bO2 2022 – Ch 5 – Depreciation and Capital Allowances

James Murphy


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CHAPTER 5

DEPRECIATION AND CAPITAL ALLOWANCES 

Capital expenditure incurred on a fixed or intangible asset will not be deductible under the general deduction provisions (section 8(1)).  However, a tax deduction (usually over a number of years) may be allowed under the capital allowance rules.

Most capital items decline in value over time, and the tax law recognises that this decline in value represents a legitimate cost deductible against business or other income.

DECLINE IN VALUE

Division 40 of the Act contains the capital allowance provisions, which allow tax deductions for the decline in value of depreciating assets.  The amount claimed in any given tax year is an estimation of the amount by which the asset’s value has fallen or depreciated.  For tax deductions to be claimed, the item of plant must be used to produce assessable income.

EFFECTIVE LIFE

Depreciation rates are determined by the estimated effective life of an asset.  Most taxpayers opt to follow the ATO’s estimates of effective life contained in TR 2021/3, an “Effective Life” tax ruling which is issued on an annual basis.

As the term suggests, effective life means the total estimated income-producing life of the asset, whether the asset is retained or sold at some point.  When determining effective life, assume that the taxpayer will retain the item until it can no longer be used economically to produce income by any taxpayer in that particular industry.

It is possible to self-assess effective lives of capital items; however, you should have specific reasons for self-assessing a shorter effective life.

TR 2021/3 only deals with the effective life of new plant, so it is permissible to self-assess for second-hand plant, which may justify a shorter effective life than determined under the ruling.

Taxpayers are able to re-estimate the effective life of plant acquired subsequent to 21 September 1999, where a change in circumstance means the original estimate is no longer accurate (section 40-110).

Note that effective life cannot be recalculated if the plant has been subject to accelerated depreciation rates.

CHOICE OF DEPRECIATION METHOD

A taxpayer has two choices for calculating the depreciation method to be claimed: the prime cost method or the diminishing value method.

Under the prime cost method, a percentage rate is applied to the acquisition cost of the plant each year until the cost is fully written off.

Under the diminishing value method, depreciation is calculated on the written down value of the plant at the start of the year.  In the first year, this will be equal to the cost, but the written down value will decrease in subsequent years.  The percentage applied is higher than that used under the prime cost method. 

CALCULATING DEPRECIATION

For assets acquired prior to 1 July 2001, general and special depreciation rates determined by the Commissioner are used.  For assets acquired after 1 July 2001, the Uniform Capital Allowance system applies, and the asset’s effective life is used.

The depreciation percentage to be used is calculated from the effective life of the asset as follows: 

Prime Cost

  • 100% divided by effective life (in years)

Diminishing Value 

  • For assets acquired prior to 10 May 2006, 150% divided by effective life (in years)
  • For assets acquired after 10 May 2006, 200% divided by effective life (in years)

LOW VALUE ITEMS

Taxpayers such as investors or employees who derive non-business income are still able to write off plant items costing less than $300 immediately.  Taxpayers who are not a Small Business Entity (SBE) may elect to write off items costing less than $1,000 through a low-value pool.

Items that may be allocated include:

  • New items of plant (costing less than $1000).
  • Existing items of plant subject to the diminishing value method with a written down value of less than $1,000 at the start of the tax year.

The low-value pool depreciation rates are:

  • 75% of the total cost of low-value items purchased in the current year.
  • 5% of the prior year’s closing balance of the low-value pool, plus the opening written down value of the existing plant newly allocated to the low-value pool at the commencement of the current year.

You may allocate items used partly for private purposes to the low-value pool, but first, be sure to deduct the private use percentage from the cost of the item.

There have been successive changes over the past six years outlined below. 

Refer to page 29 for current incentives.

SBE POOLING ARRANGEMENTS

These are discussed in Chapter 12. 

SALE OF DEPRECIATED PLANT

If an item of plant is sold for an amount less than the written down value, the shortfall can be claimed as a full deduction in the year of sale (assuming the item has been used entirely for business purposes).

Similarly, if an item of plant is sold for an amount exceeding its written down value, the difference must be included in assessable income as a balancing adjustment.

Note that this does not apply to items included in a low-value pool or SBE pool. 

REPLACEMENTS AND LOOSE TOOLS

Formerly, it was ATO practice to allow taxpayers to treat the initial purchase of low-cost items subject to frequent replacement as non-depreciable and to claim an immediate tax deduction for the expense.  As this practice has ceased, such purchases should now be allocated to the low-value pool.

