2014mlc703ws1-t04

T O P I C 4

Deductions P R E PA R E D B Y W E S O B S T A N D R A M I H A N E G B I F O R T H E U N I T T E A M

Contents

Introduction 1

Learning resources 2 Textbooks 2

General deductibility under section 8-1 2 The positive limbs 2 The negative limbs 7

Limitations on deductibility 11

Specific deductions under s. 8-5 13 Introduction 13 Division 25 ITAA 97 – specific deductions 14 Other specific deductions under Div. 25 17 Gifts – Div. 30 ITAA 97 18 Tax losses – Div. 36 ITAA 97 18 Capital allowances – Div. 40 ITAA 97 19 Capital works – Div. 43 ITAA 97 21 Other capital allowances not covered in this unit 22

Summary 22

© Deak in Univers i ty

P r inc ip les o f Income Tax Law

Introduction In topics 2 and 3 we have covered the first element of the calculation of taxable income, i.e. assessable income. In Topic 4 we cover deductions, which is the second major element of the tax equation as shown in Figure 4.1.

Figure 4 .1 The tax equat ion

From Figure 4.1 you will be reminded that the calculation of taxable income is determined by subtracting deductions from assessable income. Figure 4.1 also shows that deductions are made up of three elements just as assessable income was. Assessable income was made up of:

• ordinary income

• statutory income

• exempt income.

Following a similar structure, deductions are made up of:

• general deductions (s. 8-1(1))

• exclusions (s. 8-1(2))

• specific deductions (s. 8-5).

It is very important to remember this structure, as these are the three factors that must be considered each time you determine whether an expense is deductible or not. Whenever you consider whether an expense is deductible against assessable income, you must first ascertain whether you are entitled to a general or specific deduction, and whether any exclusion provisions apply to deny the deduction. This structure is derived from ITAA 97, ss. 4-15, 8-1 and 8-5. Following this structure, topic 4 is dealt with under these three major headings.

In a similar manner to s. 6-20, which prevents a receipt being assessable under more than one provision of the Act, s. 8-10 also prevents an expense being deductible more than once under different provisions.

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Learning resources

Textbooks Coleman et al., Principles of taxation law 2014, Thomson Reuters, Pyrmont NSW.

Deutsch, RL, Fundamental tax legislation 2014, Thomson Reuters, Pyrmont, NSW,

General deductibility under section 8-1 The basic structure of the legislation is to provide for general deductions under section 8-1 ITAA 97 and specific deductions through section 8-5 ITAA 97.

Reading s. 8-1 you will notice that it is divided into two parts, subsections (1) and (2). The first subsection contains what is known as the two positive limbs. At least one of these must be proved to apply before any amount is deductible as a general deduction. The second subsection contains four negative limbs. If any of these apply the deduction will be denied. The term ‘limbs’ has been used over the years by the courts to describe the different tests under s. 8-1, so it is important to become familiar with the language that is used.

Under the first two positive limbs of s. 8-1(1) a deduction is available from your assessable income:

(a) [First positive limb] for any loss or outgoing to the extent that it is incurred in gaining or producing your assessable income

or

(b) [Second positive limb] for any loss or outgoing to the extent that it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

T EX TB O O K Please read Coleman et al. 2014, 12.00 – 12.30.

The positive limbs The key to obtaining a deduction under either of the two positive limbs is to establish a connection or ‘nexus’ between the loss or outgoing and the assessable income. The nexus test is therefore paramount and must be the first step in determining whether any expense is deductible or not.

Sufficient nexus Over the years the courts had established a number of tests to determine whether there is sufficient nexus between the loss or outgoing and the assessable income. These tests can best be described as:

• the incidental and relevant test

• essential character test.

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E XA M P L E 4 . 1 Incidental and relevant test

It might be argued that an employee could show that there is a nexus between his income and the cost of travelling from home to work. The argument might go: ‘it is not possible to earn my assessable income without travelling to work, and therefore travel costs are incidental and relevant to earning assessable income’. However, this is not the correct application of the incidental and relevant test, which requires that the travel itself is in the course of earning assessable income. In this example there is no assessable income earned during the travel from home to work as work only starts once you arrive. In contrast, if the employee travels because of work, for example to see a client, the nexus test is proven because the travel is in the course of earning the assessable income.


Q U E S TI O N 4 .1 Write a brief summary of how the ‘incidental and relevant test’ and the ‘essential character test’ were applied in the Charles Moore and Lunney cases.

Q U E S TI O N 4 .2 Make a brief summary of the essential requirements necessary to meet the incidental and relevant test.

Necessarily incurred The second limb uses the term ‘necessarily incurred in carrying on a business’ to qualify the nexus with the assessable income. Over the years the courts have read down the word ‘necessarily’ to mean ‘appropriate’ or ‘adapted’ for commercial purposes. This means that the nexus test is proven if the expense is appropriate for the business rather than is necessary.

E XA M P L E 4 . 2 Necessarily incurred

Does an expense have to be necessary before you are allowed a tax deduction under s. 8-1?

A large newspaper company decides to spend $3 million on an advertising campaign. After consulting several advertising agencies it decides on a campaign which it knows is sexist but which the management believes will increase sales. Only two days after the release of the advertising campaign there is a public outcry, and the advertising is withdrawn. Market research over the next few months showed that sales actually declined instead of increasing.

For an expense to be deductible under the second limb of s. 8-1, it must be ‘necessarily incurred’. Although it might be argued that this expense was a waste of money, it is still appropriate or adapted towards the carrying on of the business. Therefore, it is still incidental and relevant to the earning of assessable income and therefore passes the second limb of s. 8-1.

