Capital allowances: tax break - expenditure in respect of the construction

Is the capital expenditure incurred by the taxpayer after it has committed to the construction of its assets 'expenditure in respect of the construction' of the assets for the purposes of subsection 41-25(3A) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes. The capital expenditure incurred by the taxpayer after it has committed to the construction of its assets is 'expenditure in respect of the construction' of the assets for the purposes of subsection 41-25(3A) of the ITAA 1997 because the expenditure has the necessary material and relevant connection with the construction of the assets and the incurrence of the expenditure objectively verifies the making of the commitment.

The taxpayer applies certain management processes and procedures in order to decide whether it will commit to a proposed business project involving the construction of particular tangible depreciating assets. Once a project is approved, the taxpayer has made a definite commitment to proceed with the construction of the particular assets. At the same time as the approval decision, the taxpayer also first incurs capital expenditure on labour or materials that is included in the first element of the assets' cost.

All legislative references are to the ITAA 1997 unless otherwise stated.

Division 41 allows an additional deduction for certain business investment in new, tangible depreciating assets and for new expenditure on existing assets - the 'tax break'.

To be eligible for the tax break, a taxpayer must evidence a commitment to invest in a qualifying asset within the legislated time frames. This requirement is an element of the definition of recognised new investment amount in paragraph 41-20(1)(b) which provides that the 'investment commitment time' for the amount must occur in the period starting on 13 December 2008 and ending on 31 December 2009.

The expression 'investment commitment time' is defined in section 41-25. For purchased assets, subparagraph 41-25(1)(a)(i) provides that the time of entering into the contract under which the asset is, or will be, held is the investment commitment time. In the case of self-constructed assets, the investment commitment time under subparagraph 41-25(1)(a)(ii) for an amount that is included in the first element of the asset's cost is the time at which you start to construct the asset.

For the purposes of subsection 41-25(3A), you are treated as having started to construct an asset at a time when you first incur expenditure in respect of the construction of the asset.

The use of the expression 'in respect of' indicates that the expenditure in question is not limited to expenditure incurred on the actual construction of the asset. The words expand or enlarge the range of expenditure that will be counted for the purposes of determining the investment commitment time for an amount.

This interpretation is consistent with the Tax Office interpretation of subsection 43-70(1) which uses the same expression to define 'construction expenditure' as 'capital expenditure incurred in respect of the construction of capital works'. Taxation Ruling TR 97/25 at paragraph 9 confirms that 'construction expenditure' includes not just the cost of the structure itself but preliminary expenses such as architect fees and engineering fees.

It is also consistent with the Tax Office interpretation of the former investment allowance rules. Under former subsection 82AB(1) of the Income Tax Assessment Act 1936 a taxpayer could deduct capital expenditure incurred 'in respect of the construction' of a new unit of eligible property. In FC of T v. Tully Co-operative Sugar Milling Association Limited 83 ATC 4495; (1983)14 ATR 495 Fitzgerald J said at ATC 4506; ATR 506: 'Expenditure "in respect of" construction may in appropriate cases include costs of purchases...' In addressing his honour's comments, Taxation Ruling IT 2142, states at paragraph 13: 'Since his honour suggested that such expenditure "may in appropriate cases include costs of purchases", it would follow that "construction" may commence before the actual physical work of assembly or the like begins.'

Although the statutory phrase 'in respect of' uses wide words of connection, the closeness of the connection or relation that is required between expenditure incurred and construction turns on an examination of the legislative context. Case law considering the meaning of the same expression where it is used in other legislative enactments illustrates the importance of context as an aid to establishing what Parliament intended. In Workers Compensation Board (Q) v. Technical Products Pty. Ltd . (1988) 165 CLR 642; [1988] HCA 49 and Technical Products v. State Government Insurance Office (Qld ) (1989) 167 CLR 45; [1989] HCA 24, the High Court considered the context of the particular legislative provisions as an indicator of whether the connection between two subjects was both material and relevant and so capable of being described as 'in respect of' each other. In these cases, the court found that the context constrained or narrowed the connection that was required between the two subject matters identified. The expression was not so wide as to include any distant relationship or remote nexus between the connected subjects.

The legislative context in which the expression 'in respect of' appears is therefore an important indicator of its intended scope. The purpose of the tax break is highlighted in paragraph 1.5 of the Revised Explanatory Memorandum to the Tax Laws Amendment (Small Business and General Business Tax Break) Bill 2009 (the EM) which states: 'The role of the Tax Break is to stimulate new investment by Australian businesses. The temporary nature of the measure provides an incentive for businesses to bring forward and sustain new capital investment in the current economic climate.'

To be eligible for the tax break a taxpayer must make a commitment to invest within the legislated time frames. For assets that are purchased, this commitment is evidenced at the time of entering into the relevant contract. For assets that are self-constructed, the analogous commitment occurs when expenditure in respect of the construction is first incurred.

Therefore, the context indicates that it is only expenditure that evidences a commitment to proceed with the construction which is covered by the expression expenditure 'in respect of' construction. Expenditure that falls short of evidencing this commitment because it is incurred before there is a definite decision to proceed with the construction, or expenditure that only has a remote or tenuous connection with the construction of an asset will not signify the investment commitment time. Having regard to the context of the investment commitment rules, expenditure of this type does not exhibit the material or relevant connection with the construction for it to qualify as being 'in respect of' the construction. Accordingly, it will not be expenditure that triggers the investment commitment time in relation to an asset.

This interpretation of the intended reach of the expression 'in respect of' is confirmed by examples 1.16 and 1.18 of the EM. In example 1.16 the company's directors sign off a decision to proceed with the construction of new transmission power lines and the company then incurs expenditure by ordering materials required for the construction. In example 1.18 the company starts to order some of the materials it needs to construct a new conveyor belt although work on the physical construction of the asset does not commence for a few weeks.

The examples show that 'expenditure in respect of construction' is intended to cover not just the expenditure incurred directly on the actual construction activities, but also expenditure incurred at an earlier time that evidences a commitment to future construction. They highlight that incurring expenditure on the materials has the necessary material and relevant connection with the construction of the asset. In both situations, it can be seen that there was a decision to construct the new asset and the incurrence of the expenditure on materials objectively verifies the making of the commitment. Accordingly, the expenditure signifies the investment commitment time in relation to the particular assets. As the EM notes at paragraph 1.108, the test for self-constructed assets in requiring the incurrence of expenditure in respect of the construction, is both 'objective and verifiable'. In this sense it is analogous to entering into a contract to purchase an asset.

In the present case, the taxpayer has made a decision to commit to the construction of particular assets. At the same time, the taxpayer incurs expenditure on labour or materials that is included in the first element of the assets' cost. The expenditure on labour or materials has the necessary material and relevant connection with the construction of the assets. The incurrence of the expenditure objectively verifies the making of the taxpayer's commitment to the construction. Therefore, the expenditure is 'expenditure in respect of the construction' of the assets for the purposes of subsection 41-25(3A). Note: At the time the taxpayer first incurs expenditure in respect of the construction of the assets, the taxpayer is treated as having started to construct the particular assets under subsection 41-25(3A). It follows that this is the investment commitment time for the purposes of subparagraph 41-25(1)(a)(ii).