Edited version of private advice

Authorisation Number: 1052276760464

Date of advice: 17 July 2024

Ruling

Subject: Black hole expenditure

Question 1

Is Company X (the Taxpayer) allowed to deduct under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997), the Costs incurred in connection with a proposed development of unoccupied premises (of which it was the lessee) into an alternative site on which to carry on its business, even though the development did not proceed?

Answer

No.

This ruling applies for the following periods:

Year ended 30/06/20YY

Year ended 30/06/20YY

The scheme commenced on:

DD/MM/20YY

Relevant facts and circumstances

The Taxpayer carries on a manufacturing business at Location A.

The major sources of income include regular sales and hospitality offerings (tours, retail and brand experience etc).

In order to expand the business to attract more customers and tourists, it was proposed that the Taxpayer move the manufacturing business to a bigger and more ideal site at Location B. Location B is unoccupied and is owned by Company B.

Company B issued an open Expression of Interest (EOI) for a lease of Location B.

The Taxpayer engaged an architectural firm to prepare a high-level design and EOI for submission to Company B.

The EOI was successful.

The Taxpayer and Company B subsequently entered into a Lease Agreement and a Development Agreement. The grant of the Lease was conditional on the terms of the Development Agreement being carried out (i.e. the Taxpayer undertook to develop Location B).

Preliminary design and planning permission stages

To facilitate the preliminary design stage architects and building consultants were engaged.

The preliminary design stage demonstrated building works could be carried out to match the Taxpayer's brand placement and install equipment to meet the Taxpayer's desired upgrade to production capacity.

A decision to proceed with design and engineering sufficient to achieve planning permission was made and a number of Architects, Surveyors and other Building consultants were engaged to proceed with the process.

The Development Application was submitted to R City Council and planning permission was granted.

Whilst the Development Application process was underway the Taxpayer engaged a number of Architects, Surveyors and other Building consultants to progress the detailed design to a point where a realistic project budget could be determined.

The detailed design was progressed to a point where a project budget could be confirmed. A review of the budget highlighted that a suitable quality development could not be achieved at Location B for an acceptable cost and the decision was taken not to proceed with the project. No physical works were ever commenced at Location B.

On DD/MM/20YY the Taxpayer and Company B entered into a Termination Deed where the parties agreed:

a.            to terminate the Development Agreement;

b.            to a surrender of the Lease on and from the Surrender Date and subject to the provisions of the Termination Deed:

o        the Taxpayer surrendered its interest in the Lease of the Location B site to Company B;

o        Company B, in consideration of the Taxpayer paying the Surrender Fee accepted the surrender from the Taxpayer; and

o        the Taxpayer was to vacate the Location B site and give it back to Company B.

The total expenditure in connection with the activities described above are referred to in this Ruling as 'the Costs'.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 40-880

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 995-1(1)

Income Tax Assessment Act 1997 subsection 40-25(7)

Income Tax Assessment Act 1997 section 40-25

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 section 110-35

Income Tax Assessment Act 1997 section 110-55

Income Tax Assessment Act 1997 section 116-30

Income Tax Assessment Act 1997 section 118-40

Reasons for decision

Question 1

Is Company X (the Taxpayer) allowed to deduct under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997) the Costs incurred in developing unoccupied premises (of which it was the lessee) into an alternative site from which to carry on its business, even though the development did not proceed?

Summary

The Taxpayer cannot deduct under section 40-880 of the ITAA 1997, the Costs incurred in developing unoccupied premises (of which it was the lessee) as the exception in in paragraph 40-880(5)(d) (capital expenditure which has sufficient and relevant connection with a lease) applies.

Detailed reasoning

Section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997) applies to certain business expenditure of a capital nature from 1 July 2005.

According to subsection 40-880(1) the object of section 40-880 is to make certain business capital expenditure deductible in equal proportions over five years if:

(a)           the expenditure is not otherwise taken into account; and

(b)           a deduction is not denied by some other provision; and

(c)           the business is, was or is proposed to be carried on for a taxable purpose.

Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues (TR 2011/6) sets out the Commissioner's views on the interpretation of the operation and scope of section 40-880.

Paragraph 23 of TR 2011/6 states that determining the amount allowable as a deduction under section 40-880 is a multi-step process:

•         first it is necessary to determine initial entitlement under subsection 40-880(2); and

•         then the limitations and exceptions in the subsequent subsections must be considered.

The relevant business

Subject to the limitations and exceptions contained in subsections 40-880(3) to (9), subsection 40-880(2) provides that you can deduct, in equal proportions over a period of five 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

In this case only paragraph 40-880(2)(a) is relevant as the Costs relate to the Taxpayer's current business.

The expenditure must be incurred on or after 1 July 2005

Tax Laws Amendment (2006 Measures No.1) Act 2006 repealed the former section 40-880 and replaced it with the current provision which applies to business related capital expenditure incurred on or after 1 July 2005.

It is considered that the Costs paid by Taxpayer in relation to the development of Location B, were incurred by the Taxpayer on or after 1 July 2005 for the purposes of section 40-880.

The expenditure must be capital in nature

The expression 'capital expenditure' is not a defined term for the purposes of section 40-880. Whether expenditure is revenue or capital in nature is a question of fact and degree that depends on the particular circumstances of the case, having regard to the principles established by the case law (paragraph 64 of TR 2011/6).

The High Court decision in Sun Newspapers Ltd. And Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 23; (1938) 1 AITR 403 (Sun Newspapers) is the leading authority on the distinction between revenue and capital expenditure. In Sun Newspapers, Dixon J stated:

"There are, I think, three matters to be considered, (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 its 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."

The character of the advantage sought by the Taxpayer in incurring the Costs was that as part and parcel of redeveloping the Location B site, it would enable the Taxpayer to generate additional income from running the business at a bigger and more ideal location. As the Taxpayer generates income not only from regular sales, but through hospitality (attracting tourists to visit the site), it is considered that this expenditure was directed to enlarging or improving the Taxpayer's profit-yielding structure. The Taxpayer would secure benefits which are long lasting or enduring in the form of increased tourists to the site. The payments made for the Costs were not recurrent expenses and were made 'once and for all' to secure future use or enjoyment. The Costs relate to the profit-yielding structure and were not incurred as part of the normal business operations or the continuous process by which the Taxpayer derives its income.

The capital expenditure must be business related

Subject to the limitations and exceptions contained in subsections 40-880(3) to (9), paragraph 40-880(2)(a) allows a taxpayer to deduct capital expenditure if it is incurred in 'relation to' a 'business' currently carried on by them.

Subsection 40-880(2) requires identification of the business in relation to which the relevant capital expenditure was incurred. The term 'business', is defined in subsection 995-1(1) as any profession, trade, employment, vocation or calling, but does not include occupation as an employee. The nature and scope of a business for the purposes of section 40-880 is a question of fact in each case (paragraph 20 of TR 2011/6).

In this case the Taxpayer is carrying on the business of manufacturing and the provision of hospitality packages at Location A. The Costs incurred by the Taxpayer are in relation to the current business which it carries on at Location A and from which it was intended to move the business to Location B once the development had been completed.

Immediate Deductions

Subsections 40-880(2A) provides an immediate deduction (as opposed to deductions in equal proportions over five years) for small businesses or entities not carrying on a business, in relation to expenditure for start-ups or proposed businesses. The Taxpayer's expenditure was in relation to an existing business not a proposed business, so there is no entitlement to an immediate deduction.

Taxable Purpose

Relevantly, subsection 40-880(3) provides:

You can only deduct the expenditure, for a *business that you carry on, used to carry on or propose to carry on, to the extent that the business is carried on for a taxable purpose.

Taxable purpose is defined in subsection 40-25(7) to include the 'purpose of producing assessable income'. The 'purpose of producing assessable income' is defined in subsection 995-1(1) as being something done:

a.            for the purposes of gaining or producing assessable income; or

b.            in carrying on a business for the purpose of gaining or producing assessable income.

