Private ruling: Water in storage acquired on purchase of land and business.
Published: September 2013
Ruling period: Year ended 31 December 2013 | Year ended 31 December 2014 | Year ended 31 December 2015
Date scheme commenced: 1 January 2013.

Ruling: Q1: Is the entity entitled to an income tax deduction pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), either upon acquisition or over time, for use of water in storage acquired as a result of the purchase of property? | A1: No. | Q2: If a deduction is available pursuant to section 8-1 of the ITAA 1997, can the deduction be claimed at the time the expense is incurred on a usage basis? | A2: As no deduction is allowable pursuant to section 8-1 of the ITAA 1997, there is no requirement to consider this question.

Relevant facts and circumstances: The entity settled a purchase contract to purchase a primary production business. The parties to the contract were at arms-length. At the time of settlement of the contract, there was water in farm storages (e.g. dams). The water was harvested from water licences and allocations by the vendor and will be used by the entity for crop irrigation of the primary production business. The volume of water was accurately estimated at time of settlement. The sale contract was silent as to the value of water in storage at settlement date. Deductibility is claimed for the cost of water in storage at the settlement date of the purchase of the business.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 Division 70 | Income Tax Assessment Act 1997 section 108-5

Reasons for decision: Summary: The entity is not entitled to an income tax deduction pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), either upon acquisition or over time, for use of water in storage acquired as a result of the purchase of property (including land) in which the water was situated. | Detailed Reasoning - Detailed reasoning: The general deduction provisions of section 8-1 of the ITAA 1997 state: (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. The property acquired by the entity includes the farm land. At the time of settlement, there was physical water situated on the land. Water Licences and Water Allocations acquired by the entity in purchasing the property and business are CGT assets as defined in section 108-5 of the ITAA 1997. They provide the rights to receive a supply of water including: · a right to receive a supply of a quantity of water; or · a right to receive a supply of water for a specified period; or · a tradeable right to receive a supply of water. Any values attached to these rights are not immediately deductible under section 8-1 of the ITAA 1997. The character of the physical water is treated separately from those capital assets and will vary depending on how the water is actually put to use. For instance, if it is regularly sold to other parties as a commodity, it would take on the character of trading stock under Division 70 of the ITAA 1997. Alternatively, if the water is only used for irrigating crops on the farm, it becomes an input to the crop growing process. The entity does not buy or sell water in the ordinary course of their business of primary production. Therefore, the physical water is not considered to be their trading stock. The purchase of physical water in storage is clearly incurred in gaining or producing the assessable income of the taxpayer. This is because the payments are made to acquire physical water necessary to irrigate the taxpayer's crop, and thereby earn assessable income from primary production business. As such the payments are incidental and relevant to the income earning activities of the taxpayer ( Ronpibon Tin NL and Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431). The payments are not of a private or domestic nature or incurred in gaining or producing exempt income and no other provision prevents a deduction of the amount. Therefore, the amount will be an allowable deduction under section 8-1 of the ITAA 1997 provided it is not capital or of a capital nature. We now consider if the payment is capital or of a capital nature. When determining whether or not an outgoing is of a capital nature, it is the nature of the advantage sought by the taxpayer, and not the description given to the outgoing by the parties, which is the relevant issue. Expenditure that strengthens and preserves the business entity or the profit yielding subject is capital expenditure ( Sun Newspapers Ltd & Associated Newspapers Ltd v. FC of T (1938) 61 CLR 337) ( Sun Newspapers ). In Sun Newspapers , Dixon J discussed at CLR 359; ATD 93-94 the distinction between capital and revenue expenditure by stating that it: …..corresponds with the distinction between the business entity, structure, or organisation set up or established for the earning of profit and the process by which such organisation operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns represent profit or loss. His honour discussed that the capital/revenue distinction reflected the difference between the profit-yielding subject and the process of operating it. At CLR 360; ATD 94 Dixon J stated that: …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. The latter can be considered, estimated and determined only in relation to a period or interval of time, the former as at a point of time . (emphasis added) It is considered that expenditure incurred in respect of the acquisition of physical water in storage as part of the acquisition of a business which includes land is not deductible to the purchaser under section 8-1 of the ITAA 1997 because it is of a capital nature. Such expenditure is capital in nature because it relates to the establishment of the profit yielding structure of the business ( Sun Newspapers ) rather than being incurred as part of the cost of trading operations to produce income. All the components of the business acquired, including the physical water, are considered to be expenditure on the profit-yielding subject, rather than an independent expenditure as part of the day-to-day activities of carrying on the business. The characterisation of the expenditure is determined by the character of the overall transaction that it is part of. The expenditure relates to the acquisition of the means of production or to the implements or articles employed in work and is different from the continuous flow of working expenses relating to the process of operating the business. The expenditure arises at a point of time only. It was paid by the entity as an integral and inseparable part of the purchase price in return for acquiring the business. It is therefore a capital outgoing. In QCT Resources Limited v FC of T (1997) 97 ATC 4079; (1997) 34 ATR 504 ( QCT Resources ), Drummond J at ATC 4086 confirmed this view by stating: ….where part of the cost of acquiring a new business of a kind not previously conducted by the purchaser is an outgoing which will be similar in kind to revenue outgoings which the purchaser can expect to make in the future, once it commences to trade: in this situation, the character of the advantage sought by making the particular outlay is the same as that sought from making the other outlays which together comprise the price paid for acquiring the capital asset, viz, the new business as a going concern. From a practical and business point of view, there is no justification for characterising one component of the stated price paid to acquire such an asset differently from any of its other components: the entire price has to be paid to acquire the new business. The Federal Court's decision in QCT Resources was upheld on appeal to the Full Federal Court. Accordingly, as part of the acquisition of the purchase of the business, a deduction is not allowable under section 8-1 of the ITAA 1997 for the cost of physical water stored on the primary production business land. This cost is capital in nature. In coming to our decision, we have taken into consideration ATO Interpretative Decision ATO ID 2013/49 Income Tax - Physical water purchased on acquisition of a primary production business. | Summary: As no deduction is allowable pursuant to section 8-1 of the ITAA 1997, there is no requirement to consider this question.