Chapter 14 Capital allowances 2020 Thomson Reuters Professional

Chapter 14 Capital allowances 2020 Thomson Reuters (Professional) Australia Ltd. All Rights Reserved. Kerrie Sadiq, Queensland University of Technology

Introduction • The general deduction provision prohibits a deduction for a capital item: s 8 -1(2)(a). • Specific provisions may allow a deduction over the period of time that the expense is expected to derive a benefit: Types of deductible capital expenditure Depreciation deductions Capital works deductions “Black hole” expenses Po. TL 2020 paragraph [14. 10]

Depreciation deductions • A taxpayer may claim a deduction equal to the “decline in value” of a “depreciating asset” that is “held”: s 40 -25. – Deduction usually claimed over asset’s estimated useful life. Depreciating asset acquired Year 1 Decline in value deduction End of effective life Year 2 Decline in value deduction Po. TL 2020 paragraph [14. 20]

Depreciation deductions • Depreciation rules do not apply in certain circumstances, eg: – Expenditure on capital works (ie buildings) under Div 43 – Car expenses where deduction is calculated in accordance with the “cents per kilometre” method – Depreciating assets used or installed in residential rental premises and was ‘previously used’: s 40 -27. (This exclusion does not apply if: (i) the asset is used in carrying on a business, or (ii) the taxpayer is a corporate tax entity, superannuation fund that is not a self-managed superannuation fund, or a specified type of trust, or a unit trust or partnership all of the members of which are one of these entities. ) Po. TL 2020 paragraph [14. 20]

Depreciating asset • Definition of a “depreciating asset” (s 40 -30(1)) – An asset which has a limited effective life and can reasonably be expected to decline in value over the time it is used. • Exclusions to definition: – Land; – An item of trading stock; or – Certain intangible assets, unless listed in s 40 -30(2), eg in-house software, items of intellectual property. • Common depreciable assets include computers, furniture, cars, machinery, telephones, etc. Po. TL 2020 paragraph [14. 30]

Depreciating asset Composite items • Necessary to determine if components making up a depreciable asset are: (i) separate depreciating assets; or (ii) one whole depreciating asset. • Similarly, for buildings, necessary to identify if capital expenditure relates to a depreciable asset or capital works. • Question of fact and degree: s 40 -30(4). Commissioner suggests in TR 2017/D 1 factors include: – Identifiable function – Use – Degree of integration with other components – Effect of attachment. Po. TL 2020 paragraph [14. 35]

Claiming a deduction • To claim a deduction under s 40 -25 in respect of a “depreciating asset”, it is necessary to determine: 1 • “Held” • When the taxpayer has “held” a depreciating asset 2 • Decline in value • A deduction is equal to the “decline in value” taking into account “taxable purpose” • Non-business depreciable assets costing less than $300 that are predominately used to gain or produce assessable income may be claimed immediately: s 40 -80(2). Po. TL 2020 paragraph [14. 40]

Claiming a deduction: 1. Held • The holder of an asset is entitled to the deduction for the decline in value of a depreciating asset: s 40 -25. – The “holder” is described in s 40 -40. – Jointly held: deduction reflects holder’s interest: s 40 -35. • Generally it is the legal owner, but in certain circumstances it may the economic owner, eg in hire-purchase arrangements: Legal owner provides asset to economic owner under a HP arrangement. Economic owner bears all risk. Legal Owner Economic Owner “Holder” Economic owner pays legal owner in instalments and has option to purchase the asset. Po. TL 2020 paragraphs [14. 50] – [14. 60]

Claiming a deduction: 2. Decline in value • Two methods to work out the decline in value: s 40 -65. Methods Diminishing Value Prime Cost • Prime cost: equivalent to “straight line method” in accounting where equal depreciation deductions each year. • Diminishing value: equivalent to “reducingbalance method” in accounting where greater deductions in the early years. Po. TL 2020 paragraph [14. 70]

