Income tax: when is Design Expenditure incurred by an R&D entity included in the first element of the cost of a tangible depreciating asset for the purposes of paragraph 355-225(1)(b) of the Income Tax Assessment Act 1997 (and therefore not able to be deducted under section 355-205)?

This Taxation Determination is concerned with where an R&D entity [1] incurs expenditure on various stages of design activities ( Design Expenditure ), connected with it beginning to hold a tangible depreciating asset, where that expenditure also falls within the terms of section 355-205. [2] This expenditure will typically be incurred in cases where the R&D entity is constructing the asset itself, or having another entity construct it on its behalf, as distinct from acquiring the asset 'off the shelf'. The asset begins to be 'held' by the R&D entity at the time that construction is completed. At this time the R&D entity is the legal owner of the asset, and therefore, the holder under item 10 in the table in section 40-40.

Design Expenditure is tested for whether it is included in the asset's first element of cost at the time the R&D entity begins to hold the asset: see subsection 40-180(1). This might be several years after the expenditure was incurred, and require a re-evaluation of whether or not amounts claimed under section 355-205, are deductible under that section because of paragraph 355-225(1)(b).

Subsection 40-185(1) in Division 40 relevantly means that Design Expenditure will only be included in the cost of the asset where it has been incurred 'in relation to holding' that asset. More particularly, subsection 40-180(3) will apply to include Design Expenditure in the cost of the asset where it has been incurred 'in relation to starting to hold' the asset, on the proviso that the expenditure is 'directly connected with holding the asset'. Whether Design Expenditure will be included in the cost of an asset for the purposes of Division 40 is a question of fact and degree, and will depend in large part on identifying the final shape, features and performance of the particular completed asset.

Design Expenditure will not be notionally deductible [3] under section 355-205 where it is covered by paragraph 355-225(1)(b) because it is 'included in the *cost [4] of a tangible depreciating asset for the purposes of Division 40 (as that Division applies as described in section 355-310 [5] or otherwise)'. [6]

Atlantis Innovations Limited ('AIL') carries on a worldwide salvage and undersea exploration and research business. Over what ends up being a five year project of R&D activities it contracts with various entities to design, construct and test a mini unmanned submersible vessel. If successful, AIL will use the mini unmanned submersible vessel in its undersea salvage business. All of the activities referred to below have been registered as 'R&D activities' under section 27A of the Industry Research and Development Act 1986. For the purposes of the Example it is assumed that there is no dispute that these activities do qualify as 'R&D activities' for this purpose, and for the purposes of Division 355.

In Year 1 of the project AIL engages a design company with specialist underwater vessel engineering expertise, to be involved as a technology partner. This collaboration is based however on AIL owning all the results and intellectual property arising from the project, including from the activities of the design company.

The activities of the design company in Year 1 only involve the collection and analysis of data, including numerous meetings with the directors of AIL to finalise the desired performance specifications of the new vessel, including the range of various types of sensors and other recording modules which might be able to be developed. Broad concept designs are developed by the design company in Year 1 to enable the directors of AIL to evaluate the feasibility of proceeding to the detailed design of the vessel, but no detailed designs which would allow the construction and testing of the vessel are produced at this stage.

While the work of the design company in Year 1 is directed broadly to bringing the new vessel into existence it concerns a preliminary stage of the project in which there is considerable uncertainty over the final shape, features and performance of the vessel. It is not possible therefore to say there is a direct connection between this expenditure AIL incurred to the design company and the bringing into existence of the vessel.

AIL decides to notionally deduct all of this expenditure under section 355-205 as it considers none of the expenditure will be included in the cost of the vessel for the purposes of Division 40.

In Year 2 AIL and the design company engage with a range of hardware and software developers and suppliers to evaluate the performance of existing sensor and recording module products in order to decide which new products of this type AIL will itself need to develop. At the end of Year 2 AIL has sufficient information to decide to build the full scale vessel, knowing however, that proof of the performance of the new technology will require a period of undersea trials.

The decision to commit to building the full scale vessel is also made knowing that during the detailed design and initial testing phase various technological challenges concerning the integration of the hardware and software elements may arise, and analysis of a range of options is likely to be necessary in order for these to be overcome.

AIL decides to notionally deduct all of this expenditure under section 355-205 as there is still considerable uncertainty over the final shape, features and performance of the vessel and it considers none of the expenditure incurred to the design company during Year 2 will be included in the cost of the vessel for the purposes of Division 40. This expenditure lacks the necessary direct connection to AIL beginning to hold the vessel as a tangible depreciating asset.

During Year 3 the design company spend a considerable amount of time in preparing detailed design documentation for the new vessel, including descriptions of the performance specifications for the new hardware and software elements. Various simulation techniques are used to test the integration of these elements, but these are limited in their ability to identify all of the problems that might be encountered in the construction of the new vessel.

