Allowable deductions – essentials
August 2012
Presented by:
The Institute Tax Training Specialists
Allowable deductions – essentials
Current as at August 2012
Disclaimer
The Institute of Chartered Accountants in Australia owns the copyright in this document. The
document must not be copied or made available to third parties, in whole or in part, in any
form or by any means, without the prior written consent of The Institute.
The contents are for general information only. They are not intended as professional advice
- for that you should consult a Chartered Accountant or other suitably qualified professional.
The Institute expressly disclaims all liability for any loss or damage arising from reliance upon
any information in these papers.
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Contents
Objectives ...................................................................................................................... 4 1. Introduction ........................................................................................................... 5 1.1 Summary - point of reference...................................................................................................... 5 2. Deductions........................................................................................................... 10 2.1 General deductions ................................................................................................................... 11 2.2 Specific deductions ................................................................................................................... 30 2.3 Non-deductible losses and outgoings ....................................................................................... 45 3. Part IVA ................................................................................................................ 50 Copyright © The Institute of Chartered Accountants in Australia 2012
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Objectives
This paper, aimed at a junior audience level, focuses on allowable deductions – essentials. The
paper is presented as part of the Institute of Chartered Accountants in Australia (the Institute) special
topics program.
Specifically, the paper will examine:
• When the question of whether or not deductions are allowable arises
• The positive and negative limbs of the general deduction provision under section 8-1 of
the ITAA 1997
• Some of the specific deductions contained in the tax acts
• Certain expenditure that the tax acts do not permit taxpayers to deduct
• The anti-avoidance provisions in Part IVA of the ITAA 1936
References in this paper to the Tax Acts are references to the Income Tax Assessment Act 1997
(Cth) (ITAA 1997), Tax Administration Act 1953 (TAA) and/or Income Tax Assessment Act 1936
(Cth) (ITAA 1936), as applicable.
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1. Introduction
The net income tax payable by an entity is calculated as follows:
assessable income
(Division 6)
less allowable deductions
(Division 8)
=
taxable income
(section 4-15)
×
applicable tax rate
(Income Tax Rates Act 1986)
less credits, rebates and tax offsets
=
net tax payable
(section 4-10)
Each of these concepts will be discussed in detail below.
1.1 Summary - point of reference
The table below sets out some of the basic taxation principles underlying the concepts of
assessable income and allowable deductions:
Aspect
Assessable
income
Legislative
Reference
Division 6 of the
ITAA 1997
Explanation
• Consists of ordinary income and statutory
income
• It excludes the ordinary income and statutory
income that is:
¾ Exempt income (section 6-20); and
¾ Non-Assessable Non-Exempt (NANE) income
(section 6-23).
Allowable
deductions
Division 8 of the
ITAA 1997
• Consists of general deductions and specific
deductions
• Certain amounts are not allowed as deductions
even though they may otherwise fall within the
allowable deduction rules (sections 8-1(2) and 85(2)).
• Where an amount could be considered under two
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different provisions, the most appropriate provision
applies and the amount cannot be claimed twice
(section 8-10).
Taxable
income
Section 4-15 of the
ITAA 1997
• Taxable income for an income year is calculated
as follows:
assessable income – allowable deductions
Calculating
income tax
Section 4-10 of the
ITAA 1997
• Amount of income tax calculated as follows:
(taxable income x tax rate) – tax offsets
Applicable
tax rate
Income Tax Rates
Act 1986
• Tax rates will differ depending upon the type of
entity, whether it be an individual, company or a
superannuation fund.
• The tax rates applied may be either flat or
marginal.
• For instance, a flat rate of 30% is applied for
companies, whereas a marginal tax rate applies to
individuals (the rate increases in steps depending
on the amount that a person earns).
Credit
Refer to section 13-1
of the ITAA 1997
•
Credit is used in the ITAA 1936 for an amount of
tax that is credited to the taxpayer (e.g. PAYG
instalments). Tax offsets that correspond with
credits given under the ITAA 1936 are taken to be
credits.
Rebate
Refer to section 13-1
of the ITAA 1997
•
Rebate is used in the ITAA 1936 for a tax
concession granted due to a taxpayer’s
circumstances that reduces the tax payable
Tax offset
Refer to section 13-1
of the ITAA 1997
•
Offset is used in the ITAA 1997 to describe
rebates and credits
Medicare
levy
Refer Medicare Levy
Act 1986
•
The Medicare levy and Medicare Levy Surcharge
are deemed to be taxes (refer to section 251R(7)
of the ITAA 1936).
•
The Medicare levy is calculated at a base rate of
1.5% and added to the net tax payable (refer to
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section 6 of the Medicare Levy Act 1986).
Other
special
levies
•
Individual taxpayers earning more than $80,000
for the 2011-12 year (or $160,000 in family
income, increased by $1,500 for each dependent
child after the first child) pay an additional 1% if
they do not have appropriate private health
insurance (refer sections 8B-8D of the Medicare
Levy Act 1986; sections 10-16 of the A New Tax
System (Medicare Levy Surcharge – Fringe
Benefits) Act 1999).
•
Under planned legislative changes that have
passed the House of Representatives and are
before the Senate, from 1 July 2012 the thresholds
for the Medicare Levy Surcharge will increase to
$83,000 for individuals and $166,000 for families,
and the rate of the Medicare Levy Surcharge will
also increase depending on the income of the
taxpayer or their family, with the surcharge rate
ranging from 1% to 1.5% depending on income.
•
From time to time, other special levies apply. For
instance, the Temporary Flood and Cyclone
Reconstruction Levy (Flood Levy) applies to
individual taxpayers for the 2011-12 year (refer
section 4-10 of the Income Tax (Transitional
Provisions) Act 1997). Under the Flood Levy,
extra income tax is payable at the following rates:
¾ A rate of 0.5% for the part of the taxpayer's
taxable income between $50,000 and $100,000,
and
¾ A rate of 1% for the part of the taxpayer's
taxable income over $100,000.
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The following example illustrates how some of these basic concepts are applied.
Example – Company
XYZ Pty Ltd’s assessable income for the 2012 income year was $6,000. Its allowable
deductions for the 2012 income year were $5,000.
$6,000 – $5,000 = $1,000
XYZ Pty Ltd’s taxable income for the 2012 income year was $1,000.
The corporate tax rate for the 2012 income year is 30% and applies to XYZ. XYZ has no tax
offsets for the 2012 income year.
For the 2011 income year, XYZ is liable for income tax of $300.
($1,000 x 30%) – $0 = $300
The following two examples illustrate the calculation of the tax payable of a resident
individual compared with that of a resident company.
Example – resident individual (applying 2012-13 tax rates)
$
Assessable income
70,000
Allowable deductions
(10,000)
Taxable income
$
60,000
Calculation of tax payable
Tax on first $18,200
nil
Tax on surplus up to ($37,000) at 19%
3,522
Tax on surplus up to ($60,000) at 32.5%
7,475
Medicare levy 1.5%
Tax offsets
11,047
900
(2,100)
9,847
PAYG instalments
Tax payable (refundable)
(11,300)
(1,453)
NB: this example does not take into account the low income offset.
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Example – resident company
Assessable income
Allowable deductions
Taxable income
$
70,000
(10,000)
$
60,000
Calculation of tax payable ($60,000)
Tax offsets
18,000
(2,100)
15,900
PAYG instalments
Tax payable
(8,300)
7,600
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2. Deductions
Division 8 of the ITAA 1997 contains the core rules for deductibility of losses and outgoings.
The Division draws a distinction between general deductions and specific deductions.
A general deduction is a loss or outgoing
Section 8-1 of the ITAA 1997
which is deductible under the general
principles of deductibility. Broadly, this
requires the loss or outgoing to have the
relevant connection with assessable income
or the carrying on of a business provided that
it does not have a capital, private or domestic
nature.
A specific deduction, on the other hand, is
Section 8-5 of the ITAA 1997 (section 12-5
a loss or outgoing which is deductible under
contains a summary list of provisions about
a specific provision of the Tax Acts other
deductions)
than section 8-1 of the ITAA 1997.
Where a loss or outgoing is deductible under
Section 8-10 of the ITAA 1997
two or more provisions of the Tax Acts, a
taxpayer can only deduct the amount under
the provision that is most appropriate.
For example, a loss arising from a debt on
the revenue account written off during the
year of income (i.e. a bad debt) may qualify
for deduction under the general deduction
provision of section 8-1 as well as the
specific deduction provision of section 25-35
of the ITAA 1997.
Division 8 of the ITAA 1997, as originally enacted, commenced on 1 July 1997 and applies to
assessments for the 1997-1998 and later income years (refer to section 4-1 of the Income
Tax (Transitional Provisions) Act 1997 (Cth)).
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Section 8-1 is intended to restate the former general deductibility provision of repealed
subsection 51(1) of the ITAA 1936. In this regard, the operation of subsection 51(1) is limited
to 1996-1997 and earlier income years.
Section 8-1 was not intended to disturb the
language of subsection 51(1) or affect previous interpretations (refer to Explanatory
Memorandum to the Tax Law Improvement Bill 1996 (Cth)).
Given this intention, and the fact that the key words used in section 8-1 are virtually identical
to those used in subsection 51(1), the significant amount of case law handed down over the
years on subsection 51(1) is directly relevant to the interpretation of section 8-1. For this
reason, much of the law on general deductions arises from decisions relating to subsection
51(1) of the ITAA 1936.
