Deductions

1 Are bonuses paid under a phantom share plan (Transaction Bonuses) deductible under section 8-1?

Yes Question 2 In the alternative, should the Commissioner find the Transaction Bonuses are capital in nature, 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 : XXXY income year The scheme commences on: 1 July XXXY

1.         One year after a takeover, a business made payments to certain staff under a phantom share plan. The A Group 2.         The A Group is a group of companies which carries on a manufacturing business. •                The A Group includes several companies; the number isn't material for the purposes of this edited version. •                The A Group manufactures products and supplies them to retailers, wholesalers, and distributors to earn assessable income. •                The A Group's businesses didn't earn exempt income or non-assessable-non-exempt income in the relevant income years. The takeover 3.         A buyer acquired the A Group through a share purchase in the XXXX income year. The buyer had previously formed an income tax consolidated group, with B Pty Ltd as the head company. C Pty Ltd is an (indirectly) wholly-owned subsidiary of B. C purchased 60% of the A Group's shares during the XXXX income year. We'll call this the 'takeover transaction'. 4.         C purchased X% of the A Group's total shares from another group, and X% from the A Group's founders.

5.         No employees were made redundant because of the takeover transaction and key management personnel remained the same afterwards. 6.         The buyer increased its ownership to 100% through a subsequent transaction. During the XXXY income year, C acquired the remaining X% shares. The founders received shares in B in exchange, which meant they still had a stake (indirect) in the A Group. We'll call this the 'subsequent transaction'. 7.         After the subsequent transaction, B owned the A Group indirectly through interposed entities. •                B was the head company of an income tax consolidated group. •                B owned (either directly or indirectly) all shares for all other companies in the group. •                One of B's (indirectly) 100% owned subsidiaries owned 100% of the shares in the A Group (either directly or indirectly). The earlier transaction 8.         Previously, another group had acquired shares in A Group. Roughly three years before the takeover transaction, A Group's founders sold X% (less than 50%) of their shares to that other group. We'll call this the 'earlier transaction'. The A Group's phantom share plan

9.         The A Group established a phantom rights plan giving rights to some of its employees. That plan was established around three years before the takeover transaction, and shortly before the earlier transaction. Employees could choose whether or not to participate. The A Group made offers to selected employees by letter. The letter was accompanied by an acceptance form, and terms and conditions for the offer. To broadly summarise those terms and conditions, if trigger events occurred and they met performance conditions, participating employees were entitled to receive a cash bonus. PAYG withholding and superannuation guarantee would apply to the cash bonus. See Table 3 for a chronology. 10.      The applicant gave us a sample offer. We've summarised the terms in Table 2 , but we'll describe what we see as the main features in paragraphs 11 through 15. 11.      There were four types of trigger events. •                First, an initial sale trigger. This would happen if the founders disposed of shares in an A Group entity, where the purchaser acquired more than 50% of the entity's shares.

•                Second, a subsequent sale trigger. This would happen if the founders disposed of any shares in an A Group entity to a purchaser after an initial sale trigger. •                Third, a trade sale. This would happen if an A Group entity sold all or substantially all of its business or assets. •                Fourth, an IPO. This would happen if a recognised stock exchange admitted and quoted A Group shares. 12.      Each trigger event caused phantom rights to 'vest'. The percentage of rights which vested depended on the trigger event. For an initial sale trigger, the percentage equalled the proportion of shares sold by the founders in the initial sale. 13.      There were performance conditions for receiving a cash bonus. Participants would be eligible for the cash bonus as soon as any of three alternative performance conditions were satisfied, unless their phantom rights had lapsed. Very broadly, the performance conditions would be satisfied if either: •                one year passed after the trigger event (without the rights having lapsed) •                the participant became redundant •                the board exercised a discretion to pay participants.

14.      Phantom rights lapsed in five specified circumstances unless the board exercised its discretion. Rights lapsed if a participant: •                ceased employment before meeting the performance conditions for any reason apart from being made redundant •                breached the plan •                (for vested rights) received their full cash payment •                (for unvested rights) was made redundant, or the board terminated the plan. 15.      The payment amount depended on the value of ordinary shares when a trigger event happened. For an initial sale, the payment was worked out under a formula: see Table 1. Very broadly, the formula was the sale proceeds divided by the number of ordinary shares and phantom rights on issue at the trigger time. Table 1: summary of the Phantom Plan terms Topic Summary Summary The plan is an offer to selected employees to be issued with phantom rights. Participants receive a right to a cash bonus if the vesting conditions and performance conditions are satisfied. The performance conditions may differ between participants. When will phantom rights vest?

