1 Are the transaction bonuses deductible under section 8-1?
Yes. Question 2 In the alternative, should the Commissioner find that the transaction bonuses are not deductible under section 8-1, are the transaction bonuses deductible under section 40-880? Answer Not applicable because the answer to Question 1 is yes. This ruling applies for the following period : 1 July 20XX to 30 June 20XX The scheme commences on: 1 July 20XX
Overview 1. This ruling is about whether bonus payments - made by a company to senior employees after the company successfully sought a friendly takeover - are deductible. 2. We'll briefly sketch the facts this way. • There was a target company which ran a business. • The buyer was in a group. • On the day of the takeover, the business made payments, totalling roughly $XM, (which it called transaction bonuses) to a number of continuing staff (more than ten and less than thirty), which it identifies as senior employees. • The target company's ostensible reason for making the payments was to reward staff for long service, past performance, and additional efforts in implementing the takeover project. Business and structure: the target company is the trading business, and uses a payroll entity to pay its key management staff. 3. The target company was 100% owned by the A family from establishment until the takeover during the 20XX income year.
4. The target company conducts a business in the B industry. It produces and distributes B industry products. It sells to major supermarkets, specialty stores, and wholesale customers. It has a small retail clientele. It generates assessable income from selling B industry products. It doesn't have any exempt or non-assessable non-exempt income, and doesn't plan to generate any over the next five years. 5. The target company uses a payroll entity to pay some of its key management staff. The payroll entity is a 100% subsidiary. The payroll entity acts as the payroll entity for the target company for certain key management personnel. The payroll entity payments are ultimately borne by the target company: payments made by the payroll entity are reimbursed by the target company. This is done to ensure privacy for senior employees. Payments are performed by an external accountant. 6. The business's employment expenses make up a significant proportion of its expenditure. Its financial statements for the 20XX financial year show that its employee benefits expenses were about $X, or about 40% of total expenses excluding raw materials and consumables. See Table 1.
Some information has been redacted for the purposes of this edited version. Table 1: employee benefits expenditure Item 20XX 20XX Employee benefits Redacted Redacted Total expenses Redacted Redacted Employee benefits/total expenses (%) About 20% About 20% Total expenses excluding raw materials Redacted Redacted Employee benefits/total expenses excluding raw materials (%) About 40% About 40%
7. The target company pays performance bonuses to key staff. Employment contracts for the recipients show that company performance bonuses are paid at the board's discretion, dependent on business productivity, and individual performance. The CEO's employment contract also has a performance bonus of up to X% of base salary ($X), with components for 'company financial performance', 'lost time injuries', and 'culture and sales'. the target company has paid bonuses to staff, based on their individual performance and continued service. the target company's records show it paid about $XM (very roughly approximated for this edited version) in bonuses to its employees throughout a three year period before the transaction bonuses were paid. Some recipients of those bonuses were members of the A family. Other recipients were senior employees who received transaction bonuses on the takeover. 8. The target company didn't have any other employee incentive schemes such as employee option or share schemes while it was owned by the A family. Tax characteristics: consolidation and residency
9. The buyer's group is an income tax consolidated group. It has a head company. One of its wholly owned subsidiaries acquired the target company. The buyer's group had formed an income tax consolidated group when the target company (and the payroll entity) joined it during the 20XX income year. 10. All relevant entities (being the target company, the payroll entity, the buyer's holding company, and the entity buyer which acquired the target company) were incorporated in Australia, and are tax residents of Australia. Details about the takeover: the target company's former owners sold their shares to the buyer's group, under a strategic plan to attract new capital.
11. The takeover happened this way. The parties executed a share sale agreement several months into the 20XX financial year. Completion happened roughly two months later. On that day, the target company's shareholders disposed of all their shares in the target company to the buyer's group. In exchange, they received a combination of cash, and equity in the buyer's group. Under the share sale agreement, the buyer's group's holding company agreed to issue X% of its ordinary shares to the sellers (that is, the target company's original shareholders). 12. The target company actively sought the takeover, under a strategic plan. the target company's senior management wished to attract new shareholders with additional capital to grow the target company's business. It engaged an advisory firm as financial adviser for the takeover project. The project sought bids from potential buyers. The buyer was one of the bidders, and it submitted a proposed business plan for the target company as part of its application. The buyer's business plan included injecting capital and achieving rapid growth. The target company decided that the buyer had the capacity to achieve that business plan.
13. The applicant supplied a copy of the share sale agreement to support this private ruling application. We'll summarise a few features of the agreement. • The buyer was required to pay cash consideration, and issue X% of the buyer's group's head company's ordinary shares to the target company's original shareholders. • The target company's original shareholders agreed not to: terminate any employees with a salary package exceeding $X, except for cause, or alter terms or conditions for any employees with a salary package exceeding $YK, except for cause, other than consistently with past practices. • the target company's original shareholders agreed to execute deeds of release under which the directors (that is, the former directors from the period when the A family controlled the target company) resigned and were replaced with the buyer's group's nominees. • The parties agreed to sign a co-investment deed. Under that deed, two representatives of the former shareholders were appointed as observers in the buyer's group's head company. As observers, they could attend board meetings but not vote.
• The buyer's group undertakes not to make claims against the target company's former directors, officers, or employees (except for fraud). 14. We sketch the chronology of the takeover in Table 5. Transaction bonuses: the target company's board resolved to pay unconditional transaction bonuses on completion, purportedly to reward staff for past performance and long service. 15. The payroll entity paid transaction bonuses totalling roughly $XM to X employees (more than 10, but less than 30) on the takeover date. • All recipients of the transaction bonuses were current and continuing employees on that day (when they received them). • The founding shareholders weren't paid any transaction bonuses. • On the takeover date, the target company board didn't have any information to suggest that any recipient would retire or resign after payment of the bonuses. • Payment of the transaction bonuses wasn't contingent on any conditions being met, including conditions based on future events. They had no conditions attached.