In summary:

  • Formerly, SBE taxpayers could claim an outright deduction for items costing $6,500 or less (see Chapter 12). The Government then reduced the immediate write off to $1,000 from 1 January 2014. In the 2015 Federal Budget, the Government expanded the threshold significantly for small businesses. SBE’s can immediately deduct depreciating assets costing less than $20,000 for depreciable assets acquired and ready for use between 7.30 pm (AEST) 12 May 2015 and 28 January 2019, then increased again to $25,000 from 29 January 2019 to before 7.30 pm 2 April 2019.
  • As a result of the 2019/20 Federal Budget, assets purchased by an eligible Small Business Entity with aggregated turnover of less than $10 million were able to immediately deduct purchases up to the value of $30,000 from 7.30 pm 2 April 2019 to 30 June 2020.
  • Businesses with aggregated turnover of more than $10 million but less than $50 million were able to immediately deduct purchases up to the value of $30,000 from 7.30 pm 2 April 2019 to 30 June 2020.
  • Non-business taxpayers claim an immediate deduction for items up to $300.
  • Items costing $100 or less can generally be claimed in full.

IMPORTANT CHANGES 12 MARCH TO 31 DECEMBER 2020 

From 12 March to 31 December 2020, the instant asset write-off: 

  • Threshold will increase to $150,000 per asset (up from $30,000).
  • Eligibility has been expanded to cover businesses with aggregated turnover of less than $500 million (up from $50 million). 

BACKING BUSINESS INVESTMENT – ACCELERATED DEPRECIATION 

Eligible businesses, for the 2019–20 and 2020–21 income years, may be able to deduct the cost of new depreciating assets at an accelerated rate using the backing business investment – accelerated depreciation rules.

For each new asset, the backing business investment – accelerated depreciation deduction applies in the income year that the asset is first used or installed ready for use for a taxable purpose.

You claim the deduction when lodging your tax return for the income year. The usual depreciating asset arrangements apply in the subsequent income years that the asset is held.

If you are eligible for backing business investment – accelerated depreciation, you can choose not to apply these rules to an asset. The choice can be made on an asset-by-asset basis but cannot be changed once made.

For most businesses, you must:

  • make a choice in your tax return
  • notify the ATO by the day you lodge your tax return for the income year the choice relates.

Businesses are eligible for the backing business investment – accelerated depreciation deduction if they have aggregated turnover of less than $500 million in the year they are claiming the deduction. The deduction is available in the 2019–20 and 2020–21 income years.

Eligible businesses must check the eligibility criteria carefully before claiming, as the ATO will review claims as part of their compliance activities.

Eligible assets 

To be eligible to apply the accelerated rate of deduction under backing business investment, the depreciating asset must:

  • be new and not previously held by another entity (other than as trading stock)
  • be first held on or after 12 March 2020
  • first used or first installed ready for use for a taxable purpose on or after 12 March 2020 until 30 June 2021
  • not be an asset to which an entity has applied either:
  • temporary full expensing
  • the instant asset write-off rules

There is no limit on the number of eligible assets you can apply accelerated depreciation to in an income year under backing business investment.

Eligible assets do not include:

  • second-hand depreciating assets
  • some specific Division 40 assets subject to low value and software development pools
  • certain primary production assets (water facilities, fencing, horticultural plants or fodder storage assets), unless you are a small business entity that chooses to apply the simplified depreciation rules to these assets
  • buildings and other capital works for which you can deduct amounts under Division 43
  • assets that:
  • will never be located in Australia
  • will not be used principally in Australia for the principal purpose of carrying on a business
  • other specific capital asset and expense deductions
  • assets you were committed to acquiring before 12 March 2020.

There is no limit on the cost of an eligible asset unless it is a passenger vehicle.

You cannot claim a backing business investment – accelerated depreciation deduction if you use temporary full expensing or instant asset write-off for the same asset.

The ATO has prepared a high-level snapshot to help you work out how backing business investment, temporary full expensing, or instant asset write-off may apply to you.

Opting out

You can choose to opt-out of backing business investment – accelerated depreciation for an asset if you are not using the simplified depreciation rules. The choice can be made on an asset-by-asset basis, and you cannot revoke your choice once it is made for an asset.

For most businesses, you must:

  • make a choice in your tax return
  • notify the ATO by the day you lodge your tax return for the income year the choice relates.

