Edited version of your written advice

Authorisation Number: 1051408555112

Date of advice: 5 October 2018

Ruling

Subject: Income Tax: Deduction for water facilities under section 40-515

Question

Does XYZ Pty Ltd qualify for income tax deductions under section 40-515 of Subdivision 40-F of the Income Tax Assessment Act 1997 (ITAA 1997) in respect of the capital expenditure incurred on the new fish production plant ?

Answer

No

This ruling applies for the following periods:

Year ending 30 June 20xx and 30 June 20xx

The scheme commences on:

1 July 20xx

Relevant facts and circumstances

XYZ Pty Ltd (XYZ), a resident company, is a primary producer.

Broadly, the water for the production facility is initially sourced through an underground aquifer and rainwater harvesting which is then pumped to a holding tank and subsequently conveyed via concrete channels to the filtration plant for treatment and fish production.

XYZ raised $xx million in 2015 to fund the construction of a new facility plant at its premises.

For the year ended 30 June 2016 and 2017, XYZ incurred capital expenditure of $xx and $xx respectively on new ‘water conserving’ assets as part of its new plant. The majority of the expenses were in relation to plant and engineering design.

XYZ’s fish production facility effectively saves considerable water.

XYZ has provided a detailed asset register, schematics and presentation materials as part of the ruling application.

XYZ contends that the plant that forms part of its new system qualifies as a ‘water facility’ that is primarily and principally for the purposes of conserving or conveying water for use in its primary production business.

Relevant legislative provisions

Section 40-515 ITAA 1997

Section 40-520 ITAA 1997

Section 40-525 ITAA 1997

Section 45-40 ITAA 1997

Reasons for decision

These reasons for decision accompany the Notice of private ruling for XYZ Pty Ltd.

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Summary

You are not entitled to claim a deduction for water facility under subdivision 40-F of the ITAA 1997.

Detailed reasoning

Subdivision 40-F of the ITAA 1997 allows immediate deductions for capital expenditure incurred on certain depreciating assets used in primary production. One of these depreciating assets is a ‘water facility’ (paragraph 40-515(1)(a) of the ITAA 1997). If the expenditure was incurred prior to 12 May 2015, but after 1 July 2004, it would have qualified for deduction spread over three years.

Under subsection 40-520(1) of the ITAA 1997 a ‘water facility’ is defined as:

a) plant or a structural improvement that is primarily and principally used for the purpose of conserving or conveying water for use in a primary production business that you conduct on a land in Australia, or

b) a structural improvement, or an alteration, addition or extension that is reasonably incidental to conserving or conveying water.

The legislation provides examples of a water facility which include a dam, tank, tank stand, bore, well, irrigation, pipe, pump, water tower and windmill. Examples of things reasonably incidental to conserving or conveying water include a culvert, a fence to prevent livestock entering an irrigation channel and a bridge over an irrigation channel.

In order to claim a deduction for the decline in value of a water facility, the conditions in subsection 40-525(1) of the ITAA 1997 must be satisfied that is the capital expenditure you incurred on the construction, installation or acquisition of the water facility must have been incurred primarily and principally for the purpose of conserving or conveying water for use in a primary production business that you conduct on land in Australia.

The 'primary and principal' requirement recognises that capital expenditure on irrigation and water conservation measures may be undertaken for more than one reason. Where the expenditure is incurred for dual purposes it will always be necessary to establish the primary and principal function or purpose of the result of the expenditure.

Background to the legislation and Parliament's intention

In interpreting this purpose test and especially its strictures in relation to conserving or conveying water, it is worth considering the broader underlying policy rationale for the concession, which is to encourage drought mitigation strategies by providing incentives and concessions to primary producers to invest in water storage facilities for irrigation. As stated in para 6.3 of the Explanatory Memorandum to Act 23 of 2005 which introduced the current version of the provision:

…to encourage primary producers to undertake expenditure on water management to increase their capacity to withstand drought and to improve their on-farm water management

Accelerated depreciation deduction for water facilities for primary producers has been allowed for some time. Various iterations of the measures over the years, as stated below, have provided tax concessions on capital expenditure over extended periods or as immediate write-offs. Initially capital expenditure on water infrastructure was deductible over a period of ten years. In 1980, the Fraser Government enabled expenditure on water infrastructure to be immediately deductible in full. Again the purpose of this was to encourage primary producers to increase their ability to withstand drought.

