Edited version of your written advice

Authorisation Number: 1012684025392

Ruling

Subject: Public Private Partnership

Question 1

Will the Payments incurred by Entity M be deductible pursuant to section 8-1 of the Income Tax Assessment Act 1997 (the 'Act')?

Answer

Yes

Question 2

Will Division 250 of the Act apply to Entity M in relation to its interest in the assets on the basis that Entity A satisfies the general test by virtue of paragraph 250-15(d) of the Act?

Answer

No

Relevant facts and circumstances

Entity M entered into an Agreement with Entity B to design, construct and provide services in respect of a facility asset for Entity Q (the Project).

The Project comprises of a design and construction phase followed by a services phase. At the conclusion of the Project, Entity M's rights to access the Project under the Agreement will come to an end and Entity Q will have unencumbered legal ownership of the Project. The terms of the Agreement are such that Entity M will have no underlying proprietary right in the Project.

Entity Q will grant Entity M rights to access the areas necessary for the construction of the Project and to provide the services for the duration of the Project. Entity M pays licence payments to Entity Q over the services phase for the non-exclusive rights to enter the Project in order to provide the contracted services. The rights revert to Entity Q at the relevant time.

Entity Q will pay certain payments to Entity M over the construction phase. The payments will equal the costs incurred by Entity M. Entity Q will also pay certain other payments to Entity M during the services phase. The payments are income of Entity M according to ordinary concepts.

Entity M will subcontract the design and construction of the Project and the provision of the services.

Relevant legislative provisions

Income Tax Assessment Act 1997, section 8-1

Income Tax Assessment Act 1997, paragraph 8-1(1)(a)

Income Tax Assessment Act 1997, paragraph 8-1(2)(a)

Income Tax Assessment Act 1997, Division 230

Income Tax Assessment Act 1997, subsection 230-20(4)

Income Tax Assessment Act 1997, subparagraph 230-460(2)(e)

Income Tax Assessment Act 1997, Division 40

Income Tax Assessment Act 1997, Division 43

Income Tax Assessment Act 1997, Division 250

Income Tax Assessment Act 1997, section 250-15

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

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

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

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

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

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

Income Tax Assessment Act 1997, section 40-840

Income Tax Assessment Act 1997, subparagraph 40-840(2)(c)

Income Tax Assessment Act 1997, section 40-880

Income Tax Assessment Act 1997, subparagraph 40-880(1)(c)

Income Tax Assessment Act 1997, section 995-1

Reasons for decision

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

Question 1

Summary

The licence payments will be deductible under section 8-1.

Detailed reasoning

The licence payments incurred by the entity will be deductible pursuant to section 8-1. The payments that Entity M incurs are not capital or capital in nature because they are incurred in the ordinary course of the business that Entity M carries on.

Taxation of Financial Arrangements (ToFA) rules

The ToFA rules contained in Division 230 set out the income tax treatment of gains and losses on financial arrangements. Subsection 230-20(4) provides that if the ToFA rules apply then section 8-1 will not apply. Prior to considering whether section 8-1 applies it is necessary to consider if the ToFA rules apply to the payments and receipts under the Licence.

The ATO accepts that Payments made in respect of the Licence will not be subject to the ToFA rules. Should the Licence constitute a 'financial arrangement' for the purposes of Division 230, it may be the subject of an exception pursuant to paragraph 230-460(2)(d) as an arrangement that is substance or effect depends on the use of an asset that is real property and gives a right to use that asset.

Entity M will enter into a Licence with Entity Q which will give Entity M access to the Project in order to perform the services in accordance with the Agreement. The lease will be an arrangement that gives Entity M the right to use the Project in order to perform its obligations under the Agreement and therefore will not be subject to the TOFA rules.

Section 8-1 of the ITAA 1997

Paragraph 8-1(1)(a): Licence Payments incurred in gaining or producing the entity's assessable income?

The connection between a taxpayer's outgoings and the generation of assessable income was considered in Ronpibon Tin NL and Tongkah Compound NL v FC of T (1949) 78 CLR 47. The High Court of Australia stated at 56-57 that:

For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end. The words "incurred in gaining or producing the assessable income" mean in the course of gaining or producing such income.

and:

In brief substance, to come within the initial part of the sub-section it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income.

Under the Agreement, Entity M must perform its contractual obligations to provide the Services or ensure the provision of the Services. In return the entity will derive assessable income from Entity Q.

As part of the arrangements under which Entity M is to perform the Services, Entity Q will grant the entity non-exclusive right to access the Project. The entity will pay Licence Payments in exchange for the right.

The occasion of the payment of the Licence Payments will be found in what will be productive of Entity M's assessable income. Each Licence Payment will be an outgoing incurred by Entity M in gaining or producing its assessable income for the purpose of paragraph 8-1(1)(a).

Having satisfied the positive limb in subsection 8-1(1), the Licence Payments must also not fall within any of the negative limbs in subsection 8-1(2).