16. The bonuses were paid from existing the target company cash reserves, with the cash being set aside the day before the takeover. The costs are ultimately borne by the target company, but the payments were done by the payroll entity, which was reimbursed by the target company. This was done to ensure privacy for senior employees. Payments were performed via an external accountant. 17. While the target company's board had been considering paying transaction bonuses for some time beforehand, it didn't make a formal resolution until shortly before completion. • The board had discussed the prospect of paying bonuses with the CEO sometime before completion. • the target company told the General Manager Finance about the potential transaction bonuses (but not specific amounts) late in the 20XX income year, about 8 months before the takeover. • The board discussed the prospect of paying transaction bonuses (to X identified staff) in a board meeting around 3 months into the 20XX income year, but didn't resolve to make the payment. • At the next board meeting (in the following month), the board resolved to make the payment.
• Shortly after that, the board resolved to pay bonuses to an additional Y staff. 18. We'll summarise the stage negotiations had reached at the point the board resolved to pay the bonuses. The buyer had already submitted an indicative offer and a reconfirmed offer early in the 20XX financial year, and had also been granted exclusivity for a certain period. The buyer was still completing final due diligence, arranging financing facilities and arranging W&I insurance coverage before final agreement of the transaction and execution of the transaction documents. Draft share sale agreements and other transaction documents were also being reviewed and negotiated. Table 2 lists the amounts paid to each employee. Table 2: transaction bonus amounts and recipients Role Amount paid (partly redacted for this edited version) Start date with the target company (approximated for this edited version) CEO $X00K About 3 years ago GM Finance $XX0K About 2 years ago GM Risk & Compliance $X00K About 20 years ago X Manager $X00K About 30 years ago GM X Operations $X0K About 2 years ago Business Development Manager $X00K About 10 years ago Distribution Manager $X0K About 40 years ago
Planning Manager $X0K About 20 years ago X Manager $X0K About 20 years ago X Manager $X0K About 30 years ago X Manager $X0K About 20 years ago X $X0K About 20 years ago X $X0K About 30 years ago 19. The senior employees were involved in the transaction process. This included (but wasn't limited to) discussions with key bidders, preparing and participating in management presentations, assistance with due diligence and Q&A workstreams, assistance with site tours, review and input into legal agreements and completion accounts. Table 3 gives more detail. Table 3: involvement of senior employees in the transaction process Employee Involvement CEO Involved in the entire process, sat in on project calls, lead management presentations, sat in on discussions with key bidders in relation to business specific matters, assisted with Q&A, reviewed relevant deal material. General Manager Finance Involved in the entire process, sat in on project calls, participated in management presentations, sat in on discussions with key bidders in relation to business and accounting specific matters, heavily involved in Q&A, reviewed relevant deal material. General Manager Risk & Compliance
Sat in on and led environmental and quality assurance specific calls with key bidders. Involved in the Q&A process. X Manager Involved in site tours for all bidders. General Manager - X Operations Involved in preparing deal related materials, involved in Q&A. Others Continued to be involved in managing the target company during the sale process, but were not as actively and directly involved as the other employees. The client submits that the efforts of these employees in continuing to run the business to a high standard throughout the demanding sale process (while dealing with other impediments brought about by COVID-19) were instrumental in successfully implementing the takeover project. 20. The meeting minutes for the relevant board meeting record reasons or justifications for paying transaction bonuses to selected staff members. Table 4 lists these comments. Table 4: the target company's reasons for paying transaction bonuses Employee Amount Reason CEO $X00K Worked diligently since their employment commenced. Brought the target company to the next level. Instrumental during the sale process. General Manager Finance $XX0K
Set up finance department and put in extremely long hours during the sale process. General Manager Risk and Compliance $X00K Long term employee. Started at a low level but educated themselves with support from the business. Became manager of QA & recently appointed as Compliance Manager. Dedicated to Covid Compliance including Testing and Vaccinations. X $X0K Relatively new Employee as Manager of X division on the Y site. Added to the list because of their commitment to drive production, including the set up and introduction of a new X. The employee has also assisted invaluably during the sale process and managing the covid situation in the X. X $X00K Long Term Employee who has been instrumental in improving X Performance which is ongoing. X $X00K Long Term Employee who goes above and beyond in their role. Extremely loyal staff member. X $X0K Long Term Employee X $X0K Long Term Employee X $X0K Long Term Employee. Dedicated to offering out of hours assistance when any issues arise. X $X0K Long Term Employee who has worked in several areas of the X department.
21. The target company states that the board decided to pay bonuses to a number of additional employees on "various grounds related to past or great performance, and continued loyalty. 22. The recipients were made aware about the transaction bonuses through verbal discussions, and a letter, in the two weeks leading up to completion. The CEO was aware about the transaction bonuses before this, in discussions with the target company's board. The General Manager Finance was made aware of the potential transaction bonuses late in the 20XX financial year but wasn't told about the specific amounts until just before the takeover, when other recipients were told. Table 5: Chronology of the takeover Date Notes Some months before the advisory firm was appointed The target company began considering the takeover project. A few months into the 20XX financial year An advisory firm formally engaged to act as financial adviser for the takeover project. Towards the end of the 20XX financial year The General Manager Finance was made aware of the potential transaction bonuses but wasn't told about the specific amounts. Towards the end of the 20XX financial year
Buyer executed a confidentiality deed poll. About a month later Buyer received marketing materials. About 2 months later Buyer had submitted an indicative offer. About 2 months later Buyer submitted a reconfirmed offer. About a month later, several months into the 20XX financial year The buyer had been granted exclusivity for this month. several months into the 20XX financial year The target company's directors meeting. Minutes show the transaction bonuses were discussed, but not agreed. Some names listed. One director suggested an extra name be included. Directors agreed to discuss at the next meeting in a few weeks. A few weeks later, but about 2 months before the takeover The target company's directors meeting. Transaction bonuses to X recipients approved. Shortly after the relevant directors meeting. The board decided to pay bonuses to a few additional staff bonuses after the meeting when the board reviewed the list of recipients. The board decided that they should also receive bonuses on various grounds related to past or great performance, and continued loyalty. About the same time The target company told the buyer about the amount for the proposed transaction bonuses.
