Edited version of private advice

Authorisation Number: 1052193724184

Date of advice: 24 January 2024

Ruling

Subject: Deductions - revenue v capital or blackhole

Question 1

Is the Key Money Payment deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

If the answer to question one is 'No', is the Key Money Payment deductible under section 40-880 of the ITAA 1997?

Answer

No

Question 3

If the answer to question two is 'No', is the Key Money Payment included in the cost base of a CGT asset?

Answer

Yes

Question 4

Does CGT event C2 happen when the rights under the Key Money Payment expire after 15 years, or an earlier time if terminated?

Answer

Yes

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commenced on:

11 July 20XX

Relevant facts and circumstances

•                     Company A is an Australian company that was incorporated to act as a hotel management company. It is owned by a foreign group that owns a hotel portfolio that includes both directly owned hotels and hotels it manages under its branding for third parties.

•                     Company B is part of an unrelated group that constructed and fitted out a hotel and apartment complex (the Property).

•                     Company A and associated companies in the group entered into a Management Agreement, Technical Assistance Services Agreement, Centralised Services and Marketing Agreement, and Licence Agreement (collectively the Property Agreements) with Company B to manage and operate the Property.

•                     The Management Agreement covers the operations and management of the hotel business and apartments at the Property. It includes details on items such as bank accounts, books and records, insurance, fixed asset sinking fund and other operational needs. Company A is entitled to a management fee from Company B for the services it provides, calculated as a percentage of revenue. Company A can also earn an additional incentive fee based on an adjusted gross operating profit calculation.

•                     The Technical Assistance Services Agreement was to cover concept and design phase guidance during the construction of the Property. However, as the Property construction was already well advanced at the time of signing the Property Agreements, the Technical Assistance Services Agreement was waived by Company A.

•                     The Centralised Services and Marketing Agreement covers the reservation and marketing of the Property. A foreign company that is part of the group is entitled to various set up and reservation fees from Company B for the central reservation system it operates which derive from calculations based on both room revenue and reservation numbers. An additional global marketing and advertising fee is also payable based on room revenue.

•                     The Licence Agreement covers the various names, trademarks, designs and other identifying characteristics of the brand. A foreign company that is part of the group is entitled to a licence fee from Company B for the use of intangible assets it owns, calculated as a percentage of revenue.

•                     In further consideration for entering into the Property Agreements, Company A and Company B also entered into a Key Money Deed of Agreement. Under this agreement, Company A agreed to pay Company B $X (Key Money Payment) within 14 days after the Property commenced business operations. The Key Money Payment was paid as a one-off lump sum due to commercial reasons, as the amount paid would be less than the aggregate of annual payments over the term of the Property Agreements due to the time value of money.

•                     The term for the Property Agreements is set with reference to the Management Agreement which has an initial term of 15 years. Where for any reason the Management Agreement is terminated early, the Key Money Deed of Agreement provides that the 'Unamortized Key Money' (which is based on the remaining unexpired term of the Management Agreement at the time) is to be repaid by Company B to Company A.

•                     The Key Money Payment amount was based on internal forecasts by the group. The forecasts estimated a payback period of three to four years with reference to the amounts of management fees and incentives fees expected to be earned. The revenue raised by the other fees are generally expended by the group to maintain services and marketing the brand.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

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

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

Income Tax Assessment Act 1997 paragraph 8-1(2)(a)

Income Tax Assessment Act 1997 section 40-880

Income Tax Assessment Act 1997 subsection 40-880(5)

Income Tax Assessment Act 1997 paragraph 40-880(5)(f)

Income Tax Assessment Act 1997 subsection 104-25(1)

Income Tax Assessment Act 1997 paragraph 104-25(1)(a)

Income Tax Assessment Act 1997 paragraph 104-25(1)(c)

Income Tax Assessment Act 1997 subsection 104-25(2)

Income Tax Assessment Act 1997 subsection 104-25(3)

Income Tax Assessment Act 1997 section 108-5

Reasons for decision

Question 1

The Key Money Payment is not deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

The general deduction provision in section 8-1 of the ITAA 1997 allows a deduction for a loss or an outgoing to the extent that it is incurred in gaining or producing assessable income (paragraph 8-1(1)(a)), or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income (paragraph 8-1(1)(b)).

However, a loss or an outgoing is not deductible to the extent that it is of capital, or of a capital nature (paragraph 8-1(2)(a) of the ITAA 1997).

The Key Money Payment was paid by Company A to Company B to secure acceptance of the Property Agreements and in particular, the Management Agreement. This agreement gives Company A the right to access and manage the Property in return for management fee income. As the management fees are included in the assessable income of Company A, the Key Money Payment is a loss or outgoing incurred in gaining or producing assessable income in accordance with paragraph 8-1(1)(a) of the ITAA 1997.