2.1 General deductions
The general deduction provision of section 8-1 of the ITAA 1997 states that:
(1)
You can deduct from your assessable income any loss or outgoing to the extent
that:
(a)
it is incurred in gaining or producing your assessable income; or
(b)
it is necessarily incurred in carrying on a business for the purpose of
gaining or producing your assessable income.
(2)
However, you cannot deduct a loss or outgoing under this section to the extent
that:
(a)
it is a loss or outgoing of capital, or of a capital nature; or
(b)
it is a loss or outgoing of a private or domestic nature; or
(c)
it is incurred in relation to gaining or producing your exempt income or your
non-assessable non-exempt income; or
(d)
a provision of this Act prevents you from deducting it.
Accordingly, a taxpayer will be entitled to a general deduction under section 8-1 for a loss or
outgoing if the loss or outgoing satisfies either one of the two positive limbs in subsection 81(1) and none of the four negative limbs in subsection 8-1(2) apply.
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2.1.1 Positive Limbs
As noted above, subsection 8-1(1) of the ITAA 1997 contains two positive limbs which allow
a taxpayer to deduct a loss or outgoing from their assessable income to the extent that:
(a)
it is incurred in gaining or producing the taxpayer’s assessable income (first
positive limb); or
(b)
it is necessarily incurred in carrying on a business for the purpose of gaining or
producing the taxpayer’s assessable income (second positive limb).
The first positive limb is available to all taxpayers that generate assessable income,
irrespective of whether or not the loss or outgoing is incurred in the carrying on of a business
(refer to FCT v Green (1950) 81 CLR 313).
On the other hand, the second positive limb applies only where the taxpayer carries on a
business for the purpose of gaining or producing assessable income. Taxpayers carrying on
a business may rely on either or both of the positive limbs (refer to FCT v Snowden & Willson
Pty Ltd (1958) 99 CLR 431).
It should be noted that although the two positive limbs have separate tests, they are not
mutually exclusive and there are areas of overlap.
An example of a case that appears to fall within the second positive limb, but not the first
positive limb is Charles Moore & Co (WA) Pty Ltd v FCT (1956) 11 ATD 147 ("Charles
Moore's Case"). In that case, a department store was allowed a deduction relating to the
theft of the previous day’s takings, that occurred while an employee was taking the cash to
the bank. The High Court found that the banking of each day’s takings was as essential to
the conduct of the taxpayer’s business as the purchase of stock or the paying of employees
and as such the losses suffered during that activity were losses necessarily incurred in
carrying on the taxpayer's business (irrespective of whether or not the losses were
themselves incurred in gaining or producing assessable income). The losses were therefore
deductible. For completeness, section 25-45 of the ITAA 1997 now allows a deduction for
certain losses by theft so these losses would be specific deductions rather than general
deductions.
However, whether a loss or outgoing satisfies the first positive limb or the second positive
limb is ultimately a question of fact and degree (refer to Maryborough Newspaper Co Ltd v
FCT (1929) 43 CLR 450 at pages 452-453).
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2.1.2 What is a “loss or outgoing”?
Generally, the term outgoing refers to all types of expenditure and implies an actual
movement of resources from a taxpayer (such as a payment of money or provision of
property), while the term loss covers situations where no payment is involved (for example,
theft). It is generally accepted that loss also covers involuntary payments.
Both of the positive limbs require the identification of a loss or outgoing. As such, where
there is no loss or outgoing (as is the case for notional expenditure), no deduction will be
allowed.
Example – Lease incentives
Where a lessor provides a lease incentive (to induce the lessee to enter into the lease) in the
form of a rent-free or reduced rent period, the lessor is not entitled to a deduction for the
forgone rent because it is not possible to characterise that foregoing as a loss or outgoing
(refer to Taxation Ruling IT 2631).
2.1.3 Meaning of “to the extent”?
The phrase to the extent is used in both of the positive limbs and all four of the negative
limbs, so it is clear that where a loss or outgoing has more than one purpose or
characterisation or where the loss or outgoing either only partly satisfies the positive limbs, or
in part falls within a negative limb, taxpayers are required to apportion the expenditure
between different purposes or characterisations (refer to subsection 8-1(1) and (2) of the
ITAA 1997 and Ronpibon Tin NL v FCT (1949) 78 CLR 47 (Ronpibon Tin’s case)).
The Tax Acts do not specify how losses or outgoings that are deductible as general
expenses need to be apportioned, and the appropriate method of apportionment is
determined on a case by case basis (refer to Ronpibon Tin's case).
When the appropriate method of apportionment is discussed, the distinction is often drawn
between the process of apportioning an outgoing which is incurred in acquiring a single thing
or service which is used to serve multiple purposes (such as directors' fees where the
company generates assessable income and exempt income), and the process of
apportioning an outgoing which is incurred acquiring things or services that can be divided
into distinct parts that are ultimately used for different purposes (such as trading stock which
is acquired in bulk, but which is ultimately used for different purposes).
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The overarching principle adopted by the Commissioner is that apportionment must be fair
and reasonable in all the circumstances, with the further guidance provided that where an
outgoing falls in the latter category, the actual use of the things acquired is likely to constitute
a fair and reasonable basis for apportionment. In contrast, the very nature of the outgoings
in the former category make it much harder to identify an objective arithmetic measure of
apportionment, although the decided cases may be used to provide some guidance.
Example – apportioning undivided services
A taxpayer company has operations which produce both assessable income and exempt
income. The directors of the company are paid a single annual fee for their services.
However, in running the company's operations, the directors are necessarily required to
manage and supervise the activities that go towards producing both the company's
assessable income (for which a deduction would be allowed) as well as its exempt income
(for which no deduction would be allowed).
In these circumstances, the company should apportion the directors' fees between the two
purposes based on what is fair and reasonable.
Example – apportioning between distinct purposes
Brian borrows $100,000 from the bank. He uses $50,000 to purchase shares which he will
hold and from which he will receive franked dividends.
He uses the other $50,000 to
renovate his home. In the first year he incurs $8,000 in interest on the loan.
As a portion of the loan is used for income-producing purposes (the purchase of the shares)
and another portion is used for a private or domestic non-deductible purpose (the
renovation), Brian can only deduct the interest that relates to the portion of the loan used to
purchase the shares.
In this example, an interest deduction of $4,000 should be available (being 50% of the total
interest of $8,000).
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2.1.4 Sufficient nexus to claim a deduction under the first positive limb
A deduction is only allowed under the first positive limb if there is the requisite link or nexus
between the loss or outgoing and the activities that the taxpayer carries out to gain or
produce its assessable income.
While the connection that is required to satisfy the nexus requirement has been accepted to
be quite broad, some connections are simply too remote to satisfy it. In this regard, it is
useful to note that just because an outgoing is necessarily incurred in order for the income to
be earned does not automatically mean that it was incurred in the production of assessable
income. For example, a taxpayer who claimed he was required to eat certain foods to be fit
to earn assessable income as a footballer failed to show a relevant nexus between his
outgoings for groceries and his wages.
There is no requirement that the expenditure has a nexus with income earned or to be
earned in the year of expenditure in that it produces assessable income in the same year in
which the expenditure is incurred. However, the longer the time period between expenditure
and income, the less likely it becomes that a nexus will be found, and in particular, losses or
outgoings incurred too far prior to, or too long after, the production of assessable income
may result in the taxpayer not being allowed a deduction (in addition to the difficulty in
identifying a nexus between the outgoing and the assessable income, these losses or
outgoings can sometimes be of a capital nature).
While it will ultimately depend on the specific facts of the case, a number of tests have been
expressed as being of assistance in determining whether there is an appropriate connection
between the outgoing and the production of assessable income. Because they come from
case law, they are often described as the "unlegislated tests", and while they should not be
substituted for the actual words of the legislation, they are summarised below:
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Test
Reference
The outgoing will be deductible if it is
incidental and relevant to the taxpayer’s
operations that result in the generation of
assessable income.
Ronpibon Tin’s case, Amalgamated Zinc (de
Bavay's) Ltd v FCT (1935) 54 CLR 295 and
W Neville & Co Ltd v FCT (1937) 56 CLR
290
In summary, the outgoing will be incidental if
it is related to the income generating process
(without needing to be related to a specific
item of income) and it will be relevant if there
is a degree of dependency between the
production of the assessable income and the
outgoing, although it does not follow that just
because an outgoing is a necessary precondition to the production of assessable
income, it is also incidental and relevant.
The outgoing will be deductible if it has the
essential character of an assessable
income producing expense, as opposed to
being incurred for other purposes.
Charles Morre's case, Lunney v FCT; Hayley
v FCT (1958) 100 CLR 478
This is not intended as a stand-alone test,
and instead imposes a further limit on the
deductions that would otherwise be allowed
under the incidental and relevant test.
Accordingly, it is not enough to show that an
outgoing is incidental and relevant to the
generation of income, and consideration
must still be given to the purpose for which a
taxpayer incurred a certain expenditure.
Of lesser authority to the incidental and
relevant and essential character tests, it has
also been suggested that it may be indicative
that an outgoing will be deductible if:
•
There is a perceived connection
between the outgoing and the gaining
or producing of assessable income;
or
FCT v Hatchett (1971) 71 ATC 4184
•
The outgoing is incurred by an
individual taxpayer as a term or
Although compare FCT v Cooper (1991) 29
FCT 177
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condition of employment.
