Edited version of your written advice

Authorisation Number: 1051379428735

Date of advice: 31 May 2018

Ruling

Subject: Publishing expenses

Question 1

Are Pre-Publication Expenses incurred by Company A as part of its Pre-Publication Process deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Is the Master Copy of each print title and digital content produced at the end of the Pre-Publication Process an item of trading stock for the purposes of section 70-10 of the ITAA 1997?

Answer

No.

Answer

This ruling applies for the following periods:

1 January 20xx to 31 December 20xx

1 January 20xx to 31 December 20xx

1 January 20xx to 31 December 20xx

1 January 20xx to 31 December 20xx

Relevant facts and circumstances

Introduction

Company A is an Australian tax resident company and is part of the Company A Group.

Since its incorporation, Company A has carried out its publishing business in accordance with Company A Group’s corporate strategy.

Company A’s overall business operations are broadly split into two business units, namely:

● Business Unit A - which represents its core business, and

● Business Unit B.

Business Unit A constitutes the majority of the day to day activities undertaken by

Company A

(NB as the Pre-Publication Expenses (as defined below) forming the subject of this ruling and questions 1 and 2 above are only relevant to Business Unit A, no expenses of any kind related to Business Unit B are referred to in, nor addressed by, this ruling.)

Business Unit A: the Pre-Publication Process

Overview

Products of Business Unit A include print and digital content based on Master Copies, course design and development and the delivery of online learning courses.

Company A is required to continually develop new content for the above products that is relevant and/or tailored to the Australian market. This content is developed with insight from each key market segment in order to best meet local needs and opportunities.

Business Unit A currently employs people in the finance, Human Resources, legal and technology departments. Company A employees perform specific and defined roles in relation to the development of print and digital products. Regular activities also include support from in-house departments for functions such as accounting, finance, human resources, information technology, etc.

The lifecycle of the two products, print and digital content produced by Company A as part of its standard Business Unit A processes, can be categorised into ‘Pre-Publication’ and ‘Post-publication’ process, as detailed below.

Pre-Publication Process

Specific activities undertaken in Business Unit A are highly structured and divided into project phases spanning from concept inception through to manufacturing (for final print content) and uploading onto digital platforms (for final digital content).

Comprehensive systems and processes are in place to ensure that these activities are performed and managed in a standardised and routine manner and that their outcome is thoroughly monitored, documented and reported to relevant stakeholders.

The Pre-Publication Process lasts approximately 2-3 years and is comprised of the

following four key phases:

● Research and concept development

This includes the exploration and identification of market opportunities that drive

new content development. As part of this phase, Company A aims to create concept

abstracts, set product goals and outcomes, create content plans, define program

components and writing schedules and set proposed publication dates. Both

internal employees and outside contractors can be involved in this process.

Project components are set up in Company A’s accounting software

which details costing information, specifications, sales estimates, pricing etc. Full

profit and loss statements are then created for project components and modelling

is performed for various costing scenarios. As a general rule, a separate

component budget is created for every product which will have its own revenue

stream.

Business cases are integrated with proposed profit and loss statements for various

costing scenarios. These business cases are then presented to Senior Management

for consideration of relevant projects. Once approved, budgets are released in Company A’s accounting software. Budget spreadsheets and work-in-progress (WIP) accounts are

created in the system. These expenses are then recorded and monitored

against a project for the duration of the Pre-Publication Process.

● Content development

This involves the identification and retrieval of any archived source materials

required for content authoring (e.g. previous editions). Company A develops sample

design plans and manuscripts, cover and text design and creates relevant artwork.

These activities are primarily undertaken by external vendors (e.g. authors are

contracted to write new books).

● Editing

This comprises the undertaking of a structural and copy edit of full books, checking

artwork briefs, and editing artwork grids and styles with reference to annotated

text design. Designs are finalised and a page review process is undertaken. During

the editing phase, there is usually two to three rounds of review and revision. This

phase is primarily undertaken by external vendors.

● Master Copy development

This consists of a ‘Pre-press Process’, which includes the undertaking of additional

proofs and confirmation of specifications (e.g. cover and paper stock, trim size

etc.).

At the completion of the Pre-press Process, a Master Copy of each print title

and digital content is created in electronic form. This Master Copy does not form

part of the physical materials that make up the printed books, nor is it

manufactured in any way. Master Copy development is the final stage of the Pre-Publication phase.

