Edited version of your private ruling

Authorisation Number: 1012637794060

Ruling

Subject: Division 43 Capital Works

Question 1

Will the 'foundation works' qualify as capital works that are "structural improvements" for the purpose of subsection 43-20(2) of the Income Tax Assessment Act 1997, such that the construction expenditure proposed to be incurred in respect of the works will be deductible under section 43-10 of the Income Tax Assessment Act 1997?

Answer

No.

Question 2

To the extent that the 'foundation works' expenditure does not qualify for capital allowances under Division 43 (Question 1), will that construction expenditure proposed to be incurred in respect of the works qualify as a project amount which can be added to a project pool and deducted over the life of a project, pursuant to section 40-830 of the Income Tax Assessment Act 1997?

Answer

Yes.

This ruling applies for the following periods:

A specified period

The scheme commences on:

1 July 2013

Relevant facts and circumstances

Background:

X Limited ("X Ltd") is an Australian resident company.

X Ltd as head company formed a consolidated group with its two wholly owned subsidiaries, Y Pty Ltd ("Y Co") and Z Pty Ltd ("Z Co").

Y Co holds the land in relation to the precinct for a specific purpose under a lease (the "Lease") from the Commonwealth Government ("Commonwealth").

The principal activity of Y Co is the operation and development of the precinct.

The Lease:

The Lease was granted to Y Co for a set period with an option to renew.

The terms of the Lease provide Y Co with the right to operate and develop the precinct.

At the end of the lease term Y Co does not have the ability to purchase the land. The reversionary interest is held by the Commonwealth.

Y Co must develop the site at its own cost with regard to the actual and anticipated future growth of the precinct.

The Project:

X Ltd through its subsidiary Y Co, is planning to build and operate a new structural improvement contained within the boundaries of the precinct.

The key elements of the new project include:

• Construction and operation of a new structural improvement; including construction of land based infrastructure.

• Sourcing and transport of fill to the construction site.

The new structural improvement has been designed consistent with the relevant code system that specifies standards for these types of structural improvements suitable for their intended use.

The design of the new structural improvement provides maximum flexibility for the design and development of future infrastructure between the existing and new structures.

The new project construction will be undertaken in various stages with the relevant stage being:

• Foundation works: This stage involves undertaking certain ground treatments to improve geotechnical conditions of the site; sourcing and transport of fill to the site as well as a settlement period.

Relevant legislative provisions

Income Tax Assessment Act 1997, Division 40-I

Income Tax Assessment Act 1997, Section 40-830

Income Tax Assessment Act 1997, Subsection 40-830(1)

Income Tax Assessment Act 1997, Subsection 40-830(3)

Income Tax Assessment Act 1997, paragraph 40-840(2)(a)

Income Tax Assessment Act 1997, paragraph 40-840(2)(b)

Income Tax Assessment Act 1997, paragraph 40-840(2)(c)

Income Tax Assessment Act 1997, paragraph 40-840(2)(d)

Income Tax Assessment Act 1997, paragraph 40-840(2)(d)(ii)

Income Tax Assessment Act 1997, Division 43

Income Tax Assessment Act 1997, Section 43-10

Income Tax Assessment Act 1997, Subsection 43-10(1)

Income Tax Assessment Act 1997, Section 43-20

Income Tax Assessment Act 1997, Subsection 43-20(2)

Income Tax Assessment Act 1997, Subsection 43-20(3)

Income Tax Assessment Act 1997, Subsection 43-20(4)

Reasons for decision

Issue 1

Question 1

Summary

The 'foundation works' are not capital works that are "structural improvements" for the purpose of subsection 43-20(2) of the Income Tax Assessment Act 1997("the Act"), and consequently are not deductible under section 43-10 of the Act. This is because the 'foundation works' do not satisfy the meaning of earthworks that are integral to the construction of a structural improvement at paragraph 43-20(3)(b). Instead, they are earthworks which affect the general usefulness of the land. As they are earthworks which affect the general usefulness of the land, they are excluded from being deductible under Subsection 43-20(4).

Detailed reasoning

All references are to the ITAA 1997 unless otherwise stated.

Subsection 43-10(1) provides that you can deduct an amount for capital works for an income year.