The outgoing need not be paid for the
purpose of earning the assessable income,
as long as the outgoing occurs in the course
of earning the assessable income.
FCT v Anstis [2010] HCA 40
(Although the actual deductions allowed in
that case will be prevented in future by
statutory provision)
These tests tie into the process of
determining whether the loss or outgoing is
incidental and relevant to the generation of
assessable income. For example,
demonstrating that an outgoing is incurred as
a condition of employment suggests that the
outgoing will be incidental and relevant to the
generation of assessable income, and
therefore deductible.
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The following scenarios give you practical examples of the nexus requirement:
Example 1 – No nexus (amount settled on discretionary trust)
Joshua borrows $100,000 from the bank and settles this into his discretionary family trust (JJ
Trust). The trustees of the family trust are Joshua and his wife Jennie. The JJ Trust will use
the $100,000 to derive assessable income.
In the past, Joshua has been the main beneficiary of all income and capital distributions from
the JJ Trust.
The interest Joshua incurs on the loan from the bank will not be deductible as there is not the
sufficient nexus between the outgoing and the income Joshua might in the future derive from
the JJ Trust because distributions from the trust are up to the discretion of the trustees,
notwithstanding the fact that Joshua settled $100,000 into the trust.
Example 2 – Nexus (amount invested in fixed trust)
Assume the same facts as Example 1 except that Joshua uses the $100,000 to purchase
units in a fixed trust (the JJ Fixed Trust). The units Joshua is purchasing have rights to
income and capital distributions.
The interest incurred on the $100,000 borrowed is likely to be deductible because there is a
nexus between the interest outgoings and the derivation of assessable income through the
distributions made by the JJ Fixed Trust.
Example 3 – Nexus (loan to discretionary trust)
Assume the same facts as Example 1 except Joshua lends the money to the JJ Trust.
The interest charged by Joshua is 1% higher than the interest rate on the loan from the bank.
The interest incurred by the JJ Trust will be deductible, assuming that it uses the loan to
derive assessable income.
The interest Joshua incurs in relation to the bank loan will also be deductible and the interest
he receives from the JJ Trust will be assessable.
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2.1.5 Sufficient nexus to claim a deduction under the second positive limb –
“necessarily incurred”
The second positive limb states that losses or outgoings may be deducted to the extent
they are necessarily incurred in carrying on a business for the purpose of gaining or
producing assessable income. In contrast to the first positive limb, this limb requires the
connection to be between the loss or outgoing and the carrying on of a business, rather than
the production of assessable income itself.
Business is defined in the ITAA 1997 to include any profession, trade, employment, vocation
or calling, but does not include occupation as an employee. Further, although the loss or
outgoing must be incurred in the carrying on of a business, the loss or outgoing will generally
be deductible if the occasion for the loss or outgoing is found in the business operations. In
saying this, there is clearly scope for losses and outgoings to be disallowed as deductions
where they are incurred too early before or too long after the business operations.
The term necessarily incurred does not mean that the expenditure must be absolutely or
logically necessary, or that it must be the best way of achieving the taxpayer’s business
objectives and is instead intended to mean no more than that the expenditure was clearly
appropriate or adapted for the taxpayer's business objectives (refer to Ronpibon Tin’s case
and Tweedle v FCT (1942) 2 AITR 360).
In this context, a voluntary outgoing will be necessarily incurred if it was reasonably
capable of being seen as desirable or appropriate from the point of view of the taxpayer’s
business (refer to Magna Alloys & Research Pty Ltd v FCT (1980) 80 ATC 4542).
For practical purposes, it is for the person carrying on the business to be the judge of what
outgoings are necessarily incurred and it is not for the Courts to go back and reassess
whether it was appropriate to incur the outgoing (refer to TR 95/33).
In deciding whether a loss or outgoing was necessarily incurred, an objective assessment
of the circumstances is usually sufficient. However, if an examination of the objective facts
and circumstances does not disclose an obvious commercial connection between the loss or
outgoing and the carrying on of the taxpayer's business, it may be necessary to have regard
to the taxpayer's subjective purpose. In particular, where the scope of the outgoing is
disproportionately high compared to the assessable income earned, it may be necessary to
have regard to the subjective purpose of the taxpayer. If this is the case, the uncommercial
terms may themselves suggest that the loss our outgoing is being incurred for purposes
other than those of the taxpayer's business. This is the case in the following example:
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Example – Not necessarily incurred - no obvious commercial connection
Ms Skeam borrows $100,000 from her spouse, who does not earn sufficient taxable income
to be subject to income tax, at 17% interest in a non-arm's length transaction to finance the
purchase of a rental property. The commercial rate of interest is 10%.
Ms Skeam's subjective purposes in agreeing to pay the higher rate of interest are to earn
assessable income from the rental property, but also to obtain a greater tax deduction than if
she makes the borrowing at 10% and in that way to secure a tax benefit to the extent of the
additional interest that she pays because while she in intending to claim a deduction for the
interest, her spouse will not be paying tax on the interest that he earns because of his level
of taxable income.
Ms Skeam would only be allowed a deduction under section 8-1 of the ITAA 1997 at the rate
of 10% for the period of the loan.
For completeness, it should be recognised that the Commissioner may also seek to apply the
anti-avoidance provisions in Part IVA of the ITAA 1997 to this situation in order to deny some
of these deductions.
These anti-avoidance provisions are discussed briefly later in this
paper.
This example has been adapted from paragraph 53 of TR 95/33.
2.1.6 Timing of deductions - meaning of “incurred”
Both of the positive limbs require a loss or outgoing to be incurred by the taxpayer in a
particular income year in order for the loss or outgoing to be deductible in that year. The
concept is therefore about identifying the correct timing of the deduction.
The term incurred is not defined in the Tax Acts, and as such it is necessary to have regard
to common law principles. While it is clear that an amount that has been paid has been
incurred other situations also exist where an amount is incurred without having been paid.
As stated in New Zealand Flax Investments Ltd v FCT (1938) 61 CLR 179:
"Incurred" does not mean only defrayed, discharged, or borne, but rather it includes
encountered, run into, or fallen upon. It is unsafe to include exhaustive definitions of a
conception intended to have such a various and multifarious application. But it does not
include a loss which is no more than impending, threatened or expected.
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Generally, a loss or outgoing that is not paid will be incurred if the taxpayer is definitively
committed to it. This is the case where there is a presently existing liability, as opposed to
just a threatened, contingent or anticipated obligation (no matter how certain it may appear
that the obligation will arise in the future). Taxation Ruling TR 94/26 sets out guidelines
based on common law principles that are used by the FCT to determine whether a loss or
outgoing has been incurred in a particular year:
Guideline
Reference
A liability will be “incurred” even though it remains FCT v James Flood
unpaid, provided the taxpayer is “definitively committed”, (1953) 88 CLR 492
or has “completely subjected” itself to the liability.
Flood’s case) and New
Flax Investments Ltd
(1938) 61 CLR 207
Pty Ltd
(James
Zealand
v FCT
A liability may be incurred in an income tax year FCT v Australian Guarantee
notwithstanding that at the end of the year it represents a Corporation Ltd (1984) 84 ATC
present liability that is currently due but payable in the 4642
future.
A pecuniary obligation must actually exist for a liability to Nilsen Development Laboratories
be incurred. Without an actual obligation to pay money Pty Ltd & Ors v FCT (1981) 81
to another party, then the loss or outgoing is not ATC 4031
incurred, “no matter how certain it is in the year of
income that that loss or expenditure will occur in the
future”.
For example, an employee's entitlement to long service
leave is not a liability incurred for the purposes of the
Tax Acts until the employee in fact takes long service
leave as no pecuniary obligation arises until this point.
It is not necessary that the amount of the liability can be Commonwealth
Aluminum
precisely determined so long as it is capable of Corporation Ltd v FCT (1977) 7
reasonable estimation. For example, an insurance ATR 376
company becomes liable to pay under a policy when an
accident occurs. At the end of the year, the company will
not have received notification from policy holders in
respect of all accidents giving rise to liability during the
year.
An outgoing may be incurred even though it is James
Flood’s
Commonwealth
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Case
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21
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defeasible.
Corporation Ltd v FCT (1977) 77
ATC 4151
A presently existing liability may not be necessary where FCT v Raymor (NSW) Pty Ltd
the taxpayer makes a voluntary payment or a (1990) 90 ATC 4461
prepayment.
However, not all voluntary payments will be deductible.
An outgoing is not incurred in a year of income in which James Flood’s case and Hooker
it is no more than contingent, pending, threatened or Rex Pty Ltd v FCT (1988) 88
expected no matter how certain it may be in the year of ATC 4392
income that the loss or expenditure will occur in the
future.
It should be recognised that the question of whether or not a loss or outgoing is incurred is to
be determined on legal principles, rather than accounting principles, although factors such as
commercial or accounting practices may assist in ascertaining the true nature or incidence of
a loss or outgoing, or may be used as evidence that, as a matter of commercial practice, a
liability has definitively arisen such that it has been incurred at a specific time.
Example
An Agency acted as broker for advertisers.
Once a certain number of days before
publication was reached, the advertisement became non-cancellable, and from that time the
agency accepted responsibility for paying the media outlet. However, the agency was not
actually invoiced by the media outlet, nor did it invoice its own client, until after the
advertisement had appeared.
Can the advertising agency claim a deduction for the advertising expense once the
advertisement has become non-cancellable?