A few weeks later, about 6 weeks before the takeover Share sale agreement was signed (executed). Last 2 weeks before the takeover Recipients were told about the potential transaction bonuses in discussions and by letter. Day before the takeover The target company set aside the cash for the transaction bonuses. Takeover An entity in the buyer's group acquired 100% of the shares in the target company. The target company joined the buyer's group (income tax consolidated group). The payroll entity paid the transaction bonuses. 23. The target company also told the buyer about the prospect of paying transaction bonuses. The concept of paying transaction bonuses was disclosed in a term sheet/share subscription agreement provided to various bidders, including the buyer. The target company told the buyer about the amount of the proposed transaction bonuses about two months before the takeover. 24. The applicant submits that the transaction bonuses were paid for four reasons. • Reward the senior employees for successfully implementing the takeover project, reflecting their instrumental and often difficult task.
• Reward and incentivise them for their past performance and continued loyalty as employees of the target company. • Retain them by paying bonuses through a remuneration policy that was consistent with past events and practice. • Reward their additional efforts during the COVID-19 pandemic (e.g. additional administrative obligations, facilitating compliance with testing and vaccinations, navigating processing facility shutdowns in light of COVID-19 outbreaks.
Section 8-1 of the Income Tax Assessment Act 1997 Section 40-880 of the Income Tax Assessment Act 1997 Section 701-1 of the Income Tax Assessment Act 1997 Section 703-5 of the Income Tax Assessment Act 1997 Section 703-15 of the Income Tax Assessment Act 1997 Section 703-30 of the Income Tax Assessment Act 1997
All legislative references are to the Income Tax Assessment Act 1997. Question 1 Are the transaction bonuses deductible under section 8-1? Answer Yes Summary 25. The payments are deductible to the buyer's group's head company under section 8-1. The target company made the payment when the buyer's group's head company was the head company of an income tax consolidated group. Therefore, the payments will be treated as having been made by the buyer's group's head company under the consolidation rules. We've chosen to characterise the payments as being made to retain staff and maintain staff productivity. Therefore, we accept the payments were incurred in gaining or producing assessable income, and weren't capital or private expenditure. The payments meet the positive limbs and aren't excluded under any of the negative limbs. Detailed reasoning Consolidation Consolidation: income tax consolidated groups are treated as a single entity for income tax purposes
26. Section 701-1 says if an entity is a subsidiary member of a consolidated group, it's taken to be parts of the head company for both head company core purposes and entity core purposes. Head company core purposes are working out the head company's tax liability or loss. Entity core purposes are working out the entity's tax liability or loss. 27. Broadly, Division 703 explains concepts relevant to consolidated group membership. Section 703-5 says a consolidated group includes a head company and all its subsidiary members. Section 703-15 says a subsidiary member must be a wholly-owned subsidiary of the head company. Section 703-30 says a subsidiary is a wholly-owned subsidiary if all its membership interests are beneficially owned by the holding entity, or other wholly-owned subsidiaries of that holding entity. The target company was part of the buyer's group's head company's income tax consolidated group, so the buyer's group's head company will be treated as making the payment. 28. Here, the payroll entity made the payment on the takeover date, but was reimbursed by the target company. On that date:
• the payroll entity was a 100% subsidiary of the target company • the target company was a 100% subsidiary of an entity in the buyer's group • the acquiring entity was a 100% subsidiary of the buyer's group's head company • the buyer's group's head company was the head entity of an income tax consolidated group. 29. It follows that the target company (and the payroll entity) will be treated as being part of the buyer's group's head company from the takeover date. Therefore, the tax consequences for any payment will apply to the buyer's group's head company, not the target company. General deductions under section 8-1: payments need to meet either of two 'positive limbs' and avoid being denied by any of four 'negative limbs'.
30. Section 8-1 allows deductions for losses or outgoings if they meet one of two conditions in subsection 8-1(1), and don't meet any of four conditions in subsection 8-1(2). We'll call them the 'positive limbs' and 'negative limbs' for convenience. Under the positive limbs in subsection 8-1(1), the loss or outgoing must be either incurred in gaining or producing assessable income, or necessarily incurred in carrying on a business for the same purpose. The negative limbs disallow deductions for losses or outgoings to the extent they are: • of capital, or of a capital nature • of a private or domestic nature • incurred in gaining or producing exempt or non-assessable non-exempt income • disallowed by a specific provisions. 31. A payment will be treated as an outgoing which has been 'incurred' for general deduction purposes. TR 97/7 [1] summarises some statements taken from case law about the meaning of incurred, at paragraphs 4 through 7. Very broadly, incurred means either an actual payment, or a presently existing liability. Where there's no presently existing liability, the expense is incurred when the money is paid.
32. Here, there's no question that the buyer's group's head company incurred the payments for section 8-1 purposes. the target company set aside the funds and made them available to the payroll entity, which made the physical payment on the takeover date. One of them must have incurred a loss or outgoing. Arguably the target company was the legal entity which 'incurred' the payment because it provided the funds to the payroll entity, which was a mere conduit or intermediary. But here, both the target company and the payroll entity were part of the buyer's group's income tax consolidated group when the payments were made on the takeover date. Both the target company and the payroll entity are treated as being part of the buyer's group's head company, so the buyer's group's head company will be treated as incurring the payment for tax purposes. 33. There's a substantial body of case law which have advanced propositions or principles relevant to interpreting and applying the positive and negative 'capital' conditions. Very broadly, that case law suggests that expenses will:
• usually meet the positive limbs if they are incidental to, or their 'occasion' arose out of, an income producing or business objective • be disallowed under the 'capital' negative limb if they were paid with the purpose of obtaining a lasting benefit for the business (as opposed to a short-term, recurring type income producing reason). We'll discuss the positive limbs and negative limbs in turn. The positive limbs of section 8-1 General principles about the positive limbs: payments need to be incurred 'in the course of' income earning activity, the connection doesn't necessarily need to be direct or immediate. 34. Case law about the positive limbs has established many propositions, principles, or glosses to help interpret and apply them. (We'll use the term 'gloss' as this acknowledges that many of these statements are ways of explaining and understanding the text, not directly grounded in the legislation. They shouldn't substitute for reading and applying the words of the legislation.) We'll list and discuss a few in Table 6. Table 6: glosses from case law about the positive limbs Gloss Discussion