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Q U E S TI O N 4 .3 From Snowdon and Wilson, who should be the judge of whether an expense is necessary?

Q U E S TI O N 4 .4 From the decided cases make a brief summary of whether a nexus can be shown for a business expense under the second limb that is:

(a) past business income of a continuing business

(b) current business income

(c) future business income which may or may not eventuate

(d) income of a business that ceased three years ago and is not likely to resume

(e) income of a company that ceased operating for six months and then resumed operation in an unrelated area of business

(f) income of a business that has been put into liquidation.

Apportionment The phrase in s. 8-1 ‘to the extent that’ clearly contemplates the notion that an expense may only be partly deductible. It may have to be apportioned between an amount which is incidental and relevant and an amount that is not.


E XA M P L E 4 . 3 Apportionment of expenses

Miss Lee conducts a small photography business which she operates from the front two rooms of her private home. Her electricity account of $250 is undissected and applies to both the rooms used for her business and her private home. Only the proportion of electricity used for her business is incidental and relevant to earning assessable income, and therefore the total amount of $250 is not deductible. As the electricity used in the business is not measured separately, it is necessary to make some reasonable apportionment of the total account. This may be done by estimating the percentage of the total home that is occupied by the shop, or some other reasonable method.

The ATO suggests that a rate of 26 cents per hour is reasonable, and the total number of hours used during the year should be determined by keeping a diary for four average weeks during each year.

Q U E S TI O N 4 .5 If a motor vehicle is used for both business and private purposes is any part of the cost of running the motor vehicle an allowable deduction?

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Q U E S TI O N 4 .6 The taxpayer incurs a cost of $1500 for an airline ticket to Hong Kong to investigate the prospects of exporting the company’s produce into the Chinese market. While in Hong Kong the taxpayer spends seven days meeting with trade and industry representatives, and five days on an organised bus tour of the local sites. Is any part of the $1500 airfare deductible, and if so, how could the deductible proportion be determined?

Amount of deduction Up until this stage of our discussion of the positive limbs of s. 8-1, we have accepted that an expense meets the positive tests if there is a connection between the expenditure and earning assessable income. This analysis tends to be very objective, so that in deciding the cases up until the 1980s the courts took the view that something could be determined as incidental and relevant by looking at the legal rights that were obtained. However, this approach could be exploited by the taxpayer by concealing a non-income earning purpose within a legitimate income earning activity. Consequently, the courts have in more recent times considered the subjective purpose of the expense, but this approach is only used where the taxpayer has created a tax loss situation, for example, assessable income is less than the allowable deductions (see Example 4.4).

E XA M P L E 4 . 4 Subjective purpose approach

In the case Ure v. FCT the taxpayer borrowed money at 12% interest which he on lent to his wife at 1% interest. The taxpayer argued that all of the 12% interest was deductible because the loan was for the purpose of earning assessable income – the 1% interest.

Applying the legal rights approach it might be concluded that the taxpayer has shown that the expense of 12% interest is incidental and relevant to earning the 1% interest, which is assessable. However, looking behind this purely objective approach, the purpose approach would ask whether there is some other purpose in the borrowing, other than the earning of the 1% interest. In this case it was clear that the money was ultimately borrowed for the construction of the taxpayer’s private home. Therefore, the court only allowed a tax deduction equal to the amount of interest earned from lending the money to his wife. The remainder of the interest he incurred was held to be private as it had a private purpose.


SA M P L E PR O B L EM 4 . 1

Deductions under s. 8-1

Daylee Paper Ltd publishes the UNTRUTH newspaper. In the course of producing that paper, it printed an article which later was the result of a successful libel action against Daylee Paper Ltd. Daylee Paper paid compensation of $100 000 and legal fees of $50 000.

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Issue: The compensation and the legal fees will be deductible under s. 8-1 if they are incidental and relevant to producing assessable income, or are necessarily incurred in carrying on the newspaper publishing business.

Principle: In answering the above questions it is necessary to determine whether under the second positive limb of s. 8-1, there is a nexus between the expenses and the carrying on of the business of newspaper publishing. Whether or not there is a nexus between the expense and the assessable income can be determined by applying the ‘incidental and relevant test’ (Charles Moore v. FC of T 11 ATD 147).

Application: In Herald & Weekly Times Ltd. v. FC of T (1932) 48 CLR 113 it was decided that an expense is connected with the business if it is appropriate or adapted to the carrying on of a business. In this case the key issue was whether the expense of the defence of a libel action was one that was brought about by the nature of the business.

Conclusion: The expenses of Daylee Paper Ltd for compensation and legal fees arose because of their business activities, and therefore they are incidental and relevant to carrying on the business. Although these expenses were not foreseen and unplanned, they are still incurred in relation to the income-earning activities of the business. Therefore both these expenses meet the requirements of the second positive limb s. 8-1.

Q U E S TI O N 4 .7 Make a summary of the key elements that must be considered when deciding whether a loss or outgoing is deductible under either of the two positive limbs of s. 8-1.

Q U E S TI O N 4 .8 Discuss the deductibility of the following expenses based on each of the two positive limbs of s. 8-1. (At this stage it is not necessary to consider whether they may be excluded by some other provision of the Act.)

(a) The traffic and parking fines paid by a taxi driver that were incurred while using the taxi for income-producing purposes.

(b) Interest of $500 paid to the local city council by the owner of a rented property on monies outstanding to the council for road construction costs.

(c) A sum of $1.4m paid to an advertising agency for the development of an advertising campaign that was to run for the next two years.

(d) Interest paid on a loan that was borrowed for the purposes of acquiring a rental property.

(e) Expenditure incurred by an airline company in defending against the right of other airlines to fly similar routes.

