Capital Allowances: deductible balancing adjustment amount for plant started to be constructed before 1 July 2001

Can the taxpayer deduct an amount under subsection 40-285(2) of the Income Tax Assessment Act 1997 (ITAA 1997) equal to the cost to it of constructing plant on land it leases under a sublease agreement at the time the taxpayer terminates the sublease?

No. The taxpayer cannot deduct any amount under subsection 40-285(2) of the ITAA 1997 because Division 40 of the ITAA 1997 does not apply to plant whose construction started before 1 July 2001, nor had the taxpayer deducted amounts for plant under the depreciation provisions in former Division 42 of the ITAA 1997, nor could the taxpayer have deducted amounts under that Division for the plant if the taxpayer had used it, or had it installed ready for use, for the purpose of producing assessable income before 1 July 2001.

The taxpayer subleased land from an entity (the sublessor) in 1995. The land was to be developed and used in the taxpayer's business.

The sublessor is not an exempt Australian government agency or an exempt foreign government agency. The land was leased to the sublessor by an exempt Australian government agency.

Subsequent to securing the sublease from the sublessor and during the remainder of 1995, the taxpayer incurred capital expenditure on constructing improvements on the site intended for use in its production process. The improvements were attached to the land.

Problems encountered with the development of the site, together with the fact that significant further expenditure was required before production could start, caused the taxpayer to cease further development. The taxpayer had not deducted amounts for the plant under former Division 42 of the ITAA 1997.

In 2007 the taxpayer terminated the sublease.

An amount may be deducted under subsection 40-285(2) of the ITAA 1997 if: (a) a balancing adjustment event occurs for a depreciating asset a taxpayer holds and: (i) whose decline in value was worked out under Subdivision 40-B of the ITAA 1997, or (ii) whose decline in value would have been worked out under that Subdivision if the taxpayer had used the asset, and (b) the asset's termination value is less than its adjustable value just before the event occurred.

Division 40 of the ITAA 1997 applies to depreciating assets a taxpayer constructed if the construction started after 30 June 2001. However, section 40-10 of the Income Tax (Transitional Provisions) Act 1997 (IT(TP)A 1997) ensures that Division 40 of the ITAA 1997 applies to certain plant held by a taxpayer at 1 July 2001, or of which a taxpayer was the owner or quasi-owner at the end of 30 June 2001. In particular, Section 40-10 of the IT(TP)A 1997 applies if, among other things, the taxpayer: • has deducted or can deduct amounts for plant under the depreciation provisions in former Division 42 of the ITAA 1997, or • could have deducted amounts under that Division for the plant if the taxpayer had used it, or had it installed ready for use, for the purpose of producing assessable income before 1 July 2001.

The taxpayer in this case started constructing the plant before 1 July 2001 and did not deduct amounts for it under former Division 42 of the ITAA 1997. Therefore, for section 40-10 of the IT(TP)A 1997 to apply to effectively transition the plant into Division 40 of the ITAA 1997, the taxpayer would need to have been able to deduct amounts for the plant under former Division 42 of the ITAA 1997 if the taxpayer had used it, or had it installed ready for use, for the purpose of producing assessable income before 1 July 2001.

The depreciation provisions in former Division 42 of the ITAA 1997 applied to assessments for the 1997-98 income year and later income years until the introduction of Division 40 of the ITAA 1997 which took effect on 1 July 2001.

To deduct an amount for depreciation of plant for an income year under former Division 42 of the ITAA 1997, the taxpayer must have been the owner or quasi-owner of the plant in that year (former section 42-15 of the ITAA 1997).

The common law principle is that if an improvement is attached to land, it becomes part of the land and is legally owned by the landowner. In this case the taxpayer is not the owner of the plant attached to the land as the taxpayer does not own the subleased land.

The meaning of 'quasi-owner' relevant to this case is contained in former section 42-310 of the ITAA 1997. Under that section, a taxpayer is a quasi-owner of plant only if, among other things, the plant is attached to land the taxpayer holds under a quasi-ownership right granted by an exempt Australian government agency or an exempt foreign government agency.

