New treatment of capital contributions

2010 amendments mean capital contribution recipients can treat contributions as income spread over 10 years, or reduce the tax book value of the subsidised assets.

Sections CG 8, DB 64, EE 48 and YA 1 of the Income Tax Act 2007

A capital contribution is a subsidy or similar payment to a person that compensates them for some capital expenditure. A common example is a payment from a farmer to an electricity lines company towards the cost of connecting their farmhouse to the company's network.

Amendments have been made to the Income Tax Act 2007 so that recipients of capital contributions will have to choose either to treat the contribution as income spread over 10 years, or alternatively, reduce the tax book value of the subsidised assets.

Background

Previously, capital contributions were generally not taxable in the hands of the recipient as they are of a capital nature. In addition, the recipient may have been able to deduct, by way of depreciation, the cost of the assets acquired with the capital contribution. This meant that it was possible for the recipient to claim deductions for expenditure that had been funded through untaxed receipts.

Key features

Businesses that now receive a capital contribution must choose, for income tax purposes, to treat the receipt as income or as a reduction in their depreciation base. Different treatments can be elected for each capital contribution but once an election is made it may not be changed.
If a business decides to treat a contribution as income, it must return 1/10th of the contribution as taxable income every year for 10 years.
If a business decides to reduce its depreciation base, it must reduce the tax book value of the relevant assets to the extent that they have been funded through the capital contribution.

Detailed analysis

Capital contributions either income or non-deductible

The definition of "capital contribution" in section YA 1 has been amended. Outside of section HG 11, a capital contribution now means an amount that:

is paid to a person (the payer) by a person (the recipient) under an agreement between them that is not a contract of insurance;
is paid by the payer other than in their capacity of settler, partner or shareholder of the recipient;
is not income of the recipient, ignoring section CG 8;
is paid, under the express terms and conditions of the agreement, as a contribution for depreciable property owned or to be acquired by the recipient.

Part (i) of this definition ensures that insurance pay-outs to cover the replacement of damaged assets do not fall within this definition, as they are not capital contributions. Part (ii) ensures that payments by settlers, partners or shareholders who are introducing capital into their own businesses in their capacity as owners are not included.

New section CG 8 provides that a capital contribution that a person receives is treated as income in the income year it is received and the nine following income years. The formula for calculating the amount that is income in each income year is set out in section CG 8(2). This is simply the amount of the contribution divided by 10.

Section CG 8 provides the default treatment. However, if a person elects, they can instead use the treatment in section DB 64. This election is provided because it was recognised that some businesses would have difficultly implementing section DB 64.

Section DB 64 applies when a person derives a capital contribution and would be allowed an amount of depreciation loss for the acquired assets. Subsection (2) provides that the amount of the capital contribution would be excluded from the item's adjusted tax value, base value, cost, or value, as applicable, for the purposes of part EE (Depreciation). Essentially, this means the recipient would not be able to claim depreciation deductions to the extent that any acquired assets have been paid for by capital contributions.

Any election must be made in the recipient's tax return for the income year in which the relevant capital contribution is derived. Each new capital contribution would require a new election, and the recipient can elect to treat different contributions differently. Once an election has been made in respect of a contribution, it is unchangeable.

Effect on disposal

Section EE 48 has been amended so that, if a person has elected to apply section DB 64, the amount of the capital contribution is added to the calculation of subsection (1)(b) for the purposes of calculating depreciation recovery income.

Example: Capital contributions

Under the old rules

Ben's Electricity Company is an electricity lines company. On 1 June 2009, a farmer requested that his farmhouse be connected to Ben's Electricity network. As the work, costing $10,000, would otherwise be uneconomic, Ben's Electricity required a $6,000 capital contribution from the farmer.

Ben's Electricity Company can claim depreciation deductions on the full $10,000 cost of the connection to the farmhouse. Also, Ben's Electricity Company successfully argues that the capital contribution payment is a capital receipt and, therefore, is not taxable.

Under the new rules

On 1 June 2010, a different farmer requested for his farmhouse to be connected to Ben's Electricity network. The work, again costing $10,000, would have otherwise been uneconomic, so Ben's Electricity again required a $6,000 capital contribution from the farmer.

Election to treat as income

If Ben's Electricity Company elects to treat the capital contribution as income, it will return 1/10th of the $6,000 capital contribution as taxable income for the next 10 years. In other words, it will return $600 extra income in its 2010-11 income year, and continue to do this until its 2019-20 income year.

Election to reduce depreciation base

If Ben's Electricity Company elects to reduce its depreciation base, it will be unable to claim depreciation on the cabling and other assets that make up the new connection to the extent that they were funded by the capital contribution. In other words, it can only claim depreciation deductions on the $4,000 cost for which it bore the financial burden.

Application date

These amendments apply to capital contributions derived after 20 May 2010.