Contract Purchases or Prepayments

Two Australian trusts that were to be the franchisees for seven McDonald’s restaurants agreed, at the same time as they agreed to enter into leases (“FLLs”) of the premises for base rents plus sales-based percentage rents, to make a lump sum “prepayment of rent” so as to reduce the percentage rent payable. With one exception, the leases did not provide for any refund of the prepaid rent in the event of early lease termination.

The trusts deducted the rent prepayments over a 10-year period. In finding that the rent prepayments were capital expenditures, so that such deduction was not permitted, Mckerracher and Stewart JJ stated (at paras 74-75, 79, 81):

There is no principle that a payment that substitutes for future revenue outgoings or which compensates for them, or which more accurately in this case obviates or removes the need for them, must itself be revenue. …

[I]f the term … of the lease was irrelevant to the method of calculation of the payment, then any argument that the payment was in truth … a computation of prepayment of rent is extremely difficult to mount. …

The taxpayer has, in effect, purchased the right to have the better lease with the lower rent. …

The method of calculation of the prepayments was the same across the different leases, even though the duration of the leases varied. This shows that the prepayments bore no relationship to the duration of the leases, and were therefore unconnected to the obligation to pay rent.

Two family trusts (MFT and MIT) agreed to lease restaurant premises from McDonald’s Australia Limited (MAL). The agreements-to lease (FLLs) had a term of 20 years (where MAL owned the premises) or of one day less than the headlease (where MAL leased the premises), and provided for a monthly base rent plus percentage rents calculated based on monthly sales. At the same time as the trusts agreed to enter into the leases, they agreed to make a lump sum payment described as “prepayment of rent” so as to reduce the percentage rent payable. Apart from one store, which had a shorter lease and less certain prospects of renewal, the FLLs did not provide for any refund of the payment.

The trusts deducted the rent prepayments over a 10-year period. In finding that the rent prepayments were capital expenditures, so that such deduction was not permitted, Jagot J stated (at paras 115, 119 and 125):

…[T]he payments in dispute are of capital or are of a capital nature. They were … a one off, lump sum, non-refundable payment made to secure an enduring advantage (the right to pay the lesser percentage rent) for the term of the FLL and most likely the term of any renewal of the FLL. The payments negated or extinguished any obligation to pay the higher percentage rent and did not thereby relate to any future obligation to pay rent. As a matter of substance the payments, although called the prepayment of rent, did not involve the payment of rent at all.

… What MFT acquired through the payments was a business with a different structure, a business in which the percentage rent payable was permanently reduced from what it otherwise would have been. …

… The non-refundable nature of the payments suggests that they were not made to secure the right to occupy the premises under the lease and, rather, were capital in nature.

The taxpayer was an Australian public company that provided (including, relevantly, through a subsidiary trust (“Idameneo”) whose results were consolidated for tax purposes with its own medical centre facilities and services to doctors in consideration for 50% of the fees generated by them. In order to induce a doctor to join one of the medical centres operated by it, it would typically pay a lump sum in the range of $300,000 to $500,000 to the doctor in consideration for the doctor’s promise to conduct his or her practice from the medical centre for a specified period (generally around five years) and not to provide medical services to anyone within a radius of, say, 7km of the medical centre or the doctor’s own former practice at that practice’s previous location within that period. In the four-year period, the taxpayer entered into 505 such agreements.

In finding that such payments were not outgoings of ‘capital or of a capital nature’ within the meaning of s 8-1(2)(a) of the Income Tax Assessment Act 1997 (Cth), so that they were deductible when incurred, Perram J found that:

• “the payments of the lump sums are to be seen as recurrent and ongoing as Idameneo consistently tried to engage doctors to meet its ongoing demand for them. It did so 505 times in the relevant period…” (para. 55)
• “I accept, of course, that the enduring nature of an outgoing is a very relevant matter … but I do not think that the five year term obtained under the contracts here was of such a nature. At the end of the five year period, the doctor was free to go and the evidence disclosed several examples where Idameneo had had to make further payments to keep a doctor whose five year term had expired working in one of its medical centres" (para. 70)
• "the Commissioner’s submission that by paying the lump sums Idameneo acquired the practices of the doctors or their goodwill ... [was] not consistent with ... ‘what the payments were really for’" (para. 62)
• “the character of the outgoings was as a payment to win a customer” (para. 72)
• “This is analogous to the position of the petrol company in BP Australia where Lord Pearce at 405 had referred to the fact that ‘[t]he benefit was to be used in the continuous and recurrent struggle to get orders and sell petrol’.”

The taxpayer had been receiving a percentage of the income derived from 18 gaming machines at its hotel premises. However, the licence of the gaming machine operator was not renewed due to a regulatory change that provided for gaming machine entitlements ("GMEs") to be allocated directly to gaming venue operators. Consequently, the taxpayer bid for and was allocated 18 GMEs permitting it to operate gaming machines at its premises for 10 years, arranging to pay the purchase price to the state government by instalments from 2010 through to 2016.

In finding that the $600,300 paid for the allocation of the 18 GMEs was a capital expenditure, and not an outgoing on revenue account that was deductible under s 8-1 of the Income Tax Assessment Act 1997(Cth), the Court stated (at paras. 33-34):

[T]he determination of whether an outgoing is incurred on capital account or revenue account depends on the nature and purpose of the outgoing: specifically, whether the outgoing is calculated to effect the acquisition of an enduring advantage to the business. And the identification of what (if anything) is to be acquired by an outgoing ultimately requires … a comparison of the expected structure of the business after the outgoing with the expected structure but for the outgoing, not with the structure before the outgoing. Other things being equal, it makes no difference whether the outlay has the effect of expanding the business or simply maintaining it at its present level. If a once-and-for-all payment is made for the acquisition of an asset of enduring advantage which, once acquired, forms part of the profit-earning structure of the business, the payment is incurred on capital account.

… It was necessary for the Trustee to purchase the GMEs in order to continue to carry on its business as it had done up to that point. But the purchase price was a once-and-for-all payment for the acquisition of an asset of enduring advantage – the 18 GMEs – which once acquired formed part of the profit-earning structure of the Trustee's business. It was incurred on capital account.

A sum of U.S.$16.3 million that the taxpayer paid, at the same time that it purchased a business of the vendor, as consideration for the assignment to it of long-term supply contracts for feedstock, represented an expenditure on income account given that the particular expenditure was carefully segregated in a separate agreement and represented part of the operating cost to it of obtaining the feedstock.