Edited version of private ruling

Authorisation Number: 1011700450469

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Ruling

Subject: Research and Development

Issue 1

Question 1

Is the rulee entitled to carry forward expenditure from the year ending 30 June 2008 that is less than $20,000 to the year ending 30 June 2009 in order for the rulee to be entitled to claim a deduction for this expenditure under subsection 73B(14) of the Income Tax Assessment Act 1936 (ITAA 1936) in the income year ending 30 June 2009?

Answer

No. Subsection 73B(14) of the ITAA 1936 does not entitle the rulee to claim a deduction in an income year for expenditure incurred in an earlier income year.

Question 2

Is the rulee entitled to claim a deduction for travel expenses for the income year ending 30 June 2009 under subsection 73B(14) of the ITAA 1936 in the income year ending 30 June 2009?

Answer

Yes (in part). The rulee is entitled to claim a deduction (in full) for the expenditure incurred in respect of domestic travel as the requirements of subsection 73B(14) of the ITAA 1936 are satisfied. The rulee is not entitled to claim a deduction for overseas travel expenditure as the rulee did not obtain a certificate under section 39ED of the Industry Research and Development Act 1986 (the IR&D Act) from Innovation Australia prior to undertaking the travel as required by subsection 73B(17A) of the ITAA 1936.

Question 3

Is the rulee entitled to claim a deduction for the cost of developing prototypes for the income year ending 30 June 2009 under subsection 73B(14) of the ITAA 1936 in the income year ending 30 June 2009?

Answer

No. As the prototypes are depreciating assets under section 73BA of the ITAA 1936, the expenditure on such items constitutes excluded plant expenditure and therefore does not fall within the meaning of research and development expenditure and is not deductible under subsection 73B(14) of the ITAA 1936. A deduction for the decline in value of the prototypes may be available under subsection 73BA(2) of the ITAA 1936 (refer Issue 2, Question 1).

Question 4

Is the rulee entitled to claim a deduction for the following expenses under subsection 73B(14) of the ITAA 1936 in the income year ending 30 June 2009:

- Office supplies

- Freight

- Research, standards and policies?

Answer

Yes. The rulee is entitled to claim a deduction (in full) for the expenditure incurred in respect of the office supplies, freight and research, standards and policies as the requirements of subsection 73B(14) of the ITAA 1936 are satisfied.

Issue 2

Question 1

Is the rulee entitled to claim a deduction for the decline in value of the prototypes under subsection 73BA(2) of the ITAA 1936 in the income year ending 30 June 2009?

Answer

Yes. The rulee is entitled to a deduction under subsection 73BA(2) of the ITAA 1936 equal to the notional Division 40 (in accordance with section 73BC of the ITAA 1936) deduction for the prototypes multiplied by 1.25.

Question 2

Is the rulee entitled to claim a deduction for the decline in value of the Mobile Phone under subsection 73BA(2) of the ITAA 1936 in the income year ending 30 June 2009?

Answer

Yes. The rulee is entitled to a deduction under subsection 73BA(2) of the ITAA 1936 equal to the notional Division 40 deduction (in accordance with section 73BC of the ITAA 1936) for the Mobile Phone multiplied by 1.25.

Issue 3

Question 1

Is the rulee eligible to claim a deduction under section 73BF of the ITAA 1936 in respect of the prototypes for the year ending 30 June 2009?

Answer

No. As there was no cessation of use of the prototypes by the rulee during the 30 June 2009 income year, no balancing adjustment arose during the 30 June 2009 income year which gave rise to a deduction under subsection 73BF of the ITAA 1936.

Question 2

Does the rulee have an assessable amount due to the operation of section 73BF of the ITAA 1936 to the prototypes for the year ending 30 June 2009?

Answer

No. As there was no cessation of use of the prototypes by the rulee during the 30 June 2009 income year, no balancing adjustment arose during the 30 June 2009 income year which gave rise to an assessable amount under subsection 73BF of the ITAA 1936.

Issue 4

Question 1

Can expenditure on trademarks be claimed over a ten year period as a tax deduction under subsection 40-880(2) of the Income Tax Assessment Act 1997 (ITAA 1997) as the trademark expires at the end of ten years?

Answer

No. A deduction for the cost of the trademark registration is a business related cost and can be claimed over 5 years starting from the year in which the expenditure was incurred (subsection 40-880(2) of the ITAA 1997).

Question 2

If the expenditure on trademarks cannot be claimed over the ten year period, can the total amount then be claimed at the expiry of the trade mark as a tax deduction under subsection 40-880(2) of the ITAA 1997?

Answer

No. A deduction for the cost of the trademark registration is a business related cost and can be claimed over 5 years starting from the year in which the expenditure was incurred (subsection 40-880(2) of the ITAA 1997).

Relevant facts and circumstances

Background

The rulee is an Australian proprietary company limited by shares.

