Edited version of your private ruling

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Ruling

Subject: Income Tax: Deduction -Capital works

Question 1

Will the roadwork expenses incurred by X Unit Trust be deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Will the roadwork expenses incurred by X Unit Trust be deductible under Division 43 of the ITAA 1997?

Answer

No

Question 3

Will the roadwork expenses incurred by X Unit Trust be deductible under section 40-880 of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods:

Financial year ended 30 June 2010

Financial year ended 30 June 2011

Financial year ended 30 June 2012

Financial year ended 30 June 2013

Financial year ended 30 June 2014

The scheme commenced on

1 July 2009

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

X Unit Trust (the taxpayer) owns a business. The taxpayer desired to develop a vacant land adjacent to their business into a car park. This became necessary due to the construction of a workshop on land previously used.

During the 2010 income year the taxpayer opened a new division of the business opposite to their business premises.

The taxpayer was granted a Material Change of use in respect of the land in 2000 and in 2007, the taxpayer applied for a minor change from the relevant Government Department.

After negotiation, the Government Department agreed to consent to the minor amendment subject to the business agreeing to carryout road works.

The taxpayer agreed to undertake the road works, an acceleration and deceleration lane, in order to obtain approval for the development of a new venture.

The roadwork has been constructed on the Crown land. The taxpayer does not own or have any rights to the pavement, which is on Crown land.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1.

Income Tax Assessment Act 1997 subsection 8-1(2).

Income Tax Assessment Act 1997 section 40-880.

Income Tax Assessment Act 1997 subsection 40-880(2).

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

Income Tax Assessment Act 1997 paragraph 40-880(2)(b).

Income Tax Assessment Act 1997 paragraph 40-880(2)(c).

Income Tax Assessment Act 1997 paragraph 40-880(2)(d).

Income Tax Assessment Act 1997 subsection 40-880(3).

Income Tax Assessment Act 1997 subsection 40-880(4).

Income Tax Assessment Act 1997 subsection 40-880(5).

Income Tax Assessment Act 1997 paragraph 40-880(5)(a).

Income Tax Assessment Act 1997 Paragraph 40-880(5)(f).

Income Tax Assessment Act 1997 subsection 40-880(6).

Income Tax Assessment Act 1997 section 43-10.

Income Tax Assessment Act 1997 section 43-75.

Income Tax Assessment Act 1997 section 43-115.

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

While these reasons are not part of the private ruling, we provide them to help you understand how we reached our decision.

Question 1

Summary

The expenses incurred on the construction of the acceleration and deceleration lane is considered as capital in nature. Therefore, not deductible by virtue of paragraph 8-1(2)(a) of the ITAA 1997.

Detailed reasoning

Section 8-1 of the ITAA 1997 states that you can deduct from your assessable income any loss or outgoing to the extent that it is incurred in gaining or producing your assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

However, subsection 8-1(2) of the ITAA 1997 states that you cannot deduct a loss or outgoing under this section to the extent it is a loss or outgoing of capital or of a capital nature.

The guidelines to distinguish between capital and revenue outgoing were laid down in the Sun Newspapers Ltd. and Associated Newspapers Ltd. v Federal Commissioner of Taxation (1938) 5 ATD 87; [1939] ALR 10; (1938) 61 CLR 337. It was pointed out that expenditure in establishing, replacing and enlarging the profit-yielding structure itself is capital and is to be contrasted with working or operating expenses. An expenditure incurred with a view to bringing into existence an asset or an advantage for the enduring benefit of the business will be capital in nature (British Insulated & Helsby Cables v Atherton (1926) A.C.205.

The working or operating expenses, which relate to the day-to-day running of the business are considered to be revenue expenses. These are generally recurrent in nature, the benefit of which is for a specific period and incurred in carrying on a business for the purpose of gaining or producing assessable income.

For an expenditure to be deductible under section 8-1 of the ITAA 1997, it must have the essential character of an outgoing incurred in gaining assessable income (Lunney v. FCT; Hayleys vs. FC of T, 11 ATD 404) and there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL vs. FC of T, 8 ATD 431).

In Steele v. FC of T 99 ATC 4242 (1999) 41 ATR 139, the majority of the judges, in considering whether expenditure made prior to the derivation of expected assessable income is incidental, explained the temporal relationship in the following way:

There are cases where the necessary connection between the incurring of an outgoing and the gaining or producing of assessable income has been denied upon the ground that the outgoing was entirely preliminary to the gaining or producing of assessable income or incurred too soon before the commencement of the business or income producing activity. The temporal relationship between the incurring of an outgoing and the actual or projected receipt of income may be one of a number of facts relevant to a judgment as to whether the necessary connection might, in a given case, exist, but contemporaneity is not legally essential, and whether it is factually important may depend upon the circumstances of the particular case.