If you choose not to apply backing business investment – accelerated depreciation to an asset, you apply the general depreciation rules to that asset.

Working out your deduction

Different rules apply when working out your deduction, depending on whether you use the simplified depreciation rules for small businesses.

Small business entity

Suppose you are a small business with  aggregated turnover of less than $10 million, and you use the simplified depreciation rules. In that case, you add to your general small business pool assets that:

  • cost $150,000 or more (instant asset write-off applies to assets costing less than this)
  • are eligible for backing business investment – accelerated depreciation
  • are not eligible for temporary full expensing.

You then deduct an amount equal to 57.5% (rather than 15%) of the business portion of a new depreciating asset in the year you add it to the pool. In later years the asset will be depreciated under the general small business pool rules.

Normal rules apply to assets allocated to the general small business pool that are not eligible for backing business investment – accelerated depreciation.

Example 1 – Small business benefits from backing business investment – accelerated depreciation

NC Transport Solutions Pty Ltd operates a haulage business. NC Transport Solutions Pty Ltd has aggregated turnover of $8 million for the 2019–20 income year. On 1 May 2020, NC Transport Solutions Pty Ltd purchases a new truck for $260,000, exclusive of GST. For the 2019–20 income year, the truck was only used for business purposes.

Under past tax arrangements, NC Transport Solutions Pty Ltd would depreciate the truck using its general small business pool. This means that NC Transport Solutions Pty Ltd would deduct 15% of the truck’s value when it added the asset to the pool, leading to a tax deduction of $39,000 for the 2019–20 income year (assuming there are no other assets in the pool).

Under the new backing business investment – accelerated depreciation, NC Transport Solutions Pty Ltd will instead claim a deduction of 57.5% when it adds the truck to the pool, leading to a deduction of $149,500 for the 2019–20 income year.

Other business entities

Suppose you are an entity with aggregated turnover of less than $500 million in the income year and do not use the simplified depreciation rules. In that case, you may be eligible to deduct an amount under backing business investment – accelerated depreciation if the asset is eligible and you cannot or have chosen not to apply temporary full expensing to that asset.

The amount your entity can deduct in the income year the asset is first used or installed ready for use is:

  • 50% of the cost (or adjustable value where applicable) of the depreciating asset
  • plus the amount of the usual depreciation deduction that would otherwise apply but calculated as if the cost or adjustable value of the asset were reduced by 50%.

Effectively, the backing business investment – accelerated depreciation deduction applies to eligible assets with a cost (or adjustable value if applicable) of $150,000 or more in the:

* 2019–20 income year, if the eligible asset is first held on or after 12 March 2020 and first used or installed ready for use for a taxable purpose in the 2019–20 income year.

* 2020–21 income year, if the eligible asset is first committed to or held on or after 12 March 2020 and first used or installed ready for use for a taxable purpose in the 2020–21 income year. 

INSTANT ASSET WRITE-OFF FOR ELIGIBLE BUSINESSES 

Eligible businesses can claim an immediate deduction for the business portion of the cost of an asset in the year the asset is first used or installed ready for use.

Instant asset write-off can be used for:

  • multiple assets, if the cost of each individual asset is less than the relevant threshold
  • new and second-hand assets.

If you are a small business, you will need to apply the simplified depreciation rules in order to claim the instant asset write-off. It cannot be used for assets that are excluded from those rules.

The instant asset write-off eligibility criteria and threshold have changed over time. You need to check your business’s eligibility and apply the correct threshold amount depending on when the asset was purchased, first used or installed ready for use. 

Recent changes 

For assets first used or installed ready for use between 12 March 2020 until 30 June 2021, and purchased by 31 December, the instant asset write-off. 

  • threshold amount for each asset is $150,000 (up from $30,000)
  • eligibility extends to businesses with aggregated turnover of less than $500 million (up from $50 million). 

From 7.30 pm AEDT on 6 October 2020 until 30 June 2023, temporary full expensing allows a deduction for: 

  • the business portion of the cost of new eligible depreciating assets for businesses with aggregated turnover under $5 billion or for corporate tax entities that satisfy the alternative test
  • the business portion of the cost of eligible second-hand assets for businesses with aggregated turnover under $50 million
  • the balance of a small business pool at the end of each income year in this period for businesses with aggregated turnover under $10 million. 

COMPUTER SOFTWARE 

Since 1 July 2001, taxpayers have been able to pool expenditure on commissioning or developing software to be used solely for business purposes.  Software directly acquired cannot be pooled. Alternatively, a claim for depreciation may be made based on the effective life, which is determined to be four years.

