Private ruling: deductions
Published: June 2015
Ruling period: Year ended 30 June 2007 | Year ended 30 June 2008 | Year ended 30 June 2009 | Year ended 30 June 2010
Date scheme commenced: 1 July 2006

Ruling: Q1: Are you entitled to a deduction for the cost of developing concept building plans under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No.

Relevant facts and circumstances: You were incorporated several years ago. You are the trustee of the Unit Trust (the trust). The trust was established several years ago. The purpose of the trust was the conducting of a business involving: • Commercial property development; and • The holding and leasing of the property in the long term. No other business has been conducted by the trust. Prior to several years ago, a related entity purchased a small property development with the purpose of aiding the development of a competitive environment. Tenant A was situated in this property development. This property development was dilapidated and in decay. Some tenants terminated and the development shut down. Subsequently, the development was demolished and the land sold years later as vacant land. Several years ago, you purchased land nearby the above development. The land was to be used in the development of a new commercial property (including a commercial lease enterprise with the securing of an anchor tenant and then smaller tenants). You have stated that an anchor tenant is crucial for the success and financial stability of a project such as this as they 'draw' traffic and accordingly, other tenants into the development, especially for this type (and size) of development. Your directors' duties included liaising with leasing agents and indirectly with prospective tenants, and also communicating with relevant government departments. They also had charge of conferring with consultants and experts as well as the executive decision making and financial review of the project, and liaised with investors and financiers. A director also acted as project manager, and now manages most aspects of the development and leasing of the development. Your directors are experienced in property development. One of the directors has a long history in property development, and is the owner and director of a company that specialises in property development. Currently one of the directors is involved in the development of another property development. The other director is an experienced property developer who is also has a profession. Shortly after acquisition of the land, you appointed a marketing and leasing agent to procure and manage future tenancy arrangements. Their first role was to secure the anchor tenant. At a later date, you began discussions with Tenant A on a proposed tenancy agreement in the development with the hope that they would become its anchor tenant. You have stated that in order to provide for your financial security and stability, you were seeking to lock them in as an anchor tenant for more than 15 years and in consideration of this, you designed a layout and concept plan for them. You engaged architects, designers, engineers, surveyors and planners to work on the requirements of the proposal being negotiated with Tenant A. As part of this, you engaged a Design Group to prepare a concept plan and then the more detailed 'working drawings' (for example the placement of tiling, air conditioning, refrigeration, lighting, toilets, internal walls and ceilings (cold fit-out)). After approximately two years and after you became concerned about Tenant A's lack of evidence supporting their financial commitment (for example directors guarantees and related guarantees), the low rate of rental offered and their demands for $xM to be contributed by you towards the fit-out, negotiations between you and Tenant A ended. As a result, the concept and working drawing plans for Tenant A were concluded. You had received no income from Tenant A during this period in relation to the development. At another later date, you commenced lease arrangements with Tenant B. In order to negotiate their tenancy, you had to incur expenses to prepare a new concept plan and a new architect was engaged (this architect was familiar with the requirements of Tenant B). Continuing on from this, you incurred further expenditure on the next phase of the project which involved the development of detailed drawings and plans. You continued to work with Tenant B on the final drawings for the development. The Tenant B plans were later agreed to and Tenant B signed as the anchor tenant. Negotiations with Tenant B to this point had taken approximately two years. After securing the anchoring tenant and marketing the new development (including the presence of its anchor tenant), you were able to secure subsequent tenancies. Construction of the property development commenced (after securing finance for the construction costs from the Bank) and was completed. The property development opened. The first lease payments were received from Tenant B once they commenced operations at the development.

