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Ruling

Subject: Infrastructure Project - General deductions

Question 1

Will variation construction costs in respect to project variations initiated and funded by Entity B and paid by Company A in respect of the a construction project be allowable deductions under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) in the year they are incurred?

Advice/Answers

Yes.

Relevant facts

Company A's principal business activities are those of designing, constructing and operating large-scale assets.

Company A is responsible for the construction and operation of the large scale assets, and engages subcontractors in order to meet these responsibilities.

On a particular date, Company A entered into a Project Deed with Entity B.

Under the Project Deed:

(a) Entity B has a requirement for certain facilities and services for a specified period.

(b) Company A agreed to finance, design, construct, commission, operate and maintain certain facilities and provide certain other services in connection with such facilities in order to fulfil Entity B's requirements on the terms set out in the Project Deed.

(c) Entity B will pay fees to Company A to provide such facilities and services in accordance with the Project Deed.

(d) Company A will transfer possession of and facilities management responsibility for relevant facilities to, or in accordance with the direction of, Entity B, in accordance with the Project Deed.

All chattels and non-fixtures comprising the facilities designed and constructed by Company A will revert to Entity B at the end of the project and Company A must transfer all of its title, interest and rights in and to the facilities to Entity B at that time.

With the completion of the construction of the facilities, Company A's core business relates to the long term operation and management of the construction project (the project).

In return for operating and maintaining the facilities, Company A is entitled to receive payments from Entity B (the service payments). The service payments are reflective of an annuity income stream commensurate with the risks of large scale design, financing and construction and long term operation and maintenance activities.

Company A also conducts ancillary construction operations. Circumstances may arise that require variations to be made (project variations) to the original design of the facilities. Entity B may, therefore, request that Company A undertake the project variation.

In return for undertaking an Entity B initiated project variation, Company A receives compensation from Entity B (the variation payment) that reflects the costs to Company A of undertaking the project variation plus a margin to compensate Company A.

In order to undertake the project variations Company A necessarily incurs costs (the variation construction costs) in engaging subcontractors to carry out the necessary works. The project variations vary in size and cost.

The Project Deed allows Entity B to request that Company A makes alterations, additions or modifications to the facilities.

The Project Deeds sets out the procedure that must be followed to enable Company A to undertake the project variations.

The Project Deed states that Entity B is required to compensate Company A for these project variations.

Once Company A has been requested to undertake the project variations, a subcontractor or subcontractors will be engaged to undertake the necessary works to effect the project variation. Company A is responsible for making the variation construction costs to the various subcontractors engaged to carry out the project variation.

Company A is then entitled to the variation payment from Entity B equal to:

· the subcontractor costs incurred in undertaking the project variation; plus

· a margin.

An Entity B initiated and funded project variation may result in increased service payments to Company A. It is noted that Entity B has the option to engage another contractor to undertake the works if the parties cannot agree on the variation payment.

The increases in service payments are made to compensate Company A for the cost of the ongoing operation and maintenance of the project variations.

Company A undertakes the project variations to profit from the variation payment rather than increases to service payments.

Project variations do not increase Company A's capacity to earn revenue from third-parties.

Legal title to any fixtures created will pass to Entity B upon construction.

Project variations have occurred and are expected to occur in the future. Project variations cannot be anticipated until Entity B informs Company A of the intention to issue a request to undertake a project variation.

A project variation may result in increased service payments to Company A. Entity B has the option under the Project Deed to engage another contractor to undertake the works if the parties cannot agree on the variation payment.

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997.

Summary

Variation construction costs in respect to project variations initiated and funded by Entity B are allowable deductions under section 8-1 in the year they are incurred.

Detailed reasoning

General deductions are allowable under section 8-1:

Subsection 8-1(1)  

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)  

However, you cannot deduct a loss or outgoing under this section to the extent that:

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

(b) it is a loss or outgoing of a private or domestic nature; or

(c) it is incurred in relation to gaining or producing your ^*exempt income or your ^*non-assessable non-exempt income; or

(d) a provision of this Act prevents you from deducting it.

Positive limbs under section 8-1

For a deduction to be allowable under section 8-1 the first requirement is that the loss or outgoing has to be incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

The relevant loss or outgoing here are the variation construction costs incurred by Company A for carrying out Entity B initiated and funded project variations under the terms of the Project Deed.

Company A's core business relates to the long term operation and management of the project. The principal business activities carried on by Company A are those of designing, constructing and operating large-scale assets.

Company A is contracted for a specified period to perform services in relation to the property it has constructed and which is occupied by the Entity B. Company A receives payment for the services, and payment for project variations that are initiated and funded by the Entity B.

Company A has carried out numerous Entity B initiated and funded project variations. Each project variation has been and will be carried out in accordance with the terms of the Project Deed.

Many of the project variations have resulted in increased annual service payments for repairs and maintenance; however the increases in service fees are made to compensate Company A for the cost of on-going operation and maintenance of the project variation.

