Draft Taxation Ruling

TR 97/D18

Income tax: Steele's case

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draft only - for comment

What this Ruling is about

Class of person/arrangement

1. This Ruling considers the implications of the decision of the Full Federal Court in Steele v. FC of T 97 ATC 4239; (1997) 35 ATR 285. The case concerns, amongst other things, the deductibility of interest on money borrowed to purchase land intended to be developed. It should be noted, however, that the taxpayer has sought special leave to appeal to the High Court of Australia. Accordingly, further developments in this area of the law may ensue.

2. Although the case deals with the issue in terms of subsection 51(1) of the Income Tax Assessment Act 1936 ('the Act'), the decision in the case and the discussion in this Ruling have equal application to section 8-1 of the Income Tax Assessment Act 1997. All references to subsection 51(1) should therefore be taken as including a reference to section 8-1.

Ruling

3. The general rule about interest deductibility was stated by the High Court in Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613 and discussed by the Full Federal Court in FC of T v. Roberts and Smith 92 ATC 4380; (1992) 23 ATR 494. In Fletcher the High Court said (at ATC 4958; ATR 623):

'To the extent that the outgoings of interest incurred in the borrowing can properly be characterised as of a kind referred to in the first limb of s. 51(1), they must draw their character from the use of the borrowed funds.' (emphasis added)

4. In Roberts and Smith it was said (at ATC 4388; ATR 504) that the character of the interest 'will generally be ascertained by reference to the objective circumstances of the use to which the borrowed funds are put.'

5. Regard must be had to the use of the borrowed funds because the direct object or advantage of incurring the interest, or the effect of making the payment, is to secure an amount of capital: Ure v. FC of T 81 ATC 4100; (1981) 11 ATR 484. Interest only becomes a tax deduction if the principal amount secured is itself employed to produce income. For example, in Farmer v. Scottish North American Trust Limited [1912] AC 118 interest paid on money borrowed by an investment company for the purposes of investments from which it earned its profits was held to be deductible. The Court said that the interest must be (at AC 127):

' ... an outgoing by means of which the company procures the use of the thing by which it makes a profit ...'

6. In Australian National Hotels Limited v. FC of T 88 ATC 4627; (1988) 19 ATR 1575 Bowen CJ and Burchett J said (at ATC 4633; ATR 1582):

' ... there is a special feature of loan capital, which flows from the ephemeral nature of a loan. The cost of securing and retaining the use of the capital sum for the business, that is to say, the interest payable in respect of the loan, will be a revenue item. It creates no enduring advantage, but on the contrary is a periodic outgoing related to the continuance of the use by the business of the borrowed capital during the term of the loan. ...

Rent ... and interest are both periodic payments for the use, but not the permanent acquisition, of a capital item. Therefore, a consideration of the often-cited three matters identified by Dixon J in Sun Newspapers Limited v. F.C. of T. (1938) 61 CLR 337 at p. 363 assigns interest and rent to revenue.'

7. However, in Steele, the majority (Burchett and Ryan JJ) said that in The Texas Company (Australasia) Limited v. FC of T (1940) 63 CLR 382, when Dixon J discussed the way the Australian system treats interest on money borrowed to secure capital, he was speaking in the context of current income-gaining activities. They said he regarded interest payments as part of 'the recurrent expenditure which must be incurred to obtain the use of the money'. In Steele, they said that interest paid in relation to the acquisition or creation of a capital asset, which is later to be utilised in income-gaining activities, is paid so that, when the time comes, an enduring asset will be available for use in the intended activity.

8. The implication is that in such circumstances, the interest is a capital expense or is of a capital nature. The fact that, while the capital asset is being created, the payments of interest are recurrent, is not enough to change this conclusion. In the circumstances where those payments 'are not part of the recurrent operations of any existing business activity' (at ATC 4248; ATR 295) they do not satisfy the terms of subsection 51(1). The Court has decided that the interest is a capital, not a revenue, expense at the time it is incurred.

9. Accordingly, in a case where the relevant business or other income-producing activity is yet to be commenced, interest payments on money borrowed for the construction or acquisition of an asset to be used later in that business or other income-producing activity are not deductible until those activities actually commence.

10. Issues of some significance arise as a result of the decision in Steele. We have previously taken the view that, as a general proposition, interest is an expense that would be characterised for taxation purposes as inherently revenue in nature rather than capital in nature. See, for example, the discussion in The Texas Company and in Australian National Hotels. The question for subsection 51(1) purposes became simply whether the expense was incurred in gaining or producing the assessable income or was necessarily incurred in carrying on a business for that purpose. That is, the ability to gain a deduction turned on the question of whether the positive tests in subsection 51(1) were satisfied. In practice, the issue of whether interest could be a capital expense did not arise.

11. It was for this reason, no doubt, that the amendments in 1991 to section 160ZH of the Act, enabling non-deductible interest to enter the calculation of the cost base and indexed cost base of an asset for capital gains tax purposes, were enacted in the manner they were.

12. It has been said that the majority found for Mrs Steele under the first limb of the positive test in subsection 51(1). While we believe the decision in Steele does not involve a finding that the interest expense satisfied the first limb of the subsection, it is a truism that expenditure can satisfy the positive tests of subsection 51(1) and yet still not be deductible because it is capital expenditure or capital in nature (see John Fairfax & Sons Pty Ltd v. FC of T (1959) 101 CLR 30). Because it was found that the interest was, in the circumstances, capital expenditure, the question arises whether interest that satisfies the positive tests in the subsection can nonetheless not be an allowable deduction because it is capital or has a capital nature.

13. In view of the intrinsic qualities of interest (see Australian National Hotels), we think it cannot fall within the very wide class of expenditure that is at the same time a loss or outgoing incurred in gaining assessable income and capital in nature. For those taxpayers whose income earning activities have commenced, interest is deductible if it satisfies the positive tests in the subsection. At this stage, until the litigation in Steele is finalised and we know the final position on the point, we will not adopt the position that the interest expenditure may be nonetheless not deductible when it satisfies the positive tests, on the basis that it is an affair of capital.

14. If non-deductible interest is capital expenditure, it cannot form part of the cost base of an asset for the purposes of the capital gains and capital losses provisions of the Act. However, as the relevant provisions in section 160ZH are based on the notion that interest is an inherently non-capital expense, non-deductible interest may still be included in the cost base of the asset until the issues in Steele are finally decided.

15. Non-deductible interest on a loan used to acquire an item of plant does not form part of the cost of that item for depreciation purposes. Nor, for example, does interest expenditure qualify for the building allowance under Division 10D of the Act.

Date of Effect

16. This Ruling applies to years commencing both before and after its date of issue. However, the Ruling does not apply to taxpayers to the extent that it conflicts with the terms of a settlement of a dispute agreed to before the date of issue of the Ruling (see paragraphs 21 and 22 of Taxation Ruling TR 92/20).

17. Taxation Rulings IT 166, IT 2374 and IT 2461 were withdrawn as from 2 July 1997 (see paragraph 113 below). Accordingly, this Ruling does not affect the deductibility of interest and other holding costs in respect of assets acquired, or which were commenced to be constructed, before 2 July 1997 within the circumstances described in Taxation Rulings IT 166, IT 2374 or IT 2461 and where the loan on which the interest was incurred was entered into before that date.

