The Full Federal Court has dismissed the taxpayers’ appeal from the decision reported at 2020 ATC [2020] FCA 544 after agreeing with the primary judge that upfront payments made as part of lease and licence agreements to operate McDonald’s stores were capital in nature.

Facts

The taxpayers were the corporate trustee of the Mussalli Family Trust (the MFT) and 4 individual beneficiaries of a discretionary trust, the Mussalli Investment Trust (the MIT). The MFT made distributions to the corporate trustee and the MIT; the MIT in turn made distributions to the individual beneficiaries. One of those beneficiaries, Mr M, was the sole director of the trustee.

Between 2005 and 2011, Mr M was offered lease and licence agreements to operate McDonald’s restaurants at various sites. Under the agreements, payments were required to be made for a base rent amount and a “percentage rent amount” calculated using a specified percentage. The agreements included an option to make a fixed upfront payment that would reduce the specified percentage. Apart from the agreement in respect of one restaurant, the agreements did not allow for a refund of the payment or provide for automatic renewal. However, Mr M (who had been employed by McDonald’s since 1983) was confident the agreements would be renewed at the reduced percentage rate.

The trustee exercised the options for each site and made the upfront payments. It then claimed deductions spread over 10 years for the upfront amounts as “prepaid rent”. Following an audit, the Commissioner denied the deductions claimed and issued amended assessments to MFT and the other taxpayers for the 2012 to 2015 income years. The taxpayers objected to the amended assessments and then appealed to the Federal Court against the Commissioner’s decision to disallow their objections.

The taxpayers submitted that the upfront payments were revenue outgoings and not capital in nature. The payments were said to be components of rent made for the occupancy of the sites over the terms of the agreements. There was no asset, right or advantage obtained other than the use of each site in carrying on the business. Moreover, the payments were described in the letters of offer, agreements and tax invoices as “prepaid rent”.

The Commissioner submitted that the payments were on capital account or of a capital nature. It was contended that the payments were made in connection with obtaining rights on more favourable terms for operating the restaurants. The profit-earning structure of the restaurants could not have been obtained without payment of the upfront amount. The effect of the payment was to procure a benefit that would remove or extinguish the obligation to pay a higher percentage of rent.

First instance decision

The court at first instance held that the payments were capital or capital in nature as they secured an enduring advantage for the term of the agreements (2020 ATC [2020] FCA 544). The payments secured the acquisition of a better business structure and were not for the carrying on of the business. The non-refundable nature of the payments further suggested that they were not made for occupying the premises. In so finding, Jagot J observed that the labelling of the payments and accounting treatment was not determinative of their true character. The payments operated to change the obligation to pay rent itself, not to account for future obligations to pay rent.

From that decision the taxpayers appealed to the Full Federal Court, where both parties essentially maintained the submissions put forward at first instance. The taxpayers argued that the primary judge’s finding that the relevant payments made by the MFT “negated or extinguished any obligation to pay the higher percentage rent” was incontrovertible and answered the critical question of what the payment was for and identified the character of the advantage sought. The taxpayers asserted that a payment made to secure a reduction in a revenue outgoing was itself on revenue account.

It was argued that the taxpayers had simply converted a future revenue outgoing into a present revenue outgoing. The payments in question did not secure any change in the relevant assets acquired by the MFT. Moreover, the fact that a payment in lieu of the rent payable each month was “paid as a lump sum in advance” was not sufficient to displace the presumption that the moneys outlaid were paid on revenue account. It was also submitted that the primary judge erred in having regard to the internal calculations and valuation methodology of McDonald’s in considering the deductibility of the payments in the hands of the MFT.

Full court decision

The full court unanimously dismissed the appeal, saying that the primary judge was correct in finding that the upfront payments were of capital or were capital in nature. That conclusion necessarily followed from the correct identification of the advantage sought by MFT in making the upfront payments. Irrespective of how Jagot J approached the task of identifying the advantage sought by MFT in making the upfront payments, she correctly concluded that the payments were made for an enduring advantage in the form of a right to pay the lesser rent for the term of the full lease and license agreement, and most likely longer. This gave MFT a preferable profit-making structure.

Contrary to the taxpayers’ arguments, the court said there was no principle that a payment that substituted for future revenue outgoings or which compensated for them, or which more accurately in this case obviated or removed the need for them, must itself be revenue. Further, it was not necessarily the case that a payment made to secure a reduction in a revenue outgoing was itself on revenue account. There was no principle of general application that a lump sum paid to reduce or eliminate future revenue expenses was always to be characterised in the same way as the expenses for which it was substituted.

The full court also considered that Jagot J did not err by taking into account the expert valuation evidence that explained how McDonald’s had calculated the upfront payments. The way in which the upfront payments were calculated by McDonald’s was an objective fact centrally relevant to the question of what the payments were made for and the character of those payments. The primary judge was entitled to take this evidence into account as part of the wider commercial context.

Source: Mussalli & Ors v FC of T 2021 ATC [2021] FCAFC 71, 14 May 2021.