Accordingly, the relevant expenses addressed and answered by the questions asked in this ruling are Company A’s internal labour costs and the external vendor costs incurred by it in respect of the following Pre-Publication activities (Pre-Publication Expenses):

Text design

Cover design

Typesetting

Text corrections

Text and cover separation

Animations

Author fees

Page make up

Composition

Film

Artwork

Photos

Text and cover illustrations

Alterations

Plates

Permission research and fees

Scanning

Editorial costs

Gallery and page proofs

Sample pages.

It is noted by the Commissioner that in respect of the work produced by external vendors (predominantly the provision of authorship services), copyright protection will automatically come into existence in relation to work performed by such authors throughout Company A’s Pre-Publication Process. The applicant advises that pursuant to the terms of engagement, such copyright falls to rest with Company A, either by way of license or direct acquisition (depending on the final terms agreed to).

The labour costs of Company A employees/personnel working in all of the above phases of the Pre-Publication Process are captured and recorded against relevant projects

through timesheets – see below under the heading ‘Capturing and accounting for Pre-Publication Expenses’.

Post-Publication Process

The Post-Publication Process is not relevant to this Application, as it does not give rise to any Pre-Publication Expenses. However, the following is noted for completeness and to provide, by way of comparison, a greater elucidation of the Pre-Publication Expenses.

With regard to print content, this process broadly includes publishing, assigning

relevant International Standard Book Numbers (ISBNs), printing required quantities of each title and commercialising the books.

With regard to digital content, the software platforms hosting digital content are updated to include new digital content, as developed.

Post-Publication expenses include raw materials and other directs costs of the

manufactured goods held for sale (i.e. trading stock in the form of physical books).

Indirect costs (such as overheads) also form part of the unit cost of the manufactured goods held for sale.

Capturing and recording Pre-Publication Expenses

At present, Company A’s Pre-Publication Expenses are captured as follows:

● The time of Company A personnel that is attributable to pre-publication activities performed in a given week is captured in timesheets. These are submitted, reviewed and allocated to specific projects in excel files on a weekly basis.

● The cost of the above time is calculated with reference to staff levels and the number of working hours after allowing for leave, public holidays and non-chargeable administration hours.

● Other Pre-Publication Expenses (such as external vendor costs) for services received in a given month are also reviewed, allocated to specific projects and recorded in excel files on a monthly basis. External costs are processed for various functions as and when the suppliers provide invoices.

For this purpose, reference is made to either amounts invoiced by the relevant vendor for that month or, in the absence of those invoices, a reasonably accurate estimation of the amount to be invoiced by the relevant vendor for those services based on contractual arrangements in place with that vendor.

● Pre-Publication Expenses captured for internal labour and external vendors is then recorded in the relevant periods through specific general ledger accounts, in accordance with the Company A accounting policy.

● At any given time, Company A holds Pre-Publication Expenses in numerous work-in progress (WIP) accounts on its balance sheet. Pre-Publication WIP accounts are categorised by the type of content being developed.

● Company A ensures that accurate record keeping is maintained to allow the Pre-Publication Expenses to be recorded, monitored and disclosed for statutory reporting purposes, as described above.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 8-1(1)

Income Tax Assessment Act 1997 section 8-1(2)

Income Tax Assessment Act 1997 paragraph 8-1(1)(b)

Income Tax Assessment Act 1997 section 70-10

Income Tax Assessment Act 1997 subsection 70-10(1)

Reasons for decision

All references are to Income Tax Assessment Act 1997 unless otherwise stated.

Question 1

The general deduction provision in section 8-1 states:

1) You can deduct from your assessable income any los or outgoing to the extent that:

a) It is incurred in gaining or producing your assessable income; or

b) It is necessarily incurred in carrying on a *business for the purpose of gaining or producing your assessable income.

2) However, you cannot 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 gaining or producing your *exempt income or your *non-assessable non-exempt income; or

d) A provision of this Act prevents you from deducting it.

Broadly, subsection 8-1(1) provides an entitlement to a deduction from assessable income for any loss or outgoing, to the extent that the loss or outgoing:

● is incurred in (the course of ) gaining or producing your assessable income or

● is necessarily incurred in (the course of) carrying on a business for the purpose of gaining or producing your assessable income.

These two alternatives are commonly referred to as the positive limbs of subsection 8-1(1).

Whilst in many cases losses and outgoings can factually satisfy both positive limbs, a loss or outgoing need only satisfy one of these limbs to be claimed as a general deduction pursuant to subsection 8-1(1).

However, subsection 8-1(2) prevents a general deduction for a loss or outgoing being claimed under subsection 8-1(1) to the extent that the relevant loss or outgoing is:

● a loss or outgoing of capital, or of a capital nature,

● a loss or outgoing of a private or a domestic nature,

● incurred in gaining or producing exempt income, or

● prevented from being deductible under a specific provision of the ITAA 1997 or the Income Tax Assessment Act 1936 (ITAA 1936).