'incurred in gaining or producing' means 'incurred in the course of gaining or producing': Amalgamated Zinc; [2] Ronpibon Tin. [3] This means the expense doesn't need to directly generate assessable income. The expense can be part of a series of events or plan directed at earning assessable income or carrying on a profitmaking business. Outlay must be incidental and relevant to gaining or producing assessable income: Ronpibon Tin. [4] As above. 'necessarily incurred' means appropriate or adapted for - it doesn't mean logical necessity: Ronpibon Tin [5] ; Snowden & Willson. [6] As above. Voluntary and optional payments under a genuine business judgment are okay. They don't have to be legally required or practically necessary. It is both sufficient and necessary that the occasion of the outgoing must be found in earning assessable income or carrying on business for that purpose: Ronpibon Tin. [7] The Macquarie Dictionary says one of the meanings of 'occasion' is "the ground, reason, immediate or incidental cause of some action or result." [8]
This suggests that either 1) the purpose of earning assessable income/carrying on business caused the payment, or 2) activities carried on for that purpose caused the payment. Voluntary outgoings can meet the positive limbs even if the income earning/business advantages are indirect and remote: Magna Alloys. [9] These comments suggest business taxpayers have some scope to make reasonable subjective judgments about how to run their business. It isn't necessary for the payment to be a successful business strategy. But the payment still needs to be objectively directed towards earning assessable income or carrying on business. Obviously irrational payments which couldn't have achieved that end may not be deductible. Within limits of reasonable human behaviour, it is for the business person to determine how much should be spent in running their business or income producing enterprise - not the Commissioner: Ronpibon Tin [10] ; Snowden & Willson. [11] The deductibility (and character) of an expense doesn't depend on the success or failure of what the outlay was intended to achieve: Clough; John Fairfax & Sons. [12]
Whether an expense is incurred 'in' or 'in the course of' earning assessable income depends on the essential character of the expense: Lunney & Hayley. [13] Lunney & Hayley was about deductibility of home to work travel. This test is arguably stricter than a 'but for' type relevance test. Travel expenses are arguably an 'essential prerequisite' to earning assessable income, but their 'essential character' isn't about earning income - it's private, or preparatory. [14] Purpose is an objective attribute of a transaction - not the individual's state of mind. Was the expense incurred in circumstances conducive to carrying on a business or earning assessable income? Robert Nall; [15] Magna Alloys. [16] Purpose is objective. While there's room for reasonable business judgments, the expense still needs to be rationally capable of achieving those aims. It isn't enough to subjectively think the expense might earn income if the plan is obviously irrational. Equally, a subjective intention to pursue other ends might not necessarily prevent deductibility, if objectively, it will help a business earn income or run a profitable business.
Where no income is identified, or the expense is disproportionate to the income, the circumstances may show the taxpayer had a collateral purpose. The taxpayer's subjective purpose may be one factor to consider in determining the objective purpose for the payment. The payment may need to be apportioned if there are multiple (deductible and non-deductible) purposes. Fletcher. [17] This is consistent with the objective approach taken in the other glosses. While there is room for reasonable business judgments, a strategy which is losing income is naturally suspect. The courts and the Commissioner can disallow deductions where the expense doesn't rationally earn income or help carry on a profitable business. 35. IT 2656 [18] is an ATO view document about the deductibility of takeover defence costs. Broadly, this says that costs incurred to prevent a takeover: • aren't deductible under the first positive limb because they aren't incidental and relevant to producing income [paragraphs 12-13]
• are unlikely to be deductible under the second limb because they are concerned with share ownership, not a working expense incurred in carrying on the company's business [paragraphs 14, 16] • might be deductible under some limited circumstances, where the directors perceived the takeover would threaten the business and impair its income earning activities [paragraph 17] • are likely to be capital because they are relevant to business structure or ownership [paragraphs 26-27]. 36. The same considerations apply to employment costs. While most payments made to staff would be deductible as having an ordinary trading character, this always depends on the circumstances. We think it's helpful to summarise some case decisions illustrating whether payments to employees are deductible. 37. Payments to retiring staff aren't deductible if the payments aren't connected to producing future income but are voluntary grants out of gratitude for long service. See Union Trustee Co. of Australia [19] and Telecasters North Queensland Ltd. [20] 38. However, payments to induce an employee to retire for business reasons may be deductible. For illustrations, see: •
W. Nevill and Company Limited [21] (payout allowed the company to stop an inefficient joint management system) • Maryborough Newspaper Company Limited [22] (failing to make a gratuity payment to a retiring director with many years' service might have alienated staff, potential candidates for employment, and readers) • Mitchell (Inspector of Taxes v B.W. Noble Limited [23] (director accused of improper conduct was paid to leave the firm to avoid a scandal which might have damaged the business) . 39. Salary payments won't be deductible if they are grossly disproportionate to the employee's duties or the company's income: in that case, there's no link to earning assessable income. See Robert G Nall Limited. [24] 40. Cancellation payments made to employees holding options (under an employee option plan) mightn't be deductible if they were made to secure a takeover. In that case, the 'occasion' for the payment could be a shareholder matter, outside the course of ordinary trading operations. See Clough Limited. [25] Characterising the payments: what were the payments made for?
41. We need to characterise the payments to determine whether they meet either positive limb. To do that, we need to consider their context and objective purpose. Given the relevant facts and circumstances, what were the payments made for? Were the payments incurred for the purpose of earning assessable income, or part of a broader business plan to achieve the same end? We identify some relevant circumstances and discuss their significance in Table 7. Table 7: circumstances relevant to characterising the payments Circumstance Discussion Recipients: the payments were made to current, ongoing staff. the target company had no information suggesting any staff were retiring. This links the payment to the business's ordinary trading activities. Employing staff is a routine trading operation needed to keep the business operating day-to-day. Remunerating staff is usually an ordinary business expense.
Staff remuneration wouldn't always have an ordinary business character. For example, payments couldn't be described as ordinary operations where payments were motivated by the director's personal relationship with the recipient. Another example would be where the payment is directly connected with unusual duties, such as acquiring a capital asset or changing the business structure. Conditions: the payments were unconditional. The absence of any condition might suggest they'd have a limited incentive effect, assuming staff act as rational, self-interested economic actors. Staff members aren't prevented from leaving employment after receiving the bonus. Further, there's no specific incentive to work harder in future. Of course, staff might reasonably expect that they may receive similar bonuses if they continue to perform at their current standard. Nevertheless, it's still reasonable to expect that an unconditional bonus has the potential to improve staff productivity and retain staff. Staff aren't purely rational economic actors.