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

Reasons for decision: Detailed Reasoning - Deductions: Subsection 8-1(1) of the ITAA 1997 states: 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. Subsection 8-1(2) of the ITAA 1997 continues: However, 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 a 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 your non-assessable non-exempt income; or (d) a provision of this Act prevents you from deducting it. You have stated that you are relying on the provisions of paragraph 8-1(1)(b) of the ITAA 1997 which is concerned with carrying on a business for the purpose of gaining or producing assessable income. It is important to break down this paragraph to fully examine some of its elements. | Detailed Reasoning - Business: Business is defined in section 995-1 of the ITAA 1997 as: "any profession, trade, employment, vocation or calling, but does not include occupation as an employee." The question of whether a taxpayer is engaged in a business is essentially based on the facts of each taxpayer's own situation. A number of factors need to be considered. We stress that no one indicator is decisive ( Evans v. FC of T 89 ATC 4540; (1989) 20 ATR 922), and there is often a significant overlap of these indicators. The indicators must be considered in combination and as a whole. Whether a business is being carried on depends on the 'large or general impression gained' ( Martin v. FC of T (1953) 90 CLR 470 at 474; 5 AITR 548 at 551) from looking at all the indicators, and whether these factors provide the operations with a 'commercial flavour' ( Ferguson v. FC of T (1979) 37 FLR 310 at 325; 79 ATC 4261 at 4271; (1979) 9 ATR 873 at 884). However, the weighting to be given to each indicator may vary from case to case. Indicative factors to determine whether a business is being carried on are listed at paragraph 18 of Tax Ruling TR 97/11 Income Tax: am I carrying on a business of primary production? (TR 97/11). Whilst TR 97/11 is concerned with identifying the business of primary production, the factors listed are common to all businesses and are as follows: whether a significant commercial activity exists, the purpose and intention of the taxpayer in engaging in the activity, whether is an intention to make a profit, the regularity and repetition of the activity, whether the activity is carried on in a similar manner to that of ordinary trade, whether it is carried on in a businesslike manner, the size and scale of the activity, whether the activity could be classified as a hobby, recreation or sporting activity, whether there is a commercial sale of product, and if the taxpayer has the knowledge or skill in this area. | Detailed Reasoning - Your circumstances: The issue in your case is perhaps not so much whether or not you are carrying on a business, as it is what that business might be. An entity's business is usually defined by the activity that generates its income. In your case, you were formed to develop and lease out a property development. The only income you generate is from the leasing of space within the development. The only business it could therefore be said that you operate is the leasing out of commercial premises. It cannot be accepted that you conduct a business of developing commercial rental developments. To date you have only developed a single property development and that was for the purpose of leasing out that centre long term. There has been no repetition in your development activities, nor the derivation of any income directly from the construction of the development you did construct, such as from its sale short term. It is accepted that the costs were incurred as part of an overall business activity of leasing commercial space; but not part of a separate and distinct development business. Although the construction of the property development was part of your final business activity (leasing commercial space); this is seen as no different to having purchased an existing development to lease out. | Detailed Reasoning - For the purpose of gaining or producing your assessable income.: For paragraph 8-1(1)(b) of the ITAA 1997 to apply to the expenditure at issue, it would need to be considered to have been necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. The courts have used different approaches to determine whether an expense was necessarily incurred in carrying on a business. Hill J described these approaches in Commissioner of Taxation v. Firth (2002) 120 FCR 450; 2002 ATC 4346; (2002) ATC 4336: The nature of that connection has been expressed in different ways in the cases. It is sometimes said that there must be a "perceived connection" between the loss or outgoing and the assessable income or business: FC of T v Hatchett 71 ATC 4184 at 4187; (1971) 125 CLR 494 at 499. In other cases it has been said that the expenditure must be "incidental and relevant" to the operations or activities regularly carried on by the Taxpayer for the production of income: Ronpibon Tin NL & Tongkah Compound NL v FC of T (1949) 8 ATD 431 at 435; (1949) 78 CLR 47 at 56, FC of T v Smith 81 ATC 4114 at 4117; (1980-1981) 147 CLR 578 at 586. These ways of describing the connection that is a necessary prerequisite to deductibility are but part of the process of identifying the essential character of the expenditure in order to determine whether a particular loss or outgoing is in fact incurred in gaining or producing the assessable income or in carrying on a business which more directly contributes to the gaining or production of the assessable income: Lunney v FC of T (1958) 11 ATD 404 at 413; (1957-1958) 100 CLR 478 at 499. [emphasis added] | Detailed Reasoning - Your circumstances: The expenses relating to the concept plan development for the tenants were incurred while you were developing the property development. You did not receive (and did not expect to receive) any income during the development stage; these expenses were therefore not incurred for the 'purpose of gaining or producing your assessable income'. In your case, the expenses at issue were incurred prior to you producing any assessable income. It was only after the property development was built that you were in a position to derive income; income in the form of lease payments. You have stated that the design and developmental work, ongoing negotiations and approvals and licences are all 'part and parcel' of the work to market and secure financially viable lease agreements. Whilst we understand the connection between this work and the subsequent securing of tenants, we consider the purpose to be one that was incurred too remote in time from the production of