This was extended to 5 years from 1 July 2015. The decline in value of in-house software must be calculated using the prime cost method. If the in-house software costs $300 or less and is used mainly for producing non-business assessable income, an immediate deduction may be claimable. The SBE simplified depreciation rules do not apply to computer software.

If in-house software becomes obsolete, the written down value may be claimed in full.  Expenditure incurred in website maintenance is fully deductible; such expenses include content updating, ISP fees, regular domain registration costs and the annual registration costs.

Website setup costs are capital in nature if incurred prior to the commencement of business or in establishing, replacing, or extending a profit yielding structure in an existing business.   We also draw your attention to Taxation Ruling TR 2016/3, which discusses the ATO view on the deductibility of expenditure on a commercial website. 

BUSINESS ‘BLACK HOLE’ EXPENDITURE 

Since 2005 the Income Tax Assessment Act 1997 has provided tax for treatment for legitimate business expenses, known as ‘black hole’, expenditures for income tax purposes.

Black holes occur when business expenses are not recognised under the income tax laws.  The need for an appropriate treatment for black hole expenditures was identified in the Review of Business Taxation.  The systematic treatment comprises of:

  • Permitting deductions for capital expenditures incurred by businesses that are carried on for a taxable purpose.
  • Providing deductions for certain pre-business expenditures incurred by existing businesses; and
  • Recognising these expenditures in a new provision that will only apply where the expenditures do not have tax treatment or are denied a deduction, elsewhere in the tax laws. Therefore, the new provision will be a provision of last resort.

Consistent with the systematic treatment, some black hole expenditures will be recognised by increasing the range of expenditures that form the cost base of an asset for capital gains tax purposes.

The provisions apply to expenditures incurred on or after 1 July 2005.  Expenditure can be written off on a straight-line basis over five years for the purposes of the uniform capital allowance regime.

Examples include:

  • Business setup costs, incorporation costs, costs to establish a partnership or trust. Search fees and other relevant costs used to obtain information
  • Costs of equity raising
  • Takeover defence costs; and
  • Costs to restructure an existing business.

If expenditure is not eligible for depreciation or otherwise deductible, you should check if it is eligible under the uniform capital allowance scheme provision.

From 1 July 2015, small businesses have been allowed to claim an immediate write-off for various professional expenses associated with starting a new business, such as professional, legal, and accounting service. 

LUXURY CAR DEPRECIATION LIMIT 

The 2021/22 limit on the depreciable cost of a motor vehicle is $60,733 ($59,136 2020/21), and this figure had hardly changed since the 2002/03 tax year when it was $57,009.

There also appears to be a consensus that $60,733 is too low and that the luxury car limit should be revised upwards.

If you pay, say, $95,000 for a car, depreciation can only be claimed up to the depreciation cost limit of $60,733.

When luxury vehicles are leased, the luxury car limit will be deemed a hire purchase agreement with depreciation allowed up to the depreciation cost limit.  These restricted depreciation claims along with interest (implicit in the lease) will be claimed in lieu of lease rentals.

The luxury car tax (LCT) was increased from 25 per cent to 33 per cent from 1 July 2008.  Note that the luxury car threshold for general cars for 2021/22 is $69,152 and $68,740 for 2020/21. The fuel-efficient car limit is $79,659 for 2021/22 and $77,525 for 2020/21.  Refer to Luxury Car Tax Determination LCTD 2021/1 for further details. 

PRIMARY PRODUCTION 

There are a number of concessions:

  • Land care operations – deductible in full in the first year claimed.
  • Water facilities – immediate write off.
  • Telephone lines and mains electricity – may be written off in equal instalments over a period of 10 years.
  • Forestry roads and timber mill buildings – deductible over 25 years or the effective life, whichever is shorter.
  • Horticultural plants and grapevines – accelerated write-off.  Refer to Section 40/545 of ITAA 1997 and TR2016/1.

It is recommended that further investigation regarding eligibility be undertaken before claiming any deductions for the above.

From 7.30 pm (AEST) 12 May 2015, the Government  allowed all primary producers to:

  • Immediately deduct capital expenditure on fencing and water facilities; and
  • Depreciate all capital expenditure on fodder storage assets over 3 years.

 

DEDUCTIONS FOR CAPITAL WORKS EXPENDITURE 

A taxpayer can claim a deduction for capital expenditure incurred in constructing eligible buildings and structural improvements.

