Australia: Final ruling regarding deductibility of labor costs relating to capital assets

The Australian Taxation Office (ATO) released the final ruling (TR 2023/2) regarding the deductibility of labor costs relating to the construction or creation of capital assets.

The ATO maintains its view, as outlined in its prior draft ruling (TR 2019/D6), that labor costs incurred specifically in relation to the construction or creation of capital assets are capital in nature and therefore not deductible under the general deduction provision (Section 8-1 of the Income Tax Assessment Act 1997 (ITAA97)).

The final ruling made some small changes to the draft ruling, including two additional examples, and applies both before and after the date of issue.

The ruling applies to a broad array of labor costs, including salary and wages for employees who perform functions in relation to the construction or creation of capital assets, as well as other costs associated with the employment of that labor (e.g., leave-related payments and bonuses). In addition, other amounts for labor (or principally for labor) incurred in relation to the construction or creation of capital assets, such as contractor payments, are also covered. However, costs for which statutory deduction is available (e.g., super contributions, costs of managing tax affairs) are not covered.

Capital assets are defined as those assets constructed or created which form part of the profit yielding structure of a business entity, structure or organization. This includes both tangible and intangible assets, and therefore could cover activities such as software development.

While the ATO accepts that not all capital asset labor costs will be considered capital in nature, when capital asset labor costs are incurred specifically for constructing or creating a capital asset, the ruling states that the character of the costs is capital or capital in nature. These costs can be either direct functions (e.g., employee physically constructing or creating the asset), in support of the direct functions (e.g., project manager), or in support of functions that are a necessary component of the construction or creation activity (e.g., project finance manager). This analysis generally turns on the employment or other contractual arrangements and/or an understanding of the functions undertaken by the employees or contractors. Other factors include the terms of employment, job descriptions, key performance indicators of staff, the pattern of deployment, and working profile and practices of internal labor in those activities, and the accounting, control and governance systems used. A new example in the ruling outlines that employees seconded to the construction of an extension to a mine, but on standby due to industrial disputes, will still be considered to be employed specifically for the construction of that asset. That is, despite the fact that they are not working on the construction, the essential character of the labor costs is capital in nature.

The ATO considers that it is more likely that capital asset labor costs will be revenue in nature when the employee is employed specifically for undertaking functions and activities directed to the ordinary recurrent operations of the business, notwithstanding that an infrequent and incidental part of their time is spent on the construction or creation. The ATO now adds that this is a relative assessment based on the overall activities or functions of the employee or worker concerned. Here the ATO distinguishes employees employed in the day‑to‑day and ongoing operations of a business, who engage in activities that are capital in nature, but that engagement is infrequent or incidental in the context of their overall activities, duties and functions. The ATO considers that the essential character of the capital asset labor costs of those employees is wholly revenue in nature and apportionment is not relevant. Examples provided include a general manager responsible for overseeing the ongoing operations of an established and ongoing business, and who spends some time overseeing the construction or creation of a capital asset.

On the matter of apportionment of capital asset labor costs, the ATO states that the apportionment must be undertaken on a fair and reasonable basis, and that this includes a consideration of what information is practically available. A time-based apportionment may be the most appropriate methodology, when a business maintains records of the time spent by employees on particular activities. However, this may not always be appropriate. Examples of other methods which may be reasonable include an analysis of an employee’s job description or functions and expectations or historical knowledge about the proportion of time that the employee will devote to capital activities. One of the examples in the ruling cites a work breakdown structure as being appropriate for those facts.

While the ruling outlines that the accounting treatment is not a determinative factor of the character of the expenditure for income tax purposes, it can be a useful indicator in ascertaining the true nature of the costs. Further, it may also prove a useful indication of a reasonable basis for apportionment.

This matter is complex and has been the subject of ongoing technical debate. While the finalization of the ruling provides a level of clarity regarding the ATO’s view, there will continue to be many situations in which the delineation between costs “specifically” for the construction of asset and costs that are merely “incidental” with the construction will be difficult to determine.

While the comments in relation to apportionment have been somewhat expanded (e.g., to include some examples of the records and information that may assist in an apportionment), the guidance in this regard is still limited. The ATO states in the compendium to the ruling that it will continue to monitor the treatment of labor costs and the situations faced by business with a view of potentially issuing further guidance where necessary.