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Ruling

Subject: Application of Division 250 of the ITAA 1997, to the Partnership

Question 1

Will Division 250 of the Income Tax Assessment Act 1997 apply to a partnership in relation to its interest in a project with a state?

Answer

No

This ruling applies for the following periods:

XX/XX/XXXX to XX/XX/XXXX

The scheme commences on:

XX/XX/XXXX

Relevant facts and circumstances

A consortium of companies ('the Consortium') has been formed and appointed as preferred bidder for the right to design, construct, commission, maintain and provide services to an asset ('the Asset') for the State ('the Project'). The State will make payments in consideration for the above services ('the Payments').

A partnership ('the Partnership') will enter into an agreement with the State over the construction and development of the Asset.

The Project will be comprised of a design and construction phase followed by an operating phase. At the conclusion of the Project, the Partnership's rights to access the Asset under the Agreement will come to an end and the State will have unencumbered legal ownership of the Asset. The terms of the Agreement are such that the Partnership will have no underlying proprietary right to the Asset.

The Agreement

The Partnership will enter into the Agreement with the State. Under the Agreement, the State will, amongst other things:

Procure the design, construction and commissioning of the Asset from the Partnership in exchange for a payment to be paid to the Partnership upon completion of a phase of the Project ('the Completion Payment').

Procure the provision of services in relation to the Asset from the Partnership by providing consideration in the form of payments ('Service Payments').

Design and construction phase

The State will grant the Partnership a right to access the area necessary for the construction of the Asset for the duration of the design and construction phase.

The Partnership will subcontract the design and construction of the Asset to an unincorporated joint venture ('the D&C Subcontract').

The State will pay the Completion Payment to the Partnership upon the completion of a phase of the Project. The Completion Payment is expected to be at least equal to the design and construction costs incurred by the Partnership under the D&C Subcontract. However, the final value of the Completion Payment will depend upon the time taken to complete the design, construction and commissioning of the Asset.

Operating Phase

Upon completion of the first stage, the State will grant the Partnership an operating phase licence ('Licence') over the Asset for the purposes for providing the services under the Agreement.

The Partnership will pay market value licence fees ('the Licence Payments') periodically in arrears over the term of the Licence from entry into the Licence as consideration for access to the Asset (in accordance with the terms of the Licence).

The Licence provides that the Partnership will not acquire permanent ownership rights over the Asset; all rights granted under the Licence will revert to the State upon expiry of the Licence and the Partnership will not have any right to remove assets fixed to the land.

Provided certain performance standards are met, the State will pay the Partnership's Service Payments for the duration of the Licence as consideration for the provision of the services in respect of the Asset.

The Partnership will subcontract, under a subcontract, the provision of services in respect of the Asset.

The Partnership will also subcontract, under a services agreement, the provision of services in respect of the Asset.

Receivables Purchase Deed

The State, the Partnership and Finance Co will enter into the Receivables Purchase Deed at Financial Close.

Under the Receivables Purchase Deed the State will assign its right, title to, and interest in all of the Licence Payments (as they fall due) at a specified point in time during the Project in consideration for the payment by Finance Co of the Receivables Purchase Payment in a lump sum payment at that time.

Over the term of the Licence, therefore, the Partnership will effectively pay the Licence Payments to Finance Co in accordance with the Receivables Purchase Deed.

The Receivables Purchase Payment will be calculated as the present value of the Licence Payments payable to the State. This will, in turn, depend on the time taken to complete the design, construction and commissioning of the Asset (eg. any delay is expected to reduce the operational term of the Project, resulting in lower Licence Payments). It is currently expected that the Receivables Purchase Payment will be approximately $X million.

The Partnership will be entitled to a Receivables Refund Payment from the State in the event the Project is terminated in certain circumstances.

State Loan

The State and Finance Co will enter into the State Loan Agreement at a specified point in time during the Project.

Under the State Loan Agreement, Finance Co will advance funds to the State at specified point in time during the Project. The State Loan and the Receivables Purchase Payment will provide the State with sufficient funds to pay the Completion Payment to the Partnership. It is currently expected that Finance Co will advance $XXX to the State under the State Loan Agreement.

The State Loan will be interest bearing at a rate not less than the rate payable by Finance Co under the Syndicated Loan Facility and the State will repay the State Loan during the operating phase of the Project.

On-Lending Agreement

Finance Co and the Partnership will enter into the On-Lending Agreement at the time the State Loan Agreement is entered into.

Under the On-Lending Agreement, Finance Co will advance funds to the Partnership from Financial Close to enable the Partnership to fund the design and construction of the Asset. It is expected that approximately $XXX will be outstanding under the On-Lending Agreement; of this, approximately $XX will be repaid by the Partnership at a specified point in time during the Project (leaving an amount outstanding which will be repaid by the Partnership during the operating phase).