In the case of Ogilvy and Mather Pty Ltd v FCT (1990) 90 ATC 4836 it was decided that no
deduction could be claimed until the year in which the advertisement appeared. It was not
until this time that the agency became “definitively committed” to pay the money. The mere
fact that the non-cancellable period had commenced did not mean that the liability had been
incurred.
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Where a loss or outgoing is deductible as a general deduction, it is generally allowable in full
in the year in which it is incurred. However, special prepayment rules apply to alter the
timing of deductions for expenditure of more than $1,000 that is paid but relates to certain
things that will in part be done in later income years.
Simply put, if the prepayment rules apply the deduction that would otherwise be allowable is
instead apportioned over the “eligible service period” for the prepaid thing.
Generally, the eligible service period is the period beginning on the later of either the day the
thing commences to be done or the day the expenditure is incurred, and ending on the day
that the thing ceases to be done, limited to a maximum of 10 years.
The specific apportionment rules vary depending on the nature of the taxpayer.
For
example, taxpayers who carry on a business but who are not a small business entity are
required to apportion the expenditure over the whole eligible service period for the
expenditure, whereas taxpayers who are small business entities may in some cases be
allowed the deduction in full in the year that it is incurred.
2.1.7 “properly referable”
In certain cases, even though an amount has been incurred at one point, the deduction may
be limited to the amount that is “properly referable” to that year. The full deduction would
then be spread over more than one year of income. This principle was advanced by the High
Court in Coles Myer Finance Ltd v FCT1.
In that case the taxpayer borrowed funds by way of commercial bills of exchange. The cost
of the finance is the difference between the amount advanced (at a discount from the face
value determined by the implicit interest rate), and the face value which must be paid back
on maturity by the taxpayer. These bills typically had a maturity of 180 days.
Clearly, the discount (in the nature of interest) will be deductible if there is a nexus with
assessable income and it is also clear that the amount is “incurred” on entry into the contract
at the start of the 180 days. The question in Coles Myer was whether, if the end of an
income year occurs during the 180 days, is the whole discount deductible in the first year –
on the basis that it has been “incurred”?
1
(1993) 25 ATR 95
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The decision of the High Court was that the first year deduction should be only so much of
the discount as is properly referable to that year. This apportionment is done on a straightline time basis.
This principle seems to have a narrow application to this and perhaps similar cases and does
not seem to have displaced “incur” as the dominant test of timing of deductions. It should be
noted though, that even in cases where the properly referable test is applied, it is essential to
deductibility that the amount be “incurred” for a deduction to be allowed.
2.1.8 Negative Limbs
A loss or outgoing which satisfies the positive limbs is not deductible if it falls within any one
of the negative limbs.
The four negative limbs contained in subsection 8-1(2) provide that a taxpayer cannot deduct
any loss or outgoing under section 8-1 to the extent that:
•
It is a loss or outgoing of capital, or of a capital nature (first negative limb);
•
It is a loss or outgoing of a private or domestic nature (second negative limb);
•
It is incurred in relation to gaining or producing the taxpayer’s exempt income or nonassessable, non-exempt income (third negative limb); or
•
A provision of the Tax Acts prevents the taxpayer from deducting it (fourth negative
limb).
Because each negative limb is framed in using the phrase "to the extent that", the section of
this paper that deals with that phrase and the apportionment of deductions are also relevant
to any consideration of the negative limbs.
2.1.9 First negative limb – capital losses or outgoings
The first negative limb denies a deduction for a loss or outgoing of capital or of a capital
nature.
The Tax Acts do not provide guidance as to whether a loss or outgoing is capital or revenue
in nature. The dividing line between capital and revenue expenditure is in some instances so
thin that, in IR Commrs v British Salmson Aero Engines Ltd (1938) 22 TC 29, the Court said
that:
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…in many cases it is almost true to say that the spin of a coin would decide the matter
almost as satisfactorily as an attempt to find reasons.
Despite this, the common law has developed a number of tests to assist in distinguishing
between capital and revenue expenditure. Arguably the leading test for Australian purposes
is from the case Sun Newspapers Ltd v FCT (1939) 61 CLR 337. Broadly, this involves
looking at the purpose for which the expenditure was incurred, with the relevant distinction
being whether the expenditure was made for the purpose of the income earning process or
the income earning structure, with the latter being of a capital nature.
The question of capital vs revenue expenditure was recently considered in St George Bank
Limited v FCT [2008] FCA 453 where the Federal Court held that interest payments under a
debenture made by St George Bank Limited (SGB) to its US subsidiary company were
outgoings of a capital nature (rather than revenue) for the purposes of section 8-1(2)(a) of
the ITAA 1997. This was so because the advantage sought and obtained by them was not
the use by the borrower of the money during the term of the loan, but the maintenance and
support of the capital raised by the St George Funding Company LLC (LLC). In Sinclair v
FCT [2010] AATA 902, the AAT recently disallowed a taxpayer's deduction of $99,000
claimed as "interest on loans" on the basis that the sum of $99,000 was part of the purchase
price of the property, and in the circumstances, the expenditure in the hands of the taxpayer
was in the nature of capital expenditure, and therefore not deductible. This was despite the
fact that the taxpayer paid the $99,000 to cover interest payments that were required to be
made by the vendor to a third party.
The Tribunal also concluded that while the taxpayer correctly understood that any interest
paid on a loan was deductible, what was misunderstood was that section 8-1(1) only permits
the deduction of a loss or outgoing to the extent that the taxpayer had incurred it in gaining or
producing assessable income. In this regard, the Tribunal noted that the amounts of interest
owed were incurred by the vendor and not the taxpayer.
The court said that the advantage sought from the periodic payment of interest was one that
accrued to the taxpayer itself. The advantage consisted of the maintenance of the expansion
and strengthening of the taxpayer’s and the group’s capital standing and the satisfaction of
the regulatory capital requirements as a condition of its banking licence. In other words, the
expenditure went to their income earning structure.
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Over the years, the courts have formulated the following indicia to assist in determining
whether a loss or outgoing is capital or revenue in nature:
The process-structure test – This test requires an enquiry as to whether the expenditure
relates to the structure within which the profits are earned or whether it relates to part of
the money-earning process (refer to Sun Newspapers Ltd; Associated Newspapers Ltd v
FCT (1936) 61 CLR 337);
Recurrent vs once and for all expenditure – This test suggests that if expenditure is
recurring, it is more likely to be revenue in nature; conversely, if it is a one-off expenditure,
it is more likely to be capital in nature (refer to Vallambrosa Rubber Co Ltd v Farmer
(1910) 5 TC 529);
Enduring benefit or once and for all test – This test focuses on the effect of the
expenditure and suggests that if a loss or outgoing gives rise to a benefit of an enduring
nature, the loss or outgoing is more likely to be capital in nature (refer to British Insulated
& Helsby Cables v Atherton (1926) 10 TC 155);
The distinction between fixed or circulating capital – These accounting concepts have
been referred to by the Courts to suggest that if the outgoings relate to the business's
fixed capital they are capital in nature, whereas if they relate to circulating capital they
are of a revenue character although this distinction does not always hold true; and
Requirement of an economic sense – This suggests that a loss or outgoing can only be
capital or of a capital nature when it is expended to obtain what can properly be described
as capital in the economic sense.
None of the above indicia provides an exhaustive test but, taken together, they represent the
comprehensive approach that courts, especially in later cases, have applied to difficult cases.
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Allowable deductions – essentials
Current as at August 2012
Example – outgoings of a capital nature
The following expenditure has been held to be of a capital nature:
A taxpayer’s deduction for the interest element in an annuity was denied on the grounds that
it was wholly of a capital nature (refer to AJC Investment Co Pty Ltd v FCT (1977) 77 ATC
4201, but compare the treatment of interest on loans in Steele v DFCT (1999) 41 ATR 139;
Company formation expenses, and the cost of an alteration to or reduction in share capital
are not deductible (refer to Archibald, Thompson, Black & Co Ltd v Batty (1919) 7 TC 158).
Note that section 40-880 of the ITAA 1997 allows a deduction for this expenditure over five
years; and
An amount paid by a newspaper to another newspaper company to buy out its threat to
launch a cheaper competing paper was held to be capital (refer to Sun Newspapers Ltd v
FCT (1938) 61 CLR 337).
2.1.10 Second negative limb – private or domestic losses or outgoings
The second negative limb denies a deduction for a loss or outgoing to the extent that it is of
a private or domestic nature. Because of the phrase "to the extent" in each of the positive
limbs and in this negative limb, even where the deduction is permitted, it may need to be
apportioned. The question of whether or not deductions are allowable (or required to be
apportioned) as a result of this negative limb is an area where disputes commonly arise
between taxpayers and the Australian Taxation Office ("ATO").
As such, as a matter of practice, regard should be had to Tax Rulings issued by the ATO,
and in particular the industry and occupation specific publications where the FCT sets out his
views on the income tax treatment of certain types of individual taxpayer. While the ATO
Rulings and these summaries outline the FCT's view of the correct position rather than the
strict legal position, as a matter of tax administration it is important to understand that
position.
Private expenditure relates to the taxpayer personally and domestic expenditure relates
to the taxpayer's household or other domestic affairs.
The existence of the second negative limb implies that a loss or outgoing of a private or
domestic nature could satisfy the positive limbs. Comments in cases, however, indicate
that it would only be in rare situations that a private or domestic loss or outgoing could satisfy
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the positive limbs of the provision, one such example being in the context of home office
expenses.
