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Capital Allowances - the deduction you CAN claim for capital outgoings

Capital outgoings - what are they and why can't you claim them as a deduction?

The problem: Sometimes capital payments resemble revenue expenses more closely than they resemble capital payments.

The solution: Capital Allowances

What if you dispose of, lose, destroy or otherwise terminate the capital asset before the end of the write off period?

Common rules for capital allowances

Common rule 1: Roll-over relief

Common rule 2: Non-arm's length transactions

Common rule 3: Anti-avoidance rules relating to property

There are 2 classes of tests applied by section 8-1 to losses & outgoings claimed as a deduction against assessable income.. The first determine whether the expenditure was 'incurred in' gaining assessable income -You can review those in the topic on the positive tests for deduction under section 8-1.

There are also certain negative tests. You can read about these in the topic explaining why expenditure which is capital, domestic or private in nature can not be deducted.

So how do you work out whether an expense has a capital or revenue nature?

Three questions can be asked to help arrive at an answer to this question.

1. What advantage was sought?

	*Capital* Think of it as the tree which produces the fruit		*Revenue* Think of it as the fruit which comes from the tree
Enduring advantage = capital		short term advantage = revenue

2. How will the advantage be used?

	*Capital* Think of it as the tree which produces the fruit		*Revenue* Think of it as the fruit which comes from the tree
Over the long term = capital		In the short term = revenue

3 What means was adopted to acquire it?

	*Capital* Think of it as the tree which produces the fruit		*Revenue* Think of it as the fruit which comes from the tree
One off payment = capital		periodic payments = revenue

The problem! Sometimes capital payments resemble revenue expenses more closely than they resemble capital payments.

Think of a miner, who incurs capital expenditure building a mine.

After a few years, all the mineral bearing ore has been ripped out of the earth, so a new mine will have to be built on another ore bearing deposit somewhere else.

It is different from the factory that can churn out product indefinitely.

The solution: Capital Allowances

To alleviate this problem, and make the assessment of income tax payable better reflect the reality of such industries, certain capital allowances are specifically allowed as deductions. In such cases, the Assessment Act breaks the rule in section 8-1 about not being allowed to deduct expenses of capital for certain income-producing activities.

The most obvious of these are the depreciation provisions. But there are others, scattered through the Act, and that tended to be the problem. Finding them in the 1936 Assessment Act, was something of an achievement. If finding these provisions was difficult, then working out the conditions and consequences which attached to each of them could be mind boggling.

The rewritten Assessment Act has endeavoured to bring order to this chaos by listing all such capital allowances in section 40-30 (2), along with details about

what kind of expenditure qualifies for the allowance;

who may deduct it;

how long the write off period is;

what happens when you dispose of the property.

Section 40-20 summarises how you work out the deduction you can claim for such capital allowances. It works like the depreciation provisions.

To work out the amount of your deduction for each income year, you divide:

the amount of expenditure you incurred;

by:

the length of the write off period, in income years.

The table in section 40-30 (2) tells you the write off period for each type of expenditure.

So each year you deduct the amount worked out in the formula, until you have deducted all entire amount of the capital expenditure.

Example: You spend $10,000 on preparing a mining site for mining operations. In this example, assume the write off period for mining is 10 years. You may deduct $1,000 for that income year and for each of the next 9 income years.

What if you dispose of, lose, destroy or otherwise terminate the capital asset before the end of the write off period?

Section 40-25 makes a balancing adjustment to ensure you get to write of the appropriate amount of expenditure to reflect your loss or gain on the disposal of the asset. You can read about balancing adjustments in the topics on the depreciation provisions

Common Rules for capital allowances

Division 40 has eased the burden of tracking down all the different capital allowances, which will be found in different divisions of the specialist groupings part of the Assessment Act.

But there is still the problem of working out the conditions and consequences, which attach to each of them. There is no easy solution to this problem, because the rules for each capital allowance will be as different as the industries for which they have been written.

However an attempt has been made to formulate some common rules. These common rules must be specifically mentioned by the division which authorises the deduction for the capital allowance, before they have any effect.

