Edited version of private advice

Authorisation Number: 1051738834502

Date of advice: 18 August 2020

Ruling

Subject: Long term construction contract

Question 1

Is entity H, as the head company of a consolidated group, entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the expenditure incurred by:

(a)  The Developer entity in fulfilling its obligations under the Development Agreement with entity A and entity B (collectively the Land Owners)? and

(b)  The Builder entity in fulfilling its obligations under the Construction Contract with the Developer?

Answer

(a)  Yes

(b)  Yes

Question 2

Will any of the sections 82KJ, 82KK and 82KL of the Income Tax Assessment Act 1936

(ITAA 1936) dealing with losses and outgoings incurred under tax avoidance schemes apply to entity H in relation to the arrangement?

Answer

No

Relevant facts and circumstances

1. Entity H is the head company of an income tax consolidated group (the Consolidated Group).
2. The Taxpayer's business focuses on owning and developing properties.

Land Owners

3.    Entity A is the legal owner of Stage 1.

4.    Entity B is the legal owner Stage 2.

5.    Stage 1 will comprise of X,XXX square metres of retail Gross Floor Area (GFA) and XX,XXX square metres of residential GFA (estimated XX units, XXX car spaces) plus the associated landscaping and roadworks. Construction works have commenced on the site and are expected to complete mid-20XE.

6.    Stage 2 will comprise of XX,XXX square metres of retail GFA and XX,XXX square metres of residential GFA (estimated XXX units and XXXX1077 car spaces) plus the associated landscaping and roadworks.

7.    The redevelopment of Stage 2 will commence after the completion of Stage 1.

8. To achieve the separation of development risk from the equity in the land, a Development Agreement was entered by the Land Owners with the Developer entity (Developer). The Developer will develop both Stage 1 and Stage 2.
9. The Developer is responsible for:

a.    Approvals for the development including all planning required by planning authorities

b.    The financing and construction of the units, apartments and common property on the Land;

c.     Registering the stratum plans and facilitating the sale of the units;

d.    All insurances required by legislation or that the builder is required by legislation; and

e.    All associated works, procedures and requirements to enable or facilitate such activities.

10. The Developer engaged the Builder entity (the Builder) to subcontract the construction of this project. Both the Developer and Builder entities are subsidiaries of entity H. The Construction Contract was entered between the Developer and Builder.
11. Members of the Consolidated Group include entity C, the Developer and the Builder, as well as other companies not involved in this transaction, which undertake activities such as owning land to be developed or carrying on property development activities.
12. Entity A and entity B are not members of the Consolidated Group.
13. Entity A and entity B have treated the transactions in the same manner for both taxation and accounting purposes, which has involved treating the interest in their respective parcels of Land as trading stock.
14. Entity H has recognised its taxable income in accordance with section 4-15 of the ITAA 1997 in respect to its long-term construction contract. That is, entity H has applied the "basic approach" (using the terminology of the Taxation Ruling TR 2018/3 Income tax: tax treatment of long term construction contracts).
15. Relevant terms of the Development Agreement and Construction Contracts have been provided.

Consolidated Group

23. Entity H is the shareholder of several other subsidiary companies which are active in property development amongst other business activities.
24. The Consolidated Group operates as a single entity for income tax purposes and lodges an income tax return to report its taxable income or losses for each financial year.

The Consolidated Group consists of several other wholly owned subsidiaries.

Builders Fee

25. Under the Construction Contract, the Developer will pay the Builder progress claims for performing construction services up to the contract value.

Development Fee

26. Under the Development Agreement, the Land Owners will pay the Developer the Development Fee in relation to performing the development services defined in the Development Agreement
27. Under the Development Agreement, the Land Owners agree to pay the Developer the Development Fee which is the sum of:

a.    Development costs (GST exclusive); plus

b.    b. X% of the development costs (GST exclusive).

