The ATO recently finalised its guidance (Taxation Ruling TR 2023/2) on when it considers labour costs incurred specifically for constructing and creating capital assets to be capital in nature and therefore not deductible under section 8-1 of the Income Tax Assessment Act 1997.
The guidance has significant implications for taxpayers as labour costs are generally deductible. In practice, immediate deductions are often claimed for such costs without further regard to whether the costs relate to the creation or construction of capital assets that provide a lasting advantage. Although the guidance is most likely to have implications for taxpayers in the property, construction and infrastructure sectors, it will be relevant to any taxpayers that create or construct new assets (e.g. a taxpayer constructing an office building for their own use). It can also impact taxpayers who are developing significant intangible assets such as computer software.
What costs are targeted by the ruling?
The ATO accepts that labour costs are generally revenue in nature and would form part of a business’ ordinary deductible working expenses. However, it considers “capital asset labour costs” to be a particular category of labour costs that are on capital account and not deductible on the basis that such costs are not incurred to secure the labour of workers for a short period of time and instead provide an enduring benefit to the taxpayer.
Broadly, capital asset labour costs are:
- Salary and wages (including on-costs, leave entitlements, bonus payments and allowances) for employees who perform functions in relation to the construction or creation of capital assets; and
- Other amounts for labour or principally for labour (such as payments made to contractors and can potentially extend to payments to related service entities) incurred in relation to the construction or creation of capital assets.
Capital assets are defined to be those assets (tangible and intangible) constructed or created which form part of the profit-yielding structure of a business entity, structure or organisation. Common examples of capital assets include buildings, infrastructure facilities and intellectual property.
When will labour costs be non-deductible?
Under the ruling, labour costs incurred directly or indirectly in relation to the construction or creation of capital assets are treated as capital expenditure and non-deductible. Examples of such costs include the cost of workers who physically construct or create assets as well as the cost of project teams dedicated to managing the construction or creation of assets.
In contrast, costs of workers who have a remote connection with, or have a broader role that involves incidental activities connected with constructing or creating capital assets will generally not be regarded as being of a capital nature. For example, the costs of a general manager responsible for the day-to-day operations of an established ongoing business but spends a relatively small amount of time overseeing the construction of a capital asset are likely to be deductible.
It is ultimately a question of fact and degree whether costs are incurred specifically for constructing or creating a capital asset. Factors such as the terms of employment, contractual arrangements, the functions undertaken by the employees or contractors and the nature of the business can be relevant in analysing the treatment of costs. The accounting treatment of the expenditure can also be relevant (although not determinative) to the analysis.
Can you apportion labour costs?
In some cases, it may be necessary to apportion labour costs (with a deductible and non-deductible component) where employees are employed for both constructing or creating capital assets and other day-to-day duties. This can be done on a fair and reasonable basis supported by things such as time records, cost centre allocations, job descriptions, written reports and notes.
What costs are excluded from the ruling?
It should be noted that the ruling does not apply to costs that are made specifically deductible under other provisions of the income tax legislation (e.g. superannuation contribution costs and the cost of managing tax affairs) even where the costs are incurred in creating or constructing a capital asset.
What are the next steps?
The ruling applies to income years commencing both before and after its date of issue (7 June 2023). Accordingly, we recommend taxpayers to:
- Understand whether capital asset labour costs have been appropriately identified and consider whether amendments are required to the prior year treatment of such costs; and
- Review whether existing systems and procedures enable capital asset labour costs to be appropriately captured and what systems and procedures should put in place to manage this going forward.
Please contact your Pitcher Partners representative if you require assistance to review your existing arrangements and determine what action is required in light of the changes.