Private ruling: Making of an election under section 40-365 of the ITAA 199
Date of advice: 15 August 2016
Published: September 2016
Ruling period: Year ended 30 June 20WW | Year ended 30 June 20XX | Year ended 30 June 20YY
Date scheme commenced: 1 July 20VV

Ruling: Q1: Will the Commissioner exercise his discretion under subsection 40-365(3) of the Income Tax Assessment Act 1997 (ITAA 1997) and extend the time required to acquire a replacement asset up to 20YY? | A1: Yes

Relevant facts and circumstances: The taxpayer is seeking an extension to 20YY in which it can make the choice to apply the balancing adjustment against the cost of the replacement machine. In the 20VV income year the taxpayer suffered an incident in one of their factories which destroyed a machine they use in their production process. This machine was written off by their insurer. After a clean-up compensation was received from the insurer in 20VV. The amount received was disclosed in the application. During the year ended 20WW the taxpayer reviewed possible replacement machines. This review included travelling to examine similar machines in operation. The manufacturer of the written off machine was chosen as the best supplier of the replacement machine and an order was made in late 20WW. A deposit of 10% was made with the total cost on the same date. It was the taxpayer's intent to apply a balancing adjustment against the cost of the replacement asset. In 20WW the taxpayer was advised by their insurer that they were potentially going to subrogate the claim against the written off machine back to the manufacturer. In 20XX the insurer advised the taxpayer that they would not insure the replacement machine if certain conditions were not rectified. The taxpayer attempted to arrange an engineering solution so that the replacement machine would be acceptable to the insurer. After a number of months of negotiations no resolution was obtained so the taxpayer cancelled the order and a refund of the deposit was received in 20XX. The taxpayer is now looking for another machine and still wishes to apply a balancing adjustment against the cost of the replacement asset. Once ordered the machine will take up to a year to manufacture.

Relevant legislative provisions: ITAA 1997 subsection 40-365(3)