For the purpose of former Division 42 of the ITAA 1997, a quasi-ownership right over land means a lease of the land; an easement in connection with the land; or any other right, power or privilege over the land, or in connection with the land (subsection 995-1(1) of the ITAA 1997). This same definition of quasi-ownership right over land applies for the purposes of Division 40 of the ITAA 1997. Relevantly, paragraph 1.41 of the Explanatory Memorandum to the New Business Tax System (Capital Allowances) Bill 2001, which introduced Division 40 of the ITAA 1997 states (at paragraph 1.41): An entity has a quasi-ownership right if it is the successive owner of such a right. For example, a sublessee will have a quasi-ownership right. The quasi-ownership right need not be held from an Australian government or government agency, a requirement for depreciation under the current law.

As the taxpayer in this case holds a sublease of the subject land, it has a quasi-ownership right over the land.

However, to be the quasi-owner of plant under former section 42-310 of the ITAA 1997, the taxpayer's quasi-ownership right over land must have been granted by an exempt Australian government agency or an exempt foreign government agency.

The former meaning of 'exempt Australian government agency' in subsection 995-1(1) of the ITAA 1997 was: (a) the Commonwealth, a State or a Territory; or (b) an authority of the Commonwealth, or of a State or Territory, if ordinary income derived by the authority would be exempt from income tax because of a provision referred to in the definition of relevant exempting provision in section 160K of the Income Tax Assessment Act 1936 .

The meaning of 'exempt foreign government agency' in subsection 995-1(1) of the ITAA 1997 covers certain governments and authorities of governments of foreign countries.

The lease of the subject land to the sublessor was granted by an exempt Australian government agency. However, the sublessor is not itself an exempt Australian government agency or an exempt foreign government agency.

Former section 54AA of the Income Tax Assessment Act 1936 (ITAA 1936) provided that a taxpayer who was the lessee of land under a Crown lease and who installed property on the land was the deemed owner of the property for the purposes of the former depreciation provisions in the ITAA 1936. Since the meaning of 'lessee of land under a Crown lease' in that section was effectively adopted by former Division 42 of the ITAA 1997 as the meaning of 'quasi-owner' when that Division replaced the depreciation provisions in the ITAA 1936, it is relevant to consider the Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 5) 1992, which inserted a number of amendments to former section 54AA of the ITAA 1936 to broaden its application. That Explanatory Memorandum stated: Also covered are "sub-interests" in land such as sub-leases and licences in relation to easements. For instance, a Commonwealth authority may hold a lease of land granted by a State and a sub-lease of that land granted by the authority would constitute a Crown lease. Similarly, a State authority may hold an easement over private lands for the purposes of installing water or gas pipes. A licence or other right in relation to that easement granted by the authority will again constitute a Crown lease.

It is clear from the examples given in the Explanatory Memorandum that, while a Crown lease could include 'sub-interests' such as a sublease of land and a licence in relation to an easement, it was necessary that the sublease or licence be granted by (in the language of the ITAA 1936 provision) an 'eligible government body' (the equivalent of 'exempt Australian government agency' and 'exempt foreign government agency' for the purposes of former Division 42 of the ITAA 1997).

In this case, as the sublease of the subject land was not granted to the taxpayer by an exempt Australian government agency or an exempt foreign government agency, the taxpayer is not the quasi-owner of the plant for the purpose of former Division 42 of the ITAA 1997.

As the taxpayer is neither the owner nor the quasi-owner for the purpose of former Division 42 of the ITAA 1997, it follows that it could not have deducted amounts under that Division for the plant, even if it had been used, or installed ready for use, for the purpose of producing assessable income before 1 July 2001.

This means that Division 40 of the ITAA 1997 does not apply to the plant and at the time the taxpayer, by terminating the sublease, stops holding the land under a quasi-ownership right, it will not be entitled to any deduction under subsection 40-285(2) of the ITAA 1997.