Edited version of your written advice

Authorisation Number: 1051421265684

Date of advice: 27 August 2018

Ruling

Subject: Local government entity contribution expenditure

Question 1

Will the local government entity contribution expenditure incurred by X Pty Ltd in the course of obtaining development approvals for land to be developed and held as a long term investment be deductible in terms of section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) in the income year in which it is incurred?

Answer

No.

Question 2

Where the local government entity contribution expenditure is not deductible under section 8-1 will the expenditure be deductible in terms of Division 43 of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods:

Income year ending 30 June 2017

Income year ending 30 June 2018

Income year ending 30 June 2019

Income year ending 30 June 2020

The scheme commences on:

The scheme has commenced.

Relevant facts and circumstances

X Pty Ltd is the head company of the X Group.

The X Group has a focus on accommodation.

The X Group holds units as investments for the longer term.

This ruling relates to losses and outgoings on investments.

The X Group treats investment properties as being capital in nature.

The X Group is required by local government entities to make various types of contributions in the course of attaining development approval.

Those contributions are to be used for public amenities and services including car parks.

Several agreements with local government entities were provided.

Relevant legislative provisions

Income Tax Assessment Act 1997

subsection 8-1(1)

paragraph 8-1(2)(a)

Division 43

section 43-20

paragraph 43-20(1)(a)

section 43-70

subsection 43-70(1)

paragraph 43-70(1)(a)

subsection 43-70(2)

subsection 43-75(1)

Reasons for decision

All legislative references are to provisions of the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.

Question 1

Summary

The High Court judgement of Dixon J in Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 is considered. The three matters identified by Dixon J in determining whether expenditure is of a capital or revenue nature are examined. It is determined that the expenditure is an outgoing of capital or of a capital nature. Accordingly the expenditure is not deductible in terms of section 8-1.

Detailed reasoning

Under both the first and second limb of subsection 8-1(1), the deductibility of a loss or outgoing depends upon the nexus between the expenditure and the generation of assessable income.

X Pty Limited (the Company) is carrying on a business of developing buildings which it holds as investments for the longer term. The rent derived from these investments is assessable income of the Company.

The local government entity contribution expenditure is incurred by the Company in gaining or producing assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, it is necessary to consider whether a deduction is denied by subsection 8-1(2) because it is a loss or outgoing of capital or of a capital nature.

In Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers) the High Court considered the circumstances in which a loss or outgoing is an outgoing of capital or of a capital nature. This is pertinent for the purposes of the negative limb of subsection 8-1(2).

In Sun Newspapers Dixon J at p 359 said

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss.

The present case requires the Company to incur local government contribution expenditure in connection with the construction of each building held for investment. This can occur in the situation where a one-off once and for all payment is undertaken in order to secure the issue of a Construction Certificate by a local government entity. The Construction Certificate allows the construction of the building to take place and consequently in turn for rental income to be derived from that building. That is to say it is an outgoing made to obtain development approval or a building permit in order to commence to create the profit yielding subject or profit yielding structure of the Company.

Given the purpose for which the local government entity contribution expenditure is undertaken it is capital in nature. The Company has incurred expenditure which will allow the creation of a valuable capital asset, namely a building, being an asset of an enduring nature. The local government entity contribution expenditure is a cost of establishing or enlarging the Company’s profit yielding subject or structure. Consequently, the local government entity contribution expenditure is capital expenditure which is not deductible in terms of subsection 8-1(1) because of the operation of subsection 8-1(2).

This view about the capital nature of one-off once and for all expenditure was considered in Vallambrosa Rubber Co Ltd v Farmer (1910) 5 TC 529 where Lord Dunedin said (at p 536):

I do not say that this consideration is absolutely final or determinative; but in a rough way I think it is not a bad criterion of what is capital expenditure as against what is income expenditure to say that capital expenditure is a thing that is going to be spent once and for all, and income expenditure is a thing that is going to recur every year.'

Further, in Sun Newspapers Dixon J at p 363 said:

There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

These three matters identified by Dixon J are examined below.

First is the character of the advantage sought. In the present case the advantage sought is significant because it is an essential and fundamental element of the establishment of the setting within which the asset of the Company, the building, can be created.

The document supplied in relation to the approval granted in 2014 by a consent authority, is taken to be representative of the grant of approval of development applications generally.

That approval, which was in respect of the development application to construct a building containing apartments, was subject to many conditions. Amongst those conditions was the requirement to make a monetary contribution. This was in accordance with the X Local Government Entity Contribution Plan where such contributions were for public amenities and services.

The grant of approval stated that the monetary contribution must be paid prior to the issue of a Construction Certificate.

There may also be the requirement to make contributions of apartments to a local government entity in terms of a program for the provision of affordable housing. Clearly such apartments will not come into existence until the building is completed; however the commitment to their provision will need to be made before the Construction Certificate is issued.