The rulee obtained registration for its research and development activities under section 39J of the IR&D Act from Innovation Australia for the year of income ended 30 June 2009.

Research and Development Activities

The rulee's sole business is the undertaking of Research and Development activities Project.

It is accepted as a fact of this ruling, that the activities undertaken by the rulee are, in fact, research and development activities within the meaning of subsection 73B(1) of the ITAA 1936.

The Research and Development Tax Concession 2008-09 Application Form submitted by the rulee shows that the overall project expenditure is expected to be $xx.

Research and Development expenditure - income year ended 30 June 2008

The rulee incurred expenditure of an amount less than $20,000 in the income year ended 30 June 2008.

Research and Development expenditure - income year ended 30 June 2009

The rulee incurred expenditure of $xx for office supplies in the course of the Research and Development activities for the Project in the year ended 30 June 2009.

The rulee incurred expenditure of $xx for a mobile phone in the course of the Research and Development activities for the Project in the year ended 30 June 2009. The rulee proposes to include the Mobile Phone in the small business pool in accordance with Subdivision 328-D of the ITAA 1997.

The rulee incurred expenditure of $xx for freight in the course of the Research and Development activities for the Project in the year ended 30 June 2009.

The rulee incurred expenditure of $xx for research, standards and policies in the course of the Research and Development activities for the Project in the year ended 30 June 2009. This expenditure related to purchasing reference copies of Australian standards, handbooks and other regulatory, advisory or policy documents referenced in the course of planning or carrying out Research and Development activities.

The rulee incurred expenditure of $xx for domestic travel in the course of the Research and Development activities for the Project in the year ended 30 June 2008. The travel was for key stakeholder consultation.

The rulee incurred expenses of $xx for international travel in the course of the Research and Development activities for the Project in the year ended 30 June 2008. The international travel was an overseas trip to develop prototypes in conjunction with a third party. The rulee did not obtain a provisional certificate under section 39ED of the IR&D Act from Innovation Australia prior to the travel and expenditure occurring.

The rulee incurred expenditure of $xx for developing prototypes in the course of the Research and Development activities for the Project in the year ended 30 June 2009. The rulee is the owner of each prototype. Due to the electronic circuitry, prototypes are rendered obsolete once a change or improvement is made. Some of the Prototypes may be rendered obsolete, redundant and of no commercial value by the rulee after a change or improvement is made and this could be within one to three months. After that time, the asset does not stop being held by the rulee but rather the asset ceases being used by the rulee. However, the prototype units have been retained for historical purposes so as to keep details of the developmental journey. That is, they form an aspect of record keeping and historical proof that events did occur and that developmental evolution did take place. It is expected that the prototypes will be retained until such time as the Research and Development on the Project concludes. The rulee's tax agent has advised that the rulee would be entitled to deduct an amount under Subdivision 328-D of the ITAA 1997 (Simplified Depreciation for Small Business) for the cost of the prototypes.

Trademarks

The rulee incurred costs in registering certain trademarks relevant to its business structure.

Aggregate research and development amount

The ATO was instructed to assume that the aggregate research and development amount under subsection 73B(1) of the ITAA 1936 for the rulee would be met for the 30 June 2009 income year.

On Own Behalf

The ATO has accepted as a fact of this ruling that the rulee's research and development activities were conducted on its own behalf and not on behalf of another person. in accordance with subsections 73B(1), 73BC(2) and 73B(9) of the ITAA 1936.

Reasons for decision

Issue 1 Question 1

Summary

Subsection 73B(14) of the ITAA 1936 does not entitle the rulee to claim a deduction in an income year for expenditure incurred in an earlier income year.

Detailed reasoning

Subsection 73B(14) of the ITAA 1936 states:

Subject to this section, where:

(a) an eligible company incurs research and development expenditure (other than contracted expenditure) during a year of income; and

(b) the aggregate research and development amount in relation to the company in relation to the year of income is greater than $20,000,

the amount of that expenditure multiplied by 1.25 is allowable as a deduction from the assessable income of the company of the year of income.

This means that, for an amount to be deductible in a year of income under subsection 73B(14) of the ITAA 1936, the research and development expenditure must be incurred by the rulee in that year of income. Accordingly, for an amount to be deductible to the rulee in the income year ending 30 June 2009, the research and development expenditure must be incurred in that year and not in some earlier year (such as the income year ended 30 June 2008). Therefore, subsection 73B(14) does not entitle the rulee to claim a deduction in an income year for expenditure incurred in an earlier income year.

Issue 1 Question 2

Summary

The rulee is entitled to claim a deduction (in full) for the expenditure incurred in respect of domestic travel as the requirements of subsection 73B(14) of the ITAA 1936 are satisfied.

The rulee is not entitled to claim a deduction for overseas travel expenditure as it did not obtain a certificate under section 39ED of the IR&D Act from Innovation Australia prior to undertaking the travel as required by subsection 73B(17A) of the ITAA 1936.

