A majority of the Full Federal Court has dismissed the Commissioner’s appeal against an AAT decision allowing a $600k deduction, for expenditure on gaming machine entitlements (GMEs), allocated by the State of Victoria. The Court held that this expense was deductible under s8-1 of the ITAA97 or, in the alternative (if the expense was ‘capital’ in nature), deductible over 5 years under the ‘blackhole’ provisions in s40-880 of the ITAA97

The issues and background

The applicant/taxpayer was a corporate beneficiary of a Trust, and, as such its ‘assessable income’ (from the Trust) depended on its ‘share’ of the tax law‘net income’ of that Trust (s97(1)(a) of the ITAA36)). ‘Net income’, in this sense, is a kind of proxy for the ‘taxable income’ of the Trust (s95(1)). It was for this reason that the Taxpayer-Beneficiary, was litigating the tax effect, of what the Trustee had done.

The following, is therefore, relevant.

  1. In 2005, the Trustee, of this Trust, purchased an hotel, with 18 gaming machines.
  2. The licenses for those machines were due to expire in 2012.
  3. But, in 2010, the Victorian Parliament changed the way these machines were regulated (see explanation below). The conceptual change was that, as the ‘Venue Operator’ (the Trustee) no longer got a commission from Tatts (the Gaming Operator), but rather became the person conducting the gaming, itself. In practice, the change was less spectacular than this might suggest.
  4. Under these new provisions, the trustee had to compete, in an auction, and succeeded in getting 18 of these new ‘gaming machine entitlements’ (so that it could still have 18 machines on its premises).
  5. As a result of the auction, the Trustee became liable to pay $600,300 for these ‘entitlements’.
  6. It became a matter of significance, that this expenditure, extended the Trustee’s right to earn income, from these gaming machines, by 10 years (as explained below).

Two alternate ways of deducting the $600k

It was the tax treatment, of this $600k, that was in issue, in this case. The Taxpayer-Beneficiary claimed, that the Trustee could deduct this $600k amount, in one of two alternate ways.

  • The first was, that the whole amount, should have been ‘deductible’, in the 2010 year, when it was incurred (under s8-1 of the ITAA97). This would be on the basis that the expenditure was incurred to derive ‘assessable [gaming and pub] income’ and that it was not ‘capital’ in nature. Predictably, the Commissioner contended, that the expenditure wasof a ‘capital’ nature.
  • Alternatively, if the expenditure were capital in nature, the Taxpayer-Beneficiary argued, that the $600k amount, ought to have been deductible, over 5 years, under the ‘blackhole’ provision, in s40-880 of the ITAA97. Broadly, this provision was designed to give some ‘tax basis’, where none would otherwise be given (that is, expenditure that would, otherwise, have fallen into a fiscal ‘blackhole’). The Commissioner opposed this, too.

The AAT decision (at first instance)

I covered the first instance decision, of the AAT, in Sharpcan Pty Ltd v CofT  [2017] AATA 2948), in this related Tax Technical article.

The AAT held that the outgoings was deductible under s8-1 as it was not capital. It said (at para [13]):

The amounts paid for the gaming machine entitlements were amounts, like those considered in BP Australia Limited v Federal Commissioner of Taxation (1965) 112 CLR 386 at 398, “which had to come back penny by penny with every order during the period in order to reimburse and justify the particular outlay”. The close connection between the amounts paid for the gaming machine entitlements and the income stream expected from the payments was in part reflected, as a practical business and commercial matter, in the amount which the purchaser had been willing to pay for the business when it had included commissions income from 18 gaming machines.

For the 5-year ‘blackhole’ write-off claim (in the alternative), the AAT had to wrestle with the tricky interaction between the ‘cost base’ provisions in s110-25 of the ITAA97 and the write-off provisions in s40-880, as they were amended with relation to goodwill. Broadly, however, the situation is as follows (though, see also the above Tax Technical article).