Subsection 43-20(2) addresses the relevant category. It states:

This Division also applies to capital works (other than capital works referred to in subsection (1)) begun after 26 February 1992 that are structural improvements, or extensions, alterations or improvements to structural improvements, whether they are inside or outside Australia.

Subsection 43-20(3) provides:

a) …

b) earthworks that are integral to the construction of a structural improvement (other than a structural improvement described in subsection (4)), …

Subsection 43-20(4) states that this Division does not apply to structural improvements being:

a) earthworks that:

(i) are not integral to the installation or construction of a structure.

The main construction is a structural improvement for the purposes of Subsection 43-20(2) in their own right. However, in order for the 'foundation works' to be deductible under Division 43 they must satisfy Subsection 43-20(3)(b) and not be excluded by the negative limb at Subsection 43-20(4).

The term 'earthworks' is not defined in the ITAA 1997. ATO Interpretive Decision ATO ID 2003/670 Income Tax - Capital Works: shipping channel - excluded earthwork provides the term 'earthworks' "generally connotes some form of excavation, movement and/or placement of earth". As set out in the facts, the 'foundation works' broadly involves the placement, handling and rehandling of deposited fill. The nature of these works is consistent with the Commissioner's definition of earthworks as provided in ATO ID 2003/670.

The term 'integral' is also not defined in the ITAA 1997 and in this instance it is necessary to look to the ordinary meaning. The Macquarie Dictionary defines 'integral' as:

'Of or relating to a whole; belonging as a part of the whole; constituent or component; necessary to the completeness of the whole; made up of parts which together constitute a whole; entire or complete.'(The Macquarie Dictionary, 2003, rev. 6th edn, The Macquarie Library Pty Ltd, NSW).

The ordinary meaning indicates that something is integral when it belongs as part of a whole. To become an integral part of a structure, goods must lose their own separate identity and become part of the property itself.

Section 124ZFB of the Income Tax Assessment Act 1936 (ITAA 1936) was the predecessor to section 43-20 and the Commissioner is of the view (in ATO Interpretive Decision ATO ID 2009/96 Income Tax: Capital Works - reclaimed land - structural improvement) that the former and current provision express the same idea. Section 1-3 states that the ITAA 1997 contains provisions of the ITAA 1936 in a rewritten form and that if the ITAA 1997 appears to have expressed the same idea in a different form of words in order to use a clearer or simpler style, the ideas are not to be taken to be different.

The explanatory memorandum to Taxation Laws Amendment Bill No 3 of 1992 (No. 93 of 1992), which introduced section 124ZFB of the ITAA 1936, states (at paragraph 9.18) that earthworks which affect the general usefulness of the land are not treated as integral to the construction of a structure. The EM provides guidance as to earthworks that would qualify under Division 43 as being integral to the installation or construction of a structure.

At paragraphs 9.17 and 9.18, the EM provides that

"Cuttings, culverts and embankments as part of a road would qualify, as would foundation excavations for a bridge. Such earthworks are unlikely to have any practical use other than to accommodate the structure.

By comparison, earthworks that affect the general usefulness of land are not to be treated as integral to the construction of a structure. So, the cost of site clearing (tree removal, demolition of existing structures, etc) and site levelling would not qualify as part of the cost of constructing a car park, whereas the cost of stone, gravel etc underlay and concrete or bitumen surfacing would."

The EM provides that these examples are integral because they are unlikely to have any practical use other than to accommodate the structure.

The guidance given in the EM therefore indicates that where earthworks have no other practical use than to accommodate the installation or construction of a structure; these should be regarded as integral to the structure. However, if the earthworks affect the general usefulness of the land they should not be treated as integral to the structure.

Further guidance as to when earthworks should be regarded as integral can be found in ATO ID 2009/96. Here the taxpayer deposited dredged material to reclaim land and intended that eventually, transport facilities and buildings would be constructed on this land. These works were controlled and overseen by engineers and the controlled placement of the various materials was critical to the permanent stability of the reclaimed land. The Commissioner found the reclaimed land did not constitute a structural improvement for the purposes of Division 43. The reclaimed land was land of improved general usefulness and suitable for many purposes. Although the works undertaken to improve the land were strictly supervised and controlled to achieve a stable and enduring result, the works objectively result in improvement to land alone that is merely land on which any type of construction may occur in the future.