Negative Limbs

In the current case, the relevant negative limb in subsection 8-1(2) is whether the interest is capital, or of a capital nature pursuant to paragraph 8-1(2)(a).

Paragraph 8-1(2)(a): Will the Licence Payments be outgoings of capital, or of a capital nature?

The courts have established a number of principles or tests to be applied in determining whether a loss or outgoing is capital, or of a capital nature (as opposed to being of a revenue nature). In Sun Newspapers Ltd v FC of T (1938) 61 CLR 337 (Sun Newspapers) at 359 Dixon J said:

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss.

and at 363:

There are, I think, three matters to be considered [in determining whether expenditure is on revenue or capital account], (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play a part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

Character of the advantage sought

In considering these matters in Hallstroms Pty Ltd v FC of T (1946) 72 CLR 634 Dixon J said (at 646-647):

…it may be useful to recall the general consideration that the contrast between the two forms of expenditure [income and capital] corresponds to the distinction between the acquisition of the means of production and the use of them; between establishing or extending a business organisation and carrying on the business; between the implements employed in work and the regular performance of the work in which they are employed; between an enterprise itself and the sustained effort of those engaged in it…. What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.

and at 648:

What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view...

In Colonial Mutual Life Assurance Society Ltd v FC of T (1953) 89 CLR 428 at 454 Fullagar J said:

The questions which commonly arise in [determining whether expenditure is on revenue or capital account] are (1) What is the money really paid for? - and (2) Is what it is really paid for, in truth and in substance, a capital asset?

In FC of T v CityLink Melbourne Limited 2006 ATC 4404 the High Court stated at 4427 that:

The characterisation of an outgoing depends on what it is calculated to effect to be judged from a practical and business point of view…The character of the advantage sought by the making of the expenditure is critical.

In relation to the character of the advantage sought by the expenditure it is necessary to examine whether the expenditure secures an enduring benefit for the business. This test was outlined in British Insulated and Helsby Cables Ltd v Atherton [1926] AC 205 at 213-214 by Viscount Cave where he stated:

But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

Enduring benefit for the business

In FCT v CityLink Melbourne Limited 2006 ATC 4404 (CityLink) the High Court of Australia considered the deductibility of concession fees paid by a taxpayer to the State of Victoria in consideration for the right to design, construct, operate and impose a toll in respect of certain City Link roads. The concession fees were payable in two instalments per year and adjusted pro-rata for any part year periods. The majority of the High Court found that the concession fees did not secure any enduring asset in terms of the roads built but, rather, resulted in the acquisition of the right to build, operate and earn a profit from the tolls charged for the use of those roads for the duration of the concession period. Crennan J (with whom Gleeson CJ, Gummow J, Callinan J and Heydon J agreed) applied the 'three matters' laid down by Dixon J in Sun Newspapers in determining that 'concession fees' paid to the State in respect of a public private partnership arrangement were on revenue account and stated at 4427 that:

The characterisation of an outgoing depends on what it is calculated to effect to be judged from a practical and business point of view .. [and] .. [t]he character of the advantage sought by the making of the expenditure is critical.

In particular, Crennan J noted, at paragraph 154:

The concession fees are only payable during the term of the concession period. The respondent does not acquire permanent ownership rights over the roads or lands used. All rights granted under the Concession Deed revert to the State at the expiry of the concession period [cf Cliffs International Inc v Federal Commissioner of Taxation (1979) 142 CLR 14]. Unlike periodic instalments paid on the purchase price of a capital asset, the concession fees are periodic licence fees in respect of the Link infrastructure assets, from which the respondent derives its income, but which are ultimately "surrendered back" to the State. Accordingly, they are on revenue account.

Similarly, Entity M does not and will not acquire permanent ownership rights over the Project. All rights granted under the Licence revert to the Entity Q on the expiration or termination of the Lease. Further, the Licence Payments does not reflect the purchase price of a capital asset. Accordingly, this factor supports the view that the Licence Payments is on revenue account.

Advantage Sought

In FC of T v Star City Pty Ltd (2009) FCR 39 at 51-52, Goldberg J said:

The primary judge correctly identified the relevant principles to apply in determining whether [the outgoing] was an item of revenue or of capital and in determining the character of the advantage sought and the characterisation of the [outgoing]. In particular, the primary judge observed that an examination of the character of the advantage sought was assisted by asking two questions: What was the [outgoing] really paid for; and, is what it was really paid for, in truth and in substance, a capital asset? Her Honour accepted that the answer to these questions…depended upon what the expenditure was calculated to effect from a practical and business point of view.

The character of the advantage sought provides important guidance as to the nature of the expenditure because it says the most about the essential character of the expenditure itself. The decision of the High Court in GP International Pipecoaters Pty Ltd v Commissioner of Taxation (1990) 170 CLR 124 at 137; (1990) 90 ATC 4413 at 4419; (1990) 21 ATR 1 at 7 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 Federal Commissioner of Taxation (1938) 61 C.L.R 337, at p.363 ...

