In brief - In Clough Limited v Commissioner of Taxation [2021] FCAFC 197, the Full Federal Court finds that payments to employees to cancel their entitlements under employee option and incentive schemes, in the context of a takeover transaction, were not an outright deduction for income tax purposes

The decision is a very useful reference for any business considering the tax deductibility of payments.

Clough appeals Commissioner's and Federal Court's decision that payments were not an outright deduction

Clough conducted an engineering, project management and construction business. It had many employees and offered certain employees incentives under an employee option plan and an employee incentive scheme. The incentives were entitlements to shares or cash and were crystallised if a change of control event occurred.

Murray & Roberts Limited owned approximately 60% of the shares in Clough. It wanted to acquire the balance of the shares but did not want to make any changes to the business, its leadership or strategy. It acquired the shares under a scheme of arrangement, which was a change of control event under the option plan and incentive scheme.

The terms of the scheme of arrangement required Clough to make offers to employees to cancel their entitlements and to use its best endeavours to ensure that the employees accepted the offers. Clough did so and it caused its subsidiary to pay approximately $15 million to the employees in consideration of the cancellation of their entitlements.

Clough prepared its tax return on the assumption that the payments were not deductible. Clough objected to the assessment, the objection was disallowed, and Clough appealed to the Federal Court. 

Shortly before the trial, the Commissioner accepted that the payments were deductible over five years under the black hole provisions in section 40-880 of the Income Tax Assessment Act 1997 (ITAA), but maintained that the payments were not an outright deduction.

The single judge held that the payments were not an outright deduction and Clough appealed to the Full Federal Court.

Findings of the Full Federal Court in Clough Limited v Commissioner of Taxation

The Full Federal Court found that the payments were not an outright deduction. It also found that the concession made by the Commissioner in relation to the black hole provisions was properly made.

The judgement of the Full Federal Court was delivered by Justice Thawley. He noted that to be an outright deduction under section 8-1 of the ITAA, the payments had to be incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. Further, the payments could not be of a capital nature.

He considered each of these requirements and found that:

  • the payments were not incurred in gaining or producing assessable income because the occasion of the payments was the takeover, not the entitlements of employees under the option plan and incentive scheme

  • the payments were not necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income because:

    • the payments were not in the nature of a working expense in the carrying on of Clough's business

    • the payments were not payments to reward the employees

    • the payments were required for the takeover

  • the payments were on capital account because:

    • the immediate advantage which was sought by making the payments was to cancel the options and rights

    • the object of the payments was to complete the takeover

    • the cancellation of the options and rights had an immediate effect on the capital structure of Clough

    • the options and rights were cancelled by Clough in performance of its obligations under the scheme of arrangement

    • the payments were made all at once to secure an enduring change being that Clough would become wholly owned by Murray & Roberts

    • the payments were calculated by reference to the share price, not by reference to the service or performance of the employees

    • the payments were conditional on the scheme of arrangement proceeding

    • the payments were unusual and not in the nature of a working expense.

Decision in Clough Limited v Commissioner of Taxation contains a very useful review of case law 

Some of the points made were:

Incurred in gaining or producing assessable income

  • "incurred in gaining or producing" means "in the course of" gaining or producing

  • "in the course of" gaining or producing requires the occasion of the payment to be found in whatever produces assessable income, or if there is no assessable income, whatever would be expected to produce assessable income

  • the occasion of the payment is to be found after examining all of the relevant circumstances 

  • the occasion of the payment is not restricted to the immediate causes for the payment, but these are relevant and may in some cases be decisive

  • causation (for example whether a payment would have been made were it not for the existence of a particular circumstance) and purpose are relevant.

Necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income

  • to be incurred in the carrying on of a business, the payment must be part of the cost of trading operations

  • a payment incurred in the course of extending a business rather than incurred as a working expense is not incurred in the carrying on of a business

  • to be necessarily incurred in carrying on a business, the payment must be appropriate and adapted for the carrying on of the business or reasonably capable of being seen as desirable or appropriate for the pursuit of the business ends 

  • to work out whether a payment is appropriate and adapted requires an examination of all of the business operations carried on over time and the whole course of events relevant to the payment

  • the payment does not have to be unavoidable or essential.

Payment of a capital nature

  • the difference between a payment on revenue account and on capital account corresponds to the difference between the business entity, structure or organisation established to earn profits, and the process by which it operates to obtain profits

  • the difference depends on what the payment is calculated to effect from a practical and business point of view, although an examination of legal rights is also relevant

  • the whole commercial context of the payment must be considered

  • the characterisation of the payment must be decided from the perspective of the party making the payment, not the recipient of the payment

  • there is no rule that a payment which relieves a person of a liability to make payments in the future which would be deductible, is itself deductible.

This is commentary published by Colin Biggers & Paisley for general information purposes only. This should not be relied on as specific advice. You should seek your own legal and other advice for any question, or for any specific situation or proposal, before making any final decision. The content also is subject to change. A person listed may not be admitted as a lawyer in all States and Territories. © Colin Biggers & Paisley, Australia 2022.

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