• The impact of this case on ATO policy is discussed in Decision Impact Statement: Retirement Village Operator and Commissioner of Taxation (2012/5734-5737).

CASE 12/2013

Members:
R Deutsch DP

Tribunal:
Administrative Appeals Tribunal, Sydney

MEDIA NEUTRAL CITATION: [2013] AATA 887

Decision date: 13 December 2013

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Prof R Deutsch (Deputy President)

FACTUAL BACKGROUND

1. The Applicant owns and manages a number of retirement villages in New South Wales. This application concerns the treatment of payments to outgoing residents of one of these retirement villages which for the purposes of this decision I will call "Glenmaree".

2. Glenmaree contains more than 250 accommodation units which are largely made up of self-care units, other forms of nursing home style accommodation and various associated facilities.

3. Glenmaree is a "retirement village" for the purposes of the Retirement Villages Act 1999 (NSW) ("RVA") and thus is regulated under that Act. Retirement villages in general in New South Wales are regulated under the RVA.

4. In order for a person to become an occupant of a self-care unit within Glenmaree, he or she must enter into a Resident Licence Agreement ("RLA") with the Applicant in respect of a particular unit. Upon doing so, the person becomes a Resident of Glenmaree and is granted as part of the RLA a right to use, occupy and reside in the designated unit from the commencement date until determined as provided for in the RLA.

5. At the time of entering into the RLA, the Resident selects either Plan A or Plan B. The Plans impose different loan and other requirements, with Plan A being more expensive. They also give rise to different monetary entitlements, with Plan A being more generous to the Resident.

6. Under the terms of the RLA, the following payments must be made:

• (a) First required payment - before taking up residency, the incoming Resident must pay to the Applicant in the form of a loan a designated amount which is set by reference to the market value of comparable real estate in the relevant area ("the Ingoing Contribution");
• (b) Second required payment - during the residency, the Resident must pay to the Applicant the Applicant's estimate of the total operating costs for the Glenmaree village which are proportionately attributable to the Resident ("the Maintenance Fee").
• (c) Third required payment - upon cessation of the residency, the Applicant must repay a percentage of the Ingoing Contribution to the outgoing Resident ("the Incoming Contribution Refund"). The amount to be repaid will be somewhere between 60% and 90% of the Ingoing Contribution, the exact amount depending on whether Plan A or Plan B was originally selected when entering into the RLA and the duration of the Resident's occupancy. The Applicant may deduct from this repayment all arrears of Maintenance Fees, all costs and expenses incurred by the Applicant by reason of any default by the Resident and all other money due and payable by the resident under the RLA which remain unpaid (the amount retained is referred to as a "Deferred Management Fee");
• (d) Fourth required payment - upon cessation of the residency, the Applicant must pay to the outgoing Resident 50% (if under Plan A) and 30% (if under Plan B) of the amount by which the ingoing contribution advanced by the next incoming resident exceeds the Ingoing Contribution that had been advanced by the outgoing Resident ("the Loan Increment Adjustment").

7. The Fourth required payment is not required to be made if the Resident ceased to occupy the relevant unit as a consequence of the making of an order by the Residential Tribunal.

8. At no time does ownership of the unit change hands during the occupancy of the Resident or upon a new resident taking up residency. The Applicant remains the owner throughout this process and continues to be the owner until such time as the Applicant sells the freehold title.

9. For each of the years ended 30 June 2006, 2007, 2009, 2010, the Applicant had in its relevant income tax returns claimed a deduction for the amounts which represent payments made by the Applicant to various residents (or their legal personal representatives) in respect of their share of the difference between the ingoing contribution made by the next incoming resident and the ingoing contribution made by the outgoing resident (that is, either 50% under Plan A or 30% under Plan B of the unrealised capital gain in respect of the unit).

10. On 30 April 2012, the Respondent disallowed the Applicant a deduction for these amounts and issued Notices of Amended Assessments for each of those years ("the Amended Assessments").