Amounts lent under the On-Lending Agreement will be interest bearing at a rate not less than the rate payable by Finance Co under the Syndicated Loan Facility and repayable in accordance with a repayment schedule.

Partnership: income tax profile

The applicant states that the Partnership will be treated as a flow-through entity for income tax purposes, with the partners (ie. the Partnership Trusts) including in their taxable income their share of the net income or partnership loss of the Partnership in accordance with Division 5 of the ITAA 1936.

Furthermore, the application states that the Partnership will be treated as if it were a separate entity for the purposes of determining the net income or partnership loss (ie. its net income will be its taxable income and its partnership loss will be its tax loss calculated as if it were a separate entity).

The applicant states that the Partnership's assessable income and allowable deductions over the Project will be as follows:

Assessable income:

· Net gain arising from the design and construction of the Asset, being the Completion Payment less the payments under the D&C Contract (which is expected to be nil).

· Service Payments (as consideration for operating the Asset).

· Interest from bank deposits.

Allowable deductions (including amounts deductible over time):

· Licence Payments paid to the State under the Operating Phase Licence (as consideration for on-going access to the Asset).

· Interest to Finance Co under the On-Lending Agreement.

· Payments under the FM Subcontract.

· Payments under the services agreement.

· Various bid costs and related expenses.

· Various borrowing and other ongoing operating costs.

The applicant has stated that it is intended that over the term of the Project the assessable income of the Partnership will exceed the allowable deductions of the Partnership, producing overall net income for the Partnership.

The applicant has stated that the Partnership will not be deriving any non-assessable non-exempt income.

Finance Co: income tax profile

The applicant states that Finance Co's assessable income and allowable deductions will be as follows:

Assessable income:

· Received less Receivables Purchase Payment) under the Receivables Purchase Deed

· Interest income from the Partnership under the On-Lending Agreement.

· Interest income from the State under the State Loan.

Allowable deductions

· Interest to the Lenders incurred on the Syndicated Loan Facility.

· Finance Co is not expected to make any distributions to Finance Holding Co.

Relevant legislative provisions

Income Tax Assessment Act 1997, Division 40

Income Tax Assessment Act 1997, section 40-40

Income Tax Assessment Act 1997, section 40-840

Income Tax Assessment Act 1997, section 40-880

Income Tax Assessment Act 1997, Division 43

Income Tax Assessment Act 1997, section 43-75

Income Tax Assessment Act 1997, Division 250

Income Tax Assessment Act 1997, section 250-15

Income Tax Assessment Act 1997, subsection 250-15(a)

Income Tax Assessment Act 1997, subsection 250-15(b)

Income Tax Assessment Act 1997, subsection 250-15(c)

Income Tax Assessment Act 1997, subsection 250-15(d)

Income Tax Assessment Act 1997, subsection 250-15(e)

Income Tax Assessment Act 1997, paragraph 250-15(d)(i)

Income Tax Assessment Act 1997, paragraph 250-15(d)(ii)

Income Tax Assessment Act 1997, subsection 995-1(1)

Reasons for decision

The general test for application of Division 250 of the ITAA 1997 is set out in section 250-15 of the ITAA 1997 which provides:

This Division applies to you and an asset at a particular time if:

(a) the asset is being put to a tax preferred use; and

(b) the arrangement period for the tax preferred use of the asset is greater than 12 months; and

(c) financial benefits in relation to the tax preferred use of the asset have been, will be or can reasonably be expected to be, provided to you (or a connected entity) by:

(i) a tax preferred end user (or a connected entity); or

(ii) any tax preferred entity (or a connected entity); or

(iii) any entity that is a foreign resident; and

(d) disregarding this Division, you would be entitled to a capital allowance in relation to:

(i) a decline in the value of the asset; or

(ii) expenditure in relation to the asset; and

(e) you lack a predominant economic interest in the asset at that time.

Each of the conditions in section 250-15 of the ITAA 1997 must be met for the general test to be satisfied. If one of the conditions is not met then the general test will not be satisfied and Division 250 of the ITAA 1997 will accordingly not apply.

Subsection 250-15(d) ITAA 1997: Capital allowance

Subsection 995-1(1) of the ITAA 1997 defines 'capital allowance' as:

capital allowance means a deduction under:

(a) Division 40 (capital allowances) of this Act; or

(ab) Division 43 (capital works) of this Act; or…

Division 40

Deductions for capital allowances are only available if the taxpayer is the holder of a depreciating asset. The table in section 40-40 of the ITAA 1997 explains how to work out who holds a depreciating asset.

The primary rule is that the taxpayer holds an asset if they are the owner of it. On the facts of the ruling application, the Partnership will not be the legal owner of any assets in relation to its interest in the Project. Accordingly, the Partnership will not be a holder of any assets in relation to the Asset under Item 10 of the table in section 40-40 of the ITAA 1997.