The Explanatory Memorandum to the Income Tax Assessment Bill 1947 at Clause 12 – Certain Expenditure on Land Used for Primary Production proposed to extend concessions for primary producers to cover capital expenditure incurred in constructing specified improvements intended for use in improving or conserving water supplies………

It further states that ……

The present law allows depreciation in respect of most of the assets used by primary producers for water conservation. The recoupment of capital cost of these improvements is, however, extended over a somewhat lengthy period. If the full cost of construction of such improvements as dams, earth tanks, underground tanks, and irrigation channels, as well as the cost of sinking bores and wells were allowed as a deduction in the year in which the expenditure is incurred, primary producers would be able to add to their improvements at an earlier date than is, at present, possible…..

The Explanatory Memorandum to Income Tax Assessment Bill (No 2) 1969 extended the deduction to include capital expenditure on improvements made to conserve water.

Note to Clause 6: Certain Expenditure on land used for Primary production states …..

As observed in the note on clause 5, section 75 of the Principal Act authorises a full deduction, in the income year in which the expenditure is incurred, for certain capital expenditure made by primary producers. In its present form it extends to the cost of structural improvements for water conservation purposes, such as dams, earth tanks, underground tanks, bores and wells. The proposed new paragraph (h) of sub- section (1.) of section 75 will, by sub-paragraph (i), extend the scope of the structural improvements covered by the section to all improvements for conserving water, including, e.g., concrete tanks and stands for tanks.

Sub-paragraph (ii) of the new section (h) will, in effect, re-enact an existing provision providing a deduction for the cost of irrigation channels and similar improvements for conveying water.

The Explanatory Memorandum to Taxation Laws Amendment (Drought Relief Measures) Bill 1995 addressed water facilities deduction in context of Drought Investment Allowance Measures.

1.2 The purpose of the amendments was to encourage farmers throughout Australia to prepare for future droughts by providing incentives to invest in fodder and water storage for livestock, in water conveyancing ……

1.4 These measures are part of the Government's drought assistance package which recognises that drought is a feature of Australian farming. The current drought shows the need for measures that enable farmers to prepare better for drought, and so survive without undue hardship.

1.16 In drought, primary producers need stored water for livestock, and may need that water at several appropriate points. Facilities for use on the particular farm in storing water mainly for livestock are water storage facilities, and so drought mitigation property, provided their use is in accordance with an approved water conservation plan. These facilities are listed as including dams, earth tanks, underground tanks, or above ground tanks, or the bases, stands or covers of these tanks, or any other structures or improvements.

1.23 Some ways of improving drought preparedness include the use of water storage facilities or water transport facilities to water stock closer to available pasture or hand feeding sites (to reduce land degradation), to water stock away from waterways and enable them to be excluded from waterways (to protect riverbanks, vegetation, and water quality), and to reduce wastage of surface or ground water by conveying water more efficiently (for example, in pipes rather than open channels where appropriate).

Application to your circumstances

The first limb of the definition sets the following requirements for your system to be a water facility as relevant to your circumstances:

(1) The system must be:

(a) plant; or

(b) a structural improvement.

(2) It must be primarily and principally for the purpose of:

(a) conserving water; or

(b) conveying water.

‘Plant’ is not defined, but there are specific extensions of the phrase in s 45-40. Relevantly, these extensions include ‘articles, machinery, tools, rolling stock’, fences, dams and structural improvements used in agricultural and pastoral operations.¹

The word is much-discussed in case law. Its definition given in Yarmouth v France by Lindley LJ, stated that ‘in its ordinary sense, [plant] includes whatever apparatus is used by a businessman for carrying on his business – not his stock-in-trade which he buys or makes for sale; but all goods and chattels, fixed or movable, live or dead, which he keeps for the permanent employment of his business’.² Though some qualifications and extensions have been introduced to this explanation by subsequent cases,³ it remains authoritative with respect to the general nature of plant.

The system falls within this definition, being a facility comprising different parts and components collectively employed in fish farming.

