Edited version of private ruling

Authorisation Number: 1011784165561

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Ruling

Subject: Long Term Construction

Question 1

Will Division 250 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to the assets constructed by the head company of a tax consolidated group (X) that will form part of a infrastructure project (project)?

Answer

No.

Question 2

Will construction payments received by X in relation to the project from an Australian state government (State Government) be assessable under section 6-5 of the ITAA 1997?

Answer

Yes.

Question 3

Will costs incurred by X in paying subcontractors for the construction of the project be deductible under section 8-1 of the ITAA 1997?

Answer

Yes.

Relevant facts and circumstances

Construction Stage

The description of the scheme is based on information provided by the applicant including diagrammatic representations of the proposed transactions that will occur during the various stages of the project.

A consortium of investors represented by X (as head company of a tax consolidated group) has been selected as the successful bidder to construct stage 1 of the project. X has entered into a contractual arrangement with the State Government.

X is a company incorporated in Australia and resident of Australia for income tax purposes. Equity contributions are currently nominal, however these will increase over time during the construction period. All equity contributions from establishment until the completion of the construction period will be pro rata.

X shareholders will acquire their initial holding prior to X holding any interest in land or entering into any contract or agreement to acquire any interest in land.

The State Government has contracted with X to construct the project. X intends to subcontract this project to third parties.

Y is a company incorporated in Australia and is a resident of Australia for income tax purposes.

Y will borrow funds from financial institutions which it will on lend at interest to X in order to fund the construction and associated costs of the project.

X will have the right to access the land during the construction phase for the purpose of constructing the project infrastructure.

The project will be jointly funded.

Construction - State Contribution

The transactions occurring once 100% of the equity is committed, and 50% of the debt is contributed. These requirements trigger the contribution by the State Government of an amount on a progressive basis.

The applicant has stated that Y will draw down additional funds from financial institutions (beyond the previously mentioned 50% contribution) under an 'on-lending facility' established at the commencement of the project.

Y will then loan these funds to X at an interest rate approximating the rate on the funds it has borrowed.

During this stage, X will pay further construction costs to the third party contractors.

Completion Securitisation Stage

X will have initially paid for the construction of the project infrastructure. However, on completion the State Government will reimburse X for the relevant costs in accordance with the contractual arrangement.

Further, upon completion, the State Government will enter into a lease over the land comprising the project with X for a period of years.

The State Government will then enter into an agreement with another entity (Y) and X, by virtue of which Y will pay an amount to X at the direction of the State Government. In exchange for Y receiving the State Government's entitlement to the future lease payments which are to be made by X.

The size of this payment made by Y upon completion of construction of the project (to X on behalf of the State Government), will be calculated utilising the interest rate(s) associated with Y's financing costs. Further, the amount of the lease rental payments (which will ultimately be paid from X to Y under the contractual arrangements) will be negotiated between X and the State Government. At no point will X hold the freehold title in the land the subject of the project.

The State Government will in part use this upfront securitisation payment to meet its obligations under the contractual arrangement with X.

X will repay part of an outstanding loan it obtained from Y utilising the funds from the construction payment made by the State Government.

The applicant has stated that any gain (or loss) made by Y under the arrangement between Y and the State Government will be spread using the compounding accruals methodology (refer paragraph 230-135(2)(a)) of the ITAA 1997.

The applicant has further stated that the taxpayer has not (and will not) make an election under Division 230 of the ITAA 1997 (in relation to the methodology to be applied in determining the amount of the gain or loss).

Operation Stage

Once completed, X will derive payments from the State Government in return for the operation of the project. These payments are subject to certain levels of performance. These payments are contemplated under the contractual arrangement. The final calculation of the amount of the payments has formed part of the pricing detailed in the contractual agreements between the parties.

X will be obliged to make lease payments under a lease with the State Government.

At the end of the project period, the (leasehold) interests of X in the relevant project assets revert to the State Government for no further consideration.