Claiming a deduction: 2. Decline in value • Choice of method is made on an asset-by-asset basis: – A different method can be chosen for each asset. – Method cannot be changed once chosen: s 40 -130. – Replacement assets do not need to follow original asset. • Taxpayer does not have a choice in certain circumstances, eg: – Assets acquired from an associate: the same method as the method used by the associate (s 40 -65(2)). – Assets allocated to a low value pool (s 40 -65(5)). Po. TL 2020 paragraph [14. 70]

Claiming a deduction: 2. Decline in value Diminishing value method • Formula to calculate the decline in value under the diminishing value method: – Assets held pre-10 May 2006 (s 40 -70): – Assets held on or after 10 May 2006 (s 40 -72): Po. TL 2020 paragraph [14. 80]

Claiming a deduction: 2. Decline in value Example: Diminishing value method • Depreciable asset purchased for $6, 000 (excluding GST) on 1 July 2019 and has an effective life of 3 years. Year 1: Year 2: Year 3: Po. TL 2020 paragraph [14. 80]

Claiming a deduction: 2. Decline in value Prime cost method • Formula to calculate the decline in value under the prime cost method (s 40 -75). Po. TL 2020 paragraph [14. 80]

Claiming a deduction: 2. Decline in value Example: Prime cost method • Depreciable asset purchased for $5, 000 (excluding GST) on 1 July 2019 and has an effective life of 3 years. Year 1: Year 2: Year 3: Po. TL 2020 paragraph [14. 80]

Claiming a deduction: 2. Decline in value Elements from the formulae Term Explanation Base value • For first year the asset is held, it is the asset’s “cost”. • Subsequent years, it is the “opening adjustable value” (cost less decline in value from previous years). Cost • Detailed rules in Subdiv 40 -C, broadly: • First element: cost of asset and acquisition costs; + • Second element: costs incurred after acquisition of the asset to bring the asset into its present condition. • Note adjustments to cost on next slide. Days Held • Number of days that the asset is used or installed ready for use (s 40 -70(1)). Effective life • Number of years the asset is expected to be used by the taxpayer for the particular purpose. Po. TL 2020 paragraph [14. 90]

Claiming a deduction: 2. Decline in value Adjustments to the asset’s cost • Key adjustments to the asset’s cost can include: – Cost can include value of non-cash benefits: s 40 -185 – Deductible costs under a different provision cannot be included in the cost: s 40 -215 – Exclude GST input tax credits from cost: s 27 -80 – Market value substitution rules apply to non-arm’s length transaction: s 40 -180(2) – When the depreciating asset is a car, the cost is limited to the car limit of $57, 581 (for 2019 -20). Po. TL 2020 paragraph [14. 90]

Claiming a deduction: 2. Decline in value Effective life • Under s 40 -95, the taxpayer can choose either: – To use the effective life determined by the Commissioner for a depreciating asset under s 40 -100 (see Ruling TR 2019/5); or – To self-assess the effective life themselves. • No choice of effective life in certain circumstances, eg, asset acquired from an associate, certain intangible assets • Note: – A capped life may apply to a depreciating asset when the Commissioner’s determination is used. – Self-assessment may lead to a greater risk of audits and penalties if estimates are unrealistic. Po. TL 2020 paragraph [14. 90]

Claiming a deduction: 2. Decline in value Taxable purpose • Decline in value can only be claimed in relation to depreciating assets that are used for taxable purposes: s 40 -25(2). – A taxable purpose generally exists where the asset is used in the production of assessable income: s 40 -25(7). – Deduction reduced by the percentage of any non-taxable purpose. Po. TL 2020 paragraph [14. 100]

Balancing adjustments • Taxpayer’s taxable income adjusted where a “balancing adjustment” event occurs under s 40 -295: – Broadly, an event occurs when the taxpayer stops holding the asset, stops or never uses the asset. • Adjustment: Termination Value Adjustable Value Difference is included in assessable income Termination Value Adjustable Value Difference is included in deductions Po. TL 2020 paragraph [14. 110]

