Private ruling: Deductibility of insurance expense for construction of a facility
Date of advice: 15 August 2018
Published: October 2018

Ruling: Q1: Is Company A entitled to a deduction for all or part of the amount of the insurance expense under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No | Q2: Is Company A entitled to a deduction for all or part of the amount of the insurance expense under Division 43 of the ITAA 1997 commencing no earlier than from when construction is completed? | A2: Company A is entitled to a deduction for a part of the expenditure under Division 43 of the ITAA 1997. | Q3: Is Company A entitled to a deduction for all or part of the amount of the insurance expense under Division 40 of the ITAA 1997? | A3: Company A is entitled to a deduction for the remaining part of the ‘Construction Works Insurance’ expense under section 40-880 of the ITAA 1997 over five years.

Relevant facts and circumstances: 1. Company A is an Australian resident which is wholly owned by a foreign resident company. 2. Company A commenced construction of a facility during the previous year of income. 3. The construction of the facility includes the construction of certain facilities and plant. 4. The construction costs of the facility including plant is approximately $ZZZ. 5. The construction costs for the first part of the facilities which are entirely capital works is approximately $YYY. The construction costs for the second part of the facilities which are for ‘plant’ is $XX1 and for capital costs which are neither for capital works nor for plant and other depreciating assets to which Division 40 applies is $XX2. 6. Company A incurred an amount of insurance expense (the Amount) relating to the construction of the facility including the construction of certain facilities and plant. 7. Company A will complete the construction in the current year of income. 8. Company A will start deriving assessable income in the next year of income from using the facilities and plant.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 8-1 | Income Tax Assessment Act 1997 Division 40 | Income Tax Assessment Act 1997 Division 43 | All legislative references are to provisions of the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise specified.

Reasons for decision: Summary: Company A is not entitled to a deduction for any part of the amount of the insurance expense under section 8-1. | Detailed Reasoning - Detailed reasoning: Section 8-1 allows a deduction for all losses and outgoings to the extent to which the losses or outgoings are incurred in (or are necessarily incurred in carrying on a business for the purposes of) gaining or producing assessable income, except where the losses or outgoings are of a capital, private or domestic nature, or relate to gaining or producing exempt income. Company A incurred the insurance expense in respect of the construction of a facility on land it owns. Company A incurred the expense before it commenced its business and therefore there is insufficient nexus (or connection) between the expense and Company A deriving its assessable income. In addition to Company A incurring the expenditure too soon, the insurance expense was incurred in relation to the construction of numerous capital assets, in the facility including the facilities and plant, and therefore the character of the insurance expense is capital in nature. Accordingly, Company A is not entitled to a deduction for any part of the amount of the Amount under section 8-1. | Summary: Company A will be entitled to a deduction under Division 43 (calculated under section 43-210 and subject to the relevant rates in Division 43) in respect of part of the Amount commencing in the next year of income. | Detailed Reasoning - Detailed reasoning: Pursuant to subsection 40-45(2), Division 40 does not apply to capital works to which Division 43 applies. The following discussion about the nature of expenditure for the first part of the facilities provides the basis for apportioning Company A’s expenditure on the insurance premium of the Amount between: ● the part of the insurance premium which relates to capital works (and within this part, between the 2.5% rate and the 4% rate) ● the part of the insurance premium which relates to ‘plant’ to which Division 40 applies, and which is also discussed in the Detailed reasoning for Question 3 below, and ● the remaining part of the insurance premium which we refer to as ‘indirect costs’. The remaining part is apportioned across capital works and ‘plant’ in proportion to their respective costs. This approach applies the Commissioner’s view and approach set out in Taxation Ruling TR 97/25 Income tax: property development: deduction for capital expenditure on construction of income producing capital works, including buildings and structural improvements (TR 97/25). We consider that the insurance expense is a preliminary expense of the type listed in paragraph 9 of TR 97/25 which includes architect fees, engineering fees and costs of building permit. Furthermore, the insurance expense is also