Completion of Construction Phase - X's position

During the construction phase of the project, X will have borrowed an amount from Y. Further, during the construction phase the applicant expects that an amount of interest will be payable on these outstanding borrowings.

X will use a portion of the amount borrowed under the loan facility to make payments of interest during the construction phase. In other words, X is borrowing both its capital and interest requirements during the construction phase of the project. At the completion of this construction phase, an amount of principal will be outstanding.

As stated previously, upon entering into the contractual arrangements at the completion of the construction phase, the State Government will direct a payment to X in respect of the relevant construction costs in accordance with the parties' contractual arrangement.

Accordingly, once X applies the proceeds of this payment towards its outstanding borrowings, X will have an amount still outstanding. These outstanding funds, and future interest payments, will be repaid over time from operating cash flows.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 subsection 6-5(1)

Income Tax Assessment Act 1997 section 8-1

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

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 section 40-40

Income Tax Assessment Act 1997 Division 43

Income Tax Assessment Act 1997 subsection 43-10(2)

Income Tax Assessment Act 1997 section 43-85

Income Tax Assessment Act 1997 section 43-120

Income Tax Assessment Act 1997 Division 250

Income Tax Assessment Act 1997 section 250-15

Income Tax Assessment Act 1997 paragraph 250-15(a)

Income Tax Assessment Act 1997 paragraph 250-15(b)

Income Tax Assessment Act 1997 paragraph 250-15(c)

Income Tax Assessment Act 1997 paragraph 250-15(d)

Income Tax Assessment Act 1997 subparagraph 250-15(d)(i)

Income Tax Assessment Act 1997 section 250-60

Income Tax Assessment Act 1997 subsection 250-60(2)

Reasons for decision

Note: Unless specified otherwise, all legislative references in the following reasons for decision are to the Income Tax Assessment Act 1997.

Question 1

Section 250-15 sets out the general test for determining whether (or not) Division 250 applies to an arrangement. Paragraph 250-15(a) requires that an asset be put to a tax preferred use. The term 'put to a tax preferred use' is a defined term, the meaning of which is explained by section 250-60. So far as is relevant, subsection 250-60(2) provides that an asset is put to a tax preferred use at a particular time if:

(a) at that time the asset is, or is to be, used (whether or not by you) wholly or partly in connection with:

…

(ii) the provision of services or facilities; and

(b) … the following subparagraph(s) is satisfied at that time:

(i) some or all of the goods, services or facilities are, or are to be, produced for or supplied, carried, transmitted or delivered to or for an *end user who is a *tax preferred end user because of paragraph 250-55(a) (tax preferred entity) but is not an *exempt foreign government agency;

Numerous assets will either be constructed or acquired to fulfil the requirements of the project (e.g., plant, rolling stock, buildings). X will use those assets in connection with the provision of services. Further, X will be delivering these services on behalf of, and ultimately for, the State Government who is a tax preferred end user. Therefore, the Commissioner is satisfied that paragraph 250-15(a) is satisfied.

The Commissioner is satisfied that paragraphs 250-15(b) and (c) are also satisfied.

Paragraph 250-15(d) requires that X be otherwise entitled to a capital allowance in relation to:

(i) a decline in the value of the asset; or

(ii) expenditure in relation to the asset.

Decline in the value of the asset

Entitlement to a capital allowance deduction in relation to the decline in the value of an asset (subparagraph 250-15(d)(i)) requires that X be the holder of the asset; see section 40-40.

Section 40-40 sets out a table that helps you work out if an entity holds an asset.

Of the various items contained in the table within section 40-40, items 2, 3, 4 and 10 are those which have potential application to X under the scheme as defined in the relevant facts and circumstances.

Item 2 - an asset fixed to land subject to a quasi-ownership right where the owner of the right has a right to remove the asset

A quasi-ownership right over land includes leases, easements, and any other right, power or privilege over land or in connection with it. The land comprising the project will be leased from the State Government. Accordingly, the leasehold interest in the land will constitute a quasi-ownership right.