28.  After the issue of the occupation certificate, the Developer will submit to the Land Owners a claim for the Development Fee.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subdivision D of Division 3 in Part III

Income Tax Assessment Act 1936 section 82KH

Income Tax Assessment Act 1936 subsection 82KH(1)

Income Tax Assessment Act 1936 subsection 82KH(1B)

Income Tax Assessment Act 1936 subsection 82KH(1F)

Income Tax Assessment Act 1936 paragraph 82KH(1F)(b)

Income Tax Assessment Act 1936 section 82KJ

Income Tax Assessment Act 1936 paragraph 82KJ(b)

Income Tax Assessment Act 1936 paragraph 82KJ(d)

Income Tax Assessment Act 1936 section 82KK

Income Tax Assessment Act 1936 subsection 82KK(1)

Income Tax Assessment Act 1936 subsection 82KK(3)

Income Tax Assessment Act 1936 section 82KL

Income Tax Assessment Act 1936 subsection 82KL(1)

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 8-1(2)

Income Tax Assessment Act 1997 section 701-1

Reasons for decision

Question 1

Summary

Entity H is entitled to a deduction under section 8-1 of the ITAA 1997 for expenditure incurred by the Developer and the Builder in the income year it is incurred.

Detailed reasoning

1. Section 8-1 of the ITAA 1997 states that you can claim a deduction for any loss or outgoing to the extent it is incurred in gaining or producing assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. A loss or outgoing is not deductible to the extent that it is: capital or of a capital nature; of a private or domestic nature; in relation to gaining or producing exempt income or non-assessable non-exempt income; or a provision of the ITAA 1997 prevents you from deducting it.

Revenue in nature

2. Broadly speaking, business expenditure is deductible as a general (revenue nature) deduction if it has the necessary and relevant connection with the operation or activities which directly gain or produce assessable income (Charles Moore & Co (WA) Pty Ltd v. Federal Commissioner of Taxation (1956) 95 CLR 344; 11 ATD 147; 6 AITR 379, Federal Commissioner of Taxation v. Smith (1981) 147 CLR 578; (1981) 11 ATR 538; (1981) 81 ATC 4114, Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).
3. Provided that a loss or outgoing can be objectively viewed as a necessary or natural consequence of the taxpayer's income earning activities, it will be 'incidental and relevant' to the income earning activities of the taxpayer and deductible as a revenue deduction under section 8-1 of the ITAA 1997, except to the extent that it is a loss or outgoing of capital or of a capital nature (see discussion of the High Court in Steele v. Deputy Commissioner of Taxation (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139).
4. The established principles on the distinction between capital and income are well known; see for example, Dixon J's judgement in Sun Newspapers Ltd & Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87 (Sun Newspapers Case), and the Full Federal Court decision in FC of T v. Email (1999) 99 ATC 4868 at 4873; 42 ATR 698 at 704). The character of the advantage sought provides important direction. The decision of the High Court in G.P. International Pipecoaters v. Federal Commissioner of Taxation (90 ATC 4413; (1990) 170 CLR 124; 21 ATR 1) emphasised this, stating:

(a)  The character of expenditure is ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure, for the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid: Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337, at 363; 1 AITR 353;...

5. The nature or character of the expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

Long term construction contracts

6. Taxation Ruling TR 2018/3 Income tax: tax treatment of long term construction contracts provides that a 'long term construction contract' refers to a contract under which construction work extends beyond one year of income and excludes a contract for the sale and supply of trading stock. In this context, the word 'construction' takes its ordinary meaning (paragraphs 2 and 3 of TR 2018/3).
7. TR 2018/3 further provides the principles and practices which apply in recognising for income tax purposes income derived from and expenses incurred in long term construction contracts. One of the acceptable methods is referred to as the "basic approach" under which all progress and final payments received or receivable during the income year are to be included in assessable income. Under this approach, expenditure is allowed as an income tax deduction (to the extent permitted by law) in the year in which it is incurred (paragraphs 5 and 7 of TR 2018/3).
8. Whichever of the acceptable methods of determining taxable income from long term construction contracts is adopted, it is to be applied consistently to all years during which the particular contract runs and to all similar contracts entered into by the entity (paragraph 6 of TR 2017/3).

