Is a payment referred to as 'return by way of interest' made by Company X to Company Y under an agreement to acquire Company Z's business, deductible under section 8-1 of the Income Tax Assessment Act 1997?
Yes This ruling applies for the following period : Year ended 31 December 20XX The scheme commences on: 1 November 20XX
1 Company X is the head company of an income tax consolidated group. Company Z is part of Company Y's business. 2 A sale and purchase agreement was entered into for Company Z's shares to be acquired by Company X (share sale). Due to unforeseen delays, Company X and Company Y renegotiated the agreement to allow for the acquisition of Company Z's business (asset transfer) instead of shares as an alternative settlement of the sale. 3 The purchase price was the same under both alternative settlements. 4 While waiting for the relevant approvals, Company X and Company Y also entered into an agreement (Business Management Agreement) whereby Company X obtained the right to manage Company Z with limited exceptions and economic control of Company Z. This included economic exposure to post-tax profits and entitlements to any agreed dividends. Further, the rights obtained by Company X allowed Company X to consolidate Company Z for accounting purposes.
5 Upon entering the Business Management Agreement, Company X was obliged to pay the purchase price for Company Z's business in instalments to Company Y prior to the legal transfer of ownership. Under the sale and purchase agreement, Company X was also obliged to pay an amount calculated by reference to the unpaid instalments of the total purchase price payable to Company Y prior to obtaining legal ownership. The payment was calculated as a X% per annum (Business Management Payment). The relevant clause referred the payment as a 'return by way of interest' and provided that the payment was not part of the purchase price. 6 The amount of the Business Management Payment paid was relatively insignificant compared to the purchase price. 7 Company X then obtained legal ownership of Company Z's business after all instalments had been paid and the relevant approvals had been obtained.
Income Tax Assessment Act 1997 section 8-1
Section 8-1 contains the general rules for deductibility. It consists of both positive limbs (those provisions which set out the criteria necessary for a loss or outgoing to be deductible) and negative limbs (those provisions which set out exclusions from deductibility). The positive limbs are contained in subsection 8-1(1), which allows a deduction for a loss or outgoing to the extent that it is: i) incurred in gaining or producing assessable income (First Positive Limb), or ii) is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income (Second Positive Limb). Subsection 8-1(2) contains the negative limbs and restricts the availability of a deduction to the extent that the expenditure: i) is capital, or is of a capital nature ii) is of a private or domestic nature iii) is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income (NANE), or iv) is prevented from being deductible due to the operation of a provision of the ITAA 1997 or the Income Tax Assessment Act 1936 (ITAA 1936).
To be deductible, the payment must satisfy one of the positive limbs, and not be excluded by any of the negative limbs. Positive limbs To be deductible under section 8-1, the positive limbs in subsection 8-1(1) require there to be a sufficient nexus between the Business Management Payment by Company X and the gaining or producing of its assessable income, or the carrying on of its business. In this case, it is necessary to consider the character and the nature of the Business Management Payment to establish the nexus required under section 8-1. This will also be relevant when it comes to consider the negative limbs; particularly whether the Business Management Payment was capital, or of a capital nature. Character and the nature of the payment Under the arrangement, the Business Management Payment was made to Company Y calculated by reference to the unpaid instalments of the total purchase price payable to Company Y prior to obtaining legal ownership of Company Z's business. The payment was calculated as a X% per annum and was referred to as a 'return by way of interest'.
The word 'interest' is not defined in the ITAA but there are numerous cases which consider the meaning of 'interest' as referred to in ATO ID 2010/133 Income tax: Commitment Fee payable on the undrawn balance of funds available under a credit facility (ATO ID 2010/133). In Federal Commissioner of Taxation v. The Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; 18 ATR 693 (Myer Emporium) , the High Court stated (at CLR 218): ... Interest is regarded as flowing from the principal sum ( Federal Wharf Co. Ltd v. DFCT (1930) 44 CLR 24 at 28) and to be compensation to the lender for being kept out of the use and enjoyment of the principal sum: Riches v. Westminster Bank Limited (1947) AC 390 at 400... The Full Federal Court in Federal Commissioner of Taxation v. Century Yuasa Batteries Pty Ltd (1998) 82 FCR 288; 38 ATR 442; 98 ATC 4380 , referred to Myer Emporium and stated (at FCR 291) that the ordinary meaning of 'interest': ... is the return, consideration or compensation for the use or retention by one person of a sum of money belonging to, or owed to, another, and that interest must be referable to a principal. ATO ID 2010/133 states that:
'A common feature of these definitions is that in order for a payment to be interest, it must be paid in respect of keeping a person out of the use and enjoyment of a principal sum. It must be paid in respect of an amount of money which the person can require to be repaid either upon demand or at a fixed date.' FC of T v Broken Hill Pty Ltd [2000] FCA 1431 ( BHP ) is a case where the Full Federal Court considered the characterisation of the payment (referred to as 'interest') under a contract for the completion of sale of shares. Hill J noted that the label used by the parties to describe the payment is not determinative and that a payment may be in the nature of interest if it is made in respect of credit given otherwise than by way of loan. In addition, Hill J stated the following: 43. ... where under a contract of sale a purchaser is allowed into possession as at the date of the contract and becomes entitled to receive the benefits and bear the burdens of the property as at that date, it is not unusual for there to be an undertaking to pay money on the outstanding purchase price, or for that obligation to speak in terms of the purchaser paying "interest ".