However, the applicant has stated that at no time will X have a right to remove any of the assets (or part thereof) from that land. The Commissioner accepts the applicant's contention that item 2 has no application.

Item 3 - improvement to land subject to a quasi-ownership right for the use of the owner of the right where the owner of the right has no right to remove the asset

As discussed under item 2, the leasehold interest in the land will constitute a quasi-ownership right. The applicant has stated that ultimately, construction is being undertaken on the land for the State Government, not X. The applicant has submitted that any improvement to the land will immediately become the property of the State Government and is not for X's own use. The Commissioner accepts the applicant's contention that X has not 'improved' the land on behalf of itself. X undertakes any and all improvements on behalf of the State Government. Accordingly, item 3 has no application.

Item 4 - asset subject to a lease where the asset is fixed to land and the lessor has the right to recover the asset

In the context of the between the State Government (lessor) and X (lessee), the State Government has the right to recover any of the assets fixed to the land comprising the project. Therefore, the Commissioner accepts the applicant's contention that under item 4, the State Government would be the 'holder' of any asset under the project.

Item 10 - any depreciating asset

The broadest item is item 10. Should our interpretation of item 4 not be correct, the application of item 10 would result in the State Government being considered to be the holder of the assets that comprise the project

X has merely acquired or constructed the items referred to as 'depreciating assets' under the terms of the Contract and the contractual arrangement entered into between X and the State Government. The situation is analogous to a taxpayer having an external party constructing an item of plant and equipment for them or a taxpayer acquiring an item of plant and equipment from a supplier. In both examples it is the taxpayer who is the holder of the equipment. The supplier or contractor of the item is not the holder for Division 40 purposes. Item 10 will be of particular relevance for depreciable items of plant that are not fixed to the land. Therefore, the Commissioner accepts the applicant's contention that the State Government, and not X, would be the 'holder' of any relevant asset under item 10. As such X will not have an entitlement to a capital allowance deduction in relation to a decline in the value of an asset (subparagraph 250-15(d)(i)).

Expenditure in relation to the asset

Entitlement to a capital allowance deduction for expenditure in relation to an asset (subparagraph 250-15(d)(ii) requires that X have a 'construction expenditure area' (see paragraph 43-10(2)(a)), and a 'pool of construction expenditure' (see paragraph 43-10(2)(b)) under Division 43 (deductions for capital works).

The project will include the construction of a number of assets that could qualify for a deduction under Division 43 (deductions for capital works). Further, the Commissioner accepts that for the purposes of section 43-120, X will have a quasi-ownership right over the land when the lease is entered into.

Whilst X will enter into various contracts with different sub-contractors during the course of the project, ultimately the project is being undertaken by virtue of a construction contract (embodied in the contractual arrangement) entered into between the State Government and X. It follows that expenditure on the construction of the project is not incurred by X in the manner contemplated by Division 43.

The expenditure incurred by X to construct the project is within its ordinary course of business, and therefore will be on revenue account. There will be no 'capital' component of the construction expenditure (see section 43-70) as required under subsection 43-10(2). As such, X will not have an entitlement to a capital allowance deduction for expenditure in relation to an asset under subparagraph 250-15(d)(ii).

Therefore, the requirement to be entitled to capital allowances under paragraph 250-15(d) is not satisfied, and as all requirements need to be satisfied before Division 250 is enlivened, the Commissioner confirms that Division 250 has no application to the scheme as identified in the application.

Question 2

Subsection 6-5(1) sets out the basic proposition that assessable income includes income according to ordinary concepts, which is called ordinary income. Generally speaking, this results in all 'ordinary' income being included in a taxpayer's assessable income unless it is exempt, or is specifically made non-assessable by another provision.

Typical examples of income include salaries, wages, proceeds of carrying on a business, rent, interest, and dividends. Typical examples of items which are not generally income include lottery prizes, proceeds from a mere hobby, loans, and gifts.