All of the expenditure incurred by AIL to the design company in Year 3 is directed to bringing the new vessel into existence. However, it is not possible, at the end of Year 3, to predict accurately how much of this expenditure concerns elements of the design that will be part of the vessel that is constructed. The expert engineering evidence available to AIL shows however, that a considerable part of the design work performed in Year 3 that is the subject of this expenditure is likely to relate to features to be part of the final full scale vessel. That is, a considerable degree of certainty exists about the final shape, features and performance of the final full scale vessel.

AIL decides not to claim any of the expenditure as a notional deduction under section 355-205. AIL decides to wait until it begins to hold the vessel as a tangible depreciating asset in order to decide what proportion of the expenditure will be included in the cost of the asset for the purposes of Division 40.

During Year 4 construction of the full scale vessel commences along with onshore trials of various hardware components and their associated software in a mock-up of the vessel. These trials show a need to investigate three specific options for the integration into the vessel of certain sensors and four specific options for implementing the command system.

Eventually, after a considerable period of investigation by the design company, AIL is able to decide which one of the three specific sensor options is best, and which one of the four specific command system options is most appropriate.

During Year 4 there is a portion of expenditure incurred to the design company in this year that cannot be said to result in the final shape, features and performance of the vessel. That portion relates to those options for the sensors and command system which were investigated but ultimately rejected in deciding the final shape, features and performance of the vessel. AIL decides to notionally deduct that portion of expenditure under section 355-205.

In Year 5 AIL conducts additional trials. Various tests are performed at this time of the new hardware and software components to be incorporated [7] into the vessel. During the tests it becomes apparent that there are complications with the option chosen for the command system in Year 4.

AIL decides to review the other three specific command system options which had previously been rejected. AIL decides that one of those options should be re-considered in light of the complications encountered with the option that was chosen in Year 4.

AIL conducts some further investigation and decides that option is preferable to the one that was chosen. As a result, AIL incorporates that option into the completed vessel and confirms that option is most appropriate through further tests.

Completion of the construction of the vessel occurs towards the end of Year 5 and AIL is able to commence a detailed examination, in accordance with section 40-180, of the expenditures which form the 'cost' of holding the asset for the purposes of Division 40.

AIL decides that the cost will include the expenditure incurred to the design company in Year 3, as the examination shows all of this expenditure is directly connected with bringing the vessel into existence.

AIL decides that the cost will also include the expenditure incurred to the design company in Year 4 in relation to the command system option which was ultimately decided to be included in the completed vessel in Year 5 (refer paragraph 21 above). AIL therefore decides that expenditure related to that option should not have been claimed in Year 4 as a notional deduction under section 355-205 as it is excluded by paragraph 355-225(1)(b). Similarly, AIL decides that the cost will not include the expenditure incurred to the design company in Year 4 in relation to the command system option which was chosen in paragraph 17 above but subsequently rejected in Year 5 which can be notionally deducted under section 355-205 as it is not excluded by paragraph 355-225(1)(b).

AIL requests an amendment of its assessment for Year 4 to reflect the decisions made in paragraph 24 above about what expenditures can and cannot be claimed as notional deductions under section 355-205. The Commissioner is satisfied that in the circumstances of this example AIL had a reasonably arguable position and exercised reasonable care at the point in time when a notional deduction was claimed under section 355-205 for the expenditure incurred on the command system option which was investigated and rejected in Year 4 but included in the completed vessel in Year 5. As such, AIL will not be liable to any shortfall penalty amount for incorrectly claiming a notional deduction under section 355-205 for this expenditure.

In summary, the following expenditures incurred to the design company are not excluded under the cost exclusion as they are not included in the cost of the vessel for the purposes of Division 40: • Year 1 expenditure associated with the collection and analysis of data, identification of various types of sensors and other recording modules which might be able to be developed and the creation of broad concept designs. • Year 2 expenditure associated with evaluating the performance of existing sensor and recording module products in order to decide which new products of this type will need to be developed. • Year 3 and 4 expenditure on the sensor and command system options or on any other aspect of the design of the vessel not finding its way into the completed vessel. [8] The following expenditures incurred to the design company are excluded under the cost exclusion because, as AIL determines in relation to the completed vessel, once it has begun to be held, they are included in the cost of the vessel for the purposes of Division 40: • Year 3 expenditure associated with preparing detailed design documentation, including descriptions of the performance specifications for the new hardware and software elements, as well as expenditure on testing integration of the elements. • Year 4 expenditure on the sensor and command system options which were included in the completed vessel.