As Company A will meet the requirements of paragraph 8-1(1)(a) of the ITAA 1997 it is not necessary to consider paragraph 8-1(1)(b). However, for completeness the Key Money Payment was necessarily incurred in carrying on a business for the purpose of gaining or producing Company A's assessable income. Company A cannot carry on a hotel management business without the right to manage the hotel. In this instance the Key Money Payment was made to help secure the management rights for the Property.

The expression 'capital expenditure' is not a defined term. Whether expenditure is revenue or capital in nature is a question of fact and degree that depends on the particular circumstances of the case, having regard to the principles established by case law.

The High Court decision in Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers) is the leading authority on the distinction between revenue and capital expenditure. In Sun Newspapers, Dixon J formulated the following test:

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.

Character of the advantage sought

The character of the advantage sought provides important direction. It provides the best guidance as to the nature of the expenditure because it says the most about the essential character of the expenditure itself (GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124). If expenditure produces some asset or advantage of a lasting character for the benefit of the business, it will be considered to be capital expenditure.

The Key Money Deed of Agreement does not explicitly state what the Key Money Payment is for. In the background on page 2 of the Key Money Deed of Agreement it is stated:

(2) In further consideration of Owner entering into the Property Agreements, Manager agrees to pay the Key Money to Owner pursuant to the terms of this Deed.

As the Key Money Payment was made by Company A to induce Company B to enter into the Property Agreements, it is reasonable that it be treated as consideration provided by Company A to acquire the hotel management rights.

The hotel management rights are a capital asset of Company A and are an essential feature of the business. Company A is not in the business of trading the rights. They are instead acquired to enhance Company A's profit yielding structure. If Company A did not hold the hotel management rights, it would have no business.

The High Court noted in Commissioner of Taxation v Sharpcan Pty Ltd [2019] HCA 36 that:

Authority is clear that the test of whether an outgoing is incurred on revenue account or capital account primarily depends on what the outgoing is calculated to effect from a practical and business point of view. Identification of the advantage sought to be obtained ordinarily involves consideration of the manner in which it is to be used and whether the means of acquisition is a once-and-for-all outgoing for the acquisition of something of enduring advantage or a periodical outlay to cover the use and enjoyment of something for periods commensurate with those payments. Once identified, the advantage is to be characterised by reference 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; and between an enterprise itself and the sustained effort of those engaged in it. Thus, an indicator that an outgoing is incurred on capital account is that what it secures is necessary for the structure of the business.

Company A will derive management fees through operating the Property for the 15-year duration of the Management Agreement. This shows the Key Money Payment has brought into existence an asset of enduring benefit to Company A. In British Insulated and Helsby Cables Ltd v Atherton [1926] AC 205, Viscount Cave 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 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.

When a taxpayer enters into an agreement that involves an outgoing, the length of the agreement may affect whether the outgoing is seen as recurrent or once and for all. In BP Australia Ltd v Federal Commissioner of Taxation (1965) 112 CLR 386, arrangements securing petrol outlets were entered into for an average period of five years. With regard to the length of the agreements, the Privy Council said:

That must be a question of degree. Had the agreements been only for two or three year periods that fact would have pointed to recurrent revenue expenditure. Had they been for twenty years, that fact would have pointed to a non-recurring payment of a capital nature. Length of time, though theoretically not a deciding factor, does in practice shed a light on the nature of the advantage sought. The longer the duration of the agreements, the greater the indication that a structural solution was being sought. In this case the periods varied between 3 and 15 years, but the average appears to be something just under 5 years and the predominant number of agreements was for a five-year period. ... That length of time appears to be neutral, and in itself indicates neither capital expenditure nor revenue by its mere length. It therefore does not add effectively to the argument either way. The question must be decided by other weights in the balance.

The term of Company A's Management Agreement, along with the other matters, is consistent with that of a capital payment.

Company A has acquired an exclusive right to manage the Property under article 5.01(a) of the Management Agreement:

Except as otherwise provided in this Agreement, the Owner grants to the Manager the exclusive right to manage and operate the Property ...

A payment that provides immunity from competition for a specified period takes on the character of capital expenditure (United Energy Ltd v Federal Commissioner of Taxation 97 ATC 4796).

The manner in which it is to be used, relied upon or enjoyed

The Key Money Payment paid to Company B resulted in Company A securing the hotel management rights which are to be 'enjoyed' by Company A for the 15-year term of the Property Agreements. This is an ongoing use by Company A of the hotel management rights as a prerequisite to earning its income.

Consistent with the Management Agreement, all Property expenses are incurred by Company B with Company A acting as agent for Company B in the operation of the Property. This indicates that the Key Money Payment was not paid by Company A as an operating expense or to cover anticipated operating expenses of the Property.

