Wages: Deductible or a capital expense?

We’ve made our New Year resolutions but there are some challenges ahead flowing from one of the Commissioner’s early Christmas presents.

The dividing line between capital and revenue expenditure has long been murky, despite ~50 years of guiding principles.  On 21 November 2019, the Commissioner released Draft Taxation Ruling TR 2019/D6 (Draft Ruling) outlining the Commissioner’s view on when certain labour costs related to constructing or creating capital assets (tangible or intangible) are capital expenses and therefore cannot be deducted under section 8-1 of the Income Tax Assessment Act 1997 (Cth) (1997 Act).

Before we get into the detail of the Draft Ruling, it is important to know that the Australian Taxation Office (ATO) has held this view for decades but, until now, they had not provided any definitive ruling in this regard (save for some ATO Interpretive Decisions issued in relation to utilities providers).

The ATO has indicated that there were three key factors that prompted the publication of the Draft Ruling:

• The ATO wished to clarify with sufficient detail their longstanding view on the deductibility of labour costs related to constructing or creating capital assets.
• The Draft Ruling allows the ATO to address an alternative view on the issue that has been gaining traction with some tax practitioners, under which the Steele v Deputy Commissioner of Taxation [1999] HCA 7 (Steele) case is authority for the deductibility of labour costs in this context.
• The Draft Ruling explicitly provides that the ATO’s view extends to both tangible and intangible capital assets. This is particularly relevant given recent large-scale developments in the energy & resources industry (for example, mining projects) which have resulted in the creation of new intangible assets (for example, operations manuals).

So here we are, with the Draft Ruling stirring up the waters of the largely untested principle that labour costs are deductible as revenue in the broader debate of capital expenditure versus revenue expenditure.

The Draft Ruling is likely to have significant tax and accounting implications for a number of industries – primarily affecting construction, but also energy production and distribution, infrastructure, and oil, gas and mining.  However, the Draft Ruling also has broader implications for any business creating internal, tangible or intangible, capital assets.

In light of this, employers are encouraged to carefully ascertain the nature of their labour costs to avoid claiming any incorrect deductions under section 8-1 of the 1997 Act.  It is worth noting that even if an expense is of a capital nature and thus not deductible under s 8-1 of the 1997 Act, it may still be available as a specific deduction under another provision of the 1997 Act.

What are ‘capital assets’?

In the Draft Ruling, the ATO identifies capital assets as those assets (tangible and intangible) constructed or created which form part of the profit yielding structure of a business entity, structure or organisation.  Capital assets have been described as the tree structure that bears fruit (ie income) in judicial metaphor.  Common examples include scientific or technical knowledge, design and implementation of new processes or systems, licences, intellectual property, market knowledge and trademarks (including brand names and publishing titles).

Capital vs revenue: drawing the line

The question of whether an expense is of a capital nature (and thus not deductible under s 8-1 of the 1997 Act) or of a revenue nature (which is ordinarily deductible) has few clear cut examples.  AusNet Transmission Group Pty Ltd v Federal Commissioner of Taxation[1] established that it is necessary to consider ‘the guidance of approaches developed in decisions [of the High Court] over many years’.[2]  Individual cases that support a particular proposition may be relevant but not determinative.

The character of the expenditure is ‘ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure’.[3]  Expenditure is capital in nature where it is made with a view to bringing into existence an asset or an advantage (whether tangible or intangible) for the enduring benefit of the business, but it was noted there may be special circumstances leading to different conclusions.[4]

The ordinary starting point can be found in the three criteria described by Dixon J in his judgment in Sun Newspapers Limited v Federal Commissioner of Taxation (Sun Newspapers).[5]  The Sun Newspapers test requires us to consider this question by reference to these three criteria:

• the nature of the advantage sought, and attention to the lasting qualities of the advantage may play a part;
• the way the advantage is to be used, relied on or enjoyed; and
• the means adopted to obtain the advantage, such as by a periodical reward or outlay, payment for periods to cover the use or enjoyment of the advantage, or by making a final provision or payment to secure future use or enjoyment.

More recent case law has emphasised that the chief, if not critical, factor is the character of the advantage sought by the taxpayer in incurring the expenditure, i.e. what the outgoing is calculated to effect from a practical and business point of view.[6]

Regarding the means adopted to obtain the advantage (the third criterion), it may be necessary to go beyond the description of the payment in whatever relevant documentation into a more substantive consideration to discover the true nature of the payment.[7]  For example, payments may be called rent and be made periodically, but the substantive factual scenario may point to an outgoing of a capital nature.