(f) A lecturer at Deakin University incurred expenditure of $1200 in moving to Sydney to take up a position at the University of NSW.

(g) The taxpayer incurs travel expenditure of $1300 for the use of his own car. He manages two farming properties which are some distance apart. His employer requires him to live at one property and supervise both. He does not receive any travel allowance.

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(h) T Smart lives in Melbourne and has two children attending Deakin University’s Warrnambool campus. In an attempt to reduce the cost of accommodation for his children, he purchases a small house in Warrnambool at a cost of $360 000 for his children to live in. To do this he borrowed money at 8% per annum and charged his children $5 per week rent and gave them the responsibility of maintaining the house. T Smart also pays each child an allowance of $180.00 per week.

(i) A Scribe is a freelance TV scriptwriter who has a room in her house where she does most of her work, even though she has been given an office at the television studio. On most days she rises at 5.00 am and begins work on either the television scripts or her freelance activities. At about lunch time she travels to the studio to discuss progress with the program director. Her costs include:

• electricity for lighting and heating

• rates on her home

• interest on a housing loan

• travel to and from the television studio.

(j) A law/accounting student spends $1000 on postage trying to find a job.

(k) The following expenses are incurred by a company that manufactures shoes for the surf-wear market:

• company formation expenses

• employee wages

• factory rent

• purchase of trading stock

• repairs to production plant

• telephone and administration costs

• insurance on factor and plant

• childcare expenses of an employee.

Q U E S TI O N 4 .9 Coleman et al. 2014, Question 12.1

The negative limbs The first step in determining whether an expense is a general deduction under s. 8-1 is to determine whether or not either of the two positive limbs allow a deduction. Once this is proved, the next step is to ascertain whether the expense will be excluded from deductibility by one of the four negative limbs. Section 8-1(2) excludes from deductibility losses and outgoings that are:

(a) [First negative limb] capital: or

(b) [Second negative limb] private or domestic; or

(c) [Third negative limb] incurred in earning exempt income; or

(d) [Fourth negative limb] excluded under specific provisions of the Act.

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The first two of these exclusions from deductibility are the most important and need to be considered in some detail. The third negative limb is self explanatory, and the fourth negative limb is covered in the last part of this topic as it applies to both general and specific deductions.

First negative limb – capital expenses The exclusion of capital expenses from deductibility produces a symmetry between deductions and assessable income. In topics 2 and 3 we saw that capital receipts are not ordinary income and are only assessable because of their specific inclusion under the capital gains provisions. A similar approach operates for deductions. Capital expenses are excluded from general deductibility, but the specific deductions do allow some capital expenses such as depreciation (see later discussion in this topic).

Capital expenses are not defined in the legislation, giving rise to the same difficulties that occurred with defining ordinary income. When considering the meaning of capital, in the context of income, we needed to resort to case decisions. Although there are some similarities between the courts’ approach to defining capital for income and expenses, it is important not to confuse the two. The leading decision on the deduction side is Sun Newspapers Ltd v. FCT (1938) 61 CLR 337 in which Dixon J drew a distinction between structural expenses, being capital, and process expenses, being deductible. The analysis used by Dixon J has become known as the ‘business entity test’ but is also referred to as the ‘profit yielding structure test’.

Even though the ‘business entity test’ has become the most significant test of capital in Australia, it is still important to recognise that the ‘once and for all’ and the ‘enduring benefit’ tests should still be considered when deciding whether an expense is capital or not.

E XA M P L E 4 . 5 Capital expenditure

Simple examples of capital expenditure will include obvious expenses such as the construction of a new factory and the acquisition of new manufacturing plant. It is the intangible expenses such as legal fees and the cost of undertaking a feasibility study that are more difficult to distinguish.

In Sun Newspapers Dixon J contrasts capital expenses which alter the way in which business is done, with non-capital expenses which simply allow the business to operate. This difference can be seen using the example of a business loan acquired to purchase new business premises. The cost of the new premises is clearly capital as it has an enduring benefit, is once-off and alters the way in which the business is carried out. However, the interest on the loan used to acquire the capital item is not capital.

This is because the interest payments enable the loan to continue, and so are part of the process of operating the business rather than changing it. A similar example can be given with insurance. Insurance on a capital item may be thought to be capital, but if you apply the tests of capital you will see that it is not. The insurance does not show an enduring benefit, is not once-off and does not alter the way in which the business is carried out. It simply protects the asset so that the business can continue free of risk.

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You should note in this example that it is important to consider all three tests, although more emphasis should be given to the ‘business entity test’, especially if the other tests give conflicting conclusions.


R EA D IN G Please read the Justice Dixon’s Judgment in Sun Newspapers case - http://law.ato.gov.au/atolaw/view.htm?dbwidetocone=05%3ALRP%3AHigh%20Court%3A1938%3ASun%20Newspapers%20Ltd%20%26%20%20Anor%20v%20Federal%20Commissioner%20of%20Taxation%3A%2303%23Judgment%20by%20Dixon%20J%3B


Capital exclusion under s. 8-1

FreeFlight Pty Ltd airlines incurred an expense in connection with the unsuccessful application for variation in the company’s air traffic rights. This was an attempt to increase the number of routes available to the company.

Issue: Is the expenditure capital in nature or not?

Principle: Outgoings of a capital nature are specifically excluded from deductibility under s. 8-1(2). Following Sun Newspapers Ltd. & Associated Newspapers Ltd. v FC of T (1938) 661 CLR 337 the expense will be capital if it alters the business entity rather than simply operating it. An expense is also more likely to be capital if it has an enduring benefit or is incurred once and for all.

