantee to a bank on an overdraft for the company. The taxpayer was required to make a payment to the bank under the guarantee agreement. The payment under the guarantee was the subject of the claim for deduction. Hely J found the payment of the guarantee to be capital in nature because: [7] It is the character of the advantage sought by the taxpayer for itself by making the outgoing for which deduction is sought which is the chief factor in determining whether the outgoing is on revenue or capital account.

Hely J went on to say: [8] The nature of the benefit or advantage sought was the propping up of BMM so that the applicant could continue to trade with it. That is the type of enduring benefit which will ordinarily result in the cost of acquiring it as being characterised as capital in nature.

Hely J further observed that: [9] ...insofar as the guarantee is undertaken to secure a source of income the payments required to be made under the guarantee are associated with the acquisition of a position from which to earn income rather than with the day to day revenue costs of deriving income.

Similarly, the objective purpose of a support payment arrangement is to secure the subsidiary as a source of future income, whether in the form of fees, royalties, dividends or other amounts. The purpose of the payments by the parent entity is to create or maintain a profit yielding asset as opposed to the process of operating it, and accordingly those payments have the character of capital from the parent entity's perspective.

Although support payments secure a future source of income, their character differs fundamentally from the payments made to secure exclusive trading rights considered BP Australia Ltd v. Federal Commissioner of Taxation (1965) 112 CLR 386; 9 AITR 615; 14 ATD 1 and National Australia Bank Ltd v. Federal Commissioner of Taxation 97 ATC 5153; (1997) 37 ATR 378. The payments considered in those cases were not calculated by reference to the losses or profits of, or to otherwise 'prop up', a subsidiary entity.

Subsection 40-880(2) provides deduction, in equal proportions over 5 income years, for capital expenditure an entity incurs: • in relation to its business • in relation to a business that used to be carried on • in relation to a business proposed to be carried on, or • to liquidate, deregister or wind up certain entities.

However, an amount cannot be deducted under subsection 40-880(2) to the extent that the expenditure could be taken into account in working out the amount of a capital gain or capital loss from a CGT event (paragraph 40-880(5)(f)).

The cost base and reduced cost base of a CGT asset have five elements and are defined in section 110-25 and 110-55 respectively.

The fourth element of cost base and reduced cost base comprises capital expenditure incurred for the purpose or the expected effect of increasing or preserving the value of the CGT assets (subsections 110-25(5) and 110-55(2)). The objective purpose and effect of a support payment is to increase or preserve the value of a parent entity's investment in a subsidiary. A support payment is therefore considered to be included in the fourth element of the cost base and reduced cost base of a parent's direct or indirect investment in the subsidiary.

To the extent that the parent holds its investment directly by owning membership interests in the subsidiary, the payment is included in the cost base and reduced cost base of those interests. To the extent that the parent holds its investment indirectly through interposed entities, it is included in the cost bases and reduced cost bases of the parent's interests in those entities.

You are invited to comment on this draft Determination including the proposed date of effect. Please forward your comments to the contact officer by the due date.

A compendium of comments is prepared for the consideration of the relevant Rulings Panel or relevant tax officers. An edited version (names and identifying information removed) of the compendium of comments will also be prepared to: 1. provide responses to persons providing comments; and 2. be published on the ATO website at www.ato.gov.au Please advise if you do not want your comments included in the edited version of the compendium. Due date: 22 May 2013 Contact officer: Natasha Zorzi Email address: Natasha.Zorzi@ato.gov.au Telephone: 07 3213 5888 Facsimile: 07 3213 5500 Address: Australian Taxation Office GPO Box 9990 Brisbane 4001