These four exceptions are commonly referred to as the negative limbs of section 8-1.

Losses or outgoings incurred

The term ‘outgoing’ is generally taken to encompass all types of expenditure and suggests a movement of resources from a taxpayer (e.g. a payment), while the term loss ensures that losses where no payment is involved (e.g. theft) and involuntary payments are potentially covered.

In respect of what amounts to a loss or outgoing incurred for the purpose of subsection 8-1(1), Crennan J in FC of T v Citylink Melbourne 2006 ATC 4404; [2006] HCA 35; 62 ATR 648; (2006) 228 ALR 301; (2006) 228 CLR 1 stated at paragraph 122:

122. In considering the test for deductibility, Dixon J said^[119]:

"To come within [the] provision there must be a loss or outgoing actually incurred. ‘Incurred' does not mean only defrayed, discharged, or borne, but rather it includes encountered, run into, or fallen upon. It is unsafe to attempt exhaustive definitions of a conception intended to have such a various or multifarious application. But it does not include a loss or expenditure which is no more than impending, threatened, or expected."

It has long been recognised that an outgoing may be "incurred", but not "discharged"^[120], in the relevant year of income. In Federal Commissioner of Taxation v James Flood Pty Ltd^[121] Dixon CJ, Webb, Fullagar, Kitto and Taylor JJ considered commercial and accounting practice and the test for deductibility and said of s 51(1)^[122]:

"The word 'outgoing' might suggest that there must be an actual disbursement. But partly because such an interpretation would produce very strange and anomalous results, and partly because of the use of the word 'incurred', the provision has been interpreted to cover outgoings to which the taxpayer is definitively committed in the year of income although there has been no actual disbursement."

The Court went on to say "outgoings" could only have been "incurred" if "in the course of gaining or producing the assessable income or carrying on the business, the taxpayer has completely subjected himself to them"^[123]. (emphasis added)

The applicant has stated that Pre-Publication Expenses captured and recorded in any given year are outgoings that Company A has either:

● actually paid for or

● has completely subjected itself to (by committing and agreeing to pay a pecuniary sum) in the relevant income year.

Accordingly, the Commissioner accepts that the labour costs and external vendor costs associated with Pre-Publication Expenses are outgoings as opposed to losses (i.e. they are payments/shifts of money) that have been incurred for the purposes of subsection 8-1(1).

Relevant nexus

Next, the two positive limbs of subsection 8-1(1) require determining whether there is sufficient connection/nexus between:

● the loss or outgoing that is incurred and the production of assessable income (in respect of the first positive limb) or

● the loss or outgoing necessarily incurred in the carrying on of a business and the producing of assessable income (in respect of the second positive limb).

The case of Ronpibon Tin NL and Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431; (1949) 4 AITR 236 (Ronpibon) established the use of the 'incidental and relevant test' to determine whether there was a connection or nexus between a loss or outgoing and the derivation of assessable income for the purposes of the two positive limbs. The Court in this case found that for a loss or outgoing to come within the meaning of ‘in the course of gaining or producing assessable income’ 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.' (emphasis added)

Furthermore, in Charles Moore & Co (WA) Pty Ltd v FC of T (1956) 95 CLR 344; 11 ATD 147 the court held that the loss or outgoing had to be ‘…a necessary part of the operations that are directed to the gaining or producing day by day of what will form at the end of the accounting period the assessable income.’(emphasis added)

The Commissioner accepts that the Pre-Publication Expenses are sufficiently connected with the production of Company A’s assessable income for the purposes of both positive limbs of subsection 8-1. This is because Pre-Publication Expenses are day to day expenses incurred routinely and regularly by the company and it is ‘clearly appropriate’ for these expenses to be incurred in order for Company A to carry on the business of Business Unit A. Without the incurring of these expenses, the creation of the Master Copies, from which Company A ultimately derives its income, is not possible. It is clear that Pre-Publication Expenses are incurred for the purpose of increasing the efficiency of the company (specifically Business Unit A) and therefore increasing Company A’s income-producing capacity.

The Commissioner accepts therefore that the Pre-Publication Expenses are not only incurred (for the reasons described above) but are also necessarily incurred by Company A for the purposes of paragraph 8-1(1)(b).

Provided, therefore, that none of the negative limbs apply in the circumstances, Company A will be entitled to a deduction for Pre-Publication Expenses it incurs pursuant to paragraph 8-1(1)(b).

Negative limb - Capital or Revenue?

