Edited version of private advice

Authorisation Number: 5010070487744

Date of advice: 30 April 2021

Ruling

Subject: Deductibility of expenses

Question 1

Is Company B entitled to include unrecovered civil works costs to its cost for trading stock and claim a deduction as the individual lots are sold?

Answer

Yes

Question 2

Is Company B entitled to deduct preliminary expenses under section 40-880?

Answer

Yes

This ruling applies for the following period(s)

I July 20XX to 30 June 20XX

The scheme commences on

XX/XX/20XX

Relevant facts and circumstances

Company A acquired in the 20XX income year a large landholding of primary production land which was subsequently rezoned to residential use.

Company A holds the land in its capacity as trustee for a self-managed superannuation fund (the Fund).

On XX/XX/20XX, the Fund executed XX Infrastructure Deeds as landowner that required the landowner to fulfill certain civil works and cede land to Council.

If the Landowner (the Fund) intended to transfer any part of the Site before paying the Landowner Contribution stipulated in the Deed then it was obligated to ensure the transferee executed a deed for the portion of the site and deliver that to the Minister.

Company B was established to be the property developer, including assisting with the subdivision and development of the land.

The residential development is intended to be split into numerous stages, comprising approximately a thousand residential lots.

On XX/XX/20XX, Company B signed a contract for the purchase of initial stages land from the Fund for $XXXX that included GST, but not stamp duty.

A condition precedent in the sale contract required Company B to enter into the infrastructure deeds for the sale land on the same conditions as were agreed to by the Fund.

A further condition precedent in the sale contract, required the Fund and Company B to enter into a Development Agreement (DA) that was subsequently varied by a Deed of Variation. The Deed of Variation notes the DA as being executed several years earlier.

Material clauses from the DA included the following:

(a)  A condition precedent required settlement of the Developer Land Contract within two years.

(b)  Company B was to develop each of the stages as a landowner over its land and property developer over the Fund land.

(c)   The Fund was to pay Company B an Annual Development Fee.

(d)  The Fund's Land Expenditure Account was increased by Developer Fund Land Expenditure which was defined as the Development Costs incurred by Company B for the purposes of developing Fund land. Development Costs incurred on Company B land or incurred/funded by the Fund did not form part of Developer Fund Land Expenditure.

(e)  Development Costs were defined in the DA as all reasonable costs and expenses incurred to bring the land to market in accordance with the DA. These costs included development plan approval and authorisation costs, marketing and sales costs, statutory rates and taxes, the costs of engineering, construction, planning, surveying and other admin costs, stamp duty, registration fees and other taxes.

(f)    Development Works were not included as part of the Fund Land Expenditure. These works were defined in the DA as Internal Works and External Works. Internal works included building and constructing roads, stormwater systems, sewers, water supply, other essential services, landscaping and other works required by the local council. External Works were works required to be undertaken by Company B outside the residential development including road upgrading and headworks relating to stormwater, sewers, water and electricity.

(g)  Company B was liable for all Development Costs in its name. Where Company B incurred a cost that partially related to the development of Fund land and Company B land, Company B was required to determine the amount to be allocated to Development Fund Land Expenditure.

As the DA stipulated that the Fund would only pay for development costs incurred over Fund land, the Fund would not contribute to development works on Company B land that vested in the council. The Fund contributes to development works on Fund land that vests in the council.

Company B started incurring 'preliminary expenses' on XX/XX/20XX which were not recoverable from the Fund, as they were incurred prior to the finalisation of the DA.

On XX/XX/20XX, development approval was given by the council for Stages XX and overall approval to subdivide the land into a thousand lots. The development plan approvals were submitted by the Fund, but Company B incurred the costs of these submissions.

As part of council approval, Company B was required to undertake work on land that would vest in the council upon subdivision of the lots. This included building key infrastructure common to all stages, including roads, drainage, footpaths, key services infrastructure, kerbing and roundabouts.

Settlement of the initial stages land was executed by the Fund for Company B as one parcel (the Company B land).

Company B and the council took title to the allotments some months later thereby confirming Company B furnished the council with the requisite landowner infrastructure deeds.