Balancing adjustments • Elements Term Explanation Termination Value • Amount received by the taxpayer in relation to the balancing adjustment event: s 40 -300. Adjustable Value • Asset’s cost less prior year decline in value less decline in value up to the date of the balancing adjustment event: s 40 -85. • Example – Asset purchased on 1 July X 1 for $3, 000. Effective life is 3 years. Method: prime cost. Sold 30 June X 2 for $2, 500. Termination Value: $2, 500 Adjustable Value: $2, 000 ($3, 000 - $1, 000) Difference: $500 included in assessable income Po. TL 2020 paragraph [14. 110]

Balancing adjustments: Asset used for non-taxable purpose • Balancing adjustment amount is reduced where the taxpayer used the asset for non-taxable purposes: s 40 -290. • Reduction is calculated as follows: Sum of reductions Total decline Balancing adjustment amount Where: – Sum of reductions = reductions in decline in value due to non -taxable purpose – Total decline = total decline in value. • CGT implications apply to non-taxable component (CGT Event K 7): see Chapter 11. Po. TL 2020 paragraphs [14. 115] – [14. 118]

Special rules for cars Car expenses • Taxpayers cannot claim a deduction for depreciation in relation to the car when car expenses have been calculated under the cents per kilometre method: s 40 -55. Adjustment to cost: car limit (s 40 -230) • First element of cost of a car (for carrying passengers) is limited to the “car limit” of $57, 581 (for 2019 -20) – Car limit applied after any GST input tax credits that the taxpayer may be entitled to. Po. TL 2020 paragraph [14. 125]

Pooling of assets • Taxpayers may claim deductions for the decline in value of certain assets on a group basis. • Two pools may be utilised by a taxpayer: Pools Low-value pool Software development pool • Reduction of compliance costs as individual depreciation calculations are not required for each asset. Po. TL 2020 paragraph [14. 130]

Pooling of assets: Low-value pool • A low-value pool is comprised of the following assets: 1 • Low-cost assets • A depreciating asset whose cost at the end of the income year in which the taxpayer started to use it, or installed ready for use for a taxable purpose is less than $1, 000. 2 • Low-value assets • A depreciating asset held by a taxpayer that has been depreciated under the diminishing value method has an opening adjustable value of less than $1, 000. • Exclusions include: – Immediately deductible non-business income producing depreciating assets under $300. – Assets deductible under small business entities rules. Po. TL 2020 paragraph [14. 140]

Pooling of assets: Low-value pool Decline in value • The decline in value of low-value pool assets for each year is calculated in accordance with the s 40 -440(1): Step Method 1 Multiply the taxable use percentage cost of any low-cost assets by 18. 75% 2 Multiply the taxable use percentage of any second element costs relating to low-value assets added to the pool by 18. 75% 3 Multiply the closing pool balance for the previous year and the opening adjustable values of low-value assets added to the pool by 37. 5% 4 Sum up the amounts in Steps 1, 2 and 3. The result is the decline in value of the low-value pool. Po. TL 2020 paragraph [14. 150]

Pooling of assets: Software development pool • Taxpayers who develop software generally required to capitalise expenditure. • Taxpayers may be entitled to claim a deduction for the decline in value of the software (asset) over its effective life; or allocate expenditure to an “in-house software” pool. Po. TL 2020 paragraph [14. 160]

Pooling of assets: Software development pool • Decline in value of an in-house software development pool is calculated in accordance with s 40 -455, as follows: Year Expenditure Allocated to the Pool Deduction % 1 No deduction 2 30% 3 30% 4 30% 5 10% Po. TL 2020 paragraph [14. 160]

Small business entity concessions • Small business entities can access simpler depreciation rules. – A small business entity is a sole trader, partnership, company or trust that operates business, for whole or part year, and has an aggregated turnover less than $10 m. • Concessions: 1 2 • Immediate deduction for assets < $1, 000. Note: further immediate deduction also allowed for assets acquired between 12 May 2015 and 30 June 2020, up to $30, 000 • Pool all other assets into a general small business pool which are treated as a single asset subject to one rate Po. TL 2020 paragraph [14. 165]

