Edited version of your written advice

Authorisation Number: 1012879169656

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This edited version has been found to be misleading or incorrect. It does not represent the ATO's view of the relevant law.

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Date of advice: 16 September 2015

Ruling

Subject: Government grants to commence business

Question 1

Will the funds that are received by the entity from a government agency (the Funds) be assessable to the entity as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Will the Funds be assessable to the entity as statutory income under section 15-10 of the ITAA 1997?

Answer

No

Question 3

Will the Funds be assessable to the entity as a capital gain under section 102-5 of ITAA 1997?

Answer

No

Question 4

Will the Funds be assessable to the entity as statutory income under the assessable recoupment rules in Subdivision 20-A of the ITAA 1997?

Answer

Yes

This ruling applies for the following period:

1 July 2014 - 30 June 2037

The scheme commences on:

1 July 2014

Relevant facts and circumstances

1. The entity is a newly incorporated entity that will construct and operate an asset.

2. A government agency will provide funds (the Funds) to pay for part of the construction of the asset (the Project) under a funding agreement (the Funding Agreement).

3. The entity has no tangible assets, other than a nominal amount of cash, and has no employees.

4. On commencement of the Project, a company will acquire 100% of the share capital in the entity and provide all future equity finance.

5. The company will only acquire the shares if the entity receives the government funding.

6. The entity has completed certain activities prior to receipt of the Funds, including;

a. Acceding to its company constitution

b. Holding a board meeting related to the issue of ordinary shares

c. Registering for GST

d. Borrowing a small sum from prospective investors to pay consulting fees

e. Entering into the Funding Agreement with the government agency

f. Entering into agreements for provision of legal advice and financial modelling consulting services.

7. The entity has also paid a consulting company to, along with the company conduct a number of further activities in relation to the Project.

8. The government agency has agreed to contribute approximately a third of the costs of construction of the Project.

9. The government agency will pay the Funds into a specially created bank account owned by the entity.

10. The entity will be the sole legal and beneficial owner of the Funds on receipt.

a) Prior to receipt of the Funds, the entity must satisfy a number of conditions precedent including the provision of executable versions of key documents associated with the Project.

11. These documents will only be executed after the Funds have been received, and will not be executed if the Funds are not received.

12. Further obligations on the entity of entering the Funding Agreement include risk management planning, community consultation, the procuring of shareholder contributions, meeting work health and safety (WH&S) guidelines, and maintaining insurance requirements.

13. The Funds can only be used by the entity to construct the asset, and purposes that are incidental to the construction of the asset in accordance with the budget set out in the Funding Agreement.

14. The government agency is entitled to recover from the entity any amount of the Funds which has not been spent for purposes of construction.

15. The government agency is entitled to recover any unspent Funds from the entity which have not been committed for spending (as a current liability).

16. The entity is entitled to use any interest earned on the Funds for the purposes of the Project. This amount is recoverable by the government agency where it is not spent.

17. The entity retains all legal and beneficial title of the asset.

18. The entity upon completion of the Project has no obligation to the government agency to repay the Funds used for the Project.

19. The entity expects to complete the construction of the asset in the second half of 20XX.

20. The entity must open and maintain an account in its own name which must be subject to the government agency's security.

21. The entity must establish the account solely for the purposes of accounting for, and administering the Funds paid to it, and must keep it separate from its other accounts.

22. The entity must ensure that the account bears a reasonable market rate of interest.

23. The government agency must be a signatory on the account, and may in certain default or insolvent circumstances, by notice to the bank, take exclusive control of the operation of the account.

24. The entity may only withdraw Funds from the account when it meets certain construction and business milestones as set out in the Funding Agreement.

25. Once the entity has met the milestone, it will be entitled to withdraw the Funds correlating with completion of that milestone. The withdrawal process is as follows:

b) The entity must first provide the government agency with a withdrawal claim, together with evidence and verification that the milestone has been completed, and an unsigned bank withdrawal form.

c) Provided these requirements are met, the government agency must countersign the withdrawal form and release the Funds from the account. The government agency has no discretionary power to sign, and must do so if the requirements are met by the entity.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 15-10

Income Tax Assessment Act 1997 section 20-20

Income Tax Assessment Act 1997 section 20-25

Income Tax Assessment Act 1997 section 20-30

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 subsection 118-37(2)

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Question 1

Summary

The Funds will not be assessable as ordinary income under section 6-5 of ITAA 1997 as the Funds are a capital receipt in the hands of the entity.

