GENERAL DEDUCTIONS The basic formula to determine taxable

GENERAL DEDUCTIONS The basic formula to determine “taxable amount” is : “Assessable Income less deductions” We already looked at what is assessable income i. e. Ordinary Income + Statutory Income so the next step is to determine what is meant by “deductions”. Deductions are made up of General deductions (s. 8 -1) and Specific deductions (s. 8 -5) Unlike financial accounting rules, not all expenses are deductible by the TP

DEDUCTIONS 1. Assessable income represents gross income 2. Gross income includes recovery of costs and thus does not represent profit 3. To better accord with accounting concepts taxable income is a net amount 4. This net amount is arrived at by allowing deductions against the gross (assessable) amount 5. Thus the taxing formula is:

DEDUCTIONS ASSESSABLE INCOME LESS ALLOWABLE DEDUCTIONS DETERMINES TAXABLE INCOME

DEDUCTIONS Primary § Deduction Section 8 -1 ITAA ‘ 97 Two Positive Limbs Four Negative Limbs Negative limbs override positive limbs

Legislation – Positive Limbs Section 8 -1 You can deduct from your assessable income any loss or outgoing 1 to the extent 2 that: a) it is incurred 3 in gaining or producing 4 your assessable income; or b) it is necessarily 5 incurred in carrying on a business 6 for the purpose of gaining or producing your assessable income

Positive Limbs Terms Common to Both Limbs § Losses or outgoings § To the extent § Incurred / Necessarily incurred § Gaining or producing

Loss / Outgoing “Loss” arises where taxpayer’s financial resources diminish “Outgoing” involves some form of payment, outlay or expenditure “To the extent that” indicates a loss or outgoing may need to be apportioned

Legislation – Negative Limbs 8 -1(2) However, you can not deduct a loss or outgoing under this section to the extent that: a) it is a loss or outgoing of capital, or of a capital nature; or b) it is a loss or outgoing of a private or domestic nature; or c) it is incurred in relation to the gaining or producing your exempt income; or d) a provision of this Act prevents you from deducting it

DEDUCTIONS Was expenditure for Producing Income? YES NO Does the expenditure Satisfy 8 -1(1) only YES NO Does a Specific provision apply YES DEDUCTIBLE NO NOT DEDUCTIBLE

GENERAL DEDUCTIONS S 8 -1 nexus q • What is a sufficient link between income and outgoing? a. First limb Must be in gaining or producing assessable income. b. Second limb must be in carrying on a business for gaining or producing assessable income.

DEDUCTIONS § What deductions do either limb allow which would not be allowed by the other? • There appears to be no significant difference in what can be claimed under either limb. • Who can rely on each limb differs however. Ø Business can rely on both limbs Ø Individual can rely on 1 st limb

Nexus requirement Courts have adopted a broad view of nexus requirement Particular losses/outgoings not required to be matched to specific assessable income For a loss/outgoing to be deductible in a year, it does not necessarily have to produce income in that year Sufficient if the loss/outgoing is designed to earn income in future years

Loss / Outgoing Most expenses are deductible under the conditions of s 8 -1 these are described as outgoings such as advertising expenses, wages � Outgoings are seen to be voluntary actions of the part of the tax payer � Losses are more difficult to define they can include loss of value from sale, up to loss through fire or theft

The connection between the loss / outgoing and the production of assessable income is determined in the context of the TP’s overall activities In Charles Moore v FCT, the company employee was robbed while taking that day’s earnings to the bank. The High Court held that the loss was deductible. The TP’s normal biz op included banking in the daily earnings and the loss was incurred as part of their normal biz op.

Objective approach to characterisation of outgoings Courts traditionally characterise outgoings by reference to the legal rights or advantages that a taxpayer obtains from incurring the expenditure (Cecil Bros v FCT, FCT v Phillips ) In Cecil Bros v FCT the High Court allowed deductions to a shoe retailer for the 10% mark-up amounts it paid to acquire trading stock from a Company whose shareholders were relatives of the TP’s shareholders. The Court said that even though the amount was higher that the amount it would have paid the usual suppliers, it was a biz expense. Owen J : 'it is not for the Court or the Commissioner to say how much a taxpayer ought to spend in obtaining his income, but only how much he has spent. '