an indirect cost because in the context of construction, and accounting records or other documentation, it cannot be allocated wholly to an individual element of the construction project, such as the building or plant (paragraph 13 of TR 97/25). The apportionment approach for indirect costs is set out in paragraph 13 and the Example at paragraphs 36-38 of TR 97/25. Paragraph 13 of TR 97/25 states: Indirect costs, in the context of construction activities, are those that, by reference to accounting records or other documentation, cannot be allocated wholly to an individual element of a construction project, such as the building or plant. We take the view that, in determining construction expenditure in respect of capital works, indirect costs generally are allocated between elements to which they relate in the same proportion that the direct costs of those elements bear to one another …: Capital works Division 43 explains how to calculate deductions for capital expenditure on the construction of capital works. Subsection 43-20(1) provides that Division 43 applies to capital works that are buildings, or an extension, alteration or improvement to a building. The total estimated costs for constructing the first part of the facilities is $YYY (out of the total estimated costs of $ZZZ in constructing the facility). Before apportioning the insurance premium as to the extent it applies to t the first part of the facilities, it is necessary to also establish how much of the construction expenditure for the facility is for ‘plant’, and how much are indirect costs that are for both capital works and ‘plant’. Subsection 43-70(2) specifically excludes from the definition of ‘construction expenditure’ any expenditure on ‘plant’, therefore a deduction for any expenditure on plant would not be available under Division 43. Plant (and other non-Division 43 construction expenditure) Taxation Ruling TR 2004/16 Income tax: plant in residential rental properties sets out, among other things, the Commissioner’s view and explanation on the ordinary meaning and extended meaning of ‘plant’. The extended meaning of ‘plant’ includes articles and machinery. Accordingly, we consider that the expenditure of $XX1 on the second part of the facilities are for ‘plant’ under the ordinary meaning or extended meaning due to their respective function, usage and their direct or close connection with the income-producing activities of Company A’s business. Therefore, we consider that expenditure of $XX1 on the second part of the facilities does not constitute the relevant ‘capital expenditure’ for the purposes of Division 43. The ‘insurance premium to the extent it relates to the capital expenditure of $XX1 on ‘plant’ is not deductible under Division 43. That is, the insurance premium as it relates to the amount of $XX1 is not capital expenditure pursuant to subsection 43-70(2), as it is expenditure in relation to plant. However, the ‘insurance premium to the extent it relates to the capital expenditure of $XX2 is neither capital expenditure on ‘plant’ (under its ordinary or extended meaning) nor expenditure on other depreciating assets to which Division 40 applies, and does not constitute ‘construction expenditure’ for capital works the purposes Division 43, section 43-70. Indirect costs We consider that the remaining costs of $XX2 for constructing the facility are indirect costs which relate to or serve the purposes of both the construction of capital works and the construction of ‘plant’ (or if not on plant or depreciating assets, is also not on capital works). The insurance premium which relates to the remainder of $XX2 is apportioned in the same proportion that the direct costs of the other elements (in Company A’s circumstances, the capital works and the ‘plant’ (or non-Division 43 items) bear to each other. Therefore, adopting the approach in TR 97/25, the insurance premium of Amount is apportioned in line with the total cost of construction of $ZZZ which are – inclusive of the apportioned, indirect costs as follows: ● Insurance relating to capital works ● Insurance relating to non-capital works such as ‘plant’ Construction expenditure The term ‘construction expenditure’ is defined in section 43-70 as capital expenditure incurred in respect of the construction of capital works. In this case, the insurance expense of $ZZZ is in part capital expenditure incurred in respect of the construction of capital works and in part in respect of something that is not ‘capital works’ such as the construction of ‘plant’ or Division 40 assets. In applying the approach in TR 97/25, we consider that the part of the Amount for capital works is deductible under Division 43. Construction expenditure area Section 43-115 provides that: (1) Your area is the part of the construction area that you own. (2) Your construction expenditure is the portion of the pool of construction expenditure that is attributable to your area. Company A owns the construction area (that is, ‘Your area’) and construction of the capital works will be completed in the current year of