Although there is the possibility that in respect of each separate project the Company may make a number of different contributions in order to secure approval of a development application and those contributions may not occur simultaneously it does not alter the capital nature of the contributions. There is a single purpose for the outgoings which renders them outgoings of capital and that is that they are made in order to obtain consent to construct the building. That consent is an advantage which confers an enduring benefit upon the Company.

Turning to a consideration of the manner in which the advantage is to be used, relied upon and enjoyed, this has been indicated above in the enduring nature of the advantage. In view of the fact that the advantage obtained from the local government entity contribution expenditure is consent to construct the building, and as a consequence that capital asset is brought into existence which gives rise to the derivation of assessable income during the life of the building, the advantage is likewise enjoyed during the life of the building.

The means to obtain the advantage has been dealt with in part above with respect to the one-off once and for all character of the local government entity contribution expenditure. Although it is recognised that in view of the forms which the local government entity contribution may be made namely cash, land owned by the Company or an apartment owned by the Company, these may not be made simultaneously. In the case of the apartment it cannot be contributed until it is brought into existence when the building is completed. This can be contrasted with cash which can be contributed immediately and land which may require a specific title to be created by way of subdivision before it can be contributed.

While there may be a number of occasions upon which different forms of local government entity contribution expenditure occur in respect of a single project such outgoings are not considered to be recurrent to the degree that they are of a revenue nature. Such outgoings remain affairs of capital or of a capital nature because of the enduring advantage obtained by their expenditure.

In all these circumstances the advantage sought by the Company in the grant of development approval and a Construction Certificate is simply permission to build the building that will become a capital asset of the Company to be used for income producing purposes. This advantage is therefore of an enduring character. Given that the advantage is sought and obtained by the making of the local government entity contribution expenditure in all its forms whether cash, land or an apartment, each outgoing of local government entity contribution expenditure is an outgoing of capital or of a capital nature.

Therefore the local government entity contribution expenditure is not deductible in terms of subsection 8-1.

Question 2

Summary

Division 43 provides an allowable deduction for certain capital expenditure on assessable income producing buildings and other capital works.

The serviced apartments, residential apartments and commercial units built by the Company and used for income producing purposes are buildings to which paragraph 43-20(1)(a) applies.

The capital expenditure incurred in the construction of those capital works comes within the meaning of construction expenditure in subsection 43-70(1).

The local government entity contribution expenditure is capital expenditure that comes within the meaning of construction expenditure and is not excluded by subsection 43-70(2).

Further, each separate building site upon which such an income producing building project is built is a “construction expenditure area” in terms of subsection 43-75(1).

Therefore a deduction for the local government entity contribution expenditure is allowable in terms of Division 43.

Detailed reasoning

Division 43 provides an allowable deduction for certain capital expenditure on assessable income producing buildings and other capital works.

The key operative provisions are contained in Subdivision 43 -A (section 43-10 to section 43-55) while Subdivision 43-B (sections 43-60 to section 43-100) contains provisions establishing the deduction base.

A deduction for capital works under Division 43 is based upon the amount of “construction expenditure”, that is, capital expenditure incurred in respect of the construction of those capital works as defined in subsection 43-70(1).

It is first necessary to determine whether the buildings owned by the Company which are used for income producing purposes come within the capital works that are subject to Division 43.

Section 43-20 distinguishes three types of capital works. Paragraph 43-20(1)(a) is relevant in this case as it applies to buildings, or an extension, alteration or improvement to a building where the capital works are in Australia and began after 21 August 1979.

The Company’s buildings that were used for income producing purposes in the income years ended 30 June 2017 and 30 June 2018 meet all of those conditions. Therefore paragraph 43-20(1)(a) applies to all those buildings. Similarly, those conditions will also be met for the buildings to be built and used for income producing purposes by the Company in the income years ending 30 June 2019 and 30 June 2020. Therefore paragraph 43-20(1)(a) will apply to those buildings also.

Having established that the income producing buildings owned by the Company are subject to Division 43 it is necessary to consider the application of Division 43 to the local government entity contribution expenditure incurred by the Company in respect of those buildings.

In answer to question 1 above it has been found that the local government entity contribution expenditure is not deductible in terms of subsection 8-1 because it is capital expenditure.

Accordingly it is necessary to consider whether that capital expenditure comes within the meaning of “construction expenditure” in subsection 43-70(1) which relevantly reads:

43-70(1) Construction expenditure is capital expenditure incurred in respect of the construction of capital works.

Subsection 43-70(2) lists expenditure which is not included in construction expenditure however the local government entity contribution expenditure is not listed in that excluding provision.

Thus the local government entity contribution expenditure is construction expenditure in terms of subsection 43-70(1).