Subjective approach to characterisation of outgoings Courts are prepared to also take subjective criteria into account to characterise voluntary outgoings where the income produced is less than the amount of the outgoings (Ure, Fletcher) In Ure v FCT the TP had borrowed money at 12. 5% interest and lent it to his associates (his wife and a family Co) at 1% interest. The funds were used to discharge mortgages on properties beneficially owned by the TP and to purchase a new family home. He was only allowed to claim a deduction for the 1%

“TO THE EXTENT” (APPORTIONMENT) To the extent (apportionment) i. If expense is made for a dual purpose then it may need to be apportioned. In Ure v FCT the courts held that interest expenditure incurred by TP on a loan that was used for both income producing activity as well as private purpose must be apportioned accordingly. In Ronpibon Tin NL v FCT (1949) 78 CLR 47 involved the apportionment of admin expenses and directors’ fees paid by some companies that closed down their mining operations in Siam (Thailand) and Malaya (Malaysia) during WWII.

The courts held that there are 2 kinds of expenditure that required apportionment : A) distinct and severable expense : undivided items of expenditure w. r. t. things / services of which distinct and severable parts are used for gaining or producing assessable income B) Indifferent expense : A single outlay or charge that cannot be segregated.

Distinct and severable expenses ‘distinct and severable expense’ is an an expense that has been incurred in respect of a thing or service where a distinct or severable part is devoted to: gaining or producing the assessable income; or gaining or producing the non-assessable income. In this circumstance, the expense should be apportioned according to these distinct and severable parts.

Example a $2, 000 expense has been incurred by a super fund in relation to a custodian’s fee. The fund is able to determine that $1, 500 of the fee relates to segregated current pension assets producing exempt income (that is, non-assessable income) and $500 relates to other assets producing assessable income. In these circumstances, the super fund should apportion the expense between these two distinct and severable parts, being $500 in relation to producing assessable income and $1, 500 relating to producing non-assessable income.

Indifferent expenses an ‘indifferent expense’ to be an expense that is incurred in respect of a thing or service that relates to the production of assessable income and non-assessable income indifferently. In these circumstances, the expense must be apportioned by way of a fair and reasonable assessment of the extent to which it relates to gaining or producing the TP’s assessable income. Although the ATO states that it cannot provide a single or standard method for apportioning such expenses, the ATO generally accepts what is known as the ‘income ratio method’. The ‘income ratio method’ is applied by determining all the income of the fund that is assessable income and dividing it by the total income of the fund for the year that an expense is incurred. This percentage is then applied to the expense to determine the portion that relates to gaining or producing assessable income.

Example where a super fund incurs a $200 expense in relation to the ongoing maintenance of the fund which is an indifferent expense. For the income year that the expense was incurred, $100, 000 of the fund’s income was assessable income and $100, 000 was non-assessable income. That is, 50% of the fund’s income is assessable income. Applying the ‘income ratio method’, the ATO considers that a fair and reasonable apportionment results in $100 (or 50%) of the expense relating to the gaining or producing of assessable income.

DEDUCTIONS Loss or Outgoing To the extent “Incurred” o Means encountered, run into, or fallen upon. It does not include a loss or expenditure that is impending, threatened or expected. (from NZ Flax Investments Ltd v FCT ) A potential liability or one that is subject to or dependent on certain contingencies is not incurred until the contingencies have been satisfied. FCT v Flood (James) Pty Ltd (1953) 88 CLR 492

“Incurred” 'the word used is 'incurred' and not 'made' or 'paid'. The language lends colour to the suggestion that, if a liability to pay money as an outgoing comes into existence, [the section is satisfied] even though the liability has not been actually discharged at the relevant time. . . it is only the incurring of the outgoing that must be actual; the section does not say in terms that there must be an actual outgoing - a payment out. '

INCURRED A tax payer can obligate itself to pay an expense in a future year but the expense will be incurred progressively over the period to which it is referable i. e. pro rata the expense over the period of liability Coles Myer Finance Ltd v FCT 93 ATC 42 (case 119 in Australian tax Cases by cch) The principles in Coles Myer Finance will generally apply to: (a) financing transactions; or (b) a liability accruing daily; or (c) a liability accruing periodically.

