CONSIDERATION
65 Before turning to the four key arguments summarised above (at [42]-[46]) it is essential to revisit the factual context to characterise the nature of the payments.
66 The evidence established that MAL operates two sorts of stores or restaurants. There are those that are owned by MAL, and those which are owned by franchisees. From time to time, MAL makes offers to individuals whom they consider suitable to take over a company-owned store and run it instead as a franchisee store.
67 Mr Mussalli was a high-ranking corporate officer in MAL with substantial experience. He had decided to move out of that employment position and sought from MAL the opportunity to take over and run as franchisee, via MFT, stores which had previously been run by MAL. Mr Mussalli was given detailed information on their previous and recent results so that he could make a decision as to whether MAL's offers to operate the stores as franchisee were acceptable or not.
68 There were seven stores. On all seven occasions, between 2005 and 2011, Mr Mussalli chose to take over, pursuant to the terms of the FLL, operation of a store. It was also likely that the terms would be renewed beyond the initial period. On seven occasions Mr Mussalli made the lump sum upfront payments.
69 The FLL required him to step into the existing store, make a payment in respect of the existing movables located in the store, and take over running the store. The commercial attraction was that, as MAL was going to charge fees by reference to existing turnover, if Mr Mussalli could perform better than the store had been performing as a company-owned store, then it would be profitable for him to do so. There was to be a seamless takeover.
70 The letter of offer for Erina Fair II is an example of others in the Group One restaurants. The license term was almost 13 years from 2005 to 2018. There were various fees to be paid. The "percentage rent" is designated at 13.93% of monthly gross sales as defined. It shows equipment that MFT is required to purchase for $465,000 and there is an option to "prepay rent" in the amount of $475,000 described as follows:
EQUIPMENT: You are required to purchase from [MAL], all equipment, decor, furniture, fittings, signage and air conditioning (including all computer hardware and software) for $465,000 plus GST. [MAL] make no warranty in respect of the equipment, the equipment is purchased in its present condition.
OPTION TO
PREPAY RENT: This agreement includes an option for you to reduce your Percentage Rent, as referred to above, to 9.40% of monthly gross sales (as defined) plus GST minus the amount paid as base rent plus GST, subject to a prepayment of rent of $475,000 plus GST on the day of handover.
71 That prepayment reduced Mr Mussalli's rent from 13.93% of gross sales to 9.4% of gross sales. MAL routinely values these stores, that is, the land and the business operated on them, by reference to a multiple of adjusted yearly profits. That multiple was approximately five to five and a half. In this case, MAL's attribution of the value of the store was $940,000 which is the sum of the equipment purchase price and the optional upfront "rent prepayment", ($465,000 and $475,000 respectively).
72 Mr Mussalli's case was based on the language in the document (and others), that the $475,000 represented a prepayment of rent, and was therefore, revenue, as a payment in advance of a revenue expense. The Commissioner's case was that it was not in truth a prepayment of rent in any sense of the word. In particular, it was not a payment made to be set off or applied against future rental obligations. It was a payment to gain a capital advantage.
73 The Commissioner's expert said that from an accounting point of view, what was really being acquired was what he called a "lease right". The payment secured a better version of the lease. Significantly this was supported by the way that MAL calculated the upfront amount as a residual which was left over after deducting the value of the equipment from the business price, itself determined by a valuation multiple of between 4.76 and 5.5 times yearly earnings, entirely irrespective of the lease term. This was said to be an indication that the franchisee was making a capital acquisition by the payment.
74 On appeal, the case has been put slightly more broadly. The appellants are saying, in effect, that it is a payment which has some effect on a future outgoing, or at least a potential future outgoing. Those future outgoings, if paid on a recurrent basis, would have been revenue hence the payment that substitutes for them is also revenue. But there is no principle that this will always be so. 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.
75 Also significantly, if the term, that is the duration, of the lease was irrelevant to the method of calculation of the payment, then any argument that the payment was in truth (as distinct from its description) a computation of prepayment of rent is extremely difficult to mount.
76 Both experts confirmed that MAL values stores at about five to five and a half times yearly earnings, such that the value of the Erina Fair II store was approximately $940,000 as a going concern. $465,000 was attributed to the value of the equipment and it followed that $475,000, simply being the difference between the business value and its equipment, was the figure described as prepaid rent.
