ATO ID 2004/861: Capital works: balancing deduction - partly deductible capital works - insurance received - reasonable apportionment of insurance proceeds
Date of decision: 17 September 2004
Year of income: Year ended 30 June 2003
Business line: Public Groups and International

Issue
If capital works are destroyed and Division 43 of the Income Tax Assessment Act 1997 (ITAA 1997) had applied to only part of the capital works, in working out the deduction allowable under section 43-40 and set out in section 43-260, is it reasonable to apportion the insurance proceeds receivable by the taxpayer by taking into account the relative replacement costs of the deductible and non-deductible capital works?

Decision
Yes. A reasonable approach is an apportionment of the insurance proceeds based on the relative replacement costs of the capital works to which Division 43 of the ITAA 1997 does apply, and those to which the Division does not apply.

Facts
The taxpayer purchased a residential rental property and carried out extensive renovations to the house. The house and the renovations were capital works under Division 43 of the ITAA 1997. Because of its construction date, the original building was not a capital work to which Division 43 of the ITAA 1997 applied. However, the taxpayer's improvements were carried out at a later time such that the resultant improvements were deductible capital works. The house (including the renovations) was completely destroyed by fire and a balancing deduction was allowable under section 43-40 of the ITAA 1997 in respect of the renovations. The taxpayer expected to receive a lump sum insurance payout in respect of the building, including the renovations. The insurance policy had been entered into on a replacements basis.

Reasons for decision
Summary: Section 43-40 of the ITAA 1997 allows a taxpayer to deduct an amount for the destruction of capital works (called a balancing deduction) if all or part of their capital works are destroyed in an income year and they meet certain requirements for the deduction. On the facts of this case, the amount of the balancing deduction the taxpayer can deduct under section 43-40 of the ITAA 1997 is equal to the undeducted construction expenditure at the date of the destruction of the capital works, less the amounts the taxpayer has received or has a right to receive for the destruction of the capital works. If an amount is received or receivable by a taxpayer in respect of the destruction of both: the taxpayer must make a reasonable apportionment of the amount (section 43-260 of the ITAA 1997). What is reasonable will often depend on the particular circumstances. As stated by Windeyer J in Giris Pty Ltd v. Federal Commissioner of Taxation (1969) 119 CLR 365; 69 ATC 4015; (1969) 1 ATR 3, there are no absolute, precise or objectively determinable tests of what is reasonable or unreasonable. Court decisions illustrate that reasonableness should be viewed objectively. The test looks at whether the actions of the person would be the same as the actions of a reasonable person in the same set of circumstances. It is reasonable, in this context, to apportion the insurance proceeds based on the relative costs of replacing the deductible and non-deductible capital works. This means that the proportion of the insurance proceeds that is used in calculating the balancing deduction is the proportion of the total cost of replacing the destroyed building (as it existed at the time of destruction) which relates to replacing the renovations. As required by subsection 262A(1D) of the Income Tax Assessment Act 1936, the taxpayer may need to show at a later time how the apportionment was worked out.

Legislative references: Income Tax Assessment Act 1997 Division 43 section 43-40 section 43-260
Case references: Giris Pty Ltd v. Federal Commissioner of Taxation (1969) 119 CLR 365 69 ATC 4015 (1969) 1 ATR 3
Related ATO interpretative decisions: ATO ID 2004/860 | ATO ID 2004/862
Subject references: Construction expenditure area Pool of construction expenditure Insurance