A percentage of phantom rights vest when a trigger event happens to any A Group company. There are 4 trigger events: -     an initial sale trigger: a disposal of ordinary shares by founders resulting in a purchaser owning more than 50% of the ordinary shares -     a subsequent sale trigger: a disposal of ordinary shares in a group member to a purchaser by one or more of the founders after an initial sale trigger -     a trade sale: the sale of all or substantially all of a business or its assets -     an IPO: the successful admission and quotation of shares on a recognised stock exchange. How many phantom rights vest if a trigger event occurs? The percentage: -     for an initial sale trigger is the number of ordinary shares disposed by the founders, divided by the total number of ordinary shares held by those founders immediately before then -     for a subsequent sale trigger is the number of ordinary shares disposed by the founders divided by the number of ordinary shares held immediately before then -     for a trade sale or an IPO is 100% of the unvested phantom rights.

A worked example says that phantom rights may vest progressively if multiple trigger events happen. For example, if the founders sell 60% of the shares, that's an initial sale trigger, and 60% of the phantom rights vest. If the founders then sell another 20% (or 50% of the remaining shares), then another 20% of the phantom rights vest. Valuing the phantom rights Unvested phantom rights and lapsed phantom rights have no value. The value of vested phantom rights depends on the relevant trigger event: -     for an initial sale trigger, or subsequent sale trigger: NSP/(OSS+VPR) -     for a trade sale: NSP/(OSI+VPR) -     for an IPO: the ordinary share price under a prospectus. NSP means net sale proceeds (gross sale proceeds reduced by any adjustments, costs, expenses, and liabilities for the trigger event, including phantom rights liabilities incurred by the group members). OSS means ordinary shares sold by the selling founders. OSI means the number of ordinary shares on issue. VPR means the total number of vested phantom rights.

The trigger event value is capped. The value can't exceed the net proceeds received by founders/group members, less any adjustments. (The value won't be increased if completion post-completion adjustments cause the net proceeds received by the founders to be higher than the trigger event value.) The plan documents give two worked examples for initial and subsequent sale triggers. The examples suggest the value of a phantom right will equal the price per ordinary share received by a selling founder, after completion adjustments. Performance conditions Participants receive a cash bonus (including superannuation) equal to the trigger event value for the vesting phantom rights, on the earlier of three events, being: -     the board deciding (at its absolute discretion) to pay the bonus by instalments over a period that can't exceed one year from the date the vesting conditions were satisfied -     the first anniversary of the date the vesting conditions were satisfied -     the date the employee became redundant. Phantom rights lapse (and cease to exist) once they vest. Lapsing Phantom rights vest on the earliest of the following events: -     when the participant leaves employment

-     a participant breaches the plan -     a participant is paid in full (vested rights only) -     a participant is made redundant (unvested rights only) -     when the board terminates the plan (unvested rights only). However, rights won't vest where the board (at its absolute discretion) determines otherwise. Lapsed rights are cancelled immediately for no consideration. Terminating and suspending the plan The board can suspend or terminate the plan at any time at its absolute discretion. Where the board terminates, it can't grant any further phantom rights, but rights which have already vested continue until they are paid out or lapse. Unvested rights lapse on termination unless the board determines otherwise. Dealing in phantom rights Phantom rights are a contractual entitlement in connection with employment. They're non-transferable. Reorganisation event The board can increase or decrease the number of phantom rights issued if a reorganisation event happens, so long as the participants aren't disadvantaged. A reorganisation event could be a share issue, a share split, or internal reorganisation. Plan administration

The plan is administered by the board. The board can make conclusive and binding decisions about interpreting the terms. It isn't under any obligation to other people when exercising powers or discretions. It can delegate powers or discretions to officers, directors, or employees. The company isn't liable for participants' tax obligations. Amending the rules The board may amend provisions at any time, but can't adversely impact participants' rights which have already been granted (except to comply with law, correct mistakes, facilitate disposal, reduce tax etc). Amendments may be retrospective. Participant rights The plan doesn't confer any extra rights beyond what's explicitly granted under it. For example, phantom rights don't give them dividends or rights to vote at company general meetings. Confidentiality The participant must keep the terms of their participation strictly confidential. Failure to maintain confidentiality is a breach of the plan which may result in phantom rights lapsing or being cancelled. Participants can disclose for the purpose of receiving professional advice, or if required by law. Costs Plan costs and expenses are borne by the company. Payment net of tax