Detailed reasoning

Subsection 73B(14) of the ITAA 1936 (as stated above in full) allows a deduction at 125% where the following four requirements are satisfied:

§ the rulee is an eligible company for the year of income;

§ the rulee incurs the expenditure on eligible research and development activities;

§ the rulee's aggregate research and development amount (as defined in section 73B of the ITAA 1936) for the year is greater than $20,000; and

§ the expenditure is research and development expenditure (as defined in section 73B of the ITAA 1936).

In respect of the first requirement, it is accepted that the rulee was an eligible company for the income years ended 30 June 2009 for the purposes of subsection 73B(14) of the ITAA 1936.

In respect of the second requirement, it is accepted that the rulee incurred expenditure on eligible research and development activities in the 30 June 2009 income year.

In respect of the third requirement, it is assumed that the aggregate research and development amount (as defined in section 73B of the ITAA 1936) for the rulee would be met for the 30 June 2009 income year. Please refer to the end of the Reasons for Decision for our concerns regarding this assumption.

Research and Development Expenditure

The fourth requirement is that the travel expenditure falls within the meaning of research and development expenditure.

Domestic Travel

Subsection 73B(1) of the ITAA 1936 defines research and development expenditure as follows

research and development expenditure, in relation to an eligible company in relation to a year of income, means expenditure (other than core technology expenditure, interest expenditure, feedstock expenditure, excluded plant expenditure or expenditure incurred in the acquisition or construction of a building or of an extension, alteration or improvement to a building) incurred by the company during the year of income, being:

contracted expenditure of the company;

(a) salary expenditure of the company, being expenditure incurred on or after 1 July 1985; or

(b) other expenditure incurred on or after 1 July 1985 directly in respect of research and development activities carried on by or on behalf of the company on or after 1 July 1985;

and includes any eligible feedstock expenditure that the company has in respect of the year of income in respect of related research and development activities.

Under paragraph (c) of the of the definition in 73B(1) of the ITAA 1936, travel expenditure may qualify as 'research and development expenditure' where it is expenditure incurred directly in respect of the research and development activities carried on by the company. Expenditure is taken to be 'directly in respect of' research and development activities where:

§ the carrying on of eligible Research and Development activities contributed to the incurring of all or an identifiable part of the expenditure; or

§ the conduct of eligible Research and Development activities by the company could be materially impaired if the expenditure were not incurred.

The rulee incurred expenditure of $xx in respect of domestic travel which comprised interstate trips to consult with stakeholders and to conduct proof of concept trials. Accordingly, such travel expenditure was incurred directly in respect of the rulee's Research and Development activities and therefore falls within the meaning of research and development expenditure. Therefore, the amount is deductible under subsection 73B(14) of the ITAA 1936.

International Travel

Subsection 73B(14) of the ITAA 1936 is subject to other provisions in section 73B of the ITAA 1936. More specifically, the effect of subsection 73B(17A) of the ITAA 1936 is to disallow a deduction under subsection 73B(14) for expenditure on overseas Research and Development activities unless the expenditure is certified expenditure. The term 'certified expenditure' is defined in subsection 73B(1) of the ITAA 1936 as:

expenditure that was incurred by an eligible company on overseas research and development activities in respect of which the Board gave a provisional certificate under section 39ED of the Industry Research and Development Act 1986 before the expenditure was incurred;

This means that the rulee must have obtained a provisional certificate under section 39ED of the IR&D Act from Innovation Australia in advance of undertaking overseas Research and Development activities to be able to claim a deduction under subsection 73B(14) of the ITAA 1936. The rulee did not obtain a provisional certificate from Innovation Australia prior to the travel and expenditure occurring.

Since 2004, the Commissioner of Taxation has administratively adopted a practice of accepting minor amounts of expenditure on overseas Research and Development activities as being deductible without a provisional overseas certificate. The kinds of expenditure accepted for this purpose are expenditures on overseas Research and Development activities that are incidental to, or de minimus of, an Australia Research and Development project.

This means that a deduction may still be allowed for overseas travel expenditure where the amount is directly related to Research and Development activities on a project being undertaken in Australia and is of a relatively small value so that it would be unreasonable to enforce a need for a certificate under section 39ED of the IR&D Act. When claiming such expenditure, the taxpayer would need to establish that the amounts are directly related to an eligible Research and Development project that is predominantly conducted within Australia and that the amounts are insignificant in relation to expenditure on the project as a whole.

The rulee incurred expenditure of $xx in respect of international travel which comprised a trip to Canada by the rulee's director to develop prototypes in conjunction with a third party supplier.

