Edited version of private advice

Authorisation Number: 1052010310982

Date of advice: 22 July 2022

Ruling

Subject: Division 40 capital allowances - composite assets

Question 1

Do various components of the relevant assets owned and installed by Entity X, together constitute a single composite item that is itself a depreciating asset for the purposes of subsection 40-30(4) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Is Entity X's expenditure to install the relevant assets included in the first element of cost amount for that depreciating asset under section 40-180 of the ITAA 1997?

Answer

Yes.

Question 3

Is Entity X's expenditure to install the relevant assets included in the second element of cost amount for that depreciating asset under section 40-190 of the ITAA 1997?

Answer

No.

Question 4

If Entity X's expenditure to install the relevant assets are not included in the first or second element of cost amount for that depreciating asset under section 40-180 or 40-190 of the ITAA 1997, will these costs be deductible under section 40-880 of the ITAA 1997?

Answer

Not applicable.

Question 5

Is Entity X's restoration expenditure for the damage associated with the installation of the relevant assets deductible under section 8-1 of the ITAA 1997?

Answer

No.

Question 6

If the answer to Question 5 is 'No', is Entity X's restoration expenditure for the damage associated with the installation of the relevant assets deductible under section 40-880 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods

00 Month 20XX to 00 Month 20XX

00 Month 20XX to 00 Month 20XX

The scheme commences on

00 Month 20XX

Relevant facts and circumstances

Entity X carries on a business as a service provider. Entity X owns and installs the relevant assets to provide relevant services to its customers.

Each of the relevant assets consist of various components.

Each of the relevant assets are not able to perform the function required until all components are connected and installed. Once installed, all the components of each asset contribute to the function of the asset as a whole.

There is a high degree of physical integration between various components of the relevant asset. The high level of physical integration means that, whilst possible to remove the relevant asset, it would require considerable work to detach the various components of the relevant asset.

Costs associated with the installation of the relevant assets

Entity X incurred the following costs associated with the installation of the relevant assets:

1. Installation costs
2. Damage restoration costs.

Installation costs

Entity X incurs certain costs in order to install the relevant assets.

Damage restoration costs

After installation of the relevant assets, Entity X is required to restore the damage associated with the installation to its original condition.

Entity X does not own, hold or use the property where the damage occurred or generate its assessable income from the property for which it incurs the damage restoration costs.

Entity X's damage restoration expenditure is incidental to the installation of its relevant assets.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Subdivision 40-A

Income Tax Assessment Act 1997 section 40-15

Income Tax Assessment Act 1997 Subdivision 40-B

Income Tax Assessment Act 1997 section 40-25

Income Tax Assessment Act 1997 section 40-30

Income Tax Assessment Act 1997 subsection 40-30(4)

Income Tax Assessment Act 1997 subsection 40-45(2)

Income Tax Assessment Act 1997 section 40-60

Income Tax Assessment Act 1997 Subdivision 40-C

Income Tax Assessment Act 1997 section 40-180

Income Tax Assessment Act 1997 section 40-190

Income Tax Assessment Act 1997 Subdivision 40-I

Income Tax Assessment Act 1997 section 40-880

Income Tax Assessment Act 1997 Division 43

Income Tax Assessment Act 1997 section 43-20

Reasons for decision

Question 1

Summary

The various components of the relevant asset owned and installed by Entity X together constitute a single composite item that is itself a depreciating asset for the purposes of subsection 40-30(4) of the Income Tax Assessment Act 1997 (ITAA 1997).

Detailed reasoning

Subdivision 40-B of the ITAA 1997 provides the core provisions and explains the rules that apply to most depreciating assets. It provides an explanation of what constitutes a depreciating asset, when amounts can commence being deducted and how those amounts are calculated.

Depreciating assets

A 'depreciating asset' is broadly defined in subsection 40-30(1) of the ITAA 1997 as an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used.

Composite items

Subsection 40-30(4) of the ITAA 1997 provides that whether a particular composite item is itself a depreciating asset or whether its components are separate depreciating assets is a question of fact and degree which can only be determined in the light of all the circumstances of the particular case.

