26 May 2006
Key Points:
While the new regime is to be welcomed, the detail reveals some drawbacks, and some remaining gaps, in the practical operation of the measures.
For years it has been generally accepted that the income tax laws have not adequately dealt with capital expenditure incurred in connection with business activity, whether it be current, prospective or terminated. Following a limited attempt to deal with the inadequacy, a new broad-based regime has now been enacted, providing a more comprehensive regime of allowable deductions and cost recognition for business capital expenditures - the Tax Laws Amendment (2006 Measures No. 1) Act 2006.
The amendments introduce a revised section 40-880 into the Income Tax Assessment Act 1997 and make many other significant changes. The changes represent the first attempt in the tax laws at an all-embracing treatment of business capital expenditure.
The key elements of these amendments are:
Key elements for amortising business capital expenditure
Although the new measures are comprehensive, they have two key inbuilt limitations:
The business nexus requirements are that the capital expenditure must be incurred by the taxpayer:
(a) in relation to the taxpayer's business; or
(b) in relation to a business that "used to be carried on"; or
(c) in relation to a business "proposed to be carried on"; or
(d) to liquidate or deregister a company of which the taxpayer was a member, to wind up a partnership of which the taxpayer was a member, or to wind up a trust of which the taxpayer was a beneficiary, that "carried on a business".
The business mentioned in categories (a)-(c) must also satisfy a "taxable purpose" test. That is, deductions will be available only to the extent that the business is carried on, was carried on or is proposed to be carried on "for a taxable purpose". The definitions extend this to the conventional requirements of gaining or producing assessable income or carrying on a business for the purpose of gaining or producing assessable income, but certain mining and environmental protection activities are also included. The business nexus requirements mean that the revised section 40-880 will not apply to capital expenditure relating to non-business commercial activity that generates assessable income, such as passive investment.
Entitlement to the straight-line deduction is determined on a once-off basis at the time the expenditure is incurred. The expenditure is deducted in equal 20 percent amounts over the five year period, beginning with the year in which it was incurred. It is not essential for the business in question to continue for the five years. Similarly, it is not material whether or not a prospective business actually commences, as long as it can be objectively shown that there was a reasonable commitment to commence the business.
The need for "capital expenditure" means that it must have that character under general law principles - for example, because it relates to the acquisition of a "structural asset", or relates to the "business entity, structure or organisation" established for income-producing purposes.
Expenditure covered
The extension of the regime means that a range of expenditure preliminary to the commencement of a business will now be expressly catered for - such as, feasibility studies, due diligence expenses, tenders, and market research - where the expenditure is not otherwise deductible or taken into account for tax cost purposes. Costs of establishing a business or winning new business (eg. tender expenses) will also be covered by these measures (again, providing they do not form part of the cost of a depreciating asset or the cost base of a CGT asset).
Both preliminary expenditure and expenditure in relation to a business that "used to be carried on" will raise particular factual and timing issues. The Explanatory Memorandum adopts the view that "used to be carried on" implies a permanent cessation or end of business operations. A business "in abeyance" is regarded as a current business rather than a business that used to be carried on.
Other examples of business capital expenditure potentially within the measure include expenses of changing business structures, raising equity for a business, and attempting or defending a takeover (these were specific categories under the former provision). A range of business compensation payments could also fall with the new provision.
Expenditure to terminate a lease or licence
A separate specific deduction is provided for capital expenditure to terminate a lease or licence when incurred in the course of carrying on a business or in ceasing a business. A lease or licence includes an "authority, permit or quota" but a specific exclusion applies to a lease that is a finance lease under Australian Accounting Standards Board accounting standards (AASB 117 - Leases). A lease surrender payment, or other qualifying payment, will be able to be deducted in five amounts from year in which the lease or licence is terminated, without the need to consider the possible prior operation of other provisions. Those able to claim the deduction may be either a lessor/licensor or a lessee/licensee, or any other party that incurs the expenditure in order to terminate the lease or licence.
