Private ruling: The making of a choice under section 40-365 of the Income Tax Assessment Act 1997 (ITAA 1997)
Date of advice: 16 January 2019
Published: April 2019
Ruling period: 1 July 2018 to 30 June 2019
Date scheme commenced: 15 December 2016

Ruling: Q1: Is the taxpayer eligible to make the choice under subsection 40-365(1) of the Income Tax Assessment Act 1997 (ITAA 1997) to exclude all of the amount applied to acquire a replacement asset as a result of a balancing adjustment event that occurred during the income year ended 30 June 2017 on the basis that the expenditure was incurred within one year after the end of the year of that balancing event? | A1: Yes | Q2: Will the Commissioner allow a further period, in accordance with paragraph 40-365(3)(b) of the ITAA 1997? | A2: Yes | Q3: Is the taxpayer eligible to apply the adjustment amount under subsection 40-365(5) of the ITAA 1997 notwithstanding that the asset will be installed ready for use by the taxpayer, and shortly thereafter title to the asset will transfer to the potential new buyer of the asset? | A3: Yes

Relevant facts and circumstances: The taxpayer has been in a manufacturing business since 19XX when the business assets were acquired and is part of a larger group of companies. The business assets included X specific machines. The machines had been fully depreciated for tax purposes and had a written down value of $nil. Towards the end of a calendar year one of the machines was damaged. The taxpayer was the company that owned the original machine and will own the replacement machine. The machine was shown in the accounts and books of the taxpayer as a fixed asset. The taxpayer’s insurer employed a consulting firm to determine whether the coating machine was repairable or whether it should be written off. The insurance policy is held in the name of the wider Group. Towards the end of the same financial year, the consultants confirmed that the machine was a write off. The taxpayer sent an employee overseas in an attempt to source a replacement machine. The taxpayer received a quote from an overseas company and the insurer agreed to pay for the replacement machine. The insurer approved the purchase and the replacement machine was ordered on almost 12 months after the original was damaged. The Purchase Order and the Invoice are in the name of the Group because the payments made by the insurance company are paid into the Group account. However, once the purchase transaction has completed the replacement asset will be taken up in the accounts and books of the taxpayer. The agreement is for the insurer to remit to the Group the deposit, the progress payments and the final balance, as and when the payments fall due. The Group will then make the payments to the overseas company on behalf of the taxpayer. The terms of the order are: ● An initial X% deposit was payable on date (a). ● Progress payment 1 was payable on date (b). ● Progress payment 2 was payable on date (c). ● Progress payment 3 was payable on date (d) and ● The balance will be payable after successful commissioning (ie. delivery, installation and testing). The machine was fully built and approved by the end of the next calendar year. The machine is currently being shipped and is anticipated to arrive shortly. The machine was disassembled for shipping and will be reassembled once it arrives. It will be installed ready for use within the next 2 months. In accordance with the terms and conditions of the contract for purchase of the machine: “Title to goods sold shall pass upon delivery to carrier at the point of shipment, irrespective of any freight allowance, prepayment of freight, or other designation to the contrary, and thereafter risk of loss or damage shall be upon the buyer”. The taxpayer is about to enter into an agreement to sell their business and assets to a third party, with the business assets including this replacement machine. The total consideration for all assets and goodwill is subject to negotiation and it is anticipated if a specific allocation is not agreed upon the consideration will be apportioned across all assets in proportion to their relative market values. The agreement to sell the business assets (including this machine) may be entered into before the taxpayer takes delivery and installs the replacement asset. The replacement asset will be delivered to the taxpayer and will be installed and tested by the taxpayer prior to the transfer to the prospective buyer. During this intervening period the replacement asset will be leased by the taxpayer to the prospective buyer. Once it has been operational and successfully used and tested, title will transfer to from the taxpayer to the buyer. The clauses in the sale contract relevant to the replacement machine are clauses 1.1 to 1.5 inclusive.