Even though the expenditure may be considered to be directly related to the rulee's Research and Development activities, the expenditure is not allowable under subsection 73B(17A) of the ITAA 1936 as a provisional certificate was not obtained by the rulee from Innovation Australia. While the Commissioner will allow a deduction for minor amounts of expenditure on overseas Research and Development activities that are incidental to or de minimus of the Project, the amount of $xx is not considered to be a relatively small amount in relation to the expenditure on the project as a whole ($xx). The expenditure amounted to approximately 1% of the entire project and is not considered to be a trivial, insignificant, minor or 'trifling' amount (refer to Farnell Electronic Components Pty Ltd v. Collector of Customs (1996) 72 FCR 125 and Taxation Ruling TR 2002/1 Income tax: research and development: plant expenditure (pre 29 January 2001) paragraph 36).

Accordingly, the expenditure is not deductible under subsection 73B(14) of the ITAA 1936.

Issue 1 Question 3

Detailed reasoning

Subsection 73B(14) of the ITAA 1936 (as stated above in full) allows a deduction at 125% where the following four requirements are satisfied:

§ the rulee is an eligible company;

§ the rulee incurs expenditure on eligible research and development activities;

§ the rulee 's aggregate research and development amount is greater than $20,000; and

§ the expenditure is research and development expenditure (as defined).

Therefore, for the rulee to claim a deduction for the cost of developing prototypes pursuant to subsection 73B(14) of the ITAA 1936 for the income year ended 30 June 2009, it must satisfy these four requirements.

In respect of the first requirement, it is accepted that the rulee was an eligible company (as defined in subsection 73B(1) of the ITAA 1936) for the income year ended 30 June 2009 for the purposes of subsection 73B(14) of the ITAA 1936.

In respect of the second requirement, it is accepted that the rulee has incurred expenditure on eligible research and development activities for the 30 June 2009 income year.

In respect of the third requirement, it is assumed that the aggregate research and development amount for the rulee would be met for the 30 June 2009 income year.

Research and Development Expenditure

The fourth requirement is that the prototype costs fall within the meaning of research and development expenditure.

As discussed, research and development expenditure, as defined in subsection 73B(1) of the ITAA 1936, includes salary expenditure, contract expenditure paid to Registered Research Agencies, and other expenditures (including overhead and consumables) that are incurred directly in respect of eligible Research and Development activities. This definition does not cover expenditure on core technology, interest, residual feedstock expenditure, excluded plant expenditure, structural improvements and buildings - although some of these may attract deductions under other Research and Development provisions.

The term 'excluded plant expenditure' is defined in subsection 73B(1) of the ITAA 1936, more particularly paragraph (b), to include:

any other expenditure incurred by an eligible company in the acquisition or construction or that otherwise forms part of the cost of a section 73BA depreciating asset (as defined by section 73BB) or a unit of section 73BH plant (as defined by section 73BI).

The issue therefore, is whether each prototype is a section 73BA depreciating asset. If so, the prototype costs would constitute excluded plant expenditure and therefore not fall within the meaning of research and development expenditure and not be deductible under subsection 73B(14) of the ITAA 1936. Instead, the decline in value may be deductible under subsection 73BA(2) of the ITAA 1936. Alternatively, if a prototype is not a section 73BA depreciating asset, then the full cost of the prototype may be deductible under subsection 73B(14) as 'other expenditure'.

Section 73BA Depreciating Asset

The term 'section 73BA depreciating asset' is defined in subsection 73BB(1) of the ITAA 1936 as:

A "section 73BA depreciating asset" of an eligible company is an asset for which the eligible company could (ignoring section 73BA) deduct an amount under section 40-25 of the Income Tax Assessment Act 1997 if the following assumptions were made:
(a) contrary to paragraph 40-30(1)(c) and subsection 40-30(2) of that Act, all intangible assets were excluded from the definition of "depreciating asset" in section 40-30 of that Act;
(b) subsection 40-45(2) of that Act did not, except in the case of buildings, prevent that Division from applying to capital works to which Division 43 of the Income Tax Assessment Act 1997 applies, or to which that Division would apply but for expenditure being incurred, or capital works being started, before a particular day;
(c) the eligible company satisfied any relevant requirement for deductibility under that Division.

As can be seen from this definition, to qualify as such an asset, a deduction should be available under section 40-25 of the ITAA 1997 (given certain assumptions).

Section 40-25 of the ITAA 1997 provides an annual deduction to a holder of a depreciating asset for the decline in value of the asset as worked out under Division 40 of the ITAA 1997. Subject to some specific exclusions, a depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used. The definition of depreciating asset is, therefore, based on a life in effective use such that a depreciating asset is identified by having its own life in that use. This means that a depreciating asset will generally be identified by its functionality. It follows that an asset may be a depreciating asset if it is in a condition that enables it to function or to be used as a depreciating asset even though the asset requires further refinement to its functionality or use.

The meaning of 'use' depends on the context in which the word is employed and the purpose for which the asset has been acquired or created (see Newcastle City Council v. Royal Newcastle Hospital (1956) 96 CLR 493). In the context of Research and Development activities, it is sufficient that the asset can perform the functionality for which it was designed to be used. A discussion of the meaning of 'used' is set out in ATO Interpretative Decision ATO ID 2006/259 Capital Allowances: depreciating asset - section 73BA depreciating asset - full-scale test model.