The company can deduct or withhold tax when making payments to participants. Assignment Participants can't assign or deal with their rights or allow them to be varied without the board's written consent. Rights and payments under the phantom rights plan 16.      A Group issued rights to employees under the plan. •                It made offers to X employees; all accepted their offers. •                A Group issued phantom rights to those X employees. •                All participants were still employed when the takeover transaction happened. 17.      A Group treated the share transactions in this way. •                It didn't treat the earlier transaction as a trigger event because the other group didn't purchase more than 50% of the shares in A Group. •                It treated the takeover transaction as an Initial Sale Trigger, because C acquired X% (more than 50%) of the shares in all A Group entities. •                It didn't treat the earlier transaction as a trigger event. It considered that the transaction didn't cause a Subsequent Sale Trigger because it was an internal restructure.

18.      D (part of the A Group) made cash payments to X of the X participating employees under the plan. X participants met the performance conditions because they were still employed one year after the initial sale trigger date, during the XXXY income year. The X resigned before then, and therefore didn't meet the performance conditions. D was the legal entity which made the payments. The cash payments totalled $X. The entire bonus amount was attributable to the takeover transaction. 19.      Some of the phantom rights lapsed under the scheme. X lapsed when the qualifying employees received their payments. X phantom rights held by the remaining employee lapsed when he or she left employment. 20.      The board didn't use its discretions to pay the bonus early or allow employees to retain rights when they lapsed.

21.      The applicant gave details about the remaining participants who received payments under the phantom rights plan. These details include their position title, job description, rights issued, and bonus paid. Two of the X participants had some involvement in the takeover transaction: assisting with management presentations, and for one employee, helping to prepare diligence information. See Table 2 for more detail. Table 2: Details of the participants and bonuses Position title Job description Involvement in takeover transaction Head of Sales Accounts Managing sales accounts Helped with management presentation General Manager General manager of business operations None Group Financial Controller Head of finance function Helped with preparation of diligence information and management presentation Senior Engineer Preparation and management of engineering work streams None Export Manager Managing export transactions None X Sales Manager Managing lead of X sales None Y Sales Manager Managing lead of Y sales None Maintenance Manager Managing business and asset maintenance None Table 3: Chronology Date Event About 3 years before the takeover transaction

A Group established a phantom rights plan. About 3 years before the takeover transaction Earlier transaction: A Group's founders sold X% (less than 50%) of their shares to another buyer. This wasn't treated as a trigger event under the phantom rights plan. End of XXXX income year Takeover transaction: C bought X% (more than 50%) of the shares in A Group (some from the other buyer, and some from the A Group's founders). This was treated as an initial trigger event under the phantom rights plan. A few months later - during the XXXY income year A Group's founders sold the rest of their shares to C. This wasn't treated as a trigger event under the phantom rights plan. B was the head company of an income tax consolidated group, and all A Group entities joined that group. One year after the takeover transaction - end of XXXY income year D made payments to eight staff under the phantom rights plan. Other points

22.      The A Group's founders, shareholders, and board didn't actively seek out trigger events. They didn't have a policy, plan, or strategy to achieve a takeover or successful IPO. Since the business commenced, A Group's founders had sought to grow the business through ordinary commercial transactions. They didn't have a broader plan to achieve a takeover. However, before the earlier transaction, the group started receiving unsolicited offers. They later engaged advisers to assess the unsolicited offers and consider alternatives. 23.      The applicant submits that the phantom plan was introduced to recognise the continued loyalty and important contribution by A Group employees to A Group's success and was designed to reward and incentivise A Group employees by aligning their remuneration with equity returns realised by the A Group founders.