TEMPORAL NEXUS Sometimes costs is incurred in relation to but NOT WITHIN an income producing activity. prior to the commencement of a business After the cessation of a business Such expenses are deductible if the TP can show the existence of a temporal connection between that loss / outgoing and the gaining of the assessable income.

TEMPORAL NEXUS § Must expenditure be incurred in the same year the income is derived? • NO Amalgamated Zinc v FCT (1935) 54 CLR 295 The payment of an allowance does not automatically entitle the taxpayer to a deduction. The expense must be incurred in the course of producing assessable income Steele v FCT 99 ATC 4242 : a taxpayer may be entitled to a deduction after a business has ceased, provided the occasion of the business outgoing it to be found in the business operations directed towards the gaining or production of assessable income generally. " FCT v Brown 99 ATC 4600 : held that the interest expense may cease to be deductible if the time period between the cessation of the business and the repayment of the loan is so long that it is no longer sufficiently connected to the business: TR 2004/4

AMALGAMATED ZINC v FCT TP closed down his mining biz in 1924. According to the laws at that time they were still liable to make annual workers compensation payments to its former employees. TP claimed deduction for 1932 -33 tax year. Held : They could not claim the deductions as these payments were completely dissociated the gaining or producing of the TP’s assessable income.

STEELE v FCT The taxpayer acquired land in 1980 with a view to building a motel on the property. The development never went ahead despite plans being drawn up and applications being made to the council. The property was sold in 1987, during which time interest was incurred on the loan that had been taken out to buy the land. The taxpayer claimed interest was incurred in respect of land purchased to be developed for business purposes but which was subsequently not developed

Held The High Court held that the temporal relationship between the interest incurred and the actual receipt of income was one of the many considerations in determining the deductibility of interest. Contemporaenity is not legally essential, but the time gap between the incurring of the expense and the income may indicate that the expense was either not connected or was preliminary in nature. Once it has been determined that the expense is incurred for the purpose of gaining assessable income, the fact that little or no income is derived in the year the interest expense is incurred is not relevant. It is the purpose for borrowing funds and the use of those funds that is the determinative factor.

Judicial Tests The determination as to whether the expense is incurred in the “course of gaining or producing” assessable income can be approached by utilizing the following 3 test : v The Incidental and relevant test v The essential character test v The occasion of the Expenditure test

“Incidental and relevant” Loss or outgoing must be incurred “in the course of” gaining or producing assessable income. “For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end” - Does not refer to purpose of expenditure; only the scope of the operation / activities and the relevance of the expenditure or outgoing to that operation / activity : (Amalgamated Zinc) - Charles Moore v FCT (1956) 6 AITR 379 – allowed a deduction for loss of money due to a robbery while taking the money to the bank. - Whether the expenditure / outgoing is “incidental and relevant” depends on the NATURE or CHARACTER of the outgoing

Incidental and Relevant Test This case considered the issue of the timing of allowable deductions and whether or not a payment made in instalments to a manager to terminate his employment was deductible in one financial year even though the instalments continued over two financial years. Held : deduction allowed Dixon J : a loss or outgoing would be sufficiently connected to the production of assessable income where “the expenditure……. is incidental and relevant to the operations / activities regularly carried out for the production of income”

Essential Character Test It is clear from Charles Moore Case that in determining whether a loss / outgoing is incurred in the course of gaining or producing assessable income, we have to focus on the “nature” i. e essential character of that loss / outgoing. In Lumley & Hayley v FCT (1958) the High Court held that the cost of travel between work and home is NOT a work or business related expense. For it to be deductible, the expenditure must be incurred in or in the course of that activity that produces the income.

FCT v COOPER (91 ATC 4396) a professional rugby player was not allowed deductions for extra food and drinks that he had to consume as per his coach’s instructions. The income was gained from his playing on the field not from the food he consumes. His income producing activity did not include the consumption of food and drinks.

