Edited version of administratively binding advice

Authorisation Number: 1012433799367

Advice

Subject: Availability of deductions under Division 40 and Division 43 of the ITAA 1997.

Question

Will Company A 'hold' depreciating assets affixed to the Land and Adjacent Land in accordance with section 40-40 of the ITAA 1997?

Answer

Yes.

Question

Will Company A be entitled to claim deductions under Division 43 of the ITAA 1997 in respect of capital works carried out on the Land and Adjacent Land?

Answer

Yes.

This advice applies for the following periods:

Year ending 30 June 20XX

The arrangement commences on:

1 July 20YY

Relevant facts and circumstances

1. Company B carries on a business on land it owns (the "Land").

2. Company C owns land (the "Adjacent Land") which is adjacent to the Land.

3. Company B and Company C entered into an agreement (the "Agreement") whereby Company C agreed to grant Company B legal easements over part of the Adjacent Land.

4. Pursuant to the Agreement, Company B affixed depreciating assets to, and carried out capital works on, the Adjacent Land.

5. Company B also affixed depreciating assets to, and carried out capital works on, the Land which overhang the Adjacent Land.

6. Company B is currently claiming depreciation deductions under Division 40 in respect of the depreciating assets affixed to the Land and the Adjacent Land.

7. Company B is currently claiming capital works deductions under Division 43 in respect of the capital works expenditure carried out on the Land and the Adjacent Land.

8. Company B proposes to grant a 60 year lease ("the Lease") of the Land and its business to Company A.

9. The terms of the Lease give Company A exclusive possession of the Land and the right to remove depreciating assets from the Land at any time.

10. No legal easements have been granted by Company B to Company A.

Assumptions

· The capital works carried out by Company B constitute capital works which are included within the scope of Division 43 pursuant to subsection 43-20(2); and

· In respect of the capital works carried out:

(i). The capital works have a construction expenditure area in accordance with paragraph 43-10(2)(a); and

(ii). There is a pool of construction expenditure for that area under section 43-10(2)(b).

(iii). Company A will use the capital works in the way set out in the table in section 43-140, ie for the purposes of producing assessable income.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Section 40-25

Income Tax Assessment Act 1997 Section 40-40

Income Tax Assessment Act 1997 Division 43

Income Tax Assessment Act 1997 Section 43-10

Income Tax Assessment Act 1997 Paragraph 43-10(2)(a)

Income Tax Assessment Act 1997 Paragraph 43-10(2)(b)

Income Tax Assessment Act 1997 Paragraph 43-10(2)(c)

Income Tax Assessment Act 1997 Subsection 43-50(3)

Income Tax Assessment Act 1997 Section 43-75

Income Tax Assessment Act 1997 Section 43-85

Income Tax Assessment Act 1997 Section 43-115

Income Tax Assessment Act 1997 Section 43-120

Income Tax Assessment Act 1997 Subsection 43-120(1)

Income Tax Assessment Act 1997 Subsection 43-120(2)

Income Tax Assessment Act 1997 Paragraph 43-120(2)(a)

Income Tax Assessment Act 1997 Paragraph 43-120(2)(b)

Income Tax Assessment Act 1997 Paragraph 43-120(2)(c)

Income Tax Assessment Act 1997 Subsection 43-120(3)

Income Tax Assessment Act 1997 Section 104-110

Income Tax Assessment Act 1997 Section 104-115

Income Tax Assessment Act 1997 Section 995-1

Income Tax Assessment Act 1936 Former subsection 54AA(8)

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997, unless otherwise stated.

Question 1

Law

Division 40 contains the capital allowance provisions which allow deductions for the decline in value of depreciating assets.

Section 40-25 provides:

"(1) You can deduct an amount equal to the decline in the value for an income year (as worked out under this Division) for a *depreciating asset that you *held for any time during the year."

The definition of "held" in section 995-1 refers to the definition of "hold" in that section. Paragraph (b) of the definition of "hold" in section 995-1 refers to the meaning given by section 40-40.