Application: The expenditure was incurred in an attempt to obtain rights to air routes presently unavailable to the company. As the company earns income from conducting flights on the various air routes available to it, the right to fly a particular air route may be viewed as part of the business structure which generates the income. Asking the question that Dixon J. posed ‘what is the character of the advantage sought?’, it would be concluded that the airline company sought to increase the size of its business, rather than simply operating the business.

This expense also has an enduring benefit because if the application is successful the benefits will last for some time. The fact that the application was unsuccessful is irrelevant because the intention was to alter the way the business was done. Although this expense may occur on a number of occasions it is nevertheless once off, unless the airline is in the business of trading in air traffic rights.

Conclusion: As there is no indication that the company is in the business of trading in air traffic rights, the fact suggest that this expenditure is capital in nature and therefore excluded from deductibility under the first negative limb of s. 8-1. This expense goes towards the structure of the business rather than the process of its operation.

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Q U E S TI O N 4 .1 0 (a) In Sun Newspapers, what three considerations did Dixon J use to

determine whether an expense alters the taxpayer’s business entity?

(b) To what extent do these three matters incorporate the earlier tests adopted by the courts?

(c) How would Dixon J treat advertising?

Q U E S TI O N 4 .11 How would you characterise a feasibility study undertaken by a gold mining company as to whether it should also mine for nickel on some of its existing mining leases?

Q U E S TI O N 4 .1 2 Explain how the following expenses would be treated under the ‘business entity test’. Note the different taxation effects of the different forms of holding assets.

(a) Costs of purchasing a new shop to operate a retail business.

(b) Interest paid on the money borrowed to purchase the new shop.

(c) Costs of leasing a shop to operate a retail business.

(d) Costs of leasing a motor vehicle that will be used for business purposes only and can be acquired at the end of the lease for a fraction of its market value.

Q U E S TI O N 4 .1 3 Discuss the deductibility of the following items for taxation purposes, giving reasons.

(a) A bonus of $10 000 paid to a building contractor by the owner of the building, for the early completion of an income producing building. This bonus represents a share of the extra income received due to early completion.

(b) The taxpayer is a large pharmaceutical firm and conducts continuous research on a cure for the common cold.

(c) A retail business borrowed $500 000 to expand its business by building a new shop. The loan was for 10 years. When borrowing these funds the business incurred expenses of $2000 to arrange and establish the loan.

(d) A large beer manufacturer operates a system whereby it pays hotels a fee of $50 000 for entering an agreement that requires the hotel to only sell the manufacturer’s brand of beer. This practice has been undertaken for the last 2 years and hundreds of hotels throughout Australia have taken up the offer. During the current year the company paid $1m to hotels under these arrangements.

(e) The taxpayer is in the business of gas exploration and spends $2m investigating the viability of commencing a business of laying gas pipelines.

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(f) A company has spent $50 000 advertising against a government proposal to remove taxation concessions currently enjoyed by the business.

Second negative limb – private or domestic expenses Section 8-1(2)(b) denies a deduction for loss or outgoing that is private or domestic in nature. Consequently, personal expenditure is specifically excluded from deductibility. It is interesting to note that there is no equivalent notion of private transactions in relation to income.

Part of the difficulty with private and domestic expenses revolves around the fact that many expenses that could easily be described as private or domestic, could also be business or employment related. For example, clothing might be normally a private expense but how would we treat a business suit or a barrister’s wig? What about business lunches where deals are struck or child minding fees incurred to allow an employee to be able to attend work?

When considering this exclusion it is important to consider whether or not passing one of the positive limbs of s. 8-1, excludes the possibility of the expense being private or domestic. This would seem a reasonable argument, because if you can show that an expense is incidental and irrelevant to earning assessable income, then by that very nature it is not private. However, in FCT v. Forsyth (1981) 148 CLR 203 and Handley v. FCT (1981) 148 CLR 182, the High Court indicated that expenditure of a domestic nature may nevertheless satisfy one or either of the positive limbs.

T EX TB O O K Please read Coleman et al. 2014, 12.220.

Third negative limb – losses or outgoings in relation to exempt income Because exempt income is not assessable income (s. 6-20), expenses incurred to gain such non-assessable income should not be deductible. The third negative limb of s. 8-1 confirms that proposition.

Limitations on deductibility

Fourth negative limb – excluded by the Act The fourth negative limb (s. 8-1(2)(c)) limits a deduction where a provision of the Act (both ITAA 97 and ITAA 36) prevents a taxpayer from obtaining such a deduction. Some of the more important exclusions are dealt with in this topic.

As already discussed, s. 8-1 has three general exclusion provisions which deny a deduction for capital expenditure, private or domestic expenditure, or expenditure incurred in earning exempt income. The fourth negative limb excludes expenditure that is specifically excluded under the Act.

In addition to these specific exclusion provisions it is also important to note that a deduction may also be denied because adequate records are not kept, or because the deduction was part of a tax avoidance scheme. These issues are covered in topic 8. Also, in April 2005 the Federal Government introduced legislation (s. 26-54) to deny the deduction of expenses associated with the earning of income from illegal activities. This amendment resulted from the courts allowing a deduction of $220 000 to a taxpayer involved in an illegal drug-dealing business (La Rosa (2003)).

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In this unit we will cover the following more important exclusion provisions:

• GST credits

• provisions for employee leave

• fines and penalties

• payments to related entities

• leisure facilities and club memberships

• non-commercial losses

• expenses relating to illegal activities

• leisure facilities and club memberships

• HECS and self-education expenses

• entertainment expenses.



Excluded deductions

Harris runs an overnight delivery service and he employs six drivers to deliver in all areas of the city. After leaving school Harris’s daughter Emily could not get a job so he employed her to give her something to do. Because Emily had no other income Harris decided to pay her twice as much per hour as his other employees.