In relation to the character of the advantage sought by the expenditure it is necessary to examine whether the expenditure secures an enduring benefit for the business. This test was outlined in British Insulated and Helsby Cables Ltd v Atherton [1926] AC 205 at 213-214 by Viscount Cave where he stated:

But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

The Licence Payments will be payable by Entity M on a recurring basis and allow it access to the Project. This is part of the contractual arrangements under which the entity performs contracted Services under the Agreement in return for Payment from Entity Q.

In terms of the character of the advantage which is sought by Entity M, the periodic payment of the Licence Payments over the duration of the Agreement enables Entity M to operate and manage the Project and profit from the operation and management of the Project.

When the matters stated by Dixon J in the Sun Newspapers Case are considered, the character of the advantage sought by making the expenditure is the chief, if not the critical factor in determining the character of what is paid. The nature or character of the expenditure will therefore follow the advantage that is sought to be gained by incurring the expenditure.

The Licence Payments is, from a practical and business point of view, expenditure calculated to effect Entity M's provision of its Services to fulfil its obligations under the Agreement. Each Licence Payment secures for Entity M the right to access and use the Project to provide the Services for the period to which the Licence Payment relates.

The character of the advantage sought by Entity M is the fulfilment of its obligations to deliver the Services to Entity Q under the Agreement, allowing derivation of its ordinary business income. Each Licence Payment is a recurring expense Entity M and represents an outgoing in the ordinary course of carrying on the entity's business rather than an outgoing to establish its business organisation or structure. This advantage does not have any lasting quality or enduring benefit beyond the period to which the Licence Payment relates.

Therefore, the Commissioner regards the Licence Payments as revenue in nature and the character of the Licence Payments is not altered by virtue of the fact that the payments will occur over an extended period of time.

Therefore, the Licence Payments incurred is not capital, or of a capital nature and accordingly, will not fall within any of the negative limbs in subsection 8-1(2).

Question 2

Summary

Division 250 will not apply as Entity M is not entitled to a deduction for capital allowances for the decline in value of an asset, nor for capital expenditure in relation to an asset in respect of the Project.

Detailed reasoning

Division 250 denies or reduces capital allowance deductions that would otherwise be available in relation to an asset if the asset is put to a tax preferred use and the taxpayer has insufficient economic interest in the asset.

The general test for application of Division 250 is set out in section 250-15 which provides that the Division will apply to a taxpayer and an asset at a particular time if:

(a) the asset is 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 to be expected to be provided to you by a tax preferred end user; and

(d) disregarding this Division you would be entitled to a capital allowance in relation to a decline in value of the asset; or expenditure in relation to the asset; and

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

Each of the conjunctive requirements in paragraphs 250-15(a)-(e) must be present for the general test to be satisfied. If one of the paragraph requirements is not present, it is sufficient to conclude that the general test is not satisfied and, accordingly, that Division 250 does not apply.

Entity M is in the business of procuring, facilitating and managing the design, construction, and provision of the Services in respect of the Project. It conducts this business by subcontracting the services. The income it receives from Entity Q is incidental and relevant to its activities as the Facilitator of the services and will be included in its assessable income.

Similarly the payments Entity M makes to the sub-contractors under the relevant agreements are made in the ordinary course of its business. Further, these payments are not capital, or of a capital nature as Entity M is reimbursed for these costs.

On the basis that the payments incurred by Entity M are deductible under section 8-1, the payments are not capital or of a capital nature and it is therefore not necessary to consider if Entity M is entitled to claim a deduction for capital allowances under Division 40 or for expenditure on project works pursuant to Division 43. Therefore, as Entity M does not satisfy one of the conjunctive requirements for Division 250 to apply, in this circumstance paragraph 250-15(d), Division 250 will not apply.

Therefore, Division 250 does not apply to Entity M on the basis that it is not and will not be entitled to a deduction for capital allowances, as required by paragraph 250-15(d).

Where Entity M is seeking to claim capital allowances under section 40-880 and section 40-840 for expenses incurred in creating the Project entities and certain costs of putting a tender for the project; the question arises as to whether or not those expenses can be considered to have been incurred 'in relation to an asset' as provided for in subparagraph 250-15(d)(ii).

Pursuant to paragraph 40-880(1)(c) and paragraph 40-840(2)(c), ), the capital expenditure incurred by Entity M will be expenditure either in relation to a business that is proposed to be carried on for a taxable purpose or as expenditure in relation to a project amount. This is confirmed in Example 11 of Taxation Ruling 2011/6, whereby expenditure relating to the establishment of a business structure or submitting a tender is of a kind which relates to a business that is proposed to be carried on for a taxable purpose as per paragraph 40-880(1)(c).

Therefore, expenditure incurred by Entity M which is deductible under section 40-880 and 40-840 will not be expenditure incurred by Entity M 'in relation to an asset' as required by subparagraph 250-15(d)(ii).

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