The purpose of subsection 40-30(4) of the ITAA 1997 is to require the consideration, in an objective way, of a composite item as to whether the composite item or its separate components are or are not depreciating assets for the purposes of Division 40 of the ITAA 1997.

The Commissioner's draft view on determining whether a composite item is itself a depreciating asset or whether its components are separate depreciating assets is set out in Draft Taxation Ruling TR 2017/D1 Income tax: composite items and identifying the depreciating asset for the purposes of working out capital allowances (TR 2017/D1).

Paragraph 4 of TR 2017/D1 describes composite items and states that a 'composite item' is an item that is made up of a number of components that are capable of separate existence.

The guiding principles found in TR 2017/D1 provide that for a component (or more than one component) of a composite item to be considered to be a depreciating asset, it is necessary that the component (or components) is capable of being separately identified or recognised as having commercial and economic value.

Paragraph 6 of TR 2017/D1 states that 'purpose or function' is generally a useful guide to the identification of an item. The main principles that are taken into account in determining whether a composite item is a single depreciating asset, or more than one depreciating asset, are:

(a)  'Identification': the depreciating asset will tend to be the item that performs a separate identifiable function, having regard to the purpose or function it serves in its business context.

(b)  'Use': a depreciating asset will tend to be an item that perform a discrete function. However, the item need not be self-contained or able to be used on a stand-alone basis.

(c)   'Degree of integration': the depreciating asset will tend to be the composite item where there is a high degree of physical integration of the components.

(d)  'Effect of attachment': the item, when attached to another asset having its own independent function, varies the performance of that asset.

(e)  'System': a depreciating asset will tend to be the multiple components that are purchased as a system to function together as a whole and which are necessarily connected in their operation.

Purpose or function

The purpose and function of Entity X's assets is to provide relevant services to its customers.

The relevant assets owned by Entity X comprise a number of components.

Whilst each of these components has its function or purpose at an individual item level, the relevant function in the context of Entity X's business being conducted is to provide relevant services to its customers.

The function of the relevant assets can be operated as a whole by combining these components in an interdependent way as per the guiding principles provided in paragraph 6 of TR 2017/D1.

This circumstance supports the conclusion that the various components of the relevant assets owned and installed by Entity X together constitute a composite item.

On this basis, it is considered that the relevant assets, rather than each of its components, is a composite item and the depreciating asset in these circumstances.

Question 2

Summary

The costs of installing Entity X's relevant asset are included in the first element under section 40-180 of the ITAA 1997

Detailed reasoning

The cost of a depreciating asset is a component in working out the amount you can deduct for its decline in value under Division 40 of the ITAA 1997. The cost of a depreciating asset you hold consists of two elements, the first and second element of cost, and is worked out under Subdivision 40-C of the ITAA 1997 (section 40-175 of the ITAA 1997).

The first element of cost is worked out at the time the holder begins to hold the asset. Generally, the first element of cost is the amount paid, or taken to have been paid, to hold the asset (sections 40-180 and 40-185 of the ITAA 1997).

Section 40-180 of the ITAA 1997 provides the provisions for the first element of cost and states:

(1)  The first element is worked out as at the time when you began to hold the depreciating asset...It is:

(a)  If an item in that table applies - the amount specified in that item; or

(b)  Otherwise - the amount you are taken to have paid to hold the asset under section 40-185.

(2)  If more than one item in this table covers the asset, apply the last item that covers it.

(3)  The first element of cost includes an amount you paid or are taken to have paid in relation to starting to hold the depreciating asset if that amount is directly connected with holding the asset.

(4)  The first element of cost of a depreciating asset does not include an amount that forms part of the second element of cost of another depreciating asset.