Item 2 of the table in section 40-40 applies to a depreciating asset that is fixed to land subject to a quasi-ownership right where the owner of the quasi ownership right has the right to remove the asset. In that situation, the owner of the quasi-ownership right will hold the depreciating asset.

In relation to item 2 of the table in section 40-40, paragraph 1.43 of the Explanatory Memorandum to New Business Tax System (Capital Allowances) Bill 2001 states:

"Where … a depreciating asset is fixed to land where the owner of the quasi-ownership right has a right to remove the asset, the uniform capital allowances system recognises them as the holder while the right to remove exists."

The term "quasi-ownership right" over land is defined in section 995-1 to mean:

a) a lease of land; or

b) an easement in connection with the land; or

c) any other right, power or privilege over the land, or in connection with the land.

Application of law to facts

There are two requirements that Company A needs to satisfy to hold the depreciating assets under item 2 of the table in section 40-40. They are:

a) Company A must own a quasi-ownership right over the relevant land; and

b) Company A must have the right to remove the assets fixed to the land.

For ease of reference, the depreciating assets have been separated into the following two categories:

depreciating assets that are attached to the Land but overhang the Adjacent Land ("Type A Depreciating Assets");

depreciating assets that are attached to or rest upon the Adjacent Land that is subject to an easement ("Type B Depreciating Assets").

Type A Depreciating Assets (ie depreciating assets attached to the Land but overhang the Adjacent Land)

(a) Quasi ownership right

The term "quasi-ownership right" over land is defined in section 995-1 to include a lease of the land. The term "lease" is not defined in the ITAA 1936 or the ITAA 1997. LexisNexis Encyclopaedic Australian Legal Dictionary states that the term "lease" in relation to real property means:

"A right to exclusive possession of land given by one person (lessor or landlord) to another person (lessee or tenant), usually in return for rent: Radaich v Smith (1959) 101 CLR 209: [1959] ACLR 1253 … "

The Lease gives Company A the right to exclusive possession of the Land subject to the Company B's rights of inspection etc, that would normally be found in a lease. Thus Company A will have a quasi-ownership right over the Land to which the Type A depreciating assets are affixed.

(b) Right to remove

In ATO ID 2012/9, the Commissioner stated that a taxpayer has the right to remove depreciating assets for the purposes of item 2 of the table in section 40-40 if the taxpayer has the right to remove the assets during the term of the quasi-ownership right even though the taxpayer does not have the right to remove the assets at the end of the term of the quasi-ownership right.

In the fact scenario considered in ATO ID 2012/9, the taxpayer had the right to remove obsolete assets, and to remove assets as the taxpayer considered necessary or desirable in the proper conduct of its business. Once the assets were removed from the land, the taxpayer became their legal owner. The taxpayer did not have the right to remove the assets at the end of the lease.

In his Reasons for Decision, the Commissioner stated:

"… The right of the taxpayer to remove obsolete assets and those which it considers necessary or desirable to remove for the proper conduct of its business is a right to remove for the benefit of the taxpayer. As the taxpayer obtains the legal title to the assets that are removed, the removed assets are for the taxpayer's benefit rather than the lessor's benefit.

Therefore, as the taxpayer has the right to remove the depreciating assets during the term of its quasi-ownership right and the meaning of 'right to remove' in item 2 of the table in section 40-40 is not limited to the right to remove assets at the end of the term of the quasi-ownership right, the taxpayer has a right to remove for the purposes of item 2 of the table in section 40-40." [Emphasis added]

The Lease grants Company A the right at any time to remove improvements. Company A therefore has the right during the term of the Lease to remove improvements and deal with them for their own benefit.

As the conditions in item 2 of the table in section 40-40 are satisfied in respect of the Type A Depreciating Assets, Company A will hold those assets for the purposes of claiming capital allowance deductions under Division 40.

Type B Depreciating Assets (ie depreciating assets attached to or resting upon the Adjacent Land which are subject to an easement)

(a) Quasi ownership right

As noted above, the Lease gives Company A the right to exclusive possession of the Land and thus a quasi-ownership right over the Land. The question to be determined is whether Company A will also have a quasi ownership right over that part of the Adjacent Land upon which Type B Depreciating Assets are attached or rest.