Detailed reasoning

Section 6-5 of the ITAA 1997 states that ‘your assessable income includes income according to ordinary concepts, called ordinary income.' Ordinary income generally falls into three categories;

● Income from providing personal services

● Income from property, and

● Income from carrying on a business.

Ordinary income can be distinguished from capital receipts, which will not constitute income according to ordinary concepts.

The entity is receiving the Funds from the government agency to design, construct and operate the asset. The question is whether this payment is income from carrying on a business, or a capital receipt to the entity.

Ordinary income v capital receipts

In First Provincial Building Society Ltd v Federal Commissioner of Taxation (1995) 56 FLR 320 (First Provincial), Hill J discussed the key principles that emanated from the judgment of the full High Court in GP International Pipecoaters Proprietary Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124 (International Pipecoaters) in determining whether a particular receipt had the character of income or capital:

1. Whether a particular receipt is income is to be determined by reference to the character of that receipt in the hands of the taxpayer (Scott v Federal Commissioner of Taxation (1966) 117 CLR 514.).

2. The question is not decided by determining whether the expenditure by the payer is of an income or capital nature

3. The fact that the amount in question must be applied for a capital purpose will not determine its character as capital

4. In many cases it will be necessary to determine the scope of a taxpayer's business by reason of which the amount in question is received (Federal Commissioner of Taxation v Myer Emporium Ltd (1987) 163 CLR 199.).

5. The ascertainment of the character of receipt involves the application of ‘a business conception to the facts of the case.' (Federal Commissioner of Taxation v Becker (1952) 87 CLR 456.).

The primary income producing activity of the entity is the relevant business of the entity. The payment is clearly for a capital purpose, but this is not determinative.

In International Pipecoaters, the taxpayer won a tender process to coat pipes for the State Energy Commission of Western Australia used to transport natural gas. The taxpayer incorporated a special purpose vehicle to perform the activities of the tender. As part of the contract with SECWA, it was agreed that the pipe coating should take place in Australia. Certain amounts in the tender were subsequently reduced to allow for the insertion of a payment for ‘establishment costs,' which was paid in advance to assist in construction of the plant, though the taxpayer was not required to use the funds for that purpose. The taxpayer argued that its business was only the coating of pipes, and any establishment cost to construct the plant would be capital. The High Court found that its business was to enter into and perform the contract, including the construction of the pipe coating plant. Once the business had been defined as such, the ‘establishment costs' payment made to the taxpayer for constructing the plant was ordinary income of a business, and assessable. The High Court said:

‘The receipt of moneys to recoup a recipient's capital expenditure can be considered a capital receipt where the amount is received by way of gift or subsidy to replenish or augment the receiver's capital; for in such a case the receipt cannot fairly be said to be a product or incident of the payee's income-producing activity.'

It was found that as the ‘income producing activity' of the business constituted the performance of the contract in whole (both construction of the plant and pipe coating) and as such the amount could not be to replenish or augment the recipient's capital, and instead was ordinary income.

In First Provincial, the taxpayer's business was a building society. The taxpayer received a payment from the government when a contingency fund it was party to was wound up. The payment was found to lack a necessary connection with a building society's business activities to constitute ordinary income. It had no relation to any trading activities of the taxpayer. The payment was categorised as capital.

For the entity, although the payment of the Funds is clearly related in some capacity to the business of construction and operation, the trading activity of the entity is ultimately the relevant business. The payment for the construction of a capital asset to commence the business is capital, and the payment cannot be considered ‘consideration for some trading activities' but rather an ex gratia payment to assist in capital costs.

The Funds received from the government agency must be used solely in accordance with the Funding Agreement to build the asset, distinguishing it from International Pipecoaters where the funds though labelled as establishment costs had no restrictions on use, and were within the same contract as the pipe coating. It is a ‘subsidy to replenish or augment the receiver's capital, which cannot fairly be said to be a product or incident of the receiver's income-producing activity.'

The treatment of the grant as capital is further supported by ATO Interpretative Decision ATO ID 2004/937 Assessability of payments made by a government authority under a capital support fund (ATO ID 2004/937). The Commissioner was asked to consider whether a payment to a taxpayer from a relevant government authority under a capital support fund program was assessable under section 15-10 of ITAA 1997. The payments were designed to assist with the capital costs of establishing infrastructure, and were paid at the completion of specific milestones. The payments in this case were considered capital.