Positive Limbs 1. (many of these cases also can be referred to in relation to the “apportionment concept). Necessarily Incurred “Necessarily” Was defined in FCT v Snowden & Willson Pty Ltd to mean expenditure that is “dictated by the business ends to which it is directed, those ends forming part of or being truly incidental to the business”. Also see : Magna Alloys 2. Carrying on a business (already considered in Business Income) 3. For purpose of gaining your assessable income (already considered in this chapter)

What is “necessarily” a voluntary outgoing will be necessarily incurred if it was reasonably capable of being seen as desirable or appropriate from the point of view of the taxpayer’s business For practical purposes, it is for the person carrying on the business to be the judge of what outgoings are necessarily incurred and it is not for the Courts to go back and reassess whether it was appropriate to incur the outgoing (refer to TR 95/33).

SECOND POSITIVE LIMB Necessarily Incurred What is clearly appropriate or adopted for the tax payer FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431 : deductions allowed for cost in defending a legal suit W Neville & Co Ltd v FCT (1937) 56 CLR 290 : deduction allowed on payment made to MD for hism to resign as it was to increase co’s efficiency and therefore it’s income producing capacity. Magna Alloys & Research Pty Ltd (1980) 11 ATR 276 : deductions allowed for defending its directors and agents

Necessarily incurred Herald & Weekly Times v FCT Newspaper was allowed deduction for costs incurred in defending and settling a defamation claim as it was related to their income producing activity. FCT v Snowden & Wilson This case considered the issue of legal expenses and advertising incurred in defending a legal claim and protecting the goodwill and reputation of a company. The issue was whether these expenses were necessarily incurred in the carrying of the companies’ business and whether or not the expenses were capital in nature. Held : The expenses were deductible as it is necessarily incurred for biz purpose when it is a part of or incidental to the biz itself.

PURPOSE OF EXPENDITURE In Magna Alloys it was said: It is for the man carrying on the business to be the judge of what outgoings are necessarily to be incurred. It is no part of the function of the Act or of those who administer it to dictate to taxpayers in what business they shall engage or how to run their business profitably or economically § Does this mean courts will not examine the purpose of the expenditure i. e. Is expenditure to reduce tax payable “in producing assessable income”?

PURPOSE OF EXPENDITURE What is the indirect intention or motive of the tax payer? Magna Alloys & Research Pty Ltd v FCT (1980) 80 ATC 4542 Ure v FCT 81 ATC 4100 Fletcher v FCT 91 ATC 4950 FCT v Phillips (1978) 78 ATC 4361 Hart v FCT (2004) HCA 26 Compare the older decision of Europa Oil (NZ) Ltd (No 2) v Inland Revenue Commissioner (NZ). (1976) 76 ATC 6001.

Purpose § Key principles Where the outgoing is involuntarily incurred or solely incurred in acquiring an asset under a contract or discharging a legal liability The amount involved is commercially realistic The nature and scope of the taxpayer’s operation are not in dispute then The subjective purpose and motive of the tax payer does not matter

Purpose Key principles Where § The outgoing is voluntary and excessive There is no obvious commercial explanation for incurring the expenditure The nature and scope of the tax payer’s operations are in dispute then The subjective factors (motive and purpose of the tax payer) are relevant

Negative Limbs A loss or outgoing is not deductible where it is : 1. Capital or of a Capital Nature 2. Private or Domestic Nature 3. Gaining Exempt Income 4. Specific Provisions denies Deduction

CAPITAL / CAPITAL IN NATURE “Capital” losses / outgoings can be distinguished from “revenue” losses/outgoings by : The “once and for all” test The “enduring benefit” test The “business entity” test

Once & for all Test Where a payment is made "once and for all" instead of periodically then prima facie it is of a capital nature : Vallambrosa Rubber Co Ltd v Farmer

Enduring benefit Test when an expenditure is made, with a view to bringing into existence an asset or advantage for the enduring benefit of a trade, it is capital in nature : British Insulated and Helsby Cables Ltd v Atherton

Business Entity Test Business Entity test distinguishes the cost of TP’s “profit yielding structure” and the cost of “operating” the business. Expenses relating to establishment, organisation, enlargement or protection of the biz entity are capital in nature. Expenses incurred in operating the biz are revenue in nature.