77 Having calculated in this way the figure of $475,000, MAL then converts it by assessing that the equivalent of $475,000 would, if described as a rent prepayment, be in effect an increase in rent to 13.93%, and then, in this instance offers to reduce the rent back to 9.4% if the $475,000 is paid. The Commissioner contends that this payment, (following the principles in Sharpcan), was to obtain a more profitable business structure.
78 In our view, this assessment is correct for the reason that the taxpayer is offered an existing profitable business which he or she can take over, and he or she can either take it over at the 13.93% rent level or the 9.4 % rent level, but by paying $475,000 as a once and for all payment he or she receives the benefit of what is in reality a better version of the lease or a more profitable lease. Clearly, the FLL is a capital asset of the business. In fact, it is by far the most important capital asset. By comparison, in Sharpcan the GMEs assisted the profit-making capacity of the business by increasing revenue. The price for the GMEs in Sharpcan was held to be capital because it improved the capital structure of the business by way of intangible advantages and improved profit-making (see, for example, at [40]).
79 By the time the FLL is executed, there is no consideration of the higher rent. The taxpayer has, in effect, purchased the right to have the better lease with the lower rent.
80 As senior counsel for the Commissioner correctly submitted:
the taxpayer opted for which version of the rent - of the lease [he] wanted - there was never a time when [he was] obliged to pay the high rent. So [it is] very difficult to see how a payment to elect between a universe where you have a low rent and a universe where you have a high rent can operate as a prepayment of high rent that never becomes payable...
81 Further considerations supporting the analysis that the purpose of the upfront payment was to obtain a more profitable business structure rather than to pay rent upfront include the following. 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. Also, on renewal or extension of the lease no new prepayment would be payable, the rental obligation being calculated with reference to the lesser rental option that had been chosen on inception; and, on termination or surrender the prepayment would not be reduced pro rata.
82 The position is essentially the same with the Group Two restaurants. The obligation to pay higher rent never existed in the Group One restaurants and never took effect in the Group Two restaurants. The principal distinction between the Group One and Group Two restaurants is that MFT acquired the right to operate the Group Two restaurants at the higher percentage rent when the FLLs were granted, but was given the option to change the obligation to pay rent under the lease forming part of the FLL from the higher percentage rent to the lower percentage rent for the term with effect from handover. Exercising the option and making the upfront payment in respect of the Group Two restaurants altered the profit-making structure by making it more favourable as a result of the change to the obligation to pay rent. A change of this kind to the terms of a capital asset is an affair of capital: Tucker v Granada Motorway Services Ltd [1979] 2 All ER 801 per Lord Wilberforce (at 805) and per Lord Fraser of Tullybelton (at 811-812), cited with approval in Mount Isa Mines Ltd v Commissioner of Taxation (Cth) (1992) [1992] HCA 62; 176 CLR 141 (at 150).
83 In addition to that objective analysis which is in itself conclusive on the issue of capital or revenue, Mr Mussalli knew that MAL's method of calculation of the payments had nothing to do with the duration of the lease and therefore the amount of the savings. Rather, payments were simply computed by deducting the value of the equipment from the value of the restaurant, being five to five and a half times its yearly profit.
84 This process applied on seven separate occasions in the period from December 2005 to December 2011, with MFT entering into FLLs with MAL to takeover and operate a pre-existing McDonald's restaurant for a specified term.
85 The primary judge was correct in finding that the upfront payments were of capital or were capital in nature, and not deductible by reason of s 8-1(2)(a) of the ITAA 1997, claimed over a 10 year period under s 82KZMD of Subdiv H of Div 3 of Part III of the ITAA 1936, including the years in dispute. That conclusion necessarily followed from the correct identification of the advantage sought by MFT in making the upfront payments. Irrespective of how the primary judge approached the task of identifying the advantage sought by MFT in making the upfront payments, her Honour 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 FLL, and most likely longer. This gave MFT a preferable profit-making structure. Therefore, her Honour was correct to reject the appellants' contention made below that the upfront payments were prepayments of rent. The payment, contrary to their description, were in truth never for prepayment of rent or any other deductible outgoing.
