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Ruling

Subject: Government grant and deductibility of associated expenditure

Question 1

Will the funds (the Funds) that are received by the taxpayer company (the taxpayer) from the Australian Relevant Agency (XYZ) be assessable to the taxpayer as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Will the Funds, received from XYZ, be assessable to the taxpayer as statutory income under section 15-10 of the ITAA 1997?

Answer

No.

Question 3

Will the Funds, received from XYZ, be assessable to the taxpayer as a capital gain under section 102-5 of the ITAA 1997?

Answer

No.

Question 4

If the answers to Question 1, Question 2 and Question 3 are 'no', will the Funds, received from XYZ, be assessable to the taxpayer as statutory income under the assessable recoupment rules in Subdivision 20-A of the ITAA 1997?

Answer

Yes.

Relevant facts and circumstances

The taxpayer and its controlling entities

1. The taxpayer is a company incorporated in Australia and an Australian resident for income tax purposes.

2. The taxpayer is a special purpose entity that was incorporated with the intention that it will construct and operate a solar farm project (the Project).

Australian Relevant Agency

3. XYZ was established under section 7 of the Australian Renewable Energy Act 2011 (the XYZ Act) as a body corporate. The XYZ Act commenced on 1 July 2012.

4. The main object of the XYZ Act is to improve the competitiveness of relevant technologies and to increase the supply of relevant energy in Australia (section 3 of that Act).

5. XYZ is responsible for approving the entry into contracts and financial assistance under the Accelerated Step Change Initiative (ASCI). ASCI provides funding for projects not captured by other XYZ programs. ASCI is aimed at projects which require an XYZ contribution of $X million or more and have an overall project cost of more than $X0 million. Merit assessments of proposals are undertaken on a case-by-case basis to determine appropriateness of funding.

Activities preliminary to the construction of the solar farm

6. The grant to the taxpayer from XYZ is to be administered in accordance with the Australian Relevant Agency Accelerated Step Change Initiative Agreement (the Funding Agreement), detailed below. (A copy of the Funding Agreement was supplied with the private ruling application.)

7. The taxpayer has carried out preliminary activities in preparation for the Project's commencement, such as entering into the Funding Agreement, adopting a constitution, registering for GST and holding board meetings to approve the private ruling application and the issue of ordinary shares.

8. The Project has not commenced and will not do so until the taxpayer has received the Funds from XYZ.

9. Before receiving the Funds, the taxpayer intends to arrange and raise finance and capital for the Project, as required under the Funding Agreement. It also intends to enter into agreements to establish the provision of services and sharing of assets. These agreements will have no consequences for (and will place no material obligations on) the taxpayer, if the Funds are not received.

10. At present, apart from 'nominal cash', the taxpayer has no tangible assets or employees and has not entered any agreements other than those identified above.

11. A number of preliminary activities relating to the Project, such as: feasibility studies; acquiring planning approvals; site geotechnical investigation; ecology investigations; and surveys will be conducted by an entity associated with the taxpayer. This entity (or its subsidiaries) will also negotiate with suppliers, enter into land agreements and obtain insurance for the taxpayer, in accordance with the Funding Agreement. Should the Project proceed, the taxpayer will be charged for these services under an agreement to be entered into by the parties.

The Funding Agreement

12. XYZ will contribute the Funds for the construction of the Project and must deposit them within 10 Business Days of receipt of the tax invoice that the taxpayer is required to provide immediately prior to Financial Close. (It is stated in the private ruling application that this funding is critical to the Project, which cannot proceed without the Funds.)

13. Financial Close is the event which occurs when all Conditions Precedent have been satisfied or waived by XYZ in accordance with the Funding Agreement, which also lists the Conditions Precedent.

14. Stipulated percentages of the Funds may be withdrawn by the taxpayer upon the achievement of Project Milestones, subject to the satisfaction of certain Withdrawal Precedents in relation to those Project Milestones.

15. The taxpayer must spend or legally commit the Funds for the purposes of undertaking the Project and purposes incidental to the Project, and must spend the Funds only in accordance with the Budget and the Financial Close Financial Model.

