Topic 6 Specific Deductions and Capital Allowances

Specific deductions, specific non-deductions, depreciation deduction and

capital works deductionChapters 11 and 12

Specific Deductions

Section 8-5(1) You can also deduct from your assessable income an amount that a provision of this Act (outside this Division) allows you to deduct.

S 8-5(2) Some provisions of this Act prevent you from deducting an amount that you could otherwise deduct, or limit the amount you can deduct.

S 8-5(3) An amount that you can deduct under a provision of this Act (outside this Division) is called a specific deduction.

For a summary list of provisions about deductions, see section 12-5.

Specific Deductions

Section 8-10 - No double deductions - If 2 or more provisions of this Act allow you deductions in respect of the same amount (whether for the same income year or different income years), you can deduct only under the provision that is most appropriate.

• The Explanatory Memorandum states that when an expense is potentially deductible under s 8-1 – general deductions, or Division 25 – specific deductions, the preferred option is to claim a deduction under a specific provision.

Specific deductions – Division 25

• S 25-1- This Division sets out some amounts you can deduct. Remember that the general rules about deductions in Division 8 (which is about general deductions) apply to this Division.

• Table of sections - • 25-5 Tax-related expenses• 25-7 Advice about family tax benefit• 25-10 Repairs• 25-15 Amount paid for lease obligation to repair• 25-20 Lease document expenses• 25-25 Borrowing expenses• 25-30 Expenses of discharging a mortgage

Specific deductions – Division 25

• 25-35 Bad debts• 25-40 Loss from profit-making undertaking or plan• 25-45 Loss by theft etc• 25-50 Payments of pensions, gratuities or retiring allowances• 25-55 Payments to associations• 25-60 Parliament election expenses• 25-70 Deduction for election expenses does not extend to

entertainment• 25-75 Rates and land taxes on premises used to produce

mutual receipts• 25-80 Upgrading plant to meet GST obligations etc• 25-85 Certain returns in respect of debt interests• 25-90 Deduction relating to foreign exempt income• 25-95 Deduction for work in progress

Section 25-5 - Tax-related expenses

Section 25-5(1) - You can deduct expenditure you incur to the extent that it is for:– (a) managing your tax affairs; or – (b) complying with an obligation imposed on you by a

Commonwealth law, insofar as that obligation relates to the tax affairs of an entity; or

– (c) the general interest charge under Division 1 of Part IIA of the Taxation Administration Act 1953 ; or

– (ca) a penalty under Subdivision 162-D of the GST Act; or

– (d) obtaining a valuation in accordance with section 30-212 or 31-15.

Section 25-5 - Tax-related expenses

• You buy a computer to prepare your tax returns. The expenditure you incur in buying the computer is capital expenditure and cannot be deducted under this section.

• However, to the extent that you use the computer in preparing your income tax return, you will be able to deduct the decline in value of your computer under Division 40. That is because, under this subsection, the computer is property that you are taken to use for the purpose of producing assessable income.

Section 25-10 - Repairs

• 25-10(1) You can deduct expenditure you incur for repairs to premises (or part of premises), or a depreciating asset that you held or used solely for the purpose of producing assessable income.

• 25-10(2) If you held or used the property only partly for that purpose, you can deduct so much of the expenditure as is reasonable in the circumstances.

• 25-10(3) You cannot deduct capital expenditure under this section.

Capital issues - Repairs

• Main issue- is the ‘repair’ a capital outgoing or deductible under s 25-10

• Capital issues:- part - v - entirety - improvements- initial repairs

PART - v - ENTIRETY

Issue - replace the entirety - a new asset, therefore a capital expense. What is an entirety - question of fact and degree? Function test - does it function on its own ?

Lurcott v Wakely & Wheeler -replaced wall - a part.Lindsay v FCT - replaced an old slipway -an entirety. Rhodesia Railways v Collector of Income Tax -

replaced sleepers - a part - a repair - the whole railway line was the entirety.

W Thomas v FCT repairs to roof & walls plus some painting - building was the entirety - but initial repairs - no deduction.