86 The character of the advantage sought is generally the chief, if not critical, factor in distinguishing between outgoings of revenue and capital. The proper identification of the advantage sought sometimes arises as a threshold issue to be dealt with prior to characterisation: see AusNet per French CJ, Kiefel and Bell JJ (at [23] and [66]). An outgoing may be on capital account even though no asset is acquired: Mount Isa (at 147-148). As the High Court said in Sharpcan (at [18]), the identification of the advantage sought to be obtained ordinarily involves consideration of the manner in which what is acquired is to be used and whether the "means of acquisition is a once-and-for-all outgoing for the acquisition of something of enduring advantage or a periodical outlay to cover the use and enjoyment of something for periods commensurate with those payments". The focus is therefore to be on identifying an enduring advantage rather than an asset, as such.
87 The terms on which an asset is acquired can affect how advantageous or disadvantageous, or valuable, that asset is. Therefore it is necessary to have regard to the terms on which the assets were acquired, or any subsequent variation to the terms governing the asset, to identify whether the upfront payments secured an enduring advantage.
88 In the case of both the Group One and Group Two restaurants, making the upfront payments resulted in a reduction in the outgoings subsequently incurred by MFT as a consequence of either the more favourable profit-making structure it acquired or the change to the profit-making structure to make it more favourable: cf Sharpcan where the structural rights increased revenue. Although not permanent, the advantage secured by MFT in making the upfront payments endured for the term of each FLL at a minimum but probably for the extension, which was a period of between 7.83 to 20 years. This was an enduring advantage: cf Sharpcan (at [24]).
89 The conclusion that the upfront payments were made to secure a preferable business structure for MFT involves a comparison of the expected structure of the business after making the upfront payments with the expected structure if the upfront payments had not been made. This comparison involved a counterfactual of the type described in Sharpcan (at [33]). That approach taken by the primary judge (at [117]) was also correct.
90 Further, the payments were not made to secure to the trustee of the MFT the ongoing use and enjoyment, or occupancy, of each store over the term of its lease because that advantage was otherwise secured.
91 Further again, although by no means conclusive, it is relevant that the means by which MFT acquired the better terms as to rent involved the making of a one off lump sum payment made at the start of the transaction in respect of each restaurant, which payment was not made to meet a continuous demand. With the partial exception of the Bateau Bay FLL, the upfront payments were not refundable, suggesting that the payments were not made to secure the right to occupy the premises under the lease: Star City per Goldberg J (at [87]) and Dowsett J (at [195]). The use of the label "rent" is not determinative: Battery Makers per Gibbs ACJ (at 655); and Star City per Goldberg J (at [61]-[63]) and Jessup J (at [264]). It may be accepted that an amount that is actually rent incurred in the course of carrying on a business would generally be deductible on the basis that rent is a revenue expense. However, these payments were not "rent" properly so called, nor were they a lump sum substitute for future rental expenses as the upfront payments were not incurred to secure the use and enjoyment, or occupation, of the restaurant premises. Rather, the payments extinguished any obligation to pay the higher percentage rent and could not therefore relate to any future obligation to pay rent that accrued periodically. In the case of the Group One restaurants, the obligation to pay the higher percentage rent never existed under the lease at all.
92 In any event, the prepayment would not necessarily lead to any reduction in expenditure on the revenue account. If the turnover rent did not exceed the base rent, then no turnover rent would in any event be payable with the result that the prepayment would not in fact have achieved any reduction in expenditure on the revenue account. Also, if the benefit of the lower percentage of turnover rent was less than the value of the prepayment no reduction in expenditure on the revenue account would have been achieved. It is therefore not the case that the prepayment necessarily secured a reduction in a revenue outgoing.
93 Although the appellants also argue that a payment made to secure a reduction in a revenue outgoing is itself on revenue account, this is not necessarily so: see, for example, Commissioner of Taxation (Cth) v Ilbery [1981] FCA 188; (1981) 12 ATR 563 per Toohey J, with whom Northrop and Sheppard JJ agreed (at 571-572). There is no principle of general application that a lump sum paid to reduce or eliminate future revenue expenses is always to be characterised in the same way as the expenses for which it is substituted.