On the facts provided, the 'foundation works' are, broadly, the sourcing, transportation, placement and handling of fill to improve the geotechnical conditions of the site. This will consolidate the current site in order to minimise post construction settlement, elevate the site to provide flood protection and is engineered to provide a reliable platform to enable the construction of the structural improvement at a later date. The 'foundation works' are being undertaken over the entire future site, including areas which will be used for future improvements at a later date on the site.

In considering the guidance provided by the EM and ATO ID 2009/96, while the 'foundation works' are being undertaken over the entire future site to improve the land on which the structural improvements will be constructed at a later time, the earthworks are not integral to the structural improvement itself. The 'foundation works' are not being undertaken to provide direct foundations for the structural improvement (such as the excavations for the foundation of a bridge as provided in the EM examples at paragraph 9.17). Rather, the 'foundation works' are earthworks which encompass the sourcing, transport, handling and placement of fill to improve the broad area of land upon which the infrastructure will be constructed, along with other future structural improvements.

Further, the 'foundation works' will affect the general usefulness of the land in such a way that there may be other practical uses for the land, for example the future construction of the other infrastructure. While the process is supervised and controlled to meet the requirements of stability and endurance that are necessary for the structural improvement; and the Lease dictates a purpose for the use of the land; this does not preclude the land on which the structural improvement will be constructed from being of improved general usefulness and suitable for many purposes with the design of the site providing maximum flexibility for the design and development of future infrastructure.. This is consistent with the facts and the Commissioner's view provided in ATO ID 2009/96.

In order to construct a 'structural improvement', the applicant is first required to improve the land by undertaking these 'foundation works'. This will create an area of land which is suitable for the construction of the required 'structural improvement', but which is also suitable for other uses. The 'foundation works' are earthworks to improve the land; and are not integral to the structural improvement which will be subsequently constructed on that land; as the improved land is merely land on which other types of construction can occur.

Thus the 'foundation works' are consistent with earthworks that affect the general usefulness of the land and are not integral to the construction of a structural improvement. They are excluded under Subsection 43-20(4) and consequently do not qualify as structural improvements for the purposes of Subsection 43-20(2) and are not deductible as Capital Works under Section 43-10.

Question 2

Summary

The construction expenditure proposed to be incurred in respect of the 'foundation works' will qualify as a 'project amount' as it satisfies the requirements as per Subsection 40-840(2). This project amount can be added to a project pool and deducted over the life of the project pursuant to subsection 40-830 of the Act.

Detailed reasoning

All references are to the ITAA 1997 unless otherwise stated.

Subdivision 40-I provides for the deduction of certain capital expenditure over time. It provides that you can deduct amounts for certain capital expenditure associated with projects you carry on over the life of the project, using a project pool.

Specifically, section 40-830 provides that a taxpayer can allocate "project amounts" to a project pool and deduct the amounts allocated to the pool over the life of the project. "Project amount" is a defined term for the purposes of Section 40-830 and takes its meaning from Section 40-840.

Subsection 40-840(2) is concerned with project amounts (that are not mining or transport capital expenditure). This provision states that:

Another amount of capital expenditure you incur is also a project amount so far as:

(a) it does not form part of the cost of a depreciating asset you hold or held; and

(b) you cannot deduct it under a provision of the Act outside this Subdivision; and

(C ) it is directly connected with a project you carry on or propose to carry on for a taxable purpose; and

(d) it is one of these:

…(ii) an amount incurred for site preparation costs for depreciating assets (except, for horticultural plants, in draining swamp or low lying land or in clearing land)…

In order for the 'foundation works' to be a "project amount" that can be allocated to a project pool, the cost of these works must satisfy the requirements of Subsection 40-840(2).

On the facts provided, each paragraph of 40-840(2) is considered as follows:

(a) it does not form part of the cost of a depreciating asset you hold or held:

A depreciating asset is defined at subsection 40-30(1) as an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used, except land; or an item of trading stock; or an intangible asset, unless it is mentioned in subsection 40-30(2).

While the structural improvement itself would constitute a depreciating asset for the purposes of subsection 40-30(1), the 'foundation works' are not considered to be earthworks that are integral to the construction of the structural improvement, as reasoned in Question 1. It follows then that they do not form part of the cost of the depreciating asset.