The Fund retained the remaining land for the other stages (the Fund land). It is intended that the Fund will continue to own the Fund land until it is progressively sold off as house and land packages.

Preliminary expenses were incurred such as obtaining development approval from council, build feasibility, masterplanning, legal expenses, marketing, training, project management and various site rezoning and EPA costs. The preliminary expenses were allocated for accounting purposes to land owned by Company B and to land owned by the Fund.

Company B developed the Company B land in the first two income years and the Stage X Fund land in the later income years, in the process incurring costs in development works for common areas that vested in the council. The development work expenses were incurred during Stage X construction.

Whilst these costs were incurred on the Company B land, they were works that were considered to be beneficial to Fund land in the later stages. Whilst some of the headworks were required to be completed under the development plan with the council, the works were completed to a higher than required standard to enhance the appearance and amenity of the development. The works were also specifically designed and constructed to enhance the community feel of the estate and act as a key selling point for land sales across the development.

Whilst these costs were incurred over the three income years, the majority of these costs were incurred in the first income year.

These Company B development work expenses were allocated for accounting purposes as Costs of Goods Sold across all stages of the development based on the number of lots in each stage. Accordingly, they were allocated to Company B and the Fund on a proportionate basis.

The development work expenses were allocated to the Company B land for accounting purposes on the basis of costs incurred plus costs to complete where the works were not yet complete.

The accounting allocation methods have seen some development costs and preliminary expenses) allocated by Company B to the Fund land. These costs are not recoverable from the Fund under the DA.

For accounting purposes, the development fee to Company B is recorded as income, as it is charged and the unrecovered costs are amortised over the whole Fund development project, as each stage or lot is completed and sold.

The value of the unrecovered costs has not been deducted in any tax returns in the three income years.

As at 30 June 20XX, not all of the lots on the Company B land have been sold. The remaining stages are intended to be developed over an estimated 10-year period, subject to sales. Company B's estimated profit for each remaining stage is expected to be approximately $XX per stage.

Company B's Summary of Tax and Accounting positions report a development fee being paid to Company B in the last two income years resulting in taxable income for each income year.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 Subsection 8-1(1)

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

Income Tax Assessment Act 1997 Subsection 70-10(1)

Income Tax Assessment Act 1997 Section 70-5

Income Tax Assessment Act 1997 Section 70-15

Income Tax Assessment Act 1997 Section 70-25

Income Tax Assessment Act 1997 Section 70-35

Income Tax Assessment Act 1997 Subsection 70-35(2)

Income Tax Assessment Act 1997 Subsection 70-35(3)

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

Income Tax Assessment Act 1997 Section 40-880

Income Tax Assessment Act 1997 Subsection 40-880(2)

Income Tax Assessment Act 1997 Paragraph 40-880(2)(a)

Reasons for decision

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

Question 1

Is Company B entitled to include unrecovered civil works costs to its cost for trading stock and claim a deduction as the individual lots are sold?

Summary

Company B is entitled to include the unrecovered civil works costs in the value of your trading stock and to claim a deduction when an amount is included in Company B's assessable income when the individual lots are sold.

Detailed reasoning

Subsection 8-1(1) states:

You can deduct from your assessable income any loss or outgoing to the extent that:

(a)          it is incurred in gaining or producing your assessable income; or

(b)          it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

A deduction is not allowed under this provision if the loss or outgoing is capital or an outgoing of a capital nature.[1]

This exception is modified by section 70-25 for the costs of acquiring items of trading stock, which states:

An outgoing you incur in connection with acquiring an item of trading stock is not an outgoing of capital or of a capital nature.

Trading stock is defined in subsection 70-10(1) as including:

(a)          anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business; and

(b)          livestock.

The term 'business' is defined under subsection 995-1(1) as including:

any profession, trade, employment, vocation or calling, but does not include occupation as an employee.

Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production (TR 97/11) considers the indicators that are relevant to whether or not an entity is carrying on a business of primary production. Although TR 97/11 is targeted to primary production activities, it is accepted that these indicators are no different from the indicators to be considered to determine whether activities in any other area constitute the carrying on of a business. These indicators are set out at paragraph 13 of TR 97/11 as follows:

•         whether the activity has a significant commercial purpose or character;

•         whether the taxpayer has more than just an intention to engage in business;

•         whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity;

•         whether there is repetition and regularity of the activity;

•         whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business;

•         whether the activity is planned, organised and carried on in a businesslike manner such that it is directed at making a profit;

•         the size, scale and permanency of the activity;

•         whether the activity is better described as a hobby, a form of recreation or a sporting activity.

TR 97/11 emphasises that no one indicator is decisive and there is often a significant overlap of these indicators. The weighting to be given to each indicator may also vary from case to case. The indicators must be considered in combination and as a whole and whether a business is being carried on depends on the 'large or general impression gained'.

While the indicia set out in case law, as discussed in TR 97/11, are relevant to companies, companies are typically formed for the purpose of carrying on a business (American Leaf Blending Co Sdn Bhd v Director-General of Inland Revenue [1979] AC 676 (American Leaf) and Inland Revenue Commissioners v Westleigh Estates Co Ltd [1924] 1 KB 390 (Westleigh). In Westleigh and American Leaf, it was observed that where a company aims to make, and has a prospect of profit, it is presumed that the company intends to, and does in fact, carry on a business. In American Leaf, Diplock LJ observed that this means any gainful use to which a company puts its assets will, on its face, amount to the carrying on of a business. Unlike individuals, a company's profitable activities are unlikely to be in the nature of a hobby or be undertaken to meet a domestic need. Thus, any profit-making activities a company conducts are unlikely to have a domestic or personal character and are likely to be characterised as being commercial in nature.

Company B was was established with the intention to be the property developer for the Fund, including assisting with the subdivision and development of land.

Company B signed a contract with the Fund for the purchase of initial stages land for $XXX. A condition precedent in the land sale contract required both parties to enter into a DA. The Deed of Variation to the DA was entered into a few years later. A condition precedent in the DA required settlement of the land sale contract within two years.

A further condition precedent in the land sale contract required Company B as purchaser to enter into the infrastructure deeds that obligated the landowner to fulfil certain civil works and cede land to council.

The DA obligated Company B to:

(a)  develop each of the stages as a landowner over the Company B land and property developer over the Fund land.

(b)  apportion Development Costs defined in the DA as all reasonable costs and expenses incurred to bring the land to market in accordance with the DA. These costs included development plan approval and authorisation costs, marketing and sales costs, statutory rates and taxes, the costs of engineering, construction, planning, surveying and other admin costs, stamp duty, registration fees and other taxes between Company B and Fund land being developed by Company B.

(c)   provide Development Works defined in the DA as Internal Works and External Works. Internal works included building and constructing roads, stormwater systems, sewers, water supply, other essential services, landscaping and other works required by the local council. External Works were works required to be undertaken by Company B outside the residential development including road upgrading and headworks relating to stormwater, sewers, water and electricity.

The DA requires the Fund to pay to Company B an annual fee comprised of a monthly payment and a top up calculated on the average monthly closing balance of the Funds Land Expenditure account and reimbursement of Development Costs on Fund land.

Settlement of the initial stages land was executed by the Fund for Company B as one parcel. Until settlement occurred, the DA was not binding on either party and any prior expenditure incurred by Company B would not be in the way of obtaining a profit from those activities.

However, by settlement, Company B had established not only intent but the means to make a profit from its trading activity of property development. It fulfilled the case law indicia outlined in TR 97/11 by entering into the sale contract and DA that furnished it with the reasonable prospect of making a profit from its commercial activities of developing a large housing subdivision over a ten year period. Those activities are conducted on a regular and repetitive basis consistent with industry practice. Company B commenced earning a development fee in the 20XX income year and derived taxable income in that and the next income year.

As stated in TR 97/11, the indicators of a business being carried on must be considered in combination and as a whole, and whether a business is being carried on depends on the 'large or general impression gained'. The large and general impression gained after examining Company B's circumstances is that Company B is carrying on a business of property development.

