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Is the cost of physical water stored on a farm at the time of acquiring the primary production business an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No. A deduction is not allowable under section 8-1 of the ITAA 1997 for the cost of the physical water stored on a farm where it is included as part of the cost of acquiring the primary production business.

Taxpayer settled a purchase contract to purchase a primary production business.

The parties to the contract were at arm's length.

At the time of settlement of the contract, there was water in farm storages (for example, dams). The water was harvested from water licences and allocations by the vendor and will be used by the taxpayer for crop irrigation in the primary production business.

The volume of water was accurately estimated at the time of settlement. The sale contract was silent as to the value of the water in storage at settlement date.

Section 8-1 of the ITAA 1997 allows a deduction for all losses or outgoings to the extent that they are incurred in gaining or producing assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, no deduction is allowed where the losses or outgoings are of a capital, private or domestic nature, or are incurred in gaining or producing exempt income, or another provision of the ITAA 1997 prevents the taxpayer from deducting them.

The purchase of harvested physical water in storage is clearly incurred in gaining or producing assessable income of the taxpayer. This is because the payment is made to acquire physical water necessary to irrigate the taxpayer's crop, and thereby earn assessable income from the crop. As such, the payment is incidental and relevant to the income earning activities of the taxpayer ( Ronpibon Tin NL and Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431; (1949) 4 AITR 236). The payment is not of a private or domestic nature or incurred in gaining or producing exempt income and no other provision of the ITAA 1997 prevents a deduction of the amount. Therefore, the amount will be an allowable deduction under section 8-1 of the ITAA 1997 provided it is not capital or of a capital nature.

Expenditure that strengthens and preserves the business entity or the profit-yielding subject is capital expenditure ( Sun Newspapers Ltd & Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87;) ( Sun Newspapers ). In Sun Newspapers Dixon J discussed at CLR 359; ATD 93-94 the distinction between capital and revenue expenditure by saying that it: ...corresponds with the distinction between the business entity, structure, or organisation set up or established for the earning of profit and the process by which such organisation operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns represent profit or loss.

His Honour discussed that the capital/revenue distinction reflected the difference between the profit-yielding subject and the process of operating it. At CLR 360; ATD 94 Dixon J stated that: ...expenditure and outlay upon establishing , replacing and enlarging the profit yielding subject may in a general way appear to be of a nature entirely different from the continual flow of working expenses which are or ought to be supplied continually out of the returns or revenue. The latter can be considered, estimated and determined only in relation to a period or interval of time, the former as at a point of time (emphasis added).

It is considered that expenditure incurred in respect of the acquisition of physical water in storage as part of the acquisition of a business is not deductible to the purchaser under section 8-1 of the ITAA 1997 because it is of a capital nature.

Such expenditure is capital in nature because it has the character of that which relates to the profit-yielding structure of the business ( Sun Newspapers ) rather than being incurred as part of the cost of trading operations to produce income. All the components of the business acquired, including the physical water, are considered to be expenditure on the profit-yielding subject, rather than an independent expenditure as part of the day-to-day activities of carrying on the business. The characterisation of the expenditure is determined by the character of the overall transaction that it is a part of. The expenditure relates to the acquisition of the means of production or to the implements or articles employed in work and is different from the continuous flow of working expenses relating to the process of operating the business. The expenditure arises at one point in time only. It was paid by the taxpayer as an integral and inseparable part of the purchase price in return for acquiring the business. It is therefore a capital outgoing.

In QCT Resources Limited v. Commissioner of Taxation (1997) 97 ATC 4079; (1997) 34 ATR 504 ( QCT Resources ), Drummond J at ATC 4086; ATR 512-513 confirmed this view by stating: .....where part of the cost of acquiring a new business of a kind not previously conducted by the purchaser is an outgoing which will be similar in kind to revenue outgoings which the purchaser can expect to make in the future, once it commences to trade: in this situation, the character of the advantage sought by making the particular outlay is the same as that sought from making the other outlays which together comprise the price paid for acquiring the capital asset, viz, the new business as a going concern. From a practical and business point of view, there is no justification for characterising one component of the stated price paid to acquire such an asset differently from any of its other components: the entire price has to be paid to acquire the new business.

The Federal court's decision in QCT Resources was upheld on appeal to the Full Federal Court.

Accordingly, as part of the acquisition of the primary production business, a deduction is not allowable under section 8-1 of the ITAA 1997 for the cost of the physical water stored on the farm. This cost is of capital in nature.