Edited version of your written advice

Authorisation Number: 1051373101857

Date of advice: 17 May 2018

Ruling

Subject: Eligibility for Division 43 deductions

Question 1

Does Subdivision 124-B of the Income Tax Assessment Act (ITAA 1997) reduce the capital gains tax (CGT) cost base of the Replacement Asset?

Answer

Yes.

Question 2

Is a capital works deduction available pursuant to Division 43 of the ITAA 1997 for the capital expenditure incurred on the construction of the Replacement Asset?

Answer

Yes.

Question 3

Does the deduction of capital expenditure under Division 43 of the ITAA 1997 reduce the CGT cost base of the Replacement Asset?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2018

Year ended 30 June 2019

Year ended 30 June 2020

Year ended 30 June 2021

Year ended 30 June 2022

Year ended 30 June 2023

Year ended 30 June 2024

Year ended 30 June 2025

Year ended 30 June 2026

Year ended 30 June 2027

The scheme commences on:

1 July 2017

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.

1. The Entity conducts a business.

2. The Entity’s premises were destroyed (the Original Asset). All assets lost or damaged were all acquired on or after 20 September 1985.

3. The Entity has received insurance proceeds under its insurance policy (the Policy). The Policy included cover for loss of earnings, property damage and business interruption.

4. The portion of the insurance proceeds considered in the private ruling request are the insurance proceeds received under the ‘property damage’ head of risk.

5. The Original Asset had a cost base at the time it was destroyed.

6. The Entity received insurance proceeds under a number of heads, including property damage and business continuity.

7. The Entity received insurance proceeds under the ‘property damage’ head of risk that exceed the written down cost base of the Original Asset.

8. The insurance proceeds are limited to monies received by the Entity and will not include the receipt of a replacement asset.

9. The insurance proceeds received under the ‘property damage’ head of risk have been used to fund the construction of the Entity’s new premises (the Replacement Asset).

10. The construction cost of the Replacement Asset was equal to the insurance proceeds.

11. The use of the Replacement Asset will be the same as the use of the Original Asset.

12. The construction of the Replacement Asset commenced during 2017 and was completed within 12 months.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 43

Income Tax Assessment Act 1997 Section 43-10

Income Tax Assessment Act 1997 Section 43-70

Income Tax Assessment Act 1997 Section 43-75

Income Tax Assessment Act 1997 Section 43-140

Income Tax Assessment Act 1997 Section 43-145

Income Tax Assessment Act 1997 Section 43-150

Income Tax Assessment Act 1997 Section 43-210

Income Tax Assessment Act 1936 Section 45-40

Income Tax Assessment Act 1997 Section 104-20

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Section 110-37

Income Tax Assessment Act 1997 Section 110-45

Income Tax Assessment Act 1997 Section 112-110

Income Tax Assessment Act 1997 Subdivision 124B

Income Tax Assessment Act 1997 Section 124-70

Income Tax Assessment Act 1997 Section 124-75

Income Tax Assessment Act 1997 Section 124-85

Reasons for decision

Question 1

Summary

The application of subsection 124-85(2) of the ITAA 1997 will reduce the cost base of the Replacement Asset.

Detailed explanation

Replacement-asset roll-over

Subsection 104-20(1) of the ITAA 1997 provides that CGT event C1 happens if a CGT asset a taxpayer owns is lost or destroyed. The timing of CGT event C1 is when the taxpayer receives compensation for the loss or destruction of the asset, or if no compensation is received – when the loss is discovered or the destruction occurred. A capital gain is made from CGT event C1 if the capital proceeds from the loss or destruction of the CGT asset are more than the asset’s cost base.

Paragraph 124-70(1)(b) of the ITAA 1997 provides that a rollover may be available when a CGT asset, or part of it, is lost or destroyed. Subsection 124-70(2) of the ITAA 1997 states that the taxpayer must receive money or another CGT asset, or both, as either compensation for the event happening, or under an insurance policy against the risk of loss or destruction of the original asset.

Subsection 124-75 of the ITAA 1997 provides that if the taxpayer receives money for the event happening, they can only choose to obtain a roll-over if certain other requirements are satisfied. Firstly, the taxpayer must incur expenditure on acquiring another CGT asset or, if part of the original asset is lost or destroyed, the taxpayer must incur expenditure of a capital nature in repairing or restoring it.