Taxation of consolidated groups

9. The single entity rule under section 701-1 of the ITAA 1997 deems subsidiary members of a tax consolidated group to be parts of the head company of the tax consolidated group rather than separate entities.
10. As a consequence:

(a)  Expenditure incurred by a subsidiary member of a tax consolidated group becomes an allowable deduction of the head company;

(b)  Income derived by a subsidiary member of a tax consolidated group is assessable income of the head company; and

(c)   Intra-group transactions are ignored for consolidated taxation purposes.

Application of the law to the circumstances

Developer's Expenditure

11. The Developer's core business relates to the management of the long term construction project.
12. The principal business activities carried on by the Developer include carrying on a business of property development and providing services to the Land Owners pursuant to the Development Agreement.
13. The most significant loss or outgoing incurred by the Developer in carrying out the Development Agreement with the Land Owners are the payments to the Builder in respect of the construction of the buildings.
14. The advantage sought (and gained) by the Developer in entering into the Development Agreement is to earn a margin provided for in the Development Fee which is assessable as ordinary income.
15. In order to earn their Development Fee, the Developer is required to undertake certain activities including: obtaining development finance; securing relevant development approvals; engaging professionals to undertake the Development; marketing and selling the units and registering the strata and stratum plans. The liability the Developer discharges by making the expenditure they incur in providing services in accordance with the terms of the Development Agreement and in the course of carrying on business, is the obligation to ensure construction of the buildings as required.
16. The services provided by the Developer do not create an enduring benefit to the capital or profit-making structure of the Developer's business. The development costs incurred by the Developer in providing the services under the Development Agreement are therefore not a loss or outgoing of a capital nature, nor will they fall within any of the other negative limbs in subsection 8-1(2) of the ITAA 1997.

1. The Developer, upon discharging their respective liability and paying the development costs, has instead incurred a loss or outgoing that is deductible under section 8-1 of the ITAA 1997.

Builder's Expenditure

17. The Builder's core business relates to the delivery of the Construction Contract., The principal business activities carried on by the Builder include but are not limited to:

(a)  Procurement of building materials and subcontractors;

(b)  Engagement with consultants;

(c)   Management of the design process;

(d)  Co-ordination of the disciplines and elements of the design;

(e)  Comply with workplace health and safety regulations;

(f)    Supply all necessary property plant and equipment; and

(g)  Hold compliant licenses, registrations and insurances.

18. The construction expenses incurred by the Builder are amounts that are incurred in undertaking the above business activities in accordance with the Construction Contract. The Builder will pay the construction expenses in the course of carrying on the business of operating and building the project.
19. Further, there was no asset created or acquired, and no long-term enduring benefit to the capital or profit-making structure of the Builder's business. Like the Developer, the benefit gained is the margin gained from the building of the project and not an enlargement of the framework from which the Builder carries on its Business to earn service payments.
20. Therefore, the construction and other costs incurred by the Builder are revenue in nature and deductible under section 8-1 of the ITAA 1997 and are not considered to be a loss or outgoing of a capital nature. These expenses will not fall within any of the negative limbs in subsection 8-1(2) of the ITAA 1997.

Single Entity Rule

21. As the head company of the Consolidated Group, the single entity rule will apply to the entity H.
22. Taxation Determination TD 2005/3 Income tax: consolidation: will a choice to consolidate under Part 3-90 of the Income Tax Assessment Act 1997 affect the method of income recognition of the consolidated group? considers the method of income recognition of a consolidated group undertaking a range of business activities and provides, at paragraph 4:

(a)  The head company of a consolidated group may conduct a range of business activities. Like any other taxpayer, the head company must apply the method of income recognition for each business activity that gives a 'substantially correct reflex of the taxpayer's true income' (CT (S.A.) v. Executor Trustee and Agency Co of South Australia Limited (1938) 63 CLR 108); see Taxation Ruling TR 98/1.

The Developer and the Builder are the Taxpayer's subsidiaries and are part of the Consolidated Group (as subsidiary members).

