Key points

  • The decision of the Full Court of the Federal Court in Clough Limited v Commissioner of Taxation [2021] FCAFC 197 confirmed that payments totalling $15m made to employees to terminate their entitlements under 2 employee incentive schemes were non-deductible under s. 8-1.

  • The fact that the payments were made in conjunction with a takeover was a key factor in holding that the payments were not incurred in carrying on the business for the purpose of producing assessable income.

  • The takeover context was also important to a second conclusion, that the payments were capital in nature.

  • The $15m payments were instead viewed as deductible over 5 years under s. 40-880. But comments in the case may cast some doubt on this conclusion.

In detail

The Full Court of the Federal Court has upheld the taxpayer's appeal from a decision of Colvin J disallowing a deduction under s. 8-1 for payments totalling $15m made to employees to redeem their accruing entitlements under various incentive schemes, paid as part of the process of cleaning up the company in anticipation of a takeover. Our Tax Insight on that decision is available here. However, even though the taxpayer won this skirmish, it lost the war.


The facts were relatively straightforward. Clough Ltd operated 2 employee incentive schemes: a share option scheme and an incentive scheme which entitled employees to choose either cash or shares. At the time of these events, employees had rights under these schemes which had not yet vested. The majority owner of Clough wanted to buy out the minority shareholding, making Clough a wholly-owned subsidiary. After some negotiations, a scheme of arrangement was proposed which involved terminating the unvested rights of the employees under these schemes. The Board had a discretion to accelerate the vesting of entitlements under the schemes if a 'Change of Control Event' (such as entering a scheme of arrangement) occurred, and so the Board wrote to employees offering them a choice – they could surrender their unvested rights for cash, and if not the Board would accelerate vesting so that the employees would become shareholders and therefore governed by the terms of the scheme of arrangement, if approved by the shareholders. The scheme was approved by members and implemented, and a subsidiary of Clough made payments totalling $15m to various employees who had agreed to cancel their rights.

Clough adopted a conservative position and prepared its tax return on the basis that the $15m payment was not immediately deductible. It then objected against the deemed assessment arising from the return asserting the $15m was deductible under s. 8-1. The ATO disallowed the objection and Clough appealed to the Federal Court. At the hearing, the ATO maintained its position that the amount was not deductible under s. 8-1, but just before the trial, accepted that the amount was instead deductible over 5 years under s. 40-880. Colvin J held that the amount was not deductible under s. 8-1 because it lacked the necessary connection to earning assessable income:

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 [the majority shareholder] 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.

His Honour did not consider whether the amount would have been non-deductible on the basis that it was an outgoing of a capital nature, he made no order about deductibility under s. 40-880, and did not make an order about costs.

The appeal

The Full Court began its analysis by emphasising this case involves the difficult terrain of characterisation: the payments were made to employees to cancel their rights under the incentive schemes, and they were also paid in connection with the change of control to the ownership of Clough. So, which circumstance is the more influential in characterising the payments:

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. For the reasons which follow, in a practical business sense, the payments are better characterised as payments made pursuant to an agreement to secure a change in control rather than as meeting employee entitlements on a change of control.

We noted above that the taxpayer's appeal was allowed, but the Full Court did not disagree with the characterisation and reasoning of Colvin J:

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.

This conclusion was sufficient to make the amount non-deductible, but the Full Court went further concluding the $15m would also have been non-deductible as an outgoing of a capital nature:

The amounts of the payments were calculated by reference to the share price, not by reference to time served by particular employees or by reference to performance criteria achieved. Payment of the amounts was conditional on the scheme of arrangement proceeding. The payments were unusual and not in the nature of an ordinary working expense… Assessing all of these matters as a whole, the payments were on capital account.

The Court was not persuaded by the observation that the payments extinguished an obligation to pay cash to some employees and ordinarily those cash payments would have been on revenue account. It concluded some payments to employees will be more accurately characterised as a payment made as part of the consideration for the sale of a business:

This conclusion [that the payment was capital in nature] is not denied by the fact that, if the takeover had not occurred, and an obligation to meet performance rights arose, performance rights if paid in cash rather than the issue of shares, might have been characterised as being on revenue account … [if] the contested payment was part of the consideration for the acquisition of the business.

While the Full Court allowed Clough's appeal, it did so because of problems in the orders made by Colvin J: Colvin J should have ruled the assessment was excessive because it did not allow a deduction under s. 40-880. And to emphasis just how Pyrrhic Clough's victory was, even though its appeal was upheld, Clough was ordered to pay the ATO's costs of the appeal.


The case is interesting both for what it reveals and for what it hints at.

Importantly, the Court was not interested in the argument that this was simply an aspect of employee remuneration and that fact was sufficient to make the amount deductible:

… the occasion of the outgoing, and identification of what the outgoing is for … 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.

But the central holding of the case – that payments lacked a sufficient connection to carrying on the business – is troubling. The test the Court was applying was, '… any loss or outgoing to the extent that … it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.' That test describes the connection that must exist between an outgoing and a business for s. 8-1. The Court held the test was failed.

Section 40-880 also requires a connection between an outgoing and a business. The test in s. 40-880(2) requires that 'capital expenditure [be incurred] in relation to your business …' and s. 40-880(3) requires '… the business [be] carried on … for a taxable purpose' and s. 40-25(7) defines a taxable purpose to include, 'the purpose of producing assessable income …'

It will need a little linguistic creativity to conclude that a payment might not be 'incurred in carrying on a business …' but yet still be 'capital expenditure [incurred] in relation to your business …'; that the words 'in relation to …' express a looser connection requirement than the word 'in …'

The ATO accepted that s. 40-880 would be met, and the Court approved: '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.' But the scope of the s. 40-880 connection test – and whether it is different to the scope of the s. 8-1 connection test – was never examined. So maybe the ATO's concession means the taxpayer won after all, albeit neither the ATO nor the taxpayer appreciated it at the time the concession was made.

Finally, given that s. 40-880 was originally introduced to allow a deduction for certain takeover costs, it would be a very unwelcome development if the ATO or the Courts sought, in the future, to narrow the application of s. 40-880 because of the takeover context.