Small business concessions: Immediate deduction concession • Immediate deduction for assets < $1, 000. • Further immediate deduction for assets acquired after 12 May 2015: – $20, 000 if asset first used or installed ready for use before 29 January 2019; – $25, 000 if asset first used or installed on or after 29 January 2019 and before 7. 30 pm on 2 April 2019; – $30, 000 if first used or installed on or after 7. 30 pm on 2 April 2019 and before 30 June 2020. • Concessions also apply to general small business pool. Po. TL 2020 paragraph [14. 165]

Small business concessions: General small business pool • Under s 328 -190, small business entities are entitled to a deduction of: – 30% of the value of existing assets in the general small business pool. – 15% of the value of general small business pool assets acquired in the current income year. • Opening pool balance determined under s 328 -195. • Closing pool balance determined under s 328 -200. Po. TL 2020 paragraph [14. 165]

Capital works deductions (Div 43) • Division 43 provides taxpayers with a deduction for capital expenditure on buildings used for income-producing purpose. • Capital works include (s 43 -20): – Buildings – Structural improvements – Environmental protection earthworks. Po. TL 2020 paragraph [14. 170]

Calculation of capital works deduction • Capital works deductions are calculated using the following formula in ss 43 -210; 43 -215: Construction Expenditure Applicable Rate Days Used 365 • Applicable rate is 2. 5% or 4%, depending: – When construction of the capital works started; and – The use to which the capital works are put. • Deduction only available once construction is completed: s 43 -30. • On disposal of a building, there is no “balancing adjustment”: – Captured by capital gains tax provisions. Po. TL 2020 paragraph [14. 170]

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. • Excludes: – Expenditure on acquiring land – Demolishing existing structures – Landscaping or expenditure on plant. • See, s 43 -70 ITAA 97. Po. TL 2020 paragraph [14. 170]

Black hole expenses • “Black hole” expenses are outgoings that are not recognised for tax purposes, for example: – Not deductible under s 8 -1 ITAA 97 (eg, preliminary costs) – Not recognised by capital allowances provisions – Not recognised under capital gains tax provisions. • Two categories of “black hole” expenses: 1 2 • Project pools • Business-related costs Po. TL 2020 paragraph [14. 180]

Black hole expenses: Project pools • Capital expenditure associated with a project carried on for a taxable purpose and mining or transport capital expenditure allocated to a “project pool”: s 40 -830 – Pooled expenditure must not form part of a depreciable asset or be deductible under another provision: s 40 -840 – Broadly, a deduction is spread over life of project. Po. TL 2020 paragraph [14. 190]

Black hole expenses: Business-related costs • Provides a deduction for expenditure that is capital in nature, with the key limitation: – Only applies to expenses that are not otherwise taken into consideration under income tax legislation: s 40 -880. • Examples include: – Expenditure to establish a business structure (eg, legal expenses, company incorporation costs). – Expenditure to raise money for a business (eg, advertising). – Costs to stop carrying on a business, including liquidation and deregistration costs. • Qualifying capital expenditure can be deducted in equal proportions over five years: s 40 -880(2). Po. TL 2020 paragraphs [14. 200] – [14. 210]

Black hole expenses: Business-related costs • For expenditure relating to a proposed business, it must be reasonable to conclude that the business is proposed to be carried on within a reasonable time: s 40 -880(7). – Demonstration of commitment: business plan, establishing business premises, undertaking research on the business, investments. Po. TL 2020 paragraph [14. 210]

Black hole expenses: Start-up expenses • Immediate deduction available to qualifying individuals and small business entities incurring expenditure that relates to a proposed business or structure: s 40 -880(2 A) – Expenditure would need to have been otherwise deductible under s 40 -880. Po. TL 2020 paragraph [14. 215]