Section 40-185 of the ITAA 1997 is titled 'Amount you are taken to have paid to hold a depreciating asset or to receive a benefit' and provides:

(1) This Division applies to you as if you had paid, to hold a depreciating asset or for an economic benefit for such an asset, the greater of these amounts:

(a) the sum of the amount that would have been included in your assessable income because you started to hold the asset or received the benefit, or because you gave something to start holding the asset or receive the benefit, if you ignored the value of anything you gave that reduced the amount actually included: or

(b) the sum of the applicable amount set out in this table in relation to holding the asset or receiving the benefit.

(2)  In applying the table in subsection (1) to a liability of yours to pay an amount or provide a non-cash benefit, don't count any part of the liability you have already satisfied.

The table included in subsection 40-185(1) of the ITAA 1997 provides:

Subsection 40-180(3) of the ITAA 1997 states that the first element of cost includes an amount the holder is taken to have paid in relation to starting to hold the depreciating asset if that amount is directly connected with holding the asset.

The table in section 40-40 of the ITAA 1997 identifies who will be taken to 'hold' a depreciating asset. Generally, a holder of a depreciating asset is its economic owner. In most cases, the economic owner of a depreciating asset will be its legal owner (item 10 of the table in section 40-40 of the 1997). In the present case, Entity X owns and installs its relevant assets. Therefore, Entity X is the holder under item 10 of the table in section 40-40 of the ITAA 1997.

As established above, Entity X starts to hold the relevant depreciating assets once they are installed and ready for use to provide relevant services to its customers. The cost of installation is incurred by Entity X before Entity X becomes the holder of the relevant assets. Therefore, there is a clear and direct connection between the cost of installation of the assets and starting to hold that assets. Entity X's relevant assets are not previously used or installed ready for use by Entity X or by any other entity for any purpose.

Accordingly, the cost incurred by Entity X to install its relevant assets is included in the first element of the cost of the depreciating assets pursuant to subsection 40-180(3) of the ITAA 1997.

Question 3

Summary

The costs of installing Entity X's relevant assets are included in the first element of the cost of the depreciating assets under section 40-180 of the ITAA 1997. As such Entity X's expenditure to install its relevant assets is not included in the second element of cost amount for the depreciating assets under section 40-190 of the ITAA 1997.

Detailed reasoning

As detailed in Question 2 above, Subdivision 40-C of the ITAA 1997 explains that there are two elements of the cost of a depreciating asset.

The second element of cost is the amount that is taken to have been paid to bring an asset to its present condition and location from time to time and includes the cost of modifications, alterations or improvements made to the asset during the relevant income year as well as costs such as transporting the asset to its current location.

Section 40-190 of the ITAA 1997 is the operating provision for the second element of cost and states:

(1) The second element is worked out after you start to hold the depreciating asset.

(2) The second element is:

(a)  the amount you are taken to have paid under section 40-185 for each economic benefit that has contributed to bringing the asset to its present condition and location from time to time since you started to hold the asset; and

(b)  expenditure you incur that is reasonably attributable to the *balancing adjustment event occurring for the asset.

The second element of cost is worked out after the holder has begun to hold the asset and includes the amount the holder is taken to have paid for economic benefits that have contributed to bringing the asset to its present condition and location (section 40-190 of the ITAA 1997).

For completeness, the installation cost was incurred by Entity X before and not after Entity X started to hold the depreciating assets. Therefore, the installation cost does not form part of the second element of the depreciating assets under subsection 40-190(2) of the ITAA 1997.

Question 4

Reasoning

Section 40-880 of the ITAA 1997 is a provision of last resort. In other words, section 40-880 only applies to expenditure if no other provision allows or denies a deduction or otherwise takes the expenditure into account.

Entity X's installation costs are included in the first element of cost amount for the depreciating assets under section 40-180 of the ITAA 1997. Accordingly, these costs will not be deductible under section 40-880 of the ITAA 1997.

Question 5

Summary

Entity X is not entitled to claim the restoration costs for the damage on the relevant property under section 8-1 of the ITAA 1997 as the costs are capital in nature.