... equity would intervene, even where the terms of the agreement were silent, to impose an obligation of interest. International Railway Company v Niagara Parks Commission [1941] AC 328 at 345 , Public Trustee v Schulz ( 1964) 111 CLR 482 at 498 and Harvela are all examples of the equitable doctrine that it would be unconscionable for the purchaser to have the use of both the purchase price, and the benefit of profits in the meantime, while the price remains unpaid. It is noteworthy, however, that there is no case where an amount has been held in equity to be payable to the vendor as a percentage of the unpaid purchase price, calculated from the date of contract, unless the purchaser has gone into possession. Something more would seem to be necessary (for example, the giving of extended credit on settlement) before the required payment would be referred to as interest. In concluding that the relevant payment was part of the total consideration paid for the shares and therefore had the character of capital, Hill J went on to observe that: 44. ... there is no loan that has been made by GE to BHP. An unpaid purchase price is not a loan: cf Duggan & Anor v FCT
(1972) 129 CLR 365...The purchaser had not entered into possession of that which was sold - essentially the shares... 45. ... it is not at all obvious, indeed the indications are to the contrary, that the so-called interest payment was for some extended credit that was to be given to BHP. 46. ... it is simply not the case that BHP was put into possession on that date or for that matter on the date of the contract, when it might more readily have been obvious that the amount in question had the character of interest... 47 Thirdly, the contract provided that the whole of the moneys payable, both the 'purchase price' and the 'interest' was payable on completion in exchange for the shares which were to be purchased... The so-called interest was merely part of the overall consideration pursuant to which, on completion, BHP would acquire the shares, there being covenants that would ensure that dividends not be paid in the period from contract to completion.
Although labels are not determinative, it is accepted that the Business Management Payment had the character of interest. It was payable in recognition that, although the transaction had not yet settled, the buyer was given earlier possession of the business under the Business Management Agreement. Company X obtained the right to manage Company Z with limited exceptions and economic control of Company Z. Company X was able to consolidate Company Z for accounting purposes. Particularly, Company X obtained economic exposure to post-tax profits and entitlements to any agreed dividends. Though there was no loan or credit provided to Company X by Company Y, Company X obtained the benefits of Company Z's business during a period when the balance of the purchase price remained unpaid. It may be expected therefore that there would be an undertaking for Company X to pay interest on the outstanding purchase price in this circumstance - it would be unconscionable for the buyer to have the use of the unpaid purchase price and the benefit of the business in the meantime.