Income Tax Assessment Act 1997 Section 8-1 Section 40-80 Section 701-1 Section 703-5 Section 703-15 Section 703-30

All legislative references are to the Income Tax Assessment Act 1997. Question 1 Are bonuses paid under a phantom share plan (Transaction Bonuses) deductible under section 8-1? Summary 24.      This ruling is about whether bonuses paid to staff under a phantom rights plan are deductible. 25.      Very broadly, section 8-1 allows deductions for expenses incurred in earning assessable income unless they're capital or capital in nature. Roughly speaking, case law establishes that payments may be deductible if they are means to achieve business purposes, even if those means are indirect or unsuccessful. The payments need to be made 'in the course of' earning assessable income, and those activities must be the occasion for the payments. However, they won't be deductible if they produce an asset, or some lasting or structural type benefit for the business: that would mean the payments are 'capital'.

26.      Here, the applicant introduced a bonus arrangement described as a phantom rights plan for employees. If certain trigger events happened and performance conditions were met, participating employees received cash payments. Trigger events included a share sale. A performance condition required the employee to remain employed one year after the trigger event. The bonus was calculated by a formula which broadly linked the payment to the share price at the trigger event date. The purchaser acquired X% of the group's shares, and then later acquired the remaining X%. One year later, the taxpayer (the holding company of the purchaser's consolidated group) paid $X in cash bonuses to selected employees under the phantom rights plan. Are the bonuses deductible under section 8-1?

27.      Yes. We think the payments were made to retain staff and encourage them to increase or maintain their performance in their day-to-day duties. Therefore, we've characterised the payments as being incurred to help the business earn assessable income, and not capital. We don't think the payments were made to achieve a takeover: if they were, that might have achieved some benefit for the shareholders, or structural benefit for the business. Payments with those characters wouldn't be deductible. Detailed reasoning Consolidation Income tax consolidated groups are treated as a single entity for income tax purposes. 28.      Section 701-1 says if an entity is a subsidiary member of a consolidated group, it's taken to be part 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.

29.      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. When D made the payment, it will be treated as being part of B: it was a wholly owned subsidiary of the head company of a consolidated group. 30.      Here, D made the payment in the XXXX income year. On that date: •                B was the head entity of an income tax consolidated group •                B owned 100% of the shares (either directly or indirectly) in all entities in that group, including C •                C owned 100% of the shares (either directly or indirectly) in all entities in the A Group, including D.

31.      D will be treated as being part of B on the payment date for income tax purposes. B was the head company of a consolidated group. D was a wholly-owned subsidiary of B, because B owned 100% of D through a chain of 100% owned subsidiaries. Working out eligibility for deductions is relevant to B's tax liability, so it's a head company core purpose. Therefore, any payments made by D on the payment date would be treated as if they were made by B. 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'. 32.      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 provision. 33.      There's a substantial body of case law which has advanced propositions or principles relevant to interpreting and applying section 8-1. 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 income-producing reason). 34.      The rest of these reasons will discuss whether the payments were incurred, whether they meet any positive or negative limbs. The payments were 'incurred' on the payment date: at that date, and not before, D had an inescapable obligation to make a payment.

35.      The ATO view is that outgoings are usually incurred when the taxpayer becomes definitively committed to making a payment. TR 97/7 explains this at paragraph 6(a): a taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitively committed in the year of income. Accordingly, a loss or outgoing may be incurred within section 8-1 even though it remains unpaid, provided the taxpayer is 'completely subjected' to the loss or outgoing. That is, subject to the principles set out below, it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum. 36.      We'll briefly restate the relevant facts. •                A Group started a phantom plan around three years before the takeover transaction, where it would pay staff amounts based on a formula, if trigger events happened, and the employee was still employed one year after the trigger.

•                That trigger event happened at the end of the XXXX income year - the liability was calculated at that point. •                A Group made the payments exactly one year later at the end of the XXXY income year. 37.      Applying the principles in TR 97/7, we think D incurred the payment in the XXXY income year, and not before. •                When the phantom rights plan was set up, the liability was 'merely contingent'. It depended on a trigger event happening and the employees meeting other conditions one year after that. •                At the takeover transaction, the trigger happened, crystalising the amount of the potential liability. But it was still contingent on each employee being still employed after one year. •                The business wasn't definitively committed to paying until the payments, one year later. •                Therefore, it was incurred in the XXXY income year (not earlier). 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.