Detailed reasoning

Relevant connection between the outgoing and the business

A deduction is allowed under section 8-1 of the ITAA 1997 for losses or outgoings to the extent that the loss or outgoing is incurred in gaining or producing assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

Subsections 8-1(1) and (2) of the ITAA 1997 provide:

(1) You can deduct from your assessable income any loss or outgoing to the extent that:

(a)  it is incurred in gaining or producing your assessable income; or

(b)  it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

(2)  However, you cannot deduct a loss or outgoing under this section to the extent that:

(a)  it is a loss or outgoing of capital, or of a capital nature; or

(b)  it is a loss or outgoing of a private or domestic nature; or

(c)   it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or

(d)  a provision of this Act prevents you from deducting it.

As Entity X is carrying on the business of a service provider, the cost incurred by Entity X in restoring the damage to the relevant property as part of the installation of its assets will be expenditure incurred in carrying on a business for the purpose of gaining or producing assessable income.

The only relevant question then in determining whether a deduction is allowed under section 8-1 of the ITAA 1997 is whether the restoration cost incurred by Entity X is capital in nature.

Outgoing must not be capital or of a capital nature

Even where an outgoing satisfies the requirements of subsection 8-1(1) of the ITAA 1997, it will not be deductible under section 8-1 if capital or of a capital nature.

The decision of the High Court in Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 61 CLR 337 (1938) 5 ATD 23; (1938) 1 AITR 403 (Sun Newspapers Case) is the leading authority on the distinction between revenue and capital expenditure. The general rule is found in the frequently quoted statement of Dixon J where he 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... As general conceptions it may not be difficult to distinguish between the profit yielding subject and the process of operating it. In the same way expenditure and outlay upon establishing, replacing and enlarging the profit-yielding subject may in a general way appear to be of a nature entirely different from the continual flow of working expenses which are or ought to be supplied continually out of the returns or revenue.[1]

In the Sun Newspapers Case, Dixon J stated that there are three matters to be considered when deciding whether expenditure incurred is revenue or capital in nature.[2] These are:

(a)  the character of the advantage sought by the outgoing,

(b)  the manner in which the advantage is to be used, relied upon or enjoyed by the taxpayer, and

(c)   the means adopted to obtain the advantage, such as recurring payments.

ATO Interpretative Decision ATO ID 2005/77 states that:

[t]he character of the advantage sought provides important direction. It provides the best guidance as to the nature of the expenditure because it says the most about the essential character of the expenditure itself.

The decision of the High Court in G P International Pipecoaters Pty Ltd v. Commissioner of Taxation (1990) 170 CLR 124 at 137; (1990) 90 ATC 4413 at 4419; (1990) 21 ATR 1 at 7 emphasised this, stating:

The character of expenditure is ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure, for the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid: Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 61 C.L.R 337, at p.363....

In relation to the character of the advantage sought by the expenditure it is necessary to examine whether the expenditure secures an enduring benefit for the business.

As noted above, when the matters stated by Dixon J in the Sun Newspapers Case are considered, the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid. The nature or character of the expenditure will therefore follow the advantage that is sought to be gained by incurring the expenditure. If the advantage to be gained is of a capital nature, then the expenditure incurred in gaining the advantage will also be of a capital nature.

It is appropriate for the nature of the expenditure incurred by Entity X on the restoration of damage on the relevant property to be characterised by reference to the advantage that is sought to be gained by incurring the expenditure.

In this case, the expenditure incurred by Entity X on the restoration is part of achieving the installation of Entity X's assets. This installation of the relevant assets secures Entity X's ability to generate income from providing services to its customers. Entity X incurs expenditure to undertake this installation, which includes restoring the damage after the relevant assets are installed.

The advantage that is sought to be gained by incurring of the expenditure, which includes the cost of restoring the damaged property during installation, is Entity X's ability to provide services to its customers. This is a resource that Entity X can create a customer base and expand the size of that customer base, thereby resulting in an enlargement of the profit yielding structure of its business. Entity X's expenditure to restore the damaged property is a one-off expense related to the installation of its relevant assets.