18. However, because of the potential impact of the withdrawal of these Rulings in cases where construction had commenced before 2 July 1997 but the proposed debt funding arrangements in relation to the construction were not formally entered into by that date, interest may, depending on the circumstances of the case, still be allowed as a deduction. Each case is to be considered having regard to all the surrounding circumstances of the relevant project. As a minimum requirement, this Ruling applies to interest on loans entered into after 2 July 1997 in respect of projects where construction commenced before that date if it cannot be said that the borrowing transactions were in reasonable contemplation before that date as part of the envisaged funding arrangements. This Ruling also applies to interest on borrowings which relate to the extension of a project that was originally commenced before 2 July 1997.

Explanations

Steele's case: the facts

19. In December 1980 Mrs Steele purchased 7.4 hectares of land with the intention of developing the land. Over the ensuing three-year period the taxpayer submitted to the local council a number of proposals for development that included erecting a motel-style complex, a restaurant and townhouse-type units either self-contained or serviced from the motel administration area. Discussions with other local authorities occurred with a view to obtaining the necessary planning approvals. At the time the land was acquired a horse training and agistment business was being conducted on the property. During the period in which she owned the property Mrs Steele continued to agist horses.

20. About a year after she acquired the property, Mrs Steele sold a half-share of the property to a building contractor so they could jointly develop the property. She also had a number of unsuccessful negotiations with other potential participants in the project.

21. Early in 1984 and prior to obtaining formal approval to commence construction, Mrs Steele and her partner in the project fell out over the direction the project was taking. No further development activity was undertaken and she eventually took over the property by re-purchasing it at auction from her joint venturer in December 1986. She later sold the property in two parcels without having carried out any development or improvements. No formal plans for the development were ever approved by the local council.

22. During the period the property was held (1980 to 1987), Mrs Steele received income from agistment which she returned as assessable income. The amounts received were small in comparison with the costs incurred in holding the land during that period. The total loss suffered and claimed was $909,649. A very large part of this was interest on the loan to acquire the property.

23. The Commissioner disallowed the losses claimed and the objection to that decision was also disallowed. The decision to disallow the taxpayer's objection was referred to the Administrative Appeals Tribunal ('the AAT').

AAT

24. There were two hearings at the AAT. In its first decision the Tribunal found the property was acquired with two purposes in mind. The dominant purpose of the acquisition was 'to erect a motel upon the site' and the agistment activities were subsidiary to that main purpose. Accordingly, the issue became one of apportionment with the amount referable to the dominant purpose of erecting a motel not being an allowable deduction under subsection 51(1) of the Act. The matter was remitted to the Commissioner for reconsideration on that basis, with liberty to apply to the Tribunal on questions of quantum.

25. The second AAT decision resulted from the taxpayer going back to the Tribunal to tender new evidence about her income and expenses relevant to the agistment activity for the years ended 30 June 1981 to 30 June 1987. The decision following the second hearing did not disturb the earlier finding that the property was acquired for a dual purpose - development and agistment. However, the agistment activities were said to amount to the carrying on of a business from which assessable income was derived. Notwithstanding this added dimension, the Tribunal still concluded that the main purpose of developing the property was an activity that could not in itself amount to a present purpose of gaining assessable income. 'There were too many contingencies to say with any certainty that income would ever be derived from the dominant purpose': see Steele v. FC of T 96 ATC 4131; (1996) 31 ATR 510.

The Federal Court

26. The taxpayer appealed to the Federal Court from the decision of the AAT. Nicholson J indicated that, in his view, there were two main grounds of appeal. The taxpayer argued that the Tribunal was wrong in law to distinguish Mrs Steele's situation from the decision in Travelodge Papua New Guinea Ltd v. Chief Collector of Taxes 85 ATC 4432; (1985) 16 ATR 867.

27. Secondly, the taxpayer disputed the finding of the Tribunal that apportionment was appropriate. The outgoings claimed by Mrs Steele were properly deductible because they were necessarily incurred in deriving her assessable agistment income. That is:

' ... if a taxpayer purchases property which yields assessable income and the cost of deriving that assessable income is principally interest paid on borrowings, then the interest is deductible even though it may exceed the income from the property unless it can be shown that there is another use to which the property is put apart from the derivation of assessable income. It is not enough to support apportionment, so the submission runs, that the taxpayer had a possible redevelopment in mind at the time of purchase of the property.' (at ATC 4139; ATR 519)

28. In relation to the Travelodge decision, Nicholson J indicated that the Tribunal was not in error in distinguishing that case. In essence, the matter was whether there was a sufficient connection between outgoings incurred and the earning of assessable income. In Travelodge the Court found there was that requisite connection which enabled the outgoings to be deductible. Here, Nicholson J decided that the evidence relied upon by the Tribunal fully entitled it to conclude there was an insufficient connection between the outgoings and the derivation of income as a result of any development that may have occurred. In particular, Nicholson J pointed to evidence that: existing zoning was inappropriate; only informal and preliminary inquiries had been made about zoning, road closure and sewerage connection; the particulars of the project were varied a number of times; other equity participant negotiations stalled; no final development plans were ever settled; development finance was never obtained; and the land was ultimately sold.

29. In relation to the apportionment question, Nicholson J held that the Tribunal appropriately decided that apportionment of the outgoings was required. In particular, he pointed to the Tribunal's conclusions that:

*

the property was mainly held for the purpose of redevelopment but also for the purpose of derivation of agistment income;

*

this was a finding of two present purposes;

*

the determination of the deductibility of interest required a further inquiry about the use of the funds; and

*

accordingly, because there was a dual objective in acquiring the property [one revenue - the derivation of assessable income from agistment activities; one capital - the development of a profit-yielding structure for a future business enterprise] apportionment was required.

The Full Federal Court

30. Mrs Steele appealed from the decision of Nicholson J to the Full Federal Court. By majority (Burchett and Ryan JJ, Carr J dissenting) the Full Federal Court disallowed the appeal.

31. Two broad arguments were raised in the appeal, each being referenced to the question of interest deductibility.

32. Mrs Steele's first argument was that the interest was deductible as an expense of earning the income constituted by the agistment fees. Her second argument was that the interest was deductible having regard to what was said to be the principle in Travelodge on the basis that Mrs Steele, when she bought the property, embarked on a business of constructing and operating for profit a development in the nature of a motel.

Burchett and Ryan JJ

33. Their Honours said that the question raised by the taxpayer's purpose of erection of a motel or similar complex, to be operated by the taxpayer so as to earn assessable income, is whether that purpose is sufficient to make payments of interest in respect of the borrowed purchase moneys deductible on revenue account under subsection 51(1).

34. Their Honours then looked at the Tribunal's responses to this question. Essentially, there were two responses. They indicated that the Tribunal had decided:

' ... that [Mrs Steele's] object was "to develop a profit-yielding structure of a future business enterprise - an affair of capital".' (at ATC 4243; ATR 289)

35. Secondly, they said (ibid.) that the Tribunal appeared to put forward an independent ground of its decision - that:

' "[t]here were too many contingencies to say with any certainty that income would ever be derived", and that Mrs Steele's aim "was never more than an idea or hope - plans were never finalised nor finance ever secured." '

36. In response to this 'independent ground' for decision they said (at ATC 4243; ATR 289):

'If the Deputy Commissioner's case depended upon these further propositions, we would find it difficult to accept.'