38.      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 4. Table 4: 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; [1] Ronpibon Tin. [2] 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. [3] As above. 'necessarily incurred' means appropriate or adapted for - it doesn't mean logical necessity: Ronpibon Tin [4] ; Snowden & Willson. [5]

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. [6] The Macquarie Dictionary says one of the meanings of 'occasion' is 'the ground, reason, immediate or incidental cause of some action or result.' [7] 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. [8]

These comments suggest business taxpayers have some scope, but not unlimited scope, to make reasonable business judgments. It isn't for the Commissioner or the court to interpose their own subjective judgments about how they would have run the taxpayer's business. Further, 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 might not qualify for deductions. 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: Snowden & Willson. [9] The deductibility (and character) of an expense doesn't depend on the success or failure of what the outlay was intended to achieve: Clough [10] ; John Fairfax & Sons. [11] Whether an expense is incurred 'in' or 'in the course of' earning assessable income depends on the essential character of the expense: Lunney & Hayley. [12] This test is arguably stricter than a 'but for' type relevance test. Lunney & Hayley

was about deductibility of home to work travel. 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. [13] 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; [14] Magna Alloys. [15] 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. [16] This is consistent with the objective approach taken in the other glosses. While there's 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. 39.      The ATO has some guidance relevant to takeover expenses. IT 2656 [17] is 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] •                are likely to be capital because they are relevant to business structure or ownership [paragraphs 26-27]. 40.      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 law illustrating whether payments to employees are deductible. 41.      Payments to retiring staff aren't deductible if the payment isn't connected to producing future income but is a voluntary grant out of gratitude for long service. See Union Trustee Co. of Australia [18] and Telecasters North Queensland Ltd. [19] 42.      However, payments to induce an employee to retire for business reasons may be deductible. For illustrations, see: • W. Nevill and Company Limited [20] (payout allowed the company to stop an inefficient joint management system) • Maryborough Newspaper Company Limited [21]

(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 [22] (director accused of improper conduct was paid to leave the firm to avoid a scandal which might have damaged the business) . 43.      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. [23] 44.      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. [24] Characterising the payments: what were the payments made for?

45.      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? 46.      We've identified four different ways we could characterise transaction bonuses which a business pays to staff on achieving a takeover. •                First, as payments to retain staff and encourage them to perform well in their ordinary duties, to help maintain ordinary business performance. •                Second, as payments to encourage staff to help the founders profit by achieving a takeover or other trigger event. •                Third, as payments to encourage staff to achieve business objectives through a takeover or other trigger event. •                Fourth, as a private gesture by the founders, on exiting the business, to reward their former staff.

47.      Before we can decide whether the payments pass the positive limbs, we need to choose one of these four competing characterisations. We identify some relevant circumstances and discuss their significance in Table 5. Table 5: circumstances relevant to characterising the purpose for these payments Circumstance Discussion Recipients: the payments were made to current, ongoing staff. A Group 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 business transactions where payments were motivated by the director's personal relationship with the recipient. (If directors acted under personal rather than business motivations, they may be in breach of corporate law obligations. [25]

) Another example would be where the payment is directly connected with unusual duties, such as acquiring a capital asset or changing the business structure. The takeover was the trigger event which caused the phantom rights to vest. But for the takeover, the payments wouldn't have happened. This suggests the phantom rights 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, the recipients weren't closely involved in the takeover. Only X of the X employees were directly involved in takeover discussions. Those X staff merely helped prepare management presentations, and for one of them, help prepare diligence information. For the other X staff, their influence on a takeover outcome could only be indirect. Businesses are more likely to become attractive takeover targets if they perform well. Other staff could have helped achieve a takeover to the extent that performing their ordinary duties improved or maintained the business' performance.

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. The A Group created the phantom rights scheme about four years before the takeover happened This might suggest the A Group entered the phantom rights scheme to achieve long-term objectives. A scheme entered for temporary reasons would be unlikely to last four years. That objective would be relevant to characterising the purpose for payments made under that scheme. See paragraph 46 for possible purposes we've identified.

The A Group's founders had no plan to achieve a takeover or trigger event: they only sought advice (and set up the phantom rights scheme) after receiving unsolicited offers. This makes it seem less likely that the scheme was entered to achieve strategic goals for the A Group. The payments were required under a contract The payment simply fulfilled a previous obligation entered some years ago. Very broadly, some comments in Nevill suggest that if an original contract was entered for ordinary business reasons, making a payment to discharge, renegotiate, or settle obligations under that contract should be characterised the same way. [26] But this argument (even if correct) doesn't help characterise the original transaction. The original phantom rights plan may have been entered in the ordinary course of business. Alternatively, it could have had an equity or capital character. The employee effectively had to be still employed one year after the takeover The phantom rights create an incentive for staff members to stay on after a takeover, except where the board exercises a discretion or the employee becomes redundant.

