PRBL003 Australian Taxation Law Topic 7 Specific Deductions and Deduction Limitations Objectives To understand how to apply: Specific deductions Limitations Part A: Specific Deductions 1. Introduction Numerous specific deduction provisions are scattered throughout the 1936 and 1997 ITAAs. These provisions are important as these deduction provisions extend the range of deductible expenses beyond the general deduction provision: see ITAA 1997 ss 8-1, 8-5. Section 8-10 states that the provision that is most appropriate takes precedence, and the legal maxim is that the specific deduction provision takes precedence. Online Activity 1: Read ITAA 1997 ss 8-5, 8-10 The more common specific deduction provisions are: 2. ITAA 1997 Specific deductions Tax-related expenses: s 25-5 Expenses incurred in managing business taxes are deductible. These expenses include: having a bookkeeper prepare your business records having tax returns and activity statements prepared and lodged objecting or appealing against an assessment attending an Australian Taxation Office (ATO) audit. As an ordinary business expense the cost of obtaining tax advice about the everyday running of your business is deductible. Online Activity 2: Read s25-5 Repairs Rental Property s25-10 Repairs and maintenance expenses in respect of premises (or parts of premises) to produce assessable income can be claimed as income tax deductions. Repairs are work to make good or remedy defects in, damage to or deterioration of the property. Example: 1
replacing part of the guttering or windows damaged in a storm replacing part of a fence damaged by a falling tree branch repairing electrical appliances or machinery. There is no deduction for the costs of repairs in the year you paid them if they did not relate directly to wear and tear or other damage that occurred due to the use of the property to produce assessable income. These are capital expenses that may be claimed over a number of years as capital works deductions or deductions for decline in value. Also, there is no deduction for the cost of repairing defects, damage or deterioration that existed when the property was obtained, even if the repairs were carried out to make the property suitable for income production / renting. These expenses relate to the period before the property became an income producing property. Replacements Replacing something identifiable as a separate item of capital equipment (such as a complete fence or building, a stove, kitchen cupboards or a refrigerator) is not a repair. However, the cost maybe claimed as a capital works deduction or a deduction for decline in value. Improvements? Improvements are not deductible in the year you incur them. An 'improvement' : provides something new generally furthers the income-producing ability or expected life of the property generally changes the character of the item you have improved goes beyond just restoring the efficient functioning of the property. Example Doug replaced a fibro wall inside his rental property, which was damaged by tenants, with a stone wall. The new wall is an improvement because it did more than just restore the efficient function of the wall. It is not deductible as a repair. Repairs Business s 25-10 Repairs to machinery, tools or premises used to produce business income are deductible (excluding expenses are not capital expenses). Allowable claims include the cost of: replacing broken parts of fences or broken glass in windows repairing machinery. painting conditioning gutters maintaining plumbing repairing electrical appliances mending leaks 2
A repair generally means to fix defects, including renewing parts. It does not mean totally reconstructing something. There is no requirement to own the property or item that is repaired. Repairs exclude substantial improvements to an item or property, such as replacing a dilapidated ceiling with an entirely new and better ceiling; repairs made to machinery, tools or property immediately after you purchase or acquire them. Online Activity 3: Read s 25-10 Bad debts: s 25-35 You can deduct a debt (or part of a debt) that you write off as bad in the income year, if it was included in your assessable income for the income year or for an earlier income year, or it is in respect of money that you lent in the ordinary course of your business of lending money. Online Activity 4: Read s 25-35 Travel between workplaces: s 25-100 Section 25-100 provides deductions for individuals for transport expenses incurred in travel between workplaces (places of employment or business) and thus overcomes the High Court decision in FCT v Payne (2001) 202 CLR 93; 46 ATR 228. The deductions apply from 2001-02 and later tax years. Motor vehicle expenses The deduction for motor vehicle expenses depends on the taxpayer s business structure. If the business is operated as a company or trust, a full deduction for expenses incurred in running a motor vehicle the company or trust leases or owns it is deductible. If private use of the vehicle the entity may have to pay fringe benefits tax (FBT). The cost of FBT is also a deduction. For sole traders or a partnerships that includes at least one individual, then a claim can be made for a: full deduction for a business-purpose vehicle - a larger truck or van, or a smaller vehicle, such as a ute, wagon or panel van that has been heavily modified for business use, or where private use is restricted to home-to-work travel and very minor other use vehicle expense deduction for a vehicle you own, lease or hire under a hire purchase agreement - for an ordinary car, station wagon or four-wheel drive, or for most other vehicles designed to carry less than one tonne or fewer than nine passengers. If personal services income is received, restrictions may apply. The four methods 3
