Edited version of private advice

Authorisation Number: 1051524585798

Date of advice: 30 May 2019

Ruling

Subject: Capital works - qualifying expenditure - structural improvements

Question

Will expenditure incurred by the Company on labour costs paid to its regular subcontractors to perform work on the construction of a mezzanine at the Company's factory, constitute a deduction for capital works in accordance with Division 43 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following period:

Year ended 30 June 20XY

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Company leases a commercial factory and is constructing a mezzanine which will be treated as capital works.

The Company operates a commercial plastering and carpentry fitout business, and engages subcontractors most of whom are deemed employees for WorkCover and superannuation purposes, to carry out works on commercial jobs.

These subcontractors work for The Company full time on other commercial jobs, but spend some of their time constructing the mezzanine in the factory. The director of the business, also spends time constructing the mezzanine in the factory.

No subcontractors will be hired specifically to work on the mezzanine.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 43

Income Tax Assessment Act 1997 Section 43-2

Income Tax Assessment Act 1997 Subdivision 43-A

Income Tax Assessment Act 1997 Subsection 43-10(1)

Income Tax Assessment Act 1997 Subsection 43-10(2)

Income Tax Assessment Act 1997 Section 43-15

Income Tax Assessment Act 1997 Section 43-20

Income Tax Assessment Act 1997 Section 43-30

Income Tax Assessment Act 1997 Section 43-70

Income Tax Assessment Act 1997 Subsection 43-70(1)

Income Tax Assessment Act 1997 Subsection 43-70(2)

Income Tax Assessment Act 1997 Section 43-75

Income Tax Assessment Act 1997 Section 43-85

Income Tax Assessment Act 1997 Subdivision 43-C

Income Tax Assessment Act 1997 Section 43-110

Income Tax Assessment Act 1997 Subsection 43-120(1)

Income Tax Assessment Act 1997 Section 43-140

Reasons for decision

·         All further legislative references are to the ITAA 1997, unless otherwise stated.

Division 43

Division 43 contains the rules for working out the deduction for certain capital expenditure on assessable income producing buildings and other capital works.

Section 43-2 contains a diagram which provides a visual representation of the workings of Division 43. Importantly, the two main categories are;

1. The capital works; and
2. The amounts of capital expenditure relating to those works.

The capital works

Subsection 43-10(1) explains that a capital works deduction may be available to a taxpayer in any income year.

For a capital works deduction to be available in respect of an amount of capital works expenditure, subsection 43-10(2) requires that:

(a)  the capital works have a " construction expenditure area " (section 43-75); and

(b)  there is a " pool of construction expenditure " (section 43-85 ) for that area; and

(c)  the taxpayer uses the taxpayer's capital works area (Subdivision 43-C) in a way set out in Table 43-140 (for the purpose of producing assessable income).

As per Note 1 to subsection 43-10(2), the deduction is limited to capital works to which this Division applies (see section 43-20).

As per Note 2 to section 43-10(2), the definition of your area ensures that only owners and certain lessees of capital works, and certain holders of quasi-ownership rights over land on which capital works are constructed, can deduct an amount under this Division.

Section 43-20 describes the types of capital works to which Division 43 applies. These are broadly categorised under three headings in the section as follows:

·         buildings;

·         structural improvements; and

·         environment protection earthworks.

The deduction amount depends on when the construction started and how the capital works are used (section 43-15). No amount can be claimed before the completion of construction of the capital works (section 43-30).

Section 43-110 explains that a capital works deduction under Division 43 is only available the taxpayer is the owner, quasi-owner or lessee of capital works.

A lessee can claim a deduction, under subsection 43-120(1), in respect of an area leased.

To claim a deduction, the lessee must have:

·         incurred the construction expenditure or been an assignee of the lessee who incurred the expenditure

·         continuously leased the capital works area itself, or lease the area that has been so held by previous lessees or assignees since the completion of construction, and

·         used the area to produce assessable income.

The amounts of capital expenditure relating to those works

Subsection 43-70(1) widely defines construction expenditure as capital expenditure incurred in respect of the construction of capital works (section 43-20).

Construction expenditure is determined on the basis of the actual cost incurred in relation to the construction of a building, structural improvement, extension, etc. Such construction costs include:

·         architect's fees

·         engineering fees

·         surveying fees

·         costs associated with obtaining the necessary building approvals

·         costs necessary to comply with building approvals, such as the cost of building a temporary road on public land and restoring the area afterwards

·         foundation excavations, and

·         the cost of structural features that are an integral part of the income-producing buildings or income-producing structural improvements, such as atriums and lift wells.