It is considered that the expenditure is characterised as part of the establishing and enlarging the profit-yielding structure of Entity X's business rather than being a working expense. As pointed out in the Sun Newspapers Case, expenditure incurred by a business that establishes or enlarges the profit yielding structure of the business, rather than being a working or operating expense, is considered to be capital in nature.[3]

Further, it is considered that the expenditure incurred by Entity X on the damage restoration which supports Entity X's relevant assets will secure an enduring benefit for Entity X's business. The enduring benefit obtained from installing the relevant assets is the ability to provide ongoing access to a service capability which is a resource that Entity X can generate income from by establishing and expanding its customer base. This is an advantage for the enduring benefit of trade which continues to exist notwithstanding that Entity X does not own the property that is required to be restored after the installation of its assets.

The advantage for which the expenditure on the damage restoration as part of installation of its assets was paid is of a permanent and enduring character and an indispensable part of the profit-yielding structure of Entity X. Restoring the damage after the one-off installation of its assets is not considered to be a working or operating expense Entity X incurred in order to provide services to its customers.

This approach was confirmed by Latham CJ in the Sun Newspapers Case where he said:

It is true that the payments did not result in obtaining a new capital asset of a material nature, but they did obtain a very real benefit or advantage for the companies, namely, the exclusion of what might have been serious competition. When the words "permanent" or "enduring" are used in this connection it is not meant that the advantage which will be obtained will last forever. The distinction which is drawn is that between more or less recurrent expenses involved in running a business and an expenditure for the benefit of the business as a whole.[4]

For these reasons, the expenditure incurred by Entity X on the restoration of the damaged property will be capital in nature. Accordingly, Entity X will not be entitled to a deduction under section 8-1 of the ITAA 1997 for expenditure incurred by Entity X on the damage restoration as part of the installation of Entity X's assets.

Question 6

Summary

The restoration costs on the damaged property are deductible as capital business expenditure under section 40-880 ITAA 1997.

Detailed reasoning

Division 40 relates to expenses for capital allowances. The restoration costs are incurred by Entity X to restore the relevant property which are damaged during the installation of Entity X's assets. The relevant property is not owned by Entity X or used by Entity X to produce assessable income. Accordingly, the restoration costs are not related to repairing the depreciating asset held by Entity X.

Subsection 40-880(1) of the ITAA 1997 provides that the object of the section is to make certain business capital expenditure deductible over 5 years if:

(a)  the expenditure is not otherwise taken into account,

(b)  a deduction is not denied by some other provision, and

(c)   the business is, was or is proposed to be carried on for a taxable purpose.

The Commissioner's view on the operation and scope of section 40-880 of the ITAA 1997 is set out in Taxation Ruling TR 2011/6 Income tax: business related capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues (TR 2011/6).

Paragraph 10 of TR 2011/6 states that the following key concepts apply in relation to the current section 40-880:

• It is a provision of last resort. In other words, section 40-880 only applies to expenditure if no other provision allows or denies a deduction or otherwise takes the expenditure into account.
• The expenditure must be capital expenditure which is business related. This excludes revenue expenditure and non-business expenditure such as expenditure relating to occupation as an employee or to passive investment.
• The expenditure must be incurred on or after 1 July 2005.
• If the expenditure relates to an existing business then the entity that incurs the expenditure is only entitled to a deduction if they are carrying on that business.
• The business in relation to which the taxpayer incurs the expenditure is not limited to the taxpayer's existing business. The expenditure may relate to a former or proposed business, or to the liquidation, deregistration or winding up of a company, partnership or trust that carried on a business and of which the taxpayer was a member, a partner or a beneficiary.
• The expenditure which the taxpayer incurs must relate to a business to the extent to which that business is carried on for a 'taxable purpose'.
• The eligibility for a deduction is determined, once and for all, as at the time the expenditure is incurred. There is no need to test in subsequent years whether that expenditure is eligible.
• The expenditure is allowed as a straight-line write-off over five years and the expenditure is not apportioned if it is incurred part way through the year.
• A deduction of more than one fifth of the expenditure cannot be claimed in any particular income year.
• Only the entity that incurs the expenditure qualifies for the deduction.
• Once eligibility is established a number of limitations and exceptions may apply to limit the amount deductible or to deny a deduction.

