Edited version of your written advice

Authorisation Number: 1051378023792

Date of advice: 28 May 2018

Ruling

Subject: Assessability of a government grant to fund development of a new production line.

Question 1

Is the grant received by a subsidiary of the Rulee assessable income of the Rulee under section 6-5 of the Income Tax Assessment Act 1997 (1997)?

Answer

No

Question 2

Is the grant received by a subsidiary of the Rulee assessable income of the Rulee under section 15-10 of the Income Tax Assessment Act 1997 (1997)?

Answer

Yes

Question 3

On the basis that capital allowances are claimed under Division 40, will the grant received by a subsidiary of the Rulee be an assessable recoupment of the Rulee under Subdivision 20-A of the ITAA 1997?

Answer

No

This ruling applies for the following period(s)

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

The Rulee is the head entity of a consolidated group for income tax purposes (the Head Entity).

A subsidiary of the Head Entity and a member of the group of companies (Subsidiary 1) operates a manufacturing business, producing various types of product.

Subsidiary 1 via Media release announced its intentions to expand its business and manufacturing facilities.

Subsidiary 2 was incorporated to manufacture a new product from the new factory. At the same time Subsidiary 2 joined the consolidated group.

Prior to the incorporation of Subsidiary 2, Subsidiary 1 applied for, and was approved to receive, a State Government grant.

The Draft Funding Agreement between Subsidiary 1 and the State Government sets out that:

● The project is to support the investment in a major business expansion to develop a new world class, high volume production line,

● Eligible Project Expenditure means expenditure (exclusive of GST) incurred by the Recipient and/or Participating Organisations directly on the Project within 18 months from the Date this Agreement on –

(a) Project related non-capitalised expenditure (excluding expenditure on vehicles, internal costs or salaries);

(b) manufacturing product and process improvements (including significant improvements in technical specifications, components and materials, software for the Project, user friendliness or other functional characteristics and/or new or significantly improved production or delivery methods;

(c) prototyping, evaluation and testing of new products and manufacturing processes;

(d) supply chain capability development;

(e) tooling’

(f) external training costs specific to the technology for the Project;

(g) labour and contractors for the Project (but does not include internal salaries);

(h) manufacturing machinery and equipment, (for example repurposing state-of-the-art automotive manufacturing equipment); or

(i) minor alterations and fit-out costs to existing buildings.

● Grant: An amount not exceeding $xxx.xxx (excluding GST)

● Total Project Expenditure: $x,xxx,xxx (excluding GST)

The executed deed of the Funding Agreement has not changed from the draft version that has been provided to us.

The grant amount will be paid in three instalments over 20XX, 20XX and 20XX.

The first instalment of $xxx,xxx was received by Subsidary 1 in the 20XX income tax year.

Relevant legislative provisions

Income Tax Assessment Act 1997

Section 6-5

Section 15-10

Subdivision 20-A

Section 20-20

Section 20-25

Section 20-30

Division 40

Section 701-1

Subsection 701-1(1)

Subsection 701-1(2)

Subsection 701-1(3)

Reasons for decision

Question 1

Summary

The grant paid by the State Government to Subsidiary 1 under the Funding Agreement is not assessable under section 6-5 of the ITAA 1997.

Detailed reasoning

Consolidation and the single entity rule

According to the facts of the case, the Head Entity is the head entity of a consolidated group, and Subsidiary 1 and Subsidiary 2 are subsidiary members of the consolidated group.

Section 701-1 of the ITAA 1997 sets out the single entity rule (SER). Subsection 701-1(1) states:

If an entity is a subsidiary member of a consolidated group for any period, it and any other subsidiary member of the group are taken for the purposes covered by subsection (2) and (3) to be parts of the head company of the group, rather than separate entities, during that period.

Taxation Ruling TR 2004/11 Income tax: consolidation: the meaning and application of the single entity rule in Part 3-90 of the Income Tax Assessment Act 1997 (TR 2004/11) explains how the SER applies to members of a consolidated group.

Paragraph 4 of TR 2004/11 explains that the SER operates for the purposes set out in subsections 701-1(2) and (3) of the ITAA 1997. These purposes are to work out the amount of the head company and subsidiary member's liability for income tax and the amount of a loss for a relevant period. They include all matters relevant and incidental to those calculations. The intended operation of the SER is to apply the income tax laws to a consolidated group as if it were a single entity.

