Edited version of your written advice

Authorisation Number: 1012805996098

Ruling

Subject: Capital expenditure which is deductible over time - project amounts and business related costs.

Question 1

Is Company A's payment to Company B in relation to the upgrade of Company B's infrastructure deductible as a project amount under Subdivision 40-I of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

If the answer to Question 1 is affirmative, what is the project life under section 40-845 of the ITAA 1997?

Answer

N/A

Question 3

Is Company A's payment to Company B in relation to the upgrade of Company B's infrastructure deductible under section 40-880 of the ITAA 1997?

Answer

Yes.

Question 4

Will Company A's expected payment to Company B in relation to the upgrade of a further item of Company B's infrastructure be deductible under section 40-880 of the ITAA 1997, starting from the income year in which the payment is made?

Answer

Yes.

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Company A

Company A owns and operates infrastructure across state lines. Its primary role is to maintain and develop that infrastructure, and it primarily earns revenue from granting third parties access rights to the infrastructure for a fee. Company A's objectives, outlined in its Constitution, are to:

• provide efficient and seamless access to the infrastructure;

• manage the scheduling of use of the infrastructure;

• pursue a growth strategy for use of the infrastructure, and

• to operate on commercially sound principles.

Company B

Company B is an Australian proprietary company, limited by shares, and is unrelated to Company A. Company B owns and operates the same type of infrastructure as Company A, but only in one state of Australia. Geographically, Company A and Company B's infrastructure connects.

Brief history

The previous owner of Company B's infrastructure entered into a 15 year Agreement with Company A regarding the mutually beneficial operation, maintenance and pricing of Company A and (what is now) Company B's infrastructure. When Company B took over the infrastructure, they also took over the Agreement.

Request for funding support

During the Global Financial Crisis, Company A requested equity funding from its shareholders to embark on a suite of capital works. Company A claimed the works would provide a combination of national economic benefits and commercial benefits to Company A.

The suite of works included upgrading specific areas of Company A's infrastructure which were rundown. However, one of the identified works consisted of upgrading a portion of Company B's infrastructure. The cost of this portion of the upgrade represented less than 10% of the total funding requested. Company A's funding proposal described multiple benefits which would flow to Company A as a result of the upgrade, including that it would achieve an internal rate or return > 7%. It was anticipated that completing an upgrade to Company B's infrastructure would be beneficial to Company A, as Company A's customers also relied on Company B.

The proposal also made it clear that undertaking this particular work item was subject to Company A negotiating a new Agreement with Company B, as the Agreement then in operation was due to expire.

Company A undertook commercial negotiations with Company B and eventually formed a view that the negotiations were unlikely to deliver the commercial outcomes expected. In particular, Company B did not agree to an outcome that would provide improvements to its infrastructure commensurate with the investment Company A was offering.

Company A accordingly undertook a review of its investment strategy in relation to Company B's infrastructure, to ensure that its shareholder would receive the maximum benefit from its equity investments. As a result, Company A decided to devise an alternate investment package.

The revised investment strategy

The revised package included three key components;

• a smaller contribution to Company B's upgrade of the relevant infrastructure than was originally proposed;

• contribution of a further amount conditional upon Company B undertaking further infrastructure upgrades in later income years, and

• conclusion of a new Agreement between Company A and Company B on terms acceptable to both parties.

Company A believes the strategy will provide a number of benefits, including extension of the Agreement to support the provision of a common access framework across the infrastructure owned by the two separate parties, provision of future price certainty for users of the infrastructure, a positive return on equity to its shareholders, and improved reliability performance for users of the infrastructure.

Company A's understanding is that, had Company B funded the whole of the improvement costs itself, Company B would have included additional costs in its pricing calculations, allowing it to charge higher access fees to customers (including Company A's customers), which would increase the total cost of accessing Company A and Company B's infrastructure.

Company A's commercial view is that the market would not sustain such an increase, with Company A consequently either suffering reduced custom, or having to reduce its fees in order to maintain existing volumes - either way, Company A believed its revenues would fall.

Company A believes this alternative use of funds provides for a better economic outcome, improved returns for its shareholders and will support its company objectives.

Agreement

Company A's Board approved the issue of a large number of shares to its shareholder at $1 a share.

A new Agreement, effective for over 15 years, was executed between Company A and Company B. The Agreement sets out the obligations of Company A and Company B for managing and optimising the efficiency of their respective infrastructure. It also requires Company A to pay Company B a particular sum, which Company B will utilise in the completion of the upgrading of the relevant infrastructure.