Paragraph 41 of TR 2011/6 provides that:

The taxable purpose of the business is tested as at the time the expenditure is incurred. Where expenditure is incurred for an existing or proposed business, the test takes into account all known and predictable facts about the taxable purpose of the business in future years - not just in the year the expenditure is incurred or the years for which a deduction under section 40-880 is sought.

The Costs were incurred to expand the Taxpayer's income-yielding structure into the future, therefore the expenditure is being incurred for a taxable purpose, that is, the carrying on of the business to derive assessable income. Although no assessable income would have been earned from Location B during its development, the intention was to move the business there once the development was completed. As such, subsection 40-880(3) will not apply to limit the Taxpayer's deduction under section 40-880.

Business that another entity used to carry on or proposes to carry on

Subsection 40-880(4) is not relevant as the Taxpayer is not claiming deductions for a business that was carried on or proposed to be carried on by another entity for a taxable purpose.

Exceptions to allowing a deduction

Once entitlement is initially established under subsection 40-880(2) and the limitations in subsection 40-880(3) or 40-880(4) are considered, further restrictions may be placed on the amount of expenditure which is deductible under section 40-880. That is, further restrictions may apply to the amount of the Costs which are deductible under section 40-880(2). There are a further twelve possible restrictions which are contained in subsection 40-880(5), 40-880(8) and 40-880(9).

These are:

1.            Expenditure which forms part of the cost of a depreciating asset - paragraph 40-880(5)(a)

2.            Expenditure is deductible under another provision - paragraph 40-880(5)(b)

3.            Expenditure that forms part of the cost of land - paragraph 40-880(5)(c)

4.            Expenditure in relation to a lease or other legal or equitable right - paragraph 40-880(5)(d)

5.            The expenditure would otherwise be taken into account in working out a profit including in the taxpayer's assessable income, or a loss that they can deduct - paragraph 40-880(5)(e)

6.            The expenditure could be taken into account in working out the amount of a capital gain or capital loss from a CGT event - paragraph 40-880(5)(f)

7.            Another provision would make the expenditure non-deductible if it was not of a capital nature -paragraph 40-880(5)(g)

8.            Another provision expressly prevents the expenditure being taken into account as described in paragraphs 40-880(5)(a) to (f) for a reason other than the expenditure being of a capital nature - paragraph 40-880(5)(h)

9.            The expenditure is of a private or domestic nature - paragraph 40-880(5)(i)

10.            The expenditure is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income - paragraph 40-880(5)(j)

11.            The expenditure is excluded from the cost of a depreciating asset or the cost base or the reduced cost base of a CGT asset because of a market value substitution rule - subsection 40-880(8)

12.            The expenditure is a return of an amount previously received or a return on or of debt or equity - subsection 40-880(9)

Expenditure in relation to a lease or other legal or equitable right - paragraph 40-880(5)(d)

Paragraph 40-880(5)(d) provides that the taxpayer cannot deduct anything under section 40-880 for an amount of expenditure they incur to the extent that 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 the legislation.

For paragraph 40-880(5)(d) of the ITAA 1997 to apply in this case, the capital expenditure incurred by the Taxpayer on the Costs must be 'in relation' to the Lease agreement between the Taxpayer and Company B. In this regard paragraph 239 of TR 2011/6 elaborates on the application of this exception as it states:

The legislative context of section 40-880 indicates that expenditure 'in relation to a lease or other legal or equitable right' must be relevantly related to a lease or right. To be relevantly related there must be an objective connection between the expenditure and the acquisition, creation, alteration or termination of the lease or right. The context also indicates that the expenditure that relates to a lease or right is expenditure in addition to expenditure which falls within the other exceptions in subsection 40-880(5) such as paragraph 40-880(5)(a) or 40-880(5)(f). In other words, expenditure incurred by the taxpayer which has the requisite connection with a lease or right and which is not captured by another subsection 40-880(5) exception will fall within paragraph 40-880(5)(d).