  • Generally, expenditure to ‘increase or preserve’ an assets value is included in the ‘fourth element’ its ‘cost base’ as (under s110-25(5)).
  • However, this does not apply to ‘capital expenditure incurred in relation to goodwill (s110-25(5A)). This was a change made in 2006 to treat ‘goodwill’ differently – namely, to allow only the cost of acquiring goodwill into its ‘cost base’ and give all other expenditure (to preserve or increase its value) a 5-year ‘blackhole’ write-off.
  • The 5-year ‘blackhole’ write off is allowed on ‘capital expenditure’ incurred ‘in relation to [the taxpayer’s] business (under s40-880(2)).
    • However, there is a huge ‘carve-out’ in ss(5) to reflect all the ways in which the expenditure might already be taken into account in calculating taxable income. This includes, in ss(5)(d) ‘incurred in relation to a … legal right…‘ and ss(5)(f) ‘taken into account in working out … a capital gain…‘.
    • The problem for Sharpcan is that it spent $600k on ‘legal rights’ (rights to have gaming machines on its premises). On the face of it, they are their own separate asset, and the $600k would form part of their own cost base (and then be excluded from the write-off, as they would be taken into account in determining the ‘capital gain’ on their disposal).
    • However, ss(6) re-allows certain capital expenditure back into the 5-year write-off (by excluding the ss(5)(d)&(f) exclusions from the write-off). Importantly, this removes the write-off embargo for expenditure ‘in relation to a…  legal right‘ (viz: the gaming machine entitlements).
    • The expenditure that can have a ss(6) ‘write-off’ is capital expenditure that the taxpayer ‘incur[s] to preserve (but not enhance) the value of goodwill, if the expenditure [it] incur[s], is in relation to a legal … right and the value to you, of the right, is solely attributable to the effect that the right has on the goodwill.’
    • The type of thing this write-off contemplates, is a restrictive covenant, given to preserve the value of goodwill, that the purchaser of a business need.
    • However, the taxpayer was claiming the 5-year write-off, under this provision (in the alternative – if the expenditure were ‘of a capital nature’). The expenditure was ‘in relation to a legal right’, but the issues, in this case were:
      • Whether the ‘value to [Sharpcan] … [was] solely attributable to the effect that the [gaming machine entitlement right had on its] goodwill‘? The Commissioner said the value of the ‘value’ of the Gaming Rights, was not solely attributable to Shapcan’s goodwill. The Taxpayer said it was.
      • Whether the expenditure was ‘to preserve (but not enhance) the value of [its] goodwill‘? The Commissioner said that $600k spent ‘enhanced’ (not merely ‘preserved’) the value of the goodwill. The Taxpayer said the opposite.

The AAT held that the alternative claim, to write-off the $600k over 5 years, must fail, as this expenditure extended the time in which it could operate the same number (18) gaming machines by  another 10 years, and must, therefore, have ‘enhanced’ the value of its ‘goodwill’.

This did not seem inherently right to me, and so I said (in the relevant Tax Technical article):

With respect to DP Pagone, I’m not sure that I agree. I’m not sure that a person, who could lose their right to trade, but has a reasonable expectation that those rights will be renewed, has suffered a dip in the value of their goodwill, such that it is, then, ‘enhanced’ by effectively having the same right to trade extended.

The Federal Court confirmed the s8-1 general deduction of a ‘non-capital’ amount

The appeal, from the AAT, was directly to the Full Federal Court, because a judge had been sitting as the AAT member.

The Full Court (majority) agreed with the AAT, that the whole $600k was deductible, as a ‘general deduction’ under s8-1 of the ITAA97, being both incurred to derive assessable and gambling income (which was not contentious) and that this expenditure was not ‘capital in nature’ (which was contentious).

Further, they did so on the same BP Australia reasons, that Pagone J relied on (in the AAT), namely: that the amount paid was based very closely on the anticipated extra income it would generate over the relevant 10 years.

The following portion of the lead judgement, given by Greenwood ACJ (with McKerrachger J agreeing) demonstrates why this “has to come back [from the operations of the business] penny by penny” view, prevailed over the other factors that did have a flavour of ‘profit yielding subject’ (rather than the process of operating it).


140.   However, there are other factors which also point in a different direction [in favour of the taxpayer].

141.   The Commissioner says that the Tribunal’s notion that the expenditure reflected the “economic value of the income stream” expected from putting assets to use to derive income from gaming is misconceived, on the facts. The Commissioner also says that the Tribunal’s notion that the gaming machine entitlements had “no intrinsic economic value” other than by reference to the income stream expected from their use with other assets to derive gaming income, is also misconceived, on the facts.