37. Their Honours firstly indicated that there did not have to be any 'certainty' that an endeavour 'will be crowned with success' in order for an expense to be deductible: see ATC 4243; ATR 289.

38. Their response to the second part of the 'independent ground' was an observation that the Tribunal seemed to be invoking:

' ... the proposition that a sufficient connection, for the purposes of s. 51(1), between an outlay and the prospect of income requires a degree of commitment to the relevant income producing activity.' (at ATC 4243; ATR 290)

39. Their Honours said that it was not open to the Tribunal to find a relevant lack of commitment. In their Honour's view, Mrs Steele had indeed done many things that demonstrated a commitment to an income producing venture.

40. Approval for zoning changes; employment of architects and engineers; entering into joint venture arrangements; the commitment of $1,000,000 to the venture as well as substantial time, energy and expense in relation to the project, led to the view that it was not open to the Tribunal to find a lack of commitment to the relevant income producing activity (see ATC at 4243; ATR at 290).

41. It has been suggested that this aspect of the judgment indicates their Honours were explicitly accepting that because you do not need certainty there will be income produced from a particular activity and Mrs Steele had a commitment to the development project, the expenditure in question satisfied at least the first limb of subsection 51(1).

42. We do not think it follows from this aspect of their decision that their Honours so decided. While we do, with respect, appreciate the import of their Honour's comments in relation to 'certainty', it is less clear as to the role of 'commitment' in the operation of subsection 51(1). In particular, notwithstanding that Mrs Steele may have been committed to the project from which she hoped to earn income in the future, it is not apparent that their Honours actually decided that Mrs Steele did in fact incur the interest expense within the parameters of the first limb of subsection 51(1) because she was committed to the development.

43. Indeed, because of the language used in other parts of the judgment, we think the better view is that their Honours made no particular finding in relation to the first limb because, as will be seen, they considered the interest expense was, in the circumstances, an outgoing on capital account. At ATC 4243; ATR 290, their Honours said:

'However, if the Tribunal was right to treat the object of the payment of the interest as the development of a profit-yielding structure for a future business enterprise, and thus as an affair of capital, that ground alone will sustain the decision ...'. (emphasis added)

Capital expenditure

44. Notwithstanding the position actually adopted by their Honours in relation to the positive test under subsection 51(1), the ratio decidendi of their decision was that the major part of the interest was an expense of capital.

45. Their Honours said (at ATC 4247; ATR 294):

'When Dixon J, in the often cited passage in The Texas Company ... spoke of the way the Australian system treats interest on money borrowed to secure capital, he was speaking in the context of current income-gaining activities. He regarded interest payments as part of "the recurrent expenditure which must be incurred to obtain the use of the money", and as like other regular outgoings of the business incurred to obtain the use of capital assets, such as rent or hire ... . But interest paid in relation to the acquisition or creation of a capital asset, which is later to be utilized in income-gaining activities, is in an entirely different position. It is paid so that, when the time comes, an enduring asset (in this case, a motel complex) will be available for use in the intended activity. The fact that, while the capital asset is being created, the payments of interest are recurrent is not enough to change this conclusion. Those payments are not part of the recurrent operations of any existing business activity.'

46. Their Honours found that the expenditure was made for a capital purpose. That is, the chief factor in determining the character of a payment is the character of the advantage sought by the making of the expenditure. In this case, the advantage sought by the payment of the interest was the creation of a capital asset: see ATC 4239; ATR 295.

47. The Court illustrated its point, that the recurrence of the interest expense is not enough to change its nature from capital to revenue, by referring to wages paid for a period in the course of business operations by which income is earned when the wage earner is engaged in work directed to the creation of a capital asset. The Court said the wages would clearly be on capital account, recurrence notwithstanding, and the question was whether the expenditure has the essential character of a working expense. They cited Goodman Fielder Wattie v. FC of T 91 ATC 4438; (1991) 22 ATR 26 as authority for that proposition.

Apportionment

48. In both the AAT and the Federal Court at first instance, the taxpayer's agistment activities were said to be a subsidiary purpose only of the borrowing. Accordingly, an apportionment of the interest expense should be made on the same basis as was adopted in Ure v. FC of T 81 ATC 4100; (1981) 11 ATR 484. The majority of the Full Federal Court agreed with that approach. They rejected an argument that the decision in Fletcher was distinguishable because it only applied to first limb cases and that here the agistment activities, while small, were nevertheless genuine and quite ordinary business activities. In so holding, Burchett and Ryan JJ said (at ATC 4239; ATR 298):

'But the exposition in Fletcher refutes counsel's suggestion that a colourable transaction is required. A case, such as the present, involving extreme disparity and an acknowledged dominant purpose which is in reality of a capital nature, so that the little business relied on is a mere sideshow, though not colourable, raises the very considerations discussed in Fletcher. The whole of the outgoing does not meet the criteria for deduction; apportionment is required; and, being required, has been applied in a manner appropriate to the particular case ...'

This view of the decision in Fletcher confirms the approach we adopted in Taxation Ruling TR 95/33.

Carr J

49. Mr Justice Carr found for the taxpayer under the first limb of subsection 51(1). He formed the view that the evidence adduced at the Tribunal showed that the whole of the taxpayer's undertaking in this matter was commercial in character. It was a 'business deal' or 'operation of business' even assuming that the acquisition was not a transaction entered into in the course of carrying on a business. He believed that the taxpayer had set in motion a profit-making undertaking or scheme at the very latest in July 1981. In his Honour's opinion the undisputed evidence showed that Mrs Steele was determined to turn the property to account for profit in a commercial way as best she could. Such circumstances provided the necessary nexus between the interest outgoings and the gaining of assessable income.

50. His Honour thought that in view of the particular facts of this case, the Tribunal had made a legal error in dismissing too readily the taxpayer's main purpose of redeveloping the property. In particular, an important part of her activities was her purpose and plan to construct eighty townhouses for resale to investors. Any profit so realised would have been assessable income. Looking at the picture in total, Carr J could see a connection with those profits, profits from managing a motel and profits upon the disposal of the property if that was to occur. In each scenario there was assessable income and, hence, a sufficient connection existed between that income and the interest expense.

51. By way of conclusion, Carr J said that he did not disagree with the majority judges' exposition of the relevant legal principles. He just found that the facts warranted a different conclusion.

Subsection 51(1): commitment

52. The decision in Steele raises some issues of general importance about the operation of subsection 51(1).

53. A definitive statement of the requirements of subsection 51(1) was set down in Ronpibon Tin NL v. FC of T (1949) 78 CLR 47 at 56 by Latham CJ, Rich, Dixon, McTiernan and Webb JJ who said:

'For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end. The words "incurred in gaining or producing the assessable income" mean in the course of gaining or producing such income ... In brief substance, to come within the initial part of the sub-section it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income.'

