ATO ID 2011/42: Deductibility of salary or wages to the extent that employees are engaged in the self-construction of depreciating assets
Date of decision: 12 May 2011
Year of income: Year ended 30 June 2011
Business line: Private Groups and High Wealth Individuals

Issue
Is expenditure incurred by a taxpayer on salary or wages an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), to the extent that the relevant employees perform work on projects to construct and upgrade depreciating assets of the taxpayer?

Decision
No. Expenditure incurred by a taxpayer on salary or wages is not an allowable deduction under section 8-1 of the ITAA 1997, to the extent that the relevant employees perform work on projects to construct and upgrade depreciating assets of the taxpayer as it is capital or capital in nature.

Facts
The taxpayer is a public utility that owns and operates a large distribution network. The taxpayer employs a large workforce split into business units. A key responsibility of two of its business units (comprising approximately 80% of the taxpayer's total employees) involves the design, planning and co-ordination and on-site construction work of projects to expand and upgrade the taxpayer's distribution network. The construction projects involve the construction and upgrading of assets which are depreciating assets within the meaning of that term in section 40-30 of the ITAA 1997. The same business units are also responsible for the operation and maintenance of the taxpayer's network. The taxpayer has a large annual construction budget and prepares an annual capital works plan detailing the various construction projects to be undertaken each year. All employees in the relevant business units engage, to varying degrees, in some construction work as part of their normal regular duties. Further, employees may work on multiple construction projects (either concurrently or successively) as part of their normal regular duties. The taxpayer keeps records, for accounting purposes, of the time spent by employees, in the relevant business units, working on capital construction projects. Whilst the time spent by individual employees varies, on average, 60% of the overall time of all employees in these two business units is spent working on construction projects and 40% of their overall time is spent on operational and maintenance activities. The taxpayer also engages external contractors to work on construction projects. Approximately 60% of the work on the constructions projects is undertaken by the taxpayer's internal employees, and the remaining 40% is undertaken by external contractors. For accounting purposes, the taxpayer uses a full absorption costing system (which capitalises relevant contract payments and the amount of salary or wages that relates to the amount of time spent by employees working on construction projects) to determine the cost of its self-constructed depreciating assets.

Reasons for decision
Summary: A deduction is allowed under section 8-1 of the ITAA 1997 for losses or outgoings incurred in gaining or producing assessable income, or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, a deduction is not allowed under section 8-1 of the ITAA 1997 to the extent that the loss or outgoing is of a capital nature. The words 'to the extent that' indicate that an expense may be apportioned if it is partly deductible and partly non-deductible: Ronpibon Tin NL & Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431; 4 AITR 236 ( Ronpibon ); Ure v. Federal Commissioner of Taxation (1981) 50 FLR 219; 81 ATC 4100; (1981) 11 ATR 484. However, where apportionment is necessary, the method adopted must be 'fair and reasonable' in all the circumstances: Ronpibon . In the present case, the expenditure incurred on salary or wages for periods when the relevant employees were working on the relevant project is expenditure incurred in gaining or producing assessable income. However, the expenditure will not be deductible to the extent that it is a loss or outgoing of 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 87; (1938) 1 AITR 403 ( Sun Newspapers ) 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. In Sun Newspapers , Dixon J stated that there are three matters to be considered when deciding whether expenditure is revenue or capital in nature. These are: The character of the advantage sought by making the outgoing is the chief, if not the critical, factor that distinguishes revenue from capital outgoings: GP International Pipecoaters Pty Ltd v. Federal Commissioner of Taxation (1990) 170 CLR 124; 90 ATC 4413; (1990) 21 ATR 1. To a similar end, in Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 8 ATD 190; (1946) 3 AITR 436, Dixon J said that the distinction between an outgoing of capital and one on account of revenue 'depends upon what it is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured'. When considering the character of expenditure incurred on salary or wages, in Commissioner of Taxation v. Star City Pty Ltd (2009) 175 FCR 39; 2009 ATC 20-093; (2009) 72 ATR 431 ( Star City ), Jessop J said that '[m]erely to look at the legal rights and obligations which existed as between the payer and the payee (that is the employer and the employee) would be of no assistance in the task of characterisation'. In this respect, we consider that it is appropriate to have regard to the actual work done by the relevant employees in determining what the expenditure on salary or wages was calculated to effect from a practical and business point of view. Further, it is clear that expenditure incurred in relation to salary or wages paid to employees engaged wholly in affairs of capital is properly characterised as capital in nature: Goodman Fielder Wattie Ltd v. Federal Commissioner of Taxation (1991) 29 FCR 376; 91 ATC 4438; (1991) 22 ATR 26; Star City . The fact that expenditure on salary or wages is incurred periodically is not determinative. Recurrence is not a test; it is not more than a consideration, the weight of which depends upon the nature of the expenditure: Broken Hill Theatres Pty Ltd v. Federal Commissioner of Taxation (1952) 85 CLR 423; 9 ATD 423; 5 AITR 296; Sun Newspapers . As Pincus and Ryan JJ said in Commissioner of Taxation v. Mount Isa Mines Ltd (1991) 28 FCR 269; (1991) 21 ATR 1294; (1991) 91 ATC 4154 '[i]t happens in many businesses, particularly large ones, that the making of capital expenditure of one sort or another is almost continual'. In the present case, the taxpayer employs a large workforce to enable it to undertake construction projects in the continual expansion and upgrade of its distribution network. The relevant employees are engaged, in a systematic manner and as part of their normal regular duties, in the construction and upgrading of the taxpayer's depreciating assets. The depreciating assets constructed and upgraded by the relevant employees form part of the taxpayer's distribution network (that is, the taxpayer's profit-yielding structure) and result in a benefit of an enduring kind to the taxpayer. For these reasons, to the extent that the expenditure incurred on salary or wages for periods when the relevant employees were working on the relevant project relates to work undertaken to upgrade or expand the taxpayer's distribution network, the expenditure incurred by the taxpayer on salary or wages will be capital in nature. Accordingly, the taxpayer will not be entitled to a deduction under section 8-1 of the ITAA 1997 for this expenditure. As the taxpayer identifies the amount of time spent by each employee in carrying out activities that relate to the expansion and upgrading of the taxpayer's distribution network for accounting purposes, we consider that, in all the circumstances, it is fair and reasonable to apportion the expenditure incurred on the salary or wages of those employees on a similar basis for the purposes of section 8-1 of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1997 section 8-1 Subdivision 40-C section 40-30
Case references: Broken Hill Theatres Pty Ltd v. Federal Commissioner of Taxation (1952) 85 CLR 423 9 ATD 423 5 AITR 296
Related ATO interpretative decisions: ATO ID 2011/43 | ATO ID 2011/44
Subject references: Deductions & expenses Capital expenditure Labour expenses Salary & wages expenses