142.   I respectfully disagree with these contentions of the Commissioner.


143.   It is true that the amount of the outgoing as determined by the auction process at $600,300.00 does not represent something in the nature of a valuation or crystallisation of an amount which bears a relationship to the precise dollar value of the present or future cash flows generated in the business of the hotel undertaking. In that sense, there is no discounted cash flow valuation or determination of the “amount” to be paid for the GMEs by reference to the orthodoxy of attributing a precise present day value to future earnings. There is no attempt to take into account, objectively viewed, specific rates of return which bear some relationship with the carrying value of assets or even the depreciated optimized replacement cost of assets of the business in setting the amount of the outgoing.

144.   Nevertheless, the evidence is perfectly plain that the Trustee was conducting a going concern on 9 May 2010 (approaching the auction on 10 May 2010) and had been conducting that going concern for some years in a way which involved generating sustainable revenue and profit from an integrated hotel business undertaking which involved the sale of food and beverages in the restaurant; the sale of food and beverages in the café; the sale of alcohol at the various bars; income derived from gaming activities (as commissions); and income derived from wagering.

145.   The evidence is that Mr Canny, for the Trustee, took professional advice about the incremental thresholds at which the Trustee could afford, in a forwardlooking way, to bid (and pay) to acquire 18 GMEs. The commercial reality confronting the Trustee was that the expenditure on the cost of acquiring the GMEs would have to be paid for out of the proceeds of the business undertaking of the Royal Hotel over time. That might express itself in the form of funding the outgoing of $600,300.00 by debt funding with the attendant cost of funds (loan fees, recurrent management fees, interest costs etc). In that event, repayment of the debt and recoupment of the costs of funds would need to be paid out of the cash flows of the hotel undertaking. Alternatively (and as things transpired), the obligation to pay the outgoing might be discharged over time by a sequence of quarterly payments to the State of Victoria (Treasury) either with or without interest costs. As things transpired, the outgoing was paid by paying the State an amount of $60,030.00 in approximately May 2010 and by making further quarterly payments of $30,015.00 across the period from 16 August 2012 to 31 August 2016 with no interest charges payable to the State of Victoria. However, even under those arrangements, meeting the quarterly instalments had to be financed out of the proceeds of the business undertaking of the hotel.

146.   The realisation that the cost of the GMEs would need to be funded out of the cash flows of the business meant that in order for the Trustee to continue its going concern at the Royal Hotel deriving income from gaming activities (recognising that in the new environment the legal foundation for that activity would be as a venue operator “conducting” gaming), the Trustee had to form a view (and did so through Mr Canny) about the relationship or relativity between the cost of the GMEs and the capacity of the business undertaking to fund the acquisition out of future revenue (cash flows), while maintaining an acceptable rate of return in the business. That assessment had to take account of the profitability of the undertaking overall. The relationship was not one just between the cash flows derived from gaming activities but one between the cost of the GMEs and the cash flows generated from the entire business undertaking having regard to the influence gaming activities had upon contributions to revenue in other parts of the integrated hotel business. The Trustee was, after all, “running a Pub” not operating a “gaming parlour”.

147.   It is true that there is no direct relativity, dollar for dollar, between the amount paid for the GMEs and a particular discount applied to future cash flows evident in an orthodox discounted cash flow sense which might be used to determine a “value” to be paid for the acquisition of the GMEs. There is no express ratio of cost to earnings. However, there is no doubt that the thinking which informed Mr Canny’s assessment (for the Trustee) of the amount the Royal Hotel business or could afford to pay for the GMEs was determined, having regard to the bidding schedule, on the basis of the maximum amount which might be paid yet which would leave the business in a position where it achieved a reasonable rate of return on assets having regard to revenues and costs. In that sense, there is no doubt that the amount of the expenditure bore a very real relationship with the income generated by the business of the hotel and the profits the hotel business would generate in a forwardlooking way on the assumption that the cost of the GMEs might fall within the upper limits of the payment scale set out in the bidding schedule: see the discussion as to that matter at [59] to [61] of these reasons and Mr Canny’s assessment of the amount the Trustee could afford to pay in the bidding process; see the increments in the bidding schedule set out at [61] of these reasons.