16. The Funding Agreement provides that at Project Financial Close the taxpayer may request further funds from XYZ to pay for additional costs required to fund an adjustment to the price of the engineering, procurement and construction (EPC) Contract, due to adverse movements in foreign exchange rates or anti-dumping tariffs.

17. Under the Funding Agreement, the taxpayer must procure the provision by its shareholder of funds (the Recipient Contributions) to the Project, and must, at each Project Milestone, ensure that the aggregate amount of funds so procured at least matches the funds provided by XYZ up to and including that Project Milestone Date.

18. According to the Budget, the bulk of the combined Funds and Recipient Contributions are to be spent on the design and construction of the solar farm.

19. Once the Funds have been received the taxpayer will commence the Project by entering into the agreements referred to previously.

20. Upon Project Financial Close construction of the solar farm will begin. Construction is expected to take approximately nine months to complete.

21. Once completed and commissioned, the solar farm is expected to operate for XX years.

22. The electricity from the solar farm will be provided under contracts that are separate from the Funding Agreement.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 15-10

Income Tax Assessment Act 1997 paragraph 15-10(a)

Income Tax Assessment Act 1997 Subdivision 20-A

Income Tax Assessment Act 1997 section 20-20

Income Tax Assessment Act 1997 subsection 20-20(1)

Income Tax Assessment Act 1997 subsection 20-20(3)

Income Tax Assessment Act 1997 paragraph 20-20(3)(a)

Income Tax Assessment Act 1997 paragraph 20-20(3)(b)

Income Tax Assessment Act 1997 section 20-30

Income Tax Assessment Act 1997 section 20-40

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 subsection 102-5(1)

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 section 102-23

Income Tax Assessment Act 1997 paragraph 102-23(a)

Income Tax Assessment Act 1997 paragraph 102-23(b)

Income Tax Assessment Act 1997 section 102-25

Income Tax Assessment Act 1997 subsection 102-25(1)

Income Tax Assessment Act 1997 section 104-25(2)

Income Tax Assessment Act 1997 section 104-25(3)

Income Tax Assessment Act 1997 subsection 118-37(2)

Income Tax Assessment Act 1997 paragraph 118-37(2)(a)

Income Tax Assessment Act 1997 subsection 995-1(1)

Income Tax Assessment Act 1997 paragraph 995-1(1)(a)

Income Tax Assessment Act 1997 paragraph 995-1(1)(b)

All legislative references in this Ruling are to the ITAA 1997, unless otherwise stated.

Reasons for decision

Question 1

Summary

The receipt of the Funds will be by way of subsidy to augment the taxpayer's capital. The Funds cannot be said to be a product or incident of the taxpayer's income-producing activity, which will not commence until after the construction of the solar farm. Therefore, the receipt of the Funds will not be assessable to the taxpayer under section 6-5.

Detailed reasoning

The consideration of the character of the receipt of the XYZ Funds by the taxpayer requires consideration of relevant provisions and case law.

Section 6-5 states:

(1) Your assessable income includes income according to ordinary concepts, which is called ordinary income.

(2) If you are an Australian resident, your assessable income includes the *ordinary income you derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

(3) …

Whereas G.P International Pipecoaters Pty. Ltd. v. Federal Commissioner of Taxation (1990) 170 CLR 124; 90 ATC 4413; (1990) 21 ATR 1 (G.P International Pipecoaters' Case), is a precedential case on issues relating to the character of a receipt similar to that provided to the taxpayer by XYZ (but distinguishable from it). In G.P International Pipecoaters' Case the taxpayer was a joint venture company incorporated for the sole purpose of performing a contract with the State Energy Commission of Western Australia (SECWA) to coat pipes to be used in the Dampier-Perth natural gas pipeline. The contract also required the taxpayer to construct a plant in order to coat the pipes. Under the contract, SECWA agreed to pay a specified amount as 'establishment costs' for the construction of the plant.

The Commissioner included the establishment costs in the assessable income of the taxpayer. The taxpayer, appealed unsuccessfully to, in turn: the WA Supreme Court and the Full Federal Court, finally taking its case to the High Court.