There is now a wide range of unique examples of capital and revenue from case law — the diversity of which points to the complexity of drawing the distinction between capital and revenue.  By way of example, the cost of purchasing premises for use in the course of a business is capital expenditure, whereas rent paid for premises for the business is revenue expenditure and thus deductible.  Similarly, repairing a valuable capital asset is revenue expenditure, but making value-add or useful alterations, additions or modifications to the capital asset is capital expenditure.

Some examples of capital expenditure from case law are:

• Sun Newspapers: Payments made to a competing business to restrict the competitor’s activities in Sydney.
• AusNet: Imposts were paid to the State Treasurer of Victoria by the licensee of an electricity transmission business as part of the acquisition price of the business.  The liability to pay the imposts was packaged with the licence, but was not actually part of the purchase price in the sale agreement.  Nonetheless this was considered a capital expenditure (with Nettle J dissenting).
• Broken Hill Pty Co Ltd v Commissioner of Taxation [1999] FCA 1628: An amount described as ‘interest’ and paid as part of the purchase price of shares.

Some examples of revenue expenditure from case law are:

• Federal Commissioner of Taxation v Duro Travel Goods Pty Ltd [1953] HCA 32: Payments made to secure the agreement of two competitors in trade about not using trademarks or names similar to those used by the taxpayer.
• Tyco Australia Pty Ltd v Federal Commissioner of Taxation [2007] FCA 1055: Payments made to independent contractors for the assignment of security monitoring service agreements.  The asset was, in practical, business and legal terms, the winning of a customer as an activity of the business rather than the purchasing or creation of a business structure.
• Federal Commissioner of Taxation v CityLink Melbourne Limited [2006] HCA 35: Annual concession fees paid by a private road provider for the right to operate the road system and to collect tolls.  The High Court held the concession fees were periodic licence fees regarding the CityLink infrastructure that the private road provider derived income from and ultimately surrendered back to the state of Victoria.  This was distinguished from periodic instalments paid on the purchase price of a capital asset.

Past and present legal principles

This brings us to labour costs, the archetypal revenue expenditure that is rarely contested by the ATO.

It was commonly accepted (although technically unresolved) that wages were not capital in nature and were therefore deductible under section 8-1 of the 1997 Act.  This was based on the assumption that employers often do not use their own employees to create capital assets for the business, instead capital assets are frequently bought.  If employees were engaged to create capital assets, this was infrequent and for short periods of time.

In contrast, the Draft Ruling now controversially states that wages and certain other labour costs will not be deductible if they are ‘incurred specifically for constructing or creating capital assets’.

The Draft Ruling casts the first and so-called chief factor from Sun Newspapers in a new light, stating that where ‘labour costs are incurred specifically for constructing or creating a capital asset, the character of the costs is to be ordinarily determined by reference to the nature of the asset acquired by the making of the expenditure on the labour and by the fact that the labour is specifically employed or contracted to construct or create that asset’[8] (emphasis added) and since that asset is a capital asset then the labour costs are a ‘loss or outgoing of capital or of a capital nature’.[9]

This echoes Hill J’s observations in Goodman Fielder Wattie Ltd v Commissioner of Taxation.[10] There will be cases where it may be difficult to determine whether expenditure should properly be regarded as on capital account or as on revenue account.  Each case will depend on its facts.

In particular, Hill J noted that if a person is employed to carry out a capital activity, the fact that they are remunerated by a periodical outgoing does not make the salary and wages on revenue account.

Labour costs are wide ranging…

The Draft Ruling focuses in particular on whether labour costs are capital expenditure or revenue expenditure, but what is encompassed by the term ‘labour costs’?  There are two main categories:

• salary and wages for employees who perform functions in relation to the construction or creation of capital assets, and other costs associated with the employment of that labour; and
• other amounts for labour or principally for labour incurred in relation to the construction or creation of capital assets.

In the Commissioner’s view, the first category extends to losses or outgoings related to long service leave, annual leave, sick leave and similar leave, as well as bonuses and allowances, while the second category also applies to ‘payments to … a labour hire firm for people who … perform work activities for an entity on the same basis as their employees do’.[11]

…but not inclusive of everything

Deductions for labour costs that are permissible under other specific provisions in the 1997 Act can still be claimed, as the Draft Ruling only considers deductions under section 8-1 of the 1997 Act. This may include costs for research and development or employer contributions to superannuation funds.