There are four methods that can be used to work out the amount deductible. Donations Div 30 Deductions for gifts are claimed by donors that make the gift. A donor can be an individual, company, trust or other type of taxpayer. The requirements for a tax deductible gift are that it must: be made to a deductible gift recipient (DGR) truly be a gift be a gift of money or property that is covered by one of the gift types, and comply with any relevant gift conditions. Deductible gift recipient (DGRs) Entities entitled to receive tax deductible gifts are called deductible gift recipients (DGRs). Not all payments to DGRs are tax deductible. Gifts have the following characteristics: there is a transfer of money or property they are made voluntarily the transfer arises by way of benefaction, and no material benefit or advantage is received by the donor. Gift types To be deductible, a gift must be money or property covered by one of the following gift types: money - $2 or more property > $5,000 - property (including listed shares) the Tax Office has valued at more than $5,000. Tax Office valuations are made by the Australian Valuation Office (AVO) which is part of the Tax Office property < 12 months - property (including listed shares) that you purchased during the 12 months before the gift was made - irrespective of its value shares $5,000 - listed shares that you acquired at least 12 months before the gift was made, with a market value of $5,000 or less on the day you made the gift trading stock - trading stock disposed of outside the ordinary course of business cultural gifts - property gifted under the cultural gifts program cultural bequests - property gifted under the cultural bequests program heritage gifts - places included in the National Heritage List, the Commonwealth Heritage List or the Register of the National Estate. Online Activity 5: Read Div 30 4
Borrowing Expenses, s 25-25 ITAA 1997 The following types of borrowing expenses can be claimed as income tax deductions for taking out a loan for income producing purposes (such as to purchase a rental property): stamp duty charged on the mortgage loan establishment fees title search fees charged by your lender costs for preparing and filing mortgage documents mortgage broker fees fees for a valuation required for loan approval lender's mortgage insurance, which is insurance taken out by the lender and billed to you. What can't you claim: stamp duty charged by your state/territory government on the transfer (purchase) of the property title. stamp duty you incur when you acquire a leasehold interest in property such as an Australian Capital Territory 99-year crown lease (you may be able to claim this as a lease document expense) insurance premiums where under the policy your loan will be paid out in the event that you die, become disabled or unemployed (this is a private expense), or borrowing expenses on the portion of the loan you use for private purposes (for example, money you invest in a super fund). Where the total deductible expenses are more than $100, the deduction claim for those expenses must be spread over five years or the term of the loan, whichever is less. If the total deductible borrowing expenses are $100 or less, you can claim the deduction in full in the income year you incur them. Online Activity 6: Read s 25-25 Losses Business Div 36 A tax loss is incurred when total deductions for an income year (excluding tax losses from earlier income years) is more than total assessable income and net exempt income. Some deductions though cannot be used to create or increase a tax loss, including donations or gifts and personal super contributions. If the business makes a loss in an income year, you can carry forward that loss and may be able to claim a deduction for that loss in a future year. The rules differ for different business structures. Offsetting current year losses against other income This applies to sole traders and individual partners in a partnership only. People operating as a sole trader or a partner in a partnership, may be able to claim business losses by offsetting 5
them against income from other sources, such as wages. However, they will need to meet the requirements of the non-commercial losses rules. These rules determine whether they can use their business loss to offset income from other sources. Superannuation contributions: ss 290-60-290-80, 290-150 Superannuation contributions are fully deductible for employers and the selfemployed. Although, the self-employed are subject to concessional contribution caps (this is generally $25,000 per annum for the current income tax year, above that the contributions are effectively subject to a 46.5 per cent tax rate). Part B: Limitations 1. Introduction The deduction limitation provisions are scattered throughout the 1936 and 1997 ITAAs. There are a variety of provisions that operate to limit deductions that may be otherwise available under ITAA 1997 s 8-1 or other deduction provisions as follows See ITAA 1997 ss 8-1(2)(d), 8-5(3). 2. ITAA 1997 Limitations Penalties and fines: s 26-5 This provision ensures that a person does not indirectly benefit out of a tax deduction by excluding penalties and fines payable under an Australian or foreign law as deductions. Online Activity 7: Read s 26-5 HECS-HELP and student assistance: s 26-20 You cannot deduct HECS-HELP and student assistance unless it is taxed in providing a fringe benefit. Political Donations: s 26-22 Political donations made by businesses are not deductible. Employees though can claim deductions for donations to political parties and independent candidates and members up to a $1500 cap. Relative s travel expenses: s 26-30 Where an employee or business person travels in the course of producing assessable income, the taxpayer is denied a deduction for the travel costs of an accompanying relative except where the relative performs substantial duties and it is reasonable to conclude that the person would have travelled with the taxpayer even if that personal relationship did not exist. Reductions for payments to related entities: s 26-35 6