Company A made payment to Company B as a contribution to the upgrade on Company B's infrastructure.

Company B was wholly responsible for the design, planning and execution of the upgrade plans. There was no requirement in the Agreement to have the designs or plans approved by Company A, and Company A did not inspect or provide any feedback in relation to the plans. Once the upgrade was complete, although entitled to inspect the works under the Agreement, Company A declined to do so.

Had Company B not finished the works by a particular date, Company B would have been required to repay some or all of the contribution on a proportionate basis to the amount of the upgrade which was completed.

The Agreement also provides that, should Company B complete the further item of work, then Company A would provide 50% of its cost, up to a particular amount. This is not likely to become necessary until a later income year.

Relevant legislative provisions

Section 40-25 of the Income Tax Assessment Act 1997

Section 40-40 of the Income Tax Assessment Act 1997

Section 40-830 of the Income Tax Assessment Act 1997

Section 40-840 of the Income Tax Assessment Act 1997

Section 40-845 of the Income Tax Assessment Act 1997

Section 40-865 of the Income Tax Assessment Act 1997

Section 40-870 of the Income Tax Assessment Act 1997

Section 40-880 of the Income Tax Assessment Act 1997

Section 40-845 of the Income Tax Assessment Act 1997

Section 995-1 of the Income Tax Assessment Act 1997

Subdivision 40-I of the Income Tax Assessment Act 1997

Reasons for decision

All references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.

Question 1

Summary

No, Company A's payment to Company B, as a contribution to upgrading Company B's infrastructure, is not deductible as a project amount under Subdivision 40-I.

Detailed reasoning

Section 40-830 allows project amounts to be allocated to a project pool and deducted according to the formula contained in subsection 40-830(3).

To be entitled to a deduction, among other things, there must be a 'project amount' which is allocable to a project pool.

'Project amount' is defined in section 40-840. Subsection 40-840(1) provides that a project amount includes an amount of 'mining capital expenditure' or 'transport capital expenditure', subject to certain conditions. Company A's expenditure is not related to the carrying on of mining operations nor was it capital expenditure incurred on a 'transport facility'.

Where capital expenditure is neither 'mining capital expenditure' nor 'transport capital expenditure', subsection 40-840(2) relevantly states:

Another amount of capital expenditure you incur is also a project amount so far as:

(a) it does not form part of the cost of a depreciating asset you hold or held; and

(b) you cannot deduct it under a provision of this Act outside this Subdivision; and

(c) it is directly connected with a project you carry on or propose to carry on for a taxable purpose; and

(d) it is one of these:

(i) an amount paid to create or upgrade community infrastructure for a community associated with the project; or

(ii) an amount incurred for site preparation costs for depreciating assets (except, for horticultural plants, in draining swamp or low-lying land or in clearing land); or

(iii) an amount incurred for feasibility studies for the project…

In order for the relevant amount to qualify as a project amount it must satisfy paragraphs 40-840(2)(a), 40-840(2)(b) and 40-840(2)(c) as well as one of the subparagraphs contained in paragraph 40-840(2)(d).

Paragraphs 40-840(2)(a) and 40-840(2)(b)

Section 40-40 provides guidance on who holds a depreciating asset.

The relevant infrastructure is legally owned by Company B. Company A has no quasi-ownership right (as defined in section 995-1) over the land on which the infrastructure is positioned. Therefore it is neither a depreciating asset, nor part of a depreciating asset that Company A holds or held.

The Commissioner accepts that the relevant expenditure cannot be deducted under a provision of the Act outside this Subdivision.

Paragraph 40-840(2)(c)

In order to determine whether the capital expenditure incurred on the relevant infrastructure is a project amount directly connected with a project, it is necessary to determine if a project exists.

The term 'project' is not defined for the purposes of Subdivision 40-I. Taxation Ruling TR 2005/4 Income tax: capital allowances - project pools - core issues provides the Commissioner's view on the core issues relating to project pools under Subdivision 40-I. In determining what is a project for the purposes of these provisions, paragraph 21 of TR 2005/4 provides that the project must be of sufficient substance and be sufficiently identifiable that it can be shown that the capital expenditure said to be a project amount is directly connected with the project.

Paragraph 47 of TR 2005/4 states that in general terms, a project is a plan, scheme or undertaking.

Paragraph 49 of TR 2005/4 provides that the following are some of the things that define a project:

• A project has a start and a finish and is an entirety in itself. However, the point when a project 'starts' may be earlier than the point when the project 'starts to operate'. For example, a project undertaken in carrying on your business which is the construction and operation of a depreciating asset for use in the business has a construction phase before it begins to operate for a taxable purpose.

