ATO Interpretative Decision

ATO ID 2005/277

Income Tax

• This document incorporates revisions made since original publication. View its history and amending notices, if applicable.

Issue

Does the taxpayer have a 'construction expenditure area' of capital works, as provided for in section 43-75 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision

No. The taxpayer does not have a 'construction expenditure area' of capital works, as provided for in section 43-75 of the ITAA 1997, because the expenditure it incurs in constructing the works is not capital expenditure in its hands.

Facts

The taxpayer, an entity that carries on a construction business for the purpose of producing assessable income, entered into a fixed price long-term contract with an unrelated entity to construct works on land held on a leasehold basis by the unrelated entity (the lessee entity). The works are capital works to which Division 43 of the ITAA 1997 applies. The contract was entered into after 30 June 1997.

Under the terms of the construction contract, the taxpayer has access to the land under a license for the construction period to construct capital works on the site, and has no proprietary right in the works. The taxpayer will make progress payments to its subcontractors in order to fulfil its obligation under the construction contract.

The taxpayer will receive a construction payment upon its completion of the works for the lessee entity. The income from the contract is received by the taxpayer in the ordinary course of its construction business. The taxpayer will determine its taxable income from the long term construction contract on an 'estimated profits' basis as described in Taxation Ruling IT 2450: Recognition of Income from Long Term Construction Contracts.

Reasons for Decision

Section 43-10 of the ITAA 1997 provides that you can only deduct an amount for capital works for an income year if, among other things, the capital works have a 'construction expenditure area'.

For capital works begun after 30 June 1997, the 'construction expenditure' area of capital works means the part of the capital works on which the construction expenditure was incurred that, at the time it was incurred by an entity, was to be owned or leased by the entity or held by the entity under certain quasi-ownership rights (section 43-75 of the ITAA 1997). Accordingly, a threshold requirement for a taxpayer to deduct an amount for an income year under section 43-10 of the ITAA 1997 is that it incurs 'construction expenditure'.

'Construction expenditure' is defined in subsection 43-70(1) pf the ITAA 1997 as capital expenditure incurred in respect of the construction of capital works, subject to the exclusions listed at subsection 43-70(2).

In deciding whether the taxpayer has a 'construction expenditure area' for the capital works, the relevant issue is whether the outgoings the taxpayer incurs in carrying out the construction services is capital expenditure of the taxpayer.

Broadly speaking, business expenditure is deductible as a general (revenue nature) deduction if it has the necessary and relevant connection with the operation or activities which directly gain or produce assessable income (Charles Moore & Co (WA) Pty Ltd v. Federal Commissioner of Taxation (1956) 95 CLR 344; 11 ATD 147; 6 AITR 379, Federal Commissioner of Taxation v. Smith (1981) 147 CLR 578; (1981) 11 ATR 538; (1981) 81 ATC 4114, Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431). Provided that a loss or outgoing can be objectively viewed as a necessary or natural consequence of the taxpayer's income earning activities, it will be 'incidental and relevant' to the income earning activities of the taxpayer and deductible as a revenue deduction under section 8-1 of the ITAA 1997, except to the extent that it is a loss or outgoing of capital or of a capital nature (see discussion of the High Court in Steele v. Deputy Commissioner of Taxation (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139).

The established principles on the distinction between capital and income are well known; see for example, Dixon J's judgement in Sun Newspapers Ltd & Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87 (Sun Newspapers Case), and the Full Federal Court decision in FC of T v. Email (1999) 99 ATC 4868 at 4873; 42 ATR 698 at 704). The character of the advantage sought provides important direction. It provides the best guidance as to the nature of the expenditure as it says most about the essential character of the expenditure itself. The decision of the High Court in G.P. International Pipecoaters v. Federal Commissioner of Taxation (90 ATC 4413; (1990) 170 CLR 124; 21 ATR 1) emphasised this, stating:

the character of expenditure is ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure, for the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid: Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337, at 363; 1 AITR 353; ...

The nature or character of the expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

Here, the taxpayer carries on its construction business for the purpose of producing assessable income. The intention or purpose of the taxpayer in entering into the construction works is to make a gain or profit in carrying out activities that are in the ordinary course of its business operations. It receives the construction payment in the ordinary course of its business and incurs expenditure in the ordinary course of its business in providing the construction services. The liability the taxpayer discharges by making the expenditure it incurs in providing those services is its obligation to construct the works as required under the contract. In exchange, the nature of the asset acquired is the construction payment.

The character of the advantage sought by the taxpayer is the fulfilment of its obligations to deliver construction services to the lessee entity, allowing derivation of its ordinary business income. The services of the subcontractors are secured by a periodical outlay to cover their use and enjoyment for periods commensurate with the payment, and according to the principle in the Sun Newspapers Case, the advantage has no lasting qualities. The expenditure made in providing the construction services does not create an enduring benefit for the taxpayer.

In this case the taxpayer's expenditure is incurred as a consequence of the day to day activities from which the business gains assessable income and the object of the expenditure is devoted toward a revenue purpose. The expenditure is not capital, or of a capital nature when outlaid by the taxpayer because it is incurred in the ordinary course of carrying on its business in providing construction services. The taxpayer incurs its expenditure as revenue costs, accounted for under the estimated profits basis, as they are incurred.

Accordingly, the expenditure the taxpayer incurs carrying out the works under the construction contract is not capital expenditure in the taxpayer's hands. As the taxpayer does not incur capital expenditure in providing construction services, it does not have a construction expenditure area of capital works for the purpose of section 43-75 of the ITAA 1997.

Amendment History

Year of income:  Year ending 30 June 2006

Legislative References:
Income Tax Assessment Act 1997
   section 43-10
   section 43-70(1)
   section 43-70(2)
   section 43-75

Case References:
Charles Moore & Co (WA) Pty Ltd v. Federal Commissioner of Taxation
   (1956) 95 CLR 344
   11 ATD 147
   6 AITR 379

Related Public Rulings (including Determinations)
Taxation Ruling IT 2450

Related ATO Interpretative Decisions
ATO ID 2005/278

Keywords
Capital expenditure
Construction costs
Construction expenditure area

Siebel/TDMS Reference Number:  4689759;1-5VYMIBQ, 1-BTSKL50

Business Line:  Private Groups and High Wealth Individuals

Date of publication:  14 October 2005
Date reviewed:  4 July 2017

ISSN: 1445-2782