11. In addition, on the same date the Respondent issued the Applicant with the Respondent's decision not to remit in full the shortfall interest charge (SIC) imposed by way of the Amended Assessments ("the Remission Decision").

12. The deductions disallowed and the resulting tax shortfall amounts can be presented in tabular form as follows:

Income year ended	Deductions disallowed	Tax shortfall
30 June 2006	$571,250	$171,375
30 June 2007	$840,500	$252,150
30 June 2009	$201,368	$29,628.90
30 June 2010	$984,325	$295,297.50
Total	$2,597,443	$748,451.40

13. On 29 June 2012, the Applicant objected to the Amended Assessments and the Remission Decision.

14. On 2 November 2012, the Respondent disallowed the Applicant's decision. On 20 December 2012, the Respondent filed an Application for Review of Decision in this Tribunal.

THE ISSUES

15. The issues for consideration in this case arise from the treatment of the "Fourth required payment", namely the payment by the Applicant to each of the outgoing residents of the Loan Increment Adjustment ("LIA").

16. The Applicant argues, and indeed treated, such payments as deductible for income tax purposes and the Respondent argues that the amounts in question are not so deductible.

17. More particularly, the Applicant argues that:

• • the outgoings in the form of LIAs paid by the Applicant to an outgoing resident of Glenmaree are deductible under section 8-1 of the Income Tax Assessment Act 1997 ("ITAA") on the basis that they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income and they are amounts that are not losses or outgoings of capital or of a capital nature within the meaning of section 8-1(2)(a) of that Act;
• • alternatively and additionally, if the LIAs are capital in nature, they are deductible pursuant to section 25-110 (1) ITAA on the basis that the LIAs are outgoings incurred to terminate the lease or licence in the course of carrying on the Applicant's business;
• • alternatively and additionally, if the LIAs are capital in nature, they are nonetheless deductible under the "blackhole expenditure" provisions in section 40-880 ITAA. This is on the basis that the LIA expenditure is not in relation to a lease or other legal or equitable right within the meaning of section 40-880(5)(d) ITAA. Rather, the LIAs are made in relation to the Applicant's business, which is to enter into and turnover occupancy agreements which entails allowing residents to vacate by surrendering occupancy agreements so that the relevant occupancy unit be prepared for admitting the next resident;
• • alternatively and additionally, if the LIAs are capital in nature and not otherwise deductible, they should be included as part of the cost base adjustment of the underlying assets pursuant to section 110-25 ITAA;
• • finally, the Applicant contends that the decision by the Respondent not to remit the Shortfall Interest Charge in full should be set aside as the assessed charge is excessive and contrary to law and should be further partially remitted.

18. The Respondent argues that:

• • the amounts which represent payments made by the Applicant to the Resident (or to their legal personal representatives) as LIAs are not deductible under section 8-1 ITAA for the income years ended 30 June 2006, 30 June 2007, 30 June 2009 and 30 June 2010 as:
  • ○ the amounts are not a loss or outgoing that are incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income; or
  • ○ the amounts are a loss or outgoing of capital or of a capital nature;
• • the amounts which represent payments made by the Applicant to the residents (or to their legal personal representatives) as LIAs are not deductible to the Applicant under section 25-110(1) ITAA as they are not incurred to terminate a lease or licence that results in the termination of the lease or licence;
• • the amounts which represent payments made by the Applicant to the Residents as LIAs are not deductible to the Applicant under section 40-880 ITAA as they are in relation to a lease or other legal or equitable right and are thereby not deductible;
• • the question as to whether the LIAs could be included as part of the cost base of the underlying asset (being the retirement village property) pursuant to section 110-25 ITAA is not a matter for deliberation by this Tribunal in these proceedings as the cost base is only to be determined for the purposes of the ultimate sale of the retirement village property and at this stage that event has not occurred;
• • the Applicant has not provided any evidence or reasons for any further remission of the SIC and accordingly the Tribunal should affirm the objection decision of the Respondent on this point.