For income tax purposes the SER deems subsidiary members to be parts of the head company rather than separate entities during the period that they are members of the consolidated group. As a consequence the SER has the effect that:

(a) the actions and transactions of a subsidiary member are treated as having been undertaken by the head company;

(b) the assets a subsidiary member of the group owns are taken to be owned by the head company (with the exception of intra-group assets) while the subsidiary remains a member of the consolidated group;

(c) assets where the rights and obligations are between members of a consolidated group (intra-group assets) are not recognised for income tax purposes during the period they are held within the group whether or not the asset, as a matter of law, was created before or during the period of consolidation (see also paragraph 11 and paragraphs 26-28); and

(d) dealings that are solely between members of the same consolidated group (intra-group dealings) will not result in ordinary or statutory income or a deduction to the group's head company (TR 2004/11, paragraph 8).

Applying the facts in relation to the consolidated group, for income tax purposes:

● the application for the grant, and subsequent Funding Agreement, are treated as being entered into by the Head Entity instead of Subsidiary 1 alone,

● any amounts received by Subsidiary 1 under the grant Funding Agreement are treated as being received by the Head Entity,

● any outgoings for the construction of the factory are treated as being incurred by the Head Entity,

● any assets acquired by Subsidiary 1 or Subsidiary 2 using grant funds are treated as being owned by the Head Entity (while they remain members of the consolidated group), and

● any intra-group transactions between Subsidiary 1 or Subsidiary 2 will be ignored.

Is the grant assessable income of the Head Entity under section 6-5?

Section 6-5 of the ITAA 1997 states that your assessable income includes income according to ordinary concepts derived by you as an Australian resident directly or indirectly from all sources, whether in or out of Australia during the income year.

Taxation Ruling TR 2006/3 Income tax: government payments to industry to assist entities (including individuals) to continue, commence or cease business (TR 2006/3), at paragraph 84, explains that income according to ordinary concepts is not defined in the taxation legislation. The characteristics of ordinary income have been developed by case law and generally fall into three categories:

● income from providing personal services,

● income from the use of property, or

● income from carrying on a business.

Paragraphs 11 to 15 of TR 2006/3 provide examples of the cases where payments by government form part of the recipient’s assessable income under section 6-5 of ITAA 1997. The common feature in all these cases is that the government payments relate to an item that would normally be on the recipient’s revenue account (e.g. reduction in business’s ordinary income, expenses incurred in the ordinary course of business, evaluation of current business operations).

Paragraph 85 of Taxation Ruling TR 2006/3 states that case law has established various guidelines to assist in determining the nature of a receipt. Specifically, the guidelines include:

● the nature of a payment is determined by examining the character of the payment in the hands of the recipient, and

● a payment by subsidy to replenish or augment the recipient's capital is not income under ordinary concepts as it is not a product or incident of the recipient's income producing activity.

In applying the principles established in relevant cases as referred in TR 2006/3, it is our view that the payments made under the Funding Agreement are not income according to ordinary concepts as it is not a product or incident of your income producing activity. The payments are to construct the new production line.

Therefore, the receipt of the payment is not assessable as ordinary income under section 6-5 of the ITAA 1997.

Question 2

Summary

The grant paid by the State Government under the Funding Agreement is assessable under section 15-10 of the ITAA 1997.

Detailed reasoning

Section 15-10 of the ITAA 1997 provides that 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.

TR 2006/3 explains that payments of financial assistance by government are commonly referred to as 'bounties', 'subsidies' or 'grants'. As 'bounty', 'subsidy' and 'grant' are not defined terms, the ordinary meaning of these terms applies (paragraph 93).

The term 'grant' is defined to include 'that which is granted, as a privilege or right, a sum of money, as for a student's maintenance, or a tract of land'. Not all government grants are bounties or subsidies for the purposes of section 15-10 of the ITAA 1997. It is essential to determine what the grant is actually for. A reference to 'bounty or subsidy' includes a grant that encourages business or trade and also a grant to address a detrimental effect on a business or trade (TR 2006/3, paragraphs 96 and 97).

For the purposes of section 15-10 of the ITAA 1997, a bounty or subsidy must be in relation to carrying on a business, not to commencing or ceasing a business (paragraph 100 of TR 2006/3).

Paragraph 102 of TR 2006/3 clarifies that a government payment is assessable income under section 15-10 of the ITAA 1997, if it is received for the purpose of an existing business to:

● acquire or construct an asset, or

● to assist with the capital costs of restructuring to:

● improve the manufacturing, processing, distribution, administration or other operations of the business, or

● assist the business to improve its overall efficiency.