Each of the prototypes were created and used by the rulee for testing, monitoring and developmental purposes. Although each prototype was commercially incomplete in the sense that further refinement was required before it could be exploited, each prototype was nonetheless an asset.

After the testing process was completed (up to 3 months), the prototype was obsolete (as it was more cost effective to manufacture a new prototype). However, the prototype was not destroyed or otherwise consumed in the Research and Development activities but rather retained by the rulee for historical purposes, that is, to provide a detail of the developmental journey and it is expected that the prototypes will be retained until such time as the Research and Development on this project concludes, thereby forming part of the record keeping of the company's Research and Development activities.

Therefore, these articles were used in the Research and Development operations, albeit, for a short and limited period (up to three months) and will remain in tact and retained by the rulee for historical purposes during the life of the Project (as part of its Research and Development activities) which in itself serves some function or use to the rulee. This purpose is sufficient for the 'use' and 'functionality' test.

As the legal owner of the prototypes, the rulee was the holder of the assets for the 30 June 2009 income year (pursuant to item 10 of the table in section 40-40 of the ITAA 1997.

Accordingly, each prototype is a section 73BA depreciating asset, the costs of which amount to 'excluded plant expenditure' and therefore falls outside the definition of research and development expenditure. Since this fourth requirement is not satisfied, no deduction under subsection 73B(14) arises for the cost of the prototypes for the 30 June 2009 income year.

Issue 1 Question 4

Detailed reasoning

As discussed above, research and development expenditure incurred by the rulee in a year of income will be deductible in that year at 125% where the following four requirements of subsection 73B(14) are satisfied:

§ the rulee is an eligible company;

§ the rulee incurs expenditure on eligible research and development activities;

§ the rulee's aggregate research and development amount is greater than $20,000; and

§ the expenditure is research and development expenditure.

In respect of the first requirement, it is accepted that the rulee was an eligible company (as defined in section 73B(1) of the ITAA 1936) for the income year ended 30 June 2009 for the purposes of subsection 73B(14) of the ITAA 1936.

In respect of the second requirement, it is accepted that the rulee has incurred expenditure on eligible research and development activities for the 30 June 2009 income year.

In respect of the third requirement, it is assumed that the aggregate research and development amount for the rulee would be met for the 30 June 2009 income year.

Research and Development Expenditure

As discussed above, research and development expenditure, as defined in subsection 73B(1) of the ITAA 1936, includes salary expenditure, contract expenditure paid to Registered Research Agencies, and other expenditures (including overhead and consumables) that are incurred directly in respect of eligible research and development activities.

The category of expenses which can be claimed as 'other expenditure' are limited to those 'incurred directly in respect of research and development activities'. It is considered that administrative costs and overheads are 'directly in respect of' research and development activities where:

§ the carrying on of eligible Research and Development activities contributed to the incurring of all or an identifiable part of the expenditure; or

§ the conduct of eligible Research and Development activities by the company could be materially impaired if the expenditure were not incurred.

Office supplies

As a general rule, the following expenses would be accepted as being connected to eligible Research and Development projects:

§ consumables; for instance, expenses such as oils, grease and cloths used generally, including Research and Development activities;

§ postage; and

§ printing and stationery.

It is an accepted fact that the expenditure incurred on office supplies by the rulee was directly connected to an eligible Research and Development project so as to amount to research and development expenditure within the meaning of subsection 73B(1) of the ITAA 1936.

Freight

It is an accepted fact that the expenditure incurred on freight by the rulee was directly connected to an eligible Research and Development project so as to constitute research and development expenditure within the meaning of subsection 73B(1) of the ITAA 1936.

Research, standards and policies

It is an accepted fact that the expenditure incurred on research standards by the rulee was directly connected to an eligible Research and Development project so as to constitute research and development expenditure within the meaning of subsection 73B(1) of the ITAA 1936.

Issue 2 Question 1

Detailed reasoning

Subsection 73BA(2) of the ITAA 1936 provides:

If an eligible company has a notional Division 40 deduction for a section 73BA depreciating asset for a year of income, the company is entitled to a deduction under this section for the asset for the year of income.

If an eligible company's aggregate research and development amount for the year of income is more than $20,000, a deduction equal to the notional Division 40 deduction multiplied by 1.25 will be available. If the threshold is not met, a deduction equal to the notional Division 40 deduction will be available. However, no deduction under section 73BA will be allowed under subsection 73BA(4) of the ITAA 1936 where the company was entitled to a deduction for the asset for an earlier period under certain provisions of the ITAA 1997.