23. Pursuant to the operation of section 701-1 of the ITAA 1997, the development costs incurred by the Developer and the construction costs incurred by the Builder are an allowable deduction of entity H, as the head company of the Consolidated Group (and not the Developer and Builder respectively).
24. The Agreement is in respect of a long term construction contract (as defined in TR 2018/3). As such, the Developer and Builder (and in turn entity H) may elect an acceptable method to account for the Development under the Development Agreement for income tax purposes.
25. Having elected the basic approach, the development and construction costs incurred by the Developer and Builder during the Development are allowed as an income tax deduction to entity H under section 8-1 of the ITAA 1997 in the income year in which they are incurred.

Question 2

Summary

No, it is not considered that any of sections 82KJ, 82KK and 82KL of the ITAA 1936 dealing with losses and outgoings incurred under tax avoidance schemes apply to entity H in relation to the arrangement.

Detailed reasoning

26. Subdivision D of Division 3 of Part III of the ITAA 1936 was enacted to counter various tax avoidance schemes which involve the effective recoupment of expenditure so that the loss or outgoing is not really suffered.

Section 82KJ of the ITAA 1936

27. Section 82KJ of the ITAA 1936 denies a deduction under certain tax avoidance schemes involving (but is not limited to) prepayments, where a taxpayer incurs interest or other expenses with the aim of reducing the amount payable for the acquisition of property by the taxpayer or an associate. The provision reads:

SECTION 82KJ DEDUCTION NOT ALLOWABLE IN RESPECT OF CERTAIN PRE-PAID OUTGOINGS

Where:

(b)  a loss or outgoing in respect of which a deduction would, but for this Subdivision, be allowable, was incurred by a taxpayer after 19 April 1978 by reason of, as a result of or as part ofa tax avoidance agreement;

(c)   having regard to the benefit in respect of which the loss or outgoing was incurred (but without regard to any benefit relating to the acquisition or possible acquisition of the property referred to in paragraph (c)), the amount of the loss or outgoing was greater than the amount (if any) that might reasonably be expected to have been incurred, at the time when the loss or outgoing was incurred, in respect of that benefit if the loss or outgoing had not been incurred by reason of, as a result of or as part of a tax avoidance agreement;

(d)  property has been, will be, or may reasonably be expected to be, acquired by the taxpayer or by an associate of the taxpayer as a result of, by reason of, or as part of the tax avoidance agreement; and

(e)  the consideration (if any) that was payable in respect of the acquisition of that property was less, or the consideration that may reasonably be expected to be payable in respect of the acquisition of that property is less, than the consideration that might reasonably be expected to have been payable, or to be payable, as the case may be, in respect of the acquisition of that property if the loss or outgoing had not been incurred,

(f)    notwithstanding any other provision of this Act, a deduction is not allowable to the taxpayer in respect of the loss or outgoing

28. The types of schemes against which section 82KJ of the ITAA 1936 is to apply is noted in the Explanatory Memorandum to Income Tax Assessment Amendment Bill (No. 5) 1978 as follows:

(a)  'One category of schemes in relation to which the proposed amendments are to apply involves the pre-payment of an otherwise deductible expense, the effect of which is to reduce the consideration payable in respect of the acquisition of property that is, as part of the tax avoidance arrangement, to be acquired by the taxpayer or an associate.

(b)  Under one such scheme, the taxpayer borrows (say) $1,000, ostensibly for income producing purposes, and promptly makes a payment of $700 which represents a pre-payment of interest at 14% for 5 years. Upon payment of that interest, the taxpayer or an associate is entitled to acquire the lender's rights under the loan agreement. Because the terms of the loan provide for a reduced interest rate of 4% to apply after the pre-payment of 5 years' interest, the loan has a reduced value and can be acquired for $370.

(c)   The effects of the arrangement are such that the taxpayer claims a deduction for $700 in respect of a net outlay of $70 (ie, $1,070 in respect of interest and the acquisition of the rights under the loan less the $1,000 loan). The lender, on the other hand, will have received $700 interest but will seek, as a money lender, to offset against this interest income the loss sustained in selling for $370 the rights in the $1,000 loan.