The High Court observed that:

• the taxpayer was not bound by contract to meet the cost of constructing the plant out of the moneys received from SECWA as establishment costs. The taxpayer (or its parent companies) was free to choose the manner in which it would finance the construction of the plant.

• the question in the appeal was the character of the establishment costs as receipts in the hands of the taxpayer, following Scott v. F.C. of T (1966) 117 CLR 514. It was that character (as distinct from the character of the subsequent expenditure of the moneys received) that determined whether or not the receipt was income.

Therefore, whilst it was true that the plant was a capital asset, the moneys expended in its construction, including the establishment costs, were expenditure of a capital nature and the intention of SECWA was that the establishment costs would be spent in constructing the plant, nevertheless:

… the establishment costs were received by the taxpayer under the contract as part of the monetary consideration payable for the taxpayer's agreement to perform, or its performance of, the entire contract. It is impossible to treat the business of the taxpayer as limited to the coating of the pipe when the construction of the pipe-coating plant was an integral part of the work which the taxpayer was bound to perform. The establishment costs were not received under a severable part of the contract relating to the construction of the plant.

The High Court agreed with the taxpayer that a receipt of moneys intended by payer and payee to recoup a recipient's capital expenditure is a receipt of a capital nature when the amount is received by way of gift or subsidy to replenish or augment the payee's capital, as in such a case 'the receipt cannot fairly be said to be a product or incident of the payee's income-producing activity.' However:

… it cannot be accepted than an intention on the part of a payer and a payee or either of them that a receipt be applied to recoup capital expenditure by the payee determines the character of a receipt when the circumstances show that the payment is received in consideration of the performance of a contract, the performance of which is the business of the recipient or which is performed in the ordinary course of the business of the recipient.

The High Court dismissed the appeal.

Also, in Taxation Ruling TR 2006/3 Income tax: government payments to industry to assist entities (including individuals) to continue, commence or cease business, an example (Example 9) is given, in the legally binding part of the ruling, of the income tax treatment of government payments to commence business (or government payment to industry (GPI)). Within the example, at paragraph 56 of the ruling, it is stated:

As the GPI is preliminary to a business being established it is not a receipt ordinarily received in the normal course of trade, or for which business is being carried on. The GPI is not ordinary income and is not assessable under section 6-5.

Further explanation is given in the non-binding Appendix 1 of the ruling. It is stated, at paragraph 129:

A GPI to assist with the cost of evaluating whether to commence a business, or to enable a business to commence are preliminary to establishing a business. As the GPI is preliminary to a business being established it is not ordinarily received in the normal course of trade, or a receipt for which business is being carried on. The GPI is not ordinary income and is not assessable under section 6-5.

In addition, at paragraph 139 of the ruling, it is stated:

A GPI paid to assist a new business with the purchase of a depreciating asset will not be assessable under section 6-5 as ordinary income as the GPI is capital in nature.

Application to the case

The circumstances of the present case can be distinguished from those of G.P International Pipecoaters' Case. The taxpayer's obligations under the Funding Agreement are primarily limited to constructing the solar farm so that it is ready for use, and the Funds are received solely in respect of that construction and not for any other purpose. The construction of the solar farm is separate from the income generating operations of the taxpayer, being the generation and provision of electricity. Once the solar farm has been constructed and commissioned, the taxpayer will be able to generate its income, and it will do this under separate contracts for the delivery of electricity.

The taxpayer in this case does not suffer the problem of the taxpayer in G.P International Pipecoaters' Case where the establishment costs were not received under a severable part of the contract relating to the construction of the plant.

The receipt of the Funds will be by way of subsidy to augment the taxpayer's capital. The receipt cannot be said to be a product or incident of the taxpayer's income-producing activity, which will not commence until after the construction of the solar farm. The Funds are to enable the taxpayer to commence the business of generating and providing electricity. In particular, the Funds will assist with the purchase of depreciating assets, as detailed in the Budget. They are received preliminary to a business being established and therefore they are not received in the normal course of trade or as a receipt for which business is being carried on. The receipt of the Funds is properly characterised as a receipt of a capital nature.

Accordingly, the XYZ Funds do not constitute ordinary income and so are not assessable under section 6-5.