• A project may be a large undertaking but is not necessarily so. The size of the undertaking, the time it takes to complete the undertaking and the capital expenditure incurred in carrying on the undertaking are not necessarily determining factors.

An essential element of a project for the purpose of Subdivision 40-I is a finite project life which can be objectively and reasonably determined. TR 2005/4 provides that although not explicitly stated in the legislation or extrinsic material, the Commissioner's view is that this requirement is implied in the legislation.

The term 'carry on' is also not defined in the ITAA 1997. TR 2005/4 provides guidance in relation to what it means to 'carry on' or 'propose to carry on' a project for the purposes of paragraph 40-840(2)(c):

• paragraph 24 of TR 2005/4 states that the term 'carry on' should take its ordinary meaning shaped by the context in which it is found.

• paragraph 25 of TR 2005/4 states that the term 'carry on' requires some form of continuing activity and if that activity ceases it is a question of fact whether the project is still being carried on or has been abandoned.

• paragraph 26 of TR 2005/4 states that holding a passive investment would not have sufficient activity to constitute the 'carrying on' of a project.

• paragraph 27 of TR 2005/4 states that the words 'propose to carry on' require a commitment of some substance to the activity or activities identified as constituting the project.

The expression 'taxable purpose' is defined in section 995-1 as having the meaning given by section 40-25. Subsection 40-25(7) relevantly states:

Subject to subsection (8), a taxable purpose is:

a) the purpose of producing assessable income; or

b) the purpose of exploration or prospecting; or

c) the purpose of mining site rehabilitation; or

d) environmental protection activities.

Subsection 40-25(8) is not relevant for present purposes.

Is the suite of works undertaken by Company A a 'project'?

Company A first proposed to upgrade Company B's infrastructure (in a different form to what was finally completed) as part of a suite of capital works Company A hoped to perform primarily on its own infrastructure.

The individual works proposed by Company A were complementary, in that if all works were completed, users of the infrastructure would experience increased efficiency and improvements across the infrastructure owned by both Company A and Company B. However, the upgrade to Company B's infrastructure was not ancillary to any of the other works Company A was proposing, and could be completed independently. Further, if Company A was not able to negotiate a new Agreement with Company B, Company A did not intend to proceed with that part of the upgrade at all, in which event it would not have impacted the completion of the other works.

Company A estimated time frames for the commencement and completion of each item of work, however the works were not attached to any kind of ongoing operational task with an end date. Company A would continue to operate its infrastructure indefinitely, independent of whether the works were completed or not.

While it is arguable that the whole suite of works proposed by Company A were of sufficient substance and sufficiently identifiable to be a 'project' for the purposes of the Subdivision, the segmented nature of the works and the inability to identify a finite project life suggests that the better view would be that the upgrade to Company B's infrastructure could be a project in and of itself.

Is the upgrade done to Company B's infrastructure Company A's 'project'?

In relation to the upgrade to the infrastructure owned by Company B, Company B was wholly responsible for the design, planning and execution of the upgrade plans. There was no requirement in the Agreement to have the designs or plans approved by Company A, and Company A did not inspect or provide any feedback in relation to the plans. Once the upgrade was complete, although entitled to inspect the works under the Agreement, Company A declined to do so.

Further, Company B had already commenced upgrading its infrastructure prior to executing the Agreement with Company A, and it is arguable that the upgrade would have been completed without Company A's contribution. Company A's entire involvement was limited to a cash payment, effectively equating to a passive investment.

Therefore, without deciding conclusively whether the upgrade was a 'project', Company A does not in any event appear to have met the requirement that it 'carry on' some form of continuing activity (for the purposes of paragraph 40-840(2)(c)). The fact that the works commenced prior to Company A's official involvement also suggests that identifying (among other things) the start and end of any potential project's finite life would be problematic.

Conclusion

Accordingly, the Commissioner considers that the expenditure Company A incurred to Company B as a contribution towards the upgrade of Company B's infrastructure was not a project amount under subsection 40-840(2) and therefore not deductible under Subdivision 40-I.

In the alternative

For the avoidance of doubt, should the Commissioner be wrong and Company A's expenditure meet the requirements of paragraphs 40-840(2)(a), 40-840(2)(b) and 40-840(2)(c), the Commissioner considers it unlikely that Company A's relevant expenditure would meet any of the criteria in paragraph 40-880(2)(d).