IMPROVEMENT

• Improvement is more than a repair, e.g. additions and alterations

• new materials used - old materials not available - new material has better qualities. Question of fact and degree

FCT v Western Suburbs - old "celotex" ceiling replaced with "fibro" ceiling- not a repair - an improvement.

• Notional repairs - can you apportion the improvement between that representing the repairs and that representing improvements - no - see Western Suburbs case - Question is what you did - not what you could have done.

INITIAL REPAIRS

• Issue - purchase an asset in a state of disrepair and "repair" it for use.

• If the cost relates to bringing the asset into a state where it can then be used, it is a capital cost and should be part of the initial purchase price.

• Example: You buy an investment house to rent out. The house needs a new roof and other repairs before it can be used. Cost of repairs a capital expense – an initial repair.– Law Shipping v IRC - initial repair– Odeon Theatres v Jones - a repair– W Thomas v FCT - initial repair

Bad Debts – s 25-35

• No deduction for provision - debt must be bad - question of fact.

• Must write off debt before end of year and debt must have been brought to account as income.Continuity of ownership and continuity of business test apply to companies.Bad debts do not arise if accounting on a cash basis.

Payments to Associations – s 25-55

• Membership of a trade, business or professional association

• limited to $42 – but $42 limit does not apply if payment qualifies under s 8-1

• Example: membership of a professional accounting association deductible in full if working in the profession. Section 25-55 only applies if retired or working in another profession.

GIFTS - DIVISION 30

• Gift of $2 or more to an approved fund, institutions, authority or body set out in the division, is a tax deduction

• Gift can be money or property, including trading stock (during 12 months).

• Sections 30-20 to 30-105 set out the names of the institutions and organisations that you can make a deductible gift to.

GIFTS

• Raffle tickets – not deductible as a ‘true gift’ as an expectation of a material gain.

• Cannot make a deductible gift that results in a loss being made – s 26-55(1).

• It may be possible to have a loss if deductible under s 8-1 – nexus between the gift and the earning of assessable income.

PAST YEAR LOSSES - DIVISION 36

• Section 36-10 - tax loss can be carried forward and deducted in a future years – no time limit.Tax loss is equal to deductions, excluding prior year tax losses less (assessable income plus net exempt income) – a loss year.Loss must be first offset against net exempt income – s 36-20. Continuity of ownership and continuity of business test applies to companies and trusts

Capital Equipment – Tax Deduction

• You cannot claim a tax deduction for the cost of a capital item – negative limb, s 8-1.

• How can you claim a tax deduction – depreciation.

• For example: Cost of computer $2,000. Effective life 4 years. Tax deduction 2,000/4 = $500 per year for the next 4 years.

• Note: straight line or diminishing value.• Terminology – depreciating asset, deduction for

a decline in value.

Capital allowances

• plant;• certain mining and quarrying expenditure;• items of intellectual property and software;• certain primary production assets;• spectrum licences• Simplified depreciation rules apply for small business

taxpayers.• The uniform capital allowance system applies to

depreciating assets that started being held: - under a contract entered into on or after 1 July 2001;

or started being constructed on or after that day.

Division 40 – Section 40-1

• You can deduct an amount equal to the decline in value of a depreciating asset (an asset that has a limited effective life and that is reasonably expected to decline in value over the time it is used) that you hold.

• That decline is generally measured by reference to the effective life of the asset.

• You can also deduct amounts for certain other capital expenditure.

• Second-hand assets can be included as depreciating assets – market value or sale price

Section 40-15 - Objects of Division

• The objects of this Division are: – (a) to allow you to deduct the cost of a depreciating

asset; and – (b) to spread the deduction over a period that reflects

the time for which the asset can be used to obtain benefits; and

– (c) to provide deductions for certain other capital expenditure that is not otherwise deductible.

• Note:This Division does not apply to some depreciating assets: see section 40-45 – capital works, IRU (submarine cable), films

Reduction of deduction

• Must be for income producing purposes, but …• Section 40-25(2) You must reduce your

deduction by the part of the asset's decline in value that is attributable to your use of the asset, or your having it installed ready for use, for a purpose other than a taxable purpose.