Reasons for decision: Summary: The Commissioner will exercise his power under paragraph 40-365(3)(b) of the ITAA 1997 to allow the taxpayer until 20YY to incur expenditure on a replacement depreciating asset subsequent to the involuntary disposal of the original asset due to an incident. | Detailed Reasoning - Detailed reasoning: Section 40-365 of the ITAA 1997 allows a taxpayer to choose whether or not to include a balancing adjustment amount in their assessable income where they cease to hold a depreciating asset because it is destroyed. The taxpayer can choose to use some or the entire amount that would otherwise be a balancing adjustment as a reduction in the cost and/or opening adjustable value of one or more replacement assets. The cost of the replacement asset is reduced by the otherwise assessable amount. This exclusion can only be made where they incur the expenditure on the replacement assets 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 (paragraph 40-365(3)(b) of the ITAA 1997). In this instance the depreciating asset was destroyed by an incident in the 20VV income year. So in following paragraph 40-365(3)(b), unless an extention was granted, the taxpayer had until 20WW to incur the expenditure on the replacement asset. This date has passed and the taxpayer is seeking an extension to 20YY to incur the expenditure on the replacement asset. In looking at the circumstances in which the Commissioner allows a further period the Revised Explanatory Memorandum to the New Business Tax System (Capital Allowances) Act 2001 (the EM) states at paragraph 3.82: Examples of when the Commissioner may allow a further period under paragraph 40-365(3)(b) include: • in the event of a destruction of large infrastructure assets it will be likely to take… more than 12 months to rebuild those assets, and there are no suitable corresponding assets acquired within 12 months before or after the destruction; or • in the event of the replacement asset being acquired from overseas it will be likely to take more than 12 months to deliver such assets, and there are no suitable corresponding assets acquired within 12 months before or after the destruction. A further example of when the Commissioner may agree to extend the time under paragraph 40-365(3)(b) of the ITAA 1997 is provided in the Guide to Depreciating Assets 2016 (NAT 1996-06.2016), which states that if it is unlikely that the insurance claims for the original asset will be settled within the required time even though you have taken all reasonable steps to have the insurance claim settled, an extension of time may be granted. The example in the Guide to Depreciating Assets 2016 in respect of insurance delays was explained in more detail in ATO Interpretative Decision ATO ID 2002/1000 (Withdrawn) Income Tax Involuntary disposal - extension of time in acquiring a replacement depreciating asset . The reasons for decision in this ATO ID stated in part: Support for this decision can be drawn from Taxation Determination TD 2000/40 which explains the operation of paragraph 124-75(3)(b) of the ITAA 1997 (the capital gains tax treatment of acquiring another (replacement) asset). Both the wording and the operation of paragraph 40-365(3)(b) of the ITAA 1997 are similar to paragraph 124-75(3)(b) of the ITAA 1997. TD 2000/40 lists a number of examples where the Commissioner will allow further time where special circumstances exist. The circumstances outlined in those examples are analogous to the circumstances of this taxpayer. Taxation Determination TD 2000/40 Income tax: capital gains: what are 'special circumstances' for the purposes of subsection 124-75(3) of the Income Tax Assessment Act 1997? , also lists a number of examples of when the Commissioner will allow further time to incur expenditure if special circumstances exist and examples 2 and 3 state: | Detailed Reasoning - Example 2:: 5. Gordon owned a wool processing factory which was destroyed by fire. Gordon immediately commences to negotiate to purchase a nearby factory, taking possession pending settlement. After lengthy negotiations, however, the purchase of the factory falls through. He then purchases another property but just outside the 2 year time period. On these facts, we would accept that Gordon has done what is reasonable to acquire a replacement asset and we would allow him further time . | Detailed Reasoning - Example 3:: 6. Graeme had a commercial property compulsorily acquired by a State authority. Graeme is having a protracted legal dispute with the authority over the quantum of the compensation. On these facts, we would accept that there are special circumstances to allow further time . In looking at all the above examples in which the Commissioner allows further time the factors that the Commissioner uses to make a favourable decision are delays outside the control of the taxpayer or situations where construction time makes it difficult (or impossible) to replace the asset within the required time. In this case the insurance payout was received reasonably promptly. So unlike the example in the Guide to Depreciating Assets 2016 there was no great delay in the settlement of the insurance claim. However complications with the taxpayer's insurance company are a major factor in the delay in acquiring the replacement machine. In looking at the actions undertaken by the taxpayer before 20WW, they: • undertook a search for a replacement asset, • ordered the replacement asset; and • paid a deposit on the replacement asset. As at 20WW the replacement asset still had to be constructed and pay the remainder of the cost of the new machine. The replacement asset was ordered from the company that manufactured the original machine and after it was ordered the taxpayer was advised by their insurer that they were potentially going to subrogate the claim against the original machine to the manufacturer. At a later date the insurer then advised that they would not insure the replacement machine if changes were not made to the machine. The taxpayer attempted to negotiate an engineering solution with the manufacturer so that the replacement machine would be acceptable to their insurer. However a solution was not reached and they cancelled the order and has begun a search for a machine that will be acceptable to the insurer. Considering that the asset has to meet specific requirements and be constructed to order it is reasonable to expect that it could take more than 12 months to source a suitable replacement asset. In addition it is understandable that any replacement asset would need to meet the approval of the insurer. In looking at the longest gap in the time line (being the date of the insurance payout and the date the replacement was ordered), had the replacement been ordered sooner, the taxpayer would have still had the same issues with their insurer. The only change would have been that the replacement machine would have been closer to completion when the taxpayer was informed that it would not be insured. Like example 2 in TD 2000/40 the purchase of the replacement asset fell through once the taxpayer got to the position where they concluded that an engineering fix was not going to occur. The effect of this is that the taxpayer had to commence a search for a replacement machine again. There is also a lengthy built time which is similar to the examples contained in the EM so once ordered it will still take 9-12 months before the asset will be delivered to the taxpayer. On consideration of the facts and circumstances and consistent with the principles and guidance in the EM, Guide to Depreciating Assets 2016 and TD 2000/40, the Commissioner will exercise his power under paragraph 40-365(3)(b) to grant a further period of time until 20YY to incur the expenditure on the replacement asset (or start to hold it).