The consultation process is open after the Australian Taxation Office (ATO) released the long-awaited Draft Taxation Ruling 2019/D6 concerning the deductibility of labour costs related to the construction or creation of “capital assets”.
This is an issue which is an area of concern for many taxpayers, and one which we are aware that the ATO has been expending significant resources, with a particular focus on the infrastructure, energy production and distribution, oil, gas and mining industries. However, the ATO has flagged that the Draft Ruling has broader implications for any business constructing or creating capital assets. Accordingly, taxpayers across all industries where significant internal labour resources are deployed to develop capital assets should consider what impact the Draft Ruling has on their tax position
Submissions on the Draft Ruling are due 14 February 2020.
What counts as capital assets or capital asset labour costs under the Draft Ruling
In broad terms, while section 8-1 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) allows a general deduction from a taxpayer's assessable income of any loss or outgoing in certain circumstances, section 8-1(2)(a) then denies the deduction if the loss or outgoing is capital or of a capital nature.
For the purposes of the Draft Ruling, “capital assets” are tangible and intangible assets that are constructed or created and form part of the profit yielding structure of a business entity, structure or organisation.
The Draft Ruling applies to taxpayers who incur labour costs (ie. "capital asset labour costs") that are:
- salary and wages for employees who perform functions in relation to the construction / creation of capital assets and other costs associated with the employment of that labour (ie. other costs that are in substance paid because an entity’s labour has been provided such as leave / bonuses / allowances etc.); and / or
- other amounts for labour or principally for labour incurred in relation to the construction / creation of capital assets (ie. contract payments to a person or a labour hire firm for personnel who in substance perform work activities for an entity on the same basis as their employees do).
Further, the Draft Ruling does not apply to certain capital asset labour costs such as costs which are specifically taken not to be an outgoing that is capital or capital in nature or costs which are made deductible under other provisions.
How the Draft Ruling would affect the deductibility of capital asset labour costs
In broad terms, the ATO’s position as set out in the Draft Ruling is as follows:
- to the extent that capital asset labour costs are incurred “specifically” for constructing or creating capital assets, their essential character is capital or capital in nature – and therefore a deduction is denied under section 8-1(2)(a) of the ITAA 1997;
- it is a question of fact and degree whether capital asset labour costs are incurred “specifically” for constructing a capital asset;
- the cost of personnel who have a:
- remote connection with the construction / creation of the capital asset; or
- who have a broader role that involves incidental activities connected with the construction / creation of the capital asset,
- will generally not be regarded as being incurred “specifically” for constructing or creating a capital asset;
- any apportionment of capital asset labour costs should be on a fair and reasonable basis (with relevant records / evidence to substantiate such apportionment) – while the accounting principles are not a determinative factor of the character of expenditure incurred, the accounting treatment may be a useful indication of a reasonable basis of apportionment; and>
- although the High Court decision in Steele v Deputy Commissioner of Taxation [1999] HCA 7 supports the position that section 8-1(2)(a) of the ITAA 1997 should not operate to deny a deduction for capital asset labour costs (Alternative View), the ATO does not agree with the application by analogy of the High Court decision to this issue.
In broad terms, the High Court in Steele held that interest is ordinarily a recurrent or periodic payment which secures, not an enduring advantage, but rather the use of borrowed money during the term of the loan, and its character is not altered by reason of the fact that the borrowed moneys were used to acquire a capital asset.
Planning for (or commenting on) the Draft Ruling
The ATO is proposing that the final ruling applies both before and after its date of issue (though it will not apply to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of issue of the final ruling).
Once finalised, Taxation Rulings are not binding on taxpayers and they do not have the status or effect of law. Applying the law in a way that differs from a Taxation Ruling will be relevant to any penalties imposed by the ATO if the ATO seeks to apply its view by issuing an amended assessment and imposing a penalty. While this is a factor that should be considered, a Taxation Ruling is, in essence, just the ATO’s view of the application of the legislation to particular circumstances.
Nonetheless, you should carefully review the Draft Ruling and consider whether to adopt the ATO’s approach, assuming the Draft Ruling is finalised in its current form. If so, you will need to retain detailed records / evidence to substantiate apportionment consistent with the ATO’s view as set out the Draft Ruling.
Given the nature of the issue and the taxpayers affected, we expect to see taxpayers challenge the ATO’s view in court, either by claiming the deductions for the labour costs, or lodging a tax return consistent with the ATO’s view and then self-objecting. If the deductibility of labour costs related to constructing or creating capital assets is of significant value to you, you should keep records evidencing the application of the Alternative View ie. that the labour costs are deductible, even if you intend to apply the ATO’s view in the first instance as it is possible that the court may find against the ATO on this issue and subject to whether time has expired and whether any extension can be given, you could then file an amended assessment on that basis.
Those taxpayers who are concerned that the ATO’s position as set out in the Draft Ruling is not practical, workable or correct, may wish to make a submission by the deadline of 14 February 2020.
If you have concerns about the correctness of the ATO’s position or its application to your circumstances, including the effect of the Alternative View, or need help in making a submission we would be happy to help.