• Example: Ben holds a depreciating asset that he uses for private purposes for 30% of his total use in the income year. If the asset declines by $1,000 for the year, Ben would have to reduce his deduction by $300 (30% of $1,000).

Section 40-30 - What a depreciating asset is

• Section 40-30(1) A depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used, except: – (a) land; or – (b) an item of trading stock; or – (c) an intangible asset, unless it is mentioned

in subsection (2). e.g. goodwill not deductible

Depreciating Assets (cont)

• Section 40-30(2) These intangible assets are depreciating assets if they are not trading stock: – (a) mining, quarrying or prospecting rights; – (b) mining, quarrying or prospecting information; – (c) items of intellectual property; – (d) in-house software; – (e) IRUs (indefeasible rights to use an

international telecommunications submarine cable system;

– (f) spectrum licences; – (g) datacasting transmitter licences.

Effective life – intangible depreciating assets

Asset Effective Life

Standard patent 20 years

Innovation patent 8 years

Registered design 6 years

Copyright The lesser of 25 years or the period when the copyright ends

In-house software 2.5 years

Spectrum licence The term of the licence

Depreciating Assets (cont)

• Section 40-30(3) This Division applies to an improvement to land, or a fixture on land, whether the improvement or fixture is removable or not, as if it were an asset separate from the land.

• Note 1: Whether such an asset is a depreciating asset depends on whether it falls within the definition in subsection (1).

• Note 2: This Division does not apply to capital works for which you can deduct amounts under Division 43: see subsection 40-45(2).

Common law meaning of “plant”

• A simple test - is the asset a tool of the taxpayer’s trade?

• Does it in any way play an active role in the taxpayer’s trade?

• Jarrold v John Good & Sons Ltd 40 TC 681

Moveable office partitions were held to be plant on the basis that they provided flexibility of accommodation which was a commercial necessity for the taxpayer.

Wangaratta Woollen Mills v FCT

• Function test used by the Courts to determine the function of the asset and the nature of the business.

• Assets used in the business such as machinery and assets that provide the setting within which the business is conducted, e.g. office or building

Wangaratta Woollen Mills v FCT

• Could a building used as a dye house which was used in the production process be considered ‘plant’?

• The dye house was a ‘tool of the trade’ and was more than just bricks and mortar. It played a major role in the production process.

• At the time of this case no depreciation deduction under Division 43 – capital works - for income producing buildings.

Section 40-40 - Meaning of hold a depreciating asset

• Section 40-40 - Use this table to work out who holds a depreciating asset. An entity identified in column 3 of an item in the table as not holding a depreciating asset cannot hold the asset under another item.– A right that an entity legally owns but which another

entity (the economic owner) exercises or has a right to exercise immediately, where the economic owner has a right to become its legal owner and it is reasonable to expect that:

– The economic owner and not the legal owner

Meaning of hold a depreciating asset – Item 6

• A depreciating asset that an entity (the former holder) would, apart from this item, hold under this table (including by another application of this item) where a second entity (also the economic owner):– (a) possesses the asset, or has a right as against the former

holder to possess the asset immediately; and– (b) has a right as against the former holder the exercise of which

would make the economic owner the holder under any item of this table; and it is reasonable to expect that the economic owner will become its holder by exercising the right, or that the asset will be disposed of at the direction and for the benefit of the economic owner

• The economic owner and not the former holder

Meaning of hold a depreciating asset

• Example 2: Sandra sells a packing machine to Jenny under a hire purchase agreement. Jenny holds the machine under item 6 because, although she is not the legal owner until she exercises her option to purchase, she possesses the machine now and can exercise an option to become its legal owner. Jenny is reasonably expected to exercise that option because the final payment will be well below the expected market value of the machine at the end of the agreement. Sandra, as the machine's legal owner, would normally be its holder under item 10 but item 6 makes it clear that the legal owner is not the holder.

Section 40-55 - Use of certain car methods – page 266 Text

• 40-55 You cannot deduct any amount for the decline in value of a car for an income year if you use the `cents per kilometre' method, or the `12% of original value' method, for the car for that year.