Considering all the circumstances, it is concluded that the Funds would be considered a capital receipt, and therefore not assessable as ordinary income under section 6-5 of ITAA 1997.

Question 2

Summary

The Funds will not be assessable as statutory income under section 15-10 of ITAA 1997 as the Funds are received prior to the commencement of a business.

Detailed reasoning

Section 15-10 of the ITAA 1997 includes in assessable income a bounty or subsidy that is not ordinary income under section 6-5 of ITAA 1997, and is received in relation to carrying on a business.

As outlined at question 1, the Funds are not ordinary income under section 6-5 of the ITAA 1997. Therefore the key considerations are whether the funds are a ‘bounty or subsidy' and ‘received in relation to carrying on a business'.

Bounty or subsidy

The terms ‘bounty' and ‘subsidy' are not defined in the ITAA 1997. In First Provincial, a bounty or subsidy was described as ‘generally meaning financial assistance granted by the Crown'.

The Funds are a payment from a government authority to assist the entity in becoming established in its industry. The Funds are a bounty or subsidy within the meaning of section 15-10 of ITAA 1997.

‘Received in relation to carrying on a business'

For section 15-10 of the ITAA 1997 to apply, a payment must be received in relation to the carrying on of a business. In First Provincial, the words ‘carrying on' in particular were emphasised. Hill J stated in relation to paragraph 26(g) of ITAA 1936, the forerunner of section 15-10 of ITAA 1997 that;

‘the relationship must be to the ‘carrying on' of the business. These words may perhaps be understood in opposition to the relationship with the actual business itself. They would make it clear for example that a bounty received, merely in relation to the commencement of a business or the cessation of the business, would not be caught. The expression ‘carrying on of the business' looks, in my opinion, to the activities of that business which are directed towards the gaining or producing of assessable income, rather than merely to the business itself.'

Taxation Ruling TR 2006/3 Income tax: government payments to industry to assist entities (including individuals) to continue, commence or cease business (TR 2006/3) provides the Commissioner's view on this issue. TR 2006/3 breaks down government payments and grants into three categories; payments to continue, commence, or cease business.

Paragraph 26 of TR 2006/3 states that ‘government payments to industry to commence a business are not assessable as ordinary income of the recipient under section 6-5 or as a bounty or subsidy in relation to carrying on a business under section 15-10'. In contrast, as a broad proposition, payments received to continue business, whether they are income or capital, are assessable under either section 6-5 or section 15-10 of the ITAA 1997.

The question therefore is whether the entity's business will have commenced prior to the point in time the Funds are received.

Has a business commenced at the time the payment is received?

Whether or not a business is being carried on is a question of fact to be determined in an objective manner on the specific facts of each case (Evans v Federal Commissioner of Taxation (1989) 20 ATR 922.). The Commissioner in paragraph 18 of Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? (TR 97/11) provides a non-exhaustive list of factors to consider when determining whether a business exists. These factors include:

• a significant commercial activity

• an intention to make a profit from the activity

• size and scale of the activity

• a business plan exists

• taxpayer has knowledge or skill

• the activity is or will be profitable

The activities that have been undertaken by the entity prior to receipt of the Funds include:

a. Acceding to its company constitution

b. Holding a board meeting related to the issue of ordinary shares

c. Registering for GST

d. Borrowing a small sum from prospective investors to pay consulting fees

e. Entering into the Funding Agreement with the government agency

f. Entering into agreements for provision of legal advice and financial modelling consulting services.

It is clear the entity has been incorporated with the intention of operating a business of constructing and operating the asset, and profiting from its trading activities once the asset has been commissioned.

However intention, though a strong indicator, is insufficient. Establishing the point in time at which a taxpayer commences carrying on a business is not a matter merely of intention, it is a matter of activity (Inglis v Federal Commissioner of Taxation (1998) 39 ATR 60.).

The nature of the activities required to demonstrate that a taxpayer carries on a business will differ depending on the relevant business that is carried on. For smaller businesses, a smaller amount of activity may suffice to demonstrate the taxpayer is carrying on a business (Thomas v Federal Commissioner of Taxation (1972) 3 ATR 165.). Merely preparatory activities are insufficient to amount to carrying on a business, and it is only activities that are ‘directed toward the gaining or producing of assessable income,' or are absolutely essential toward this that will lead to a conclusion that a taxpayer is carrying on a business.

As the entity is in the business of constructing and operating an asset (a large scale activity), it would be expected that a significant amount of activity would be required to demonstrate that the entity has commenced business.

