Section 40-880: It’s none of your business

Readers will be familiar with the section that allows a tax deduction to be spread

Readers will be familiar with the section that allows a tax deduction to be spread over 5 years for business related capital expenditure. That section, s 40-880 of ITAA 1997, is commonly referred to as the “black hole” deduction provision.

One of the requirements to obtain a deduction is that there must be business capital expenditure incurred in relation to:

– your business; or

– a business that used to be carried on; or

– a business proposed to be carried on; or

– liquidate or deregister a company of which you were a member, to wind up a partnership or trust in which you were a partner or beneficiary (respectively), that carried on a business.

This article focuses on the requirement that the expenditure be in relation to the taxpayer’s business1. The article considers common costs incurred by businesses to illustrate areas of uncertainty.

It may seem unusual to focus on whether expenditure is incurred in relation to the taxpayer’s business. Commercially, corporate taxpayers do not typically spend money for things unrelated to their business. For example, they don’t usually spend money on someone else’s business. And if they do, in the context of a corporate group, perhaps it is because, inadvertently, the incorrect entity has contracted for the service or been invoiced for the costs.

Paragraph 2.25 of the Explanatory Memorandum accompanying the introduction of s 40-880 states:

“The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business. The concept used to establish this character or requisite relationship between the expenditure incurred by the taxpayer and the business carried on (current, past or prospective) is ‘in relation to’. The connector ‘in relation to’ allows the appropriate latitude to enable the deductibility of qualifying capital expenditure incurred before the business commences or after it has ceased.”

Taxation Ruling TR 2011/6 contains the Commissioner’s view on the operation of s 40-880. It is a very comprehensive ruling with more than 40 examples. It states at paragraph 78:

“The legislative context of section 40-880 indicates that the closeness of the association or connection must objectively support the conclusion that the expenditure is a business expense of the particular business. This is the same idea conveyed by the then Treasurer in media release no. 045 on 10 May 2005 that announced a systemic tax treatment for ‘legitimate business expenses, known as blackhole expenditures.’ The adjective ‘legitimate’ emphasises that the expenditure in question must be a genuine business expense of a particular business.”

Whilst it is reassuring that the Commissioner agrees that the provision is intended to have a wide remit and should provide a “systematic” solution, it is not immediately obvious whether costs incurred around the time of a transaction associated with the ownership of an entity should qualify as being in relation to the taxpayer’s business.

Readers may recall the former s 40-880 was prescriptive and somewhat narrow regarding what type of costs were covered by the provision (including takeover defence and unsuccessful takeover costs) and that those categories are “preserved” in the current s 40-880.2

Expenditure incurred in the context of a transaction affecting the ownership of the entity incurring it can be more difficult to characterise. Let’s assume, by way of example, that the taxpayer’s board and its shareholders are considering a proposal to acquire the shares in the taxpayer.

Specifically, there can be uncertainty whether the expense is incurred in relation to the entity (and then if it is incurred in relation to the entity’s business) or in relation to the sale of the entity. Or both. Essentially, there can be a sense that the costs were “really” incurred by the entity instead of the shareholder and are expenses to facilitate the sale.

Two examples will help illustrate the point.

First, transaction costs incurred for advisors (say, legal, financial and tax costs).

Second, costs incurred to terminate or “pay out” employee entitlements.

Transaction costs

Before considering whether the transaction costs in our example are incurred in relation to the company’s business, it is pertinent to briefly revisit the potential immediate deductibility of those costs either under the general deduction provision, s8-1 or under a specific provision.

The conventional view is that transaction costs for legal advice take their character from the nature of the advice sought. Cases such as Hallstroms3 and Magna Alloys & Research4 provide guidance and administrative pronouncements such as Taxation Determination TD 93/26 also assist. The approach is similarly relevant to the financial advisor costs. In many cases, the characterisation of costs incurred by an entity related to its potential takeover inclines to capital because the transaction is an affair of capital.

Costs related to tax advice can, perversely, be more complex. Section 25-5(1) allows a deduction for expenses incurred in managing one’s own income tax affairs or in complying with a legal obligation in relation to another entity’s income tax affairs. However, capital expenditure is not deductible under s 25-5. Unhelpfully, expenditure is not capital merely because the tax affairs concerned relate to matters of a capital nature (s 25-5(4)). In Drummond5, the Federal Court noted an amount paid for tax advice for the setting up of a superannuation fund structure would be deductible but amounts for establishing the structure would not be for “managing the taxpayer’s tax affairs” but would be capital expenditure.

This, at least in theory, leaves the door ajar for financial and legal costs to be capital (and non-deductible under s 8-1) but tax advisor costs to be deductible under s 25-5.

For simplicity, let’s assume all the transaction costs in our simple example are capital in nature.

Returning to the central focus of this article, are transaction costs incurred in relation to the taxpayer’s business?