In other words, the expenditure should not be preliminary to the income-earning activities and is not incurred too soon.

The expenditure incurred on the construction of the acceleration and deceleration lane to meet the condition of the Government Department are incurred in the construction of capital works and are preliminary in nature. These expenses are not necessarily incurred in the taxpayer's day to day business operation.

The benefits from the expenses under consideration in this case will be enduring extending beyond the year in which that is incurred. Also, the expenses are not recurrent.

Therefore, the expenses incurred on the construction of the acceleration and deceleration lane is considered as capital in nature. Therefore, not deductible by virtue of paragraph 8-1(2)(a) of the ITAA 1997.

Question 2

Summary

The taxpayer is not eligible to claim capital works deduction under section 43-10 of the ITAA 1997, for the construction of acceleration and deceleration lane for their business during the income year 2010. As the taxpayer did not own the area of capital works under subsection 43-115(1) of the ITAA 1997.

Detailed reasoning

Section 43-75 of the ITAA 1997 explains the circumstances where there is a construction expenditure area for capital works. Subsection 43-75(1) of the ITAA 1997 states that the construction expenditure area of capital works begun after 30 June 1997 is the part of the capital works on which the construction expenditure was incurred that, at the time when it was incurred by an entity, was to be owner or leased by the entity or held by the entity under a quasi-ownership right over land granted by an exempt Australian government agency or an exempt foreign government agency.

The application of Division 43 of the ITAA 1997 to quasi-owners is limited to quasi-owners of:

§ capital works that are hotel or apartment buildings started after 30 June 1997; and

§ other post-26 February 1992 capital works.

These provisions ensure that a taxpayer who is a quasi-owner of capital works cannot claim a capital works deduction in relation to those capital works where the quasi-owner was not entitled to such a deduction under Income Tax Assessment Act 1936 (ITAA 1936). The concept of rights held as a quasi-owner under ITAA 1997 encompasses what was covered under the extended definition of a "Crown lease'' in section 54AA of the ITAA 1936, ie, the ordinary meaning of a Crown lease extended to include easements and rights, powers and privileges over land. As the extended definition of a Crown lease only applied to post-26 February 1992 buildings and never applied to short-term traveller accommodation buildings, similar limitations have been placed on the claiming of deductions in relation to such rights held as a quasi-owner under ITAA 1997.

Subsection 43-115(1) of the ITAA 1997 states that "your area" for owners of capital works is the part of the "construction expenditure area'' under section 43-75 of the ITAA 1997 in relation to capital works that the taxpayer owns. The taxpayer's capital works area can be either the whole of the construction expenditure area for capital works or only a part of it.

In this case the taxpayer is required to construct the road works, an acceleration and deceleration lane, in order to obtain approval for the development of a new venture. However, the facts indicate that the roadwork has been constructed on the Crown land and the taxpayer does not own or have any rights to the pavement, which is on Crown land.

Accordingly, the taxpayer is not eligible to claim capital works deduction for the roadwork under section 43-10 of the ITAA 1997.

Question 3

Summary

The taxpayer is eligible to claim deduction for 5 years under section 40-880 of the ITAA 1997 for the expenses incurred to construct the acceleration and deceleration road work as required by the Government Department in relation to the taxpayer's business.

Detail reasoning

Section 40-880 of the ITAA 1997 provides a deduction over 5 years for certain business-related capital costs that are incurred on or after 1 July 2005 if:

§ the expenditure is not otherwise taken into account; and

§ a deduction is not denied by some other provision; and

§ the business is, was or is proposed to be carried on for a taxable purpose.

The ways in which expenditure can be taken into account are listed in subsections 40-880(5) to (8) of the ITAA 1997.

Subsection 40-880(2) of the ITAA 1997 allows the taxpayer to deduct, in equal proportions over a period of 5 income years starting in the year in which the taxpayer incurs it, capital expenditure the taxpayer incurs 'in relation to', inter alia, his business.

In considering the phrase 'in relation to' contained within subsection 40-880(2) of the ITAA 1997, paragraph 2.25 of the Explanatory Memorandum to Tax Laws Amendment (2006 Measures No. 1) Bill 2006 (the EM) states:

The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business. The concept used to establish this character or requisite relationship between the expenditure incurred by the taxpayer and the business carried on (current, past or prospective) is 'in relation to'. The connector 'in relation to' allows the appropriate latitude to enable the deductibility of qualifying capital expenditure incurred before the business commences or after it has ceased.