• Cents per kilometre – only up to 5,000 km taken into account –70 cents/km – engine over 2.6 cc -based on 2007-2008 rates

Section 40-65 - Choice of methods to work out the decline in value

• You have a choice of 2 methods to work out the decline in value of a depreciating asset. You must choose to use either the diminishing value method or the prime cost method.– Note 1: Once you make the choice for an asset,

you cannot change it: see section 40-130.– Note 2: For the diminishing value method, see

section 40-70. For the prime cost method, see section 40-75.

– Note 3: In some cases you do not have to make the choice because you can deduct the asset's cost: see section 40-80.

Section 40-70 - Diminishing value methodPost 9 May 2006

• You work out the decline in value of a depreciating asset for an income year using the diminishing value method in this way:

• Base value × Days held × 200% (150%) 365 Asset's effective life

where: base value is: • (a) for the income year in which the asset's start time occurs -

its cost; or• (b) for a later year - the sum of its opening adjustable value for

that year and any amount included in the second element of its cost for that year.

• days held is the number of days you held the asset in the income year

Example of Diminishing Value

• Item costs $10,000 (ignore GST) and has an effective life of 5 years – 20% x 200% = 40%:

• Year 1 – 10,000 x 40% = $4,000 deduction• Year 2 – written down value $6,000 x 40% = $2,400

deduction• Year 3 – written down value $3,600 x 40% = $1,440

deduction• Year 4 – written down value $2,160 x 40% = $864

deduction• Year 5 – written down value $1,296 x 40% = $518

deduction, written down value at end of life = $778

Section 40-75 - Prime cost method

• You work out the decline in value of a depreciating asset for an income year using the prime cost method in this way - where:

• Asset's cost × Days held x 100%

365 Assets effective life

Example: Greg acquires an asset for $3,500 and first uses it on the 26th day of the income year. If the effective life of the asset is 3 1/3 years, the asset would decline in value in that year by:

$3,500 × [365 - 25] x 100% = $978 365 3 1/3

Prime Cost

• Item costs $10,000 (ignore GST) and has an effective life of 5 years – 20%:

• Year 1 – 10,000 x 100% /5 = $2,000 deduction

• Year 2 – written down value $8,000 = $2,000 deduction

• Year 3 – written down value $6,000 = $2,000 deduction

• Year 4 – written down value $4,000 = $2,000 deduction

• Year 5 – written down value $2,000 = $2,000 deduction, written down value at end of life = $0

Section 40-95 - Choice of determining effective life

• You must choose either: – (a) to use an effective life determined by the

Commissioner for a depreciating asset under section 40-100; or

– (b) to work out the effective life of the asset yourself under section 40-105.

• Note: If you choose to use an effective life determined by the Commissioner for a depreciating asset, a capped life may apply to the asset under section 40-102.

Section 40-230 - Adjustment: car limit

• The first element of the cost of a car designed mainly for carrying passengers (after applying section 40-225 and Subdivision 27-B) is reduced to the car limit for the financial year in which you started to hold it if its cost exceeds that limit.

• $57,009 is the 2006-2007 cost limit for claiming a deduction for a decline in value, even if the car cost $250,000. The limit is published annually by the Commissioner. GST on this limit.

Example of a Balancing Adjustment

• Item costs $10,000 (ignore GST) and has an effective life of 5 years – 20%:

• Year 1 – 10,000 x 100% /5 = $2,000 deduction• Year 2 – written down value $8,000 = $2,000 deduction• Year 3 – written down value $6,000 = $2,000 deduction• At the end of Year 4 the asset is sold for $5,000 – written

down value $4,000 = $1,000 balancing adjustment, representing assessable income of $1,000, s 6-5.

• If it had been sold for $3,000, then a deductible loss of $1,000, s 8-1.

Section 40-425 - Allocating assets to a low-cost and low-value pool

• 40-425(1) You may choose to allocate a low cost asset you hold to a low-value pool for the income year in which you start to use it, or have it installed ready for use, for a taxable purpose.

• 40-425(2) A low-cost asset is a depreciating asset, except a horticultural plant (including a grapevine) whose cost as at the end of the income year in which you start to use it, or have it installed ready for use, for a taxable purpose is less than $1,000.