Whether the 'foundation works' themselves are a separate depreciating asset for the purposes of Subsection 40-30(1) also needs to be considered. In addition to the definition of a depreciating asset at subsection 40-30(1), subsection 40-30(3) provides that this Division applies to an improvement to land, or a fixture on land, whether the improvement or fixture is removable or not, as if it were an asset separate from the land. Therefore it needs to be ascertained whether the 'foundation works' constitute an improvement to land that is in itself a depreciating asset.

Taxation Ruling TR 2012/7 Income tax: capital allowances: treatment of open pit mine site improvements, at paragraphs 99 to 107, provides the Commissioner's view as to when an improvement to land would be a separately identifiable asset in its own right:

99. In the context of Division 40, which provides a deduction for the cost of a depreciating asset over the time of its useful life, an asset is considered something that is capable of being put to use in the taxpayer's business.

100. Further, in the context of improvements to land, subsection 40-30(3) operates to sever the improvement from the land and treats the improvement '...as if it were an asset separate from the land'. This statutory severance therefore deems the improvement to be a separately identifiable asset in its own right.

105. …An improvement to land can only be used if it is tangible and physically identifiable as separate from the land in its natural state and also capable of use as a discrete thing. Only improvements to land with that character could be used in and of themselves.

106. The law has recognised as improvements to land a range of things done to improve the land. For example, the removal of noxious weeds, the felling of trees and removal of rocks could all be described in some contexts as improvements to land because they improve the profit yielding capability of the land. However, improvements of that kind do not exist in a state that is capable of use separately from the land itself. ….

107. On the other hand, improvements to the shape of the land other than mere earthworks, such as through the construction of roads, dams, levees, and drains, all create tangible physically identifiable artefacts. Such items can be recognised as having a character separate from the land of which they are part and are capable of being put to use in that sense separately to the land of which they are part in a taxpayer's business. Such items are therefore capable of recognition as assets that could also be depreciating assets if they have a limited effective life and could reasonably be expected to decline in value over the time they are used….

In considering the Commissioner's view in TR 2012/7 and applying it to the facts of this case, the 'foundation works' would not constitute an improvement to land which would be a separately identifiable asset in its own right. While the 'foundation works' are works to improve the land, these are consistent with that described at paragraph 106 of TR 2012/7. The works improve the profit yielding capacity of the land by improving its suitability for the construction of the structural improvement; however the improvements do not exist in a state capable of use separately from the land itself. As found in Question 1, the 'foundation works' are earthworks to improve the general usefulness of the land, rather than being the types of improvements specified at Paragraph 106 of TR 2012/7.

Therefore, the 'foundation works' do not exist in a state that is capable of use separately from the land itself and would not constitute a depreciating asset for the purposes of subsection 40-830(1). Thus, the requirements of paragraph 40-840(2)(a) are satisfied.

(b) you cannot deduct it under a provision of the Act outside this Subdivision:

As per Question 1, the 'foundation works' will not be deductible under Division 43. The 'foundation works' will not be deductible under another provision of the Act outside Subdivision 40-I. Thus paragraph 40-840(2)(b) is satisfied.

(C) it is directly connected with a project you carry on or propose to carry on for a taxable purpose:

To satisfy the requirements of this paragraph, the 'foundation works' must be directly connected with 'a project that the applicant carries on for a taxable purpose'.

Taxation Ruling TR 2005/4 Income Tax: Capital allowances - project pools - core issues considers what is a 'project' for the purposes of Subdivision 40-I. At paragraphs 20 to 22, it provides that:

20. Since the word 'project' is not defined for the purposes of Subdivision 40-I it takes its ordinary meaning shaped by the context in which it is found.

21. The project, whether it is being carried on or is proposed to be carried on, must be of sufficient substance and be sufficiently identified that it can be shown that the capital expenditure said to be a project amount is directly connected with the project. These considerations require that a project be a plan, scheme or undertaking of some substance: that is, something more substantial than an idea or speculation.

22. Further, a project is an activity which is, or a set of related activities which are, distinct from any activity on which the capital expenditure which constitutes a project amount is incurred. For example, environmental assessments for a project must be directly connected with the project but they are not the project itself.