However, paragraph 102 of TR 2006/3 further clarifies that some business restructures may not be in relation to carrying on a business, for example if a business changes its structure to facilitate a new activity, but this must be decided on the merits of each case.

Taxation Ruling TR 2017/D7 Income tax: when does a company carry on a business within the meaning of section 23AA of the Income Tax Rates Act 1986? (TR 2017/D7) explains that if a company is a member of a group of companies, its purpose, and whether it carries on a business, may be determined by reference to:

● its role within the group,

● the activities of the wider group, and

● the intended activities of any of its subsidiaries at the time they are set up.

From the facts of the case it is clear that Subsidiary 1 is carrying on a business. The question is whether the production of the product is a new business or an expansion of the existing business.

Taxation Ruling TR 2007/2 Income tax: application of the same business test to consolidated and MEC groups - principally, the interaction between section 165-210 and section 701-1 of the Income Tax Assessment Act 1997 (TR 2007/2) focuses on deducting losses under the consolidation regime. However, some principles can be applied similarly in relation to groups of entities carrying on business.

Paragraph 15 of TR 2007/2 explains that:

‘When determining the one overall business carried on by a head company of a consolidated group … it is necessary to have regard to the activities of the subsidiary members of the group. …one overall business of the head company is to be identified by examining all of the activities, enterprises or undertakings carried on…

In discussing whether the same business is being carried on, TR 2007/2 confirms the concepts discussed in Taxation Ruling TR 1999/9: Income tax: the operation of sections 165-13 and 165-210, paragraph 165-35(b), section 165-126 and section 165-132, at paragraph 13, which states:

In making the analysis it needs to be acknowledged that a company may expand or contract its activities without necessarily ceasing to carry on the same business. The organic growth of a business through the adoption of new compatible operations will not ordinarily cause it to fail [be a different business] provided the business retains its identity … But, if through a process of evolution a business changes its essential character, or there is a sudden and dramatic change in the business brought about by either the acquisition or the loss of activities on a considerable scale, a company may [be a different business].

As described in the facts and discussed in question 1, although Subsidiary 1 applied for, and was approved to receive, a State Government grant, for income tax purposes (under SER) the Head Entity is taken to have applied for, and entered into the contract for the grant.

You have advised that the purpose of the grant is to help the company undertake a major business expansion in developing a new, high volume production facility.

On the basis of the facts provided, it is unclear whether the new production facility will legally be owned by Subsidiary 1 or Subsidiary 2. However, as both companies are subsidiary members of the consolidated group, for income tax purposes, the SER applies to treat the assets of both companies as assets of the Head Entity.

The Commissioner accepts that introducing the production of the product to the activities of the group of companies is not creating a new business, but is a natural expansion of the existing business. This decision is supported by the facts that:

● The group of companies has been operating for many years manufacturing this product type, and this is not changed by introducing a similar new product,

● The original decision to introduce the new product was made by Subsidiary 1 as evidenced by the grant application being submitted by Subsidiary 1 prior to incorporation of Subsidiary 2,

● Although the assets purchased by the grant may be legally owned by Subsidiary 2, as a result of the SER, for income tax purposes the Head Entity is taken to have received the grant, and

● Although Subsidiary 2 may be generating income from the sales, as a result of the SER, for income tax purposes the Head Entity is taken to be generating the income.

As such, it is considered that the activities undertaken to incorporate the new company, Subsidiary 2, and build the new production facility are not part of commencing a new business, but are an expansion of the existing business of the corporate group, which includes both Subsidiary 1 and Subsidiary 2.

Question 3

Summary

The grant paid by the State Government to Subsidiary 1 under the Funding Agreement is not an assessable recoupment under Subdivision 20-A of the ITAA 1997

Detailed reasoning

Paragraph 27 of TR 2006/3 states:

A GPI received to assist the recipient to commence business with the purchase of a depreciating asset, the cost of which is deductible under Division 40, is assessable income under the assessable recoupment provisions in Subdivision 20-A of ITAA 1997.

Under section 20-20 of Subdivision 20-A, a receipt is an assessable recoupment if:

● it is not income under ordinary concepts or otherwise assessable;

● it is received as recoupment of a loss or outgoing (as defined by section 20-25; and

● the taxpayer has deducted or can deduct an amount for a loss or outgoing in the current year or an earlier year under a provision listed in section 20-30.

As determined in Question 2, the GPI is assessable under section 15-10 of ITAA 1997. It is, therefore, not an assessable recoupment under Subdivision 20A of ITAA 1997.