54. In FC of T v. Smith 81 ATC 4114; (1981) 11 ATR 538 a medical practitioner was allowed a deduction under the first limb of subsection 51(1) in respect of monies paid under an insurance policy which provided that the insurer would pay a monthly indemnity during any period of total disability sustained by the insured as a result of injury. The High Court said this about subsection 51(1) (at ATC 4117; ATR 542):

'The section does not require that the purpose of the expenditure shall be the gaining of the income of that year, so long as it was made in the given year and is incidental and relevant to the operations or activities regularly carried on for the production of income . What is incidental and relevant in the sense mentioned falls to be determined not by reference to the certainty or likelihood of the outgoing resulting in the generation of income but to its nature and character and generally to its connection with the operations which more directly gain or produce the assessable income. It is true that the payment of the premium in June 1978 did not result in the generation of any income in that year, but there is a sufficient connection between the purchase of the cover against the loss of ability to earn and the consequent earning of assessable income to bring the premium within the first limb of sec. 51(1).' (emphasis added)

55. Note that the Court said that the expenditure had to be incidental and relevant to the operations or activities regularly carried on for the production of income.

56. So, having regard to the discussion in Ronpibon Tin and Smith, if there is a 'connection' between a loss or outgoing and the derivation of assessable income, and that 'connection' can be described as 'sufficient', the requirements of the first limb of subsection 51(1) are satisfied. If such a 'sufficient connection' exists, it may also be said that the loss or outgoing is 'incidental and relevant' to gaining or producing the assessable income. Also, the 'occasion' of the loss or outgoing will be found in those activities. They will be activities which more directly produce the assessable income.

57. In Steele, the Tribunal determined that the relevant income producing activity was the operation of a motel complex - a conclusion apparently accepted by their Honours. In the circumstances, a reasonable inference is that the taxpayer's income producing activities had not yet commenced.

58. If so, what should be taken to be the import of their Honours' statements that Mrs Steele was committed to the project? Can expenditure incurred in circumstances where there is an appropriate degree of commitment to an income producing activity, but which has yet to be commenced, be expenditure that has a 'sufficient connection' with that activity such that it is 'incidental and relevant' to it?

59. In other words, does expenditure in some way related to a project that you are committed to, and which is expected to produce income in the future if it proceeds, have the essential character of a loss or outgoing incurred in the course of gaining or producing that income?

60. It is arguable that in Temelli v. FC of T 97 ATC 4716; (1997) 36 ATR 417, Merkel J has accepted that a particular degree of commitment can establish a 'sufficient nexus' between the expenditure and the assessable income. In so doing, however, he indicated (at ATC 4719; ATR 421) that earlier decisions:

' ... clearly establish that the intent of the taxpayer alone is not sufficient to establish deductibility for outgoings or expenditures that are not of themselves productive of income, but are intended to lead in the future to the production of income.'

61. In Inglis v. FC of T 80 ATC 4001; (1980) 10 ATR 493, the taxpayer was a member of a partnership that formerly carried on a business of primary production on a property (Lammermuir). She intended to resume that activity in the future and in the meantime expended money on maintaining the property. The relevant expenditure included 'interest due on money secured on or borrowed in relation to the land'. The expenditure was claimed as a deduction under subsection 51(1) of the Act. The Court disallowed the taxpayer's appeal and at ATC 4008; ATR 500 Davies J said:

'At the time when the relevant expenditure was incurred, not only was no business being carried on on "Lammermuir" but the property had potential for use in several ways. It was a property which could be developed or subdivided. The Inglis family could use it for their own private pleasure. Stock could be grazed or crops grown on it and income earned. The contracts of sale could proceed and, in this event, the 317 acres could be stocked by the family company or by the taxpayers. Having considered the evidence, I think that it is an inescapable conclusion that, in the subject years, having regard to the uncertainties and possibilities of the future, the property was not then devoted by Mr and Mrs Inglis to the derivation of assessable income. It was then neither used to produce assessable income nor committed by Mr and Mrs Inglis to the production of assessable income.' (emphasis added)

62. The notion of commitment was also raised in Softwood Pulp & Paper Limited v. FC of T 76 ATC 4439; (1976) 7 ATR 101. The following facts are extracted from the headnote at ATC 4440:

'The taxpayer company was incorporated in 1961 for the purpose of establishing a new paper production industry in South Australia. A Canadian company (MacMillan) was a promoter of the scheme and was allotted 50,000 #1 shares in the company. Australian promoters were allotted the remaining 50,000 shares in equal parts. In February 1962 MacMillan withdrew from the project and, no other promoter being found, the venture was not proceeded with.

The taxpayer company claimed that the expenses incurred by it were deductible and sought to offset the losses incurred against its investment income of 1966 and 1967 and its business income derived in the 1969 income year. (It was accepted that the taxpayer had entered into a trading business in the 1969 income year in order to take advantage of its earlier losses.)

The expenses incurred by the taxpayer company itself related to overseas and local travel expenses, legal and accounting expenses, testing of raw material, professional fees for the conduct of feasibility studies by expert consultants and the acquisition of some raw materials. Expenses met by MacMillan were found to be mainly concerned with feasibility studies, overseas travel, tests of samples and associated matters. MacMillan claimed against the taxpayer company for $178,170.04 and the latter in turn claimed that $134,137.91 of that amount was an outgoing properly deductible by it, although it had in fact disputed MacMillan's claim and had finally made a settlement payment of $24,000. The Commissioner conceded that an outgoing of $24,000 had been incurred by the taxpayer, but denied that the taxpayer had ever incurred losses or outgoings to MacMillan of $134,137.91.

The Commissioner's principal claim was that the expenses actually incurred by the taxpayer were not deductible under the first two limbs of sec. 51(1) and, in any event, were outgoings of a capital nature.'

63. Menhennit J found for the Commissioner. At ATC 4450; ATR 113, he said:

'In my opinion, none of the amounts claimed in this case, assuming that all or any of them were incurred by the taxpayer and some of them undoubtedly were, was incurred in the course of gaining or producing assessable income.

Everything that was done in this case, up till the time when the project ceased, was in my view entirely preliminary and directed to deciding whether or not an undertaking would be established to produce assessable income.

The project had not reached anything like the stage of doing anything in the course of gaining or producing assessable income. All that had happened was that certain tests had been made to ascertain whether or not the project would be feasible. Certain technical information had been acquired and certain steps had been taken to ensure that if the project did go ahead, supplies of timber, electricity, water and the like would be available. But that is as far as the project got. I reiterate that no one was committed , at all, to go on with the project, neither MacMillan nor the taxpayer nor anyone else. Nothing was done even to prepare plans or specifications for a mill, on the part of the taxpayer. What was done by Sandwell was for purposes of obtaining quotes for testing purposes. No decisions or even tentative decisions were taken even as to plant and equipment. In other words, the project did not approach in any way a situation which could be described as being the course of gaining or producing income. It was all completely anterior thereto and in those circumstances, it appears to me that any losses or outgoings which were in fact incurred by the taxpayer were in the course of investigations to see whether the project would be feasible, and the course of steps to ensure that if it did start there would be available supplies, and indeed so far as MacMillan was concerned in the course of it making up its mind whether it would go on with the whole matter at all. But they certainly were not, in my view, incurred in the course of gaining or producing assessable income.

