29 November 2019
It always comes as a surprise when some fundamental question of tax law, which seemed to be well settled, suddenly becomes controversial. In this case, the controversy stems from the ATO’s Draft Taxation Ruling TR 2019/D6. The Draft Ruling takes the position that ‘labour costs … incurred specifically for constructing or creating capital assets [are] of a capital nature and therefore cannot be deducted …'. This position would have a significant impact during the construction phase of mining and resource projects and other large infrastructure projects.
The story so far
This is not a new question, but it has been litigated only very rarely; the ATO has almost never argued that wages were not deductible. In part, that could be because it is not common practice for employers to use their own staff to build the business’ capital assets – staff would create the trading stock and the processes leading up the creation of trading stock, but they would typically occupy, operate and repair the capital assets; capital assets would more often be bought rather than built. And in part the reason could be, on those occasions where the employer did utilise its own staff, the staff were only infrequently engaged and for short periods of time; no-one thought they were required to track and allocate the time of staff who were mostly occupied doing other things. But whatever the reason, it seems everyone accepted wages were the archetypal deductible expense.
So uncontroversial was the issue that there have been only a handful of judgments where it has been directly tested by Australian Courts:
- in the 1991 case Goodman Fielder the ATO took the position that expenses associated with one of the company’s research laboratories was not deductible. The expenses involved were (i) wages, travel, vehicle leasing expenses and journal subscriptions for staff, (ii) vehicles, laboratory supplies, consumables, computer systems, couriers and cleaning for the laboratory and (iii) entertainment of overseas visitors. The ATO lost the argument but the issue was not clearly decided: the Court took the view that the expenses were deductible either because they were not of capital nature or they were R&D expenses deductible under a dedicated provision which extended to capital outlays, so it was unnecessary to decide the issue;
- also in Goodman Fielder the ATO took the position that the salary paid to an employee who was seconded (for about 3 weeks) to assist in a suit alleging a breach of the company’s patent was non-deductible. Again, the ATO lost the argument. The Court said it was, ‘totally unreal’ to require apportionment of his salary between time spent in research and time spent working on the patent infringement matter;
- in Lister Blaxtone the ATO denied a deduction for the costs of moving trading stock to new premises, including the wages paid to staff involved in the relocation. The High Court held the expenses of moving the stock were deductible; and
- in the 1986 Ampol Exploration case the ATO argued that wages paid by a company engaged in oil exploration (as well as outlays on rent, transport and other services) were non-deductible. Again the ATO lost.
But the cases were not entirely unequivocal: in Goodman Fielder the Court emphasised that the salary being disputed was for work directed to protecting an existing patent, not work ‘towards the obtaining of patent rights …’; the judge also implied wages might be non-deductible if, ‘a person is employed for the specific purpose of carrying out an affair of capital;’ and one judge dissented in Ampol Exploration.
The Draft Ruling
Against this backdrop, the Draft Ruling says that wages and some other labour costs will not be deductible under s. 8-1 of the Income Tax Assessment Act 1997 if they are ‘incurred specifically for constructing or creating capital assets.’ There are three important elements in this formulation.
Which expenses. The Ruling says it extends beyond salary and wages to include on-costs such as long service leave, annual leave, sick leave, and similar leave, and bonuses and allowances. Presumably it would extend to the cost of providing purchased fringe benefits though and the cost of FBT since they too are deducted under s. 8-1. But the Draft Ruling does not extend to the cost of employer contributions to superannuation funds since they are deducted under other provisions. By the same logic it would not extend to retirement allowances.
The Ruling also extends to payments made to entities which are not employees: ‘payments to … a labour hire firm for people who … perform work activities for an entity on the same basis as their employees do.’ Presumably this position is asserted because the wages paid by the labour hire firm will be fully deductible, but it has the effect of denying the payer a deduction for the portion of its cost which represents the profits of the labour hire firm.
Which employees. The Ruling says it applies to the amounts paid to, ‘employees who perform functions in relation to the construction or creation of capital assets.’ Apparently this means not just payments to ‘those involved in the construction work itself,’ but extends to payments for ‘those who perform functions in relation to the construction or creation of capital assets.’ The Ruling contrasts those people with ‘employees [with] a remote connection with constructing or creating capital assets’ or employees with, ‘a broader role that involves incidental activities connected with constructing or creating capital assets …’
The Ruling alludes to the dividing line but does attempt to not define it. Instead it gives some examples:
- amounts paid to a General Manager with responsibilities for the entire business, who is currently devoting 1 day per week to a new construction project, will not be affected,
- amounts paid to members of the project team set up to establish the new construction project will be affected, until it is operational; and
- amounts paid to staff who are seconded to the construction project for part of their time will need to be apportioned.
None of the examples directly examines the treatment of amounts paid to staff undertaking general administrative functions for the entire company – eg, an in-house tax manager.
Which assets. The Ruling says it extends to amounts connected with, ‘tangible and intangible [assets] constructed or created which form part of the profit yielding structure of a business entity, structure or organisation.’ Amounts connected, ‘acquiring an item of trading stock are excluded.’
So what happens instead?
The Draft Ruling does not venture beyond answering its immediate question. The obvious question which follows is, what happens next:
- is the denied amount added to the cost of some asset, or added to a project pool, and recovered under a depreciation regime (Div 40 or Div 43), or
- is it added to the cost base of an asset and recovered when some CGT event (such as disposal or termination) happens to the asset, or
- has the Ruling simply shifted the denied expenses into the black hole regime where they will be deducted over 5 years?
What do wages buy?
Finally, there is an important question behind the Draft Ruling which our Courts have been reluctant to address. The question being, what do wages buy? We have seen this issue already in Steele’s case where the question was, what does interest buy? And we saw the issue in the Australian National Hotels case where the question was, what does an insurance premium buy?
The issue in all these cases is the same: how far beyond the immediate outlay must a taxpayer look in classifying an outlay? The issue in Steele’s case was whether interest was the cost of having the use of money for a period, or whether it was part of the cost of the asset the money was spent to buy. The issue in Australian National Hotels was whether an insurance premium is the cost for a year’s worth of insurance, or whether it was part of the cost of the asset being insured. The same issue arises here: are wages the cost of having the use of labour for the period of the engagement, or are they part of the cost of what the labour produces?
The Draft Ruling is alive to this issue and simply says, interest is different: ‘… interest is generally not capital … because it secures … the use of the borrowed money during the term of the loan [while] capital asset labour costs … do secure an enduring advantage …’ Just why interest is different is not explained; it is simply asserted. It seems equally convincing to reason that ‘[salary] is generally not capital … because it secures … the use of the [contracted labour] during the term of the [engagement].’
The Draft Ruling is open for comment until 14 February 2020. The ATO has been consulting on these issues with Industry bodies for some time and has been applying these views in audits. It is therefore unlikely that the final Ruling will be materially different. So the real next steps will be the issue of amended assessments and litigation.