As it is assumed that the rulee's aggregate research and development amount will meet this threshold, the rulee may be entitled to a 125% deduction where:

§ the rulee is an eligible company for the 30 June income year;

§ each prototype is a depreciating asset under section 73BA of the ITAA 1936 for the 30 June 2009 income year;

§ the rulee is entitled to a notional Division 40 deduction; and

§ the exceptions in section 73BA(4) of the ITAA 1936 do not apply.

In respect of the first requirement, the rulee is an 'eligible company' for the 30 June 2009 income year.

In respect of the second requirement, each prototype is a depreciating asset under section 73BA of the ITAA 1936 (refer discussion above - Issue 1 Question 3).

Notional Division 40 Deduction

In respect of the third requirement, the concept of a notional Division 40 deduction is explained in subsection 73BC(1) of the ITAA 1936 as:

An eligible company has a "notional Division 40 deduction" for a section 73BA depreciating asset for a year of income if it would be entitled to a deduction under section 40-25 of the Income Tax Assessment Act 1997 for the asset for the year of income assuming the changes set out in this section were made.

Section 40-25 of the ITAA 1997 provides a deduction to a holder of a depreciating asset of an amount equal to the decline in value of the asset for the income year as worked out under Division 40.

A depreciating asset starts to decline in value from when its start time occurs (subsection 40-60(1) of the ITAA 1997). For a holder of a depreciating asset, the start time of the asset is when the holder first uses the asset, or has it installed ready for use, for any purpose (subsection 40-60(2) of the ITAA 1997).

A taxpayer must reduce its deduction by the part of the asset's decline in value that is attributable to its use of the asset, or having it installed ready for use, for a purpose other than a taxable purpose.

The changes contemplated in subsection 73BC(1) of the ITAA 1936 are:

§ to replace the existing Division 40 purpose criteria with the purpose of carrying on research and development activities (as defined by subsection 73B(1) of the ITAA 1936);

§ the cost of the asset must be determined taking into account any of the rules in section 73BD or section 73BE of the ITAA 1936 that might affect what is included in the cost;

§ Division 40 is applied on the assumption that section 73BA of the ITAA 1936, section 40-425 of the ITAA 1997 (allocation of assets to a low-value pool) and Subdivision 328-D of the ITAA 1997 (capital allowances for STS taxpayers) had not been enacted^.

The rulee is the legal owner of the prototypes and hence the holder for the purposes of section 40-40 of the ITAA 1997 and is used 100% in the course of planning and carrying out R & D Activities. Accordingly, the rulee is entitled to a notional Division 40 deduction for the prototypes.

Exceptions in section 73BA(4) do not apply

In respect of the fourth requirement, an eligible company is not entitled to a deduction under section 73BA of the ITAA 1936 for any period if:

§ the company was entitled to a deduction for the asset for any earlier period under Subdivision 328-D of the ITAA 1997;

§ a deduction for the asset for any earlier period under Division 40 of the ITAA 1997 in a case to which section 40-440 of the ITAA 1997 (about low value pools) applied.

The prototypes were developed or acquired in the 30 June 2009 income year at the same time as when the Research and Development activities were conducted so these provisions have no effect.

As the abovementioned requirements are satisfied, the rulee is entitled to a deduction under subsection 73BA(2) of the ITAA 1936 equal to the notional Division 40 deduction multiplied by 1.25. The ATO has been instructed that the rulee will self assess the exact amount of the Division 40 deduction including effective life. The rulee will need to consider in its assessment the fact that various components have been reused in different prototypes (see ATO Interpretative Decision ATO ID 2006/328 Capital Allowances: cost - 'section 73BA depreciating asset' - new full-scale test model - re-use of components from earlier test model).

Issue 2 Question 2

Detailed reasoning

As discussed above, the rulee may be entitled to a 125% deduction under subsection 73BA(2) of the ITAA 1936 where:

§ the rulee is an eligible company for the 30 June income year;

§ the Mobile Phone is a section 73BA depreciating asset for the 30 June 2009 income year;

§ the rulee is entitled to a notional Division 40 deduction; and

§ the exceptions in section 73BA(4) of the ITAA 1936 do not apply,

In respect of the first requirement, the rulee is an 'eligible company' for the 30 June 2009 income year.

Section 73BA Depreciating Asset

In respect of the second requirement, a section 73BA depreciating asset is defined in section 73BB of the ITAA 1936 as:

A "section 73BA depreciating asset" of an eligible company is an asset for which the eligible company could (ignoring section 73BA) deduct an amount under section 40-25 of the Income Tax Assessment Act 1997 if the following assumptions were made:

(a) contrary to paragraph 40-30(1)(c) and subsection 40-30(2) of that Act, all intangible assets were excluded from the definition of "depreciating asset" in section 40-30 of that Act;

(b) subsection 40-45(2) of that Act did not, except in the case of buildings, prevent that Division from applying to capital works to which Division 43 of the Income Tax Assessment Act 1997 applies, or to which that Division would apply but for expenditure being incurred, or capital works being started, before a particular day;

(c) the eligible company satisfied any relevant requirement for deductibility under that Division.