(d)  A second scheme involves the pre-payment of rent under arrangements whereby property valued at (say) $1m that the taxpayer wishes to acquire is purchased by an exempt institution for that amount with funds provided by the promoter of the scheme. The taxpayer leases the property from the exempt institution under arrangements that provide that, on payment of $800,000 rent in advance, the property can be acquired by an associate of the taxpayer for $250,000.

(e)  The exempt institution thus receives $1,050,000 from which it repays the loan to the promoter together with a fee in the form of interest and is left with a small return for its services. Because of its exempt status, the institution is not subject to tax on the $800,000 rent received. On the other hand, for an outlay of an additional $50,000, the taxpayer, who normally would not be entitled to any income tax deduction at all in respect of the purchase of the building, claims a deduction for the $800,000 rent paid.''

Application of the law to the circumstances

29. Section 82KJ of the ITAA 1936 will not apply to deny deductions claimed by the Taxpayer under section 8-1 of the ITAA 1997 for expenditure (i.e. development costs and construction costs) incurred by the Developer and Builder under the terms of both the Development Agreement and Construction Contract as:

·                     for the purposes of paragraph 82KJ(b) of the ITAA 1936, the amount of the Costs incurred by the Developer and Builder is not considered to be greater than the amount that might reasonably be expected to have been incurred if the costs had not been incurred by reason of, as a result of or as part of the respective Agreements; and

·                     for the purposes of paragraph 82KJ(d) of the ITAA 1936, the consideration payable in respect of the acquisition of the relevant 'property' acquired is not less than that which is payable if the costs had not been incurred.

Section 82KK of the ITAA 1936

30. Section 82KK of the ITAA 1936 relates to certain schemes between associated parties and designed to secure a deduction for one party in respect of an amount which in whole or in part is not assessable to the other party until a later year or years of income. The provision reads:

SECTION 82KK SCHEMES DESIGNED TO POSTPONE TAX LIABILITY

82KK(1) [Application]

This section applies to a loss or outgoing incurred by a taxpayer if:

(a)  the loss or outgoing was incurred after 19 April 1978 and was incurred to an associate of the taxpayer;

(b)  a deduction is allowable to the taxpayer in respect of that loss or outgoing; and

(c)   the deduction allowable in respect of that loss or outgoing would, but for this section, be allowable to the taxpayer in the year of income in which the loss or outgoing was incurred and:

                                            (i)        in a case where the loss or outgoing is in respect of interest that, if it had actually been paid, would be subject to withholding tax under Division 11A - the withholding tax payable in respect of the whole or a part of the interest is not payable until a time occurring in a subsequent year of income; and

                                           (ii)        in any other case - the whole or a part of the amount incurred to the associate will not be included in the assessable income of the associate until a subsequent year of income.

31. In respect of schemes involving a payment in advance for goods or services that are to be provided by the associate in a future year or future years of income, subsection 82KK(3) of the ITAA 1936 specifically notes:

82KK(3) [Where goods or services provided]

Notwithstanding any other provision of this Act but subject to subsection (4), where:

(a)  a taxpayer incurs in a year of income a loss or outgoing in respect of the supply of goods or the provision of services at a time that occurs after, or during a period that occurs after or extends beyond, the end of the year of income and the loss or outgoing is a loss or outgoing to which this section applies; and

(b)  the loss or outgoing was incurred by reason of, as a result of or as part of an agreement that was entered into or carried out for the purpose, or for purposes that included the purpose, of securing that:

                                            (i)        a deduction would be allowable to the taxpayer in a year of income in respect of the loss or outgoing; and

                                           (ii)        the whole or a part of the amount of the loss or outgoing would not be included in the assessable income of the person to whom the loss or outgoing was incurred until a subsequent year of income,

that loss or outgoing shall, for the purposes of this Act, be deemed to have been incurred by the taxpayer in the year of income in which, or in the years of income in which, goods to which the loss or outgoing relates are supplied or services to which the loss or outgoing relates are provided.

