New Business Tax System (Capital Allowances) Bill 1999

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 5 - Submarine cables and indefeasible rights to use them

Outline of Chapter

5.1 This Chapter explains the amendments contained in Schedule 4 to this Bill which insert new Division 44 into the ITAA 1997. New Division 44 will:

modify the depreciation provisions in Division 42 of the ITAA 1997 to allow depreciation deductions for the cost of an indefeasible right to use a portion of an international telecommunications submarine cable system. The depreciation deductions will be allowed over the effective life of the submarine cable; and
treat the granting of an IRU as a disposal by the grantor of an ownership interest.

Context of Reform

5.2 Under the current law, a resident taxpayer who purchases an IRU cannot amortise the capital expenditure incurred upon entering into the IRU. Instead, the expenditure can only be written off as a capital loss when the right expires; generally at the end of the useful life of the cable.

Summary of new law

5.3 New Division 44 will modify the depreciation provisions in Division 42 so that a grantee of an IRU is able to deduct the cost of the IRU over the effective life of the cable.

5.4 The IRU will be treated as plant for the purposes of Division 42 of the ITAA 1997. The IRU holder will therefore have the choice of using either the prime cost or diminishing value methods of calculating depreciation deductions.

5.5 The deductions will commence when the taxpayer first exercises the right to use the allocated capacity of the cable for income producing purposes.

Comparison of key features of new law and current law

New Law Current Law
Depreciation deduction available over life of underlying cable No deduction. Possible capital loss when IRU disposed of, lost or destroyed.

Detailed explanation of new law

What is an IRU?

5.6 An IRU is a legal interest created by contractual agreement that confers a permanent indefeasible and exclusive right of access to some or all of the capacity in a telecommunications submarine cable system to another party. The term IRU is widely used and accepted in the telecommunications industry. The expressions 'indefeasible right of use' and 'indefeasible right of user' and 'capacity use' and 'right of use' are also used interchangeably with 'indefeasible right to use'. However described, an IRU must provide indefeasible permanent access to raw capacity in a cable system.

5.7 IRU holders in traditional consortium cable arrangements have basically the same rights and obligations as owners of the cable system except for voting and membership rights regarding cable system committees and the ability to act as a principal in claims arising in relation to the cable system. Capacity access in privately owned cable arrangements is usually only obtainable on an IRU basis.

5.8 A submarine cable system comprises not only the submarine cable itself but may also include the land based portions of the cable system including plant, testing equipment, land and buildings.

5.9 An IRU is broadly equivalent to ownership of the cable system in terms of cable operation. An IRU contract generally contains the following elements:

in consortium cable arrangements, the IRU holder uses the applicable cable system capacity to which it is entitled on the same terms and conditions as the cable system owners;
the IRU holder is generally required to contribute an upfront capital payment and to pay on-going amounts for the operation and maintenance of the cable;
the IRU holder is usually required to contribute to its proportional share of any costs which arise from the liquidation of the cable system or from claims by third parties. In addition, the IRU holder may also be entitled to any proportional share of proceeds which arise from liquidation of the cable system or from claims against third parties in respect of it; and
the IRU holder is not entitled to any compensation for the failure in or breakdown of the cable system or for any interruption of the use of the cable system.

5.10 An IRU is specifically called 'indefeasible' as it cannot be defeated or terminated by the unilateral action of one party to the IRU agreement.

An IRU as plant

5.11 IRUs will not be given a separate amortisation regime. Instead, the depreciation provisions in Division 42 will apply to IRUs as if they were units of plant [subsection 44-5(1)] . This treatment will only apply for the purposes of Division 42 and Parts 3-1 and 3-3. Application of Parts 3-1 and 3-3 is necessary to ensure that the measures removing plant from CGT (contained in Schedule 1 to this Bill) operate correctly. The treatment does not alter the nature of the contractual arrangement [subsection 44-5(3)] . The capital expenditure incurred by the purchaser of the IRU is still consideration paid for the right to use a cable system.

The cost of an IRU

5.12 When a taxpayer enters into an IRU contract it generally agrees to pay an up-front amount and also agrees to pay on-going amounts for operation and maintenance of the cable system. The former amount is the cost of the IRU for the purposes of Division 42. The latter expenses would not form part of the cost but may be deductible as normal revenue expenditure.

Commencement of deductions

5.13 A purchaser of an IRU will be able to commence claiming deductions for the year that the IRU commences to be used to produce assessable income [section 44-10] . The deduction will be apportioned if the use commences other than on the first day of the year.