TR 2005/4 also provides the following, in relation to the requirement that a project is "carried on for a taxable purpose:"

24. Since the term 'carry on' is not defined for the purposes of the Subdivision, it takes its ordinary meaning shaped by the context in which it is found.

25. The words 'carry on' in paragraph 40-840(2)(c) require some form of continuing activity….

26. The holding of a passive investment would not have sufficient activity to constitute the carrying on of a project.

29. …a project that is, of itself, carried on or proposed to be carried on for the purpose of gaining or producing assessable income is one carried on or proposed to be carried on for a taxable purpose.

30. …It is not enough that the project merely be carried on or proposed to be carried on while the business is being carried on. Rather, the carrying on or proposed carrying on of the project must occur in the course of and as an integral part of carrying on the business.

31. To constitute a project under Subdivision 40-I the activity or activities the taxpayer carries on or proposes to carry on for a taxable purpose must, on a reasonable and objective determination, have a finite project life (whether or not that project life has yet been quantified by estimation).

In this case, the construction and operation of the structural improvement is the project. The construction and operation of the structural improvement is an undertaking of substance; and is a set of continuing activities that is distinct from the capital expenditure that constitutes a project amount. The project amount is the cost of the 'foundation works'. While the 'foundation works' are an element of the construction of the structural improvement, they are not the project itself. The project will be carried on for a taxable purpose, as X Ltd will earn assessable income through the operation of the structural improvement. The project will be carried on as an integral part of X Ltd's overall business. The project will also have a finite life, as the operation of the structural improvement will not continue indefinitely; and X Ltd's ability to operate the structural improvement is limited by the terms of the Lease.

In considering these specifications, the construction and operation of the structural improvement would meet the requirements of a project for the purposes of Subdivision 40-I. Therefore, paragraph 40-840(2)(c) is satisfied.

(d) it is one of these:

an amount incurred for site preparation costs for depreciating assets (except, for horticultural plants, in draining swamp or low lying land or in clearing land)…

The final requirement under Subsection 40-840(2) is that the 'foundation works' must be one of the permitted types of capital expenditure listed in subparagraphs 40-840(2)(d)(i) to (vii). It is accepted that the 'foundation works' will not be any of the permitted types listed at (i) or (iii) to (vii).

With regard to subparagraph 40-840(2)(d)(ii), the capital expenditure must be for 'site preparation costs'; and the site preparation costs must be for 'depreciating assets'. Costs for horticultural plants, in draining swamp or low lying land or in clearing land are excluded.

There is no definition of site preparation costs for Subdivision 40-I. The 'foundation works' encompass the sourcing, transport, placement and handling of fill to prepare the site on which the structural improvement will be constructed; and thus it is reasonable to conclude they will fall within the intended meaning of 'site preparation costs'. Furthermore, the structural improvement itself will be a depreciating asset for the purposes of subsection 40-30(1) (as discussed above). Thus, the 'foundation works' will be an amount incurred for site preparation costs for a depreciating asset.

With regard to the exclusions at subparagraph 40-840(2)(d)(ii),being (amounts incurred for) horticultural plants, in draining swamp or low lying land or in clearing land; there is no extrinsic material to provide guidance on what constitutes draining swamp or low lying land. The EM, at paragraph 9.18, provides that site clearing would include such activities as tree removal and demolition of existing structures.

The 'foundation works' encompass the sourcing, transport, placement and handling of fill. On the facts provided, these works do not include amounts for horticultural plants or for draining swamp or low lying land. The works themselves are not being undertaken to drain swamp or low lying land; rather they are being undertaken to place fill into an existing site to improve that site for future construction. The 'foundation works' also do not (on the facts provided) include activities that meet the definition of clearing of the land provided by the EM. Thus, the exclusions at subparagraph 40-840(2)(d)(ii) will not apply.

Therefore, the amount incurred for the 'foundation works' meets the requirements of subparagraph 40-840(2)(d)(ii).

Conclusion:

As the requirements of subsection 40-840(2) are satisfied, the construction expenditure proposed to be incurred in respect of the 'foundation works' will qualify as a project amount which can be added to a project pool and deducted over the life of a project, pursuant to subsection 40-830.