Issue: Is Emily’s wage incidental and relevant to earning assessable income or is it excluded by a specific provision?

Principle: Under the second limb of s. 8-1, an expense will be deductible if there is a nexus between the expense and the carrying on of the business. Whether or not there is a nexus between the expense and the assessable income can be determined by applying the ‘incidental and relevant test’ (Charles Moore v. FC of T 11 ATD 147). The courts generally do not consider whether the expense is commercially justifiable (Cecil Bros Pty Ltd v. FC of T (1964) 111 CLR 430) unless it can be shown that there is another purpose for the expense (Ure v. FC of T 81 ATC 4100). However, the expense may not be deductible in part or in full if s. 26-35 applies.

Application: In Herald & Weekly Times Ltd. v. FC of T (1932) 48 CLR 113 it was decided that an expense is connected with the business if it is appropriate or adapted to the carrying on of a business. In this case the expense is clearly part of the cost of operating the business that gives rise to assessable income, albeit an unnecessary expense. The decision in Cecil Bros shows that a payment is not denied deductibility under the positive limbs of s. 8-1 just because it is unnecessary.

However, s. 26-35 limits the deductibility of a payment to a related entity to an amount considered reasonable by the Commissioner. Section 26-35(2)(a) defines a related entity as including a relative and s. 995-1(1) defines a relative as including a lineal descendant which would include Harris’s daughter.

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Conclusion: Although the daughter’s wage is incidental and relevant under the second limb of s. 8-1, the deduction will be limited to a reasonable amount as determined by the Commissioner.

Q U E S TI O N 4 .1 4 Discuss the deductibility of the following items for taxation purposes, giving reasons.

(a) Lim Emporium Pty Ltd is a large distributor of Asian foods. Much of the business of the company is negotiated at sporting clubs and football matches. As a result Lim Emporium pays one sporting club membership per person for each of its top employees.

(b) A fine of $10 000 imposed by a national sporting tribunal on a sports star who breached the organisation’s rules of conduct.

Q U E S TI O N 4 .1 5 Redo Question 4.8 now considering any possible effect of the exclusion provisions.

Q U E S TI O N 4 .1 6 Coleman et al. 2014, Question 12.3

T EX TB O O K Please read Coleman et al. 12.330 – 12.450, 12.580 – 12.850.

Specific deductions under s. 8-5

Introduction You will recall from the introduction of this topic, that to determine whether an expense is deductible against assessable income, you must first ascertain whether you are entitled to a general or specific deduction, and whether any exclusion provisions apply to deny the deduction. The general deductibility provision s. 8-1 applies to all expenditure and should be considered in all cases. On the other hand, specific deductions are only relevant to particular situations and have been included in the Act for two major purposes:

• to clarify the application of s. 8-1

or

• to make deductible expenditure that does not fall under s. 8-1.

E XA M P L E 4 . 6 Specific deductions

Graphics Ltd publishes magazines. During the year the company purchases a printing press at a cost of $1 000 000. The machine has an estimated life of 10 years. In accounting terms the cost of the machine will need to be charged

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against the revenue earned from the use of this income-producing asset over the life of the printing press.

Logically the same should be true in tax law, but if you apply the tests in s. 8-1 you would conclude that, while the cost of the machine is an outgoing incurred in earning assessable income, a deduction would be denied because the outgoing is of a capital nature (s. 8-1(2)(a)). Is this fair?

Graphics Ltd also has a visit from the Environment Protection Authority (EPA). Apparently the filters on the machine are inadequate and undesirable waste is being discharged into the local river.

As a result Graphics Ltd has to replace the filters with new filters which have a greater capacity. The cost of the new filters, including installation is $100 000. For accounting purposes the $100 000 would probably be treated as an expense. Alternatively, the cost may be capitalised and depreciated over the life of the asset. But how would the expense be treated under tax law? If you apply the general deduction tests in s. 8-1, the issue would be whether the cost of the filters is incurred in the production of assessable income, or do they add to the value of the printing press and hence are capital?

To overcome some of the inequities that would apply if the tests for deductibility were confined to s. 8-1, the Act provides for a number of specific deductions. In some cases a deduction would be allowed under either s. 8-1 or under a specific provision; for example, non-capital expenditure on repairs would be deductible under either s. 8-1 or s. 25-10. When more than one provision is applicable, s. 8-10 provides that the deduction is made under the provision that is the most appropriate.

Section 12-5 provides a very good index to the specific deductions available under both the ITAA 36 and the ITAA 97, but please notes that this section is not an operative provision and must never be cited as authority for a deduction. Division 25, ITAA 97 contains many of the specific deduction provisions but there are many others spread throughout the Act.

For this unit the following specific deductions are dealt with:

• ITAA 97 Div. 25

• Gifts – ITAA, Div. 30

• Tax losses – ITAA 97, Div. 36

• Capital allowances – ITAA 97, Div. 40

• Capital works – ITAA 97, Div. 43.


Division 25 ITAA 97 – specific deductions Before beginning your study of specific deductions under Div. 25 you should look through the list of deductions covered by this division which is contained in s. 25-1. Although we do not cover all of these provisions it is valuable to have an overview of the type of expenses that are specifically covered.

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Tax-related expenses (s. 25-5) Costs associated with the preparation of an income tax return do not meet the general requirements of s. 8-1 as there is no nexus with the production of assessable income or carrying on a business. As a result the only source of deduction for these expenses is s. 25-5.

Repairs (s. 25-10) Section 25-10 specifically allows a deduction for non-capital repairs that are carried out for the purposes of producing assessable income. Clearly s. 8-1 would also allow a deduction for repairs, however, because there is a specific provision this must be considered first (s. 8-10).