DEDUCTIBILITY UNDER S 8-1 ITAA

19. The fundamental structure that underpins deductibility under the ITAA is that an outgoing is deductible if it satisfies one of the two positive limbs provided for in subsection (1) and is not excluded by any of the negative limbs provided for in subsection (2).

20. Thus, the outgoing in question must be either:

• • incurred in gaining or producing the assessable income of the relevant taxpayer; or
• • necessarily incurred in carrying on a business for the purpose of gaining or producing the assessable income of the relevant taxpayer.

21. Further, the outgoing in question must not be:

• • an outgoing of capital or a capital nature;
• • an outgoing of private or domestic nature;
• • an outgoing incurred in relation to gaining or producing exempt income or non-assessable non-exempt income of the relevant taxpayer;
• • an outgoing which is prevented from being deducted by virtue of a provision of the ITAA.

22. In this case the Applicant relies on the second of the two positive limbs in asserting deductibility and argues that the negative limbs have no application. The Respondent argues that neither of the positive limbs apply and that the outgoing is one of capital or of a capital nature thus invoking the first of the negative limbs.

Whether the expense was "necessarily incurred in carrying on a business"?

23. Focussing only on the second of the positive limbs, there can be no doubt that the Applicant is carrying on business in this case - that business is quite clearly the operation of retirement villages including Glenmaree.

24. The critical issue is whether the LIAs are necessarily incurred in carrying on that business for the purpose of gaining or producing the assessable income of the Applicant.

25. In making this assessment of the connection between the outgoing and the business it would seem that a broad approach should be taken to the question of what is productive of the taxpayer's income, taking into account the whole of the operations of the business - see in particular
Spriggs v Federal Commissioner of Taxation (2009) 239 CLR 1 at [55] and
Federal Commissioner of Taxation v Day (2008) 236 CLR 163 at [33]. Support for this approach can also be found in
Ronpibon Tin NL v Federal Commissioner of Taxation (1949) 78 CLR 47 at 57 where it was said that "it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income" and in
Federal Commissioner of Taxation v Citylink Melbourne Ltd (2006) 228 CLR 1 at [148] "the characterisation of an outgoing depends on what it is 'calculated to effect', to be judged from 'a practical and business point of view'".

26. Taking into account the practical and business perspective, and considering the question broadly from the perspective of the Applicant, there is in my view no doubt that the LIA is part and parcel of the carrying on of the business of operating the retirement village. Such payments are merely part of the ebb and flow of the normal operation of the business.

27. This is also underscored by the fact that having regard to the age and circumstances of the occupants in question, occupancies of the various residential units are turned over on a relatively regular basis. Indeed, the evidence shows that every seven years approximately 130 units of accommodation are turned over. This equates to roughly 50% of the available units in the village. This would suggest that the payment of an LIA is not an unusual or infrequent event in the operation of the retirement village and simply forms part of the normal operation of the business.

28. In other words, the ordinary business of retirement villages includes making the payment of LIAs or similar payments - they are just an ordinary part of the carrying on of the retirement village business and are thus necessarily incurred in carrying on that business:
Re Tricare Group Pty Ltd and Commissioner of Taxation [2011] AATA 298 at [28]. There does not need to be a direct correlation between the business expenditure and business receipts, a fact which lies at the heart of the second positive limb. It is enough that the payment is necessarily incurred in carrying on the business without tying any particular payment to any particular receipt.

29. In this context, the Tribunal is of the view, based on the evidence presented, that the LIA is part of a single package of contractual rights that are given to the prospective residents in order to encourage them to take up residency in the Applicant's retirement villages, accept the Applicant's services and thereby generate income for the Applicant. In this sense it is a payment made not to secure a particular asset for the Applicant, but rather to enable it to carry on a business of the provision of retirement village accommodation.

30. It follows from all this that, in the view of the Tribunal, the payment of an LIA is a payment necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

Whether the expense was "an outgoing of capital or of a capital nature"?

31. The Respondent argued that the payments of the LIAs were payments of capital or of a capital nature and thus deductibility would be precluded by s 8-1(2).