Accordingly, I conclude that the taxpayer has not established that any of the losses or outgoings incurred, or claimed to be incurred, fall within the first limb of sec. 51(1).' (emphasis added)

64. In Goodman Fielder Wattie Ltd v. FC of T 91 ATC 4438; (1991) 22 ATR 26, the taxpayer funded research in relation to monoclonal antibodies with a view to manufacturing products that would be commercially viable. Hill J decided (at ATC 4447; ATR 36) that the activities in the relevant period were of a provisional kind only: 'The element of commitment was absent'. While it was contemplated that if the research proved successful there would be products to be marketed, the actual business activity itself needed to be understood or characterised. That activity was the manufacture and sale of the relevant products. There was not a sufficient commitment in the period under consideration to say that the taxpayer had commenced to carry on a business or that what was done was an activity of gaining or producing assessable income, so as to enable a positive conclusion to be drawn as to the essential character of the expenditure.

65. In FC of T v. Brand 95 ATC 4633; (1995) 31 ATR 326 Tamberlin J, in an obvious reference to Softwood Pulp & Paper and Goodman Fielder Wattie, said (at ATC 4649; ATR 344):

'The purpose of research expenditure or payment for a feasibility study is firstly to investigate whether a proposed or possible line of business activity is viable and secondly to decide whether to make a commitment to the activity. The third stage is the entry into such a commitment . It does not follow from a favourable research or feasibility study, for example that any commitment or outgoing will be made with a view to producing assessable income. In that sense such studies may be discrete from the relevant business activity and may be "too soon" before the business activity commences to justify classification as an activity expected to produce assessable income.' (emphasis added)

66. In Brand the taxpayer entered into certain arrangements whereby he was required to pre-pay licence fees in relation to a prawn farming scheme. The taxpayer claimed a deduction in respect of the $15,000 payment made pursuant to the agreement under which he became entitled for seven years to an area of pond in which to farm prawns.

67. The licence fees were incurred in a year of income prior to the commencement of income producing operations. Lee and Lindgren JJ (at ATC 4646; ATR 340) said the circumstances and extent of any lapse of time between incurring the lease and management fees and the commencement of income producing operations is a factor to be considered in establishing whether there is a sufficient connection with the income producing activity. Such a lapse of time may indicate that the expenditure was incurred at a 'point too soon' to be incurred 'in' gaining or producing assessable income

68. In Brand the prepayment in June 1987 was not incurred 'too soon' to deny it the character of an outgoing incurred 'in' gaining or producing assessable income. The point sought to be made by Lee and Lindgren JJ (at ATC 4647; ATR 341) was that:

' ... when the Taxpayer paid the sum of $15,000 as consideration for the bundle of promises by NQIT [the licensor], there was an irrevocable commitment by the Taxpayer and also by NQIT and GRS(PF) [the manager] to income producing activity (prawn farming ) which was bound to commence by 4 June 1988 at the latest and which they all expected would commence much earlier than that date.' (emphasis added)

69. In other words, the contractual commitment to the project allowed the finding of a sufficient connection between the expenditure and the operations, which it was expected would gain or produce the assessable income, to make the payment deductible under the first limb of subsection 51(1) - refer Tamberlin J at ATC 4650; ATR 345.

70. The position of the taxpayers in Inglis, Softwood Pulp & Paper, and Goodman Fielder Wattie (and, indeed, in Steele) may all be contrasted with that of the taxpayer in Brand. In Inglis the property itself was not committed by Mr and Mrs Inglis to the production of assessable income (see the discussion of Lee J in Associated Minerals Consolidated Limited v. FC of T 94 ATC 4008 at 4020; (1994) 27 ATR 542 at 556). In Softwood Pulp & Paper and Goodman Fielder Wattie the issue was really whether any business had commenced or whether the relevant activities were anterior thereto. In Softwood it was clear that the project had not started and that no one was committed to go on with the project in the sense that no decision had been made to undertake the business enterprise the feasibility of which was being examined.

71. Goodman Fielder Wattie was in a similar position. The decision to undertake the relevant business enterprise had not been made. When it was said there was an insufficient commitment to the future income producing activity, the point being sought to be made was that, in effect, the relevant business had not yet commenced. In Brand, having decided what activities the taxpayer was legally committed to and that he had done all in his power to begin, the Court was able to decide that a sufficient connection existed between the expenditure and the income expected to be earned from those activities in the future despite the temporal hiatus.

72. For Mrs Steele, while the Court thought there was enough evidence of what she intended to do, i.e., evidence that she intended to engage in income producing activity in the future, it was clear that she was not yet so engaged. Even if she had actually decided that she was going to build and operate a motel, and in that sense there was, therefore, some kind of commitment, does that make the relevant expenditure, in the circumstances, deductible under the first limb? We do not think that 'commitment' in that sense is enough to give the relevant expenditure the requisite character. And, moreover, we do not think it was so decided. Their Honours actually say (at ATC 4247; ATR 294):

'Here, the use to which the borrowed funds were put was the purchase of a capital asset, Tibradden. The fact that it was a capital asset is not in itself, of course, conclusive, or even particularly helpful. The statements in The Texas Company and the other cases that have been cited make the deductibility in general of interest payments quite clear where the borrowed funds provide capital (and a fortiori working capital) employed in a business or in income earning activities. But Tibradden was not so used, nor was it available for such use. It was almost vacant land. (We are still leaving aside the agistment activities.) Before Tibradden could become the income-producing property that was proposed, much capital work and expenditure would be required.'

73. We are re-inforced in that view because their Honours also said (at ATC 4248; ATR 295) that payments made in the kind of situation in which Mrs Steele found herself were 'not part of the recurrent operations of any existing business activity ' (emphasis added).

Commitment: conclusion

74. 'Commitment' seems to be an aspect of the relationship between a taxpayer and his or her income producing activities. Yet it can only be a concept that arises for consideration where those income producing activities have not yet commenced at the time the loss or outgoing is incurred.

75. When the actual income earning activities are yet to be commenced, presumably the proposition is that evidence of what the taxpayer is committed to do is necessary in order to identify sufficiently a proposed set of income earning activities so it can be determined whether or not the loss or outgoing is incidental and relevant to those proposed activities and, therefore, has the necessary connection with the production of income. If the activities had commenced, there would be no need to ask the question - the taxpayer would not only be 'committed' to a course of action but would be actually engaged in that action. The occasion of the loss or outgoing would be found in the activities that were to produce assessable income.

76. If that analysis is correct, then the expenditure due to activity that is evidence of a commitment to the process or activities that will produce income, but is not itself productive of assessable income, will satisfy what has traditionally been the test of deductibility. That is, the expense of a non-income earning activity, which is intended to lead in the future to the production of income by way of other activity, will actually be expenditure incurred in gaining or producing the assessable income.

77. With respect, this is a broader test than what has been, in our opinion, the previously understood requirements of the subsection. For example, if a taxpayer were intending to carry on a business and incurred expenditure on a 'business start-up course', that would evidence some kind of commitment to the business. But would it mean that the fees for the course were deductible? We do not think so. Assume the taxpayer were to then incur rent in respect of premises from which the business was to be conducted. If the expenditure was incurred for a period before the business had actually commenced, that may also be evidence of a commitment to the business. But that, by itself, does not mean the rent is deductible. On the other hand, however, rent incurred now in respect of the period when the premises are being used in the conduct of the business may well be deductible notwithstanding that, as a fact, it could be that the business had not yet commenced when the rent was incurred. At either time, however, the taxpayer may be said to have been in some way 'committed' to the business.