Some of the factors which may be relevant in determining whether an amount is ordinary income include whether:

· the amount has the characteristics of periodicity, recurrence or regularity

· it is convertible into money or money's worth

· it is associated with business activities or services rendered, as distinct from the mere sale of property, and

· it is solicited, as distinct from a windfall.

Whilst the presence of these factors will suggest that the amount is more likely to be ordinary income, it is not necessarily determinative. The individual factor's relative importance varies significantly according to the circumstances and to the presence of any countervailing factors.

The applicant has submitted that the payments made by the State Government to X will be assessable income, and the Commissioner confirms that this is the correct characterisation of those payments.

Further, as identified by the applicant, as the construction phase of the project extends beyond one income year, Income Taxation Ruling IT 2450 should be applied in relation to assessable amounts received during that phase. It should be noted that the application of IT 2450 is only relevant during the construction phase, as distinct to the 'operations phase', where other amounts payments may be received by X. The contractual arrangement between the parties appropriately defines what is the 'construction phase'.

The applicant has stated that it is expected that the 'Estimated Profits Basis' recognised under IT 2450 will be used to spread the ultimate profit (or loss) in relation to the construction over the years taken to complete the contract.

Subject to the treatment allowed for under IT 2450, the Commissioner confirms that construction payments received by X from the State Government in relation to the project will be assessable under section 6-5.

Question 3

Subsection 8-1(1) of the ITAA 1997 provides that you can deduct from your assessable income any loss or outgoing to the extent that:

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

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

Subsection 8-1(2) provides that you cannot deduct a loss or outgoing under section 8-1 to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature; or …

Business expenditure is deductible as a general (revenue nature) deduction if it has the necessary and relevant connection with the operation or activities which directly gain or produce assessable income ( Charles Moore & Co (WA) Pty Ltd v. Federal Commissioner of Taxation (1956) 95 CLR 344; 11 ATD 147; 6 AITR 379, Federal Commissioner of Taxation v. Smith (1981) 147 CLR 578; (1981) 11 ATR 538; (1981) 81 ATC 4114, Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).

Provided that a loss or outgoing can be objectively viewed as a necessary or natural consequence of the taxpayer's income earning activities, it will be considered 'incidental and relevant' to the income earning activities of the taxpayer and deductible as a revenue deduction under section 8-1, except to the extent that it is a loss or outgoing of capital or of a capital nature (see discussion of the High Court in Steele v. Deputy Commissioner of Taxation (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139).

The established principles on the distinction between capital and income are well known; see for example, Dixon J's judgement in Sun Newspapers Ltd & Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87 (Sun Newspapers Case), and the Full Federal Court decision in FC of T v. Email (1999) 99 ATC 4868 at 4873; 42 ATR 698 at 704). The character of the advantage sought provides guidance as to the nature of the expenditure as it says most about the essential character of the expenditure itself. The decision of the High Court in G.P. International Pipecoaters v. Federal Commissioner of Taxation (90 ATC 4413; (1990) 170 CLR 124; 21 ATR 1) emphasised this, stating:

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

X will pay various subcontractors for the construction of the project. The applicant has submitted that the construction of the project by X is analogous to any other property developer who constructs an asset on behalf of a client. The Commissioner accepts that the costs incurred by X in paying various subcontractors to construct the project will be losses or outgoings will be losses or outgoings incurred in gaining or producing X's assessable income or, in will be incurred in carrying on X's business for the purpose of gaining or producing its assessable income. Further, the Commissioner is also satisfied that the 'negative limb' of paragraph 8-1(2)(a) is not applicable to the relevant costs under the scheme as described in the application. That is the costs incurred will not be a losses or outgoings of capital, or capital in nature.

Subject to the treatment allowed for under IT 2450, the Commissioner confirms that costs incurred by X in paying subcontractors for the construction of the project, will be deductible under section 8-1.