In my opinion, this illuminates the reasons for this decision, which might otherwise look a bit flimsy. It shows how the evidence and the thinking of the taxpayer emerged to give prominence to this ‘got to come back, penny by penny’ similarity to BP Australia.


The Federal Court also found an alternative 5-year write-off (if the expenditure were capital)

In para 198, Greenwood ACJ, effectively recognised that the $600k (if it were capital in nature) could only be written-off over 5 years (under the ‘blackhole’ provision in s40-880) if the conditions I mentioned above exist, namely:

  • Whether the ‘value [of the GME rights] to [Sharpcan] … [was] solely attributable to the effect that the [GME right had on its] goodwill‘?
  • Whether the expenditure was ‘to preserve (but not enhance) the value of [its] goodwill‘?

As to the first question, the Court held that the value of the GME rights was ‘solely’ attributable to the ‘effect’ those rights had on its goodwill, because, without those rights, it’s goodwill would have collapsed. [para 254]

As to the second question, the Court held that the test was not whether the expenditure had the ‘effect’ of actually enhancing the value of goodwill, but rather, what was incurred for (at the time) – to preserve, or enhance the value of the goodwill (was the purpose of the expenditure to preserve or enhance the value of the goodwill).

To answer this question, the Court went back to the change in the statutory system, for gaming machines. Previously the tax was imposed on Tatts and it paid the venue operator only a commission. But after the change, the venue operator owned the machines and took the proceeds themselves, but the Venue Operator had to pay the Government, which it did by bidding for the machine licences. The court compared the gross and net profits from gaming both before and after this change and found them not compellingly different. [paras 66 & 252, 253]

The taxpayer’s purpose in incurring the $600k was to preserve the net contribution the gaming made to the pub’s operations. It was not to get an ‘enhanced’ overall system.

Whether the effect of the expenditure might have actually been to increase the value of the goodwill (or not) might depend on the amount the taxpayer had to bid (in the competitive bidding process) and how the estimated figures (behind those bids) actually panned out over time. None of those things, however, went to the purpose of paying something for the right to continue having 18 gaming machines, that continued to provide a gross profit that was similar to the commission it had previously received. [para 254][

In dissent, Thawley J reached the opposite conclusion to the majority and would have allowed the appeal.

(CofT v Sharpcan Pty Ltd [2018] FCAFC 163, Full Fed Court, Greenwood ACJ, McKerracher and Thawley JJ, 27 September 2018.)

FJM 9.10.18


CPD questions (answers available)

  1. Is this a case about the tax effect of payments made, by the owner of a pub, to the Victorian Government, to continue having 18 gaming machines in his premises, after the change in the statutory scheme for regulating and licensing gaming machines, in 2010?
  2. Before the change, did the pub just get a commission from Tatts (who owned and operated the machines and paid the relevant licensing fees to the Government)?
  3. After the change, did the pub own and operate the machines, get the gross revenue, and then pay a licence fee, for the next 10 years, which was determined by way of competitive bid (if that pub was the winning bidder)?
  4. Did the taxpayer seek a deduction for the full $600k it paid for these statutory rights to have the gaming machines as a general deduction, under s8-1 of the ITAA97, on the basis that they were not capital in nature, but, in the alternative, if they were capital, as a 5-year write-off under the ‘blackhole’ provisions in s40-880 of the ITAA97.
  5. Was it necessary to have one of these statutory GME rights, to have a gaming machine?
  6. Did the statutory monopoly cases, like Ausnet, apply to make the expenditure capital in nature, because it preserved part of the ‘profit-making subject’ of the business?
  7. Did the BP Australia case apply, because the $600k paid had to be recovered, penny by penny, from the operation of the ‘profit-making subject’ of the business?
  8. Did the AAT decide that the $600k was s8-1 deductible?
  9. Why was the appeal direct to the Full Federal Court (and not the Federal court, as usual)?
  10. Did the Full Federal Court uphold the AAT’s decision on the s8-1 general deduction claim?
  11. Did the AAT hold that the 5-year ‘blackhole’ write-off provisions applied (if s8-1 did not)?
  12. Did the Full Federal Court reach the same conclusion?
  13. Was the Full Federal Court decision unanimous?




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