This view is supported by Taxation Ruling TR 97/25 titled “Income tax: property development: deduction for capital expenditure on construction of income producing capital works, including buildings and structural improvements” (TR 97/25)

In TR 97/25 at paragraph 9 in respect to construction expenditure it is relevantly stated:

9. We consider that construction expenditure includes:

– preliminary expenses such as architecture fees, engineering fees, foundation excavation expenses and costs of building permits; (emphasis added)

– …

The term “building permits” is not defined in the legislation nor is a definition given in TR 97/25. Therefore it would take its ordinary meaning. It is considered that the ordinary meaning of “building permits” is interchangeable with “Construction Certificate”, “development application approval” or “planning approval” and like terms which grant permission to undertake capital works.

Therefore, in terms of TR 97/25 the local government entity contribution expenditure which is incurred by the Company is considered to be construction expenditure being a preliminary expense such as the costs of a building permit.

The definition of “construction expenditure” was also examined in ATO Interpretative Decision ATO ID 2014/37 titled “Income Tax Capital Allowances: capital works – construction expenditure – costs to build temporary roads and restoration costs” (ATO ID 2014/37) where there is a discussion of the interpretation and application of subsection 43-70(1).

The issue in ATO ID 2014/37 involved a taxpayer who derived assessable income from providing short term accommodation in cabins on land owned by the taxpayer. The taxpayer constructed new cabins on that land. Accordingly, in terms of paragraph 43-20(1)(a) the new cabins are capital works to which Division 43 applies. The taxpayer obtained a development approval (also known as a planning approval) from the local government entity for construction of the cabins. That local government entity approval imposed conditions requiring the taxpayer to construct temporary roads on public land in order to access the site during construction and to restore the area after construction of the cabins was completed. The taxpayer incurred capital expenditure in constructing the temporary roads and in restoring the public land afterwards as part of the project to construct the new cabins.

The discussion of subsection 43-70(1) in relation to this situation relevantly reads as follows:

A deduction for capital works under Division 43 is based on the amount of construction expenditure. ‘Construction expenditure’ is defined in subsection 43-70(1) as capital expenditure incurred in respect of the construction of capital works.

Subsection 43-70(1) is a broad statement of inclusion, which is then subject to the specific exclusions set out in subsection 43-70(2). The costs for building temporary roads and restoring the area afterwards are not specifically excluded in subsection 43-70(2).

Other than the specific exclusion in subsection 43-70(2), the phrase ‘in respect of’ in subsection 43-70(1) is another factor to take into account when determining if an amount qualifies as construction expenditure. The breadth of the words ‘in respect of’ indicates some connection or relation between the expenditure and the construction of the capital works. It is not only expenditure in constructing the new cabins, but also expenditure incurred ‘in respect of’ the construction of the new cabins that will qualify for a deduction under Division 43.

The Joint Explanatory Memorandum to the Income Tax Assessment Bill 1996 and Taxation Ruling TR 97/25 provide examples of construction expenditure that support this reading of subsection 43-70(1). For instance, preliminary expenses such as architects’ fees, engineering fees and the cost of foundation excavation expenses are considered to be causally connected with, and therefore ‘in respect of’, the construction of the capital works.

In the present case, the building of temporary roads and restoring the area afterwards are necessary conditions attached to the development approval. These enforceable requirements are set by council and must be completed as part of the taxpayer’s cabin building project, thus are considered to be costs that flowed as a direct consequence of constructing the new cabins. There is a sufficient connection between the expenditure and the construction of the cabins.

Accordingly, the capital expenditure is considered to be in respect of the construction of cabins, and is construction expenditure as defined in subsection 43-70(1).

Note: Notwithstanding that the works on building temporary roads are on public land adjoining the taxpayer’s land, the works are regarded as construction expenditure attributable to a ‘construction expenditure area’ in respect of that taxpayer under Division 43. Thus, any deductions that are allowable to the taxpayer will arise upon the completion of the construction of the cabins and apply for any income year during which the taxpayer uses the area for the purpose of producing assessable income.

It has been determined above that the buildings that the Company builds for the purpose of deriving assessable rental income are capital works in terms of paragraph 43-20(1)(a).

The reasoning in ATO ID 2014/37 is applied to the local government entity contribution expenditure. That expenditure is an enforceable requirement set by the local government entity and must be met by the Company as part of a project to build an income producing building. The local government entity contribution expenditure which was incurred as a direct consequence of the project of constructing the serviced apartments, residential apartments or commercial units is capital expenditure that is causally connected with and therefore in respect of the construction of the capital works.

Thus the local government entity contribution expenditure is construction expenditure in terms of subsection 43-70(1) which is in respect of the construction of those capital works.

Further, each separate building site upon which such an income producing building project is built is a “construction expenditure area” in terms of subsection 43-75(1). The local government entity contribution expenditure as a component of the construction expenditure is likewise causally connected with and therefore in respect of the capital works on the construction expenditure area.

Therefore a deduction for the local government entity contribution expenditure is allowable in terms of Division 43.