32. It has been said in
GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124 at 137 that:

The character of expenditure is ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure, for the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid…

33. Those matters are to be determined by an examination of (
Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634 at 648):

what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.

34. In doing so it is necessary to "make both a wide survey and an exact scrutiny of the taxpayer's activities":
Western Gold Mines NL v Commissioner of Taxation (WA) (1938) 59 CLR 729 at 740.

35. Thus it would seem that the fact that the LIA may be a capital gain in the hands of the resident receiving it does not impact on the characterisation of the LIA from the Applicant's perspective.

36. From the Applicant's perspective, the LIA is a payment made as part of a single package of contractual rights that are made to residents as part of the Applicant's obligations as the retirement village operator and is part and parcel of the overall process which is designed to generate income for the Applicant. They are recurring expenses in the sense that they are part of the constant demand that is being placed upon the Applicant in relation to its retirement village business and should be appropriately viewed as being ordinarily on revenue account as an expense incurred in the course of the taxpayer's business.

37. To put it another way, it is in the very nature of the conduct of this retirement village business that the operator offers to share the unrealised capital growth of the underlying property with the outgoing resident. It is simply part of the on-going cost to the operator of carrying on that business. The fact that it is reflective of the unrealised capital growth of the underlying property does not, in and of itself, put it into the realm of capital expense. It is, nonetheless, an expense which is an integral recurrent part of the business of a retirement village operator. It is therefore, in my view, a deductible expense even if it is calculated by reference to the unrealised capital growth of the underlying property.

38. An analogy could readily be drawn to the context of lease surrender payments. Thus, in
Kennedy Holdings and Property Management Pty Ltd v Commissioner of Taxation (1992) 39 FCR 495 Hill J held that a one-off lease payment is capital in nature but in doing so stressed at 499 that "[t]he present is not a case of a company whose business consisted of granting leases and obtaining surrenders of them as part of the normal ebb and flow of the business, in which event a different view of the matter might be taken". Indeed, the Commissioner has taken the view that if a lessor carries on business that involves entering into and surrendering leases as a normal incident of its business, so that lease surrender payments are a part of the normal ebb and flow of the business, then the payment would be on revenue rather than on capital account: Taxation Ruling TR 2005/6 at [83].

39. Considerable effort was made by the Respondent to outline the manner in which for internal accounting purposes the LIAs in particular are dealt with and in doing so the Respondent sought to demonstrate that the payments in question were essentially treated as capital for accounting purposes. It must be acknowledged and accepted that the payment of LIAs were debited against what were described as an asset revaluation reserve which is effectively a recognition for accounting purposes that payments of this nature are taken to diminish the reserve that is available to recognise the appreciating value of the underlying capital, being the freehold interest in the retirement village property.

40. I accept that that was the appropriate accounting treatment although the Applicant led no specific evidence in this respect. Nonetheless, whilst accounting practice may be relevant to the determination of taxation issues at a broad level (
RACV Insurance Pty Ltd v Federal Commissioner of Taxation (1974) 4 ATR 610), accounting and tax can and do differ. This in my view is one instance where they in fact do so differ.

41. In this case the recurrent payments of the LIAs were part of the on-going cost to the Applicant of carrying on its business. Such payments were an intrinsic aspect of the conduct of that business. For tax purposes, that is what matters, even if for accounting purposes it is treated as a reduction to the asset revaluation reserve. The fact that it is calculated so as to reflect changes in underlying property values carries more significance in the accounting context that it does in relation to tax.

42. As such the payment of an LIA was neither an outgoing of capital or of a capital nature.

43. Having resolved this issue in favour of the Applicant, it is unnecessary for me to consider the other grounds for deductibility.

THE SHORTFALL INTEREST CHARGE

44. Based on my view that the amounts in question are fully deductible under section 8-1, there would be no shortfall interest charge. Accordingly, the discretion to remit the shortfall interest charge does not arise.

DECISION

45. The decision under review is set aside and in substitution the Tribunal decides the objection be allowed in full.