When studying the readings covering the deductibility of repairs, you need to make certain that you understand the following basic issues:

• the definition of ‘repair’

• the distinction between non-capital and capital repairs

• apportionment of repairs where the item is only partly used for the production of assessable income.


R EA D IN G Please read from eReadings Lindsay’s case or (http://www.austlii.edu.au/cgi-bin/sinodisp/au/cases/cth/HCA/1961/93.html?query)

E XA M P L E 4 . 7 Repairs – the carpenter’s hammer

When a carpenter purchases a new hammer to use in his trade, it is clearly capital and not deductible under either s. 8-1 or 25-10. On the other hand, if he damages the head of the hammer and pays for repairs to fix it, then this is clearly a repair under s. 25-10 as it restores it to its useful state.

But what about this situation? On Monday the builder goes to work and during the day he breaks the handle of the hammer so he sends his apprentice to the hardware store to buy a new handle. Is this a repair? Most people will say ‘yes’ as the carpenter does not have a new hammer, he has simply fixed it so that it is useful again. On the very next day the apprentice borrows the builder’s favourite hammer and uses it to chip concrete, damaging the head. The builder is furious and again he sends the apprentice down to the hardware shop to buy a new head. Is this a repair, or does the builder now have a new hammer as both the handle and head are now new?

The distinction between a repair and a replacement is quite a difficult one. When approaching this problem you must first decide what is the entirety, and then decide whether the work done is a replacement of a subsidiary part or a substantial part of the entirety.

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http://www.austlii.edu.au/cgi-bin/sinodisp/au/cases/cth/HCA/1961/93.html?query

http://www.austlii.edu.au/cgi-bin/sinodisp/au/cases/cth/HCA/1961/93.html?query

TOPIC 4

Q U E S TI O N 4 .1 7 Discuss whether there is a ‘repair’ under s. 25-10 in the following situations:

(a) A rotten wooden floor in a shop is replaced with a cheaper concrete floor.

(b) The front brick fence in a rental property is badly cracked, it is removed and a new brick fence is built. The rest of the property is surrounded by a wooden fence.

(c) A brick letter box in a rental property is moved two metres to the right to avoid damage to a tenant’s car.

Q U E S TI O N 4 .1 8 A repair involves the replacement or renewal of a part but not of the entirety. Are the following ‘entireties’ or ‘parts’? What additional facts are needed to make a more accurate determination?

(a) A factory chimney into which the steam of a processing plant is discharged.

(b) External lavatories of a hotel.

(c) Foundations of a building.

(d) The front brick fence of a rental property.

(e) Floor coverings.

(f) A timber staircase to provide internal access to the second floor of a building.


Lease document expenses (s. 25-20) Section 25-20 allows a deduction for expenditure incurred by a taxpayer for the preparation, registration and stamping of a lease or of an assignment or surrender of a lease of property that has been, or will be, used by the taxpayer for the purpose of producing assessable income. Where the property is only used partly for income producing purposes, the deduction is apportioned (s. 25-20(2)). These expenses would not normally be deductible under s. 8-1 as they would usually be capital in nature.

Borrowing expenses (s. 25-25) Section 25-25 allows a deduction for expenditure incurred in borrowing money, where the money is used by the taxpayer for the purpose of producing assessable income.

It is important to distinguish between the ‘cost’ of borrowing and the ‘cost’ of the money. For example, expenditure on legal expenses, valuation fees, survey fees, stamp duty, prospectus advertising, printing and other costs relating to a debenture issue are costs of borrowing; while interest payable represents a cost of money. Interest is therefore not deductible under s. 25-25 but would need to be considered for deductibility under s. 8-1.

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Expense of discharging a mortgage (s. 25-30) Section 25-30 allows a deduction for expenditure (excluding principal and interest payments) in connection with the discharge of a mortgage given as security for the repayment of a loan. The deduction is limited to the extent that the money borrowed or property bought was used for the purpose of producing assessable income.

Bad debts (s. 25-35) Where a taxpayer is assessed on the accruals basis, the taxpayer pays tax on the income in the year it is derived, which will not necessarily be in the same year it is received. Therefore if a debt is not paid, the taxpayer should be entitled to a deduction for the resulting bad debt which has already been taxed at the time the sale was made. Section 25-35 specifically provides for such a deduction.


Q U E S TI O N 4 .2 0 An analysis of debtors as at 30 June provided by the firm’s accounts clerk showed:

$

Accounts receivable 103 000

Estimated bad debts 3 560

Estimated doubtful debts 12 500

Debts written off during the year 4 000

What amount(s) can be claimed as a deduction for the year?

Other specific deductions under Div. 25

Travel between work places (s. 25-100)

Expenses to terminate a lease (s. 25-110) Section 25-110 allows a deduction for expenditure that terminates a lease. Under this section, the expenditure is deductible over 5 years. This section only allows a deduction where the payment was in the course of business or in connection with ceasing to carry on a business.

T EX TB O O K Please read Coleman et al. 2014, 13.110.

Q U E S TI O N 4 .2 1 During the current year the taxpayer conducted a manufacturing business and incurred the following expenses:

(a) On 20 July: $350 in discharge of a mortgage on the taxpayers private home. The mortgage was used to acquire a loan that funded the purchase of business assets.

(b) On 1 June: $7000 to establish a three-year loan that was used to fund working capital. Interest for the remainder of the tax year was $3000.

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TOPIC 4

(c) During the current tax year the taxpayer incurred $1000 in travel from his private home where he runs a business of trading in shares, to his main office where he conducts his manufacturing business.

What deductions can be claimed for the year ended 30 June?