78. Accordingly, in our opinion, at this stage it is not sufficiently clear just what 'commitment' means for the purposes of subsection 51(1). In the circumstances, we feel that more judicial guidance would be appropriate before conclusions should be drawn about what seems to be a broader proposition about the operation of the subsection than has previously been expressed by the High Court.

Interest: capital expenditure?

79. The decision in Steele has been recently followed by Merkel J in the Federal Court in Temelli and is consistent with the Privy Council decision in Wharf Properties Ltd v. Commissioner of Inland Revenue [1997] STC 351. Inferentially, on one view, the decision in Travelodge Papua New Guinea Ltd v. Chief Collector of Taxes 85 ATC 4432; (1985) 16 ATR 867 is inconsistent with the decision in Steele and could not now be regarded as persuasive authority in Australia.

80. However, in terms of the first limb of subsection 51(1), the taxpayer in Travelodge might be said to have incurred expenditure in gaining or producing assessable income on the basis that the taxpayer was legally committed or contractually bound to the construction and operation of the hotel because of the terms of the agreements for the grant of the site lease. If that is correct, would the interest nonetheless not now be deductible on the basis of Steele because of the operation of the negative test - as capital expenditure?

81. In Softwood Pulp & Paper, Menhennitt J said (at ATC 4452; ATR 115):

'There is the well known and much cited statement of Dixon CJ in John Fairfax & Sons Pty. Ltd. v. F.C. of T. (1958-59) 101 CLR 30 at pp.34-35 [7 AITR 346 at 353-354] where his Honour said:

"Perhaps the most important thing to notice in subsec. (1) is the character of the phrase 'except to the extent to which they are losses or outgoings of capital, or of a capital nature.' Its character is that of an exception which necessarily presupposes the possibility of the subject matter excepted falling under the description that precedes it. In other words it is supposed by the subsection that a loss or outgoing incurred in gaining or producing the assessable income or in carrying on a business for that purpose may nevertheless be a loss or outgoing of capital. ..."

Applying those principles to the present case, I then ask whether if any of the losses or outgoings claimed fell within either of the first limbs of sec. 51(1), they are nonetheless losses or outgoings of capital or of a capital nature.

In my opinion, they clearly are. For the reasons that they were not losses or outgoings incurred in gaining or producing assessable income, or necessarily incurred in carrying on a business for the purpose of gaining or producing such income, some aspects of this concept are difficult to apply for the basic reason that the losses or outgoings do not fall within sec. 51(1) at all, because they were concerned with an anterior stage, namely whether or not to establish a business, whether it would be viable, and what kind of business would be established, and for all the reasons I have given, the losses and outgoings do not fall, in my view, within sec. 51(1).

Insofar as they may be said to do so, contrary to what I have decided, it appears to me that they all fall within the concept of establishing or creating the profit-yielding subject. Insofar, for example, as technical information was acquired, insofar as options were obtained over land, insofar as arrangements were made for the supply of water, electricity and other essential matters, insofar as arrangements were made for the supply of timber by options which would enable arrangements to be made, all those matters appear to me to be establishing or creating the profit-yielding subject.

Insofar as the tests that were conducted pointed to the conclusion that the project would be profitable and competitive, they also appear to me to be part of the profit-yielding subject in the sense of information and facts which would be the basis for the whole project being gone on with. That in my view applies equally to the studies conducted by Sandwell and to the tests conducted by MacMillan.

On this aspect of the matter I am in substantial agreement with the conclusions of all the members of the Board of Review as expressed by Mr. Todd. It appears to me no part of the amounts claimed which, if they did otherwise fall within either of the first limbs of sec. 51(1), would not, in any event, be excluded from deduction on the basis that they are losses or outgoings of a capital nature.'

82. This part of the discussion in his Honour's decision highlights the position under subsection 51(1) whereby it is clearly envisaged that expenditure can satisfy the positive tests in the subsection but nevertheless not be deductible because it is capital. However, we do not think that interest expense is within that very broad category of expenditure.

83. Applying the principles for determining whether an expense has a revenue or capital character as set down in Sun Newspapers Ltd v. FC of T (1938) 5 ATD 87, it is difficult to envisage a situation when interest expense would be capital although one case may be where, for example, there is a pre-payment of interest for a substantial period. See also the discussion in Australian National Hotels. Notwithstanding these difficulties, the view of the Full Federal Court in Steele is clear on the point. However, with the greatest respect, it may be at variance with accepted principles to characterise interest expense in the kind of circumstances under consideration as an affair of capital. We believe that the interest expense in Steele simply did not satisfy the positive tests in subsection 51(1). However, while it is another thing to then say interest in such a case is expenditure of a capital nature, it must be recognised that this may, in fact, be the law in this country.

84. In this regard, attention must also be given to what the High Court has said in FC of T v. Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52 ('ERA') (see the discussion below at paragraphs 91 to 95).

85. In view of the uncertainty now prevailing, we are prepared, in the circumstances, to accept the proposition that interest expense satisfying either the first or second limb of the positive test in the subsection cannot, in principle, be excluded from deductibility under the negative test as capital expenditure. That is to say, because of the nature of interest, if it has the essential character of a loss or outgoing incurred in gaining or producing the assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing such income, it cannot at the same time be capital expenditure or have the character of a capital expense.

Implications of the decision in Steele

86. Mrs Steele has sought special leave to appeal to the High Court. Accordingly, the decision of the Full Federal Court may remain, be altered in some respect or be overturned. If special leave is not granted, the Full Federal Court decision will be the defining statement of the law in this country for all taxpayers who find themselves in similar factual circumstances to those considered in the case.

87. Therefore, until it is known whether special leave to appeal is to be granted and, if granted, the ultimate reasons for decision of the High Court, taxpayers should self-assess (for subsection 51(1) purposes) on a basis that is consistent with the decision in Steele.

88. Mrs Steele was not, during the relevant period, carrying on a business other than a business of agisting horses. She did, however, intend to carry on a business on the land in the future that involved, at least, operating a motel.

89. Interest on funds borrowed to acquire the land in these circumstances is to be apportioned. Some part of the interest is not deductible if a purpose of the acquisition of the land is later to use the land in an income producing activity by means of constructing on it a building to be used in the intended income producing activity. If the income producing activity centres on the use of the asset that is yet to be constructed, or is being constructed, the interest expense will not satisfy the first limb of the positive test in subsection 51(1). This is because, at the relevant time, there is not a sufficient connection between the interest expense and the income producing activity. If the interest expense cannot satisfy the positive tests of deductibility, it will be a capital expense because the character of the advantage being sought by the payment of the interest is the 'creation of a capital asset'.

90. At this stage we are taking the view that, strictly speaking, the decision in Steele is not at odds with what has been said about the deductibility of interest in the earlier cases. For example, the statements by Dixon J in The Texas Company (Australasia) case, while obiter dicta, are still an accurate statement of interest deductibility in the context of a continuing business. Steele's case only has application in the situation where the relevant income earning activities are yet to commence and the interest expense does not satisfy the positive tests in subsection 51(1).