The Joint Explanatory Memorandum to the Income Tax Assessment Bill 1996 which inserted the definition of "quasi-ownership right over land" in section 995-1 states that the term is used to describe the rights over land that were previously covered by the definition of "Crown lease" in section 54AA of the Income Tax Assessment Act 1936 ("ITAA 1936").

Subsection 54AA(8) of the ITAA 1936 stated that the term "Crown lease" means, amongst other things, any other right, power or privilege over, or in connection with, land, where the right, power or privilege was granted by an eligible government body.

The Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 5) 1992 which inserted section 54AA stated:

"This new definition … extends beyond leases and now covers easements and other rights, powers or privileges over or in connection with the land (such as licenses and "right of way")" [Emphasis added]

An easement is a limited interest that an owner of land acquires over land belonging to someone else (see A J Bradbrook and M A Neave, Easements and Restrictive Covenants in Australia 2nd ed, Butterworths, Sydney, 2000, pp 2-3).

The Agreement evinces a clear and express intention on the part of Company C and Company B to grant legal easements in respect of the Adjacent Land. It also constitutes an agreement on the part of Company C to grant such easements.

At the time the Agreement was entered into, the essential characteristics for the creation of an easement were present: there was a dominant tenement (ie the Land) and a servient tenement (the Adjacent Land); the easement accommodated the dominant tenement; the same person did not own and occupy both the dominant and servient tenement; and the right claimed as an easement was not capable of forming the subject matter of the grant (Re Ellenborough Park [1956] Ch 131). Further, the right claimed as an easement was sufficiently certain (Milner v James (1910) 13 CLR 168).

The doctrine in Walsh v Lonsdale (1882) 21 Ch D 9 (the "Walsh v Lonsdale case") establishes that if two parties enter into a binding agreement to grant a lease, equity will regard the agreement as an equitable lease and treat the parties as if they had entered into a formal lease notwithstanding that the legal formalities of a lease at common law have not been satisfied. This doctrine applies equally to agreements to create easements.

Applying the principles in the Walsh v Lonsdale case, the Agreement created equitable easements in respect of the Adjacent Land on which Type B Depreciating Assets are attached or rest. The benefit of the easements will subsequently be enjoyed by Company A when it leases the Land from Company B under the Lease as an easement passes automatically on a conveyance of a dominant tenement (Leech v Schweder (1874) LR 9 Ch App 463).

As the agreement to grant an easement (ie an equitable easement) is a specifically enforceable right to a legal easement, they should be treated as one and the same right as the perfection of the equitable easement that relates to the Adjacent into a legal easement will not result in one quasi-ownership right ceasing and a new quasi-ownership right being created.

Therefore, the Lease over the Land that benefits from the easements (either equitable easements or legal easements) over the Adjacent Land on which the Type B Depreciating Assets are attached or rest falls within paragraph (a) of the definition of "quasi-ownership right" in section 995-1. Thus, Company A will own the quasi-ownership right for the purposes of applying item 2 of the table in section 40-40 by virtue of its entry into the Lease.

(b) Right to remove

The Lease provides Company A with the right to remove Improvements. For the same reasons as outlined above in relation to the Type A Depreciating Assets, Company A will have the right to remove Type B Depreciating Assets.

Accordingly, as the conditions in item 2 of the table in section 40-40 are satisfied in respect of the Type B Depreciating Assets, Company A will hold those assets for the purposes of claiming capital allowance deductions under Division 40.

Question 2

Law

Division 43 explains how to calculate deductions for capital expenditure on the constructions of capital works.

Section 43-10 provides:

1. You can deduct an amount for capital works for an income year.

2. You can only deduct the amount if:

(a) the capital works have a ^*construction expenditure area; and

(b) there is a ^*pool of construction expenditure for that area; and

(c) you use ^*your area in the income year in the way set out in Table 43-140 (Current year use).