Incentivising staff to stay on after a takeover could help the business continuing to operate effectively during that year. The managers may fear that a takeover could prompt key staff to leave, which could harm business performance. Eight recipients in a range of management roles, including general manager, financial controller, senior engineers, and several other managers (sales, exports, maintenance). We think this suggests the payments plausibly could create objective benefits for the business. -  All roles are management or senior technical roles. -  We think these roles would be important in running the business and ensuring a smooth transition if there was a trigger event. -  Incentivising these employees to improve their performance could also improve business performance in the short to medium term. -  The range and seniority of these positions suggests there are makes it seem less likely that recipients were selected for private reasons, such as personal connections to founders. We don't see any circumstances to suggest the directors - in authorising the phantom rights scheme - had any other motivations beyond improving business performance.

The board had a discretion to pay cash bonus earlier (without waiting a year) We don't think this consideration is relevant here because the board never exercised that discretion. Possible other trigger events included asset sales or IPOs Arguably this makes it less likely that the purpose for the payment was to incentivise employees to achieve the takeover. Alternatively, this may suggest the payments were meant to improve company performance. The incentive effect was to motivate employees to work at maximising the share price if any of several trigger events happened. An emerging business which performs strongly is likely to attract investment interest - that could take the form of asset sales, takeovers, or IPOs.

Here, the A Group had no strategic plan to achieve a trigger event, which makes it less likely that the purpose was to achieve a takeover. The A Group had already received unsolicited offers when the phantom group was being set up - suggesting trigger events were likely or at least possible. In our view, this suggests the phantom rights scheme was reactive. First, it sought to incentivise staff to improve or maintain their performance on the understanding that a trigger event was possible. Second, it sought to retain staff if a trigger event happened. The amount of the payment was effectively tied to the share price on a trigger event. The applicant submits it was made to recognise continued loyalty, and designed to reward and incentivise employees by aligning their remuneration to equity returns realised by the founders While it isn't for the Commissioner to determine how applicant should run a business, subjective statements aren't decisive. Determining purpose is objective. Improving the share price is arguably a good proxy for improving general business performance. Share prices will generally rise if a business performs strongly.

One question here is why the remuneration depends on certain ownership changes happening. An employee (or the business more generally) could perform well even if a takeover, business sale, or IPO didn't happen. Why not come up with a remuneration structure which rewards performance regardless of whether a trigger event happens? Does that suggest the payment was more about creating an incentive to work towards the takeover? Not necessarily: the payment could also be intended as insurance to keep the business performing well after a trigger event. Businesses of this size and age are reasonably likely to be taken over, so businesses need to prepare for that possibility. Employees may rationally fear changes if a takeover is likely. Uncertainty for staff may decrease retention and performance. These phantom rights give the employees an incentive to stay on for at least one year after any trigger event. Those incentives produce objective benefits for the business. Arguably, if improving business performance was the goal, the plan could have used other measures, rather than making the payment conditional on a takeover. [27]

For example, if the goal was to improve business profits, the payment could have been determined with reference to business profits over a specified period. However, it's also arguable that a phantom rights incentive structure could be more effective than alternative remuneration for (at least) three reasons. First, profit-based remuneration might create perverse incentives for managers to manipulate short-term profits to maximise their bonuses. [28] Share prices might be harder to manipulate in comparison. Second, a bonus structure which improved share price over time wouldn't necessarily reduce staff fear associated with takeovers. Third, a phantom rights structure may increase loyalty. It may lead staff to feel their interests are intertwined to the founders, which could encourage them to improve their general productivity. Agreement was voluntary This doesn't seem to be relevant because all staff who received offers took it up. 48.      Balancing the considerations we identified in Table 5, we think this transaction is best characterised as a payment to retain staff and improve or maintain business performance.

