Edited version of your private ruling

Authorisation Number: 1012568027490

Ruling

Subject: Deductions for capital works

Question 1

Does Entity A satisfy the requirements of subsection 43-10(2) of the Income Tax Assessment Act 1997 (ITAA 1997) in respect of the Properties?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

The scheme commenced on:

In the year ended 30 June 20xx

Relevant facts and circumstances

1. Entity A was established by B Co. As B Co owned all of the membership interests in Entity A, it became part of B Co's tax consolidated group (B Co TCG) upon its establishment.

2. As part of a restructure of the B Co TCG's operations, B Co made an in specie distribution to its shareholders of the membership interests in Entity A (the Distribution).

3. The assets of Entity A at the time of the Distribution consisted of Properties located in Australia.

4. The Properties were transferred to Entity A while Entity A was still a member of the B Co TCG. This was achieved via the entering into of contracts of sale.

5. Certain members of the B Co TCG constructed the Properties on land the group owned in the course of carrying on a business that included the construction and sale of properties. The Properties were treated as trading stock of the B Co TCG at all times up to 30 June 20xx.

6. As a result of the restructure, at some point between 1 July 20xx and the time when the Distribution occurred, the Properties ceased to be trading stock as they were no longer held for sale in the ordinary course of business by the B Co TCG.

7. Since Entity A ceased being a member of the B Co TCG it has used all of the Properties for the purposes of deriving assessable income. Entity A holds the Properties on capital account as it holds the Properties for long term capital growth and for the purpose of deriving rental income and not for resale.

8. The applicant has advised that Entity A will continue to hold the Properties on capital account over the period of this private ruling.

Relevant legislative provisions

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

Income Tax Assessment Act 1997 subsection 43-75(3)

Income Tax Assessment Act 1997 section 70-110

Reasons for decision

Subsection 43-10(2) of the ITAA 1997 contains some of the requirements to be satisfied in relation to deductions for capital works. Relevantly, subsection 43-10(2) states:

You can only deduct the amount if:

(a) the capital works have a construction expenditure area; and

(b) there is a pool of construction expenditure for that area; and

(c) you use your area in the income year in the way set out in Table 43-140 (Current year use).

The first requirement is that there is a construction expenditure area in relation to the Properties for the purposes of paragraph 43-10(2)(a) of the ITAA 1997.

When the B Co TCG constructed the Properties, there was no construction expenditure in accordance with section 43-70 of the ITAA 1997 as the B Co TCG held the Properties as trading stock.

However, there is taken to be a construction expenditure area if subsection 43-75(3) of the ITAA 1997, reproduced below, is satisfied:

There is taken to be a construction expenditure area for capital works purchased by an entity from another entity if:

(a) the capital works would have had a construction expenditure area but for the fact that the other entity did not incur capital expenditure in constructing the capital works; and

(b) the other entity is not an associate of the entity; and

(c) the other entity constructed the capital works on land that it owned or leased in the course of a business that included the construction and sale of capital works of that kind.

Note: Subsection (3) makes capital works purchased from a speculative builder eligible for deduction in the hands of the first and subsequent purchasers.

The applicant has advised that sometime during the restructure of the B Co TCG's operations, the Properties were no longer held as trading stock as they were no longer held for sale in the ordinary course of business by the group. As a result, it is necessary to consider whether section 70-110 of the ITAA 1997 has application.

Subsection 70-110(1) of the ITAA 1997 states:

If you stop holding an item as trading stock, but still own it, you are treated as if:

(a) just before it stopped being trading stock, you had sold it to someone else (at arm's length and in the ordinary course of business) for its cost; and

(b) you had immediately bought it back for the same amount.

According to the Supplementary Explanatory Memorandum (EM) to Tax Law Improvement Bill 1997 (TLIB 1997) which inserted Division 70 of the ITAA 1997, the section applies to genuine changes in an assets use and not in relation to putting trading stock to another minor use. Whether there is a genuine change is to be determined objectively (see paragraph 1.28 of the EM to TLIB 1997).

As the change in use of the Properties occurred within the context of a major restructure of the B Co TCG's operations, this is considered to be a genuine change in use as contemplated by section 70-110 of the ITAA 1997. Therefore, it is considered that section 70-110 applies when the Properties stopped being held as trading stock by the B Co TCG.

The general principle dealing with 'deeming provisions' is that they are to be applied strictly and only for the purposes that they are resorted to (see Federal Commissioner of Taxation v.Comber (1986) 10 FCR 88; (1986) 64 ALR 451 and Howard v. Commissioner of Taxation (2012) 206 FCR 329; [2012] FCAFC 149 and Howard v. Commissioner of Taxation of the Commonwealth of Australia [2013] HCATrans 268).

The context of the deemed sale and re-acquisition in subsection 70-110(1) of the ITAA 1997 is to treat the event as being between unrelated third parties. In this case, there is a 'deemed sale' by the B Co TCG at the time just before the Properties stopped being trading stock and an immediate 're-acquisition' of the Properties.

The issue in this case is how far does the statutory deeming extend for tax purposes beyond Division 70 of the ITAA 1997 (note the exemption at subsection 70-110(2) of the ITAA 1997), in particular whether it can be extended to subsection 43-75(3) of the ITAA 1997, as proposed by the applicant.

Section 70-110 of the ITAA 1997 provides no specific guidance here other than to provide examples of the deeming being relevant to capital allowances (Subdivision 40-C of the ITAA 1997) and for CGT purposes.

The EM to TLIB 1997 inserting Division 70 of the ITAA 1997 provides some commentary on this as it states that the section operates to set the cost of the asset for other income tax purposes (see paragraph 1.27 of the EM to TLIB 1997), of which Subdivision 40-C of the ITAA 1997 is one example. The statement suggests that, while not expressly stated in section 70-110 of the ITAA 1997, the deeming is meant to have broad application to other parts of the Act, particularly where it is necessary to determine a cost of the asset for income tax purposes via the deemed re-acquisition that is taken to occur by the application of paragraph 70-110(b) of the ITAA 1997.

The deemed sale and re-acquisition under subsection 70-110(1) of the ITAA 1997 satisfies the requirements of subsection 43-75(3) of the ITAA 1997 as it is taken to be between unrelated third parties. In the context of subsection 43-75(3), the statutory deeming in section 70-110 of the ITAA 1997 also extends the transaction to not being a transaction between associates. As certain members of the B Co TCG constructed the Properties, which were held as trading stock, on land the group owned in the course of a business that included the construction and sale of properties, the requirements of subsection 43-75(3) are satisfied.

Following the Distribution, Entity A exited the B Co TCG and continues to be the owner of the Properties. In accordance with the exit history rule in section 701-40 of the ITAA 1997, Entity A inherits the 'construction expenditure area' and the 'pool of construction expenditure for that area' for the Properties. Accordingly, the requirements in paragraphs 43-10(2)(a) and 43-10(2)(b) of the ITAA 1997 are satisfied in respect of the Properties.

Entity A holds the Properties for long term capital growth and for the purpose of deriving rental income and not for resale. It would follow that paragraph 43-10(2)(c) of the ITAA 1997 is satisfied in respect of the Properties.

Thus, subsection 43-10(2) of the ITAA 1997 is satisfied by Entity A in relation to the Properties.