However, there are items that identify a holder in various other circumstances, even though they are not the asset's owner.

Item 3 of the table in section 40-40 of the ITAA 1997 broadly provides that where the depreciating asset is an improvement to land subject to a quasi-ownership right then the owner of the quasi-ownership right (while it exists) will be the holder of the depreciating asset if the improvement to land was made or itself improved by the owner of the quasi-ownership right for their own use (but only where they do not have the right to remove the asset).

In this case, the State, in making the Licence Payments, incurs capital expenditure in return for the carrying out by the Partnership of the design and construction services on the land that the State owns. Under the proposed contracts, the partnership will not acquire permanent ownership rights over the Asset, these will revert to the state upon expiry of the Licence. The partnership will have no right to remove any assets fixed to the land.

Therefore, the State and not the Partnership, will receive the enduring benefit of the improvements, including any depreciating assets constructed. It has engaged the Partnership to improve the land which enables it to enter into the subsequent operation and maintenance contractual arrangements. The State is therefore the entity that has enabled itself, by the Licence Payments to access the economic benefits of the constructed depreciating assets. For the purpose of Item 3 of the table in section 40-40 of the ITAA 1997, it is the State, and not the partnership that has 'made' the improvements to the land, and so holds the depreciating assets.

As the Partnership has not made improvements to the land, item 3 of the table in section 40-40 does not apply to make it a holder of the improvements it constructs that are depreciating assets. It is further considered that there are no other applicable items in the table that would apply to the Partnership to identify it as the holder in the current circumstances. As such, the Partnership would not be entitled to any deduction for the decline in value of depreciating assets under Division 40 of the ITAA 1997.

Division 43

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'.

Section 43-75 of the ITAA 1997 provides that 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. Accordingly, to deduct an amount for an income year under section 43-10 of the ITAA 1997 that amount incurred by the taxpayer must be 'construction expenditure'.

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

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 are 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. 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.

The established principles on the distinction between capital and income are well known (Sun Newspapers Ltd & Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 and FC of T v Email (1999) 99 ATC 4868). 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. In G.P. International Pipecoaters v. Federal Commissioner of Taxation (1990) 170 CLR 124 the court stated that:

…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.

In the present case, the applicant states that the Partnership receives the Licence Payments on revenue account, which would constitute assessable income. It carries on its construction business for the purpose of producing this assessable income. The intention or purpose of the Partnership in entering into the Project is to make a gain or profit in carrying out activities that are in the ordinary course of its business operations. It receives the Licence Payments 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 Partnership discharges by making the expenditure it incurs in providing those services is its obligation to construct the works as required under the Agreement. In exchange, the nature of the asset acquired is the Licence Payment.

A taxpayer that does not incur capital expenditure in constructing works does not have a 'construction expenditure area' of capital works for the purpose of section 43-75 of the ITAA 1997.

The Partnership will receive the Licence Payments on revenue account and will account for the construction expenditure in the calculation of profit that will constitute income. It will not have a construction expenditure area of capital works for the purposes of section 43-75 of the ITAA 1997 and it will not therefore be entitled to any capital works deductions under Division 43 in relation to its interest in the Project.

Subdivision 40-I of the ITAA 1997

Subdivision 40-I of the ITAA 1997 may provide a deduction for certain other capital expenditure incurred by the Partnership associated with the Project where the Partnership is not entitled to capital allowances under Division 40 or Division 43 of the ITAA 1997.

On the facts, the Partnership will incur capital expenditure that is business related cost for the purposes of section 40-880 of the ITAA 1997 or are project amounts for the purposes of section 40-840 of the ITAA 1997.This expenditure by itself will not give rise to a separate asset to which Division 250 of the ITAA 1997 can apply. The Partnership's expenditure will not entitle it to capital allowances in relation to the decline in value of an asset for the purposes of subparagraph 250-15(d)(i) of the ITAA 1997.

For the purposes of paragraph 250-15(d)(ii) of the ITAA 1997, the expenditures the Partnership incurs that are business related costs for the purposes of section 40-880 of the ITAA 1997 or project amounts for the purposes of section 40-840 of the ITAA 1997 are not in relation to an asset for which the Partnership will be entitled to capital allowances under either Divisions 40 or 43 of the ITAA 1997.

As the Partnership will not be entitled to capital allowances under either Division 40 or Division 43 of the ITAA 1997 in relation to a decline in value of an asset, or expenditure in relation to an asset in relation to its interest in the Project, the condition at paragraph 250-15(d) of the ITAA 1997 will not be satisfied. Accordingly, as section 250-15 of the ITAA 1997 cannot apply if one of its subsections is not satisfied it is therefore unnecessary to consider subsections 250-15(a), (b), (c) or (e) of the ITAA 1997. It follows that Division 250 of the ITAA 1997 will not apply.

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