Example – outgoings of a private or domestic nature
The following expenditure has been held to be losses or outgoings of a private or domestic
nature:
•
Food is generally held to be of a private or domestic nature (refer to Commissioner of
Taxation v Cooper (1991) 21 ATR 1661);
•
Clothing is usually of a private nature, but some occupational specific clothes (including
certain uniforms and protective clothing) may be deductible (refer to Tax Ruling TR
97/12 and the various industry and occupation specific rulings);
•
A claim by an officer in the Regular Army to deduct the cost of regulation-style haircuts
was rejected, as costs of grooming are of a private nature (refer to Case L61 (1979) 79
ATC 488);
•
The cost to a fire fighter in laundering bed linen, which he was obliged to provide for
use when on night shift, was disallowed (refer to Case N16 (1981) 81 ATC 86); and
•
The costs incurred by a member of the police force engaged as a general duties officer
in renewal of his pilot’s licence and self-education costs related to the licence were
disallowed as private (Case N95 (1981) 81 ATC 512).
2.1.11 Third negative limb – losses or outgoings incurred in gaining or
producing exempt income or NANE income
The third negative limb denies a deduction for a loss or outgoing to the extent that it is
incurred in gaining or producing exempt income or NANE income.
However, it appears that the third negative limb is superfluous given that subsection 6-1(3)
and section 6-15 of the ITAA 1997 make it clear that neither exempt income nor NANE
income constitute assessable income.
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Example – Third negative limb
The ABC SMSF has one member. Peter (aged 66), who is wholly in pension phase. Peter is
in receipt of a pension that is NANE income.
The ABC SMSF incurs audit costs for the current year of $2,200. As all the income in the
SMSF will be NANE income, the $2,200 incurred on the audit fees will be non-deductible.
2.1.12 Fourth negative limb – losses or outgoings where a provision of the Tax
Acts prevents a deduction
The fourth negative limb denies a deduction for a loss or outgoing where another provision
of the Tax Acts denies the deduction.
There are various provisions in the Tax Acts which specifically deny a deduction (in part or
whole) for a loss or outgoing. Such provisions include Divisions 26 and 820 of the ITAA
1997 and Part IVA of the ITAA 1936. Other provisions, such as Division 32 (Entertainment
expenses) impose additional requirements that must be met in order for a deduction to be
allowable.
Example – Limits on deductions for certain personal superannuation
contributions
Jackson made a $50,000 personal superannuation contribution in March 2012. He satisfies
all the requirements to make a deductible superannuation contribution.
His total assessable income for the 2011/12 income year is $45,000.
Section 26-55(1)(d) of the ITAA 1997 identifies section 290-150 as a section that limits the
amount you can deduction for personal superannuation contributions where all/part of the
deduction will give rise to or increase a tax loss.
As Jackson only has $45,000 in assessable income, he can only deduct $45,000 of the
personal superannuation contribution (the $5,000 will be treated as non-concessional).
Example – Maintaining your family
Section 26-40 of the ITAA 1997 prevents you claiming a deduction for the cost of maintaining
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your family.
A farmer cannot deduct an amount for food or lodgings that the farmer provides to his or her
child who is under 16 years for the work the child performs on the farm.
2.2 Specific deductions
Broadly, a specific deduction is a deduction for a loss or outgoing under a provision other
than the general deduction provision of section 8-1 (refer to section 8-5 of the ITAA 1997).
Section 12-5 of the ITAA 1997 provides a reference guide that identifies the sections relating
to specific deductions contained in the Tax Acts.
The rule against double deductions contained in section 8-10 stipulates that where a
taxpayer may be entitled to a deduction for a loss or outgoing under two or more provisions
(such as under the general and specific deductions provisions), the deduction is allowed only
under the provision that is “most appropriate”. As a general rule of statutory interpretation,
the specific legislative provisions are likely to apply over the general deductions.
Certain specific deductions applicable to losses and outgoings are discussed below.
2.2.1 Capital allowances – Division 40 of the ITAA 1997
The capital allowance provisions in Division 40 of the ITAA 1997 allow deductions for various
types of capital expenditure. Broadly, such deductions would not otherwise be available to a
taxpayer on the basis that the loss or outgoing was capital or capital in nature.
Subdivision 40-B of the ITAA 1997 provides that a taxpayer who is the holder of a
depreciating asset may be entitled to a deduction for its decline in value.
A depreciating asset is defined as an asset that has a limited effective life and that can
reasonably be expected to decline in value over the time it is used (refer to subsection 4030(1) of the ITAA 1997). There are however three exceptions in that land, trading stock and
prescribed intangible assets are not depreciating assets (refer to subsections 40-30(1) and
40-30(2) of the ITAA 1997).
A taxpayer is a holder of a depreciating asset if it satisfies the conditions listed in section 4040 of the ITAA 1997. The general rule is that the owner (or the legal owner if there is both a
legal and an equitable owner) of the asset holds the depreciating asset. However, in addition
to the owner, another entity may be the holder of the asset under section 40-40.
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Broadly, the starting point for calculating the decline in value is to start with the depreciating
asset’s effective life and then use either the prime cost or diminishing value method for
calculating depreciation, as outlined in the example below.
Example 1 – Depreciation methods
Laura purchased a photocopier on 1 July 2010 for $1,500 and she started using it that day. It
has an effective life of five years. As set out in the ATO's “Guide to depreciating assets”
2010/11, the deductions will be calculated as follows:
Method 1 – Diminishing value method (ignoring any GST impact)
If Laura chose to use the diminishing value method to work out the decline in value of the
photocopier, the decline in value for the 2010-11 income year would be $600. This is worked
out as follows:
1,500
x
365
x
200%
365
5
If Laura used the photocopier wholly for taxable purposes in that income year, she would be
entitled to a deduction equal to the decline in value. The adjustable value of the asset at
30 June 2011 would be $900. This is the cost of the asset ($1,500) less its decline in value
up to that time ($600).
Method 2 – Prime cost method (ignoring any GST impact)
If Laura chose to work out the decline in value of the photocopier using the prime cost
method, the decline in value for the 2010-11 income year would be $300. This is worked out
as follows:
1,500
x
365
365
x
100%
5
If Laura used the photocopier wholly for taxable purposes in that income year, she would be
entitled to a deduction equal to the decline in value. The adjustable value of the asset at
30 June 2011 would be $1,200. This is the cost of the asset ($1,500) less its decline in value
up to that time ($300).
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Where the depreciating asset is part used for a taxable purpose and partly for a non-taxable
purpose, only a portion of the decline in value of the asset will be deductible.
Example 2 – Partial deduction for decline in value (ignoring any GST impact)
Adam purchased a computer for $4,000 and used it only 50% of the time for a taxable
purpose during the income year. If the computer's decline in value for the income year is
$1,000, Adam's deduction would be reduced to $500, being 50% of the computer's decline in
value for the income year. Notwithstanding the extent of use for taxable purposes and the
amount of the deduction, the adjustable value at the end of the income year would be
$3,000.
2.2.2 Capital works – Division 43 of the ITAA 1997
Division 43 of the ITAA 1997 contains the capital allowance provisions for buildings and other
capital works.
As in the case of Division 40, such deductions would not otherwise be
available to a taxpayer on the basis that the loss or outgoing was capital or capital in nature.
The Division allows the capital cost of constructing capital works to be written off. Capital
works is not a defined term, but Division 43 applies to the following expenditure:
•
Buildings, structural improvements and environmental protection earthworks; and
•
Extensions, alterations and improvements to the above.
Deductions at either 2.5% or 4% are available, depending on the date of commencement of
construction and the type of structure (refer to section 43-25 of the ITAA 1997).
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Example from the ATO publication “Rental properties – claiming capital works
deductions”
On 1 March 2012 Meg purchased a rental property for $300,000 and immediately rented it
out. Meg obtained a report from a quantity surveyor stating:
-
construction of the property commenced in February 2003;
-
the property was a residential townhouse;
-
construction was completed in November 2003;
-
the townhouse was built by a developer;
-
the estimated cost of constructing the townhouse was $200,000.
Meg claims a capital works deduction in her 2012 tax return for her rental property based on
the estimate of the construction costs she obtained from the quantity surveyor. However, she
only claims a deduction for that part of the year her property was available for rent (1 March
to 30 June 2012). The rate of deduction she claims was 2.5% as construction of her
residential property started after 15 September 1987.
Her annual capital works deduction was calculated as follows:
$200,000 x 2.5%=$5,000
As the property was only used for income producing purposes for 122 days in 2012, the
deduction available to Meg in the 2011-12 income year was calculated as follows:
$5,000 x 122/365 = $1,671.
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2.2.3 Miscellaneous deductions – Division 25 of the ITAA 1997
Division 25 of the ITAA 1997 establishes the rules for deducting particular kinds of amounts.
The general principals discussed above in relation to section 8-1 of the ITAA 1997 apply to
the Division 25 amounts.
2.2.3.1 Tax related expenses
Section 25-5 of the ITAA 1997 allows a deduction for expenses to the extent they are
incurred in managing your tax affairs and general interest charges.
The cost of accounting fees/tax agent fees will be deductible under this section. As income
tax returns are usually prepared and lodged after the end of the income year, the cost
incurred by a taxpayer to have someone lodge their return will be deductible in the year the
cost is incurred in.
