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Ruling

Subject: Infrastructure Project - General deductions

Question 1

Will variation construction costs in respect to project variations initiated by Entity B and incurred 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?

Answer

Yes.

Relevant facts and circumstances

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 an arrangement with Entity B where Company A is required to finance, design, construct, commission, operate and maintain certain facilities for a fee.

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).

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 arrangement allows Entity B to request Company A make alterations, additions or modifications to the facilities.

The arrangement requires Entity B 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.

An Entity B initiated project variation may result in increased service payments to Company A.

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

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.

Reasons for decision

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

Summary

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

Detailed reasoning

Positive limbs under section 8-1

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

The Variation Construction Costs are incurred by Company A for carrying out project variations.

Accordingly, the Variation Construction Costs will satisfy the positive limbs in subsection 8-1(1) as Company A is incurring the the Variation Construction Costs in carrying on their business of long term operation and management of projects.

The negative limbs under s 8-1(2)

In the current case, the relevant negative limb in subsection 8-1(2) of the ITAA 1997 is whether the Variation Construction Costs are capital, or of a capital nature.

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 organisation 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.

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 arrangement.

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:

· The nature or character of the advantage sought

· The way it is to be used or enjoyed

· 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 subcontractors 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. Company A agrees to undertake the project variation in accordance with the terms of the arrangement. 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 arrangement 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 project variations are periodically recurrent and can create a small enduring benefit by way of additional service payment receipts, however the additional service payment receipts represent reimbursement for the on-going maintenance costs in respect of the project variation. Company A does not retain the additional service payment receipts but passes these additional service payment receipts to the subcontractors providing the additional services and maintenance.

The essential character of the variation construction costs incurred is not capital or in the nature of capital, and therefore 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.