As such, anything produced, manufactured or acquired by Company B that is held for purposes of manufacture, sale or exchange in the ordinary course of its business as a property developer will be trading stock.[2]

Under the DA, Company B was required to provide Development Works (defined in the DA as Internal Works and External Works). Internal works included building and constructing roads, stormwater systems, sewers, water supply, other essential services, landscaping and other works required by the local council. External Works were works required to be undertaken by Company B outside the residential development including road upgrading and headworks relating to stormwater, sewers, water and electricity. During three income years, Company B incurred significant costs in Development Works. Some amounts were added to the costs of developing Company B's trading stock of house and land packages on Company B land. The remaining amount was incurred on Company B land that vested in council. The DA stipulated that the Fund would only contribute to Fund land that vests in council.

FC of T v Kurts Development Limited; Kurts Development Limited v FC of T 98 ATC 4877 (Kurts Case) involved a property developer who acquired underdeveloped land and converted it into subdivided lots for the purpose of resale. As part of the process of subdivision and sale, a portion of the land acquired was required to be converted into public infrastructure, namely roads, parks, sewerage, drainage, etc. Ownership of these infrastructures eventually reverted to the Crown or relevant public authority. In addition, certain external costs were incurred on neighbouring public land and infrastructure not owned by the taxpayer, but which would assist in the provision of services to the taxpayer's subdivided lots, and otherwise for works done by local authority in relation to the subdivision.

The issue in Kurts Case was whether the costs incurred in developing the public infrastructure, including the cost of land used for that purpose, and the external costs, formed part of the cost of the subdivided lots for trading stock purposes, and therefore part of the value of the taxpayer's trading stock on hand at year end, even after the infrastructure land became separately identifiable.

The Court decided in favour of Kurts Development Ltd stating that the infrastructure land was never a separate article of trading stock in its own right. One form of trading stock, the raw land acquired, is merely converted to a different form of trading stock, the subdivided lots. Therefore, all costs incurred in creating those individual lots were held to be part of the cost price.

On the basis of Kurts Case, the development works expenses that were incurred on Company B land that vested in council as required by the infrastructure deeds, will be included as part of your trading stock pursuant to section 70-15 and is not considered to be an outgoing of a capital or of a capital nature.[3] The development works expenses have become part of the cost of trading stock consisting of the individual lots on Company B land.

The scheme of the Act in relation to trading stock is to permit a deduction under subsection 8-1(1) for expenditure incurred in acquiring trading stock, but to defer that deduction under section 70-35 until the stock is sold or otherwise disposed of.[4] This seeks to match the timing of the deduction with the derivation of assessable income from disposal of the relevant trading stock. The net tax benefit allowable in respect of trading stock for a year of income is effectively the value of opening stock on hand, plus purchases, less the value of closing stock on hand. This is achieved as follows:

(a)          expenditure incurred in acquiring stock is deductible under subsection 8-1(1)

(b)          where the value of all trading stock on hand at the end of the year exceeds the value of all trading stock on hand at the beginning of the year, the amount of the excess is included in the assessable income of the taxpayer,[5] and

(c)           where the value of all trading stock on hand at the beginning of the year exceeds the value at the end of the year, the amount of the excess is an allowable deduction.[6]

Section 70-15 tells you in which income year to deduct under subsection 8-1(1) an outgoing incurred in connection with acquiring an item of trading stock. In relation to the unrecovered costs that is included in trading stock, the costs are deducted when an amount is included in your assessable income in connection with the disposal of the individual lots owned by Company B.

Question 2

Is Company B entitled to deduct the preliminary expenses under section 40-880?

Summary

Company B is entitled to claim the preliminary expenses incurred under section 40-880 over a period of five income years.

Detailed reasoning

Section 40-880 applies to certain business related capital expenditure incurred for a taxable purpose on or after 1 July 2005, where no other provision applies to allow or deny a deduction, or otherwise takes the expenditure into account.

Subject to limitations and exceptions specified in paragraphs 40-880(3) to (9), paragraph 40-880(2) allows a taxpayer to deduct, in equal proportions over a period of five income years, capital expenditure they incur if it is in relation to their business, or in relation to a business that is used to be carried on, or is proposed to be carried on.

