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

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.