Bonuses are likely to make staff happy and contented in their work: they may feel rewarded and valued. They may respond by seeking to remain with their employer and continuing (or even lifting) their efforts and performance. Bonuses might contribute to instilling in staff natural feelings of loyalty, trust, and gratitude towards their workplace. Those feelings might attach to board members, shareholders, fellow staff, or the business in a more general sense. Bonuses can also prevent negative reactions from staff. Staff motivation, productivity, and willingness to stay with the business might be reduced if they felt that their efforts, service, or performance haven't been recognised. If management level staff or key employees are happier and more productive, that may in turn encourage other staff, improving retention, and lifting general workplace productivity and morale.
Further, arguably a clinically constructed bonus could be less effective in some cases. People aren't purely rational economic actors. Requiring clawback if staff leave, or don't meet future performance hurdles) might encourage more mercenary or cynical staff behaviours which could counteract any aim to instil loyalty. Change in ownership: the A family sold all their shares and resigned as directors on the takeover. However, they acquired an X % interest in the buyer's group. This factor might reduce the incentive effect of an unconditional bonus. Staff will appreciate that the target company's board and ownership have changed. They may fear that the target company's bonus policy and expectations of staff might change under new management. Similarly, the change of ownership might decrease the general 'happiness' factor we discussed in the cell above. Feelings of loyalty, trust, and gratitude might attach to the former owners and directors responsible for paying them the bonus, rather than the new management or ongoing business.
However, that wouldn't necessarily mean there's no incentive effect at all. The former owners will retain an ongoing interest in the business, through their equity in the buyer's group. Staff might expect the new management to continue the same bonus policy. Also, some of the loyalty, trust, and gratitude developed through past bonuses might transfer to the workplace (including ongoing colleagues and staff relationships) rather than the owners. Trigger: the payments were made on completing a takeover. This suggests the payment could have been an incentive for staff to work towards achieving the takeover. That would be an unusual event outside the ordinary course of running a business. However, that would only be the case where staff were aware of the potential bonus in time to change their behaviour to achieve it. Further, making a payment on a particular event wouldn't necessarily make the event decisive in determining its character. For example, a company might pay a bonus at Christmas. Just because the payment is triggered
by a non-work related event (like a national holiday or religious occasion) wouldn't necessarily give it a non-business (or private) character. Ordinarily, the reasons for the payment would be more to do with staff or business performance, rather than Christmas as such. An annual milestone or event might be picked for (more or less) arbitrary reasons, just to ensure the bonus is considered at a consistent time every year. Decision makers: the board was controlled by the selling shareholders when it resolved to pay the bonuses An expense made by a business could be characterised as a non-business payment. For example, a director might cause a company to pay their personal expenses. Outgoing director/shareholders might have an incentive to appropriate business assets for personal or other non-business related purposes. Gratuitous payments to retiring staff could be explained as personal (non-business) in some circumstances: see eg, Union Trustee Co. of Australia.
Even payments to current and ongoing staff might be characterised as personal expenses. This would be appropriate where there was no connection between the payment and earning future assessable income. That would suggest they were paid for non-business reasons, such as connections between the outgoing directors and their former staff. We don't think its appropriate to make that characterisation here for three reasons. First, there are possible benefits to the business. The staff are ongoing, and the board identified them as deserving bonuses because of high performance or long service. Despite the change in management and ownership, it's still reasonable to think that the bonuses could help retain key staff and maintain (or improve) workplace performance
Second, it seems unlikely personal connections could explain the payments. The bonuses were paid to an amount of staff, more than ten but less than thirty, mostly in key management roles across the business (executive, finance, compliance, production, assets). Those staff were a mixture of recent appointments and long-serving staff members. They don't have the appearance of a departing gesture to a few close friends. (Even if that had been a subjective motivation for some directors, that isn't decisive where there are objective benefits for the business: see the reasoning in Magna Alloys. [26] )
Third, the incoming shareholders were aware of the payment, suggesting they accepted it as a bona fide payment in the business's best interests. It's clear from the share sale agreement that retaining key staff was important to them: see paragraph 13 in this private ruling. It doesn't appear that the buyer's group opposed the payments being made, or alleged any wrongdoing by the former directors in approving the payments. While the share sale agreement limits liability for claims against the former directors for their conduct, we expect that's a routine boilerplate clause. We don't take it as an admission that the former directors had breached duties to the company in making the payment. Staff knowledge: most recipients (except the CEO and finance manager) were told about the potential payments about 2 weeks before the takeover was completed.
This makes it unlikely that the bonus could have been a substantial incentive to work towards the takeover. Apart from two of them, all the recipients only became aware of the pending bonus two weeks before the takeover happens. We expect that the takeover was highly likely to proceed at that point. It seems unlikely that informing staff about the pending bonus two weeks before completion could have significantly changed their behaviour or made the takeover more likely to succeed. Arguably, their knowledge of the payment could have acted as an incentive for the CEO and finance manager. They knew about it well in advance, and were involved in the takeover project throughout. However, if the board wished to incentivise staff to work towards the takeover, we'd expect they would have informed all relevant staff about the possible bonus. For those reasons, it doesn't seem likely that the payment was made to facilitate the takeover. [27] Any incentive effect would have been incidental and secondary. Involvement of staff in the takeover Some staff were heavily involved in the takeover, but others weren't directly involved.
Four staff (the CEO, and three general managers) were directly involved, through negotiations or preparing deal materials. Another staff member (X Manager) took the bidders on site tours. The other recipients just kept managing the business as normal. This suggests the takeover's relevance was limited. Many recipients weren't directly involved. Their efforts in running the business and continuing their normal may have generally made the takeover more likely (eg, through impressing the bidders with business operations and performance). However, the takeover project didn't require those recipients to do anything outside the scope of their ordinary employment duties. Takeover negotiations The buyer's group was aware that transaction bonuses might be paid, but they don't seem to have insisted or required that they'd be paid. If that had happened, that might have suggested the payments were necessary to secure or facilitate the takeover. That would suggest the takeover was the reason (or the occasion) for the payment, like the Clough decision. [28] Decision timing: the board decided to make the payments just two months before the takeover, when the draft agreement was being reviewed.
