When are concession fees tax-deductible?

By Dan Fitts.

Key Points:
Liability to pay concession fees should not be contingent or conditional on some future factual or legal event, since a contingent liability will not in such circumstances be said to have been "incurred" in a particular tax year. A specific concession payment should be related to specific rights exercisable only for a specific period.

On 20 July 2006, the High Court delivered its decision in Commissioner of Taxation v City Link Melbourne Limited [2006] HCA 35. The case considered whether, and when, concession fees which City Link Melbourne Limited ("CML") is required to pay to the Victorian State Government in relation to the City Link toll road project are tax-deductible. The contractual arrangements between the State and CML allow payment of the fees to be deferred to a later date, with the intended tax outcome that CML may claim an immediate deduction in respect of those deferred expenses. The main issue for the High Court was whether those fees were "incurred" in the relevant tax year. The Court also considered whether they were in respect of capital or operating expenses.

The facts

The Melbourne City Link toll road project was built and is operated by CML under a Concession Deed with the State Government signed in 1995. Under the Deed, the State granted CML various rights in relation to the City Link project in exchange for, amongst other things, payment of concession fees. The project documents allow CML to defer payment of those fees by issuing concession notes to the State ("Notes"). The Notes do not bear interest and are payable at the end of the concession period in 2034, or at an earlier date depending on the financial performance of the City Link project.

The Commissioner for Taxation disallowed the deductions for the 1996 to 1998 financial years. The Commissioner argued that the liability had not been incurred in the relevant year, or alternatively, that the Notes represented a payment in the nature of a dividend or capital expense. The Commissioner was successful in the Federal Court at first instance, but lost on appeal to the Full Federal Court. A majority of the High Court dismissed the Commissioner's appeal.

The decision and implications for concessionaires

Justice Crennan, the newest member of the High Court, delivered the majority decision. In finding that the concession fees were deductible from assessable income in the relevant year, she illustrated a number of factors that a concessionaire should consider when structuring arrangements to pay concession fees:

To be deductible in a particular tax year, the obligation to pay concession fees must be incurred in that year

Justice Crennan first considered whether the concession fees were incurred in the relevant years. She noted that even though CML had not made any payment, it could deduct an expense in a given year if it was "definitively committed" to that outgoing in the relevant year. Justice Crennan held that CML incurred the expense annually or semi-annually, when it was obliged under the Deed to pay the concession fees. By issuing Notes, CML had deferred payment of that expense but it had still definitively committed and completely subjected itself to paying the fees. The timing of the actual payment was not relevant to whether the liability had been incurred.

The Commissioner had also argued that the liability was uncertain because it was subordinated to senior debt.

That meant that payment of the Notes was contingent upon the senior creditors being satisfied. Justice Crennan rejected this argument, finding that the subordination was only relevant to the timing of the payment, and that the parties always intended that the Notes would ultimately be redeemed. CML's ongoing contractual liability to pay the concession fees was unaffected by the subordination.

The lesson for concessionaires is that liability to pay concession fees should not be contingent or conditional on some future factual or legal event, since a contingent liability will not in such circumstances be said to have been "incurred" in a particular tax year. This means that while the timing of payments may be linked to the profitability of the relevant project (as in the present case), the ultimate obligation to make those payments must be unconditional.

Deductions must be referable to the year of income in which they are incurred

Justice Crennan also applied the test set out in the High Court's decision in Coles Myer Finance Ltd v Federal Commissioner of Taxation (1993) 176 CLR 640.

This requires that the amount claimed as a deduction must not only be incurred in, but also "referable" to, a particular year of income.

To determine whether an outgoing is referable, a concessionaire must look at the advantage secured by the liability in question. If the advantage secured by the liability occurs in the relevant year, the liability can be considered to be referable to that year. Justice Crennan found that, under the Deed, the liability to pay concession fees each year was incurred in exchange for the State granting to CML the right to operate the City Link project in that year. This meant that the expense was referable to that year. It was not relevant, as the Commissioner had argued, that the liability would ultimately be satisfied out of future income, nor did Justice Crennan accept the Commissioner's argument that the expense should be apportioned over the number of years until it was actually payable. Again, this was because the expense related only to the rights granted in the relevant year.

Therefore, concessionaires should ensure that outgoings such as concession fees are made in consideration for rights received in the relevant income year.

This is because a liability or outgoing intended to secure rights in future years would not be referable to the year in which it is incurred.

The outgoings must be revenue, and not a capital, in nature

The Commissioner had also argued that the concession fees should be treated as a capital, rather than an operating expense for tax purposes. Several alternative arguments were presented, and were initially successful before the Federal Court at first instance:

• the fees represented, in effect, a capital contribution to a partnership or joint venture with the State
• alternatively, they should be classed as profit-sharing or a dividend paid to the State as a joint venture partner
• the ongoing concession fees were actually instalments payable in respect of a single acquisition of a bundle of rights in relation to the City Link project; and
• the fees were a capital investment to acquire the legal and physical structure within which profits were to be earned, rather than an expense of earning those profits.

These arguments were unsuccessful before the Full Federal Court, and again before the High Court. Justice Crennan accepted the Full Federal Court's reasoning and found that that the fees were typical of the concession arrangements which applied to such projects. Rather than drawing any analogy with a joint venture or capital acquisition, they should be viewed as a periodic licence fee payable for the right to build, and then to operate and derive income from the City Link project. The concession fees did not secure an enduring asset, and she agreed that it was dangerous to draw an analogy with a joint venture, when this was not the object documented in the legal arrangements for the project.

Particular importance was placed on the concession fees being a licence to operate the project on a periodic basis. Concessionaires should therefore ensure that a specific concession payment can be related to specific rights exercisable only for a specific period. Otherwise, fees payable for a bundle of long-term rights, or rights which have a residual capital value, may not be deductible as operating expenses.

Conclusion

The decision in City Link demonstrates acceptance by the High Court of a typical structure for the payment and deferral of concession fees. However, the City Link decision is very much dependent on its facts and concessionaires should be mindful of the principles set out in this article when structuring such arrangements. Concessionaires should also be aware of Justice Kirby's strong dissent, in which he supported the view that the fees were instalments payable for a single "bundle" of rights which together constituted the concession, and as such, were paid for a capital asset. Further, the Federal Government has flagged the possibility of legislative change which would affect when expenses such as the Notes can be claimed as a deduction. Finally, this decision is only binding on the Commissioner in respect of the particular facts and income year. Although he is unlikely to challenge what is now settled High Court authority, it is possible that the Commissioner would disallow a deduction where it can be argued that the factual circumstances are sufficiently different.

For further information, please contact Dan Fitts.