However, subsection 43-70(1) is limited by subsection 43-70(2) which lists exclusions from the definition of construction expenditure.

Construction expenditure specifically excludes expenditure on:

·         acquiring land, demolishing existing structures or on landscaping; or

·         clearing, levelling, filling, draining or otherwise preparing the construction site prior to carrying out excavation work.

Expenditure excluded from being counted as construction expenditure can broadly be divided into the following three categories:

1. expenditure for which a deduction is elsewhere available under either ITAA 1997 or ITAA 1936
2. expenditure which forms part of the cost base, indexed cost base or reduced cost base of an asset for capital gains tax purposes, and
3. expenditure which falls into neither of the above two categories, ie expenditure which is not relevant for tax purposes.

Subsection 43-70(2) effectively ensures that if capital expenditure on property is deductible under provisions other than Division 43, then, by excluding those types of capital expenditure from construction expenditure, a capital works deduction cannot be available under Division 43.

Labour costs

In order to determine whether labour costs paid to regular subcontractors qualifies as capital works deductions, it is necessary to consider whether the labour costs of regular subcontractors constitutes capital expenditure in terms of sub-section 43-70(1), or whether the expenditure should be deductible under section 8-1.

ATO Interpretative Decision ATO ID 2011/42 Income Tax: Deductibility of salary or wages to the extent that employees are engaged in the self-construction of depreciating assets (ATO ID 2011/42) provides some guidance.

Briefly ATO ID 2011/42 considered that expenditure on salary and wages was not an allowable deduction under 8-1 to the extent that the relevant employees performed work on projects to construct and upgrade depreciating assets of the taxpayer, and was a loss or outgoing of capital or of a capital nature.

The taxpayer engaged external contractors to work on construction projects, and approximately 60% of the work on the construction projects was undertaken by the taxpayer's internal employees. For accounting purposes, the Taxpayer capitalised relevant contract payments and the amounts of salary and wages that related to the amount of time spent by employees working on construction projects to determine the cost of its self-constructed depreciating assets.

As the expenditure was incurred in relation to salary or wages paid to employees engaged wholly in affairs of capital, it was properly characterised as capital in nature.

In the present case the construction of the mezzanine undertaken by Proline as lessee qualifies as capital works and therefore a deduction is allowed under Division 43 for the construction expenditure, provided the conditions in section 43-10 are satisfied.

Construction expenditure, as defined in subsection 43-70(1), will be incurred by Proline in constructing the mezzanine.

Construction expenditure includes the labour costs paid to subcontractors for the time spent working on the construction of the mezzanine.

Taxation Ruling 97/25

Taxation Ruling TR 97/25 Income tax: property development: deduction for capital expenditure on construction of income producing capital works, including buildings and structural improvements (TR 97/25) is also of assistance. It addresses a number of matters that are relevant in determining entitlement to, and the amount of, a deduction under Division 43 in respect of expenditure on the construction of assessable income producing buildings and other capital works.

Paragraph 10 of TR 97/25 provides that in relation to an owner/builder entitled to a deduction under Division 43, the value of the owner/builder's contributions to the works (such as labour and expertise) and any notional profit element do not form part of construction expenditure.

Paragraph 20 of TR 97/25 further provides that in the case of capital works constructed by an owner/builder for retention as an income producing asset, the deduction is calculated with regard to capital expenditure actually incurred in respect of the construction of capital works. The value of the owner's contributions (such as labour and expertise and any notional profit element) do not form part of construction expenditure.

As previously explained 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.

Paragraphs 10 and 20 of TR 97/25 specifically provide that the cost of labour and expertise of an owner builder do not form part of construction expenditure.

In the present case, the director is considered to be an owner builder. An owner/builder includes someone who personally constructs and can therefore not include any amount for his or her own time or any amount in respect of profit (because the owner has not attributed his time in the cost of construction). Rather, the direct labour costs of the subcontractors on the construction of the mezzanine constitute construction expenditure, so that paragraphs 10 and 20 of TR 97/25 have no application.

Conclusion

The labour costs of the subcontractors engaged in the construction of the mezzanine will qualify as construction expenditure for the purpose of subsection 43-70(1), and will therefore constitute capital works deductions in accordance with Division 43.