Depreciation rate

5.14 The rate of depreciation for plant is generally determined in Subdivision 42-D. However, new Division 44 substitutes a rate which is based on the effective life of the cable over which the IRU is granted [section 44-15] . When calculating depreciation deductions for an IRU, as for any item of plant, a taxpayer will be able to choose between the diminishing value and prime cost methods. If the prime cost method is used the rate (expressed as a percentage) will be one divided by the number of years in the effective life of the cable [subsection 44-15(3)] . For the diminishing value method the rate will be 1 times the prime cost rate [subsection 44-15(2)] .

5.15 An IRU owner will not necessarily know what the cable owner has calculated as the effective life of the cable. Indeed, if the cable is owned by a non-resident, the cable may not have an effective life for Australian taxation purposes. Therefore, the IRU holder must place itself in the position of the cable owner and calculate the cable's effective life.

5.16 Treasurer's Press Release No. 58 of 1999 announced that, effective from 11.45 am AEST on 21 September 1999, taxpayers can elect to reassess the effective life of plant acquired after that time. This will mean for example, that if some years after the IRU is issued, technological developments mean that the cable will become obsolete in a shorter time than originally expected, an IRU holder will be able to reassess the effective life of the cable, and consequently, of the IRU.

Disposal of an IRU

5.17 A holder of an IRU generally has the right to assign their interest (whether in part or in its entirety) to a third party. The assignment of the whole IRU is a balancing adjustment event in terms of section 42-30 of the ITAA and, as such, is subject to the provisions of Subdivision 42-F, that calculate balancing adjustments.

5.18 The disposal of only part of an IRU will trigger the operation of new section 44-20. That section treats such a disposal as creating 2 new items of plant; the part that the taxpayer is disposing of and the part that it continues to own [subsection 44-20(2)] . Because of these new rules, the part disposal will no longer be a balancing adjustment event. Rather, it is the disposal of the new item of plant that will be a balancing adjustment event. Subdivision 42-J, which deals with partial changes of ownership in plant will have no application to partial disposals of IRUs or cable systems [subsection 44-20(5)] .

5.19 The undeducted cost (defined in section 42-175) of the IRU before the part disposal occurs must be apportioned on a reasonable basis between the 2 new items of plant. [Subsection 44-25(1)]

5.20 The plant that is disposed of is subject to a balancing adjustment calculation under Subdivision 42-F. Its written down value for the purposes of that calculation is the amount of written down value that is reasonably attributable to it. If the IRU has not been depreciated at the time of the part disposal it is necessary to calculate the cost and/or the reduced cost base of the part disposed of. This is because of the operation of new Subdivision 42-GA, which is inserted by Schedule 1 to this Bill. [Subsection 44-20(4)]

5.21 An IRU holder may grant more than one IRU at the same time. It is still taken to have split the plant into only 2 items of plant under new subsection 44-20(2). The calculation of the balancing adjustment is still done as if only one item of plant is disposed of.

5.22 The part that continues to be owned (the new plant ) will continue to be depreciated on the following basis:

it will be treated as if it is a new item of plant [subsection 44-20(3)] ;
its cost for the purposes of calculating future depreciation deductions will be the amount of the undeducted cost of the original plant as is reasonably apportioned to it [subsections 44-25(2)] ;
the method of calculation of depreciation deductions for the original plant will be the method used for the new plant [subsections 44-25(3)] ; and
where prime cost is used, the rate is adjusted to ensure that the appropriate deductions are calculated based on the remaining effective life of the cable [subsections 44-25(5)] .

Example 5.1 Disposal of a portion of an IRUOn 31 December 2000 JW Telco Ltd enters into a contract to purchase an IRU for 10% of the capacity of a submarine cable system between Australia and New Zealand for $40 million. JW Telco Ltd assesses the effective life of the cable to be 10 years and elects to use the prime cost method to calculate deductions. The depreciation rate is 10%.For the next 2 years JW Telco Ltd calculates deductions in the following manner:

Year ended Depreciation Written Down Value (WDV)
30 June 2001 $2 million $38 million
30 June 2002 $4 million $34 million
On 30 June 2002, JW Telco Ltd disposes of 40% of its capacity for $15 million.Due to the operation of section 44-20 the IRU is split into 2 assets. JWTelco Ltd apportions the WDV of $34 million in the following manner:New plant

60% * $34 million = $20.4 million

Part it stopped owning

40% x $34 million = $13.6 million

The balancing adjustment on the part it stopped owning is calculated under section 42-190 as follows:
Termination value $15 million
WDV $13.6 million
Amount included in assessable income under section 42-192 [F2] $1.4 million
Calculating later deductions for the new plantThe effective life of the IRU was originally 10 years. The disposal of 40% of the IRU had taken place in the second year. The remaining effective life of the IRU is 9 years.The prime cost method was used for the IRU and due to the operation of new subsection 44-25(3) JW Telco Ltd cannot elect to change to the diminishing value method.Using the formula in new subsection 44-25(5) the new depreciation rate for JW Telco Ltd is calculated in the following way:

(100% / Remaining effective life) = (100% / 9) = 11.11%

JW Telco Ltd calculates depreciation deductions at a rate of 11.11% on a cost of $20.4 million over 9 years.

