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Wages and salaries should be capitalised where they relate to the construction or creation of capital assets, TR 2023/2 says.
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How capital asset creation can make labour costs non-deductible
29 September 2023
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A recent ATO ruling will require business taxpayers to treat salary and wages costs as being non-deductible (and capitalised) where they relate to the construction or creation of a capital asset.
Taxation Ruling 2023/2, issued in June, provides the ATO’s view on when certain labour costs related to the construction or creation of a capital asset are to be capitalised for taxation purposes.
TR 2023/2 considers capital assets (including intangible assets) to be assets that form part of the profit-yielding structure of a business entity, structure or organisation.
The ruling applies to years of income commencing both before and after 7 June 2023 (the issue date of the ruling). However, it will not have application to taxpayers to the extent that it conflicts with the terms of a settlement of a dispute agreed to prior to 7 June 2023.
In the ruling, the ATO acknowledges that ordinarily, labour costs would be revenue expenditure in nature and would form part of a business’s working expenses (and therefore deductible for taxation purposes). However, the ATO believes that where there is a clear link with the construction or creation of a capital asset, the wages or salary expenditure should be capitalised for taxation purposes.
TR 2023/2 will apply where a taxpayer incurs the following labour costs:
- 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.
- Other amounts for labour or principally for labour incurred in relation to the construction or creation of capital assets (now referred to as capital asset labour costs).
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As readers will be aware, section 8-1(2)(a) of the Income Tax Assessment Act 1997 (Cth) provides a limitation to claiming ordinary business expenditure where the expenditure is capital or of a capital nature. It is this section that the Commissioner has used as the basis for TR 2023/2.
Where capital asset labour costs are incurred for constructing or creating a capital asset, TR 2023/2 considers that their character for taxation purposes is on capital account. Therefore, for taxation purposes such expenditure cannot be deducted pursuant to section 8-1(2)(a) of the ITAA.
The ATO acknowledges that there will be plenty of situations where salary and wages may be both deductible and non-deductible, so apportionment of such expenditure will be required for taxation purposes. TR 2023/2 states that any such apportionment of labour costs (because the employee is both involved in the creation of a capital asset and has ordinary income duties too), may be required on a “fair and reasonable” basis.
TR 2023/2 says there will also be situations where no such apportionment is required. For example, the ruling states that labour costs are likely to be revenue in nature if a worker’s role is only “remotely connected” to the construction or creation of a capital asset. Likewise, if an employee has a broader role that involves incidental activities connected with constructing or creating capital assets, labour costs are also likely to be revenue in nature.
An example in the ruling is of a general manager of a large group that has a capital asset creation division. While the wages of employees directly involved in the capital asset creation division need to be capitalised, the general manager’s wages may still be tax deductible. The ruling states that even though the general manager spends some of their time on the capital asset creation division, it is an ordinary incident of the role to oversee the group and therefore, the general manager’s wages remain fully tax deductible.
Both TR 2023/2 and the ITAA do not prescribe any specific method for apportionment of expenditure between revenue and capital account for taxation purposes. Rather, the ruling states that taxpayers may adopt any methodology that is fair and reasonable to their circumstances, provided it can be substantiated.
We expect that taxpayers will need to revisit their income tax treatment of salary and wage expenses where they are involved in the construction or creation of both tangible or intangible assets. TR 2023/2 will almost certainly be another weapon that the Commissioner will use on an audit where salary and wage expenses have been claimed in full for taxation purposes.
The further point we make is TR 2023/2 seems to imply that if taxpayers have made some attempt to apportion their labour costs between revenue and capital projects, the ATO is likely to take a more forgiving approach than where no attempt to apportion labour costs has been made.
Dennis Tomaras is a partner and Ellen Karakoussis a senior associate at Cornwalls Lawyers.
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