This suggests the takeover was highly likely to take place at that point. Therefore, it seems unlikely that the board made the payment with the intention of securing the takeover. If the takeover would happen regardless, the board can't have made the payment to achieve it. The recipients wouldn't have been incentivised to work towards achieving it to any material extent. Records: board meeting minutes record that the payments were made to reward staff for past performance and long or loyal service The meeting minutes suggest the predominant purpose for the payments was to reward staff for high performance or long service in their ordinary duties. Helping with the sale process was only referenced as a factor for four recipients (and it wasn't the only consideration even for them). For the remaining staff, past performance or long service were the only reasons. If the takeover was a substantial reason for the payment, we'd expect the bonus would be limited to those staff who were directly involved in the takeover process.
Of course, subjective reasons aren't decisive. Objective facts might suggest other reasons. But we see no surrounding circumstances which counteract or displace the reasons recorded in the minutes. Remuneration policy: the target company pays key staff performance bonuses We think this consideration has limited relevance when characterising this payment. We think the performance bonuses are different to the takeover bonuses because they were more likely to act as an incentive. The possibility of getting performance bonuses is referenced in all the sample employment contracts the target company supplied. In contrast, the takeover bonuses don't seem to be part of the standard employment contracts, and many staff weren't told about the possibility of getting them until two weeks before completion. Staff were aware that they might get bonuses if they performed well. But broadly, staff weren't aware they might get a separate bonus for the takeover, so it wasn't an incentive for them to achieve the takeover.
We expect the target company's ordinary performance bonuses would be an ordinary trading expense. Businesses need staff to operate and trade day-to-day. Performance bonuses incentivise them to work harder in their ordinary duties, and might improve (short-term) business productivity. But that doesn't mean that unusual payments with different characteristics can be treated as if they were ordinary performance bonuses. We don't think Nevill suggests otherwise. Several judges in that case made comments to the effect that expenses in reorganising staff, even unusual ones, were ordinary business expenses. [29] As Dixon J put it, "[the] purpose was transient, and although not in itself recurrent, it was connected with the ever recurring question of personnel." But in that case, the termination payment was characterised as a trading expense because it allowed the business to terminate an inefficient system, reduce future staff expenses, and reorganise the staff. It isn't authority that unusual staff payments would always have a trading character, or that you can disregard the features of a payment by grouping it as being a wider pool of expenses. [30]
That proposition would also be inconsistent with Robert Nall, [31] which illustrates that salary payments won't be deductible if they don't help run a business or earn assessable income. We characterise the payments as ordinary business expenses to retain staff and maintain their productivity, rather than a payment incurred for capital or equity purposes. 42. Balancing the considerations discussed in Table 6, we think the transaction bonuses have the character of ordinary business expenses. They are best characterised as payments made to staff to encourage them to continue to work productively in the target company's ongoing business. • The payments can be understood as arising out of ordinary trading activities. The board felt it appropriate to reward ongoing staff for past performance and loyalty in the course of their duties as employees. They can be understood as part of a broader series of activities or plan directed at carrying on a functioning business. • We think it's reasonable to think that bonuses to staff have the potential to improve or maintain staff performance.
• While the payments could perhaps have been structured differently to be more effective incentives, we don't think the failure to make them conditional on future performance takes them outside a reasonable business judgment. They can be understood as part of a broader series of activities or plan directed at carrying on a functioning business. • While the payments were authorised by departing board members, we don't think the circumstances justify characterising them as private payments serving only the directors' personal wishes. 43. The takeover doesn't seem to have been a significant reason for the transaction bonuses for two reasons. First, while it might have triggered them, we don't think its main purpose was to incentivise staff to work towards the takeover. Many of the recipients were unaware about the possible bonus until very shortly before completion, when they were unlikely to make a difference to the project's success. Second, there's no evidence that the buyer's group insisted on the transaction bonuses. Therefore, transaction bonuses don't seem to have been necessary or essential to achieve the takeover. [32]
Further, we don't think they had a significant role in enabling, facilitating, or making it more likely to happen. 44. For those reasons, we don't think the takeover should determine the character of these payments. The payments weren't essential to secure the takeover, and probably didn't have a major role in enabling it. It was a trigger, but not the reason for the payments. We don't characterise it as the 'occasion' for the payments. (If it was, that would arguably make the payments about ownership and equity, not relevant to the business. See IT 2656.) Like a Christmas bonus, the milestone or trigger to mark or prompt the payment seems to be somewhat arbitrary, and isn't decisive in characterising it. There are objective connections to the business and discernible or possible benefits for it. On balance, we think the payment was instead made to encourage staff to remain working for the target company, and to maintain their performance standards, after the takeover.
