Disappearing deductions and resisting the void

 

No capital benefits

The Federal Commissioner has been successful in a recent string of general deduction decisions.[1]  The outcomes illustrate the increasing judicial focus on the character of the advantage sought by the expenditure. The decisions also illustrate that navigating the ‘blackhole’ expenditure provisions is difficult.

Deductions for structural expenditure are classified as capital in nature requiring a consideration of the Capital Gains Tax (CGT) regime. This can lead to undesirable client outcomes as expenditure which cannot be deducted may never be incorporated into the cost base of a CGT event in a meaningful way for taxpayers.

For example, where taxpayers acquire a bundle of rights, recent case law suggests that the expenditure for these rights should form part of the first element of the CGT cost base of the asset[2]. The difficulty for taxpayers is when a CGT event is triggered, such as a surrender of rights under C2, there may be no capital proceeds to allow taxpayers to recognise the expenditure associated with the purchase of the rights. The expenditure disappears into the void, however, a concession for goodwill expenditure may provide a solution.

Goodwill avenue

Please refer to my article written for AMPLA on the elements required to substantiate legal goodwill in the capital gains and stamp duty context.

Goodwill is a CGT asset[3] but certain capital expenditure (capex) relating to goodwill may be deductible[4]. The High Court has flagged the need to consider the law on goodwill when evaluating whether expenditure is undertaken to preserve goodwill.

An analysis of the capital structure/nature of the business and the objective of the capex must be undertaken. Broadly, the intent of the ‘blackhole’ provisions is to allow a deduction for capex where:

  1. Taxpayers acquire a legal/equitable right;

  2. whose sole value/purpose to the taxpayer;

  3. is linked to preserving goodwill.

The capex must not be addressed by any other provision of the legislation (e.g. CGT regime).

Comments on the integers in the statutory formula:

  1. Legal rights – complex deals purport to grant/ transfer various rights in the transaction documentation. The onus is on taxpayers to accurately identify the particular right as the case law illustrates the Courts are reluctant to undertake a ‘juristic classification of the legal rights’[5]. Rights relating to capex in emerging technology in a subsidiary entity to protect market share against competitors (i.e. first mover advantage) or proactive steps to counter a changing regulatory landscape may qualify as eligible rights.

  2. Sole value/ purpose - The High Court[6] suggests the mental element for determining the purpose of the expenditure is likely an objective test after the majority of the Full Federal Court found the taxpayer’s subjective state of mind was sufficient to satisfy the provision.

  3. Preservation of goodwill – The case law on goodwill applies as the High Court has reinforced that a source of goodwill must be identified. Taxpayers must be careful to distinguish between sources of goodwill and the other assets of the business[7].  

The High Court again raised the risk of intertwining goodwill with the going concern value of a business citing its earlier decision in Placer Dome[8]. Namely, if a legal right is identified for the purposes of the ‘blackhole’ provisions, taxpayers must be cautious in extrapolating its effect on the entire business. It may be easier for entities with distinct diversified divisions to access the ‘blackhole’ provisions as the deduction provisions require an analysis of what the expenditure is intended to effect from a ‘business/ practical point of view[9]’.  

Recent Federal Court authority illustrates the difficulty in identifying a source of goodwill. In Healius the lump sum payments to entice the doctors was not necessarily attributed to goodwill that the doctors possessed despite (1) goodwill references in the contracts, and (2) the payments being booked as goodwill for accounting purposes[10]. Intuitively, taxpayers may ascribe a source of goodwill to an employee with particular expertise (e.g. a doctor) where clients (e.g. patients) would follow the employee to his new place of employment. The Full Federal Court declined to find that there was a transfer of goodwill from the existing practice.

Takeaway 

The High Court continues to set a high bar for taxpayers to identify a source of goodwill. In a deduction context, if the legal right is the source of goodwill, taxpayers must consider whether it is appropriate for the right to be addressed under the CGT provisions.

Capex may vanish without being embedded into a taxpayer’s profile as various CGT assets (e.g. contractual rights) and CGT events are unlikely to incorporate the expenditure (with the exception of a A1 disposal). Taxpayers should undertake the analysis required for capex or risk expenditure disappearing into the void.

[1] Commissioner of Taxation v Sharpcan Pty Ltd [2019] HCA 36
Commissioner of Taxation v Healius Ltd [2020] FCAFC 173
Origin Energy Ltd v Commissioner of Taxation (No 2) [2020] FCA 409
[2] s.110-25(1),(2) ITAA 1997 (Cth)
[3] s.108-5(2)(b) ITAA 1997 (Cth)
[4] s.40-880(6) ITAA 1997 (Cth)
[5] Drawing on Dixon J’s comments in Hallstroms Pty Ltd v Commissioner of Taxation (1946) 72 CLR 634
[6] Commissioner of Taxation v Sharpcan Pty Ltd [2019] HCA 36
[7] Federal Commissioner of Taxation v Murry (1998) 193 CLR 605
[8] Commissioner of State Revenue (WA) v Placer Dome Inc [2018] HCA 59
[9] Hallstroms Pty Ltd v Commissioner of Taxation (1946) 72 CLR 634
[10]Commissioner of Taxation v Healius Ltd [2020] FCAFC 173