Entity B has the option under the Project Deed to engage another contractor to undertake the works if the parties cannot agree on the Variation Payment. Under the terms of the Project Deed, Company A is contracted to provide annual service for repairs and maintenance and would be in receipt of additional annual service payments whether the project variation is carried out by themselves or another contractor.

Variation construction costs incurred by Company A are in respect of its contractual obligations under the Project Deed and is part of its income earning business activities. The undertaking of project variations results in a margin negotiated between Company A and Entity B; is part of the business of Company A and is inseparably connected to the production of assessable income in operating and maintaining the project. That is, the expenditure incurred by Company A is incurred in gaining or producing its assessable income as considered in the cases of Herald & Weekly Times Ltd v FC of T (1932) 48 CLR 113 (Herald & Weekly Times) and Placer Pacific Management Pty Limited v FC of T (1995) 95 ATC 4459 (Placer Pacific) which dealt with the deductibility of settlement dispute payments.

Accordingly, the variation construction costs will satisfy the positive limbs in subsection 8-1(1) of the ITAA 1997.

The negative limbs under s 8-1(2)

For the variation construction costs to fail the negative limbs it must be either a loss or outgoing of a capital nature, a private or domestic nature or be incurred in relation to the gaining or producing exempt income or non-assessable non-exempt income. The relevant limb is whether the variation construction costs are a loss or outgoing of a capital nature. That is, the other negative limbs do not apply.

To consider whether the outgoing is of a capital nature, Dixon J observed in Hallstroms Pty Ltd v FC of T (1946) 8 ATD 190 at 196; (1946) 72 CLR 634 at 648-649:

What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.…..the contrast between the two forms of expenditure corresponds to the distinction between the acquisition of the means of production and the use of them; between establishing or extending a business organization and carrying on the business; between the implements employed in work and the regular performance of the work in which they are employed; between an enterprise itself and the sustained effort of those engaged in it.

Dixon J went further in Sun Newspapers Ltd v. FC of T (1938) 61 CLR 337 (Sun Newspapers) at 359 in explaining the capital versus revenue distinction as the difference:

between the business entity, structure, or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay, the difference between the outlay and the returns representing profit or loss.

The identification of what expenditure is calculated to effect involves both a consideration of the character of the expenditure and, in many cases, an examination of the business structure and the operations of the business in the course of which the expenditure has been incurred.

Company A's core business structure for the earning of profit relates to the original large scale financing, design and construction of the large-scale assets.

The variation construction costs are payments made to building subcontractors as an ordinary consequence of its business in order to fulfil its obligations under the Project Deed.

Dixon J propounded three elements which in his view were important considerations in determining the characterisation of an outgoing in Sun Newspapers at 363 being:

(a) The nature or character of the advantage sought

(b) The way it is to be used or enjoyed

(c) The means adopted to get it

In relation to the first two elements, the lasting or recurrent character of the advantage and expenditure are important. Courts have ruled that expenditure is capital where it has been made with a view to bring into existence an asset or advantage for the enduring benefit of the business as seen in British Insulated & Helsby Cables v Atherton (1926) AC 205.

Of these three elements, the character of the advantage sought will generally be the most important factor and provide the greatest guidance, because it tells most about the essential character of the expenditure itself. More recently the High Court in a unanimous decision in the GP International Pipecoaters Pty Ltd v FC of T 90 ATC 4413 case at 4419 and (1990) 170 CLR 124 at 137 looked at the question of how the character of expenditure may fall to be determined. Their Honours said:

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.

The variation construction costs are incurred to have the sub-contractors perform the relevant work. The variation construction costs secure the short term services of the subcontractors. Company A can only derive the variation payment and subsequently the margin, if the work is undertaken. The advantage sought is the margin.

The variation construction costs are amounts that are regularly incurred by Company A to undertake project variations that Entity B initiates and funds. Company A agrees to undertake the project variation in accordance with the terms of the Project Deed. Company A pays the variation construction costs in the course of carrying on the business of operating and maintaining the project.

For Company A, the variation construction costs that are regularly incurred is a fulfilment of its obligations under the Project Deed of carrying on its business and earning its revenue. Further there was no asset created or acquired, and no long term enduring benefit to the capital or profit making structure of Company A's business. The benefit for Company A is not an enlargement of the framework from which Company A carries on its ordinary activities to earn additional service payments but the temporary benefit of the margin gained from undertaking the project variation.

The additional service payment receipts represent reimbursement for the on-going maintenance costs in respect of the project variation and Company A would be entitled to this benefit whether they undertake the project variation or another contractor undertakes the project variation.

Therefore, the variation construction costs incurred is not a loss or outgoing of a capital nature and will not fall within any of the negative limbs in subsection 8-1(2).

Conclusion

The variation construction costs paid by Company A in respect of the Project will be allowable deductions under section 8-1 in the year they are incurred.