Rather, the manner in which the hotel management rights acquired by the Key Money Payment are to be used, relied upon or enjoyed - on a recurring 15-year basis during the term of the Property Agreements - supports the character of the Key Money Payment as capital.

The means adopted to obtain it

The Key Money Payment is a one-off lump sum to secure the hotel management rights for 15 years. The absence of recurrent payments suggests that an outgoing is of a capital nature, but it is not conclusive.

The Key Money Payment was paid as a lump sum for commercial reasons which appears to be a standard industry practice. Regardless of industry practice, it does not alter the other factors discussed above that indicate the Key Money Payment is an outgoing of a capital nature, whether paid as a lump sum or by instalments.

Conclusion

For the reasons outlined above, it is considered that the Key Money Payment is not deductible under section 8-1 of the ITAA 1997, by virtue of paragraph 8-1(2)(a) as it is an outgoing of capital, or of a capital nature.

Question 2

The Key Money Payment is not deductible under section 40-880 of the ITAA 1997.

Detailed reasoning

Subsection 40-880(5) relevantly states:

You cannot deduct anything under this section for an amount of expenditure you incur to the extent that:

...

(f)           it could, apart from this section, be taken into account in working out the amount of a *capital gain or *capital loss from a *CGT event; or

...

Accordingly, expenditure that is included in the cost base of a CGT asset is not deductible under section 40-880 of the ITAA 1997.

A CGT asset is broadly defined in section 108-5 of the ITAA 1997 as:

(1)          A CGT asset is:

(a)          any kind of property; or

(b)          a legal or equitable right that is not property.

While there is no single test or determinative factor for identifying a property right, one formulation that is applied in Australia is the 'Ainsworth test' - which asks whether a right is definable, identifiable and capable of assumption by third parties, and permanent or stable to some degree (National Provincial Bank Ltd v Ainsworth (1965) AC 1175, approved in, for example, R v Toohey & Anor; ex parte Meneling Station Pty Ltd & Ors (1982) 158 CLR 327).

Courts have also focused on factors such as excludability (Milirrpum v Nabalco Pty Ltd (1971) 17 FLR 141), commercial value (Halwood Corporation Ltd v Chief Commissioner of Stamp Duties (1992) 33 NSWLR 395), and enforceability of the right against third parties generally (Wily v St George Partnership Banking Ltd (1999) 84 FCR 423). Accordingly, in determining whether something amounts to property it is necessary to weigh up a range of factors, and to treat none as definitive.

As per question 1, the Key Money Payment is to be treated as consideration provided by Company A to acquire the hotel management rights under the Management Agreement. These rights are definable and identifiable, they are capable of assumption by a third party, they are permanent for the term of the Management Agreement, they are exclusive to Company A during this term and they are enforceable. Therefore, the Management Agreement is a kind of property and is a CGT asset.

The totality of the rights of Company A under the Management Agreement are considered to be one single asset for CGT purposes, consistent with the view in Taxation Determination TD 93/86: Income tax: capital gains: are the totality of rights under a contract considered to be the one asset, or is each right considered to be a separate asset for CGT purposes?

As the Key Money Payment will be taken into account in working out the amount of any capital gain or capital loss from a CGT event happening to the Management Agreement, it follows that it is not deductible under section 40-880 of the ITAA 1997 due to paragraph 40-880(5)(f).

Question 3

The Key Money Payment is included in the cost base of a CGT asset.

Detailed reasoning

As per question 2, the Key Money Payment will form part of the cost base and reduced cost base of the Management Agreement.

Question 4

CGT event C2 happens when the rights under the Key Money Payment expire, or at an earlier time if terminated.

Detailed reasoning

Subsection 104-25(1) of the ITAA 1997 provides that:

CGT event C2 happens if your ownership of an intangible *CGT asset ends by the asset:

...

(a)          being redeemed or cancelled; or

...

(c)          expiring; or

...

Subsection 104-25(2) of the ITAA 1997 provides that the time of CGT event C2 is:

(a)          when you enter into the contract that results in the asset ending; or

(b)          if there is no contract - when the asset ends.

When the Management Agreement comes to an end after the expiration of the 15-year period, the hotel management rights of Company A will end. In the context of paragraph 104-25(1)(c) of the ITAA 1997, the use of the word 'expiring' is limited to an expiry by a lapse of time. As Company A will not enter into a contract that results in the Management Agreement ending, CGT event C2 will happen at the end of the 15-year period.

Alternately, should certain events arise, the Management Agreement may be terminated early. Company A's hotel management rights will be cancelled per paragraph 104-25(1)(a) of the ITAA 1997. CGT event C2 will happen at this time. The repayment by Company B of any 'Unamortized Key Money' will reduce the capital loss available under subsection 104-25(3).

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