Question 2

Summary

The Funds are not assessable to the taxpayer under section 15-10 because the taxpayer does not receive them in relation to carrying on a business.

Detailed reasoning

Section 15-10 states:

Your assessable income includes a bounty or subsidy that:

(a) you receive in relation to carrying on a *business; and

(b) is not assessable as *ordinary income under section 6-5.

In the present case, the Funds would constitute a subsidy according to the ordinary meaning of that term (refer Taxation Ruling TR 2006/3, paragraph 94), and the condition in paragraph (b) is satisfied (refer to the answer to Question 1). Therefore, it remains to consider whether the taxpayer receives the Funds in relation to carrying on a business.

The intention of the taxpayer in engaging in the activity under consideration is a relevant indicator (refer Thomas v. FC of T 72 ATC 4094; (1972) 3 ATR 156)), however, it is insufficient by itself. Brennan J in Inglis v. FC of T 80 ATC 4001 at 4004-4005; (1979) 10 ATR 493 at 496-497 stated that:

The carrying on of a business is not a matter merely of intention. It is a matter of activity. … At the end of the day, the extent of activity determines whether the business is being carried on. That is a question of fact and degree.

A taxpayer may engage in preliminary activities that are preparatory to carrying on a business. Such activities do not amount to carrying on a business even though they may be essential to the eventual carrying on of a business. In Southern Estates Pty Ltd v FC of T (1967) 117 CLR 481, it was found that preparing land for primary production does not, of itself, amount to carrying on a business of primary production.

Taxation Ruling 97/11 Income tax: am I carrying on a business of primary production? has the following example at paragraphs 45 and 46:

45. Lindsay and Loretta bought 700 hectares of run down rural land in 1980. They intended to start a cattle farming business. Over the next five years they spent several thousand dollars on farm machinery. They used this to clear the land, build roads and mend fences. They also bought and erected some farm buildings. No income was derived from the property until 1986 when they stocked the property with 100 cattle. Were Lindsay and Loretta carrying on a business from 1980 to 1985?

46. No, because:

• the activities of Lindsay and Loretta from 1980 to 1985 would be regarded as preparatory to the commencement of business;

• whilst they had a clear purpose to engage in cattle farming, they recognised that certain things needed to be done to the land before they were able to buy the cattle and put them on the land;

• until 1986 there was no size or scale of the relevant activity in the sense that there was no stock; and

• there was no repetition or regularity of activity with respect to cattle farming until the land was stocked.

In Softwood Pulp and Paper Ltd v. FC of T 76 ATC 4439; (1976) 7 ATR 101, it was found that experimental and pilot activities preliminary to and directed towards deciding whether or not it was viable to establishing a paper mill did not amount to carrying on a business. In addition, the element of commitment to go ahead with the paper mill was absent. This was similarly the case in Goodman Fielder Wattie Ltd v. FC of T 91 ATC 4438; (1991) 22 ATR 26.

Further, TR 2006/3 states at paragraph 133:

A GPI to assist with the cost of evaluating whether to commence a business, or to enable a business to commence is preliminary to establishing a business. As the GPI is preliminary to a business being established it is not received in relation to carrying on the business and is not assessable under section 15-10.

Whilst the taxpayer has an intention to construct and operate the solar farm prior to receiving the Funds and has carried out certain preliminary activities, all of them would be regarded as preparatory to the commencement of the business of constructing and operating the solar farm. In addition, the commitment to the construction of the solar farm is conditional on receiving the Funds.

Accordingly, the condition in paragraph (a) of section 15-10 is not satisfied, and so the Funds are not assessable under that section.

Question 3

Summary

The Funds are not assessable under the capital gains tax provisions because, albeit that CGT event C2 occurs when the Funds are received, any capital gain (or capital loss) from that event is disregarded because subsection 118-37(2) applies.

Detailed reasoning

Subsection 102-5(1) states that:

Your assessable income includes your net capital gain (if any) for the income year …

Section 102-20 states that:

You can make a capital gain or loss if and only if a *CGT event happens. The gain or loss is made at the time of the event.

Section 102-23 states that:

A *CGT event still happens even if:

(a) it does not result in a *capital gain or *capital loss; or

(b) a capital gain or capital loss from the event is disregarded.