94 The authorities relied upon by the appellants reiterate that the character of the outgoing is to be determined in accordance with the basic principles that govern deductibility. They do not establish as appears to be contended, any general principle that payments made to secure a reduction in revenue outgoings will always be on revenue account. W Nevill concerned a payment made by a company to secure a release from a contract with its managing director. The cancellation of the contract did not give rise to any capital asset or enduring benefit, rather the payment was made by the company for the purpose of organising its staff made in the ordinary course of the company's business: per Latham CJ (at 300), Rich J (at 304), Dixon J (at 306) and McTiernan J (at 308). Statements made by the Court concerning the "positive limbs of what is now s 8-1" did not govern the character of the outgoing as being on revenue account.
95 In Anglo-Persian, on which the appellants also rely, a payment made to terminate a contract under which commission was paid to agents was found to be on revenue account. But this payment was held to be on revenue account because it resulted in a more economical and efficient working of the company's trade, but also because it did not relate to any identifiable capital asset because the contracts were terminated. This was later explained by Lord Wilberforce in Tucker (at 805) and Lord Fraser of Tullybelton (at 812). In Spotlight Stores, Merkel J found (at [53] and [55]) that the advantage sought to be obtained by the expenditure under consideration was the "prepayment of bonuses" expected to become payable over the next five years, which was said to be "commensurate with the periods in which the advantage was expected to be enjoyed". In Hancock, the payment made to commute the pension was "actuarially equivalent in value and … identical in character": per Lush J (at 37).
96 In this instance, given the upfront payments were found not to be substituted expenditure because they were not made to secure the right to occupy the premises, and they had no relationship with the period over which any benefit associated with them was to be enjoyed, the upfront payments would be capital or capital in nature. This is so even if the character of the upfront payments is to be determined based on their effect on the terms of the leases, viewed in isolation.
97 The character of the advantage sought to be obtained by a taxpayer in incurring expenditure is to be determined objectively from the perspective of the entity that incurred the expenditure: Federal Commissioner of Taxation v Ashwick (Qld) No 127 Pty Ltd [2011] FCAFC 49; (2011) 192 FCR 325 per Edmonds J, with whom Bennett and Middleton JJ agreed (at [107]-[108]). The primary judge did not err by taking into account the expert valuation evidence that explained how MAL had calculated the upfront payments. The way in which the upfront payments were calculated by MAL 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. The way in which an amount described as prepaid rent is calculated is a matter that has previously been taken into account as part of the wider commercial context in determining whether a payment is properly described as "rent": Creer per Fisher J (at 59-60); and Star City per Dowsett J (at [192]) and Jessup J (at [259]). As Hancock demonstrates, the question of whether an amount is "actuarially equivalent in value" may be relevant to determining the character of a payment purportedly made in substitution for another revenue outgoing. In this case, the method of calculation was capable of being objectively determined.
98 The fact that the method of calculating a payment was determined unilaterally by the recipient of the payment, with no input from the appellants does not change the objective facts. Further, Mr Mussalli was aware of critical aspects of how MAL valued its restaurants, including with respect to the use of a multiple, and that the amount of a particular upfront payment did not have any relationship to the term of the FLL. This included that MAL valued stores at an amount of about five times an adjusted (yearly) profit and that was the value MAL applied whenever a store changed hands. It was also, significantly, the amount an exiting franchisee could expect to recover on either transferring the store back to MAL or to a new franchisee. It was also the basis for calculating an acquisition cost for a franchisee taking a store from MAL.
99 While the expert evidence with respect to the accounting treatment of the upfront payments simply confirmed the objective analysis, there was no error in taking it into account. Her Honour correctly held that the expert accounting evidence established that the accounting adopted by MFT of recording the upfront payment in its balance sheet as an asset was appropriate based on the applicable accounting standards irrespective of what the payment was for. The primary judge did not treat the accounting evidence as being determinative. The accounting treatment of expenditure may be relevant to determining whether that expenditure was incurred on revenue or capital account. The expert accounting evidence was used in a limited way, principally to determine whether the fact MFT recognised the upfront payments as an asset in its balance sheet assisted in characterising the advantage sought in making the payment in light of the applicable accounting standards.