The common rules are found in Division 41

Common rule 1: Roll-over relief for related entities

Treating the new owner as if it was the original owner

Balancing Adjustments for Capital Allowance are one way to ensure the deduction matches the effective cost of the capital

Those capital allowances which amortise (or depreciate) the expenditure on some capital item or benefit over a period of time, require a bit of guesswork on the part of the tax law.

What happens is that the law guesses the period of time over which the capital benefit will be used up. This guess as to the expected life of the capital benefit is the write off period of the expenditure.

In the original calculation as to the estimated useful life of the plant, the tax law can get it wrong. If the Commissioner been a clairvoyant, he would have allowed a depreciation rate, which would have reduced the value to nil by the time the taxpayer disposed of the item.

Because he cannot hope to have such foresight, a deduction is allowed at the end of the useful life of the plant to 'make up' the difference between the depreciation which should have been allowed and the depreciation which was allowed.

If the taxpayer retains the capital benefit over the life of the plant it does not really matter too much if the guess was right or wrong.

But if the capital item (or benefit) is

lost or

destroyed or

disposed of,

then it will be necessary to compare the written down value of the capital when it ceases to be used by the taxpayer, with the amount of money consideration received by the taxpayer as a result of that cessation of use.

You can see an example of how this is done in the topic on depreciation - balancing adjustment

But an alternative to the balancing adjustment is the roll over provision, which allow the capital allowances to be passed on to the new owner, in certain circumstances, as if he were the original owner.

Common Rule 1, in section 41-20 tells you when roll-over relief can be obtained to delay a balancing adjustment in relation to the disposal of property.

It deals with capital allowance deductions such as depreciation but also with capital gains

We will look at the capital allowance deductions here you can refer to the capital gains aspects in the appropriate topic.

Section 41-25 says that there is no need for a balancing adjustment in relation to the disposal. You can disregard any rule for the capital allowance that requires one.

Section 41-30 treats the new owner (the transferee) as if he is the old owner. The transferee gains entitlement to a deduction. It also treats the old owner (the transferor) as if he is not entitled to the capital allowance deduction.

What happens when the new owner disposes of the capital?

Section 41-35 treats the transferee (the new owner) as if he was all the taxpayers who ever owned the capital (the transferors)

Transferee taken to have inherited all the transferor’s deductions

The total amounts deducted or deductible by all the transferors are taken to have been deducted or deductible by the transferee, under the rules for the capital allowance, in relation to the property.

Transferee taken to have incurred transferor’s total deductible capital expenditure

The total capital expenditure that qualified for a deduction under the rules for the capital allowance is taken to have been total capital expenditure of the transferee

Common rule 2: Non-arms length transactions

imposes a market valuation for the amount of

Section 41-65 (1) imposes a market valuation for the amount of expenditure

in respect of which an amount is deductible for a capital allowance

if the parties to the transaction do not deal with each other at arm’s length; and

the amount of the expenditure is greater than the market value of what the expenditure is for

Section 41-65 (2) imposes a market valuation for the amount of receipts

from a disposal of property if the parties to a transaction do not deal with each other at arm’s length and

and the party disposing of the property has incurred capital expenditure in respect of the property that qualified for a deduction under the rules for the capital allowance and

that party receives an amount under the transaction that is less than the market value of what that amount is for.

How does the Commissioner know they are not dealing at arms length?

Section 41-65 (3) allows the Commissioner to consider any connection between the parties, as well as any other relevant circumstance, in determining whether the parties dealt at arm’s length,.

Common rule 3: Anti-avoidance rules

Section 41-85 allows the Commissioner to treat you as the owner of certain property, even if you can show you are not. The Commissioner can only do this if he can show tax avoidance is taking place.

Why would the Commissioner wish to treat you as the owner of property even if you are not?

The general deduction provision (section 8-1) allows a deduction to the extent to which it is incurred in gaining or producing assessable income. So if the income produced is exempt there will be no deduction.

Tax exempt bodies, or non-resident entities not operating in Australia would be producing exempt income, and thus would not be entitled to deductions.

Details of how such bodies have sought to take advantage of the deduction for expenses incurred in gaining assessable income, and the provisions of the Assessment Act which have been introduced to counter such arrangements can be found at paragraph 14-140 of the CCH Master Tax Guide