Subsection 102-25(1) states:

Work out if a *CGT event … happens to your situation. If more than one event can happen, the one you use is the one that is the most specific to your situation.

Section 104-25 states:

(1) CGT event C2 happens if your ownership of an intangible *CGT asset ends by the asset:

(a) being redeemed or cancelled; or

(b) being released, discharged or satisfied; or …

(1) The time of the event is:

(a) when you enter into the contract that results in the asset ending; or

(b) if there is no contract - when the asset ends.

(1) You make a capital gain if the *capital proceeds from the ending are more than the asset's *cost base. You make a capital loss if those capital proceeds are less than the asset's *reduced cost base.

…

Subsection 118-37(2) states that:

A *capital gain or *capital loss is disregarded if you make it as a result of receiving a payment or property as reimbursement or payment of your expenses, or receiving or using a voucher or certificate, under:

(a) a scheme established by an *Australian government agency … under an enactment or an instrument of a legislative character; or

…

The term 'Australian government agency' is defined in subsection 995-1(1) as being:

(a) the Commonwealth, a State or a Territory; or

(b) an authority of the Commonwealth or of a State or a Territory.

Under the Funding Agreement, the taxpayer has a right to the Funds once Financial Close has been achieved, except that it may only draw on stipulated percentages of the Funds as it reaches the various Project Milestones and satisfies the associated Withdrawal Conditions Precedent. The right is an intangible CGT asset. Once the taxpayer has reached the final Project Milestone and satisfied the associated Withdrawal Conditions Precedent, the right is satisfied, at which point CGT event C2 happens.

However, the capital gain (or loss) is disregarded (pursuant to subsection 118-37(2)) because the taxpayer would make it as a result of receiving the Funds, as payment of its expenses in constructing the solar farm under a scheme (ASCI) established by an Australian government agency (XYZ) which is empowered under an enactment (the XYZ Act).

Therefore, although a CGT event occurs, it is disregarded for the purposes of working out any net capital gain (or loss) under subsection 102-5(1).

Question 4

Summary

The amount of the Funds is a recoupment of a loss or outgoing as defined in subsection 20-25(1). The recoupment is not excluded (under subsection 20-20(1)) and is an assessable recoupment under subsection 20-20(3).

Detailed reasoning

Under Subdivision 20-A, certain amounts received by way of insurance, indemnity or other recoupment are assessable income if amounts are not income under ordinary concepts or assessable income under another provision outside Subdivision 20-A.

Subsection 20-25(1) defines 'recoupment of a loss or outgoing' inclusively as:

(a) any kind or recoupment, reimbursement, refund, insurance, indemnity or recovery, however described; and

(b) a grant in respect of the loss or outgoing.

Subsection 20-20(1) states that:

An amount is not an assessable recoupment to the extent that it is *ordinary income, or it is *statutory income because of a provision outside this Subdivision.

Subsection 20-20(3) states that:

An amount you have received as *recoupment of a loss or outgoing (except by way of insurance or indemnity) is an assessable recoupment if:

(a) you can deduct an amount for the loss or outgoing for the *current year; or

(b) you have deducted or can deduct an amount for the loss or outgoing for an earlier income year;

under a provision listed in section 20-30.

Subsection 20-30 contains a table of deductions under the ITAA 1997 for which recoupments are assessable. Item 1.9 of that table contains the provision, Division 40, which allows for deductions for depreciation.

Application to the case

The Funds are a grant in respect of an outgoing, being the expenses associated with the construction of the solar plant. They therefore represent a recoupment of a loss or outgoing.

As the answers to Questions 1, 2 and 3 have explained, the Funds are neither ordinary income nor statutory income because of a provision outside Subdivision 20-A, hence subsection 20-20(1) does not apply.

As the Funds are not otherwise assessable, they will be an assessable recoupment under Subdivision 20-A (subsection 20-20(3)) to the extent that the deductible loss or outgoing is deductible under Division 40.

As the expense will be deductible over 2 or more income years, the method statement in section 20-40 will apply to work out how much is included in the taxpayer's assessable income in each income year in relation to the Funds.