The most relevant criteria in the circumstances would be subparagraph 40-840(2)(d)(i), which provides that an amount of capital expenditure you incur may be a 'project amount' so far as it is an amount 'paid to create or upgrade community infrastructure for a community associated with the project'. The three relevant terms in this phrase are; 'community infrastructure', 'community' and 'project'.

What is meant by 'infrastructure' and 'community' was addressed by the Commissioner in ATO Interpretative Decision ATOID 2003/1001 Income Tax Capital Allowances: project pools - project amount - community infrastructure. Broadly, as 'community infrastructure' is not defined in legislation, it is interpreted according to its ordinary meaning. The Macquarie Dictionary (2014) relevantly defines 'community' as 'all the people of a specific locality or country', 'a particular locality, considered together with its inhabitants', 'a group of people within a society with a shared ethnic or cultural background', 'a group of people with a shared profession' and 'a group of people living together and practising common ownership'.

It is not in dispute that the relevant expenditure was incurred to upgrade infrastructure. However, the Commissioner does not consider that its upgrade was done 'for a community associated with the project'. Users of the infrastructure are varied and do not have anything in common other than their use of the infrastructure; they do not live in a particular locality and the upgrade was not for them per se, but for a myriad of reasons including;

• the commercial benefit of Company A;

• improving the efficiency of the infrastructure.

Therefore, the Commissioner does not consider that the expenditure incurred by Company A was an amount 'paid to create or upgrade community infrastructure for a community associated with the project'.

Question 2

Summary

As the answer to question 1 is negative, there is no need to answer question 2.

Question 3

Summary

Yes, Company A's payment to Company B in relation to the upgrade of the Company B's infrastructure is deductible under section 40-880.

Detailed reasoning

Subdivision 40-I provides a deduction for certain types of business related capital expenditure. These expenses are commonly referred to as black hole expenditure, because broadly, the provisions apply to certain types of business expenditure for which no other tax benefit is available.

Subsection 40-880(2) states that:

You can deduct, in equal proportions over a period of 5 income years starting in the year in which you incur it, capital expenditure you incur:

a) in relation to your business; or


b) in relation to a business that used to be carried on; or


c) in relation to a business proposed to be carried on; or


d) to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary that carried on a business.

The expenditure must be in relation to Company A's business

As Company A is still carrying on its business, to be eligible to deduct an amount of capital expenditure under subsection 40-880(2), Company A must demonstrate (among other things) that the relevant expenditure was incurred in relation to its business. This threshold requirement is explained and illustrated in paragraphs 69 to 92 of TR 2011/6 Income tax:  business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues.

These paragraphs provide that determining whether a capital contribution has the character of a business expense turns on the particular facts and circumstances. This can be approached by identifying the need or object that the contribution serves. If the facts show that Company A's contribution to Company B is genuinely intended to enhance Company A's business, then it has the character of a business expense.

Company A's primary role is to maintain and develop the infrastructure managed by Company A and to provide access to users for a fee. Two of Company A's objectives are to provide efficient and seamless access to the infrastructure, and pursue a growth strategy for its increased use.

As Company A only owns a portion of the overall infrastructure, in order to pursue the above objectives it is obliged to have good working relations with Company B. As part of its proposed suite of works, Company A identified that upgrading a section of Company B's infrastructure was necessary to improve the overall efficiency of the infrastructure. After negotiations with Company B, it became clear that the amount Company A originally planned to invest was not commensurate with the benefit that Company A would receive. It also became clear that Company B (as new owners) had the capital to undertake the relevant upgrade on its own.

As provided in the relevant facts and circumstances, Company A considered that if Company B funded the relevant upgrade itself, then they would include additional costs in its pricing calculations and charge higher access fees to its customers. As Company A and Company B share the same customers, this would result in an overall increase to the total access charges for both Company A and Company B's infrastructure.

It is Company A's commercial view that the market could not sustain such an increase, and as a result Company A would suffer reduced volumes and/or be required to reduce its fees in order to maintain existing volumes - either way, Company A believed its revenues would fall.

The contribution for the upgrade made by Company A to Company B serves to provide Company A with certainty that:

• Company B's infrastructure will be upgraded;

• Company B will use its best endeavours to enable access to interstate users;

• Company B's access fees are capped for a set period of time, and

• maintenance of Company B's infrastructure will be continued.

This certainty contributes to Company A's objectives. It also enhances Company A's business by ensuring it will not have to lower its access prices to accommodate a rise in Company B's prices. Accordingly, the relevant expenditure has the character of a business expense and meets the requirement in paragraph 40-880(2)(a) as capital expenditure that was incurred in relation to Company A's business.

