Capitalisation of all Costs to Base Cost or Not

• DOI: 10.10520/ejc-btclq_v12_n3_a3
• Published date: 01 September 2021
• Author: Michael Rudnicki Rudnicki
• Date: 01 September 2021
• Pages: 8-15

8© Siber ink

Capitalisation of all Costs to

Base Cost or Not:

MANAGEMENT FEES AND INCENTIVE PAYMENTS

MICHAEL RUDNICKI*

AbstrAct

Establishing a base cost of an asset for capital gains tax purposes is of para-

mount importance as it is a function of determining a capital gain or capital

loss. Paragraph 20 of the Eighth Schedule to the Income Tax Act (ITA),

provides the rules for establishing base cost. The rules provide for an over-

arching application to expenditure actually incurred in respect of the cost

of acquisition or creation of an asset. This article, however, focuses on two

specific base cost rules in paragraph 20, namely expenditure incurred directly

in relation to the acquisition or disposal of an asset as provided for in para-

graph 20(1)(c) of the Eighth Schedule, and expenditure actually incurred in

effecting an improvement to or enhancement of the value of an asset. The two

provisions are then applied to two examples: (i) management fees paid by

private equity investors to the private equity fund manager, and (ii) incentive

payments paid by private equity investors to the management of portfolio

companies upon a successful exit.

The relativity between the expenditure and the acquisition and disposal

of an asset is found in the word ‘directly’ in paragraph 20(1)(c). This word is

interpreted, mainly by reference to dictionary meanings, to mean ‘connected

to’ and ‘related to’. Accordingly, this base-cost rule is narrow in its applica-

tion.

The article concludes that an incentive payment by the investors to the

management of a portfolio company does not qualify within the speci-

fied categories of services rendered, such as consulting or agency services.

Management contracts to render services to its employer, the portfolio

company. Accordingly, the provisions of paragraph 20(1)(c) will not apply.

Given the very broad mandate of a private equity (PE) fund manager, it is

unlikely that the services provided are ‘directly’ related to the acquisition and

disposal of an asset.

Paragraph 20(1)(e) of the Eighth Schedule includes in base cost expendi-

ture incurred in effecting value enhancement to an asset. It is submitted that

the provision does not apply a ‘sequential’ interpretation to the expense

and then the outcome, but a purposive meaning of the words ‘in effecting’.

The interpretation is established from analysing case law and related rules in

Australia as well as removing the requirement in paragraph 20(1)(e) for the

value created to remain in the asset upon its disposal. The analysis suggests

rather a purposive meaning to the words whereby action is caused with

the intended impact of change. In other words, the present tense of the

words suggests a purpose in relation to the expense rather than an absolute

outcome.

* Tax Executive, Bowmans Attorneys.