income. The Commissioner accepts that there is or will be a pool of construction expenditure because Company A is constructing the first part of the facility. Therefore, the entire part of the Amount for capital works that relates to the insurance expense in respect of the construction of the first part of the facility is attributable to ‘Your area’. Pursuant to section 43-30, Company A is not entitled to deduct any part of the Amount for capital works until construction is completed. As set out in the Relevant facts and circumstances , Company A will complete the construction of the first part of the facility during the current year of income, and the analysis which follows is based on Company A commencing deductions from the first day of the next year of income. Section 43-210 operates based on the number of days a taxpayer used the capital works in the requisite manner during a year of income following completion. The items of capital works for the construction of a building and of other facilities will be subject to the rate of 2.5% as these are part of the construction of a facility which has the requisite purpose under ‘Time period 1: After 30 June 1997’ and relates to ‘Any capital works’ which are used ‘… for the purpose of … producing assessable income …’. Section 43-145 does not apply to these two items of capital works as these items will not be used in a manner described in the row for ‘Time period 1: After 30 June 1997’ in the table in that section. These two items do not constitute ‘industrial activities’ as defined in section 43-150 for the purposes of the row for ‘Time period 1: After 30 June 1997’ in section 43-145 Table 43-145 sets out the way that you must use your area in an income year to be entitled to claim a deduction for capital works at a rate of 4%. Company A is constructing another building which will be wholly or mainly used by workers and their supervisors who are involved in carrying out certain processes which constitute ‘industrial activities’. We consider that the capital works in respect of the ‘other building relates to use that is mainly for ‘industrial activities’ and will also provide amenities and office accommodation for workers and supervisors involved in carrying out ‘industrial activities’ for the purposes of ‘Time period 1: After 30 June 1997’ in section 43-145. Application of section 43-210 Section 43-210 is the operative provision in determining the deduction in respect of the part of the Amount for capital works which was apportioned to the construction of capital works. We can further apportion the part of the Amount for capital works on a reasonable basis using the proportion of capital works that has a relevant rate of 2.5% compared to 4%. By applying the formulas provided in section 43-210 and the undeducted construction expenditure in Subdivision 43-G to the apportioned amounts it will calculate a deduction of: ● $V for Company A for the period commencing the next income year and then for each of the following 24 income years, and, ● after the above period, $W for Company A for each of the subsequent 15 income years. | Summary: Company A will be entitled to a deduction under subsection 40-880(2) for the part of the Amount for ‘plant’ and other over a five year period commencing in the current year of income. | Detailed Reasoning - Detailed reasoning: Section 40-880 provides for a deduction for certain business capital expenditure providing: ● the expenditure is not: ● deductible under a provision of the ITAA 1936 or ITAA 1997, and ● otherwise taken into account for income tax purposes such as being included in the cost base of a CGT asset or in the cost of a depreciating asset, and ● relevantly, the business is carried on for the purposes of producing assessable income, As set out in the Detailed reasoning for Question 1 above, the ‘insurance expense of Amount is capital in nature and is the entire Amount is not deductible under section 8-1. As set out in the Detailed reasoning for Question 2 , Division 40 does not apply to capital expenditure which is deductible for capital works under Division 43, subsection 40-45(2). Therefore, the part of the Amount that will be deductible under Division 43 (subject to the relevant rates and calculations) is the part of the Amount for capital works. The part of the Amount for capital works is not deductible under Division 40. Consequently, the remaining part of the Amount for ‘plant’ and other relates to insurance expense for the construction of plant and other assets. The remaining part being the Amount for ‘plant’ and other is deductible pursuant to section 40-880 for certain business capital expenditure (as it is not deductible under another provision of the ITAA 1936 or ITAA 1997 and is not included in the cost of a depreciating asset – which includes ‘plant’ – under Subdivision 40-C, or in the cost base or reduced cost base of a CGT asset under Division 110). Therefore, Company A is entitled to a deduction of $U in each year over five years pursuant to subsection 40-880(2) commencing in the current year of income.