However, a deduction will be denied to the extent, if any, that the expenditure relates to the grant or receipt of another lease or licence for the asset that was the subject of the terminated lease or licence. The Explanatory Memorandum suggests that no deduction will be available if a payment is made to induce the termination of an existing lease or licence if the payment is in fact attributable to the grant of the new lease or licence. (In that event it may form part of the cost base of the new lease or licence. Certain lease transactions, such as granting and changing leases, are governed by particular capital gains tax provisions).
Capital expenditure generally relating to leases, and any other legal or equitable right, is broadly excluded from section 40-880 and instead is left for treatment under the capital gains tax provisions. (However, certain expenditure that maintains goodwill is left within section 40-880). This means that expenditures such as lease premiums and franchise licence fees are dealt with under the capital gains tax provisions. They may be included in the cost base of a CGT asset and a capital loss may ultimately be recognised (for a post-CGT asset) when the lease expires, is surrendered or assigned - providing the lease was used solely or mainly for the purpose of producing assessable income.
Consolidated groups
The business-related costs deduction under section 40-880 is available to the head entity of a consolidated group, in the same way as for other taxpayers, subject to the impact of the "single entity rule" that applies to consolidated groups. However, specific amendments have been made to the CGT cost base provisions, in order to provide for expenditure incurred on CGT assets held by the head company in relation to transactions between group members.
An important distinction is drawn between assets within a consolidated group that are disregarded because of the single entity rule, being rights and obligations that exist only between group members ("intra-group assets") and other assets of group members that involve parties external to the group and are treated under the single entity rule as assets owned by the head company ("non-intra-group assets").
Assets that are treated as being owned by the head company (non-intra-group assets) are dealt with under the capital gains tax provisions - for example, where stamp duty is incurred on a transfer of land from one group member to another. In these situations expenditure incurred by the head company is included in the cost base of the asset that is regarded as owned by the head company.
In the case of assets that are not recognised for tax purposes (intra-group assets), expenditure incurred by the head company to an external party may qualify for an amortised deduction under section 40-880. Examples of such assets include an intra-group lease or an intra-group debt.
Expansion of cost and cost base
The amendments broaden the kinds of expenditure that will be able to be included in the "cost" of a depreciating asset to include expenditure incurred "in relation to starting to hold" a depreciating asset where the amount is "directly connected" with holding the asset. The example is given of travel expenditure directly relating to the purchase overseas of specialised equipment. Certain amendments have also been made broadening the costs reasonably attributable on a balancing adjustment where a depreciating asset is sold or otherwise disposed of.
The costs that are able to be included in the CGT cost base or reduced cost base of a CGT asset have also been broadened to include various specific items, including borrowing expenses (eg. loan application fees and mortgage discharge fees). Other changes broaden the costs of ownership that can be included in the relevant cost base of a CGT asset. The requirement that the costs of ownership must be non-capital in nature has been removed. This means that expenses such as repairs or maintenance (on properties acquired after 20 August 1991), where not deductible, will be able to be included in the cost base of the property even if the costs are capital in nature.
Implementation
The amendments relating to business related costs (section 40-880) apply to expenditure incurred on or after 1 July 2005. The capital gains tax changes apply to CGT events on or after the same date (subject to the rule that the costs of ownership measures apply only to CGT assets acquired after 20 August 1991).
Comments
While the more comprehensive treatment of expenses for amortising deductions as business-related costs under section 40-880 is to be welcomed, there is a downside since its scope is narrowed by the wider range of items that can be included in the cost of a depreciating asset or the cost base of a CGT asset.
Other limitations will be encountered in connection with the business nexus requirements. Problems seem likely concerning expenditure incurred in connection with the liquidation and winding up of business structures. Certain capital expenditure will still fall outside section 40-880 on various grounds, including capital expenditure incurred in connection with income producing activities that do not involve a business. Expenditure of this kind is left for treatment under the revised capital gains tax provisions.