Paragraph 241 to 242 of TR 2011/6 provides an example of the requisite connection between the taxpayer's expenditure and a lease for the exception in paragraph 40-880(5)(d) to apply:

X Coy proposes to start a new business to be carried on by a soon to be incorporated subsidiary. X Coy incurs legal expenditure on lease negotiations which result in a lease ultimately being granted to the now incorporated subsidiary. The companies are not part of a consolidated group.

The expenditure incurred by X Coy falls within paragraph 40-880(5)(d).

In ATO ID 2010/30 Income Tax Capital allowances: business related costs - limitation of deduction - in relation to a lease or other legal or equitable right, the taxpayer operated a retirement village. Residents paid an "ingoing contribution" when taking a lease of a unit in the village. On termination of the lease, the taxpayer paid a "capital appreciation payment", which was the difference between the terminating resident's ingoing contribution and the new resident's ingoing contribution. The ATO considered that the capital appreciation payment was paid in relation to the lease and accordingly the taxpayer could not claim a section 40-880 deduction. Moreover, although the Capital Appreciation Payment is dependent upon an increase in value of the right to reside over the term of the lease, the payment is required to be made by the taxpayer to discharge their contractual liability to the outgoing resident under the terms of the lease between the taxpayer and the outgoing resident. As such, the Capital Appreciation Payment will be 'in relation to' the lease as a sufficient and relevant connection exists.

In this case the Taxpayer's Costs would have a sufficient and relevant connection to the Lease. Some of the Costs incurred were necessary for the Lease Agreement to come into existence. The majority of the Costs were incurred as a result of the Taxpayer fulfilling its contractual obligations under the Lease and Development Agreements. The failure by the Taxpayer to fulfil its contractual obligations could result in Company B terminating the Lease.

Would the Capital Expenditure in relation to a lease or other legal or equitable right which falls under paragraph 40-880(5)(d) also fall under 40-880(5)(a), 40-880(5)(b), 40-880(5)(c), 40-880(5)(e), 40-880(5)(f), 40-880(5)(g), 40-880(5)(h), 40-880(5)(i) or 40-880(5)(j)?

TR 2011/6 makes it clear that in the context of subsection 40-880(5) capital expenditure which has sufficient and relevant connection with a lease will only be captured by paragraph 40-880(5)(d) if it is not captured by another subsection 40-880(5) exception. In particular paragraph 47 of TR 2011/6 states that the existence of paragraphs 40-880(5)(a) and 40-880(5)(f) and section 25-110 means that paragraph 40-880(5)(d) has limited application.

Paragraph 40-880(5)(a)

Under Subdivision 40-B of the ITAA 1997 a taxpayer is entitled to a deduction for the decline in value of a depreciating asset that the taxpayer held during the particular year - (see section 40-25 of the ITAA 1997). A 'depreciating asset' is defined in subsection 40-30(1) as an asset that has a limited effective life and can reasonably be expected to decline in value over time.

Certain assets are excluded from being depreciating assets for the purposes of ITAA 1997, and include land, items of trading stock and intangible assets unless they are specifically mentioned in subsection 40-30(2). The Taxpayer does not own the Location B site which consists of the land and the buildings. It only has a lease over it. While the lease rights would be an asset, as an intangible asset it would not be a depreciable asset because it does not fall under subsection 40-30(2).

Subsection 40-30(3) states that a depreciating asset can include an improvement to land, or a fixture on land, whether the improvement or fixture is removable or not, as if it were an asset separate from the land. The Taxpayer did not commence any works on the Location B site so this does not apply.

For the above reasons paragraph 40-880(5)(a) would not apply to deny the deductibility of the Preliminary Costs under section 40-880 of the ITAA 1997.

Paragraph 40-880(5)(f)

The exception in paragraph 40-880(5)(f) will apply if the capital expenditure could be taken into account in working out the amount of a capital gain or capital loss from a Capital Gains Tax (CGT) event. The enquiry is not whether the amount has been taken into account in determining the capital gain or loss, but rather, whether it could be so taken into account. This requires the consideration of whether the amount of the expenditure forms part of the cost base of a CGT asset.

