Private ruling: Variation Construction Costs
Date of advice: 15 June 2018
Published: August 2018
Ruling period: The relevant income year
Date scheme commenced: The commencement time

Ruling: Q1: Will Variation Construction Costs incurred by Company A to undertake Project Variations to the Project be allowable deductions under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) in the year they are incurred where the Project Variations are initiated and funded by Company B? | A1: Yes

Relevant facts and circumstances: Company A operations 1. Company A’s core businesses relates to the long term operation and management of certain assets. 2. As part of that core business, Company A is first required to finance, design and construct the facility as agreed with Company B. 3. Once construction is completed by Company A and Company B agrees that construction is complete, then Company A commences operating and maintaining the facilities. 4. In return for performing these obligations, Company A is entitled to receive payments from Company B (Service Payments). 5. The Service Payments commence once the construction is complete and are based on the design of the facilities as originally agreed between Company A and Company B. 6. The commercial return obtained from the Service Payments is reflective of an annuity income stream from design, financing and construction and long term operation and maintenance activities. Construction operation after operational commencement 7. Company A also conducts ancillary construction operations. 8. These activities are commercially separate operations from Company A’s core business. 9. In particular, subsequent to the design of the facilities being agreed between Company A and Company B, circumstances may arise that require variations to be made (Project Variations) to the original design. 10. Company B may, therefore, request that Company A undertake the Project Variation. 11. In return for undertaking the Project Variation, Company A receives compensation from Company B (Variation Payments) that reflects: ● the costs to Company A of undertaking the Project Variation; plus ● a margin to compensate the Company A. 12. The commercial return from the Variation Payments in respect of the Subsidiary’s activities as a contractor / project manager of the Project Variations are variable based on the level of construction undertaken and is reflective of the risk borne in smaller scale, shorter term construction activities. 13. In order to undertake the Project Variations, Company A incurs costs (Variation Construction Costs) in engaging subcontractors to carry out the necessary works. 14. The majority of the Variation Construction Costs for any given Project Variation will be in respect of contract and design consultant labour and construction materials. 15. These are incurred for the purpose of completing the Project variation in order to derive the Variation Payment. The Project 16. Company A entered into the Project Deed (Project Deed) with Company B. 17. The Project (Project) is governed by the terms and conditions of the Project Deed. 18. The objectives of the Project contained in Clause 2.1 of the Project Deed: 19. Company B and Company A have agreed on the terms and conditions pursuant to which Company A will finance, design, construct, commission, hold and operate the Facilities. 20. Company B is required to pay a Service Payment to Company A each month. 21. Company B grants a non-exclusive licence to Company A to access the relevant site for the construction phase, and a lease over the relevant site for the operations phase. Project Completion 22. All chattels and non-fixtures, designed and constructed by Company A, will be and remain the property of Company A unless and until transferred to the Company B or a replacement contractor, at the end of the Project term. Project Variations 23. Company A is responsible for making payments (Variation Construction Costs) to the various subcontractors engaged to carry out the Project Variation. 24. Company A is then entitled to compensation (Variation Payment) from Company B equal to: ● the subcontractor costs incurred in undertaking the Project Variation; plus ● an additional administration and management fee (Margin). 25. The Variation Payments are equal to or exceed the Variation Construction Costs. 26. The Variation Construction Costs are incurred for the purposes of deriving the Variation Payments including a margin where applicable. 27. The Variation Payments are included in the Service Income which is treated as assessable income under section 6-5 of the ITAA 1997. 28. There is no increase in the Services Payment to Company A as a result of any Project Variations other than as a direct reimbursement of ongoing maintenance costs in respect of the Project Variations. 29. The Project Variations do not increase Company A’s capacity to earn revenue from third parties (e.g. they do not increase the area available for third party use).