It is also important to note that, based on the circumstances, unlike the facts in BHP, the Business Management Payment did not form part of the price for the acquisition of the business. Based on the circumstances, the Business Management Payment is considered to have the character of an interest payment on the outstanding purchase price for Company Z's business and did not form part of the purchase price. Relevant connection between outgoing and the business Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of ITAA 1997 following FC of T v. Roberts; FC of T v. Smith (TR 95/25) provides the Commissioner's view on the implications flowing from the decision of the Full Federal Court on demonstrating that a loss comprising interest satisfies the requirements of section 8-1 for deductibility. TR 95/25 provide guidance on the general principles governing deductibility of interest in paragraph 3, in particular:
(a) The interest expense must have a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income and not be of a capital, private or domestic nature. The test is one of characterisation and the essential character of an expense is a question of fact to be determined by reference to all the circumstances. (b) The character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower. However, regard must be had to all the circumstance, including the character of the taxpayer's undertaking or business, the objective purpose of the borrowing, and the nature of the transaction or series of transactions of which the borrowing of funds is an element. In some cases, the taxpayer's subjective purpose, intention or motive may be relevant in deciding the deductibility of interest Taxation Ruling IT 2606 Income Tax: Deduction for interest on borrowings to fund share acquisitions provide further guidance on interest deductibility which state
9. As a general rule, interest on money borrowed to acquire shares will be deductible under the first limb of subsection 51(1) where it is expected that dividends or other assessable income will be derived from the investment. Such expectation will usually exist as shares by their very nature are inherently capable of generating dividends, whether in short or long term. However, such expectation must be reasonable and not a mere theoretical possibility; there must be a prospect of dividends or other assessable income being received... 18. ... if the acquisition of shares by a company secures a source of supply or demand for the company's business the interest on borrowed funds used to acquire the shares would be deductible... As previously discussed, the Business Management Payment is considered to have the character of an interest payment. It was incurred in relation to the purchase of Company Z's business which is a capital asset that is expected to produce future income. Accordingly, there is a sufficient nexus between the payment to the derivation of assessable income of Company X in this instance. Negative limbs Capital vs revenue
In determining whether an outgoing is capital or revenue in nature, Sun Newspapers Ltd & Associated Newspapers Ltd v. FC of T (1938) 5 ATD 87; (1938) 61 CLR 337 outlines the established tests by Dixon J. Dixon J stated, at 363: "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 GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124, the High Court determined at 137 that 'the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid.' In considering the character of the advantage sought, the High Court provided the following guidance in
Federal Commissioner of Taxation v Sharpcan Pty Ltd (2019) 373 ALR 414 at 421-422: Authority is clear that the test of whether an outgoing is incurred on revenue account or capital account primarily depends on what the outgoing is calculated to effect from a practical and business point of view. Identification of the advantage sought to be obtained ordinarily involves consideration of the manner in which it is to be used and whether the means of acquisition is a once-and-for-all outgoing for the acquisition of something of enduring advantage or a periodical outlay to cover the use and enjoyment of something for periods commensurate with those payments...Thus, an indicator that an outgoing is incurred on capital account is what it secures is necessary for the structure of the business. However, as Dixon J explained in Sun Newspapers at 362, whilst recurrence and enduring benefit are relevant considerations, they are not determinative factors:
But the idea of recurrence and the idea of endurance or continuance over a duration of time both depend on degree and comparison...Recurrence is not a test, it is no more than a consideration the weight of which depends upon the nature of the expenditure. Again, the lasting character of the advantage sought is not necessarily a determining factor. Taxation Ruling TR 2004/4 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities further state the following in respect of interest: Can interest be capital? 8. Outgoings of interest are a recurrent expense. The fact that borrowed funds may be used to purchase a capital asset does not mean the interest outgoings are therefore on capital account (see Steele 99 ATC 4242 at 4249; (1999) 41 ATR 139 at 148). Interest incurred prior to assessable income 9. It follows from Steele that interest incurred in a period prior to the derivation of relevant assessable income will be 'incurred in gaining or producing the assessable income' in the following circumstances:
the interest is not incurred 'too soon', is not preliminary to the income earning activities, and is not a prelude to those activities; the interest is not private or domestic; the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost; the interest is incurred with one end in view, the gaining or producing of assessable income; and continuing efforts are undertaken in pursuit of that end. Although the Business Management Payment was a one off lump sum payment as opposed to a recurrent expenditure and generally interest payments are of a recurrent nature, it is not the only factor that needs to be considered in determining whether an item of expenditure is capital or revenue nature. Rather, all relevant factors must be considered collectively.
The character of the Business Management Payment has been discussed in detail above and it is considered to be interest paid on the outstanding purchase price for Company Z's business. It was not part of the purchase price as defined in the sale and purchase agreement and it did not secure Company X any enduring advantage. In considering the objective circumstances and the legal agreements the parties entered into, it is reasonable to conclude that the payment is not capital or of a capital nature. Remaining criteria - negative limbs The payment is also not considered to be: private or domestic in nature; incurred in relation to producing exempt or non-assessable non-exempt income; or prevented from being deductible due to the operation of a provision in ITAA 1997 or ITAA 1936. Conclusion Accordingly, the Business Management Payment meets the requirements to be an allowable deduction under subsection 8-1(1) of the ITAA 1997 and is not excluded by subsection 8-1(2) of the ITAA 1997. Company X is allowed an income tax deduction under section 8-1 of the ITAA 1997 for the payment.