Grant of an IRU as disposal of an ownership interest in the cable

5.23 The owner of a submarine cable system that disposes of all or part of the capacity in the cable system is treated the same way as an IRU holder who assigns part of their interest in an IRU. [Subsection 44-30(1)]

5.24 The disposal of a portion of the cable system is subject to the rules in new sections 44-20 and 44-25. That is, the disposal of a portion of the cable system creates 2 new items of plant; the part of the cable system the taxpayer is disposing of (that is applicable to the IRU granted) and the part it continues to own [subsection 44-30(2)] . Also, the undeducted cost of the original cable system is apportioned on a reasonable basis between each of the assets into which it was split.

Increase in the capacity of cable

5.25 With improvements in technology, a cable may have its capacity increased. If the cable's capacity is increased an IRU holder may be offered an increase in capacity. The increased capacity may be taken either through:

a new IRU; or
an increase in capacity of the existing IRU.

5.26 If the additional capacity is added to the existing IRU, the additional amount paid is a further addition to the cost of the IRU. The amendments will ensure that, where the IRU holder is calculating depreciation deductions using the prime cost method, the additional capital amount is added to the cost. If the diminishing value method is used then the additional capital amount is added to the opening undeducted cost for the income year in which the amount is paid. [Subsection 44-35(1)]

Recalculation of depreciation rate

5.27 Where an IRU is being depreciated using the prime cost method the amendments will require the rate to be recalculated. This recalculation will ensure that the extra cost will be written off over the remaining effective life. [Subsection 44-35(2)]

Example 5.2 Increase in the capacity of cableOn 1 July 2000, KT Communications enters into a contract to purchase an IRU over 10% of the capacity of a submarine cable system for $40million. The effective life of the cable system is 15 years.KT Communications elects to use the diminishing value method to calculate deductions and determines that the rate is 10% pa. The deductions are calculated as follows:

Year ended Depreciation Undeducted Cost (UC)
30 June 2001 $4.0 million $36 million
30 June 2002 $3.6 million $32.4 million
Due to software improvements the capacity of the cable is increased and on 31 March 2003, the cable owner offers KT Communications additional cable capacity for $15 million. KT Communications accepts the offer and this extra capacity is added to the existing IRU. The new undeducted cost is calculated as follows:
Undeducted Cost $32.4 million
Cost of additional capacity $15 million
New openining undeducted cost $47.4 million

Application of Division 41 common rules

5.28 Common rule 1 of Division 41 will apply to provide for roll-over in cases of full disposals to related entities. Common rule 2, which deals with market value substitution in situations where taxpayers do not deal with each other at arm's length, will also apply. [Subsection 44-40(1)]

5.29 Common rule 1 also allows for a joint election for roll-over relief under subsection 42-335(3). Because that section will not operate in cases of partial disposals of IRUs and cables, the opportunity will not be available to use this joint election. [Subsection 44-40(2)]

Application and transitional provisions

5.30 The amendments made by Schedule 4 relating to IRUs apply to expenditure on IRUs incurred after 11.45 am AEST on 21 September 1999. [Subitem 12(1)]

5.31 The amendments made by Schedule 4 relating to the part disposal of a cable system apply to contractual arrangements entered into after 11.45 am AEST on 21 September 1999. [Subitems 12(2)]

5.32 The amendments have no application to a submarine cable or an IRU over the submarine cable system if the cable system has been used for telecommunications purposes before 11.45 am AEST on 21 September 1999. [Subitem 12(3)]

5.33 These provisions ensure that only new cables and IRUs issued over new cables obtain the benefit of new Division 44.

Consequential amendments

5.34 Schedule 4 to this Bill also contains amendments to the ITAA 1997 which are necessary because of the introduction of a new capital allowance. These include insertion of new items in tables in:

section 12-5 (dealing with deductions [item 1] ;
section 20-30 (dealing with assessable recoupments) [item 2] ;
section 40-30 (dealing with capital allowances) [item 3] ; and
section 41-5 (dealing with common rules) [item 4] .

5.35 Other consequential amendments include insertion of notes, signposts, the removal of link notes, and an amendment to the dictionary. [Items 5 to 9]

5.36 Finally, the dictionary of the ITAA 1997 is amended to include a definition of 'IRU'. [Schedule 6, item 3]

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