Capital Allowances: depreciating asset - composite item

Are the taxpayer's aircraft engine and airframe (to which the engine may be attached) separate depreciating assets within the meaning of that term in section 40-30 of the Income Tax Assessment Act 1997 (ITAA 1997) where the engine is the subject of a particular engine rotation arrangement?

Yes. The taxpayer's aircraft engine and airframe (to which the engine may be attached) are separate depreciating assets within the meaning of that term in section 40-30 of the ITAA 1997 where the engine is subject to the particular engine rotation arrangement.

The taxpayer is the legal owner of an aircraft engine and an airframe to which the engine may be attached. The taxpayer leases, under the same lease agreement, both the engine and the airframe to an unrelated entity (the lessee). The lease does not alter the taxpayer's standing as the holder of both the engine and the airframe under item 10 of the table in section 40-40 of the ITAA 1997.

The lessee also leases, on similar terms, several other aircraft engines and airframes from their various legal owners (the aircraft lessors). The leases do not alter the respective aircraft lessor's standing as the holder of both the engine and the airframe under item 10 of the table in section 40-40 of the ITAA 1997. The taxpayer is unrelated to both the lessee and the aircraft lessors.

The lessee also leases from further unrelated entities (the engine lessors) several aircraft engines without any airframes.

All of the aircraft engines the lessee leases are interchangeable with all of the airframes the lessee leases. The taxpayer, lessee, aircraft lessor and engine lessor contemporaneously entered into an engine rotation arrangement under which any leased engine may be attached to any leased airframe at any time during the course of the respective leases. The arrangement does not alter any of the lessors' standing as the legal owner and Division 40 of the ITAA 1997 holder of their engine and/or airframe. The arrangement does, however, separately and specifically provide for certain events such as the termination of the lease and the destruction of the engine or airframe during the term of the respective lease. While the outcome can vary according to the event, the arrangement provides that the engine may be dealt with separately to the airframe with which it was leased or to which it was attached at the time of the event.

Each aircraft engine is, pursuant to a scheduled maintenance program, detached from its airframe for overhaul and replaced with an engine available to the lessee under the engine rotation arrangement. The lessee utilises the engine rotation arrangement to make the most efficient use of its engines and airframes.

(All legislative references in this Interpretative Decision are to the ITAA 1997 unless otherwise noted).

A depreciating asset is broadly defined in subsection 40-30(1) as an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used.

An aircraft is a composite item within the ordinary meaning of that expression as it comprises a number and variety of components. Some of these components have operational uses in the taxpayer's business operations in various ways and over differing periods.

For a composite item, subsection 40-30(4) requires consideration of whether the composite item is itself a depreciating asset or whether its components include separate depreciating assets. The subsection says that the answer to the question will be a matter of fact and degree to be objectively determined in light of all the circumstances of the particular case.

Subsection 40-30(4) is followed by examples which provide guidance in two situations, one in which a composite item makes a single depreciating asset, the other in which a composite item does not make a single depreciating asset.

There is no basis to conclude that subsection 40-30(4) or its examples, because they lack express reference to separate components that are not in themselves capable of being depreciating assets, must be interpreted to mean that if something that can be described as a composite item is not, as a finding of fact and degree, itself a depreciating asset, then its components must each be treated as separate depreciating assets for the purposes of Division 40.

Subsection 40-30(4) is not a provision that applies or operates to mandate or deem a single particular factual outcome. Its purpose is to require the consideration, in an objective way, of a composite item as to whether the composite item or its separate components are or are not depreciating assets for the purposes of Division 40.

In accepted principles of statutory interpretation, ascertaining the meaning of words of a provision takes account of the context in which they appear and the purpose which the words were meant to serve. The legislative history can indicate the intention to which a particular provision has been directed.

Some relevant explanation is provided by paragraph 1.15 of the Revised Explanatory Memorandum to the New Business Tax System (Capital Allowances) Bill 2001. This Bill introduced section 40-30.

The paragraph states that judgement is required to be exercised in the objective identification of the depreciating asset where the asset in question is a composite item. The paragraph further suggests that the 'functionality test' that was used as a basis of identifying a unit of plant in the then existing plant depreciation rules can be used in the identification process in a modified manner taking into account the differences in the bases to the definitions of plant and depreciating asset. The purpose of such examination then, is not to test components of a composite asset as separate 'units' but to test the components for definable, separately identifiable and discrete function and then completeness in that function but not necessarily self-containment or isolation in that function.

In the context of a provision that seeks to define what a depreciating asset is, it is apparent that the determination or question intended to be addressed by subsection 40-30(4) is identification of the relevant item or thing to be tested as to its standing as a depreciating asset.

In particular, the operative purpose of subsection 40-30(4) is to provide practical guidance about how the determination as to whether a particular composite item is itself a single depreciating asset is to be made.

In that sense, subsection 40-30(4) does not change the law as it relates to the identification of a component that is a depreciating asset. Subsection 40-30(4) does mandate an objective consideration of the relevant things that might be considered to be a composite item and its components in order to identify either the (single) thing that is a depreciating asset, or the separate (multiple) things that might themselves be depreciating assets.

Here, the thing that might be considered to be a composite item is the whole of the aircraft including the engine and the airframe. In the ordinary case of a taxpayer who starts to hold that composite item, it might be argued that the composite item is a single depreciating asset (see Taxation Ruling IT 333). However, the particular engine rotation arrangement in this case provides some further contextual environment in which identification of the relevant depreciating asset must be made. In particular: • the taxpayer can and does deal separately with the engine and airframe, particularly on destruction of one of them or on termination of their lease • an identical engine can be, and is separately leased from the airframe and from different entities • the engine is, and is intended to be, interchangeable with other engines owned and/or held by other unrelated entities • the taxpayer's engine is not, nor is it intended to be, a permanent part of any particular airframe which can, and are, owned and/or held by other unrelated entities, and • an inherent feature of the scheduled maintenance program is that the number of engines the lessee leases is always in excess of the number of airframes they lease.

In addition to the physical functionality of the aircraft engine of providing propulsion for the airframe, all of the factors listed above identify an inherent functional characteristic of mobility and inter-changeability of the engine. The particular engine rotation arrangement in this case supports that view from the perspective of all of the parties to the arrangement.

Accordingly, the taxpayer's aircraft engine has a functional identity separate from the taxpayer's airframe and is, itself, a separate depreciating asset.