The expenditure must be incurred and must be business related capital expenditure

The term 'incurred' and the expression 'capital expenditure' are not defined terms. The principles established by case law regarding the meaning of the word 'incurred' in section 8-1 also apply to section 40-880. Whether expenditure is capital in nature is determined on the facts of each particular case having regard to the principles established by case law.

The relevant business

Entitlement for a deduction under subsection 40-880(2)

Subsection 40-880(2) requires identification of the business in relation to which the relevant capital expenditure was incurred. The nature and scope of a business for the purposes of the section is a question of fact in each case.

The reference in paragraph 40-880(2)(a) to 'your business' is a refence to the taxpayer's overall business.

Subject to the specified limitations and exceptions, paragraphs 40-880(2)(a) to (c) allow a taxpayer to deduct capital expenditure they incur if it is 'in relation to' a business (either the former, current or proposed business).

For capital expenditure to be 'in relation to' a business, there must be a sufficient and relevant connection between the expenditure and the business.

Entity X incurs the cost to restore the existing property which are damaged by Entity X during the installation of its assets. Entity X is required to repair the damaged property to their original conditions after the installation.

Therefore, the restoration costs are business related capital expenditure directly incurred by

Entity X in relation to its business as a service provider.

Accordingly, Entity X satisfies the requirements under paragraph 40-880(2)(a).

Taxable purpose

Limitation under subsections 40-880(3) and 40-880(4)

Subsections 40-880(3) and (4) both contain a 'taxable purpose test' which applies to the expenditure identified in subsection 40-880(2) by reference to the extent to which it relates to carrying on the business for a taxable purpose. The taxable purpose of the business is tested as at the time the expenditure is incurred.

Entity X carries on a business as a service provider to derive its assessable income. Entity X incurs the restoration costs associated with the installation of its assets in order to provide services to its customers from which assessable income is derived.

As the expenditure is necessarily incurred by Entity X in carrying on its business wholly for a taxable purpose pursuant to subsection 40-880(3), the expenditure is fully deductible in accordance with subsection 40-880(2).

Further restrictions

Exceptions under subsection 40-880(5)

(a)  it forms part of the cost of a depreciating asset that you hold, used to hold or will hold; or

(b)  you can deduct an amount for it under a provision of this Act other than this section; or

(c)   it forms part of the cost of land; or

(d)  it is in relation to a lease or other legal or equitable right;

(e)  it would, apart from this section, be taken into account in working out:

(i)    a profit that is included in your assessable income (for example, under section 6-5 or 15-15 ); or

(ii)   a loss that you can deduct (for example, under section 8-1 or 25-40 ); or

(f)    it could, apart from this section, be taken into account in working out the amount of a capital gain or capital loss from a CGT event;

(g)  a provision of this Act other than this section would expressly make the expenditure non-deductible if it were not of a capital nature;

(h)  a provision of this Act other than this section expressly prevents the expenditure being taken into account as described in paragraphs (a) to (f) for a reason other than the expenditure being of a capital nature;

(i)    it is expenditure of a private or domestic nature;

(j)    it is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income.

None of the above exceptions apply to Entity X's circumstances as the restoration costs of the damage on the relevant property are associated with the installation of its assets in order to provide services to its customers from which assessable income is derived.

Based on the circumstances of Entity X, it is reasonably to conclude that the restoration costs are deductible over a period of 5 income years starting in the year they are incurred by Entity X pursuant to subsection 40-880(2).

[1] (1938) 61 CLR 337 at 359 - 360.

[2] (1938) 61 CLR 337 at 363.

[3] See also, paragraph 32(a) of Taxation Ruling TR 97/23 Income tax: deductions for repairs.

[4] (1938) 61 CLR 337 at 355.