A key issue is whether there is a CGT Asset. Under section 108-5 of the ITAA 1997 a 'CGT Asset' is defined to mean any kind of property, or a legal or equitable right that is not property. Examples of CGT Assets are land and buildings, shares in a company and units in a unit trust, options, debts owed to you, a right to enforce a contractual obligation and foreign currency. A Lease would be a CGT Asset as it contains rights to enforce contractual obligations. It is an intangible asset subject to CGT.

A CGT Event occurs when a lessee surrenders a lease. As outlined in paragraph 42 of Taxation Ruling TR 2005/6 Income tax: lease surrender receipts and payments (TR 2005/6) the Commissioner considers that CGT event A1 (in section 104-10 of the ITAA 1997 about the disposal of a CGT asset) happens when a lessee surrenders a lease, rather than CGT event C2 (in section 104-25 about the ownership of an asset ending by being surrendered) because CGT event A1 is the more relevant event as there is a change of ownership of the lease term from the lessee to the lessor. That is, the surrender consists of yielding up the term to the person who has the immediate estate in reversion. The lease term will then, by mutual agreement, merge in the reversion.

As set out in paragraphs 62 to 64 of TR 2005/6, while the lessee receives contractual consideration in the form of the consent of the lessor to the surrender, the lessee does not receive money or property for the purpose of the general rules about capital proceeds in section 116-20 of the ITAA 1997. As the lessee receives no capital proceeds from the CGT event, section 116-30 of the ITAA 1997 would apply. Under this section the lessee is deemed to have received the market value of the lease that is the subject of the event. The market value is worked out at the time of the event. However, where the market conditions governing rental properties are such that a lessee who is dealing at arm's length with a lessor has to make a lease surrender payment in order to obtain the consent of the lessor to the disposal of the lease, the Commissioner will accept that the market value of the lease is likely to be a negligible amount.

As outlined in paragraph 16 of TR 2005/6 a lease surrender payment made by a lessee cannot be included in the cost base or reduced cost base of the lease disposed of because it is not a cost of acquiring the lease (subsection 110-25(1), it is not an incidental cost that related to the CGT event (section 110-35), and nor does it qualify under any other element of the cost base (section 110-25).

As the Taxpayer would receive no capital proceeds from the disposal of the lease and would have to include some of the Costs in the cost base of the lease (under subsection 110-25(2) of the ITAA 1997), the Taxpayer would have made a capital loss in respect of the Costs. However, under section 118-40 of the ITAA 1997 a capital loss a lessee makes from the expiry, surrender, forfeiture or assignment of a lease (except one granted for 99 years or more) is disregarded if the lessee did not use the lease solely or mainly for the purpose of producing assessable income. The capital loss would be disregarded under section 118-40 as the Location B site was not principally used for income producing purposes during the period of the lease. Although there was a possibility that assessable income would be derived from the Location B site once the development was completed, this connection was too remote.

In summary, the Costs will not be deductible under section 40-880 as they fall under the exception in paragraph 40-880(5)(d) (capital expenditure which has sufficient and relevant connection with a lease) and the exceptions in paragraph 40-880(5)(a) (expenditure which forms part of the cost of a depreciating asset) and paragraph 40-880(5)(f) (capital expenditure that could be taken into account in working out the amount of a capital gain or capital loss from a CGT event) do not apply.

Paragraphs 40-880(5)(b), 40-880(5)(c), 40-880(5)(e), 40-880(5)(g), 40-880(5)(h), 40-880(5)(i) and 40-880(5)(j)

Based on the facts the Costs incurred by the Taxpayer would also not be captured by paragraphs 40-880(5)(b), 40-880(5)(c), 40-880(5)(e), 40-880(5)(g), 40-880(5)(h), 40-880(5)(i) and 40-880(5)(j).

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