Limitations and exclusions from section 40-880

To the extent that a payment is business-related capital expenditure, any deduction available under subsection 40-880(2) is subject to the exceptions and limitations in subsections 40-880(3), 40-880(4), 40-880(5), 40-880(6), 40-880(7), 40-880(8) and 40-880(9). Of these, subsection 40-880(5) contains the only exception that may be relevant in Company A's circumstances. Paragraph 40-880(5)(d) provides:

You cannot deduct anything under this section for an amount of expenditure you incur to the extent that:

a)…

d) it is in relation to a lease or other legal or equitable right…

The expression 'in relation to a lease or other legal or equitable right', or any part of the expression, is not defined in legislation. However, the Commissioner's view on its meaning is explored in TR 2011/6, which it states that it has limited practical application. Specifically, paragraph 47 provides that:

The existence of paragraphs 40-880(5)(a) and 40-880(5)(f) and section 25-110 mean that paragraph 40-880(5)(d) has limited practical application. It applies to expenditure incurred on or after 1 July 2005 that has a sufficient and relevant connection to a lease or right held by an entity other than the taxpayer. The 'rights' in question do not include all legal rights but only those similar to leases in that they give the taxpayer a right to exploit the asset with which the right is associated. In other words, the right is carved out of an asset but falls short of full ownership of the asset. Examples of such rights include profits à prendre, easements and other rights of access to land. The rights however are not limited to rights associated with land. (emphasis added).

The Agreement executed between Company A and Company B creates various rights and obligations on each party, including for example, that Company B must set its pricing structure in accordance with the formula agreed by both parties, and that Company A must pay Company B a set contribution towards the relevant upgrade. In relation to accessing the Company B's infrastructure, the Agreement states that 'nothing obliges Company B to grant access' to its infrastructure to any Customer. However, it also states that Company B agrees that it will use 'all reasonable endeavours to negotiate access arrangements' in respect of any customer wishing to access both Company A and Company B's infrastructure.

Given the emphatic wording of the above, nothing in the Agreement can be said to provide Company A with a right to exploit Company B's infrastructure. Company A (and its customers) do not have unfettered rights of access to Company B's portion of the infrastructure. For instance, each time a customer wishes to cross from Company A's infrastructure onto Company B's infrastructure, they must negotiate access and provide a separate payment to Company B.

The Commissioner does not consider that the Agreement provides Company A with any right similar to a lease. Accordingly, subsection 40-880(5)(d) will not apply to limit any deduction available to Company A under section 40-880.

Conclusion

For the reasons provided above, the Commissioner accepts that Company A's payment to Company B as a contribution to the upgrade of its infrastructure was incurred in relation to Company A's business. Further, the payment was not subject to any of the exceptions or limitations contained in subsections 40-880(3), 40-880(4), 40-880(5), 40-880(6), 40-880(7), 40-880(8) and 40-880(9). Accordingly, Company A is entitled to deduct under subsection 40-880(2), in equal proportions over five income years starting in the year which it was paid.

Question 4

Summary

Yes, Company A's expected payment to Company B in relation to the upgrade of a further item of Company B's infrastructure will be deductible under section 40-880 starting from the income year in which the payment is made.

Detailed reasoning

The Agreement executed between Company A and Company B provides that, should Company B complete a further item of work, then Company A will provide 50% of its cost up to a capped amount. This item of capital work would enable further improvements to Company B's infrastructure.

The conditional amount, together with the payment that Company A has already made, were both part of Company A's revised investment strategy. Company A reasoned that these two payments would provide the following benefits:

• extension of the Agreement to support the provision of a common access framework between the infrastructure belong to the two companies;

• provision of future price certainty for users of the infrastructure belonging to the two companies; and

• a positive return on equity to Company A's shareholders as the investment will enable an increase in the volume of users of the infrastructure.

As previously established in question 3, had Company B funded the whole of these improvement costs itself, this would have negatively affected Company A's customers by increasing the total prices charged to access the infrastructure.

As the two payments have the same character and were proposed for the same reasons, the reasoning in the answer to question 3 will apply equally to the additional amount that Company A may incurred to Company B, as a further contribution to upgrading its infrastructure.

Conclusion

Accordingly, the Commissioner accepts that Company A's expected payment to Company B in relation to the upgrade of a further item of Company B's infrastructure will be deductible under subsection 40-880(2) in equal proportions over five income years starting in the year in which it is paid.

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