Private ruling: Capital allowances - decline in value of an asset
Date of advice: 28 September 2020
Published: November 2020
Ruling period: Year ending 30 June 20XX | Year ending 30 June 20XX | Year ending 30 June 20XX | Year ending 30 June 20XX

Ruling: Q1: Is the Prototype a single depreciating asset within the meaning of section 40-30 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes | Q2: If the Prototype is a single depreciating asset, did Company B start to 'hold' the Prototype (within the meaning of section 40-40 of the ITAA 1997) by no later than 30 August 20XX? | A2: No | Q3: If the Prototype is a single depreciating asset, was the 'start time' for the Prototype for the purposes of section 40-60 of the ITAA 1997 no later than 30 August 20XX? | A3: No

Relevant facts and circumstances: Company A and Company B are researching and developing a range of equipment to be used for an alternative mining system. The System is one of the key elements of the alternative mining system and is comprised of a series of interconnected modules. Company B is a special purpose vehicle established to develop a prototype of the System at a particular mining complex (X mine). The prototype of the System, called the Prototype has been developed and is the subject of this ruling. The primary purpose of the Prototype is to test and develop the various systems and technologies that are required to make the System operational, so that those systems and technologies can be adapted for use in other mines. The process by which the Prototype came into existence is extensive. By 30 August 20XX, Company B had: · acquired the steel and other materials necessary to fabricate a main structural frame and elements of the canopy roof; · conducted an initial 'drop test' using an element of the canopy roof, where heavy material was dropped on the canopy element to test its strength; · conducted a second 'drop test' using a new canopy element; and · used a preliminary structural frame in conjunction with the canopy to conduct a fitment test for the proposed system. The canopy unit used during the second 'drop test' was repaired and continued to be used as part of the Prototype. The material that comprises the new (modified) canopy element that was used in the successful test on 30 August 20XX is an ongoing part of the Prototype. The Prototype was assembled at X mine on 29 June 20XX. Further testing and development of the Prototype is expected to occur in the income year ending 30 June 20XX (and potentially beyond that time). Such development is likely to result in further modifications of, and additions to, the Prototype.

Relevant legislative provisions: Income Tax Assessment Act 1997 Division 355 | Income Tax Assessment Act 1997 section 355-305 | Income Tax Assessment Act 1997 section 355-310 | Income Tax Assessment Act 1997 Division 40 | Income Tax Assessment Act 1997 section 40-25 | Income Tax Assessment Act 1997 section 40-30 | Income Tax Assessment Act 1997 subsection 40-30(1) | Income Tax Assessment Act 1997 subsection 40-30(4) | Income Tax Assessment Act 1997 section 40-40 | Income Tax Assessment Act 1997 section 40-60 | Income Tax Assessment Act 1997 subsection 40-60(1) | Income Tax Assessment Act 1997 subsection 40-60(2)