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1

Reasons for decision: Summary: Subsection 8-1(1) of the ITAA 1997 states that 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. However, under subsection 8-1(2) of the ITAA 1997, 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 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 non-assessable non-exempt income; or (d) a provision of ITAA 1997 or ITAA 1936 prevents you from deducting the amount. Relevantly, Company A will be entitled to a deduction under section 8-1 of the ITAA 1997 for the payment of Variation Construction Costs where: - the costs are incurred in gaining or producing assessable income; or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income (‘Positive Limb’); and - the costs are not capital or of a capital nature (‘Negative Limb’) | Detailed Reasoning - Outgoing must be incurred: To qualify for a deduction under section 8-1 of the ITAA 1997, a loss or outgoing must have been incurred. There is no statutory definition of the term ‘incurred’. As a broad guide, a taxpayer incurs an outgoing at the time the taxpayer owes a present money debt that they cannot escape. This must be read subject to the propositions developed by the courts, which are discussed in more detail in Taxation Ruling TR 97/7 Income tax: section 8-1 – meaning of ‘incurred’ – timing of deductions (TR 97/7) and Taxation Ruling TR 94/26 Income tax: subsection 51(1) – meaning of incurred – implications of the High Court decision in Coles Myer Finance (TR 94/26). Under the Project Deed, Company A is required to implement the Project Variation after receiving the countersigned certificate from Company B. In order to undertake the Project Variations, Company A incurs Variation Construction Costs in engaging subcontractors to carry out the necessary works. Accordingly, it is considered that the Variation Construction Costs are incurred by Company A for the purposes of subsection 8-1(1) of the ITAA 1997. | Detailed Reasoning - Outgoing must be incurred in gaining or producing assessable income or necessarily incurred in carrying on the relevant business: Further, to be deductible under section 8-1 of the ITAA 1997, an outgoing must have been incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. In order to satisfy the requirements of section 8-1 of the ITAA 1997, there must be a relevant connection between the outgoing and the business. An expense will have the relevant connection to the business when it is ‘desirable or appropriate in the pursuit of the business ends of the business’ ( Ronpibon Tin NL and Tongkah Compound NL v. FC of T (1949) 78 CLR 47 (Ronpibon); Magna Alloys & Research Pty Ltd v. Federal Commission of Taxation (1980) FCA 150 (Magna Alloys). Company A’s business is to provide operating and maintenance services. In order to undertake the Project Variations to derive the Variation Payment, Company A incurs Variation Construction Costs in engaging subcontractors to carry out the necessary works. Therefore, the Variation Construction Costs are incurred for the purposes of deriving the Variation Payments. Accordingly, the Variation Construction Costs paid by Company A to the subcontractors to undertake the Project Variation under the Project Deed are considered to be an outgoing incurred for the purpose of deriving assessable income for the purposes of subsection 8-1(1) of the ITAA 1997. | Detailed Reasoning - Outgoing must not be capital or of a capital nature: Notwithstanding that the positive limbs of subsection 8-1(1) have been satisfied, a deduction is not available if the outgoing is capital or capital in nature under subsection 8-1(2) of the ITAA 1997. Whether an outgoing is capital or revenue in nature can generally be determined by reference to the test articulated by Dixon J in Sun Newspapers Ltd and Associated Newspapers Ltd. V. Federal Commissioner of Taxation (1938) 61 CLR 337; [1938] HCA 73 (Sun Newspapers): There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former had recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment. The character of the advantage sought provides important direction. It provides the best guidance as to the nature of the expenditure as it says most about the essential character of the expenditure itself. The decision of the High Court in G.P. International Pipecoaters v. Federal Commissioner of Taxation (90 ATC 4413; (1990) 170 CLR 124; 1990); 21 ATR 1) 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 FCT (1938) 61 CLR 337, at 363; 1 AITR 353; … The nature or character of the expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature. The following factors indicate that the Variation Construction Costs incurred by Company A are not capital or capital in nature: ● The character of the advantage sought by Company A in incurring the Variation Construction Costs is not of an enduring nature but is rather a fulfilment of its obligations to deliver Project Variations, allowing derivation of its ordinary business income, being the Variation Payments. ● The services of the subcontractors are secured by a periodical outlay (the staged payments to relevant subcontractors) to cover their use and enjoyment for periods commensurate with the payment, and according to the principles in the Sun Newspapers case, the advantage has no lasting qualities. The expenditure made in carrying out the Project Variations does not create an enduring benefit for Company A. ● The expenditure does not relate to enlarging the profit yielding structure of Company A’s business as: ● The Project Variations do not increase Company A’s capacity to earn revenue from third parties (e.g. they do not increase the area available for third party use). ● There is no increase in the Services Payment to Company A as a result of any Project Variations other than as a direct reimbursement of ongoing maintenance costs in respect of the Project Variations. Accordingly, the expenditure that Company A incurs in carrying out the Project Variations under the Project Deed is not capital expenditure. Therefore, subsection 8-1(2) of the ITAA 1997 does not apply to disallow a deduction to which Company A is entitled under subsection 8-1(1) of the ITAA 1997.