Example 1 (used in ATO ID 2010/195) – Cost of managing tax affairs
The employee taxpayer uses a tax agent to prepare their individual tax return. The taxpayer
travelled 4,500 kilometres by car in the income year in relation to the taxpayer's incomeearning activities.
The taxpayer also travelled 600 kilometres by car in visiting the tax agent for the purposes of
managing the taxpayer's tax affairs.
A car is an item of property that may be used for the purpose of producing assessable
income. To the extent that a car held by a taxpayer is used for managing the taxpayer's tax
affairs or complying with an obligation imposed by a Commonwealth law relating to the tax
affairs of another entity, its use is deemed by subsection 25-5(5) of the ITAA 1997 to be for
an income-producing purpose. Car travel for the purpose of visiting the tax agent is therefore
counted as 'business kilometres' for the purposes of Division 28 of the ITAA 1997.
Example 2 – Cost of managing your tax affairs
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 section 25-5 of the ITAA
1997.
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
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because, under this subsection, the computer is property that you are taken to use for the
purpose of producing assessable income.
This example is contained in section 25-5 of the ITAA 1997.
2.2.3.2 Repairs
Section 25-10 of the ITAA 1997 generally allows a deduction for the cost of repairs to
premises or depreciating assets used or held by the taxpayer for the purpose of producing
assessable income.
The term repairs is not defined in the Tax Acts and therefore has its ordinary meaning.
Taxation Ruling TR 97/23 states that repairs ordinarily means the remedying or making
good of defects in, damage to, or deterioration of, property to be repaired (being defects,
damage or deterioration in a mechanical and physical sense) and contemplates the
continued existence of the property. Repair is generally occasional and partial. It involves a
replacement of a part of something or a correction of something that is already there and has
become worn out or dilapidated.
Case law makes it clear that repairs involve the renewal or replacement of a worn-out or
defective part and do not encompass a total reconstruction or a change that alters the
character of the thing being 'repaired', although it is irrelevant that different material to the
original is used or that the appearance, form, state or condition of the property or item is not
exactly restored.
Work done to prevent or anticipate defects, damage or deterioration is not in itself a repair
unless it is done in conjunction with remedying defects. While all repairs to property improve
the condition of the property, work that amounts to a substantial improvement, addition or
alteration beyond a restoration of the property to a previously existing state is not a repair
(refer to Taxation Ruling TR 97/23).
In addition, improvements, alterations and additions are generally not repairs. These are
instead usually viewed as capital improvements.
Generally, deductions are only allowed for repairs that bring an item of property or plant and
equipment back to a previous condition. Repairs that extend the functionality of an item, or
that considerably improve its effective life, will not be allowed as a deduction. They will
instead need to be considered under the depreciation or capital allowance provisions.
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Using the example of a rental property, tasks such as
Current as at August 2012
painting, conditioning gutters,
maintaining plumbing, repairing electrical appliances, mending leaks and replacing broken
parts of fences and windows will generally be considered repairs, rather than capital
improvements. However, if these activities occur before the income producing activity has
commenced, they are likely to be treated a capital in nature (and non-deductible). The ATO's
position in this regard is set out in its publication “Rental properties – claiming repairs and
maintenance expenses”:
Example 1 from the ATO publication “Rental properties – claiming repairs and
maintenance expenses” – Initial ‘repairs’
Stephen needed to do some repairs to a rental property he recently purchased before the
first tenants moved in. He paid tradespeople to repaint dirty walls, replace broken light fittings
and repair doors on two bedrooms. He also had to have the house treated for damage by
white ants.
Because Stephen incurred these expenses to make the property suitable for rental, not while
he was using the property to generate rental income, the expenses are capital expenses.
This means he cannot claim a deduction for them.
The key question when it comes to considering the deductibility of outgoings incurred for
repairs is whether the work in question has restored the functioning of the property or item to
its former level of efficiency, or whether it has improved the property or changed the
character of the property. In Tax Ruling TR 97/23, the FCT sets out the following examples
to assist taxpayers in understanding what constitutes a repair:
Example 2 – No repair
Sam Tabernarius, a shopkeeper, decides to replace the awning of his shop with a more
modern and aesthetic equivalent. The awning is in good condition before the work is done;
there is nothing to be restored, no decayed or worn out parts to be renewed and nothing
loose or detached which requires fixing. The expenditure involved is not for repairs - the
awning being in good repair before the work was done - and no deduction is allowable under
section 25-10 of the ITAA 1997.
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Example 3 – No repair
Elle Bashful uses her truck for income producing purposes. She replaces the truck's worn out
petrol engine with a diesel engine with a much greater economy of operation. The engine is
not an entirety but a subsidiary part of truck. However, the costs relate to an improvement of
the truck because the replacement of the engine involved a significantly greater efficiency in
the truck's function. The engine is a major and important part of the truck and is a new and
better engine with considerable advantages over the old one, including the advantage that it
reduces the likelihood of future repair bills. The costs are of a capital nature and are not
deductible under section 25-10: cf (1953) 3 CTBR (NS) Case 82 .
Example 4 – ‘Notional’ repairs
Ken-the-Shopfitter runs a factory in a building in which the wooden floor needs repairing. The
options are either to repair the old floor or to replace it with an entirely new one of steel and
concrete. Ken decides to adopt the second option because it will save future repairs and
because it has distinct advantages over the old wooden floor. By choosing the second
option, Ken cannot claim a deduction as if he had simply repaired the wooden floor. His
actual expenditure being capital, none of it is allowable as a repair.
Example 5 – New material, still repair
Mary Fabrica owns a factory in which the bitumen floor laid on a gravel base needs repairing.
She replaces it with a new floor consisting of an underlay of concrete topped with granolith (a
paving stone of crushed granite and cement). The new floor, from a functional efficiency
(rather than an appearance) point of view, is not superior in quality to the old floor. The new
floor performs precisely the same function as the old and is no more satisfactory. In fact, the
new floor is more expensive to repair than the old. Because the new floor is not a substantial
improvement, it is a repair and its cost is deductible under section 25-10: Case T75 (1968)
18 TBRD 377; (1968) 14 CTBR (NS) Case 40.
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2.2.3.3 Borrowing costs
Section 25-25 of the ITAA 1997 allows a deduction for expenditure incurred in relation to
borrowing money to the extent the money is borrowed to produce assessable income.
This section deals with costs such as loan establishment fees and other borrowing costs
charged by the lender. In most cases, the deduction for these costs will be spread over 5
years or the duration of the loan (if the duration is less than 5 years).
A taxpayer's deduction is calculated by working through the Method Statement in section 2525 of the ITAA 1997.
Because interest charges incurred on the loan will be deductible under section 8-1 when they
are incurred in accordance with ordinary concepts, interest expenses are not dealt with under
section 25-25 of the ITAA 1997.
Example 1 – 4 year loan
In September 2007-08 you borrow $300,000 and incur expenditure of $1,500 for the
borrowing. You use the money to buy a house. Throughout 2008-09 you rent the house to a
tenant. You can deduct for the expenditure for 2008-09 the maximum amount worked out
under subsection (4).
Suppose the original period of the loan is 4 years starting on 1 September 2007. What is the
maximum amount you can deduct for the expenditure for 2007-2008?
Applying the method statement:
Step 1: the remaining expenditure is $1,500 (the amount of the expenditure).
Step 2: the remaining loan period is 4 years from 1 September 2007 (1,461 days).
Step 3: the result is $1,500 divided by 1,461 = $1.03.
Step 4: the result is $1.03 multiplied by 302 days = $310.06.
Suppose you repay the loan early, on 31 December 2008. What is the maximum amount you
can deduct for the expenditure for 2008-09?
Applying the method statement:
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Step 1: the remaining expenditure is $1,500 (the amount of the expenditure) reduced by
$310.06 (the maximum amount you can deduct for 2007-08) = $1,189.94.
Step 2: the remaining loan period is the period from 1 July 2008 to 31 December 2008 (183
days).
Step 3: the result is $1,189.94 divided by 183 days = $6.50.
Step 4: the result is $6.50 multiplied by 183 days = $1,189.94.
This example is contained in section 25-25 of the ITAA 1997
2.2.3.4 Discharge of mortgage
Section 25-30 of the ITAA 1997 allows you to deduct the cost of discharging a mortgage if
the mortgage was given as security for money borrowed solely to produce assessable
income.
Example – Discharge of mortgage
You have recently inherited money and have repaid the outstanding balance on a rental
property (thereby discharging the mortgage securing the loan). The property was always held
by you as a rental property.
The bank charges you $1,000 described as a mortgage discharge fee as well as $2,000 in
penalty interest.
The $1,000 mortgage discharge fee will be deductible under section 25-30 and the penalty
interest will be deductible under section 8-1.
2.2.3.5 Bad debts
Section 25-35 of the ITAA 1997 allows a deduction when you write-off a bad debt where
either:
•
The amount has been included in your assessable income (for the current year or a
prior year); or
•
The write-off occurs in the ordinary course of your money lending business.
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Example – Bad debt
You run an accountancy firm that operates on an accruals basis for tax purposes.
You performed work for one of your clients in April/May 2011 worth $10,000. The invoice was
raised in late May 2011. The $10,000 was included in your firm’s assessable income for
2010/11.
In March 2012, after months of trying to recover the outstanding invoice, you decide to write
off the $10,000 debt.