•                The X staff were a mix of senior roles, mainly in management. Their functions seem important to running the business day-to-day. •                The takeover doesn't seem to have been a significant reason for the transaction. X of the X staff weren't involved in takeover negotiations, and the other two simply helped with management presentations and presenting diligence information. Also, the founders didn't have a strategic plan to achieve trigger events, but were aware that trigger events were possible because they had received unsolicited offers.

•                The scheme created incentives for staff to perform well in their everyday business duties to increase the share price, and remain employed for at least one year after any takeover. Those incentives could improve business performance in at least two ways. First, the scheme and payments could incentivise staff to improve their performance (given that a trigger event was possible). Second, the scheme and payments would incentivise staff to stay on (maintaining performance and continuity in an ownership transition) for one year after a trigger event. We think these possible benefits make the payments justifiable as a reasonable business judgment. •                We don't see any circumstances suggesting the payments were made for non-business-related reasons. They were paid to X staff holding management and senior technical roles, making it seem less likely that recipients were selected for personal reasons. There are possible objective benefits to the business. We don't have any reason to doubt that the directors entered the scheme and made the payments to advance the company's best interests.

49.      We don't see any circumstances suggesting the payment is a personal gesture by departing shareholders. The original shareholders continue to have an indirect stake in the business. In any event, there are discernible benefits to the business both before and after any takeover. Any subjective personal considerations felt by the directors would have limited relevance: see the reasoning in Magna Alloys. [29] 50.      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.) There are objective connections to the business and discernible or possible benefits for it. 51.      Since we think the payments were made to maintain and improve business performance, they meet the positive limbs. The negative conditions

52.      We'll discuss the negative conditions in subsection 8-1(2). We think the 'capital' condition is the most relevant here. 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? 53.      Courts have developed guidance for distinguishing capital from revenue expenses. 54.      A commonly cited test emphasises three considerations for distinguishing capital and revenue items. To paraphrase Dixon J's judgment in Sun Newspapers, [30] they are: •                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). 55.      ATO rulings summarise some other propositions extracted from case law. We'll paraphrase a few points made by TR 2019/D6 [31] , TR 2016/3 [32] , and TR 2017/1 [33] .

•                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 were made to operate the business day-to-day.

56.      Characterising the reason and purpose for the payments is important when applying the three indicia which Dixon J identified in Sun Newspapers. 57.      Before we can apply those indicia , we need to identify the advantage which the A Group sought by making the payments. Here, we identified several possible purposes for the transaction bonus payments. But we concluded at paragraph 48 that the payments were primarily made to retain staff and incentivise them to improve or maintain their performance. The transaction bonus was made under a phantom rights scheme which incentivised staff to stay on for a year after the trigger event, and work to improve company performance until the trigger event.

58.      How long were those advantages enjoyed for? The length of time was indefinite when the phantom rights scheme was established because the trigger event could have happened at any time. As it happened, the trigger day was about three years after the scheme was established. At that point, phantom rights would only retain staff for another year, and would have no further effect of improving company performance. The payment amounts are tied to share price at the trigger event, so there's no incentive to improve company performance after that point. When the payments were made one year later, all incentive or retention advantages would have been exhausted.

59.      Applying these tests, we think the payments have a revenue character. The payments were made to retain staff and encourage staff performance for an uncertain period, so we can't easily characterise it as either a lasting or a temporary benefit. But the ultimate purpose was to run the business day-to-day, not to achieve a lasting structural benefit. The directadvantage sought by the payments was variable, and potentially lasting. But the ultimate purpose was to motivate staff to stay employed and perform their ordinary duties to improve company profits and value in the short-term, for an indefinite period. Therefore, we think the payments are best characterised as being on revenue account. It follows that they aren't capital, or capital in nature. Second, third, and fourth negative limbs: private, exempt and NANE income, denied by specific deductions. 60.      The remaining limbs aren't relevant. We briefly address them in Table 6. Table 6: 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 [34] 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 5. 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 A Group 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

61.      B can deduct the payments under the phantom share plan in full in the XXXY income year. D incurred the payments in the XXXY income year. The payments meet the positive limbs of section 8-1, and don't meet any of the negative limbs. D was part of B's income tax consolidated group when it made the payments, so B can claim the deduction. Question 2 In the alternative, should the Commissioner find the Transaction Bonuses are capital in nature, are the Transaction Bonuses deductible under section 40-880? Reasoning 62.      This question isn't applicable because the answer to Question 1 is 'yes'. 63.      Very broadly, section 40-880 allows businesses to deduct capital expenditure over five 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 [35] : 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).

