ATO finalises its views on deductibility of labour costs related to capital assets

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The final Taxation Ruling TR 2023/2 confirms the ATO’s view that labour costs related to the construction of capital assets - both tangible and intangible - are generally not deductible. Now is the time to review your current and historical practices with respect to capital asset labour costs to identify any existing or emerging risk areas.

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18 August 2023

In Brief

The Australian Taxation Office (ATO) has released final Taxation Ruling TR 2023/2 on the deductibility of labour costs related to the construction or creation of capital assets, both tangible and intangible. The ruling outlines the Commissioner’s view on when these costs are not deductible because they are capital or of a capital nature, and provides guidance on how to apportion labour costs that have both capital and revenue aspects on a fair and reasonable basis.

In Detail

Since the early 2000s (and possibly earlier), the ATO has been interested in the deductibility of labour costs incurred in relation to the construction of capital assets. Employee costs are generally deductible on the basis that they are a regular recurring cost of carrying on a business and not generally incurred in establishing or enlarging the profit yielding structure of the business. This is consistent with the principles in key cases concerning capital versus revenue in the context of deductions. However, in the case of costs of employees that exclusively, predominantly or even partially, work on a capital project within a business, the matter is not so straightforward.

After many years of considering the issue, the ATO has issued final Taxation Ruling TR 2023/2 on the deductibility of labour costs related to the construction or creation of capital assets. What began as a focus on capital infrastructure and oil & gas projects now has much broader application, with the Ruling considering both tangible and intangible capital assets (for example, software development).

The Ruling contains two critical definitions - capital assets and capital asset labour costs. Capital assets are those assets (tangible and intangible) constructed or created which form part of the profit-yielding structure of a business entity, structure or organisation, whilst capital asset labour costs are labour costs that are:

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/ or,
other amounts for labour or principally for labour incurred in relation to the construction or creation of capital assets.

The Ruling focuses on deductibility under the general deduction provisions, whilst acknowledging that deductions may be specifically provided, or denied, under other provisions of the tax law. As a general proposition, the Ruling states that, to the extent capital asset labour costs are incurred specifically for constructing or creating capital assets, their essential character is considered to be capital or of a capital nature and therefore cannot be deducted in accordance with section 8-1 of the Income Tax Assessment Act 1997.

In reaching this conclusion, the Ruling contains an analysis of key cases dealing with capital versus revenue, and the key principles derived from these cases, including the character of the advantage sought, the manner in which it is to be used, and the means adopted to obtain it. Key points are summarised in the table below.

Principle	Application to labour costs in relation to construction or creation of capital assets, per TR 2023/2
Character of the advantage sought	Where capital asset 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. The mere fact that in a number of situations the costs incurred for labour are on revenue account does not change the conclusion that they may be, in other situations, on capital account.
The manner in which it is to be used	Recurrence of expenditure 'may play its part' in determining both the character of the advantage sought, as well as the manner in which it is to be used, relied upon or enjoyed. Capital asset labour costs will generally qualify as recurrent expenditure. However, it is not determinative of the question as to whether that expenditure is of capital, or of a capital nature.
The means adopted to obtain it	In the case of capital asset labour costs, the payments made are not merely to cover the use or enjoyment for the asset over a period commensurate with the payment. Rather, they are 'one-off' payments made to construct or create the asset and to secure the future use or enjoyment of that asset.

When are costs incurred specifically for constructing or creating capital assets?

The Ruling notes that costs incurred for the construction or creation of capital assets are not limited to those involved in the construction work itself, but can also include the costs of labour for those who perform functions in relation to the construction or creation of capital assets. However, not all capital asset labour costs will be considered capital or capital in nature. For example, where employees are involved in the day-to-day and ongoing operations of a business and they engage in activities that are capital in nature infrequently or those activities are considered minor or incidental in the context of their overall activities, duties and functions. The essential character of the capital asset labour costs of those employees is revenue in nature and apportionment (discussed further below) will not be required.

Whether a person is engaged specifically for the construction or creation of a capital asset is a matter of fact and degree, and must be assessed based on specific circumstances. The Ruling highlights the following factors or circumstances that may assist in determining whether persons are specifically engaged in the construction or creation of capital assets:

employment or other contractual arrangements
understanding of the functions undertaken by the employees or contractors
the nature and scope of the business
the corporate structure used to organise, plan, manage and undertake capital activities or activities related to capital assets
how the business plans and executes those activities
the business practices concerning the use of internal labour and external contractors for those activities
the terms of employment, job descriptions, key performance indicators of staff, the pattern of deployment and working profile and practices of internal labour in those activities, and
the accounting, control and governance systems you use to record the costs and resources used in those activities (although noting that the accounting treatment is not determinative of the character of expenditure incurred for income tax purposes).

The Explanation in the Ruling provides useful examples of circumstances where employee costs would be regarded as being on revenue account even though an infrequent, minor or incidental amount of the employee’s time is devoted to the construction or creation of capital assets:

A security guard who is responsible for the security of a project site where capital assets are being created or constructed
A human resource manager responsible for all of the employees or personnel of an established and ongoing business, including employees or personnel constructing or creating a capital asset
A finance manager responsible for all of the ongoing financial aspects of an established and ongoing business, including the finance aspects of constructing or creating a capital asset
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, and
A general counsel responsible for all general legal affairs of an established and ongoing business, including the legal aspects of constructing or creating a capital asset.

These cases can be contrasted with a human resources manager specifically engaged by an entity for the sole purpose of recruiting and managing workers that will be constructing a capital asset for the entity, as this would be regarded as necessary, essentially or sufficiently connected to the construction of the capital asset, and therefore on capital account.

Apportionment may be required

The Ruling acknowledges that some labour costs may have both capital and revenue aspects, depending on the nature and extent of the activities performed by the employees or contractors in relation to the capital asset. In such cases, apportionment of the costs on a fair and reasonable basis is required, using the best information available to the taxpayer.

Where the business maintains records of time spent by employees on particular activities, the Ruling indicates that this may provide a reasonable basis for apportionment. In the absence of such information, 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 may provide a fair and reasonable basis for apportionment. In some cases, the accounting treatment of expenditure which is partly, but not wholly, on capital account will provide a fair and reasonable basis for apportionment. However, the Ruling acknowledges that the accounting treatment may not be the only fair and reasonable basis.

Examples

The Ruling provides seven detailed examples to demonstrate the application of the principles to different situations involving capital asset labour costs. The examples cover various types of employees and contractors, and various types of capital assets, and illustrate how the character and apportionment of the costs may vary depending on the purpose, nature, and extent of the activities performed by the labour, the relation of the costs to the capital asset, and the documentation and evidence available to the taxpayer.

The Takeaway

The Ruling provides much needed clarity and certainty to taxpayers who incur labour costs related to the construction or creation of capital assets.

There are likely to be many cases where apportionment will be required for employees and contractors who are not wholly or predominantly engaged in the construction or creation of capital assets. In these cases, ensuring appropriate records are maintained will be vital to substantiate any claims for deductibility.

We recommend taxpayers review both their current and historical practices in relation to labour costs incurred in relation to capital assets to identify any existing or emerging risk areas.