This is designed to prevent excessive deductions for payments made to associated persons. Such payments are deductible to the extent that the Commissioner considers reasonable. A related entity is a relative or a partnership in which a relative is a partner. Online Activity 8: Read s 26-35 Family maintenance payments: s 26-40 Payments made to maintain family members (food and accommodation) are not deductible. Bribes to officials: ss 26-52, 26-53 Bribes to officials are not deductible and do not form part of the CGT cost base: see ss 26-52, 26-53. Section 26-54 denies deductions for losses and outgoings incurred in the furtherance of, or directly in relation to, activities in respect of which the taxpayer has been convicted of an indictable offence. An indictable offence is an offence that is punishable by imprisonment for at least one year. Illegal activities: s 26-54 This section prevents deductions for expenses incurred in the furtherance of a physical element of an offence against Australian law. Online Activity 9: Read s 26-54 Entertainment expenses: Div 32 Entertainment expenses are the provision of food, drink or recreation and any associated travel and accommodation. Except in a limited number of circumstances these expenses are not deductible. For example, an employer will be allowed a deduction if the expense is subject to FBT: s 32-20. Non-commercial losses: Div 35 A deduction is not allowable for a business loss for an individual taxpayer for certain small scale business activities. See anti avoidance topic. Substantiation: Div 900 Car, work and travel expenses of individuals and partnerships must be substantiated. Written documentary evidence is required for work expenses in excess of $300, laundry in excess of $150. No substantiation is required for overnight business travel and certain employee allowances. Car expenses have four alternative methods for substantiating and claiming car expenses: see Div 900. 3. ITAA 1936 Limitations Non-cash business benefits: s 51AK 7
This ensures the non-deductibility of any non-cash business benefits provided to induce business taxpayers to purchase items of plant or equipment. Example: You purchase computer services for $100,000 and receive a $5000 holiday by the supplier. The machine can only be depreciated at a cost of $95,000. Self-education expenses: s 82A You are limited to claiming the net amount of self-education expenses deductible under s 8-1 that exceeds $250. Note: This does not restrict deductions under other sections such as the depreciation and repair provisions. The Commissioner accepts that expenses for: refresher course; child care and travel from home to the place of study can be used to offset this $250 threshold. Online Activity 10: Read ITAA 1936 s 82A Prepaid Expenses s 82KZM Prepaid expense is expenditure incurred for things to be done (in whole or in part) in a later income year. Example: JC is a solicitor. On 1 July 2010, she paid $1,500 for an annual subscription for the monthly provision of a professional journal. The subscription covers the period 1 July 2010 to 30 June 2011. Because what the agreement covers - the provision of the professional publication - will be completed wholly within the expenditure year, the prepayment rules will not apply. The prepayment rule A prepaid expense is generally deductible over the eligible service period, or 10 years if that is less, rather than being immediately deductible. However, a prepaid expense may be immediately deductible if: it is excluded expenditure the 12-month rule applies, or The prepayment rules only apply to expenditure deductible under the general deduction provisions or under the research and development provisions. Also, special rules also apply to prepayments under tax shelter arrangements. Eligible service period The eligible service period is the period during which the thing is to be done under the agreement in return for the expenditure. The eligible service period begins on the day the thing under the agreement begins to be done or on the day the expenditure is incurred, whichever is later. The eligible service period continues until the end of the last day the thing under the agreement ceases to be done or 10 years, whichever is earlier. Example: Alf runs a shop from leased premises. On 1 December 2010, Mike made a lease payment to cover the period 1 December 2010 to 31 December 2011. The eligible service 8
period for this expenditure therefore started on 1 December 2010 and will end on 31 December 2011, a period of 396 days. His income year ends on 30 June of each year. As the thing to be done under the agreement - the provision of premises by the lessor - is not wholly done within the expenditure year, the prepayment rules will apply. Excluded expenditure Certain types of expenditure are excluded from the prepayment rules. These are: amounts of less than $1,000 amounts required to be incurred by a court order or law of the Commonwealth, state or territory payments of salary or wages (under a contract of service) amounts that are capital, private or domestic in nature, and certain amounts incurred by a general insurance company in connection with the issue of policies or the payment of reinsurance premiums. The 12-month rule? A small business entity, or an individual incurring deductible non-business expenditure, can claim an immediate deduction under the 12-month rule for prepaid expenditure if the payment is incurred for an eligible service period not exceeding 12 months and the eligible service period ends in the next income year. If the 12-month rule does not apply, your deduction for prepaid expenditure is apportioned over the eligible service period or 10 years, whichever is less. Online Activity 11: On 31 December of the current tax year you borrow $100,000 for a rental property with $1,000 borrowing costs, the term of the loan is 10 years. What are the borrowing costs for the current year? Online Activity 12: Just after purchasing a house in need of fixing up, Derrick listed the property with a real estate agent for rental. After listing the property, he quickly painted and rewired the house. Is Derrick entitled to a deduction for the cost of repairs? Online Activity 13: Ann owns a rental house and the ground beneath the rental property subsided as a result of the diversion of waterways. Thus she underpinned the entire foundation costing $60,000. Can Ann claim a deduction for underpinning the entire foundations? Online Activity 14: John purchased a vinyl lounge costing $500 for his spouse who suffered from certain allergies. Subsequent specialist medical advice was given against the use of a vinyl lounge. John gave the unused lounge with a market value of $400 to a charity 2 weeks after its purchase. The charity is registered as a deductible gift recipient. Is the gift deductible? Online Activity 15: Australian Tax Chapter 10 Practice Problems 1-9; Chapter 11 Practice Problem 1 9