In addition, at least some of the expenditure must be incurred no earlier than one year before the CGT event happening, or no later than one year after the end of the income year in which the event happened. Further time may be allowed by the Commissioner in special circumstances.

Subsection 124-75(4) of the ITAA 1997 also provides that if the original asset was used in the taxpayers business just before the CGT event happened, the replacement asset must be used in the business or installed ready for use in the business for a reasonable time after it was acquired.

Effect on cost base

Section 112-110 of the ITAA 1997 is a starting point regarding the way in which the first element of the cost base of a replacement asset is modified when a replacement-asset roll-over is utilised. Section 112-110 of the ITAA 1997 provides that the first element of the replacement asset's cost base or reduced cost base is replaced by the original asset's cost base at the time the replacement asset was acquired. Note 1 in section 112-110 of the ITAA 1997 provides that some replacement- asset roll-overs involve other rules that affect the cost base or reduced cost base of the replacement asset.

Section 124-85 of the ITAA 1997 outlines the consequences of a taxpayer receiving money for the event happening and choosing to obtain a rollover. Item 3 of the table in subsection 124-85(2) of the ITAA 1997 provides that where a capital gain is made, that is where the proceeds from the insurance policy exceed the cost base, but the insurance money does not exceed the expenditure incurred on the replacement asset, the gain is disregarded in working out capital gains or losses in that income year. However, the expenditure incurred on the replacement asset is reduced by the amount of the gain. In effect, the first element of the cost base for a replacement asset will be reduced by the amount of that capital gain.

The way in which the cost base modification rules in sections 112-110 and 124-85 of the ITAA 1997 are drafted results in the first element of the cost base of the Replacement Asset being modified by operation of subsection 124-85(2) of the ITAA 1997, rather than section 112-110 of the ITAA 1997. That is, the first element of the cost base of the Replacement Asset is reduced by the amount of the capital gain on the Original Asset. The first element of the cost base is not replaced by the Original Assets cost base.

In your case you have received insurance proceeds following the destruction of the Original Asset. The insurance proceeds did not exceed the total expenditure you incurred constructing the Replacement Asset, as the insurance proceeds were equal to the cost of constructing the Replacement Asset. Construction of the Replacement Asset was commenced within 12 months of the destruction of the Original Asset and the use of the Replacement Asset in your business is the same as the use of the Original Asset in your business.

If you choose to apply the Subdivision 124-B replacement-asset roll-over provisions the Replacement Asset’s cost base will be reduced by the amount of the capital gain you made when the Original Asset was destroyed. Based on the figures you have supplied you made a capital gain when the Original Asset was destroyed. By subtracting the capital gain from the expenditure incurred on the Replacement Asset, the first element of the cost base is reduced.

Conclusion

The application of the Subdivision 124-B replacement-asset roll-over provision will reduce the cost base of the Replacement Asset by the amount of the capital gain on the Original Asset. The first element of the cost base of the Replacement Asset will be reduced.

Question 2

Summary

The replacement-asset roll-over provisions will not affect the deductions available under Division 43 of the ITAA 1997. Division 43 deductions will be based on the amount of construction expenditure incurred on the capital works.

Detailed explanation

Division 43 of the ITAA 1997 allows a taxpayer to deduct capital expenditure incurred on assessable income producing buildings and other capital works. The deduction amount depends on when the construction started and how the capital works are used. No amount can be claimed before the completion of construction of the capital works.

Section 43-10 of the ITAA 1997 provides that a taxpayer can only claim a capital works deduction if:

(a) the capital works have a construction expenditure area

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

(c) the taxpayer uses the area in the income year in the way set out in the table in section 43-140 of the ITAA 1997.

A deduction for capital works under Division 43 of the ITAA 1997 is based on the amount of construction expenditure incurred on the capital works. Construction expenditure is defined in section 43-70 of the ITAA 1997 as capital expenditure incurred in respect of the construction of capital works. Construction expenditure does not include, among other things, expenditure on:

● acquiring land,

● demolishing existing structures,

● clearing, levelling, filling, draining or otherwise preparing the construction site prior to carrying out excavation works,

● expenditure on landscaping, or

● expenditure on plant.

Section 43-75 of the ITAA 1997 provides that a construction expenditure area, where capital works began after 30 June 1997, is the part of the capital works on which the construction expenditure was incurred.