64.      Section 40-880 won't apply to the transaction bonuses for two reasons. We characterised them as being on revenue rather than capital account for the reasons given in Question 1 at paragraph 59. 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] Amalgamated Zinc (De Bavay's) Limited v Federal Commissioner of Taxation (1935) 54 CLR 295, at 303 per Latham CJ. [2] 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. [3] 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. [4] 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. [5] FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431 at 436-437 per Dixon CJ. [6] Ronpibon Tin No Liability; Tongkah Compound No Liability v Federal Commissioner of Taxation

(1949) 78 CLR 47 at 57 per Latham CJ, Rich, Dixon, McTiernan and Webb JJ. [7] 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 26 September 2022. [8] Magna Alloys and Research Pty Ltd v Federal Commissioner of Taxation (1980) 49 FLR 183 at 208-209 per Deane and Fisher JJ. [9] FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431 at 444 per Fullagar J (Williams J agreeing). [10] Clough Ltd v Federal Commissioner of Taxation [2021] FCAFC 197 at [54] per Thawley J (Kenny and Davies JJ agreeing). [11] John Fairfax & Sons (1959) 101 CLR 30 at 49 per Menzies J. [12] Lunney v Commissioner of Taxation; Hayley v Commissioner of Taxation (1958) 100 CLR 478 at 497 per Williams, Kitto and Taylor JJ. [13] 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. [14]

Robert G Nall Limited v Federal Commissioner of Taxation (1937) 57 CLR 695 at 711 per Dixon J. [15] Magna Alloys and Research Pty Ltd v Federal Commissioner of Taxation (1980) 49 FLR 183 at 192 per Brennan J. [16] Fletcher v Commissioner of Taxation (1991) 173 CLR 1 at 17-19 per Mason CJ, Brennan, Deane, Dawson, Toohey, Gaudron and McHugh JJ. [17] Taxation Ruling IT 2656 Income tax: deductibility of takeover defence costs. [18] Union Trustee Co of Australia v Federal Commissioner of Taxation (1935) 53 CLR 263 at 269 per Rich J, at 270-271 per Dixon J. [19] Telecasters North Queensland Ltd v Federal Commissioner of Taxation (1989) 20 ATR 637 at 643 per Spender J. [20] W. Nevill and Company Limited v Federal Commissioner of Taxation (1937) 56 CLR 290. [21] Maryborough Newspaper Company Limited v FCT (1929) 43 CLR 450. [22] Mitchell (Inspector of Taxes) v B.W. Noble Limited [1927] 1 K.B. 719. [23] Robert G Nall Limited v Federal Commissioner of Taxation (1937) 57 CLR 695. [24] Clough Limited v Commissioner of Taxation [2021] FCAFC 197 at [18, 83-85] per Thawley J (Kenny and Davies JJ agreeing). [25] See, for example, section 181 of the Corporations Act 2001

which requires directors to act in good faith in the best interests of the corporation. [26] See, for example, W. Nevill and Company Limited v Federal Commissioner of Taxation (1937) 56 CLR 290 at 304 per Rich J, and at 307 per Dixon J. [27] Objective purpose is the consideration here, rather than subjective assessments about prudence. The business judgment rule suggests the Commissioner shouldn't determine how a taxpayer should run their business. Nevertheless, an objectively implausible explanation might suggest it wasn't incurred for business reasons, but was made for other reasons. [28] See very generally, Healy, PM (1985) 'The effect of bonus schemes on accounting decisions', Journal of Accounting and Economics, (7) pp.85-107. [29] Magna Alloys and Research Pty Ltd v Federal Commissioner of Taxation (1980) 49 FLR 183 at 196 per Brennan J, at 209-212 per Deane and Fisher JJ. [30] Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337, at 363 per Dixon J. [31] 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. [32] Taxation Ruling TR 2016/3 Income tax: deductibility of expenditure on a commercial website. [33] Taxation Ruling TR 2017/1 Income tax: deductions for mining and petroleum exploration expenditure. [34] TR 2020/1 Income tax: employees: deductions for work expenses under section 8-1 of the Income Tax Assessment Act 1997. [35] Or a business that used to be carried on, or a business proposed to be carried on.