Research and Development: building expenditure

Does the exclusion for 'expenditure incurred in the acquisition or construction of a building' in the definition of 'research and development expenditure' in subsection 73B(1) of the Income Tax Assessment Act 1936 (ITAA 1936), include revenue expenditure?

Yes. Expenditure incurred by a taxpayer in the acquisition or construction of a building, whether on capital or revenue account, is excluded from being 'research and development expenditure' as defined in subsection 73B(1) of the ITAA 1936.

A property developer acquired and subdivided land for development. On one parcel of land the property developer is constructing a commercial building under contract for a purchaser.

The building plans contain a design for an innovative heating system which runs throughout the external walls.

In the year ended 30 June 2010 the property developer registered the heating system as its research and development (R&D) project with Innovation Australia under section 39J of the Industry Research and Development Act 1986 .

The property developer's expenditure related to the construction of the building was incurred on revenue account. This expenditure includes an amount incurred on installing the heating system in such a way as to deny any basis on which that system might be regarded as a separate asset.

The property developer is an eligible company as defined in subsection 73B(1) of the ITAA 1936.

Subsection 73B(14) of the ITAA 1936 allows a concessional deduction for 'research and development expenditure', should certain conditions be met.

'Research and development expenditure' is defined in subsection 73B(1) of the ITAA 1936 and excludes, relevantly for these purposes, ...expenditure incurred in the acquisition or construction of a building or of an extension, alteration or improvement to a building.

This exclusion is referred to as 'the building exclusion'. 'Building' is defined in subsection 73B(1) of the ITAA 1936, as including 'part of a building'. However, the other parts of the building exclusion are not defined.

In Kennedy Cleaning Services Pty Ltd v. Petkoska , (2000) 200 CLR 286 at 304, the High Court confirmed that the words of a statutory definition should be given their ordinary meaning unless the contrary is clearly intended.

In determining the scope of the exclusion, consider first the meaning of 'acquisition or construction'. In Tully Co-operative Sugar Milling Association Ltd v. FC of T 82 ATC 4454; (1982) 13 ATR 410, the Supreme Court of Queensland considered these terms in relation to the eligibility of new units of property for deduction under former section 82AB of the ITAA 1936. Thomas J said that the consistent use of both 'acquisition or construction' as alternatives strengthened the view that: ... a taxpayer could acquire an item of property such as a new... pump, and ... could claim this deduction on the footing that he had acquired a new unit. But if he acquired it as a component of a larger new unit of property which he was himself constructing... it would be unnecessary for him to claim the deduction to which he would be entitled from acquiring the pump. He would be entitled to claim the full "expenditure... in respect of the ... construction by him of a new unit of eligible property" and that expenditure would include the cost of acquiring the pump.

His Honour allowed the objection in part and the Commissioner appealed to the Full Federal Court ( FC of T v. Tully Co-operative Sugar Milling Association Limited 83 ATC 4495; (1983) 14 ATR 495). The Full Court did not specifically address the above proposition. However, it held there was no error in how the primary judge had approached the case. Further, Fox J stated: As I see it, the intention of the legislature is that 'acquisition' and 'construction' are between them intended to cover all cases, although they will commonly have application at different times in the development of a project.

In the circumstances here the heating system is part of the external walls of the building and is an integral part of the building. The expenditure on installing the heating system is incurred in the 'acquisition or construction' of a building.

There is nothing in the ordinary meaning of the expressions used in the building exclusion which limits their application to expenditure on capital account. Therefore, it is necessary to look at whether there is anything else which may indicate that the ordinary meaning was not to apply in construing the building exclusion.

The proper interpretation requires the relevant context be considered in the first instance, and by using 'context' in its broadest sense ( CIC Insurance Ltd v. Bankstown Football Club Ltd (1997) 187 CLR 384 at 408).

Part of the relevant context is the legislative history. The precursor to section 73B of the ITAA 1936, section 73A of the ITAA 1936, was introduced in 1946 to 'enlarge the deductions allowable in respect of scientific research expenditure' (EM to the Income Tax Assessment Bill 1946, clause 11). Subsection 73A(1) of the ITAA 1936 provided for a deduction of an amount, '(other than any amount which is allowable as a deduction under any other section of this Act)', for a person carrying on a business for: (a) Payments to: (i) an approved research institute for scientific research related to that business; or (ii) an approved research institute, the object of which is the undertaking of scientific research related to the class of business to which that business belongs; and (b) Expenditure of a capital nature on scientific research related to that business (except to the extent that it is expenditure on plant, machinery, land or buildings or on alterations, additions or extensions to buildings or in the acquisition of rights in or arising out of scientific research).

Section 73A of the ITAA 1936 therefore contained an exclusion in relation to expenditure on buildings not dissimilar from that later introduced in subsection 73B(1) of the ITAA 1936. However, paragraph 73A(1)(b) of the ITAA 1936 was only capable of applying to expenditure of a capital nature, and hence, only had practical application where the expenditure had already met that requirement. The relevant capital expenditure excluded from deduction under paragraph 73A(1)(b) was eligible for a three year write off under subsection 73A(2) of the ITAA 1936, where the building was 'of use for scientific research purposes only'.

As paragraph 73A(1)(b) of the ITAA 1936 applies only to capital expenditure, for building expenditure incurred on revenue account to be deductible it would have to be a payment to which paragraph 73A(1)(a) of the ITAA 1936 applies. As payments to an approved research institute are in the nature of the performance of a service, it is highly unlikely they could have involved expenditure on buildings.

When section 73B of the ITAA 1936 was introduced in 1986 it contained the building exclusion as it is currently expressed. Although section 73B differed from section 73A of the ITAA 1936 (which was not repealed at that time), in some key aspects, it broadly followed the scheme of section 73A in its treatment of building expenditure.

Neither section 73B of the ITAA 1936 nor the relevant explanatory memorandum prescribed that expenditure attracting the concession had to be capital or revenue in nature. It did however, under subsection 73B(17) of the ITAA 1936, provide for a three year write-off for building expenditure of a capital nature, in circumstances where the building was exclusively used for research and development (R&D) purposes. Subsection 73B(17) of the ITAA 1936 was subject to strict integrity measures, and was repealed in 1988 to: ...ensure more efficient use of the revenue available for research and development activities by focusing upon more productive, and innovative, investments (Second Reading Speech to the Taxation Laws Amendment Bill (No 5) 1987 Taxation Laws Amendment Act (No. 5) 1988 in the House of Representatives, by the Minister assisting the Treasurer)

Building expenditure of a capital nature incurred on R&D activities has not attracted concessional treatment since.

There is no evidence of an intention that building expenditure on capital account was to be subject to these strict rules but that building expenditure on revenue account was not.

There is therefore nothing which requires an interpretation of the building exclusion which would result in building expenditure of a capital nature being ineligible for concessionary treatment, while allowing building expenditure of a revenue nature to be immediately deductible at 125% (initially 150%), and not subject to any integrity measures.

Therefore, there is no basis for reading down the building exclusion to apply to building expenditure of a capital nature only. The exclusion takes its ordinary meaning, and refers to all relevant building expenditure, whether incurred on revenue or capital account.

Accordingly, expenditure incurred on the acquisition or construction of the heating system, in circumstances where that system is an integral part of a building, whether on revenue or capital account, is excluded from the definition of 'research and development expenditure', and is not deductible under subsection 73B(14) of the ITAA 1936.