ATO Interpretive Decision 2007/109 comments:

“… capital expenditure incurred on the structure by which an entity carries on (or used to or proposes to carry on) their business, on the profit yielding structure of the business, or relating to the business’s trading operations, are capable of being described as capital expenditure incurred ‘in relation to’ that business for the purposes of subsection 40-880(2).”

The above aligns with the explanatory memorandum accompanying s 40-880 and supports the general proposition that costs related to structure can relate to the taxpayer’s business.

However, paragraph 84 of TR 2011/6 boldly states:

“In contrast, expenditure relating to the ownership of the entity carrying on the business is not business related capital expenditure unless it can be demonstrated that the change of ownership serves an objective of the business.”

There seems to be an assumption in paragraph 84 that the potential change in ownership isn’t related to the business (at least at first instance). It may seem odd to divorce the ownership from the business in this way given the owners will set an agenda and direction for the business. As mentioned above, one suspects that the underlying thought process is that such costs are “really” costs of the sale of the entity and should be more properly regarded as part of the cost base of the interests being sold. And, as such costs are being incurred by the entity (rather than the owner), they should not be deductible to the entity.

Notwithstanding the qualification in paragraph 84 of TR 2011/6, example 8 in that ruling illustrates that if a change of ownership serves an objective of the business of the entity, the expenditure incurred to facilitate the change of ownership may nevertheless be ‘in relation to’ the entity’s business for the purpose of s 40-880(2). Example 8 describes the following

“88. XYZ Pty Ltd carries on a medical research and supply business. The shareholders’ involvement in the business includes providing medical expertise and services to the company. Because of other commitments one of the shareholders has been and will continue to be unable to devote resources to the business.

89. The directors of XYZ Pty Ltd decide that in the interests of the business the ownership of the company should be restructured to replace the inactive shareholder with a private equity investor with the business acumen to push the company forward and inject capital for the purpose of future growth.

90. To facilitate the restructure XYZ Pty Ltd paid $200,000 to the shareholder as an incentive to agree to the sale of his shares to the equity investor.

91. The expenditure is capital expenditure of the company in relation to the business for the purpose of paragraph 40-880(2)(a).” (emphasis added)

As another example, in PBR 105123890975 the Commissioner accepted that the vendor costs incurred were referrable to the analysis of growth opportunities and qualified for deductibility.

The above examples provide qualified support for the proposition that transaction costs incurred in respect of a possible takeover can be incurred in relation to the taxpayer’s business.

A separate but allied issue will then be how the taxpayer goes about proving the claim that the costs are related to the requisite purpose.

Employee entitlements

The revenue/capital enigma

The conventional starting proposition is that costs incurred in relation to employees and their remuneration are deductible under s 8-1. The often-cited passage of Hill J’s judgment in Goodman Fielder6 confirms further thought is required to determine the appropriate characterisation of such outgoings.

“Where a person is employed for the specific purpose of carrying out an affair of capital, the mere fact that that person is remunerated by a form of periodical outgoing would not make the salary or wages on revenue account. On the other hand, where an employee is employed and engaged in activities which are part of the recurring business of a company, the fact that he may, on a particular day, be engaged in an activity which viewed alone would be of a capital kind, does not operate to convert the periodical outgoing for salary and wages into an outgoing of a capital nature.”

The examples in Draft Taxation Ruling TR 2019/D6 also illustrate that the Commissioner’s view is that a revenue characterisation is not automatically appropriate and that in many cases the accounting treatment will be a helpful guide. Moreover, that employee costs can be capital in nature where they relate to (in the case of the Draft Ruling) the construction or acquisition of a capital asset.

For simplicity, let’s assume the relevant employee costs in our example are capital in nature.

Aren’t employees part of my business?

Whilst the character of an outgoing is a common issue, less common is the need to consider whether employee costs are incurred in relation to the taxpayer’s business.

In Clough7, options and performance rights were granted to key employees under an Employee Option Plan and Incentive Scheme respectively, which were subject to vesting and the board held the discretion to accelerate vesting of the options or performance rights in the case of a“Change of Control Event”occurring, such as a takeover. An offer was subsequently made by the majority shareholder to purchase all of the company’s shares on the condition that Clough cancel and pay out the existing employee Option Plan and Incentive Scheme.

Clough sought to deduct the cancellation payments under s 8-1, arguing that payments to cancel the rights under the employee Option Plan and Incentive Scheme were incurred to reward its employees for past service and to incentivise their future efforts, as part of efforts to retain the employees despite the change of ownership.

The taxpayer’s argument was rejected by Colvin J in the Federal Court at first instance where it was held the schemes may have had the purpose of motivating employees while operational but the evidence did not suggest that the cancellation payment was paid to encourage the retention of employees. Rather, the payment and subsequent termination of the schemes was made due to the obligation triggered under the“Change of Control Event”provisions and to pay out accrued entitlements of Clough employees before the takeover was completed.