The "construction expenditure area" for capital works started after 30 June 1997 is that part of capital works on which "construction expenditure" has been incurred by an entity that, at that time, was to own or lease the capital works, or hold them as a quasi-owner (section 43-75).

A "pool of construction expenditure" is so much of the "construction expenditure" incurred by an entity on capital works as can be attributed to the "construction expenditure area" relating to those capital works (section 43-85).

For construction expenditure incurred after 30 June 1997, the "use" condition listed in column 3 of the "Time Period 1" row of the table in section 43-140 needs to be satisfied, ie:

"You use you area for the purpose of:

(a) producing assessable income; or

(b) Conducting R&D activities."

Section 43-115 states:

1. "(1)Your area is the part of the construction area that you own.

2. Your construction expenditure is the portion of the pool of construction expenditure that is attributable to your area."

Subsection 43-50(3) states:

You will be taken not to be the owner of any part of capital works that are the subject of a lease to which you have chosen to apply section 104-115 (CGT event F2). The lessee or sublessee will be taken to be the owner of that part."

Section 104-115 sets out the requirements for an effective CGT event F2 choice. They are:

(i). The lessor must grant a lease over land;

(ii). The lease must be for a term of at least 50 years;

(iii). At the time the lease is granted, it must be reasonable to expect that the lease will continue for at least 50 years;

(iv). The terms of the lease, as they apply to the lessee, must be substantially the same as those under which the lessor owns the land; and

(v). The lessor must choose to apply section 104-115 rather than 104-110.

Application of law to facts

The applicant has asked the Commissioner to assume:

(i). that the capital works leased by Company B to Company A include capital works to which section 43-20 applies;

(ii). the conditions in sections 43-10(2)(a) and 43-10(2)(b) are satisfied; and

(iii). Company A will use the capital works in the way set out in the table in section 43-140, ie for the purposes of producing assessable income.

Thus, the central issue in determining Company A's entitlement to the Division 43 deductions is whether paragraph 43-10(2) (c) will be satisfied.

Paragraph 43-10(2)(c) states that you can only deduct an amount for capital works if "you use your area in the income year in the way set out in Table 43-140…". It can be seen that paragraph 43-10(2)(c) requires two conditions to be satisfied, namely the "use" condition and the "your area" condition. The Commissioner has been asked to assume that the "use" condition is satisfied. Thus, the question that needs to be considered in determining Company A's entitlement to the Division 43 deductions is whether the construction expenditure area will be Company A's area.

For ease of reference, the capital works have been separated into the following two categories:

· capital works that are attached to the Land but encroach on (ie overhang) the Adjacent Land ("Type A Capital Works");

· capital works that are attached to or rest upon the Adjacent Land that is subject to an easement ("Type B Capital Works").

Type A Capital Works (ie capital Works attached to the Land but overhang the Adjacent Land)

The Type A Capital Works will be leased from Company B to Company A under the Lease.

If Company B can satisfy the requirements in section 104-115 for an effective CGT event F2 election, then Company A will be the owner of the capital works by virtue of section 43-50 and will satisfy the "your area" condition in paragraph 43-10(2)(c).

Pursuant to section 104-115, there are five key conditions that will need to be satisfied for an effective CGT event F2 choice to be made by Company B and for Company A to own the capital works. These are as follows:

1. Condition 1 - Company A grants a lease over land

Under the Lease, Company B will grant Company A a lease of the Land.

2. Condition 2 - The lease must be for a term of at least 50 years

The Lease specifies that the term of the lease is 60 years.

3. Condition 3 - At the time the lease is granted, it is reasonable to expect that the lease will continue for at least 50 years

The Explanatory Memorandum to Taxation Laws Amendment Bill (No.4) 1989 (the "160ZSA Explanatory Memorandum") which inserted section 160ZSA (the predecessor of section 104-115) of the ITAA 1936) provides:

"… The reasonable expectation requirement means that the duration of a lease will be determined at the time the lease is granted. Thus, a lease will not be an eligible long term lease in circumstances where the lease is for a term of more than 50 years but includes a provision for the determination of the lease on the occurrence of an event which is likely to occur before 50 years have elapsed.