Section 40-25 of the ITAA 1997 provides an annual deduction to a holder of a depreciating asset for the decline in value of the asset as worked out under Division 40 of the ITAA 1997. Subject to some specific exclusions, a depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used (subsection 40-30(1) of the ITAA 1997). The definition of depreciating asset is, therefore, based on a life in effective use such that a depreciating asset is identified by having its own life in that use. This means that a depreciating asset will generally be identified by its functionality.

The rulee is the legal owner of the Mobile Phone and therefore the holder for the purposes of section 40-40 of the ITAA 1997.

The phone is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used (particularly on account of the rapid developments in technology). Accordingly, it is a section 73BA depreciating asset.

Notional Division 40 Deduction

In respect of the third requirement, as the Mobile Phone was acquired on 17 February 2009 and is used 100% in the course of planning and carrying out R & D activities the rulee is entitled to a notional Division 40 deduction.

Exceptions in subsection 73BA(4) do not apply

In respect of the fourth requirement, as the Mobile Phone was acquired on 17 February 2009 (30 June 2009 income year) at the same time as when Research and Development activities were conducted these provisions have no effect.

As the above four requirements are satisfied, the rulee is entitled to a deduction under subsection 73BA(2) of the ITAA 1936 equal to the notional Division 40 deduction multiplied by 1.25. The ATO has been instructed that the rulee will self assess the exact amount of the Division 40 deduction. Please note that if a deduction is claimed under this provision, a deduction should not be claimed under the small business pool provisions as suggested by the tax agent.

Issue 3 Question 1

Detailed reasoning

Section 73BF of the ITAA 1936 provides:

If:

(a) a balancing adjustment event (within the meaning of section 40-295 of the Income Tax Assessment Act 1997) happens in relation to a section 73BA depreciating asset of an eligible company; and

(b) one or more deductions have been allowed or are allowable to the eligible company under section 73BA or 73BH for the asset for a year or years of income, or would have been so allowed or allowable if:

(i) the company had not chosen a tax offset under section 73I; or

(ii) section 73BAF had not been enacted; and

(c) no deduction:

(i) is allowable to the eligible company under section 40-25 of the Income Tax Assessment Act 1997 for the asset for any year of income; or

(ii) was allowable to the eligible company under section 42-15 of the Income Tax Assessment Act 1997, as in force before its repeal by the New Business Tax System (Capital Allowances) Act 2001, for the asset for any year of income; and

(d) a deduction would be allowable to the eligible company, or an amount would be included in the eligible company's assessable income, in respect of the balancing adjustment event under Subdivision 40-D of that Act if:

(i) the changes set out in section 73BC were made; and

(ii) section 40-292 of the Income Tax Assessment Act 1997 and this section (other than this paragraph) had not been enacted;

then the deduction mentioned in paragraph (d) is allowable to the eligible company, or the amount mentioned in paragraph (d) is included in the eligible company's assessable income, under this section for the year of income in which the balancing adjustment event occurs.

As discussed above, the prototypes are a section 73BA asset and a deduction would be allowed for the 30 June 2009 income year under section 73BA of the ITAA 1936. Furthermore, no deduction is allowed under section 40-25 or 40-15 of the ITAA 1997.

Therefore, at issue is whether a balancing adjustment event occurred during the 30 June 2009 within the meaning of section 40-295 of the ITAA 1997.

Section 40-295 of the ITAA 1997 provides:

(1) A balancing adjustment event occurs for a *depreciating asset if:

(a) you stop *holding the asset; or

(b) you stop using it, or having it *installed ready for use, for any purpose and you expect never to use it, or have it installed ready for use, again; or

(c) you have not used it and:

(i) if you have had it installed ready for use - you stop having it so installed; and

(ii) you decide never to use it.

(2) A balancing adjustment event occurs for a *depreciating asset if:

(a) for any reason, a change occurs in the *holding of, or in the interests of entities in, the asset; and

(b) the entity or one of the entities that had an interest in the asset before the change has an interest in it after the change; and

(c) the asset was a partnership asset before the change or becomes one as a result of the change.

The prototypes fall within the meaning of depreciating asset in section 40-30 as each prototype is an asset that has a limited effective life and can reasonably be expected to decrease in value over the time it is used.

There has been no change in the holding of the asset as the rulee has at all relevant times been and continues to be the legal and beneficial owner of the prototypes (item 10, section 40-40 of the ITAA 1997), Therefore, a balancing adjustment will be crystallised in the circumstances where the rulee stops using a prototype.