This Determination applies to years of income commencing both before and after its date of issue. However, this Determination will not apply to taxpayers to the extent that it conflicts with the terms of a settlement of a dispute agreed to before the date of issue of this Determination (see paragraphs 75 and 76 of Taxation Ruling TR 2006/10).

Section 355-205 allows an R&D entity to notionally deduct certain types of expenditure for the purpose of calculating any tax offset it is entitled to under section 355-100. [9]

The opening words of subsection 355-205(1) relevantly state: An *R&D entity can deduct for an income year (the present year ) expenditure it incurs during that year to the extent that the expenditure: (a) is incurred on one or more *R&D activities: (i) for which the R&D entity is registered under section 27A of the Industry Research and Development Act 1986 for an income year; and (ii) that are activities to which section 355-210 (conditions for R&D activities) applies; and ...

Section 355-225 describes a number of different types of expenditure that cannot be deducted under section 355-205. Paragraph 355-225(1)(b) describes one of these types as: expenditure included in the *cost of a tangible *depreciating asset for the purposes of Division 40 (as that Division applies as described in section 355-310 or otherwise)

The scope of the exclusion in paragraph 355-225(1)(b) (the cost exclusion ) is therefore governed by the measurement of 'cost' which applies for the purposes of Division 40, subject only to the qualification that this purpose may be affected by the modifications to Division 40 brought about by section 355-310. [10] Inclusion of the words 'for the purposes of Division 40' within the cost exclusion direct attention to how the cost of a depreciating asset is worked out under this Division. The words provide a clear textual pointer to working out the cost of an asset this way, that is, the same way as it would if only Division 40 applied to the asset, rather than Division 355.

The cost of a depreciating asset is worked out under Subdivision 40-C. Section 40-175 states that the cost of a depreciating asset held by an entity consists of two elements. The first element is specified in subsection 40-180(1) and is worked out at the time that the relevant entity began to hold the depreciating asset. Paragraph 40-180(1)(b) provides that the first element of cost is the amount the entity is taken to have paid to hold the asset under section 40-185, provided an item in the table in subsection 40-180(2) does not apply. None of the items listed in the table in subsection 40-180(2) are relevant in the circumstances to which this Taxation Determination applies.

In this regard it is important to note that there are no express or implied restrictions in Division 40 that confine the working out of the first element of cost of a depreciating asset to only expenditure incurred in the income year in which the asset starts to be held. This observation therefore also applies to the cost exclusion in paragraph 355-225(1)(b).

Subsection 40-185(1) relevantly states: This Division applies to you as if you had paid, to *hold a *depreciating asset... the greater of these amounts: ... (b) the sum of the applicable amounts set out in this table in relation to holding the asset... [emphasis added]

Subsection 40-180(3) can add to the first element of cost so that it includes an amount that the entity paid or is taken to have paid '...in relation to starting to *hold the *depreciating asset if that amount is directly connected with holding the asset. [11] ' (emphasis added)

Subsection 40-180(3) was introduced to the ITAA 1997 by the Tax Laws Amendment (2006 Measures No.1) Act 2006 and applies to expenditure incurred on or after 1 July 2005. Its introduction was part of a range of amendments to expand the cost of a depreciating asset by increasing the 'range of expenditures included as part of both the first and second elements of cost': refer paragraph 2.124 in the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No.1) Bill 2006 (the 2006 EM).

The phrase 'directly connected' is not defined, and takes its ordinary meaning according to the context in which it is used, as shaped by the purpose of subsection 40-180(3), which is to permit a broader range of amounts incurred in relation to starting to hold a depreciating asset to be included in the cost of that asset. An illustration of the type of connection that was intended to qualify as a direct connection between certain expenditure and starting to hold an asset is provided by Example 2.23 in the 2006 EM: Russ wishes to buy a computer for his business that is not available in Australia. After adequate research he concludes he would be able to obtain the computer from a company in Silicon Valley in the United States. Russ travels to Silicon Valley for the sole purpose of purchasing the computer. The travel costs would be included as part of the first element of cost of the computer because they are directed to and result in the purchase of the computer.

Example 2.23 suggests that subsection 40-180(3) involves an inquiry into how the asset in question has started to be held and how the particular expenditure is connected with the means by which that occurs. In the circumstances this Taxation Determination deals with, this inquiry involves examining the construction process and what that process has led to in terms of the final shape, features and performance of the completed asset.

Whether Design Expenditure will be directly connected with an R&D entity holding a tangible depreciating asset will therefore depend on how that asset comes into existence, and the role that the Design Expenditure played in that process. Design Expenditure to the extent it concerns the development of elements which form part of the final shape or features of the asset will qualify as being directly connected with holding that asset, and hence, come within subsection 40-180(3).

On the other hand, Design Expenditure which might be part of a project directed to bringing that asset into existence but which concerns the development of elements not forming part of the final shape or features of the asset will not come within subsection 40-180(3).