In ATO Interpretative Decision ATO ID 2010/38 Bounty and subsidies: financial assistance received in commencing a business - whether received to commence a business (ATO ID 2010/38), the Commissioner stated:

‘A bounty or subsidy is received to commence a business if the bounty or subsidy is to enable the recipient to reach the necessary point where the recipient is committed (and such commitment is demonstrated in its activities) to proceed with the implementation of its purpose to carry on a business.'

In accordance with ATO ID 2010/38 the activities undertaken to date are considered to be minor preliminary activities that enable the entity to reach a point where it will be able to commence the Project. The entity's business of construction and operation of the asset is entirely contingent on receipt of the Funds from the government agency. It is only after receiving the Funds that the entity will be required to commit and execute the various agreements it has made, and gain access to the further debt and equity finance it requires to commence the Project. Without the Funds received from the government agency, no obligations are imposed on the entity by other parties and the entity will not proceed with the Project.

It is noted that GST registration is required where an entity is carrying on an ‘enterprise', which is a far broader concept than that of the income tax concept of ‘carrying on a business,' thus mitigating its influence in the determination of whether a business has commenced.

The Funds will therefore not be assessable as statutory income under section 15-10 of ITAA 1997 as the Funds will be received in relation to commencing a business. Government payments to industry to commence a business are not assessable as ordinary income of the recipient under section 6-5 of the ITAA 1997 or as a bounty or subsidy in relation to carrying on a business under section 15-10 of the ITAA 1997 in accordance with paragraph 26 of TR 2006/3.

Question 3

Summary

The Funds will not be assessable as a capital gain under section 102-5 of the ITAA 1997 as subsection 118-37(2) provides that a capital gain made as a result of receiving a reimbursement or payment of your expenses under a scheme by an Australian government agency is disregarded.

Detailed reasoning

The Funds received by the entity may or may not trigger a capital gains tax event. If a capital gains tax event was triggered on receipt of the Funds, subsection 118-37(2) provides:

A capital gain or capital loss is disregarded if you make it as a result of receiving a payment or property as reimbursement or payment of your expenses, or receiving or using a voucher or certificate, under

a. A scheme established by an Australian government agency, a local governing body or a foreign government agency under an enactment or an instrument of legislative character.

The payment by the government agency to the entity is for the reimbursement of expenses for building the asset. It is paid under a statutory scheme. Subsection 118-37(2) therefore applies to disregard any capital gain made as a result of the payment.

Question 4

Summary

The Funds will be treated as an assessable recoupment under Subdivision 20-A of ITAA 1997 as the payment of the Funds is not ordinary or statutory income under any provision, and is received as recoupment of a loss or outgoing for construction of the asset, which will be deductible under Division 40 of the ITAA 1997.

Detailed reasoning

Subsection 20-20(3) of Subdivision 20-A of the ITAA 1997 provides that an assessable recoupment is a recoupment with respect to a loss or outgoing that can be deducted for the current year, or for an earlier income year under a provision listed in section 20-30 of the ITAA 1997. The table in section 20-30 of the ITAA 1997 includes deductions for capital allowances under Division 40 of the ITAA 1997.

Subsection 20-25(1) of the ITAA 1997 states that a recoupment includes any kind of recoupment, reimbursement, refund however described and a grant in respect of the loss or outgoing.

Subsection 20-20(1) of the ITAA 1997 specifically excludes from the definition of an assessable recoupment any payment that may be treated as ordinary or statutory income.

As previously noted, the payment of the Funds is a grant in respect to a loss or outgoing, specifically the construction of the asset. This satisfies the definition of ‘recoupment' in subsection 20-25(1) of the ITAA 1997.

From the answers to questions 1, 2 and 3, it is established that the payment is not ordinary income under section 6-5 of the ITAA 1997, or statutory income under any other section. The exclusion in subsection 20-20(1) of the ITAA 1997 is therefore not applicable.

Finally, the asset is a depreciating asset. It is an income producing asset that declines in value over its life. Under subsection 40-25(1) of the ITAA 1997, the entity would be able to claim a deduction for the decline in value of the asset for its effective life. The table in section 20-30 of the ITAA 1997 includes deductions for capital allowances under Division 40 of the ITAA 1997 as an outgoing that may be recouped under Subdivision 20-A of ITAA 1997.

The requirements of subsection 20-20(3) of the ITAA 1997 are therefore satisfied. As such, the Funds will be assessable to the entity as an assessable recoupment under Subdivision 20-A.

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