Colvin J stated:

“…payment of the Amount was not incurred by Clough in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing such income. If the scheme of arrangement by which Murray & Roberts acquired the shares in Clough had not occurred, the Amount would never have been paid. The incurrence of the outgoing was not involved in or connected to an activity that may be described as carrying on Clough’s business. Its incurrence was part of the activity by which Murray & Roberts acquired the shares in Clough. Clough did not pay the lump sum to produce income. Nor did it pay the lump sum as a necessary part of what was required in carrying on its business.”8

On appeal, the Full Federal Court agreed with the above stating, at paragraph 85:

“The primary judge was correct to conclude that the payments were not incurred in gaining or producing assessable income on the basis that the occasion of them lay in the takeover and not in gaining or producing assessable income.”

Note, however, the Commissioner had accepted that the payments did qualify for a deduction under s 40-880 in Clough.

The Full Court then went on to further conclude that the payments were on capital account.

The Full Court’s comments at paragraphs 97 and 98 illustrate the additional complexity that the payments may have been deductible if made to employees in the “ordinary course” of the incentive schemes.

“ None of this should be understood as suggesting a conclusion that the payments the subject of this appeal do reflect outgoings which relieved Clough of future deductible outgoings. Under the Option Plan (representing roughly two-thirds of the payments), Clough would have been required to issue shares if the options vested. It was only under the Incentive Scheme that cash payments were a possibility.

98. The important point is that the occasion of the outgoing, and identification of what the outgoing is for (Colonial Mutual Life Assurance Society Ltd v Federal Commissioner of Taxation (1953) 89 CLR 428 at 454 (Fullagar J); GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124 at 136-137), is not as simple as merely observing that the outgoing relates to employees or that one of the reasons the payments were made was the existence of rights or expectations arising from dealings between employer and employee.”

The Full Court concluding at paragraphs 125 and 126 that:

“In the present case, the payments as a whole were not ones which can properly be regarded as reducing future revenue expenses. Absent the change in control, those employees who held options or rights ultimately may have received shares in Clough pursuant to the Option Plan and Incentive Scheme, but that would not involve any expenditure on Clough’s part; it would result in a dilution of capital. Some employees who held performance rights may have received cash payments, if Clough had so elected.

126. The payments the subject of this appeal were not ones made on the basis of considerations about where to deploy revenue expenditure on salary. Rather, the payments were made as part of an agreement for Murray & Roberts to acquire the minority shareholding in Clough.”

For taxpayers, one of the difficulties of the decision of the Full Court is that the payments were said not to be necessarily incurred in carrying on a business. Given the similarity in wording between s8-1 (“in carrying on a business”) and s 40-880 (“in relation to your business”) one wonders whether, in the absence of the Commissioner agreeing that the costs met the s40-880 requirements for deductibility, the Court would also have found the same.

The Full Court’s comment at paragraph 127, below, are not crystal clear (at least not to me).

“The appeal would be dismissed but for the fact that the findings made show that the Commissioner’s concession before trial that the amount was deductible over five years under s 40-880 of the ITAA 1997 was properly made.”

That is, the comments could suggest that the Commissioner’s s 40-880 “concession” was appropriate or that it had just been made correctly as a matter of process.

Therefore, there is a theoretical possibility that the Courts (or the Commissioner in a different fact pattern to Clough) could seek to deny deductibility of such costs under s40-880 on the basis the employee costs were not in relation to the taxpayer’s business. That would allow for the prospect of a true “black hole” cost.


In Clough, the Full Court held, at paragraph 18, that:

Questions of characterisation are ones about which minds often differ. The difficulty this case presents is that the payments were made both to facilitate a change in control of Clough and also to honour legal or commercial obligations to employees arising out of the fact that Clough had granted options and rights to its employees in the course of running its business and for the purpose of rewarding and incentivising those employees. (emphasis added)

Provided the “commercial obligations” are sufficient to be considered to be in relation to the taxpayer’s business, the question is whether payments that have a dual purpose can be deducted under s 40-880. The provision, s 40-880(2), does not (unlike s8-1) have a mechanism to apply “to the extent” that an amount relates to the business. As such, provided the outgoings do relate to the taxpayer’s business, they meet the requirement for deductibility (even if they also relate to something else).

The Commissioner takes a different view in Taxation Ruling TR 2011/6. Paragraph 137 states that the Commissioner considers that the absence of the expression ‘to the extent that’ in subsection 40-880(2) does not prevent an apportionment if the taxpayer incurs an amount of expenditure in relation to both a matter covered by any of paragraphs 40-880(2)(a) to 40-880(2)(d) and another matter. On that view, how would such an apportionment be made in relation to the costs in Clough?


It is not easy to reconcile the possibility that transaction costs incurred in relation to a potential sale of an entity can be deductible to that entity whilst costs paid to employees in the context of the same sale may not be. The above highlights the possibility that Courts may take a narrower interpretation of the breadth of s 40-880 compared to taxpayers or even the Commissioner!

Unfortunately, the above illustrates another area of the law where uncertainty and complexity have been introduced where neither were welcome.

Sometimes, the simplest solution is best. There is no policy reason for denying deductibility for costs businesses incur in relation to their ownership structure under s 40-880.