The phrase 'in relation to' was considered by the High Court in PMT Partners Pty Ltd (In Liquidation) v. Australian National Parks & Wildlife Service (1995) 184 CLR 301. Brennan CJ, Gaudron and McHugh JJ observed, in considering the application of the Commercial Arbitration Act 1985 (NT), at 313:

Inevitably, the closeness of the relation required by the expression 'in or in relation to' in s 48 of the Act, indeed, in any instrument - must be ascertained by reference to the nature and purpose of the provision in question and the context in which it appears.

In that case, Toohey and Gummow JJ also observed:

It is apparent that the words 'in or in relation to' are particularly wide. ... Cases concerning the interpretation of this phrase in other statutory contexts are of limited assistance. However, the cases do show that the words are prima facie broad and designed to catch things which have sufficient nexus to the subject. The question of sufficiency of nexus is, of course, dependent on the statutory context. (at 330) ...

The connection which is required by the phrase 'in relation to' is a question of degree. There must be some "association" which is "relevant" or "appropriate". The question of the relevance or appropriateness of the connection is a question which cannot be divorced from the particular statutory context. (at 331)

In First Provincial Building Society Limited v. Commissioner of Taxation (1995) 56 FCR 320; 95 ATC 4145; (1995) 30 ATR 207, Hill J considered the phrase 'in relation to' within the context of paragraph 26(g) of the ITAA 1936. He considered the words 'in relation to' in that context included a relationship that may either be direct or indirect, provided that the relationship consisted of a real connection, but that a merely remote relationship is insufficient (at ATC 4155; ATR 218).

It is therefore necessary to consider the legislative context of subsection 40-880(2) of the ITAA 1997 in order to determine whether there is a sufficient and relevant connection between the incurrence of the expenditure and a particular business. In discussing the types of business capital expenditure to which subsection 40-880(2) of the ITAA 1997 applies, paragraphs 2.19 and 2.20 of the EM state:

2.19 Expenditure on the structure by which an entity carries on (or used to or proposes to carry on) their business and on the profit yielding structure of the business would ordinarily be expected to be of a capital nature. Capital expenditure can also relate to a business's trading operations or the entity that will carry on the business.

2.20 The structure covers the legal entity (such as a company) or the legal relationship (such as a partnership or trust) that is the entity that carries on the business for a taxable purpose and that holds the business assets.

These paragraphs indicate that capital expenditure incurred on the structure by which an entity carries on, or used to or proposes to carry on their business, on the profit yielding structure of the business, or relating to the business's trading operations, are capable of being described as capital expenditure incurred 'in relation to' that business for the purposes of subsection 40-880(2) of the ITAA 1997. Whether such capital expenditure is incurred 'in relation to' the particular business will depend on whether there is a sufficient and relevant connection between the incurring of the expenditure and that business on the facts of the particular case.

The statement in paragraph 2.48 of the EM below:

§ the business to which the expenditure relates is that most relevant to the expenditure

indicates that when there is such a connection between the incurring of the expenditure and more than one business, the expenditure is treated for the purposes of subsection 40-880(2) of the ITAA 1997 as incurred in relation to the business that is most relevant to the expenditure.

In identifying for the purposes of subsection 40-880(2) of the ITAA 1997 the business that is most relevant to the expenditure, it is necessary to look to the character of the expenditure and what is achieved rather than simply the broad intent of its incurrence.

In this case, the taxpayer incurred the expenses in relation to their business and for the new division of the business during the income year 2010. The road widening, with right and left deceleration lanes are Government Department's requirement for the development of the new venture.

Accordingly, it is considered that the taxpayer incurred the capital expenditure during the income year 2010 in relation to the profit yielding business of their business.

However, any deduction under section 40-880 of the ITAA 1997 is subject to the limitations and exceptions contained in subsections 40-880(3) to 40-880(9) of the ITAA 1997.

Subsection 40-880(3) of the ITAA 1997 provides that you can only deduct the expenditure, for a business that you carry on, used to carry on or propose to carry on, to the extent that the business is carried on, was carried on or is proposed to be carried on for a taxable purpose. The relevant business for the purposes of the application of subsection 40-880(3) of the ITAA 1997 is the business to which the relevant paragraph in subsection 40-880(2) of the ITAA 1997 applies. In this case, the relevant business of the taxpayer is car dealership .