Q U E S TI O N 4 .2 2 Bob and his brother Fred have been operating their wholesale business in partnership for 10 years. During the current tax year the business incurred the following expenses.

$

(a) Taxation advice about restructuring the current partnership into a company 1600

(b) Cost of lodging last year’s partnership tax return 1500

(c) GST advice 1700

(d) Cost of successfully defending Bob in a tax audit 3000

(e) Interest on overdue tax 800

Explain the taxation implications of each of the expenses above, indicating whether or not each expense is deductible and, if deductible, under what section of the Income Tax Assessment Act.

Gifts – Div. 30 ITAA 97 Gifts to charity would normally be a private and domestic expense and therefore excluded from deductibility under s. 8-1. However, Div. 30 allows a deduction for gifts or contributions over $2 to certain nominated funds or institutions. The Division mainly sets out the organisations that have been approved for tax deductible gifts. You should scan this Division to obtain an overview of the type of entities that are eligible for gift deductibility. It is not necessary to have an in-depth understanding of this division.

Q U E S TI O N 4 .2 3 A review of the records of Mary Lyon showed that during the current tax year she had given the following gifts.

(a) $500 in cash as Christmas presents to her grandchildren

(b) $50 to the Royal Children’s Hospital appeal

(c) $2600 to her Church (assume it is a recognised religious body)

(d) A compulsory payment of $4000 made to a non-profit private school building fund.

What is the amount that Mary could claim as a gift in her income tax return for the year? Explain how you derived your answer.

Tax losses – Div. 36 ITAA 97 A tax loss will arise for the year if deductions exceed total assessable income. For example, if a taxpayer has $70 000 of assessable income and deductions totalling $100 000, the tax loss would be $30 000. Division 36 allows this tax loss to be carried forward indefinitely to be used as a tax deduction against future taxable income. Without Div. 36 the excess tax deduction of $30 000 would be wasted.

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T EX TB O O K Please read Coleman et al. 2014, 13.130 - 13.210.

Capital allowances – Div. 40 ITAA 97 Under s. 8-1(2)(a) a taxpayer is denied an immediate deduction for an outgoing of capital or of a capital nature. Therefore, there are no deductions under the general provision for the depreciation of capital items or the loss in value of any wasting asset.

To overcome this problem Div. 40 allows the taxpayer a deduction for the write-off of certain depreciating assets used for income-producing purposes. Effectively, this division introduces the notion of depreciation into the income tax system, but it is important to remember that the taxation depreciation system is not the same as depreciation for accounting purposes.

Section 40-25 allows the taxpayer to claim a deduction for the decline in value for the income year of depreciating assets that are used for producing assessable income.

The key elements of Div. 40 are:

• the asset must be a depreciating asset

• the depreciating asset must be used or held ready for use for the production of assessable income during the income year

• the depreciation deduction is calculated using the asset’s cost and its effective life

• the taxpayer may choose between the prime cost and diminishing value methods of depreciation

• the amount of the deduction may be apportioned if the asset is used for non-income earning activities or is not held for all of the income year.


E XA M P L E 4 . 8 Depreciation calculations

Item 1 – Machinery: opening value $5000, cost $10 000, effective life 10 yrs, depreciation method prime cost.

• Depreciation = –10 000 x (365/365) x (100%/10) = $1000

Item 2 – Equipment: opening value $6400, effective life 10 yrs, cost $8000, depreciation method diminishing value.

• Depreciation = 6400 x (365/365) x (200%/10) = $1280

Item 3 – Motor vehicle: opening value $22 000, 30% private use, cost $30 000, effective life 5 yrs, depreciation method prime cost.

• Depreciation = 30 000 x (365/365) x (100%/5) = $6000

• Depreciation deduction = 6000 x 70% = $4200

Item 4 – Motor vehicle: purchased 1st January, effective life 12 yrs, cost $30 000, depreciation method prime cost or diminishing value.

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TOPIC 4

• Prime cost depreciation = 30 000 x (181/365) x (100%/12) = $1240

• Diminishing value depreciation = 30 000 x (181/365) x (200%/12) = $2479

Balancing adjustments When tax depreciated assets are disposed of, lost or destroyed during a year of income, there will be a tax adjustment to correct for under or over depreciation. This correction is known as a ‘balancing adjustment’.

The effect of s. 40-285 is that where an asset is sold for more than its depreciated value, the excess is assessable. Conversely, where the depreciable asset is sold for less than its depreciated value, the loss is deductible.


E XA M P L E 4 . 9 Balancing adjustment

The taxpayer has held a depreciable asset for the last five years. Over the life of the asset capital allowances of $5000 have been deducted from the original purchase price of $12 000. Therefore, the asset has an adjustable value (cost less depreciation) of $7000. The balancing adjustment for a range of sale prices is as follows:

Sale price Balancing adjustments Calculations

7000 0 7000 – 7000

4000 3000 deduction 4000 – 7000

9000 2000 assessable 9000 – 7000

13000 6000 assessable 13000 – 7000

Q U E S TI O N 4 .2 4 A part-time student purchases a new computer on 1 March to use in his course of study. The dealer estimates the effective life of the computer at four years.

The costs associated with the acquisition of the computer were:

$

Computer 2100

Installation fee 50

Computer software not an integral part of the computer 600

Extended maintenance warranty 300

Assuming that there is a direct connection between the student’s employment and the course of study so that the student is entitled to claim self-education expenses, determine what deductions may be claimed for the income year ending 30 June.

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Other capital allowance provisions Division 40 (discussed previously) provides the general rules for capital allowance deductions. However, there are several special rules that relate to small businesses and for low-cost items:

• Under s. 40-425 items costing less than $1000 may be pooled so that separate records do not need to be kept for each item. This low value pool is depreciated at a diminishing value rate of 37.5% per year.