assessable income. The purpose of incurring expenditure on concept plans was to ensure that you had an anchor tenant (and other tenants) rather than being a regular and on-going cost associated with the eventual gaining or producing of assessable income. Although we do not consider that the expenditure qualifies for a deduction under subsection 8-1(1) of the ITAA 1997, for completeness, it is still necessary to consider the conditions imposed by subsection 8-1(2) of the ITAA 1997 - the 'negative limbs' of section 8-1. | Detailed Reasoning - Negative limbs of section 8-1 of the ITAA 1997: In accordance with subsection 8-1(2) of the ITAA 1997, expenses which are capital or capital in nature are not deductible under section 8-1 of the ITAA 1997 even if these satisfy the tests set out in subsection 8-1(1). According to the decision in British Insulated & Helsby Cables Ltd v. Atherton [1926] AC 205 if an enduring benefit is gained then the expenditure is to be regarded as being capital. This type of expenditure can be distinguished from recurring operating expenses incurred prior to the earning of assessable income such as bank interest. Bank interest incurred prior to the deviation of income was held to be deductible ( Steele v. FC of T 99 ATC 4242; (1999) 41 ATR 139) (Steele's case) whereas concept plan expenditure is capital in nature regardless of whether any related income has been derived at a later date. You have referred to the decisions and commentary in Sun Newspapers Ltd and Associated Newspapers Ltd v FC of T (1938) 5 ATD 87 1938 61 CLR 337; GP International Pipecoaters v Federal Commissioner of Taxation (1990) 170 CLR 124; 90 ATAR 4413; (1990) 21 ATR 1, Tyco Australia Pty Limited v Commissioner of Taxation (2007) FCA 1055 and Western Gold Mines (NL) v Commissioner of Taxation (1938) 59 CLR 729 which all discuss the distinction between revenue and capital outgoings. It has been established from these cases (and we agree) that it is the character of the expenditure, and the nature of the advantage sought in a whole business context that is important in determining if an expense is of a capital or income nature. Further, you highlighted the decisions in BP Australia v Federal Commissioner of Taxation (1965) 112 CLR 386; 1965 9 AITR 615 (which involved incentive payments for service stations to buy BP products), National Australia Bank v Federal Commissioner of Taxation (1997) 80 FCR 352; 97 ATC 5153; (1997) 37 ATR 378 (about a payment to secure the right to provide Commonwealth subsided loans to Australian Defence Force personnel) and Tyco Australia Pty Ltd v FC of T 2007 ATC 4799 (regarding payments to contractors to secure customers). In all of these cases, the payments were made to expand upon an existing business. In other words, revenue was already being earned in their particular business and the payments were made simply to secure additional business. This can be contrasted with your situation and the cost of the developing concept plans associated with the fit outs for the anchor tenants. In that case, you were not earning income from the property development, this was not an expansion of an existing business rather it was a setting up cost of a new business. You also referred to the decision in Federal Commissioner of Taxation v CityLink Melbourne Ltd (2006) 228 CLR1 (about the fees paid to secure concession rights and impose tolls). In this case, the concession fees were likened to periodic licence fees. The costs were similar to the bank interest allowed in Steele's case but can be contrasted to the expenses in your situation, where the cost of concept plans were a capital cost and not an ongoing operating expense. You also cite Income Tax Ruling IT 2631 Income Tax: Lease Incentives (IT 2631) and in particular paragraph 38. Whilst it is true that the provision of lease incentives would usually give rise to an allowable deduction to the lessor, this is not the case 'if the landlord retained ownership of the fit-out. In that case, the expenditure is capital in nature and not an allowable deduction' (paragraph 38 of IT 2631). In your case, the 'lease incentives' in question were the provision of 'cold' fit-outs for anchor tenants (that is, flooring, tiling, general fit out etc) and the fit-outs remained your property. Accordingly, the cost of developing these fit-outs through concept plans would not be an allowable deduction under IT 2631. | Detailed Reasoning - Your circumstances: In your case, it is considered that even if the expenditure related to the concept plans for the anchor tenants could be seen as being incurred in the business of leasing property tenancies, it is not deductible as it is capital in nature. The concept plans provide an enduring benefit to both the tenant (so they have a premises that suits their business) and to you (as you have a satisfied anchor tenant who is contacted to remain in the complex for a number of years and will bring other smaller tenants into the centre). The cases you cite can be distinguished from your situation, and the Commissioner's view expressed in IT 2631 (in relation to the cost of fit outs that remain the property of the landlord) supports a view that would disallow your claim to deduct the expenditure under section 8-1 of the ITAA 1997. It is also worth noting that the Commissioner considers that preliminary expenditure such as architect fees forms part of the construction expenditure of a building (Taxation Ruling 97/25, paragraph 9). 'Construction expenditure' is capital expenditure incurred in respect of capital works. These expenses fall for consideration as a deduction under Division 43 of the ITAA 1997 rather than section 8-1; although as previously advised in the ruling which issued to you on 18 July 2014, as far as the planning in relation to a potential Tenant A's tenancy is concerned, the fact that no construction actually took place, means that a no deduction arises under Division 43. | Detailed Reasoning - Conclusion: As you derived no assessable income (and did not expect to) from the development stage of the property development, expenditure incurred on the anchor tenants concept plans cannot have been incurred for the purposes of earning assessable income. It is doubtful whether there is a sufficient connection between the concept plan expenditure for both the anchor tenants, and the business of producing assessable income as the landlord of a property development. However, regardless of whether such a connection is sufficient, the concept plans for the anchor tenants are capital in nature as they were commissioned to result in an enduring benefit and so are not deductible under section 8-1 of the ITAA 1997.