91. However, notwithstanding the position set out above, taxpayers should be aware of more recent obiter dicta of the High Court in ERA. In that case, the taxpayer issued a series of 90 day promissory notes in US dollars at a discount pursuant to a Euronote facility agreement made between the taxpayer, ERA (Canberra) Limited (which was one of its wholly owned subsidiaries), the Commonwealth Bank and a number of foreign banks. That agreement allowed the taxpayer to instruct one of the foreign banks to issue Euronotes in the taxpayer's name. A panel of banks then tendered for the notes at a price less than the face value of the notes. Under the agreement, the taxpayer agreed to pay the face value of the notes to the holder upon the maturity of the Euronotes.

92. The appeal in the ERA case turned on whether the taxpayer was entitled to deduct from its assessable income the Australian dollar equivalent of the cost of issuing and retiring promissory notes in US dollars. The cost was the difference between the face value of the notes and their issue price, which was a lower sum.

93. Prior to entering into the Euronote agreement, ERA (Canberra) Limited had the use of a finance facility ('the Schroder Wagg facility') with other banks under which it raised money and on-lent to the taxpayer. The taxpayer used the funds to finance the development and operation of the Ranger uranium mine in the Northern Territory. Funds from the issue of the first series of promissory notes were used to discharge the US dollar liabilities of ERA (Canberra) Limited under the Schroder Wagg facility. Funds from subsequent issues of the promissory notes, together with other funds of the taxpayer that it held in US dollars, were used to discharge the liabilities of the taxpayer under each preceding issue of the notes. None of the proceeds of any issue was remitted to Australia.

94. Under the heading that 'The discounts are to be regarded as revenue outgoings' , the High Court made a number of statements which have relevance to the issue raised by the decision in Steele. At ATC 4539; ATR 55 the Court said:

'The receipts from the Euronotes were not income. They were capital and not revenue receipts. The taxpayer did not trade in promissory notes; nor was it a financier. Money was not its stock in trade. Similarly, the payments made to discharge the liabilities arising from the notes were capital and not revenue payments. But that does not mean that the cost of the discounts was necessarily a capital expense. Where a taxpayer incurs loss or expense in raising funds by issuing promissory notes at a discount to their face value, its entitlement to a s 51 deduction for that loss or expense depends on the use to which the funds are to be put. If the funds are to be used as working capital, the cost of the discounts will be deductible as a revenue expense. If the funds are to be used to strengthen "the business entity, structure, or organisation set up or established for the earning of profit", the cost of the discounts will generally not be deductible because they will be a capital, and not a revenue, expense.'

95. While discount expense is different from interest expense it has a similar attribute - that is, it is a cost of raising finance. Accordingly, interest on borrowed funds to be used to strengthen 'the business entity, structure, or organisation set up or established for the earning of profit' should receive the same taxation treatment as discount expense incurred in the same circumstances. As the High Court has indicated that the cost of the discount, in the circumstances mentioned, would generally not be deductible because it will be capital, and not a revenue expense, it follows that the Court may draw the same conclusion in relation to interest expense.

Capital gains and capital losses

96. The cost base and indexed cost base of an asset, for the purposes of the capital gains and capital losses provisions of the Act, includes non-deductible, non-capital costs to the taxpayer of the ownership of the asset. Such amounts include expenditure of a non-capital nature incurred by the taxpayer by way of interest on a loan taken out to finance the acquisition of the asset.

97. If interest is a capital expense it does not meet this description. As it does not otherwise satisfy the requirements of subsection 160ZH(1) or (2) it does not form part of the cost base or indexed cost base of the asset.

98. Whilst paragraphs 160ZH(1)(ba) and (2)(ba) and subsection 160ZH(6A) apparently rest on the assumption that interest is inherently a non-capital expense, a specific provision including interest in the cost base was thought necessary because, whatever its character, it did not fit the description of expenditure that was 'consideration in respect of the acquisition of an asset'. If interest incurred in the circumstances in Steele is ultimately decided to be capital expenditure, it does not form part of the cost base or indexed cost base of the asset for capital gains purposes as section 160ZH now stands.

99. The appropriateness of such a result would need to be considered if that outcome were to eventuate.

100. In the meantime, non-deductible interest that would otherwise have been included in the cost base of an asset because of the operation of paragraph 160ZH(1)(ba) and subsection 160ZH(6A) may continue to be so included until it is finally decided whether such interest is capital in nature.

Depreciation and other capital allowances

101. If interest is not deductible because it is capital, we have been asked whether it forms part of the 'cost' of a unit of depreciable property or should be taken into account for other capital allowance provisions of the Act.

102. It is well understood that interest can be seen as compensation to the lender for being kept out of the use and enjoyment of the principal sum: FC of T v. The Myer Emporium Limited (1987) 163 CLR 199. In Coles Myer Finance Limited v. FC of T 93 ATC 4214; (1993) 25 ATR 95, Mason CJ, Brennan, Dawson, Toohey and Gaudron JJ likened discount expense to interest - both being a cost of raising funds. They said (at ATC 4222; ATR 105):

' ... the discount offered by the taxpayer is the cost of acquiring the funds which it turns over in its business, the amount of the discount serving the same purpose as the amount of interest on borrowed moneys; the amount of the discount is the cost of those moneys .' (emphasis added)

103. A distinction may be drawn between the cost of raising funds and the cost of an item of plant acquired or constructed with those funds. In Ben-Odeca Ltd. v. Powlson (Inspector of Taxes) [1978] 1 WLR 1093 the House of Lords considered that interest and commitment fees on money borrowed were not 'capital expenditure on the provision of machinery or plant' for the purposes of the Finance Act 1971 (UK). A reason for so deciding was that the interest and fees were expenditure on the provision of money to be used on the provision of plant but not expenditure on the provision of the plant. The principle was applied in Robe River Mining Co Pty Ltd v. FC of T 89 ATC 4606; (1989) 20 ATR 768. In that case, exchange losses incurred in repaying a $US loan were held not to be allowable capital expenditure for the purposes of Division 10 of the Act.

104. Accordingly, we think that on the current state of the depreciation and other capital allowance provisions, interest should not be taken to be within the meaning of 'cost' in the depreciation provisions, or, for example, as qualifying expenditure within the phrase 'expenditure of a capital nature in respect of the construction of a building' for building allowance purposes.

105. In the past (see, for example, Taxation Rulings IT 196, IT 209 and IT 359), we have accepted that the interest component of certain hire purchase contracts (and purported 'leases') in respect of depreciable assets may be capitalised and depreciation claimed on the total amount payable under the contract by the purchaser. It is clear, however, that the hiring charges, strictly speaking, were considered to be deductible under subsection 51(1) and that they did not form part of the 'cost' of the plant. Notwithstanding that, the Commissioner was prepared, in the circumstances, to accept claims under either subsection 51(1) or the depreciation provisions (but provided in the latter event the hire purchase charges were amortised over the effective life of the plant, i.e., the term of the hire purchase agreement corresponded to the effective life of the plant as determined under section 55, as it then was, of the Act).