• Items costing $300 or less can be written off in full in the year of acquisition (s. 40-80(2)) provided the asset is used for the production of assessable income and the income is not income from carrying on a business. For example; deductions relating to income from a rental property.

• Section 40-880 allows for the write-off of some so called ‘black hole’ expenses that are not deductible under any other provision of the Act, e.g. business formation expenses.

• Subdivision 328-D provides special rules for eligible small business taxpayers, i.e. businesses that have a turnover of less than $2m.


Capital works – Div. 43 ITAA 97 Prior to the introduction of Div. 40, the depreciation provisions did not allow depreciation of buildings and other structural improvements. To overcome this problem Div. 43 was introduced which allows the write-off of new structural improvements over either 25 or 40 years.

Division 43 provides for a system for deducting ‘construction expenditure’ on ‘capital works’ used to produce assessable income or carry on research and development activities. The term ‘capital works’ is defined in s. 43-20 to include buildings, structural improvements and environmental protection earthworks; and any extensions, alterations and improvements to them.

The term ‘structural improvements’ is not specifically defined although sealed roads, retaining walls, fences and earthworks integral to the construction of a structural improvement are listed among the examples given in s. 43-20(3).

Earthworks that affect the general usefulness of the land and are not integral to the installation or construction of another structure, such as excavating an artificial lake and contouring earth for golf courses and recreational facilities, are excluded (s. 43-20(4)). Earthworks carried out as part of environmental protection activities would qualify (s. 43-20(5)).

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TOPIC 4

Other capital allowances not covered in this unit • Subdiv. 40-F – water facilities, horticulture and grapevines

• Subdiv. 40-G – landcare, electricity and telephone

• Subdiv. 40-H – mining

• s. 73B – scientific research

• s. 40-880 – some black hole (not deductible, not depreciable) business expenses may be written-off over 5 years – e.g. Business establishment costs.

• 290-60 – employer superannuation contributions

• 290-150 – self-employed superannuation contributions.

Summary In Topic 4 we covered deductions, which is the final element in determining taxable income. Deductions are subtracted from assessable income to determine taxable income as shown in Figure 4.2.

Figure 4 .2 The tax equat ion

Figure 4.2 also shows that deductions are made up of three elements:

• general deductions, s. 8-1(1)

• specific deductions, s. 8-5

• exclusions, s. 8-1(2).

Each of these essential components of the determination of deductibility can be further broken down into their essential elements.

A general deduction is available under s. 8-1 if the expense meets one of the two positive limbs and is not excluded by any of the four negative limbs. General deductibility is applicable to all expenses and is only not relevant if a specific provision allows the deduction.

Specific provisions have been included in the Act to clarify the application of s. 8-1 (e.g. s. 25-10 – repairs and s. 25-35 – bad debts) or to allow deductions for expenses that are not covered by s. 8-1. Specific provisions therefore allow some

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capital expenses as deductions even though they would be excluded by the first negative limb of s. 8-1, e.g. capital allowances (Div. 40) and capital works (Div. 43).

It is also important to remember to consider whether any of the specific exclusion provisions will deny a deduction that is otherwise allowable. Most of these exclusion provisions have been introduced to limit deductibility of expenses that have been exploited as dubious tax deductions, e.g. payments to relatives and entertainment expenses.

A final point that must be emphasised is the importance to putting all the aspects of deductibility together, and remember to follow all avenues for a deduction before concluding as to the tax effect of an expense. The following questions reinforce how each of the three key elements of deductibility must be considered for all expenses.

Q U E S TI O N 4 .2 6 Felicity operates a chain of clothing stores and is in the process of building a new retail shop in an outer suburb of Melbourne. Her original plan was to open the store before the Christmas period to capitalise on Christmas sales. However, there have been several delays to the construction project and it is not envisaged that it will be completed on time. In an attempt to get the shop open as planned Felicity offered a bonus of $30 000 to the building contractor if he completes on time. Ultimately the building is finished on time and Felicity happily pays the bonus which she based on the extra income received due to early completion.

In preparing to answer this question the following points need to be considered.

(a) Is the expense incidental and relevant to the production of assessable income under either of the two positive limbs of s. 8-1?

(b) Is the expense excluded from deduction by the first negative limb of s. 8-1?

(c) If the expense is capital and excluded from s. 8-1 is a specific deduction available under Div. 40 or Div. 43?

(d) If neither Div. 40 or 43 apply can the cost be added to the cost base of a CGT asset?

Prepare an answer to this problem considering each of the questions above.

Q U E S TI O N 4 .2 7 Consider the deductibility of the following transactions taking into account the possible application of s. 8-1, any specific deduction available and any exclusions that may apply. Some of these questions have been considered before but now need to be reconsidered using all aspects of deductibility.

(a) A successful Australian retailing company sells its trade name and logo to its overseas parent company for $2m. The contract of sale states that the parent company will allow the Australian company exclusive use of the name and logo at a cost of $1m per year.

(b) Legal costs incurred in defending a challenge against a company patent that forms the basis of the company’s business.

(c) A feasibility study conducted by a large bank to determine the profitability of entering the insurance business. The feasibility study showed it was not profitable and the bank did not proceed with the new business venture.

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TOPIC 4

(d) A forestry business spends $20 000 per year controlling weeds in a timber plantation – there will be no income for 15 years.

(e) Legal expenses of a business in relation to:

• purchase of a business

• advice on whether to form a company

• action taken to prevent a competitor from breaching the company’s patent

• advice on whether they could enter an agreement with a competitor not to compete in the local area.

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