SUN NEWPAPERS LTD v FCT TP paid 86500 pounds to rival newspaper for selling its interest in it and for them not to produce a rival newspaper for 3 years within a 300 mile radius. Held : The payment was capital in nature. There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment

SUN NEWPAPERS LTD v FCT There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment

The facts of the present case show the following features: -- (i) The expenditure was of a large sum incurred to remove finally the competition feared from the Star and actually experienced from the World. (ii) It could be regarded as recurrent only in the sense that the risk of a competitor arising must always be theoretically present and that the reality or imminence of the risk depends upon circumstances which can never clearly be foreseen. (iii)The chief object of the expenditure was to preserve from immediate impairment and dislocation the existing business organization of the taxpayers.

(iv) The impairment or dislocation feared involved a lowering of selling price, a loss of circulation, a change in advertising rates and a reorganization of selling and production arrangements all of a lasting character; that is, the changes would be of indefinite duration and their effects would continue until they disappeared under influences brought by the future the exact nature of which could not be foreseen. (v) The transaction involved the acquisition for a cash consideration of the right to enjoy for three years all the property tangible and intangible of an existing undertaking, that is, the acquisition of a going concern for a period, a thing recognized as a capital asset. The advantage in terms of profit was not to be obtained by the use of the undertaking but by putting it out of use; but in itself it remained a capital asset.

Capital : Examples Broken Hill Theatres Pty Ltd v FCT : Held that legal expenses incurred to prevent competition was NOT an item that was deductible against assessable income as it was capital in nature. BP Australia Pty Ltd v FCT : the company claimed deductions for amounts paid as trade ties to service station proprietors so that those proprietors would deal exclusively in its products for a fixed period. The payments were calculated by reference to expected sales by the service stations. Held : the real object of the outgoing was not the tied network but the orders that would flow from it and therefore revenue in nature.

Capital : Examples continued National Australia Bank v FCT : the bank was required to pay a lump sum (but further amounts were payable if loan quotas were exceeded) to the Commonwealth in order to have the exclusive right to make advances to Australian Defence Force personnel for a 15 year period. The held that the payment was of a revenue nature as it did not enlarge the framework within which the Bank carried on its activities. Rather, it was incurred as part of the process by which the Bank operated to obtain regular returns by means of regular outlay. The payment was in the nature of a marketing expense and had a revenue rather than capital aspect.

Private Expenditure Self Education : expenses are deductible only if they relate to the TP’s income producing activity AND are revenue in nature. If the expenses are capital in nature (eg: buying a laptop for studying) then they are not deductible under Section 8 -1 but as a capital allowance under Div 40. If the TP’s current employment is enhanced, the expenses are deductible. HECS is not an allowable deduction (HECS is a higher education interest free govt loan)

Private Expenditure Working From Home G. R : Home is not a place of business therefore deductions are not allowed. Home office : if part of the home is the only work place of the TP, apportionment is allowed. Irrespective of whether a home is residential / office, TP can depreciate the cost of work related items and deduct utility for work related costs. Deductions Utility Fixed expenses Depreciation Travel See TR 93/30

Home Expenses IS THE ACTIVITY CARRIED ON AT HOME A: Place Of Business Can deduct Occupancy and running Home Office Can Deduct running expenses

Home as Place of Business Anti Avoidance Provisions Division 85 Individuals who are not conducting personal services businesses are denied certain deductions such as: Rent, mortgage, Interest, rates, land tax Payments to associates (with limited exceptions) Payments for associates to superannuation funds (with limited exceptions) UNLESS there is a Personal Services Business being conducted – S 85 -30 Results Test (87 -15) • 80% rule (87 -15) • • Unrelated clients test Employment test Business Premises test Business determination in force

Private Expenditure Child Is Care always private Travel Only deductible if travel is in the course of work (eg. Salesman) Home to work; work to home is not work related

Interest Was money borrowed to produce assessable income or purchase income producing asset? The ‘Use’ Test established in FCT v Munro : the character of interest is ascertained by reference to the objective use to which the loan is applied.

Salary or Wage Was Remuneration Paid to A Relative of employer? Private S 26 -35 Associate of Company? s 109 Commissioner can limit deduction

General Deductions Legal expenses Deductible if of an income nature Some Capital expenditure deductible under 2520; 25 -25 Borrowing Expenses Deductible under 25 -25 Damages Deductible activity if arising out of income producing

Car Expenses Did Business Use exceed 5, 000 Kilometres? Yes No 3 Choices 33. 3% of Car expenses Two Choices 12% of cost Log Book set rate Per of vehicle Kilometre