Primarily and principally for the purpose of conveying water

The meaning of the expression 'primarily and principally' has not been judicially considered in this context, however, the meaning of the expression 'primarily and principally' has been considered by Australian courts with respect to the purpose of the object, including in similar legislative contexts.

In Parker Pen (Aust) Pty Ltd v. Export Development Grants Board (1983) FCA 77; (1983) 46 ALR 612, Lockhart J said, in considering whether advertising expenditure was incurred primarily and principally for the purpose of creating or seeking opportunities, or creating or increasing demand, for export sales by the entity incurring the expense (at ALR 619-20):

Sub-s. 4(1) uses the adverbs 'primarily' and 'principally'. It is a curious use of language. The words have different derivations and sometimes different connotations. For example, one meaning of 'primarily' is at first or originally. 'Principally' does not bear this meaning. I have looked at various dictionaries. They all define the adjectives 'primary' and 'principal' and some define the adverbs 'primarily' and 'principally'. The modern meanings given in the dictionaries to these words is much the same. For example, Collins Dictionary of the English Language, Australian edition edited by G.A. Wilkes, defines 'primarily' so far as relevant, as 'principally; chiefly; mainly'. The Macquarie Dictionary defines the adverb 'principally' as 'chiefly; mainly'. It is in this sense that the words are to be understood in sub-s.4(1). Notwithstanding the tractability of the English language I do not think that the two adverbs have separate work to perform in the sub-section.

In my view the draftsman used both words to emphasise that it is only where the Board is satisfied that expenditure has been incurred mainly or chiefly (to use neutral adverbs) for the required purpose that the expenditure answers the description of 'eligible expenditure'.

The scope of the term 'primarily and principally' was considered in St George Leagues Club v. Commissioner of Land Tax (NSW) (1983) 14 ATR 826; 83 ATC 4736 ( St George ), where Lee J said, in considering whether a block of land was used primarily and principally for water skiing (at ATR 833; ATC 4743-4):

The expression "primarily and principally" is not the same as "solely" and does not deny exemption in a case where there is some other user of the whole or part which, however, does not prevent a conclusion that the land is used "primarily and principally" for the purposes of the sport under consideration. This may give rise to questions of fact and degree in some cases, but on the evidence in the present case there can be no doubt that the whole of the land is used "primarily and principally" for the purposes of water-skiing and, accordingly, it is within the exemption provided under para.(h).

These cases indicate that the question of what the taxpayer's business primarily and principally is can be determined as the chief or main, but not necessarily the sole, business of the taxpayer.

The St George case above indicates that land may have a primary and principal use notwithstanding that it is used for more than one purpose. This principle can equally be applied to determining what the primary and principle purpose of the expenditure incurred by a taxpayer is.

The phrase ‘primarily and principally’ has also been used in sales tax and depreciation contexts. Its interpretation appears to be fairly uniform. Courts read it to have a meaning which is synonymous with words like chiefly, mainly and predominantly (see Parker Pen (Australia) Pty Ltd v Export Developments Grant Board (1983) 67 FLR 234, 240 – 241. In the legislative context of Subdivision 40-F, there is nothing to indicate this meaning is inappropriate.

In respect of the purpose which must be primary and principal, cases indicate that the purpose is not the purpose of any particular person. It is instead the characteristic purpose which such an item would be dedicated to (see Kearney v Federal Commissioner of Taxation (1984) 15 ATR 564; Federal Commissioner of Taxation v Kearney (1985) 16 ATR 351; National Mutual Life Association of Australasia Ltd v Federal Commissioner of Taxation (1970) 122 CLR 13; Smith v Federal Commissioner of Taxation (1982) 13 ATR 115, 118; Sunchen Pty Ltd v Federal Commissioner of Taxation (2010) 190 FCR 38, 45 – 46 [38] – [41] (Edmonds and Gilmour JJ).

Taxation Determination TD 94/9 Income tax: whether a fruit grower is entitled to a tax deduction under section 75B or section 75D for the cost of changing to a different watering system which has a secondary purpose of preventing or combating land degradation? provided the Commissioner’s views of the deductibility of expenditure under former sections 75B and 75D of the ITAA 1936 where the expenditure was incurred for dual purposes, one of which was preventing and combating land degradation. Although, TD 94/9 deals with former section 75B of the ITAA 1936, there have been no changes to the test.