In Hallstroms Pty Ltd v. Federal Commissioner of Taxation(1946) 72 CLR 634, Dixon J, in considering the capital revenue distinction, referred at 647 to the general consideration that:

… the contrast between [expenditure on capital or revenue account] corresponds to the distinction between the acquisition of the means of production and the use of them; between establishing or extending a business organisation and carrying on the business; between the implements employed in work and the regular performance of the work in which they are employed; between an enterprise itself and the sustained effort of those engaged in it.

In this context, Viscount Cave in British Insulated and Helsby Cables Ltd v. Atherton (1926) AC 205 at pages 213-214 also stated:

But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is a very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

Company A’s publishing business includes continuously getting and updating content of its published or digital materials. The Pre-Publication Expenses are incurred to gain a continuous competitive edge in meeting the constant demand of the market.

Pre-Publication Expenses are everyday expenses that have to be incurred to develop the large array of Master Copies from which items of trading stock are produced and subsequently sold by Company A to generate its regular and recurrent yearly assessable income. They are not incurred to enhance or improve the business structure/operations through which Company A carries on its business. The money outlaid in respect of the Pre-Publication Expenses is not for a sustained advantage which would not be repeated.

Nothing in the facts suggests that the Pre-Publication Expenses are private or domestic in nature, or are incurred in gaining or producing exempt income, or are otherwise prevented from being deductible under a specific provision of the ITAA 1997 or the Income Tax Assessment Act 1936.

Accordingly, for the reasons described above, when a Pre-Publication Expense is incurred by Company A it will be an allowable deduction to Company A under section 8-1.

Question 2

The term trading stock is defined for tax purposes in section 70-10. Section 70-10 states:

70-10(1)

Trading stock includes:

(a) anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a *business; and

(b) *live stock.

70-10(2)

Trading stock does not include:

(a) a * Division 230 financial arrangement; or

(b) a * CGT asset covered by section 275-105 that:

(i) is owned by a * complying superannuation fund, a * complying approved deposit fund or a * pooled superannuation trust; or

(ii) is a * complying superannuation asset of a * life insurance company.

As evident from the wording of subsection 70-10(1), the definition of trading stock is not intended to be exhaustive and anything that is trading stock in the ordinary meaning would also be included unless it is specifically excluded by subsection 70-10(2).

Ordinary meaning of ‘trading stock’ is discussed in FC of T v. Suttons Motors (Chullora) Wholesale Pty Ltd (1985) 157 CLR 277; 85 ATC 4398; (1985) 16 ATR 567. In that case, the High Court of Australia said (CLR at 281-282; ATC at 4400; ATR at 570):

'The ordinary meaning of the term "trading stock" upon which sec. 6(1) [the equivalent of section 70-10 in the new Act] builds is that which is attributed to it by legal and commercial people for accounting and other purposes. That ordinary meaning has been held to include shares purchased and held for resale by a share trader ( Investment and Merchant Finance Corporation Ltd. v. Federal Commissioner of Taxation (1971) 125 CLR 249) and land which a dealer in land holds as an object of his dealing: St Hubert's Island Case ((1978) 138 CLR at 225). It has been said to include the stock of raw materials which a manufacturer holds for use in manufacture: St Hubert's Island Case ((1978) 138 CLR at 226-227) and cf. Act, s. 6(1). It is not necessary for present purposes however to explore the outer limits of the area covered by that ordinary meaning of the term. Its traditional and narrower denotation still lies at the centre of that meaning and is adequate for present purposes. That denotation is of goods held by a trader in such goods for sale or exchange in the ordinary course of his trade.' (emphasis added)

Therefore, property cannot be trading stock unless it is an asset of a business of trading in property of that kind. For this reason a property dealer' s own home is unlikely to be trading stock; similarly, "even where the owner [of shares] is a dealer in shares the circumstances may show that particular shares are not trading stock " (per Walsh J in Investment and Merchant Finance Corp Ltd v FC of T 71 ATC 4140 at p 4150.)

When section 70-10 was introduced in Tax Law Improvement Bill 1997, the explanatory memorandum stated:

What is trading stock?

Trading stock is the things (eg. goods, land, intangible property) in which a business trades. Trading stock includes the raw materials and partially finished products that a manufacturer will convert into finished goods for trading. It also includes live stock. [section 70-10] [emphasis added]

Company A trades in physical books and digital content, not in Master Copies. As the Master Copies (print titles and digital content) themselves are not held for the purpose of being manufactured, sold or exchanged in the ordinary course of Company A’s business, the Commissioner accepts that they are not trading stock pursuant to section 70-10.

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