The expression 'capital expenditure' is not a defined term. Whether expenditure is capital or revenue in nature depends on the facts of each case. The decision of the High Court 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 that case, 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...

The character of the advantage sought provides important direction. It provides the best guidance as to the nature of the expenditure because it says the most about the essential character of the expenditure itself.

It is considered that the expenditure is characterised as establishing and enlarging the profit-yielding structure of the taxpayer's business rather than being a working expense. As pointed out in the Sun Newspapers case, expenditure incurred by a business that establishes or enlarges the profit yielding structure of the business is considered to be capital in nature.

The expression 'in relation to' is also not defined. 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) states:

69. Under paragraphs 40-880(2)(a), 40-880(2)(b) and 40-880(2)(c), the taxpayer can deduct capital expenditure they incur if it is in relation to their business, or in relation to a business that used to be carried on or is proposed to be carried on.

70. The expression 'in relation to' denotes the proximity required between the expenditure on the one hand and the former, current or proposed business on the other. Establishing that the expenditure is in relation to the relevant business is the threshold step in determining whether the expenditure can be deducted under one of these paragraphs.

71. Subsection 40-880(1) describes the object of section 40-880 to make certain business capital expenditure deductible over five years. The expression 'business capital expenditure' connotes capital expenditure that has the essential character of business expenditure. This is confirmed by paragraph 2.25 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 ('2006 Explanatory Memorandum') which notes:

The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business.

72. The use of the expression 'in relation to' in subsection 40-880(2) rather than 'in carrying on' or the preposition 'on' to qualify the closeness of the required connection indicates that Parliament intended there to be greater latitude in the connection that needs to exist.

73. In contrast, for expenditure to be deducted under the second positive limb of section 8-1, it must be incurred in carrying on a business. To satisfy this requirement, the outgoing must have the character of a working or operating expense of the entity's business or be an essential part of the cost of its business operations. In John Fairfax & Sons Pty Ltd v. FC of T (1958-9) 101 CLR 30 Menzies J stated at page 49:

...there must, if an outgoing is going to fall within its terms, be found (i) that it was necessarily incurred in carrying on a business; and (ii) that the carrying on of the business was for the purpose of gaining assessable income. The element that I think is necessary to emphasise here is that the outlay must have been incurred in the carrying on of a business, that is, it must be part of the cost of trading operations.

74. The test under the second positive limb of section 8-1 is therefore a more demanding test requiring a more immediate or direct link between the expenditure and the process of operating the business than a connection that qualifies the expenditure as being 'in relation to' a business.

75. The words 'in relation to', whilst positing a test that is not as strict as 'in carrying on' however indicate that the expenditure in question is sufficiently relevant to the business to impress on it the character of a business expense of that business.

The reference in paragraph 40-880(2)(a) to 'your business' is a reference to the taxpayer's overall business rather than a particular undertaking or enterprise within the overall business. Company B was established to be a property developer, including assisting with the subdivision and development of land. Later it entered into a contract to purchase some land from the Fund, and a DA for a proposed subdivision of the remainder land owned by the Fund into lots. Both the sale contract and the DA were signed in the same month. Prior to the signing, Company B incurred preliminary expenses that were not recoverable from the Fund, as they were incurred prior to finalisation of the DA, but were all related directly to the subdivision project. These costs included, obtaining development approval from council, build feasibility, masterplanning, legal expenses, marketing, training, project management and various site rezoning and EPA costs. Company B incurred these costs in relation to the property development business it proposed to carry on.

As the preliminary expenses were incurred before Company B entered into the DA, the expenses are considered business related capital expenditure. Therefore, under subsection 40-880(2), Company B may deduct in equal proportions over five income years the preliminary expenses, starting with the income year in which the expenses occurred.

[1] Paragraph 8-1(2)(a)

[2] Subsection 70-10(1)

[3] Section 70-25

[4] Section 70-5

[5] Subsection70-35(2)

[6] Subsection70-35(3)

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