The $10,000 debt will be deductible in the 2011/12 tax year for your firm under s25-35 of the
ITAA 1997.
2.2.3.6 Loss from profit making undertaking or plan
You can deduct a loss from a profit making undertaking or plan if any profit made on the
undertaking or plan would have been assessable under section 15-15 of the ITAA 1997.
This section will apply to situations where the undertaking is not on capital account but the
activities still do not amount to the carrying on of a business.
Example – Profit making undertaking or plan
Bob decides to purchase a vacant block of land, build a duplex and sell them off for a profit.
He only intends to do this once and has never worked before as a builder. He buys the land
for $200,000 and spends $150,000 on materials, contractors and others costs associated
with the undertaking.
Bob eventually sells the finished property for $300,000.
As Bob intended to make a profit on the sale and did hold the land as a capital asset, the
loss on the sale of $50,000 will be deductible under section 25-40 of the ITAA 1997. The land
would not be treated as trading stock as Bob is not carrying on a business.
Note: GST would be payable on the sale as Bob would be carrying on an ‘enterprise’ for GST
purposes (even though he is not carrying on a business).
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2.2.4 Blackhole expenditure – Division 40 of the ITAA 1997
Section 40-880 of the ITAA 1997 allows taxpayers to deduct certain business-related capital
expenditure (also known as blackhole expenditure) that is neither deductible under a
provision of the Tax Acts, nor otherwise taken into account for income tax purposes, for
example by being included in the cost base of a capital gains tax asset or included in the cost
of a depreciating asset.
Section 40-880 applies to expenditure incurred on or after 1 July 2005. The deduction is
available over a period of five years in equal amounts, starting in the year in which the
expenditure is incurred and in the next four income years.
Specifically, a taxpayer can deduct capital expenditure that the taxpayer incurred:
•
In relation to the taxpayer’s business;
•
In relation to a business that used to be carried on;
•
In relation to a business proposed to be carried on; or
•
To liquidate or deregister a company of which the taxpayer was a member, to wind up
a partnership of which the taxpayer was a partner or to wind up a trust of which the
taxpayer was a beneficiary, if the company, partnership or trust carried on a business.
(refer to subsection 40-880(2) of the ITAA 1997).
However, a taxpayer can only deduct the expenditure for a business that the taxpayer carries
on, used to carry on or proposes to carry on, to the extent that the business is carried on,
was carried on or is proposed to be carried on, for a “taxable purpose” (refer to subsection
40-880(3) of the ITAA 1997).
In this regard, taxable purpose is the purpose of producing assessable income, the purpose
of exploration or prospecting, the purpose of mining site rehabilitation, or environmental
protection activities.
TR 2011/6 sets out the FCT's views on the interpretation of the operation and scope of
section 40-880 of the ITAA 1997. In this respect, the ruling considers:
•
The type of expenditure to which section 40-880 applies;
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•
Current as at August 2012
The nexus required for capital expenditure to be in relation to a current, former or
proposed business;
•
The requirement that the business be carried on for a taxable purpose;
•
Limitations and exceptions to a deduction;
•
Expenditure re lease or other legal or equitable right; and
•
Expenditure in working out a capital gain or loss.
The ruling is proposed to apply to arrangements begun to be carried out from 8 December
2010.
Examples (from TR 2011/6)
Example 1
Jemima decides to expand her bus charter business by purchasing another bus. She finds a
second-hand bus in another State that seems to meet her requirements and buys an airfare
so she can inspect it before committing to the purchase. Jemima inspects the bus and
concludes that it is not suitable. She does not go ahead with the purchase .
The expenditure is in relation to Jemima's bus charter business because the object of the
expenditure is directed to meeting a need of the business - that is adding to the fleet of buses
available for charter. The purpose of the expenditure is to facilitate Jemima's inspection of
the bus in order to evaluate whether it met the requirements of the business and is,
therefore, in relation to the business for the purpose of paragraph 40-880(2)(a).
Example 2
Company B approaches Company A with a merger proposal. To evaluate the proposal
Company A incurs capital expenditure on professional fees for legal, corporate and tax
advice and for the performance of financial due diligence. The object of the expenditure is to
determine the commercial merit of the proposal including the effect on the company's
structure and its trading operations. The expenditure is in relation to Company A's business
for the purpose of paragraph 40-880(2)(a).
Example 3
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Wayne and Blayne are shareholders in X Pty Ltd. As their personal relationship deteriorates
Blayne considers whether or not to sell his shares and incurs capital expenditure on
professional advice. The sale does not proceed because they resolve their relationship
issues .
Blayne's expenditure is not in relation to the business for the purpose of paragraph 40880(2)(a).
Example 4
XYZ Pty Ltd carries on a medical research and supply business. The shareholders'
involvement in the business includes providing medical expertise and services to the
company. Because of other commitments one of the shareholders has been and will
continue to be unable to devote resources to the business.
The directors of XYZ Pty Ltd decide that in the interests of the business the ownership of the
company should be restructured to replace the inactive shareholder with a private equity
investor with the business acumen to push the company forward and inject capital for the
purpose of future growth.
To facilitate the restructure XYZ Pty Ltd paid $200,000 to the shareholder as an incentive to
agree to the sale of his shares to the equity investor.
The expenditure is capital expenditure of the company in relation to the business for the
purpose of paragraph 40-880(2)(a).
2.2.5 Tax losses – Division 36 of the ITAA 1997
Division 36 of the ITAA 1997 sets out general rules governing the deductibility of tax losses
incurred in earlier income years. However, Division 36 is not self-contained and is directed
at general concepts.
Accordingly, Division 36 must be read in conjunction with the special rules that apply in
particular situations. In the context of companies, the special rules include those restricting
the availability of prior year and current year losses, as set out in Divisions 165 and 166 of
the ITAA 1997, with the 'continuity of ownership' and 'same business' tests being of particular
importance.
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Sections 36-15 (taxpayers that are not corporate entities) and 36-17 (taxpayers that are
corporate entities) of the ITAA 1997 sets out how tax losses are carried forward for deduction
in subsequent income years.
In general, if the total assessable income for the subsequent income year exceeds the total
deductions for that year (ignoring the tax loss), the tax loss is deducted from that excess. If
the excess is not sufficient to absorb the whole of the tax loss, the un-deducted part of the
tax loss is carried forward to the next income year. There is generally no limit on this carry
forward period.
For individuals and partnerships, the non-commercial loss rules in Division 35 of the ITAA
1997 may limit the ability to deduct a loss from a business activity against other assessable
income.
Example – Use of tax losses
Renee owns a negatively geared rental property in Sydney. She has no other assessable
income sourced in Australia apart of her salary.
Renee has just been offered a job in the Middle East for at least two years, starting March
2012.
The tax loss that will arise on the rental property for 2012/13 and 2013/14 will accrue for the
years Renee is overseas and Renee can utilize the loss when she has other assessable
income in Australia.
2.2.6 Superannuation contributions
An employer can claim a deduction for contributions made into a complying superannuation
fund on behalf of an employee, provided the requirements of Subdivision 290-B of the ITAA
1997 are met.
An ‘employee’ for the purposes of Subdivision 290-B of the ITAA 1997 is any person who
meets the expanded definition of ‘employee’ in section 12 of the Superannuation Guarantee
(Administration) Act 1992 and also includes certain former employees provided the
contribution is made within 4 months of their ceasing to be an employee. This expanded
definition of ‘employee’ includes directors of a company (provided they are entitled to
director’s fees) and contractors (provided the person works under a contract that is wholly or
principally for their labour) as well as general common law ‘employees’, and excludes
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persons who are paid to do work wholly or principally of a domestic or private nature for not
more than 30 hours per week.
Also, in order for the employer to obtain the deduction:
•
The employee must have been engaged in producing the employer’s assessable
income or an Australian resident engaged in the employers business;
•
The superannuation fund was a complying superannuation fund; and
•
The contribution was made on or before 28 days after the end of the month that the
employee turns 75 or the employer is required to make the contribution under an
industrial award.
An individual can also claim a deduction for personal contributions they make into a
complying superannuation fund provided they meet the requirements of Subdivision 290-C of
the ITAA 1997. An example of the ATO's treatment of this is contained in its publication
“Claiming deductions for personal super contributions”.
Example – Deductible personal super contributions
Big Bob (aged 45) runs a business as a promoter. During the 2010-11 income year, he
earned $70,000 assessable income from his business.
Bob also worked as an employee for another promoter, where he earned $6,500 before tax.
Bob may still be eligible to claim a deduction for his personal super contributions, as the
income from his employment with the other promoter ($6,500) is less than 10% of his
combined assessable income, reportable fringe benefits and RESC ($76,500 x 10% =
$7,650).
2.3 Non-deductible losses and outgoings
The Tax Acts contains various provisions which specifically deny a taxpayer a deduction (in
part or whole) for a loss or outgoing. Such provisions include Divisions 26 and 820 of the
ITAA 1997 and Part IVA of the ITAA 1936.
Certain provisions denying taxpayers a deduction for losses and outgoings are discussed
below.
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2.3.1 Penalties
Section 26-5 of the ITAA 1997 generally denies a deduction for penalties and fines.
Specifically, the following amounts are not deductible:
•
An amount (however described) payable, by way of penalty, under an Australian law or
a foreign law; or
•
An amount ordered by a court to be paid on conviction for an offence against an
Australian law or a foreign law (for example, a fine).