TD 94/9 stated that where the expenditure is incurred for a dual purpose, the ‘primarily and principally’ test does not require a consideration of the subjective or objective purpose or motives of the taxpayer in incurring the expenditure. The test requires an examination of the primary and principal function or purpose of the result produced by the expenditure.

In the case of ‘conserving’, two ordinary meanings could be relevant. It might mean preventing harm to, as with conservation dedicated to the preserving the environment or items of cultural heritage. Alternatively, it may mean saving for later use (as with, for example, an athlete in a long-distance race who conserves energy). Given that the word appears in a subdivision dedicated to primary production, where the use of water is likely to be common, the latter meaning seems more apt.

Although the system has elements that may be capable of being described as conveying and conserving water, it is a secondary consequence that the technology provides.

The benefit provided by the design of the system is a by-product of the function of the system. It is not designed to collect and store water pending its future usage or transportation in the context of a ‘water facility’ described in section 40-520.

In addition to the question of its primary and principal purpose, the plant must also be for conserving or conveying water. The items of plant in your system are not in their nature or function for conserving or conveying water. The items of plant in their particular situation are not of a kind that meets the description of being for conserving or conveying water within the meaning and usage of these terms in the context of the current provision of the law. They are not for the storage or transportation of water and are not analogous or akin to this in their situation within the facility.

Accordingly, the primary purpose or function of the system is to enable efficient fish production with minimal input of external water and not storage, conservation or conveying of water.

Structural improvement which is reasonably incidental to conserving or conveying water

The second limb of the definition of a water facility requires a structural improvement, or a repair, alteration, or extension to the structural improvement must be reasonably incidental to conserving or conveying water.

In its ruling application XYZ has not pressed its claim for a water facility deduction under the second limb of the definition, in the event that it does not satisfy the first limb. However for the purpose of completeness, the Commissioner will consider whether the system is a structural improvement, and if so, whether the structural improvement is reasonably incidental to conserving or conveying water.

The expression ’structural improvement’ is not defined hence it is to take its meaning from the ordinary understanding of that expression. It is one of the categories covered under the broad umbrella term ’Capital works’ which covers a range of structures, extensions, alterations and improvements to such structures for which deductions are available under Division 43.

Some examples of structural improvements to which Division 43 of the ITAA 1997 applies are described in subsection 43-20(3) of the ITAA 1997. They include sealed roads, sealed driveways, sealed car parks, sealed airport runways, bridges, pipelines, lined road tunnels, retaining walls, fences, concrete or rock dams and artificial sports fields.

The term 'structural' connotes some form of building or construction. This indicates the requirement for the creation of a significant feature. The term 'improvement' is not necessarily to be understood as indicating a qualitative character in the sense that it makes something better in some sense or more valuable. It equally applies to describe an alteration in characteristics (NT86/8971 and Commissioner of Taxation [1988] AATA 220; (1988) 19 ATR 3691; 88 ATC 694).

The Explanatory Memorandum accompanying the Taxation Laws Amendment Act (No 3) 1992 noted that the ordinary meaning of the phrase is “property constructed on land out of material or related parts which improves the land”. Under this measure, further examples of the kinds of structures which qualified for deductions under structural improvements included concrete and bitumen roads, driveways, carparks and airport runways; retaining walls; fences; bridges; lined tunnels; concrete or rock dams; pipelines; and artificial playing fields.

In Mount Isa Mines Ltd v Federal Commissioner of Taxation⁴ the judge commented on the meaning of the phrase. He said that the phrase ‘structural improvements’ was a phrase which had to be read as a whole, rather than dissected. Structural’ he said was an adjective meaning ‘pertaining to a structure’. ‘Improvement’ referred to the turning of land to better account, especially by cultivation or other use, or the action or process of making or becoming better.

Ordinarily, it would refer to things with the effect of improving land. Construed together, and in the context of provisions designed to incentivise certain kinds of expenditure, the judge concluded that ‘structural improvements’ referred to those things with a degree of permanence (contra e.g. scaffolding) which are of a structural nature and which have the effect of improving land.

Likewise in the context of the water facility provisions the legislation has limited guidance on the meaning of the term ‘structural improvement’. However it provides the following examples of structures which are included as examples of ‘water facilities’ - dam, tank, stand, bore, well, irrigation channel, pipe, drum, water tower and windmill.

