Australia: Ordinary income and the arm’s length value of “uneconomic assets” (Full Federal Court decision)

Australia: Ordinary income and the arm’s length value

The Full Federal Court issued its decision concerning the operation of section 21A of the Income Tax Assessment Act 1936 (ITAA 36), specifically as it applies to asset participants that operate in regulated sectors.


The case is: Victoria Power Networks Pty Ltd v. Commissioner of Taxation [2019] FCA 77. Read the Full Federal Court’s decision

Although the case relates to the regulated power industry, the question of “value” for section 21A purposes can affect a number of sectors (e.g., mining, renewables, and property).


Victoria’s five electricity distributors are responsible for the construction and maintenance of the powerlines that deliver electricity to end-users. Similar rules can apply in other states and territories.

Each distributor’s electricity distribution revenues are calculated by reference to their regulated asset base and the regulated return. Both of these are set by the Australian Energy Regulator. Consumers will contribute to their distributor’s revenues by paying the “network charges” on their electricity bills.

Over the last 20 years, 18 wind farms and 13 solar farms have opened in Victoria, with a majority of these opening in the last decade. There are many more of these projects in the planning and development stages, both in Victoria and across Australia.

Victorian distributors are required to connect these renewable projects to their distribution networks when requested to do so. These new connections (often referred to as “the powerlines” between the wind farm/solar farm and the distributor) need to be constructed. This raises the issue of which party is responsible for the construction.

The project owners will generally be given the choice to either:

  • Option one – Pay the distributor to build the powerlines
  • Option two – Build the powerlines and transfer ownership of them to the distributor

Similarly, property developers can be required to contribute to the costs of connecting new suburbs to the distribution networks, and will also need to choose between option one and option two.

Commercially, distributors will only generate revenues from owning new powerlines if their value is included in a regulated asset base. In the industry, there is a distinction between “economic” and “uneconomic” assets. This is an important distinction in the current case. Broadly, an “uneconomic” asset is when the incremental revenues available to distributors will be less than the cost of building and maintaining the powerlines. For uneconomic assets, the following outcomes would arise:

  • For option one – A project owner would pay a cash contribution to the distributor calculated as the estimated cost of building and maintaining the powerline less the incremental revenue available to the distributor (the shortfall).
  • For option two – The distributor would become the owner of the powerline, and the distributor would pay the project owner a rebate calculated by reference to the estimated construction cost and the shortfall.


The taxpayer is the head company of a tax consolidated group that includes two distributors. The taxpayer had in the 2007 to 2010 income years received option one cash contributions, and had received option two transferred assets and paid rebates to project owners. The taxpayer treated the cash contributions as an assessable recoupment (under subdivision 20-A), claimed a deduction for the rebates, and did not include the value of the transferred powerlines in its assessable income. 

The Commissioner treated the cash contributions and the value of transferred powerlines as ordinary income. The primary judge in the Federal Court agreed with the Commissioner on option one, but concluded that section 21A applied to option two arrangements. This application of option two meant that the estimated value of the powerlines should be included in assessable income.

This was a large amount of money. In addition, the underlying asset would be depreciated over a long period of time (or, if land, not at all). This concept is what gives rise to the section 21A “mismatch” for many infrastructure and property taxpayers. In turn, this can have implications on cash flow.


The Full Federal Court concurred with the primary judge that the option one cash contributions of the shortfall were assessable as ordinary income. This is because they were received in the ordinary course of the taxpayer’s business, a part of which was connecting customers to the network in accordance with the applicable regulatory regime. The payments were not the price for a capital asset, nor a gift or subsidy to replenish or augment the taxpayer’s capital.

In relation to option two arrangements, two matters were considered.

  • Whether the arrangement resulted in the taxpayer deriving ordinary income. The court concluded it did not. The Commissioner contended that option two involved an obligation of the project owner to pay a contribution to the taxpayer equal to the shortfall, and the amount of the shortfall was ordinary income. The fact that the contribution was satisfied by the delivery of the constructed powerline did not, in the Commissioner’s view, change the taxation outcomes to the taxpayer. The Full Federal Court concluded that this analysis was incorrect, as the relevant obligation in option two was for the taxpayer to pay the rebate. The taxpayer never had an entitlement to the shortfall when option two was taken, and so the shortfall amount could not be ordinary income to the taxpayer.
  • Whether section 21A applied to include an amount in the taxpayer’s assessable income. Section 21A operates to include the arm’s length value of non-cash business benefits in assessable income. For section 21A purposes, the arm's length value is defined in subsection 21A(5) as “the amount that the recipient could reasonably be expected to have been required to pay to obtain the benefit from the provider under a transaction where the parties to the transaction are dealing with each other at arm’s length in relation to the transaction.”

    When applying this section, the primary judge took a holistic view of the objectives of the regulatory regime governing new powerlines, in which the distributor would receive sufficient compensation, such that it ultimately would not bear any costs associated with their construction and maintenance. In that context, the primary judge assessed that the market value was equal to the estimated construction costs for the powerlines. The primary judge’s conclusion provided consistency in outcomes between option one and option two.

    The Full Federal Court determined that the approach of the primary judge was erroneous because it failed to “appreciate the focus of the text” in subsection 21A(5). Subsection 21A(5) specifically requires a consideration of what the recipient would be expected to pay. This, in the view of the Full Federal Court, requires a consideration of the regulated market in which the taxpayer operates. In this market, acting rationally and at arm’s length, a distributor would not be willing to pay for an asset if it is uneconomic, and in the cases under consideration no more than the rebate it had already paid. 

    As a result, the conclusion must be that the non-cash business benefit assessable to the taxpayer under option two was nil.

KPMG observation

As the economic outcomes of option one and option two align, tax professionals believe it seems absurd that the taxation outcomes would also differ. As previous court cases have indicated, economic considerations are not always relevant to concepts of assessable income, and they may not be relevant to the outcome in this case. As the Full Federal Court pointed out, option one and option two are different transactions and it is appropriate the income tax outcomes differ.

If steps were to be taken to align the economic and taxation outcomes, then the approach for this regulated sector could be that neither option gives rise to an immediate tax cost to the distributor. This would properly reflect that there has been no net economic gain to the distributors from meeting the regulatory obligations.  

Prior to this case, there had been little judicial guidance on the concept of value for section 21A purposes. However, there have been many discussions with the Australian Taxation Office and the power sector on this matter over time, including the issue of a number of private binding rulings. In many cases, taxpayers have included the value of the asset (as recognised in their financial accounts) as assessable income. The potential for this amount to be nil is one of the reasons this case is so important.

This case was very fact specific and was handed down in a unique regulatory environment. Accordingly, while taxpayers may need to consider reviewing their past treatment of assets covered by section 21A, it is possible that the storyline will continue if an appeal is lodged (filed), and heard, by the High Court.

For more information, contact a KPMG tax professional in Australia:

James Macky | +61 3 9288 6890 |

Louise Lovering | +61 3 9838 4690 |

Jenny Wong | +61 2 9335 8661 |

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