The term Australian law is defined in subsection 995-1(1) of the ITAA 1997 as a law of the
Commonwealth of Australia or of an Australian State or Territory. The term foreign law is
defined in subsection 995-1(1) of the ITAA 1997 as a law of a foreign country.
Note that section 26-5 denies a deduction for amounts payable by way of penalty.
Accordingly, it is not necessary that an amount actually be a penalty for it to be covered by
this section.
Example – Penalty not deductible
Jim is a courier who works predominately in the Brisbane CBD. While he is working, he is
pulled over for talking on his mobile phone and receives a $360 ticket.
Even if this call is a work related call, this $360 ticket will not be deductible
Even if this call is a work related call, this $360 ticket will not be deductible.
2.3.2 Interest
Generally, a taxpayer will be entitled to a general deduction under section 8-1 of the ITAA
1997 for interest, if the borrowed moneys are used for income producing purposes (refer to
Taxation Ruling TR 2004/4).
However, other provisions of the Tax Acts may operate to deny (in part or whole) the
deduction. Examples of those Divisions include those set out below.
2.3.2.1 Failure to withhold tax from interest or remit withheld tax
Where interest is paid to non-residents by an Australian resident taxpayer (and certain nonresidents), that interest may be subject to withholding tax under Division 11A of Part 3 of the
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ITAA 1936 or Subdivision 12-F in Schedule 1 to the TAA. The obligation to withhold and
remit such tax generally resides with the payer.
To ensure that Australian resident taxpayers comply with their withholding tax obligations,
section 26-25 of the ITAA 1997 denies a deduction for interest to an Australian resident
taxpayer if an amount was required to be withheld from that interest and the Australian
resident taxpayer either fails to withhold that amount or, having withheld that amount, fails to
remit the amount to the ATO.
However, once the relevant tax is withheld or remitted to the ATO, the Australian resident
taxpayer is entitled to claim a deduction for the interest in the year in which the interest was
incurred. This may require the taxpayer to amend their return for the income year in which
the interest was incurred.
The Australian resident taxpayer may also be subject to penalties and additional interest for
the failure to withhold and remit withholding tax on or before the due date.
2.3.2.2 Thin capitalisation provisions
Broadly, the thin capitalisation provisions apply in circumstances where an Australian
resident taxpayer is either controlled by a foreign resident or has foreign operations (whether
in the form of foreign subsidiaries or permanent establishments overseas). However, the thin
capitalisation provisions can also apply to foreign residents that have a permanent
establishment in Australia through which they carry on business.
The broad principle by which the thin capitalisation provisions apply (except in the case of
financial institutions) is that an entity that carries on business in Australia and in other
jurisdictions cannot excessively gear their Australian operations.
In circumstances where the thin capitalisation provisions apply and the taxpayer’s level of
debt exceeds their prescribed maximum allowable debt, any deduction for interest
attributable to that excess debt will be denied.
2.3.2.3 Interest incurred in deriving capital gains
Section 51AAA of the ITAA 1936 denies a deduction for interest (and indeed any other
deduction) incurred solely in the derivation of capital gains (that is, where the expectation of
deriving ordinary income does not exist). For example, if a taxpayer borrows to purchase an
asset (such as a vacant block of land) where the only expectation of gains is a capital gain
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and not rental income or other forms of ordinary income, then section 51AAA denies a
deduction for interest incurred on the borrowing.
This issue also typically arises in the context of private equity investments where the
prospect of deriving any ordinary income in the form of dividends generally does not exist
because of the extent of the gearing in the operating company.
2.3.2.4 Derivation of foreign income
Paragraph 8-1(2)(c) of the ITAA 1997 provides that a taxpayer cannot deduct a loss or
outgoing to the extent that it is incurred in relation to gaining or producing exempt income or
NANE income.
NANE income includes income derived by an Australian company from dividends paid by a
foreign company in circumstances where the Australian company holds at least 10% of the
voting rights in the foreign company (section 23AJ of the ITAA 1936).
Notwithstanding paragraph 8-1(2)(c), section 25-90 of the ITAA 1997 states that an
Australian entity can deduct a loss or outgoing from its assessable income if:
•
The amount is incurred by the entity in deriving income from a foreign source and the
income is NANE income under section 23AI, 23AJ, or section 23AK of the ITAA 1936;
and
•
The amount is a cost in relation to a debt interest issued by the entity that is covered by
the first subparagraph of the definition of debt deduction (that is, interest).
Accordingly, interest can in fact be claimed as a deduction where the Australian entity is
incurring that interest to derive NANE income in the form of certain types of foreign sourced
income, including dividends from foreign companies in which the Australian entity has at
least a 10% voting interest.
2.3.3 Entertainment
Division 32 of the ITAA 1997 sets out the deduction rules in respect of ‘entertainment’.
The term ‘entertainment’ means:
•
Entertainment by way of food, drink or recreation; or
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Current as at August 2012
Accommodation or travel to do with providing entertainment by way of food, drink or
recreation.
You are taken to provide ‘entertainment’ even if business discussions or transactions occur.
Examples of entertainment include business lunches and social functions.
While the general rule is that entertainment expenses are not deductible, there are
exceptions to the rule with the main exception being that entertainment will be deductible if it
gives rise to a fringe benefit.
Example – Entertainment and FBT
You recently attend a work lunch for some of your most valued clients. The total cost of the
lunch came to $2,000.
The attendees at the lunch were 5 staff (including you) and 5 clients.
The full $2,000 will be, prima facie, non-deductible due to section 32-5. However, as a fringe
benefit arises in relation to the 5 staff who attended the function, part of the total cost of the
lunch will be deductible.
Based on a per-head cost of $200, half (i.e. $1,000) the cost of the lunch will be deductible
under section 8-1 as the lunch related to the business carried-on.
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3. Part IVA
Part IVA of the ITAA 1936 is a general anti-avoidance provision which provides the FCT with
the discretion to cancel a 'tax benefit' that has been obtained, or would be obtained, by a
taxpayer in connection with a scheme to which Part IVA applies. While it does not only apply
in the case of deductions, it is often a pertinent issue that needs to be considered when
asked whether or not a taxpayer will be allowed to deduct a specific loss or outgoing. It
should be noted that if there are other reasons which result in the deduction not being
allowable (for example if there are specific provisions in the Tax Acts disallowing the
deduction or if the transaction is a sham that does not have legal effect), then the FCT will
not need to rely on Part IVA.
While the application of Part IVA is up to the FCT's discretion, the FCT can only exercise his
discretion to cancel a ‘tax benefit’ if all of the legislative requirements are met. In summary,
the following conditions must be satisfied:
•
A 'tax benefit' (as identified in section 177C of the ITAA 1936), was (or would but for
section 177F of the ITAA 1936 have been) obtained;
•
The tax benefit was (or would but for section 177F of the ITAA 1936 have been)
obtained in connection with a 'scheme' (as defined in section 177A of the ITAA 1936);
•
The sole or dominant purpose of the scheme was obtaining the tax benefit; and
•
Having regard to the eight factors in section 177D of the ITAA 1936, the scheme is one
to which Part IVA applies – broadly, these factors include:
-
The manner in which the scheme was entered into or carried out;
-
The form and substance of the scheme;
-
The time at which the scheme was entered into and the length of the period
during which the scheme was carried out;
-
The result in relation to the operation of the tax acts that, but for Part IVA, would
be achieved by the scheme; and
-
Any change in the financial position of the relevant taxpayer that has resulted, will
result, or may reasonably be expected to result, from the scheme.
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Further guidance on the FCT's approach to the application of Part IVA can be found in the
ATO's publication "Part IVA: the general anti-avoidance rule for income tax". Nevertheless,
the application of Part IVA is quite a technical process, and a detailed examination of the
legal issues raised by a proposed application of Part IVA are beyond the scope of this paper.
FCT v Hart (2004) 217 CLR 216 (Hart's case) is a useful example of a case where the FCT
has successfully exercised his discretion under Part IVA to deny interest expenses that a
taxpayer would otherwise have been entitled to deduct.
In Hart’s case, the taxpayers borrowed money through a split loan to purchase a residence
and investment property. At the taxpayers’ request, all payments were to be used to reduce
the private part of the loan until it was repaid in full, while interest on the rental property part
of the loan was to be capitalised.
In their tax returns for the relevant years of income, each of the taxpayers claimed a greater
tax deduction for interest on the investment component of the loan than would be the case if
two separate conventional loans, one for private purposes and the other for income
producing purposes, had been taken out.
The FCT exercised his power under Part IVA to cancel an amount of the taxpayers’ interest
deductions.
When considering the question as to the dominant purpose for using the split loan facility –
that is, why borrow money on the terms of the particular scheme entered into by the
taxpayers – the conclusion was that it was to obtain the additional tax benefit generated by
the use of that facility.
On this basis, the High Court found that the extra interest expense allocated under a split
loan facility to finance the purchase of a rental property is not deductible.
Part IVA is a complex provision which is often the subject of debate, and the FCT has not
always been as successful in applying Part IVA as he would have liked. This has resulted in
the Government announcing on 1 March 2012 that it would seek to introduce further
amendments to Part IVA to maintain its effectiveness in countering tax avoidance schemes
that are carried out as part of broader commercial transactions. While the Government had
not prepared its proposed amendments at the date of the announcement, it has indicated
that the amendments will apply to schemes entered into or carried out after 1 March 2012.
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