As discussed, the meaning of 'use' depends on the context in which the word is employed and the purpose for which the asset has been acquired or created (see Newcastle City Council v. Royal Newcastle Hospital (1956) 96 CLR 493). The use of a depreciating asset can take many forms, ranging from the active use of a machine in a business manufacturing process to the passive use of a statute as a decorative piece (refer to ATO Interpretative Decision ATO ID 2003/625 Capital Allowances: use and balancing adjustment events and Council of the City of Newcastle v Royal Newcastle Hospital (1957) 96 CLR 493). However, where a taxpayer decides that a test model can no longer be usefully employed to test the taxpayer's Research and Development activities and dismantles it and discards its components the taxpayer is taken to permanently stop using the existing test model (ATO Interpretative Decision ATO ID 2006/327 Capital Allowances: balancing adjustment event - 'section 73BA depreciating asset' - existing full-scale test model - discontinued use).

During the 30 June 2009 income year, the rulee built the prototypes, tested the prototypes over various periods during the year and when the testing phase was completed, either reused some components or simply retained the prototypes for historical reasons. The prototypes were not fully dismantled and discarded but rather retained as part of the rulee's record keeping and will continue to be retained until the Project ends. Therefore the prototypes were used throughout the 30 June 2009 income year either actively (as part of the testing phase) or passively (for record keeping purposes for the life of the Project). This use constitutes 'use' for the purposes of subsection 40-295(1) of the ITAA 1997.

As there was no cessation of use of the prototypes by the rulee during the 30 June 2009 income year, no balancing adjustment arose during the 30 June 2009 income year under subsection 73BF of the ITAA 1936.

Issue 3 Question 2

Detailed reasoning

Refer above- Issue 3, Question 1.

Issue 4 Question 1

Detailed reasoning

Refer below- Issue 4, Question 2.

Issue 4 Question 2

Detailed reasoning

Can a deduction be claimed under the depreciating asset provisions?

A depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time that it is used (subsection 40-30(1) of the ITAA 1997). The definition excludes land, trading stock and intangible assets except for those intangible assets listed in subsection 40-30(2) of the ITAA 1997.

A trademark is not a tangible asset and is an intangible asset. Therefore to be a depreciating asset in Division 40 of the ITAA 1997, it needs to be an intangible asset of a kind listed in subsection 40-30(2).

However paragraph 40-30(2)(c) of the ITAA 1997 provides that items of intellectual property, are depreciating assets, if they are not trading stock.

The definition of intellectual property does not include trademarks. For the purpose of applying the meaning of intellectual property in the ITAA 1997, a trademark is not an item of intellectual property. In subsection 40-30(2), a trademark is not included in any of the items listed. As a trademark is not of a kind listed in subsection 40-30(2), but is an intangible asset, it is excluded from being a depreciating asset by paragraph 40-30(1)(c) of the ITAA 1997.

Can a deduction be claimed as a business related cost?

Subject to the limitations and exceptions contained in subsections 40-880(3) to 40-880(9) of the ITAA 1997, subsection 40-880(2) of the ITAA 1997 provides that the rulee can deduct, in equal proportions over a period of five income years starting in the year in which it was incurred, capital expenditure:

1. in relation to the rulee's business; or

2. in relation to a business that used to be carried on; or

3. in relation to a business proposed to be carried on; or

4. to liquidate or deregister a company of which the rulee was a member, to wind up partnership of which the rulee was a partner or to wind up a trust of which the rulee was a beneficiary, that carried on a business.

The capital expenditure the rulee incurred was registration fees for the trade mark. The character of this expenditure is part of establishing the structure of the business. The expenditure is crucial in protecting the asset which is being developed. In this circumstance there is a sufficient and relevant connection between the incurrence of the capital expenditure and the business proposed to be carried on by the rulee. Accordingly the capital expenditure is incurred in relation to the business proposed to be carried on by the rulee and therefore paragraph 40-880(2)(c) of the ITAA 1997 applies.

Therefore the rulee may deduct the capital expenditure it incurred in the registration cost of the trademark in equal proportions over a period of five income years starting in the year it was incurred.

Further issues for the rulee to consider

Whether the rulee's aggregate Research and Development amount for the 30 June 2009 income year actually exceeded $20,000?

The ATO was instructed to assume that the aggregate research and development amount for the 30 June 2009 year for the rulee exceeded $20,000.

We note that the rulee's Profit & Loss Statement for the 30 June 2009 financial year shows total expenses in excess of $20,000. However, such costs may or may not qualify for inclusion in the 'aggregate research and development amount' as defined in subsection 73B(1) of the ITAA 1936.

For example, the definition specifically excludes expenditure on overseas Research and Development activities that is not certified expenditure. As the expenditure on overseas travel was not certified expenditure, an amount would be excluded from the aggregate research and development amount (refer Issue 1, Question 2). Further, as the prototypes and Mobile Phone are section 73BA depreciating assets, the notional Division 40 deductions for these assets (rather than the acquisition cost) will be included in the aggregate research and development amounts (rather than the full acquisition cost).

We recommend that this issue be considered in more detail by the rulee and its tax agent/adviser, as this will have an impact on the ability to claim the deductions contemplated in this ruling.