Relevant legislative provisions: Section 40-365 of the Income Tax Assessment Act 1997 | Subsection 40-365(1) of the Income Tax Assessment Act 1997 | Subsection 40-365(2) of the Income Tax Assessment Act 1997 | Subsection 40-365(3) of the Income Tax Assessment Act 1997 | Subsection 40-365(4) of the Income Tax Assessment Act 1997 | Subsection 40-365(5) of the Income Tax Assessment Act 1997

Reasons for decision: Summary: The Commissioner considers that the expenditure incurred on the acquisition of the replacement asset was incurred within 12 months of the end of the income year in which the involuntary disposal of the original asset occurred (year 1). However, the replacement asset was not ‘held’ within this period. | Detailed Reasoning - Detailed reasoning: Section 40-365 of the Income Tax Assessment Act 1997 (ITAA 1997) provides: 40-365(1) You may exclude some or all of an amount that has been included in your assessable income for a depreciating asset (the original asset ) as a result of a balancing adjustment event to the extent that you choose to treat it as an amount to be applied under subsection (5) for one or more replacement assets. 40-365(2) You can only make this choice if you stop holding the asset because:- (a) the original asset is lost or destroyed; or (b) ……. 40-365(3) You can only make this choice for a replacement asset if you incur the expenditure on the replacement asset, or you start to hold it: (a) no earlier than one year, or within a further period the Commissioner allows, before the balancing adjustment event occurred; and (b) no later than one year, or within a further period the Commissioner allows, after the end of the income year in which the balancing adjustment occurred. 40-365(4) You can only make this choice for a replacement asset if: (a) at the end of the income year in which you incurred the expenditure on the asset, or you started to hold it, you used it, or had it installed ready for use, wholly for a taxable purpose; and (b) you can deduct an amount for it. 40-365(5) For the purposes of applying this Act to the replacement asset: (a) its cost is reduced by the amount covered by the choice for the income year in which the asset’s start time occurs; and (b) if the income year is later than the one in which the asset’s start time occurs – the sum of its opening adjustable value for that year and any amount included in the second element of the asset’s cost for that later year is reduced by the amount covered by the choice. 40-365(6) If you are making the choice for 2 or more replacement assets, you apportion the amount covered by the choice between those items in proportion to their cost. In this case, the criteria established in subsection 40-365(2) are satisfied. It is therefore necessary to consider whether the criteria in subsections (3) and (4) are also satisfied. Subsection (3) requires that the expenditure on the replacement asset is incurred, or the asset starts to be held, no earlier than one year before the balancing adjustment event and no later than one year after the income year in which the balancing adjustment event occurred. The balancing adjustment event occurred on the date the machine was damaged and therefore the expenditure on the replacement asset was required to be incurred between that date and the 30 June in that year plus one year (Year 2). The taxpayer has provided a Purchase Order for a replacement asset and an Invoice from the supplier for the X% deposit. Further progress payments were due at regular intervals until the replacement asset was delivered, installed and tested. It is therefore necessary to determine whether the taxpayer had incurred the expenditure for the replacement asset during the relevant period. Taxation Ruling TR97/7 considers the meaning of the term ‘incurred’ and the subsequent timing of deductions. It provides the following explanations: 4. There is no statutory definition of the term 'incurred'. 5. As a broad guide, you incur an outgoing at the time you owe a present money debt that you cannot escape. But this broad guide must be read subject to the propositions developed by the courts, which are set out immediately below. 6. The courts have been reluctant to attempt an exhaustive definition of a term such as incurred. The following propositions do not purport to do this, they help to outline the scope of the definition. The following general rules, settled by case law, assist in most cases in defining whether and when a loss or outgoing has been incurred: (a) a taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitively committed in the year of income. Accordingly, a loss or outgoing may be incurred within section 8-1 even though it remains unpaid, provided the taxpayer is 'completely subjected' to the loss or outgoing. That is, subject to the principles set out below, it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum; (b) a taxpayer may have a presently existing liability, even though the liability may be defeasible by others; (c) a taxpayer may have a presently existing liability, even though the amount of the liability cannot be precisely ascertained, provided it is capable of reasonable estimation (based on probabilities); (d) whether there is a presently existing liability is a legal question in each case, having regard to the circumstances under which the liability is claimed to arise; (e) in the case of a payment made in the absence of a presently existing liability(where the money ceases to be the taxpayer's funds) the expense is incurred when the money is paid. 7. For the purposes of section 8-1 it is sometimes not enough that a loss or outgoing has been incurred. The outgoing must also be properly referable to the year of income in which the deduction is sought - refer Coles Myer Finance Pty Ltd v. FC of T 93 ATC 4214 at 4222; (1993) 25 ATR 95 at 105 ( Coles Myer ). The matter of the taxpayer's accounting system may be indicative, but not determinative of the income year to which an outgoing is properly referable. The Ruling then continues at