45. We don't characterise the payments as having mixed purposes. We think the purpose was to retain staff and maintain their performance standards. We don't think they had other purposes like achieving an ownership change, or securing a lasting advantage for the business. The takeover was intended to achieve those results, but the transaction bonuses weren't paid to secure the takeover. Rather, it was an arbitrary trigger, not the reason for the payments. Therefore, we think the entire transaction bonus amount was a business expense. We don't need to consider apportionment because it didn't have mixed business and non-business components. Conclusion on the positive limbs: the transaction bonuses were incurred in gaining or producing assessable income
46. It follows from our characterisation that the transaction bonuses meet the positive conditions in subsection 8-1(1). We accept that the payments were ordinary business expenses. They were incurred to retain staff and maintain staff productivity. That gives them a business character: they were an incidental part of a broader plan to operate a business for the purpose of producing assessable income. Therefore, we accept they were incurred in the course of gaining or producing assessable income, and carrying on a business for that purpose. The negative conditions 47. We'll discuss the negative conditions in subsection 8-1(2). We think the 'capital' condition is the most relevant. The first limb: expenses which are capital or capital in nature General principles about capital expenditure: does the expenditure produce a lasting advantage for the business? 48. Courts have developed guidance for distinguishing capital from revenue expenses. 49. A commonly cited test is from Sun Newspapers. [33] There, Dixon J said there are three considerations relevant to characterising payments as revenue or capital:
• the character of the advantage sought (lasting qualities and recurrence are relevant) • the manner in which it is to be used, relied upon, or enjoyed (recurrence is also relevant) • the means adopted to obtain it (for example, by periodical outlays covering commensurate periods, compared to a final payment to secure future use or enjoyment). 50. ATO rulings summarise some other propositions extracted from case law. We'll paraphrase a few points made by TR 2019/D6 [34] , TR 2016/3 [35] , and TR 2017/1 [36] . • Capital expenditure is about the business entity, structure or organisation set up to earn profit; revenue expenses are the process through which the organisation operates: making regular outlays to produce regular returns. [TR 2016/3 at paragraph 159; TR 2017/1 at paragraphs 19-20] • The character of an outgoing depends on what it's calculated to effect, judged from a practical and business point of view. [TR 2017/1 at paragraph 193; TR 2016/3 at paragraph 162; TR 2019/D6 at paragraph 43]
• To characterise expenditure, it's necessary to consider the whole picture and commercial context, making a wide survey and exact scrutiny of the taxpayer's activities. [TR 2016/3 at 158] • No single consideration (including the lasting quality of an advantage) is determinative: they are just factors to consider. [TR 2016/3 at paragraph 161] • Characterising salary and wage expenditure (as revenue or capital) is a question of fact to be determined objectively in each case. [TR 2016/3 at paragraph 168] • For the three considerations identified by Dixon J, not all are of equal weight: the first (the character of the advantage sought) is usually the most important. [TR 2019/D6 at paragraph 36] • The test isn't whether the expenditure itself provides an enduring benefit, but whether the expenditure enhances or augments the profit-making structure, or whether it's incurred as a cost of operating the business. [TR 2016/3 at paragraph 163] • For the character of the advantage sought, the focus is on what was sought, rather than what was achieved. [TR 2017/1 at paragraphs 24 and 217]
• Labour costs, while ordinarily revenue, may be capital where there's a direct link with a capital asset. [TR 2016/3 at paragraph 168; TR 2019/D6 at paragraphs 7-9, 37-55] • Where labour costs have a mixed character, apportionment may be necessary. [TR 2016/3 at paragraph 171; TR 2019/D6 at paragraphs 9, 61 and 62] Applying these principles to the takeover bonuses: we think they aren't capital, because they secured temporary benefits in operating the business more efficiently 51. Characterising the reason and purpose for the payments is important when determining whether they are best treated as capital or revenue. This depends on whether the payments were made to secure the takeover, or were primarily paid to maintain staff performance after the takeover. 52. If the payments were made to incentivise staff to stay on and continue to work productively in the target company's business, that would suggest the payments are revenue in nature. Costs of remunerating and incentivising staff for ordinary business operations don't produce a lasting advantage for the business. They are incurred regularly and recurrently to keep the business operating day-to-day.
53. On the other hand, if the payments were made to secure the takeover, they could acquire a capital character. • The payments would have been made to secure a lasting change to the business. In some circumstances, payments made to secure ownership and equity changes wouldn't be connected to the business, and wouldn't produce any advantage for it. But here, the target company sought the takeover as part of a strategic plan to inject capital and grow the business. That seems like a lasting benefit for the target company's business. • The transaction bonuses were made once and for all, not regularly or recurrently. While bonuses generally are a regular payment, a payment made to secure a takeover isn't recurrent. • The advantage secured by the transaction bonuses would be enjoyed indefinitely, for as long as the new owners kept up a plan to grow the business and inject capital.
54. We think it flows from our characterisation of the payments as ordinary trading expenses that the payments are best treated on revenue, rather than capital account. See paragraphs 42 to 45. The payments weren't directed to securing the takeover: they were made to incentivise staff to stay on and keep performing to a high standard after the takeover. That benefit is temporary, and would be enjoyed for a limited time. While the transaction bonuses themselves were a once-off, triggered by an unusual event, they had the same purpose as an ordinary performance bonus. Remunerating staff through performance bonuses arguably places them in the category of things which could be reasonably expected to recur throughout the business's existence, even though this specific payment didn't. On balance, applying the considerations Dixon J identified in Sun Newspapers, we think the payments have a revenue character. 55. It follows that the transactions weren't capital or capital in nature. Second, third, and fourth negative limbs: private, exempt and NANE income, denied by specific deductions 56. The remaining limbs aren't relevant. We briefly address them in Table 8.
Table 8: the second, third, and fourth negative limbs Negative condition Discussion Second negative condition: expenditure of a private or domestic nature The second negative limb is rarely relevant, because private expenses are unlikely to pass the positive limbs. (TR 2020/1 [37] makes this point at paragraph 47.) We don't think the transaction bonuses can be described as private or domestic in nature for the reasons discussed in Table 7. We think the payments produced objective benefits for the business. While it's possible directors may have been partly influenced by personal feelings for former staff in authorising the payments, we don't think that matters. We don't see any reason to doubt that payments were authorised and made in good faith in the best interests of the company. Third negative condition: expenditure incurred in gaining or producing exempt or non-assessable non-exempt income This isn't relevant. the target company doesn't produce exempt or non-assessable non-exempt income. Fourth negative condition: expenditure disallowed by a specific provision We haven't identified any specific provisions which would disallow a deduction here. Conclusion on Question 1:
the transaction bonuses are deductible under section 8-1 57. It follows that the transaction bonuses are deductible (in full and upfront) under section 8-1. They meet the positive conditions in subsection 8-1(1), and aren't disqualified by any of the negative conditions in subsection 8-1(2). Question 2 In the alternative, should the Commissioner find that the transaction bonuses are not deductible under section 8-1, are the transaction bonuses deductible under section 40-880? Answer Not applicable because the answer to Question 1 is 'yes'. Reasoning 58. Very broadly, section 40-880 allows businesses to deduct capital expenditure over 5 years if it isn't otherwise deductible or disallowed by another provision. To loosely summarise the conditions, the expenditure must: • be capital expenditure: subsection 40-880(2) • be 'in relation to' your business [38] : paragraph 40-880(2)(a) • not fit within a prohibition or exception: subsections 40-880(5) through (9). One prohibition or exception is that the payments are deductible under another provision. See paragraph 40-880(5)(b).