… where a new lease contains a term providing that the lease my be determined by the lessor giving notice, then ordinarily it would not be reasonable to expect that the lease would continue beyond the earliest date upon which the lease may be determined by the lessor giving such notice. …"

The following factors indicate that the Lease will continue for the full 60-year term:

· The Lease does not include any terms that allow Company B to terminate the lease by giving notice to the lessee;

· There will be no separate arrangement, agreement or understanding (whether express or implied) between the parties at the time that the Lease is granted that the lease should run for less than 50 years.

· Both Company B and Company A will be legal entities. There is nothing to suggest that it is likely that neither will exist in 50 years time.

Condition 4 - The terms of the lease, as they apply to Company A, must be substantially the same as those under which the Company B owns the land

The 160ZSA Explanatory Memorandum states:

"… a lessee should be able to use the land and buildings in the same manner as the owner of the freehold interest in the land. …"

The Lease agreement grants Company A all the usage and access rights over the Land which Company B currently holds.

Company A will obtain the right to full enjoyment of the Land without any restriction for 60 years.

As such, the terms of the Lease as they apply to Company A are substantially the same as the terms under which Company B currently owns the Land.

Condition 5 - Company B must choose for CGT event F2 to apply

Company B will choose to apply section 104-115 (ie make a CGT event F2 choice). Therefore, this condition will be satisfied.

On the basis of the above analysis, Company B will be able to make a CGT event F2 choice. As a consequence, where such a choice is made, section 43-50 will apply to treat Company as the owner for the purposes of section 43-115 of the capital works included in the Land. Thus, the construction expenditure area will be Company A's area. Accordingly, given the assumptions outlined at the beginning of this question, Company A will be able to claim capital works deductions under Division 43.

Type B Capital Works (ie capital works attached to or resting upon the Adjacent Land which are subject to an easement)

When Company B incurred expenditure on construction of the Type B Capital Works, it held an equitable easement in connection with the Adjacent Land which satisfied paragraph (b) of the definition of "quasi-ownership right" over land in section 995-1.

Under the Lease, Company B will grant to Company A a lease of the Land which includes improvements. Accordingly, the Type B Capital Works are subject to the Lease.

On the basis that Company B can satisfy the requirements in section 104-115 for an effective CGT event F2 election, Company A will be treated as the owner of the capital works constructed by Company B by virtue of subsection 43-50(3) and Company A would satisfy the "your area" condition in paragraph 43-10(2)(c).

Company B does not need to be a section 43-115(1) "owner" of the capital works for section 43-50(3) to apply. That is, section 43-50(3) specifically contemplates a choice made under section 43-115 disentitling the lessor and entitling the lessee to claim deductions. As section 43-115 applies to lessors who are freehold owners as well as lessors who are themselves lessees (i.e. holders of quasi-ownership rights), Company B does not have to be a 43-115(1) owner, and can be a section 43-120(1)-(2) owner. Indeed, this was the way that the former Division 10D of Part III of the ITAA 1936 operated (see former section 124ZF(16) of the ITAA 1936).

For the same reasons as outlined above in relation to the Type A Capital Works, Company B will be able to make a choice to apply section 104-115 instead of section 104-110 when it enters the Lease. As a consequence, where such a choice is made, subsection 43-50(3) will apply to treat Company A as the section 43-115 "owner" of the Type B Capital Works. Thus, the construction expenditure area will be Company A's area.

Where Company A incurs construction expenditure in relation to new facilities it would have a construction expenditure area under subsection 43-120(1) as it will hold a quasi-ownership interest, being an equitable easement over the Adjacent Land on which the new facilities are constructed. Company A would be able to claim Division 43 deductions in respect of the Type B Capital Works on the basis of satisfying the "your area" condition in paragraph 43-10(2)(c). Accordingly, given the assumptions outlined at the beginning of this question, Company A will be able to claim capital works deductions under Division 43 in respect of the Type B Capital Works.

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