Additionally, not all capital asset labour costs will be regarded as ‘specifically incurred’ for constructing or creating capital assets.  Labour costs will not be specifically incurred for this purpose where the employee’s role only has a remote connection with constructing or creating capital assets, or they have a broader role that involves incidental activities connected with constructing or creating capital assets.

The Draft Ruling provides some examples:

• Revenue account: A security guard who is responsible for the security of a project site where capital assets are being constructed is employed with a ‘remote connection’ to the construction or creation of those capital assets.
• Revenue account: A general manager who spends one day a week discussing and preparing reports on the progress of a construction project will be undertaking ‘incidental activities’.
• Revenue account: A human resource manager responsible for the employees who are constructing or creating a capital asset.
• Capital account: Amounts paid to a labour hire firm to secure additional labour for the construction or creation of a capital asset.
• Apportionment between revenue and capital: Electricians employed to undertake both maintenance and construct capital assets of the business.  They complete time sheets on a daily basis, which show 50% of time relates to maintenance and repairs, and 50% to capital works.  Their salary costs are to be apportioned on a rational basis.

Although the nature of the labour costs is ordinarily ascertained at the time the expenditure is incurred, the ATO notes that the employer can change the costs from the capital account to the revenue account (and vice versa) if necessary.  If an employee has mixed duties, apportionment will be ‘conducted on a fair and reasonable basis’.[12]

Apportionment raises some practical difficulties depending on whether time recording versus accounting based allocation of time has been utilised ordinarily by an employee.  Reasonableness of the methodology adopted will be a key question.

What the Draft Ruling doesn’t address is what happens to an amount that is considered a capital expense:  is this added to the cost base of the asset being created?  Could it even be considered ‘black hole’ expenditure and deducted over a 5 year period, under section 40-880 of the 1997 Act?  This is a provision of last resort, but would seem to be a better option, rather than simply being added to the cost base of an asset.  This would mean the cost could not be recovered until there is a CGT event, which could mean many years of holding onto that expenditure.

Next steps

The Draft Ruling disagrees with the alternate perspective, that in light of the decision in Steele, labour costs are analogous to interest expenses, on the basis that labour costs are incurred for the use of labour during the relevant period, and not for an ‘enduring advantage’ (which would make these costs revenue expenditure).

In light of this alternative, the question is how far does a taxpayer need to look to determine whether the expense is revenue or capital in nature?  While the Draft Ruling considers Steele, it provides a statement rather than an explanation, that interest is different as it ‘secures, not an enduring advantage, but rather the use of borrowed money’ and that the cost of labour in constructing a capital asset is different as it ‘on the other hand, do[es] secure an enduring advantage — being the construction or creation of the capital asset’.[13]

So we still end with a question, what is the cost of the labour for?  Is the answer the use of the labour or what the labour produces (the output)?  Either way, it looks like the Commissioner’s view is now clear:  labour costs incurred for constructing or creating capital assets are capital in nature.

Noting the retrospective application of the Draft Ruling, it will be very important to consider the tax treatment of labour costs related to capital or of a capital nature for the income years which are still within the limited amendment periods.

This article was written with the assistance of Graduate Lawyer, Anne Wong. 

[1] [2015] HCA 25.
[2] Ibid  [14].
[3] Ibid  [23].
[4] British Insulated and Helsby Cables v Atherton (1926) AC 205, 213-214; AusNet Transmission Group Pty Ltd v Federal Commissioner of Taxation [2015] HCA 25, [15].
[5] [1938] HCA 73
[6] GP International Pipecoaters Pty Ltd v Commissioner of Taxation (Cth) [1990] HCA 25; AusNet Transmission Group Pty Ltd v Federal Commissioner of Taxation [2015] HCA 25; Commissioner of Taxation v Sharpcan Pty Ltd [2019] HCA 36, 18.
[7] Commissioner of Taxation v Broken Hill Pty Company Ltd [2000] FCA 1431.
[8] Draft Ruling, paragraph 37.
[9] Draft Ruling, paragraph 39.
[10] [1991] FCA 264.
[11] Draft Ruling, paragraph 2 and footnotes 4 and 5.
[12] Draft Ruling, paragraph 9.
[13] Draft Ruling, paragraph 71-73.