Reasons for decision: Summary: The Prototype is a single depreciating asset as defined in section 40-30 of the ITAA 1997. [1] Company B did not start to 'hold' the Prototype by no later than 30 August 20XX. For the purposes of section 40-60, the 'start time' for the Prototype was later than 30 August 20XX. | Detailed Reasoning - Detailed reasoning: Division 355 provides eligible entities (R&D entities) with a tax offset for expenditure on qualifying research and development (R&D) activities. To be entitled to the tax offset the entity needs one or more notional deductions under Division 355. One kind of notional deduction under Division 355 is for the decline in value of tangible depreciating assets used for R&D activities. The conditions upon which an R&D entity can notionally deduct the decline in value of a tangible depreciating asset used for R&D activities are set out in section 355-305, one of which is the requirement that the R&D entity could deduct an amount under section 40-25 for the asset for the present year if Division 40 applied (subject to certain modifications set out in section 355-310). One of the relevant modifications in section 355-310 is that the reference to a "taxable purpose" in section 40-25 is taken to refer to the purpose of conducting one or more of the R&D activities. Section 40-25 provides that you can deduct an amount equal to the decline in value for an income year of a depreciating asset that you held for any time during the year. As modified by section 355-310, that deduction must be reduced by the part of the asset's decline in value that is attributable to your use of the asset, or you having it installed ready for use, for a purpose other than a purpose of conducting one or more of the R&D activities to which the R&D deductions relate. | Detailed Reasoning - Single depreciating asset: Subsection 40-30(1) states that a depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used. Subsection 40-30(4) provides that whether a particular composite item is itself a depreciating asset or whether its components are separate depreciating assets is a question of fact and degree to be determined in the light of all the circumstances of the particular case. A composite item is an item that is made up of a number of components that are capable of separate existence. The Prototype is comprised of all the individual modules in the System, and is therefore considered to be a composite item. Draft Taxation Ruling 2017/D1 Income tax: composite items and identifying the depreciating asset for the purposes of working out capital allowances (TR 2017/D1) lists the main principles that are taken into account in determining whether a composite item is a single depreciating asset, or more than one depreciating asset for the purposes of Division 40 of the ITAA 1997. These are: (a) 'Identifiable': the depreciating asset will tend to be the item that performs a separate identifiable function, having regard to the purpose or function it serves in its business context. (b) 'Use': a depreciating asset will tend to be an item that performs a discrete function. However, the item need not be self-contained or able to be used on a stand-alone basis. (c) 'Degree of integration': the depreciating asset will tend to be the composite item where there is a high degree of physical integration of the components. (d) 'Effect of attachment': the item, when attached to another asset having its own independent function, varies the performance of that asset. (e) 'System': a depreciating asset will tend to be the multiple components that are purchased as a system to function together as a whole and which are necessarily connected in their operation. The primary function of the Prototype is to test and develop the equipment necessary for the System and the secondary function is to perform the function of a System itself (at the X mine). None of the separate elements which make up the Prototype is capable of performing these functions in isolation. The individual elements which make up the Prototype are highly integrated; need to be connected and controlled together (to move accurately within an underground mine); are not designed to be interchangeable with other systems; and are not considered to have commercial value on their own. Their commercial value derives from the successful integration into a working system. Applying the principles in TR 2017/D1 to these factors, it is considered that the Prototype constitutes a single depreciating asset under section 40-30. | Detailed Reasoning - Start to 'hold' the depreciating asset: For the purposes of section 40-25 (and subsection 355-305(1)(b)), section 40-40 identifies who is taken to 'hold' a depreciating asset by focusing on the nature of the ownership interest. Item 10 of the table in section 40-40 provides that the owner (or the legal owner if there is both a legal and equitable owner) of a depreciating asset holds the asset. A depreciating asset will generally be identified by its 'use' or 'functionality'. 'Used' is a word of wide import and its meaning in any particular case will depend on the context in which the word is employed and the purpose for which the thing in question has been acquired or created (see Newcastle City Council v. Royal Newcastle Hospital (1956) 96 CLR 493). In the context of carrying on R&D activities, it is sufficient that the asset can perform the functionality for which it was designed to be used. By 30 August 2019, Company B held the structural frame and the canopy elements of the Prototype. Whilst these elements of the Prototype are important components, the Prototype (in its composite form) did not come into being as a single depreciating asset, and therefore could not have been held in accordance with section 40-40, until such time as all the relevant modules and components were integrated to perform its intended functions. See Taxation Determination TD 2014/15 for a comparable example. Whilst modifications to an existing depreciating asset over the course of its life that do not change the function of the asset will not create a new depreciating asset, modifications made before the asset exists (as a composite item) is part of the construction process of that asset. | Detailed Reasoning - Start time of Prototype as a depreciating asset: Subsection 40-60(1) states that a depreciation asset you hold starts to decline in value from when its start time occurs. Subsection 40-60(2) states that the start time of a depreciating asset is when you first use it, or have it installed ready for use, for any purpose. As the Prototype (as a composite item) is not considered to have existed by 30 August 20XX, its value could not have started to decline by that date. [1] All legislative references are to the ITAA 1997.