In the present case, the production facility comprises of some of the items of the examples stated above – pipelines, tanks and water channels. In order to determine whether these are reasonably incidental to conserving or conveying water and therefore a water facility within the meaning in paragraph 40-520(1)(b), it is necessary to consider the meaning of the expression ‘reasonably incidental to’ in this context.

The expression ‘reasonably incidental to’ is discussed in ATO Interpretive Decision ATO ID 2009/32 Income Tax Capital Allowances: water facility- reasonably incidental to conserving or conveying water and examines its meaning according to case law.

Its states that in order for a thing to be 'reasonably incidental to' another thing, the thing must be reasonably expected to happen in connection with, and be seen as naturally appertaining to that other thing. In other words, there must be a likely and generally accepted connection or relationship between the two things; and that connection must be generally accepted as one thing naturally appertaining to or liable to happen in connection with the other.

The meaning of the expression 'reasonably incidental to conserving or conveying water' has not been judicially considered, however, the meaning of the expression 'reasonably incidental to' has been judicially considered in cases dealing with other legislation.

To summarise, the interpretive decision concluded that in the view of the courts whether something is 'reasonably incidental to' another thing is a question of fact and degree and that in view of the courts there must be a clear and generally accepted connection between the two things; and that this connection must be one of some substance, and not a general facilitation or minor effect of one on the other.

Tax Laws Amendment (2004 Measures No. 6) Act 2005 extended the meaning of a 'water facility' in subsection 40-520(1) by including a structural improvement, or a repair of a capital nature, or an alteration, addition or extension, to a structural improvement that is reasonably incidental to conserving or conveying water. To clarify the meaning of 'water facility', an example was also included in subsection 40-520(1). The examples of things listed as being reasonably incidental to conserving or conveying water include a culvert, a fence to prevent livestock entering an irrigation channel and a bridge over an irrigation channel.

It has also been established that the degree of the relationship between the capital expenditure on the structural improvement and the conservation or conveyance or water is a question of fact and degree. The legislation does not outline the criteria to be used in deciding the degree of connection between the capital expenditure on a structural improvement and the purpose of conserving or conveying water.

Ordinarily, in determining the purpose behind the incurrence of an item of expenditure, the purpose may be decided based on:

● the subjective intention, purpose or motive of the entity in incurring the expenditure; or

● the objective result effected by the expenditure having been incurred.

This approach is adopted in Taxation Determination TD 94/9 which, in considering whether an irrigation system installed by a fruit grower was 'primarily and principally' for conveying water, stated that the 'primarily and principally' test requires an examination of the primary and principal function or purpose of the result produced by incurring the expenditure, rather than the purpose or motives of the taxpayer in incurring the expenditure.

The definition of 'water facility' in subsection 40-520(1) encompasses items of capital expenditure that are either 'primarily and principally for the purpose of' or 'reasonably incidental to' conserving or conveying water. It is logical to adopt the same objective purpose test to determine whether an item of capital expenditure is 'reasonably incidental to conserving or conveying water' as it is to decide whether it is 'primarily and principally for the purpose of conserving or conveying water'

Accordingly, when considering whether the plant qualifies as a water facility under paragraph 40-520(1)(b), the test to be applied is an examination of the objective result produced by your incurrence of the expenditure on the new plant, rather than your subjective intention, purpose or motive behind deciding to incur the expenditure.

In the present case, the system minimizes your production costs and has added operational benefits.

The examples of water facility infrastructure listed in section 40-520 are commonly found and utilised in the context of primary production. Their function is to access, harvest, collect and store the natural source of water for later use that would have been otherwise inaccessible, or lost to evaporation or run-off and subsequently allow for the conveyance of the collected water away from its collection point.

However the structural improvements within your system are not reasonably incidental to conserving or conveying water.

Expenditure that qualifies for a water facility deduction in your circumstances

As stated above an example of water facility includes tanks. You have incurred expenditure towards the acquisition and installation of a water tank to capture rain water in your production facility. However we have been unable to determine the quantum of expenditure that can be attributed to this facility from your records. Accordingly, once determined, this expenditure qualifies for an immediate deduction in the year that it was incurred.