• 40-425(3) You may also choose to allocate a low-value asset to a low-value pool: Where value declined using DV.

• Reason for pool – save on compliance costs

Pooled Assets

• Calculation based on Diminishing Value method and an effective life of 4 years. 25% x 150% = 37.5%. Half of that rate is 18.75%.

• Items added to the pool as low cost or low value during the year are depreciated at the rate of 18.75%.

• The pool balance, at the start of the year, is depreciated at the rate of 37.5%.

Low-Cost Items – less than $100

• For large taxpayers that are not in STS, all items of plant must be written off over their effective life. This means that even a $20 stapler had to be included in the low cost pool.

• The ATO have adopted an administrative policy, PS LA 2003/8 to overcome the compliance problem. $100 the limit – after GST deducted = $90.91 an immediate deduction pursuant to s 8-1

Low-Cost Items: Immediate Write-Offs

• An immediate 100% deduction applies for depreciating assets costing $300 or less and used by taxpayers predominantly in deriving non-business assessable income, s 40-80(2):

- the asset was not part of a set of assets acquired during the year where the total cost of the set exceeded $300; and - the total cost of the asset and any substantially

identical item that the taxpayer started to hold in that year did not exceed $300.

Black hole Expenditure – s 40-880

• 20% - deduction over 5 years• The cost of registering a company – capital cost of

establishing the business structure• Cost of preparing a prospectus to raise share capital• Costs to stop carrying on your business – legal costs in

terminating employees• Certain advertising costs • unsatisfied contingent liabilities • penalty interest associated with the sale of an asset • certain improvement expenditure• Note – interaction with CGT and cost base

Division 43 – Deduction for Capital Works

• Section 43-20:

• ''Capital works'' is an umbrella term covering a wide range of structures, and extensions, alterations and improvements to such structures.

• three broad categories: (a)   buildings;

(b)  structural improvements; (c)  environment protection earthworks

Hotel and apartment buildings- Section 43-95

• A hotel building is, broadly, a building used mainly to operate a hotel, motel or guesthouse where the building has at least 10 bedrooms that are for use mainly to provide short-term traveller accommodation.

• An apartment building is, broadly, a building consisting of at least 10 apartments, units or flats that are for use mainly to provide short-term traveller accommodation. A building's status as an apartment building is not affected if it also has facilities such as lounge rooms and games rooms.

CALCULATION OF CAPITAL WORKS DEDUCTIONS

• Capital works deductions are calculated using the following formula – s 43-210; 43-215:

• Construction x applicable x days used expenditure rate 365

• The ''applicable rate'' is 2.5% or 4% depending on:

• (a)   when construction of the capital works started; and  (b) the use to which the capital works are put

Example

• Construction of a block of flats is started in March 2001 under a contract entered into in July 2000. The 2.5% rate therefore applies. The total construction expenditure is $2m and the building is completed and first used for income-producing purposes on 24 February 2002 (the 239th day of the 2001/02 income year).

• The taxpayer is entitled to a capital works deduction in 2001/02 of $17,260 (i.e. 126/365 × 2.5% × $2m). In each of the following 39 years, the taxpayer is entitled to an annual deduction of $50,000; in 2041/42, the taxpayer is entitled to a deduction for the balance of $32,740, i.e. the remaining undeducted construction expenditure.

WHAT IS CONSTRUCTION

EXPENDITURE ?• Construction expenditure is determined on

the basis of the actual cost incurred in relation to the construction of a building, structural improvement, extension, etc.

• Construction expenditure includes preliminary expenses such as architect's fees, engineering fees, surveying fees, building fees, costs associated with obtaining the necessary building approvals and the cost of foundation excavations (Taxation RulingTR 97/25)

Construction expenditure where original construction cost

unknown• Where a taxpayer is completely unable to obtain

information about the actual cost of capital works, a building cost estimate by a quantity surveyor or other independent qualified person may be used.

• Examples of other qualified people may include clerks of works, builders experienced in estimating construction costs of similar building projects, supervising architects and project organisers. However, valuers, real estate agents, accountants and solicitors are not normally considered to be appropriately qualified.

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