32. In a case where the loss or outgoing is incurred in respect of the future provision of goods or services, a deduction will therefore be allowable in a year of income to the extent only that the loss or outgoing relates to goods or services that were actually provided in that year of income.

Application of the law to the circumstances

33. The parties involved in both the Development Agreement and Construction Contract are 'associates' as per the definition of that term in subsection 82KH(1) of the ITAA 1936.
34. The associate transactions relating to the Development consist of:

(a)  Transactions between the Land Owner within the Consolidated Group and the Developer. These transactions are ignored for taxation purposes in accordance with the single entity rule;

(b)  Transactions between the Land Owners outside of the Consolidated Group and the Developer. Those Land Owners will incur a loss or outgoing in respect of their share of the Development Fee in the same year in which their share of the Development Fee is assessable income of entity H (as per the basic approach); and

(c)   The transactions between the Developer and the Builder within the consolidated group. These are ignored for taxation purposes under the single entity rule.

35. Section 82KK of the ITAA 1997 will not apply as there is no additional benefit by way of recoupment of expenses by the Taxpayer. The development and construction expenses are incurred by the Developer and the Builder and these expenses are not reimbursed nor is any compensatory benefit received by the Developer and the Builder. The Developer and the Builder simply receive a deduction for the development and construction expenses at the time the expenses are incurred.
36. Therefore, section 82KK of the ITAA 1936 will not apply to postpone the availability of any allowable deductions as there is a no timing mismatch in payments betweenassociates outside of the Consolidated Group such that income is recognised in a later year than the matching deduction.

Section 82KL of the ITAA 1936

37. Section 82KL of the ITAA 1936 is a specific anti-avoidance provision that operates to deny allowable deductions for certain expenditure incurred, but effectively recouped, by the taxpayer.
38. Under subsection 82KL(1) of the ITAA 1936 a deduction for 'eligible relevant expenditure' (as defined in subsection 82KH(1F) of the ITAA 1936) is disallowed where the sum of the 'additional benefit' and the 'expected tax saving' in relation to that expenditure equals or exceeds the eligible relevant expenditure. The provision reads:

SECTION 82KL TAX BENEFIT NOT ALLOWABLE IN RESPECT OF CERYIAN RECOUPED EXPENDITURE

82KL(1)

Where the sum of the amount or value of the additional benefit in relation to an amount of eligible relevant expenditure incurred by a taxpayer and the expected tax saving in relation to that amount of eligible relevant expenditure is equal to or greater than the amount of the eligible relevant expenditure, notwithstanding any other provision of this Act but subject to this section, a tax benefit is not and shall be deemed never to have been, allowable in respect of any part of that amount of eligible relevant expenditure.

39. Broadly, the additional benefit (as defined in subsection 82KH(1) and paragraph 82KH(1F)(b) of the ITAA 1936) is a benefit obtained by the taxpayer in addition to the benefit in respect of which the eligible relevant expenditure is incurred.
40. The expected tax saving (as defined in subsections 82KH(1) and 82KH(1B) of the ITAA 1936) in relation to an amount of eligible relevant expenditure incurred by a taxpayer is essentially the tax saved if a deduction is allowed for the relevant expenditure.
41. Section 82KL of the ITAA 1936 applies effectively where the taxpayer receives a compensatory benefit which when taken together with the tax benefit result in no real deduction or outgoing being incurred by the taxpayer.

Application of the law to the circumstances

42. The development costs incurred by the Developer and the construction costs incurred by the Builder, are not reimbursed, nor is any compensatory benefit received by the Developer, the Builder or entity H, in respect of the development costs and construction costs. Section 82KL of the ITAA 1936 will therefore not apply to deny deductions claimed by entity H under section 8-1 of the ITAA 1997 for development costs and construction costs incurred by the Developer and Builder respectively, under the terms of the Development Agreement and Construction Contract as there is no additional benefit by way of recoupment of expenses by entity H (or the Developer and Builder).

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