Paragraphs 2.46 and 2.47 of the EM state:

2.46 The definition of 'taxable purpose' is provided by subsection 40-25(7) of the ITAA 1997 and covers various purposes, including the purpose of producing assessable income. The term purpose of producing assessable income is further defined in subsection 995-1(1) of the ITAA 1997 as being something done:

         for the purpose of gaining or producing assessable income; or

         in carrying on a business for the purpose of gaining or producing assessable income.

2.47 A taxpayer whose business is not carried on for a taxable purpose cannot deduct expenditure to that extent. This limitation is not an annual test: that is, it is not to limit deductions to only the income years in which the business is carried on for a taxable purpose. The test as to the taxable purpose of the business is applied - as at the time the expenditure is incurred - to the taxable purpose of the business by reference to all known and predictable facts in all years.

The application of subsection 40-880(3) of the ITAA 1997 requires that the taxpayer determine, as at the time the capital expenditure was incurred, the extent to which the taxpayer's business is carried on for a taxable purpose by reference to all known and predictable facts in all years.

The facts of this private ruling indicate that the taxpayer is carrying on a profit yielding business, did not derive any non-assessable non-exempt income and/or exempt income at the time the capital expenditure was incurred and there is no evidence to suggest such income will be derived.

Subsection 40-880(4) of the ITAA 1997 does not apply in the present case as it deals with business that is carried on by another entity.

Paragraph 40-880(5)(a) of the ITAA 1997 provides that you cannot deduct anything under section 40-880 of the ITAA 1997 for an amount of expenditure you incur to the extent that it forms part of the cost of a depreciating asset that you hold, used to hold or will hold.

The expenses incurred in order to construct the acceleration and deceleration lane does not form part of a depreciating asset.

Paragraph 40-880(5)(f) of the ITAA 1997 provides that you cannot deduct anything under section 40-880 of the ITAA 1997 for an amount of expenditure you incur to the extent that it could, apart from that section, be taken into account in working out the amount of a capital gain or capital loss from a CGT event.

To the extent that the capital expenditure incurred by the taxpayer in relation to the roadwork will not form the cost base on a CGT asset to work out the capital gain or loss of the property.

Since there is no CGT event for not carrying out proposed activities, the expenditure cannot be taken into account in working out a capital gain or loss.

Paragraph 40-880(5)(g) of the ITAA 1997 states that:

(g) a provision of this Act other than this section would expressly make the expenditure non-deductible if it were not of a capital nature; or

There are no provisions of this Act other than this section which expressly makes the expenditure non-deductible if it were not of a capital nature. If it was not capital in nature, the expense could be deducted as losses or outgoing in gaining or producing assessable income under section 8-1 of the ITAA 1997.

Further, paragraph 40-880(h) of the ITAA 1997 states that:

(h) a provision of this Act other than this section expressly prevents the expenditure being taken into account as described in paragraphs (a) to (f) for a reason other than the expenditure being of a capital nature; or

No provision of this Act other than this section prevents the expenditure being taken into account as described in paragraphs (a) to (f) for a reason other than the expenditure being of a capital nature.

Paragraph 40-880(5)(i) of the ITAA 1997 states that:

(i) it is expenditure of a private or domestic nature; or

The expenditure is not of a private or domestic nature.

Paragraph 40-880(5)(j) of the ITAA 1997 states as:

(j) it is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income.

The capital expenditure is not incurred in gaining or producing exempt or non-assessable non-exempt income.

Subsection 40-880(6) of the ITAA 1997 is an elaboration of the exceptions described in paragraphs 40-880(5)(d) and (f) of the ITAA 1997. Since these exceptions do not apply to the taxpayer, this subsection is not relevant.

Subsection 40-880(7) of the ITAA 1997 is also not relevant as it applies in relation to subsection 40-880(2)(c) of the ITAA 1997, ie., business proposed to be carried on. In this case the taxpayer is already carrying on a business.

Subsection 40-880(8) of the ITAA 1997 is not relevant either as this subsection deals with expenditure that is cost base of a depreciating asset or a CGT asset.

Subsection 40-880(9) of the ITAA 1997 deals with an amount of an expenditure that is incurred:

(a) by way of returning an amount you have received …; or

(b) to the extent that, for another entity, the amount is a return on or of:

(i) an equity interest; or

(ii) a debt interest that is an obligation of yours.

Therefore, the limitations and exceptions under subsections 40-880(3) to (9) of the ITAA 1997 do not apply in relation to the capital expenditure at issue in this case.

Accordingly, the expenditure in issue has not otherwise been taken into account. The deduction is not denied by any other provision of the tax legislation.

Therefore, the taxpayer is eligible to claim deduction for the expenses incurred for five years from the financial year ended 30 June 2010.