59. Section 40-880 won't apply to the transaction bonuses for two reasons. First, we characterised them as being on revenue rather than capital account for the reasons given in Question 1 at paragraph 54. Therefore, they aren't 'capital' expenditure. Second, we concluded that they are deductible under section 8-1, so they're deductible under another provision. > [1] Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions. [2] Amalgamated Zinc (De Bavay's) Limited v Federal Commissioner of Taxation (1935) 54 CLR 295, at 303 per Latham CJ. [3] Ronpibon Tin No Liability; Tongkah Compound No Liability v Federal Commissioner of Taxation (1949) 78 CLR 47, at 56 per Latham CJ, Rich, Dixon, McTiernan and Webb JJ. [4] Ronpibon Tin No Liability; Tongkah Compound No Liability v Federal Commissioner of Taxation (1949) 78 CLR 47 at 56-57 per Latham CJ, Rich, Dixon, McTiernan and Webb JJ. [5] Ronpibon Tin No Liability; Tongkah Compound No Liability v Federal Commissioner of Taxation (1949) 78 CLR 47at 56-57 per Latham CJ, Rich, Dixon, McTiernan and Webb JJ. [6] FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431 at 436-437 per Dixon CJ. [7]
Ronpibon Tin No Liability; Tongkah Compound No Liability v Federal Commissioner of Taxation (1949) 78 CLR 47 at 56 per Latham CJ, Rich, Dixon, McTiernan and Webb JJ. [8] Macquarie Dictionary Publishers (2022) The Macquarie Dictionary online, accessed at https://www.macquariedictionary.com.au/features/word/search/?search_word_type=Dictionary&word=occasion on 24 June 2022. [9] Magna Alloys and Research Pty Ltd v Federal Commissioner of Taxation (1980) 49 FLR 183 at 208-209 per Deane and Fisher JJ. [10] Ronpibon Tin No Liability; Tongkah Compound No Liability v Federal Commissioner of Taxation (1949) 78 CLR 47at 57 per per Latham CJ, Rich, Dixon, McTiernan and Webb JJ. [11] FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431 at 444 per Fullagar J (Williams J agreeing). [12] Clough Ltd v Federal Commissioner of Taxation [2021] FCAFC 197 at [54] per Thawley J (Kenny and Davies JJ agreeing); John Fairfax & Sons (1959) 101 CLR 30 at 49 (per Menzies J). [13] Lunney v Commissioner of Taxation; Hayley v Commissioner of Taxation (1958) 100 CLR 478 at 497 per Williams, Kitto and Taylor JJ. [14] See Parsons, RW ([1985] 2011), Income Taxation in Australia: Income, Deductibility, Tax Accounting,
The Law Book Company Limited, Sydney, paragraphs [8.61-8.62] at pages 470-471, discussing Lunney v Commissioner of Taxation; Hayley v Commissioner of Taxation (1958) 100 CLR 478 at 498-499 per Williams, Kitto and Taylor JJ. [15] Robert G Nall Limited v Federal Commissioner of Taxation (1937) 57 CLR 695 at 711 per Dixon J. [16] Magna Alloys and Research Pty Ltd v Federal Commissioner of Taxation (1980) 49 FLR 183 at 192 per Brennan J. [17] Fletcher v Commissioner of Taxation (1991) 173 CLR 1 at 17-19 per Mason CJ, Brennan, Deane, Dawson, Toohey, Gaudron and McHugh JJ. [18] Taxation Ruling IT 2656 Income tax: deductibility of takeover defence costs. [19] Union Trustee Co of Australia v Federal Commissioner of Taxation (1935) 53 CLR 263 at 269 per Rich J, at 207-271 per Dixon J. [20] Telecasters North Queensland Ltd v Federal Commissioner of Taxation (1989) 20 ATR 637 at 645 per Spender J. [21] W. Nevill and Company Limited v Federal Commissioner of Taxation (1937) 56 CLR 290 [22] Maryborough Newspaper Company Limited v FCT (1929) 43 CLR 450 [23] Mitchell (Inspector of Taxes) v B.W. Noble Limited [1927] 1 K.B. 719 [24] Robert G Nall Limited v Federal Commissioner of Taxation
(1937) 57 CLR 695. [25] Clough Limited v Commissioner of Taxation [2021] FCAFC 197 at [18, 83-85] per Thawley J (Kenny and Davies JJ agreeing). See also the discussion in Parsons, RW ([1985] 2011), Income Taxation in Australia: Income, Deductibility, Tax Accounting, The Law Book Company Limited, Sydney, paragraph 6.271 at page 404. [26] Magna Alloys and Research Pty Ltd v Federal Commissioner of Taxation (1980) 49 FLR 183 at 196-197 per Brennan J, and 210-211 per Deane and Fisher JJ. [27] Compare Clough , where the taxpayer and acquirer decided that it was necessary to make cancellation payments to the employees to buy out their rights under an EOP. See the Full Federal Court decision in Clough Limited v Commissioner of Taxation [2021] FCAFC 197, at [18, 83-85] per Thawley J (Kenny and Davies JJ agreeing), and the first instance decision in Clough Ltd v Federal Commissioner of Taxation [2021] FCA 108; (2021) 112 ATR 752 at 773-775 [102, 105-113] per Colvin J. [28] See footnote 27. [29] W . Nevill and Company Limited v Federal Commissioner of Taxation (1937) 56 CLR 290 at 304 per Rich J, 306 per Dixon J, 309 per McTiernan J. [30] See the discussion in Parsons, RW ([1985] 2011),
Income Taxation in Australia: Income, Deductibility, Tax Accounting, The Law Book Company Limited, Sydney, paragraphs 6.271-6.272 at pages 404-405. [31] Robert G Nall Limited v Federal Commissioner of Taxation (1937) 57 CLR 695. [32] See footnote 27. [33] Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337, at 363 per Dixon J. [34] Draft Taxation Ruling TR 2019/D6 Income tax: application of paragraph 8-1(2)(a) of the Income Tax Assessment Act 1997 to labour costs related to the construction or creation of capital assets. [35] Taxation Ruling TR 2016/3 Income tax: deductibility of expenditure on a commercial website. [36] Taxation Ruling TR 2017/1 Income tax: deductions for mining and petroleum exploration expenditure. [37] TR 2020/1 Income tax: employees: deductions for work expenses under section 8-1 of the Income Tax Assessment Act 1997. [38] Or a business that used to be carried on, or a business proposed to be carried on.