Generally, many business owners expect that the cost of labour will give rise to a tax deduction in the year they are paid. However labour costs that relate to the construction or creation of capital assets, both tangible and intangibles, are specifically excluded from being a deduction under section 8-1 of the Income Tax Assessment Act 1997. These costs are excluded because they are considered to be of a capital nature.
The ATO has very recently released a Draft Tax Ruling TR 2019/D6 to further highlight their views on this issue.
Labour costs for these purposes include that of salary and wages for employees as well as other labour expenses incurred such as contractor payments and payments to labour hire firms. When these costs are specifically for the construction or creation of capital assets the essential nature of these costs are considered to be capital. The critical aspect when classifying the character of these costs is determined by asking: what is the advantage sought by incurring the costs? Costs for labour that have a remote connection or broader role with only an incidental connection to the construction or creation of capital assets will not be of a capital nature.
The draft ruling does provide examples of employees that would be on revenue account as their time would be infrequent or incidental to the construction or creation of a capital asset:
- 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 leg aspects of constructing or creating a capital asset.
However these examples also need to be considered in reference to the day to day operations of the business and specific engagements as demonstrated in the below example from the ruling.
Example 2 centralised project management team salary
A centralised project management and procurement team (that includes a project general manager, project human resources manager and project finance manager) is established in Australian Sub Co. The team are specifically employed to manage the project and recruit personnel for the construction of the facility. They periodically report to the general manager on the performance of Australian Sub Co during the construction of the facility. Once the facility is installed and ready for use, some members of the team are retained to manage and work in the Australian Sub Co business that utilises that facility.
For the period when the centralised project management and procurement function team are specifically employed for constructing the new facility, the essential character of their salary is wholly capital or capital in nature and their salary will not be deductible due to the application of paragraph 8-1(2)(a).
Once the facility is installed and ready for use, the retained employees are then specifically employed in the recurrent ordinary business operations. The essential character of their salary will then be an ordinary working expense on revenue account and deductible under section 8-1
If there is an employee that specifically employed for both; construction or creation of capital asset and other duties, an apportionment of the costs is required on a fair and reasonable basis. A fair and reasonable basis requires all the relevant circumstances to be considered. When all things have been considered the method adopted could be time spent on capital activities or apportioned by reference to the ratio or relationship of employee costs. Below is one of the apportioning examples contained in the ruling.
Example 4 – apportionment of labour costs
Australian Head Co has another wholly owned subsidiary called Australian Operations Co. Australian Operations Co employs a team of electricians specifically to undertake maintenance and construct capital assets that will be owned by members of Australian Head Co’s consolidated group.
The electricians account for their time by completing time sheets on a daily basis. Those time sheets identify the subject entity, the type of activity (maintenance, repair or capital works) and the time spent on the activity. Records show approximately 50% of time is spent on maintenance and repair and the other 50% on capital works.
For group accounting purposes, salary costs of the electricians is expensed or capitalised in accordance with time sheets.
The salary costs of the electricians incurred by the tax consolidated group have the essential character of being in part capital or capital in nature, and to that extent are not deductible due to the application of paragraph 8-1(2)(a). The salary costs are to be apportioned on a rational basis. Since the employees account for their time in a manner consistent with the income tax capital/revenue distinction and which is also adopted for accounting purposes, it represents a reasonable basis for apportionment for income tax purposes absent any other contrary indicator.
The capital asset labour costs incurred do not extend to:
- Costs made deductible under other provision such as superannuation fund contributions.
- Costs specifically taken not to be capital under provisions such as trading stock; or
- Costs otherwise taken into account in working out assessable income or allowable deductions under a financial arrangement covered by the TOFA rules.
Importantly this is not new but rather the Commissioner stating his opinion more clearly, as there are alternative arguments that wages and salary expenses are always deductible in the year they are paid. This argument is most often used to liken employment costs to interest costs and should be deductible in the same circumstances. However the ruling dispenses with this argument by arguing that interest charges are for the use of the funds borrowed which will eventually be repaid whereas employment costs generate a more enduring advantage which is more correctly measured and added into the value of the assets constructed or created.
These costs will need to be identified and reasonably apportioned if necessary to separate those costs relating to revenue and immediately deductible from those relating to capital costs and not deductible. Instead they will be added to the carrying value for tax purposes of the assets constructed or created. The latter costs will only be brought to account upon disposal of the asset(s) in question.
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