106. While that approach may have been justified because of the nature of the arrangements in question, it must be remembered that it was clearly the case that the hiring charges were, in fact, deductible under subsection 51(1) in the first place. No inference should be drawn about the constituents of the 'cost' of plant from the practice outlined above. And the situation is not analogous to the case where interest on money borrowed to acquire or construct property is otherwise tax deductible.

Part IVA

107. For some taxpayers there are occasions when interest, previously thought to be tax deductible in the circumstances, cannot now be so considered in view of the decision in Steele. As a consequence, some arrangements may be contemplated that attempt to overcome the natural effect of the decision in Steele. Without seeking to impinge unnecessarily on otherwise acceptable tax planning practices, interest free inter-company loans, equity funded special purpose entities where the funds used are borrowed funds, deferred or delayed interest arrangements and any other arrangements designed to create a taxation deduction within a group that may not otherwise be available, may potentially attract the operation of the general anti-avoidance provisions of the Act.

Examples

108. If a taxpayer is a manufacturer who requires the use of new plant and borrows funds to undertake construction of the plant, the interest expense is deductible to the taxpayer during the construction period. This is because a manufacturing business is currently being carried on and the expense could be said to have been incurred in gaining or producing the assessable income or necessarily incurred in carrying on that business for the purpose of gaining or producing such income.

109. If a special purpose entity that is not part of a wider group of entities is formed to undertake the construction of an asset to be held as the primary income producing asset of that entity, interest on money borrowed to construct the asset would not be deductible during the construction phase unless it could be said that the business or other income-earning activities of the entity had commenced. It is a question of fact as to when a business or income-earning activity has commenced. If the entity is part of a wider group of entities it may be that, having regard to the activities of the group as a whole, the income earning activities have commenced by the time the construction begins. See Grollo Nominees & Ors v. FC of T 97 ATC 4585; (1997) 36 ATR 424.

110. If it is otherwise, then having regard to the decision in Steele, the interest would be a capital expense during the construction phase. When the asset is completed and is then employed or used to produce income, the employment of the asset in the income producing process means that the interest on the borrowings then outstanding becomes a tax deductible revenue expense. The interest can then be seen to be an operating expense incurred in the course of producing assessable income rather than a non-deductible capital expense incurred on account of the capital structure or profit-yielding structure of the business.

111. In the case of a taxpayer who constructs an asset to be sold in the normal course of its business, interest on borrowings used to fund the construction is deductible when incurred. The proceeds of sale are income of the taxpayer. That is, the asset constructed would be a revenue asset of the taxpayer sold in the ordinary course of the taxpayer's business.

112. If a transaction of construction and sale is not in the ordinary course of the taxpayer's business or is undertaken by a non-business taxpayer, and the profit on sale is nevertheless an income gain (refer to the situations discussed in Taxation Ruling TR 92/3), interest on money borrowed and used to fund the construction of the asset will be taken into account in calculating the profit to be included in the assessable income in the year in which the disposal occurs.

Previous Rulings

113. Taxation Ruling IT 166 deals with the deductibility of interest 'paid during the construction period during which no revenue is being received from the asset'. However, provided there was no room for doubt that the asset would be used to produce assessable income, the Commissioner was prepared to allow the interest as a deduction on the basis that there would be a sufficient connection with the income to be derived in the future. The Ruling was withdrawn on 2 July 1997. Taxation Rulings IT 2374 and IT 2461 re-iterated and relied on the view expressed in IT 166. For that reason, they have also been withdrawn as from that date.

114. Consistent with our usual practice, the Rulings are to have a continuing effect up to the date of withdrawal. That is, assessments will not be disturbed where the relevant interest relates to activities that commenced prior to the date of withdrawal of the Rulings. Of course, a taxpayer's particular factual position must be within the boundaries set down in the IT 166 or IT 2374. More specifically, interest will be allowed during the construction phase of an income producing asset or during the period from the acquisition of an asset until its actual employment in income producing activity, provided that in each case there is no room for doubt that the relevant asset was at all times intended to be used solely and exclusively to produce assessable income.

Your comments

115. If you wish to comment on this Draft Ruling, please send your comments by 5 December 1997 to:

Commissioner of Taxation
22 October 1997

This Draft Ruling has been replaced by TR 2000/D3

References

ATO references:
NO 97/8734-8 97/8481-1

Related Rulings/Determinations:

IT 196
IT 209
IT 359
TR 92/3
TR 95/33

Subject References:
interest

Legislative References:
- ITAA36 51(1)
- ITAA36 55
- ITAA36 160ZH
- ITAA36 160ZH(1)
- ITAA36 160ZH(1)(ba)
- ITAA36 160ZH(2)
- ITAA36 160ZH(2)(ba)
- ITAA36 160ZH(6A)
- ITAA36 Div 10D
- ITAA97 8-1

Case References:
- Associated Minerals Consolidated Limited v. FC of T
94 ATC 4008
(1994) 27 ATR 542

- Australian National Hotels Limited v. FC of T
88 ATC 4627
(1988) 19 ATR 1575
- Ben-Odeca Ltd. v. Powlson (Inspector of Taxes)
[1978] 1 WLR 1093
- Coles Myer Finance Limited v. FC of T
93 ATC 4214
(1993) 25 ATR 95
- Farmer v. Scottish North American Trust Limited
[1912] AC 118
- FC of T v. Brand
95 ATC 4633
(1995) 31 ATR 326
- FC of T v. Energy Resources of Australia Limited
96 ATC 4536
(1996) 33 ATR 52
- FC of T v. Roberts and Smith
92 ATC 4380
(1992) 23 ATR 494
- FC of T v. Smith
81 ATC 4114
(1981) 11 ATR 538
- FC of T v. The Myer Emporium Limited
(1987) 163 CLR 199
- Fletcher + Ors v. FC of T
91 ATC 4950
(1991) 22 ATR 613
- Goodman Fielder Wattie Ltd v. FC of T
91 ATC 4438
(1991) 22 ATR 26
- Grollo Nominees + Ors v. FC of T
97 ATC 4585
(1997) 36 ATR 424
- Inglis v. F C of T
80 ATC 4001
(1980) 10 ATR 493
- John Fairfax + Sons Pty Ltd v. FC of T
(1959) 101 CLR 30
- Robe River Mining Co Pty Ltd v. FC of T
89 ATC 4606
(1989) 20 ATR 768
- Ronpibon Tin NL v. FC of T
(1949) 78 CLR 47
- Softwood Pulp + Paper Limited v. FC of T
76 ATC 4439
(1976) 7 ATR 101
- Steele v. FC of T
96 ATC 4131
(1996) 31 ATR 510
- Steele v. FC of T
97 ATC 4239
(1997) 35 ATR 285
- Sun Newspapers Ltd v. FC of T
(1938) 5 ATD 87
- Temelli v. FC of T
97 ATC 4716
(1997) 36 ATR 417
- The Texas Company (Australasia) Limited v. FC of T
(1940) 63 CLR 382
- Travelodge Papua New Guinea Ltd v. Chief Collector of Taxes
85 ATC 4432
(1985) 16 ATR 867
- Ure v. FC of T
81 ATC 4100
(1981) 11 ATR 484
- Wharf Properties Ltd v. Commissioner of Inland Revenue
[1997] STC 351