The time for testing whether Design Expenditure is included in the asset's cost for the purposes of Division 40 is at the time the R&D entity begins to hold the asset: see subsection 40-180(1). In some cases to which this Taxation Determination applies, that time may be several years after the time when the expenditure was incurred.

The operation of the cost exclusion in paragraph 355-225(1)(b) can therefore only be determined when the R&D entity begins to hold the asset for the purposes of Division 40. Thus the R&D entity may need to look back over the course of a project of R&D activities, in order to identify which Design Expenditure that otherwise is able to be notionally deducted under section 355-205, is not eligible as such, because of the cost exclusion.

The potential for delay between the time when Design Expenditure is incurred and when it can be determined whether it is included in the first element of cost of a depreciating asset for the purposes of Division 40 raises a question in such cases about the effect of section 40-215 and subsection 355-715(1). Section 40-215 operates to prevent expenditure being included in the cost of a depreciating asset for the purposes of Division 40 if that expenditure can be deducted under a provision, other than one in Divisions 40, 41 or 328. Subsection 355-715(1) is aimed more widely at preventing expenditure deductible under section 355-205, 355-480 or 355-580 from being taken into account in working out any deduction or tax offset otherwise allowable outside Division 355.

Section 40-215 and subsection 355-715(1) may arguably apply to preclude Design Expenditure from being included in the cost of the relevant depreciating asset if the R&D entity can be said to have had some temporary entitlement to deduct expenditure under section 355-205. But such an argument would conflict with paragraph 355-225(1)(b), which specifically contemplates that expenditure properly included in the cost of the asset for the purposes of Division 40 will not be deductible under section 355-205.

Resolving such conflict requires '...adjusting the meaning of the competing provisions to achieve the result which will best give effect to the purpose and language of these provisions while maintaining the unity of all statutory provisions.' [12] The purpose of paragraph 355-225(1)(b) is described in paragraph 3.70 of the Explanatory Memorandum to the Tax Laws Amendment (Research and Development) Bill 2010 as follows: Expenditure included in the cost of a depreciating asset (except an intangible asset) for the purposes of working out notional decline in value of the asset under the new R&D provisions is also excluded from the R&D expenditure provision. This simply reflects the priority of the R&D depreciating asset rules over the expenditure rules.

The priority referred to indicates that any conflict between paragraph 355-225(1)(b) and either section 40-215 or subsection 355-715(1) ought to be resolved in a way that results in a harmonious operation of them all. This is achieved by disregarding any possible temporary entitlement to a notional deduction under section 355-205 once it is concluded that the expenditure is properly included in the cost of the relevant asset for the purposes of Division 40. Under this approach neither section 40-215 nor subsection 355-715(1) apply to the circumstances in question.

An alternative view is that paragraph 355-225(1)(b) requires an entity to consider in each income year whether it has started to hold an asset for the purposes of Division 40. If an entity has started to hold an asset in that income year then the entity will need to identify which Design Expenditure that otherwise is able to be notionally deducted under section 355-205, is not eligible as such, because of the cost exclusion.

However, if the Design Expenditure relates to the holding of an asset which is not actually being held at the end of the income year in which that expenditure has been incurred then, under this alternative view, that expenditure is not caught by the cost exclusion.

The alternative view rests upon a particular temporal interpretation of the operation of paragraph 355-225(1)(b). Under this interpretation the expression 'included in the *cost of a tangible *depreciating asset for the purposes of Division 40' [13] in paragraph 355-225(1)(b) operates so that Design Expenditure is only excluded from being notionally deductible if it is included in the cost of an asset for the purposes of Division 40 in the income year that an entity considers the application of paragraph 355-225(1)(b). That is, the cost exclusion will not exclude Design Expenditure that is incurred by an R&D entity in any income year prior to that in which they start to hold an asset for the purposes of Division 40.

We do not agree with the alternative view. The words of paragraph 355-225(1)(b) do not suggest that there should be any change to the ordinary operation of Division 40. The words '...as that Division applies as described in section 355-310 or otherwise' support a conclusion that there is no intention to distinguish between amounts included in the cost of a tangible depreciating asset under Division 355 and those that would ordinarily be included when working out the cost of a depreciating asset under Division 40 as detailed in paragraphs 28 to 30 above.

A further alternative view is that where there is a delay between the time Design Expenditure is incurred and when it can be determined that it is included in the cost of an asset for the purposes of Division 40, section 40-215 and/or subsection 355-715(1) apply to preclude the Design Expenditure being included in the assets cost base, in such cases, as described in paragraphs 43 to 44 of this Determination.

For the reasons set out in paragraphs 44 to 46 of this Determination, the Commissioner does not accept this view.