Private ruling: Long term construction contract
Date of advice: 11 December 2017
Published: May 2018
Ruling period: Income year ended 30 June 2013 | Income year ended 30 June 2014 | Income year ended 30 June 2015 | Income year ended 30 June 2016 | Income year ended 30 June 2017

Ruling: Q1: Is the Taxpayer entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the expenditure incurred by Subsidiary A in fulfilling its obligations under the Development Agreement in the income year it is incurred? | A1: Yes | Q2: Will Subdivision D of Division 3 in Part III of the Income Tax Assessment Act 1936 (ITAA 1936) apply to cancel the deductions claimed by the Taxpayer under section 8-1 of the ITAA 1997 for expenditure incurred by Subsidiary A in fulfilling obligations under the Development Agreement? | A2: No

Relevant facts and circumstances: The Taxpayer is a head company of a consolidated group which includes Subsidiary A and Subsidiary B. Subsidiary A has entered into a Development Agreement (the Agreement) with the Land Owners of a parcel of land. The Land Owners include Subsidiary B which owns the majority of the land, and associates (which are outside the consolidated group) owning the remaining portion. The purpose of the Agreement is that Subsidiary A will develop and organise finance of a construction project, in return for a fee. Subsidiary A carries on the business of property development and earns assessable income from invoicing a fee to the Land Owners pursuant to the Agreement. The Agreement does not result in the formation of a partnership or joint venture between Subsidiary A, the Taxpayer and the Land Owners. Subsidiary A does not hold any trading stock in relation to its activities undertaken pursuant to the Agreement.

Relevant legislative provisions: Income Tax Assessment Act 1936 Subdivision D of Division 3 in Part III | Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 section 701-1

Reasons for decision: Summary: Section 8 - 1 of the ITAA 1997 states that you can claim a deduction for any loss or outgoing to the extent it 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. A loss or outgoing is not deductible to the extent that it is capital or of a capital nature; of a private or domestic nature; in relation to gaining or producing exempt income or non - assessable non - exempt income; or because a provision of the ITAA prevents you from deducting it. Taxation Ruling TR 2017/D8 provides that a ‘long term construction contract’ refers to a contract under which construction work extends beyond one year of income, and excludes a contract for the sale and supply of trading stock. In this context, the word ‘construction’ takes its ordinary meaning (paragraphs 2 and 3 of TR 2017/D8). TR 2017/D8 further provides the principles and practices which apply in recognising for income tax purposes income derived from and expenses incurred in long term construction contracts. One of the acceptable methods is referred to as the basic approach under which all progress and final payments received or receivable during the income year are to be included in assessable income in the year in which they are derived and expenditure is allowed as an income tax deduction (to the extent permitted by law) in the year in which it is incurred (paragraphs 5 and 7 of TR 2017/D8). Whichever of the acceptable methods of determining taxable income from long term construction contracts is adopted, it is to be applied consistently to all years during which the particular contract runs and to all similar contracts entered into by the entity (paragraph 6 of TR 2017/D8). Taxation of consolidated groups The single entity rule under section 701-1 of the ITAA 1997 deems subsidiary members of a tax consolidated group to be parts of the head company of the tax consolidated group rather than separate entities. As a consequence: a. Expenditure incurred by a subsidiary member of a tax consolidated group becomes an allowable deduction of the head company; b. Income derived by a subsidiary member of a tax consolidated group is assessable income of the head company; and c. Intra-group transactions are ignored for consolidated taxation purposes. | Detailed Reasoning - Application of the law to the circumstances: As the head company of a consolidated group, the single entity rule will apply to the Taxpayer. Taxation Determination TD 2005/3 considers the method of income recognition of a consolidated group undertaking a range of business activities and provides, at paragraph 4: The head company of a consolidated group may conduct a range of business activities. Like any other taxpayer, the head company must apply the method of income recognition for each business activity that gives a 'substantially correct reflex of the taxpayer's true income' (CT (S.A.) v. Executor Trustee and Agency Co of South Australia Limited (1938) 63 CLR 108); see Taxation Ruling TR 98/1. Subsidiary A is the Taxpayer’s subsidiary and is part of the consolidated group (as a subsidiary member). Subsidiary A carries on a business of property development and provides services to the Land Owners pursuant to the Agreement. The advantage sought (and gained) by Subsidiary A in entering into the Agreement is to earn a margin provided for in the fee which is assessable as ordinary income. In order to earn the fee Subsidiary A is required to fulfil its obligations under the Agreement which includes to provide services (including but limited to making payments to a third party builder) in relation to the construction. Subsidiary A upon discharging its liability and paying the development costs has incurred a loss or outgoing that is deductible under section 8-1 of the ITAA 1997 and which is not of a capital nature. The services provided by Subsidiary A do not create an enduring benefit to the capital or profit making structure of Subsidiary A’s business. Pursuant to the operation of section 701-1 of the ITAA 1997, the Development Costs incurred by Subsidiary A are an allowable deduction of the Taxpayer, as the head company of the consolidated group. The Agreement is in respect of a long term construction contract (as defined in TR 2017/D8). As such, Subsidiary A (and in turn the Taxpayer) may elect an acceptable method to account for the development under the Agreement for income tax purposes. Having elected the basic approach, the development costs incurred by Subsidiary A during the development are allowed as an income tax deduction to the Taxpayer under section 8-1 of the ITAA 1997 in the income year in which they are incurred. | Detailed Reasoning - Question 2: The anti-avoidance provisions in Subdivision D of Division 3 in Part III of the ITAA 1936 will not apply to cancel the deductions claimed under section 8-1 of the ITAA 1997 by the Taxpayer for expenditure incurred by Subsidiary A in fulfilling its obligations under the Agreement.