A ‘pool of construction expenditure’ is so much of the construction expenditure incurred by an entity on capital works that is attributable to a particular construction expenditure area.

Section 43-25 of the ITAA 1997 provides that for capital works begun after 26 February 1992, there is a basic entitlement to a rate of 2.5% for parts used as described in the table in section 43-140 of the ITAA 1997. The rate increases to 4% for parts used as described in the table in section 43-145 of the ITAA 1997.

For capital works commenced after 30 June 1997, item one of the table in subsection 43-140(1) requires that the area be used for the purpose of producing assessable income or carrying on research and development activities.

Item one of the table in section 43-145 of the ITAA 1997 provides that where capital works are buildings, capital works deductions may be calculated annually at a rate of 4% of construction expenditure in certain situations. The 4% rate is available where a taxpayer uses a part of its area for the purposes of producing assessable income, and that part is used by any entity wholly or mainly for conducting ‘industrial activities’. The meaning of ‘industrial activities’ is set out in section 43-150 of the ITAA 1997.

The method of calculation of the deduction is set out in section 43-210 of the ITAA 1997.

There is no interaction between subsection 124-85(2) of the ITAA 1997 and Division 43 of the ITAA 1997 in terms of the quantum of construction expenditure for which you can claim a deduction under Division 43. Although subsection 124-85(2) of the ITAA 1997 requires the expenditure incurred on a replacement asset be reduced by the amount of the capital gain made upon receipt of insurance proceeds, the reduction in ‘expenditure’ is relevant for cost base calculations only.

Therefore, the amount of expenditure relevant for Division 43 deductions will be calculated after determining the quantum of construction expenditure you incurred on the Replacement Asset.

Conclusion

You can calculate your capital works deduction pursuant to Division 43 of the ITAA 1997 using the amount of construction expenditure you incurred on the construction of the Replacement Asset. This amount will not be reduced by the insurance proceeds or the capital gain you made when event C1 occurred.

Question 3

Summary

Division 43 deductions will reduce the cost base of the Replacement Asset.

Detailed explanation

The operation of the replacement-asset roll-over provisions in Subdivision 124-B of the ITAA 1997 and the capital allowances provisions in Division 43 of the ITAA 1997 may result in a mismatch between the first element of the cost base for CGT purposes and the construction expenditure a taxpayer is entitled to deduct.

Section 110-37 of the ITAA 1997 explains when expenditure does not form part of the cost base of a CGT asset. Subsection 110-37(1) of the ITAA 1997 explains that when a later provision of Subdivision 110-A states that ‘expenditure does not form part of the cost base’ this means the expenditure is initially included in the cost base, but the cost base is then reduced by the amount of the expenditure just before a CGT event happens in relation to the asset. This is to be distinguished from the situation where the expenditure is never included in the relevant elements of the cost base under subsection 110-37(2) of the ITAA 1997.

Section 110-45 of the ITAA 1997 contains a number of cost base modification rules for assets acquired after 13 May 1997.

The first element of the cost base of the Replacement Asset includes the construction expenditure incurred in acquiring the Replacement Asset. As discussed above, the operation of subsection 124-85(2) of the ITAA 1997 reduces the first element of the cost base by the amount of the capital gain on the Original Asset.

The cost base of the Replacement Asset is to be distinguished from the written down cost base of the Original Asset. The cost base of the Replacement Asset is derived from the expenditure incurred in acquiring the Replacement Asset, reduced by the capital gain that was disregarded. The cost base of the Original Asset was relevant to calculating the capital gain that was disregarded, but the two amounts relate to different expenditure.

The relevant modification in this case is in subsection 110-45(2) of the ITAA 1997 which states that ‘expenditure (except expenditure excluded by subsection (1B)) does not form part of the cost base to the extent you have deducted or can deduct it for an income year’. Read in context with subsection 110-37(1) of the ITAA 1997 this means that the expenditure is initially included in the cost base of the Replacement Asset. The cost base will then be reduced by the amount of the Division 43 capital allowance deduction each year.

Conclusion

The first element of the cost base of the Replacement Asset will reduce each year in which you are entitled to claim a capital allowances deduction under Division 43 of the ITAA 1997. The cost base reductions that happen as a result of the Division 43 deductions are limited to the amount of the expenditure that was included in the first element of the cost base.