para 15: 15. It is often the case that an outgoing will be both incurred and paid in the same year of income, and no issue of timing arises. However, the point in time when an outgoing may be taken to be deductible becomes an issue of practical concern to taxpayers who have unpaid liabilities at year end or outgoings which relate to two or more income years. | Detailed Reasoning - Presently existing liability: 16. A loss or outgoing may be incurred for the purposes of section 8-1 even though no money has actually been paid out. In W Nevill & Company Ltd v. FC of T (1937) 56 CLR 290 at 302 it was said: 'the word used is 'incurred' and not 'made' or 'paid'. The language lends colour to the suggestion that, if a liability to pay money as an outgoing comes into existence, [the section is satisfied] even though the liability has not been actually discharged at the relevant time... it is only the incurring of the outgoing that must be actual; the section does not say in terms that there must be an actual outgoing - a payment out.' (See also New Zealand Flax Investments Ltd v. FC of T (1938) 61 CLR 179 at 207 ( New Zealand Flax ); FC of T v. James Flood Pty Ltd (1953) 88 CLR 492 at 506 ( James Flood ); Nilsen Development Laboratories Pty Ltd & Ors v. FC of T (1981) 144 CLR 616 at 624 ( Nilsen Development Laboratories ); FC of T v. Firstenberg 76 ATC 4141 at 4148; (1976) 6 ATR 297 at 305.) 17. This proposition was recently confirmed by the High Court in FC of T v. Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52 ( Energy Resources ) when, quoting from James Flood , it said (ATC at 4539; ATR at 56): 'Section 51(1) "has been interpreted to cover outgoings to which the taxpayer is definitively committed in the year of income although there has been no actual disbursement".' 18. The liability must be 'more than impending, threatened or expected' - refer New Zealand Flax (CLR at 207). '[W]hat is clearly necessary is that there should be a presently existing liability' - Nilsen Development Laboratories (CLR at 624). It is not a presently existing liability if it is contingent - refer James Flood (CLR at 506); Nilsen Development Laboratories (CLR at 207); Marbren Pty Ltd v. FC of T 84 ATC 4783 at 4788-4789; (1984) 15 ATR 1145 at 1152. In this particular case, the Purchase Order was issued by the Group and an Invoice for payment was sent to the Group showing a due date for payment of the deposit. The first and second progress payments then became due and were paid. These Invoices indicate that 70% of the total amount payable for the replacement asset was made before the end of the balancing adjustment event year plus one year (Year 2). Whilst it could be argued that as at the end of Year 2 the taxpayer has a present existing liability for the total expenditure on the replacement asset, it is noted that because of the length of time that it is taking to build the machine and then ship it from overseas to Australia the taxpayer will not ‘hold’ the replacement asset as at the end of Year 2. Under the circumstances therefore the Commissioner will agree to a further period of one year from the end of the choice year to the end of the choice year plus two years (Year 3). | Summary: The Commissioner will allow a further period of one year pursuant to paragraph 40-365(3)(b) of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: It could be argued that an extended period of time in which to incur the expenditure on the replacement asset is not required because the expenditure was incurred within the criteria established in paragraph 40-365(3)(b). However, it is noted that because of the length of time that it is taking to build the machine and then ship it from overseas to Australia the taxpayer will not ‘hold’ the replacement asset as at the end of Year 2. Therefore the Commissioner will allow a further period, being 12 months from the end of Year 2 to the end of the balancing adjustment event year plus two years (Year 3) by which the taxpayer will start to hold the asset. | Summary: The criteria in subsection 40-365(5) is satisfied as long as the replacement asset is held, used or installed ready for use by the taxpayer as at the end of Year 3. | Detailed Reasoning - Detailed reasoning: As previously stated, subsection 40-365(4) provides: 40-365(4) You can only make this choice for a replacement asset if: (a) at the end of the income year in which you incurred the expenditure on the asset, or you started to hold it , you used it, or had it installed ready for use, wholly for a taxable purpose; and [emphasis added] (b) you can deduct an amount for it. The issue at hand here is whether the taxpayer will hold the asset for use or installed ready for use at the end of Year 3. According to the Terms and Conditions of the contract to buy, agreed to between the taxpayer and the provider of the replacement asset, title to the replacement machine shall pass (to the buyer) upon delivery to the carrier at the point of shipment. The taxpayer is then responsible for installation, testing and commissioning of the machine prior to the title passing to the prospective purchaser. The taxpayer likely incurred the expenditure to acquire the replacement asset before the end of Year 2, however because of the requirement for the taxpayer to ‘hold’ the asset, the Commissioner has extended this period to Year 3. In order to satisfy subsection 40-365(4) it is necessary for the taxpayer to hold, use the replacement asset, or have it installed ready for use at the end of Year 3 – which is the same period as the income year in which the replacement asset’s start time occurs. It is noted that the taxpayer is looking to enter into a contract for sale of the business and its assets, including the replacement asset. It is considered that as long as the taxpayer still holds the title to the replacement asset, and that it is held, used or installed ready for use as at the end of Year 3, there is no bar from the taxpayer applying the balancing adjustment as per paragraph 40-365(5)(a) of the ITAA 1997.