Note that the deduction is not based on the cost to the taxpayer but on the original construction cost.

Therefore, on change of ownership, the new owner is entitled to the same claims on the original cost base.

Included in the definition of construction costs are preliminary expenses such as architect fees, engineering fees and development approval costs, and the cost of foundation excavations, but not the cost of the land, clearing or demolition. 

PLANT IN RENTAL PROPERTIES 

The extent to which there is plant in a residential property is outlined in Taxation Ruling TR 2004/16.  The outcome determines whether a deduction is available under Div 40 for depreciable assets or Div 43 for capital works.

Significantly the ATO considers that an item that forms part of the setting of the residential property is not within the ordinary meaning of plant. Key considerations are:

  • Whether the item appears visually to retain a separate identity
  • The degree of permanence with which it has been attached
  • The incompleteness of the structure without it, and
  • The extent it was intended to be permanent or whether it was likely to be replaced within a relatively short period.

The applicable rates are:

Income-producing residential 

Used wholly or principally for residential accommodation, e.g. guesthouses, apartments, units, flats, rented houses. 

Construction Commenced Per Annum
18.07.85 – 15.09.87 4%
From 16.09.87 2.5%

 

Income-producing non-residential 

All income-producing buildings except residential buildings, including shops, offices, casinos, convention centres, shopping centres etc. 

Construction Commenced Per Annum
20.07.82 – 21.08.84 2.5%
22.08.84 – 15.09.87 4%
From 16.09.87 2.5%

 

Short-term traveller accommodation 

Hotels, motels, resorts etc., with at least 10 bedrooms. 

Construction Commenced Per Annum
22.08.79 – 21.08.84 2.5%
22.08.84 – 15.09.87 4%
16.09.87 – 26.02.92 2.5%
From 27.02.92 4%

 

Manufacturing 

Used wholly or principally for manufacturing, processing of primary products, printing, energy production etc. 

Construction Commenced Per Annum
From 27.02.92 4%

 

Research and Development buildings 

Research and Development carried on for the purpose of producing assessable income. 

Construction Commenced Per Annum
From 20.11.87 2.5%

Any capital expenditure claimed after 13 May 1997 must be deducted from the asset’s cost base when calculating the capital gain on the sale. Subject to this requirement, there is no other balancing adjustment on sale.  When purchasing a building, establish the date of construction to determine your eligibility to make a claim.

If you are unable to ascertain the construction costs, engage a qualified quantity surveyor to make an estimate.  This is acceptable to the ATO.  Other suitably qualified persons include a supervising architect or a clerk of works of a major building project.  Estimates from valuers, accountants, solicitors, and real estate agents are not acceptable.

Expenditure is deductible from the date the building is first used for income-producing purposes after completion of construction.  For a deduction to be claimed, the building must be used or maintained ready for use for income-producing or research and development purposes.

Be careful to exclude from claims depreciable plant and equipment such as air conditioning.  This should be separately identified as normally much higher depreciation rates can be claimed.

RENTAL PROPERTIES & THE 2017 BUDGET

From 1 July 2017, deductions against rental income for travel will no longer be available in relation to travel costs to inspect or maintain the property or collect rent.

In addition, depreciation deductions for plant and equipment in residential rental properties will be limited to outlays actually incurred by the investor.

This affects purchases of second-hand properties.

Consequently, depreciation can no longer be claimed against items in situ at the time of purchase (e.g. dishwashers, ceiling fans etc., installed by a previous owner). Grandfathering arrangements apply to existing investments as at 9 May 2017.

MAY 2021 FEDERAL BUDGET EXTENDING TAX INCENTIVES FOR BUSINESSES THAT INVEST 

In the May 2021 Federal Budget, the Government extended temporary full expensing and temporary loss-back for an additional year, i.e. until 30.6.2023.

Case Study 1

In December 2021, Emu Deliveries Pty Ltd (EMU) plans a business expansion and would like to use temporary full expensing for $2.5 million worth of assets, which would result in a $500,000 loss. The time it would take to obtain approvals ad contractors means Emu will not install the assets until March 2023. Emu also wants to take advantage of loss carry-back to offset the $500,000 loss in 2022-23 against tax it paid in 2018-19, resulting in a tax refund of $125,000. Without the extension of the incentives, Emu would pay around $400,000 in tax in 2022-23 after the expansion, making it unaffordable.

Case Study 2

The owners of Fleur’s Flour, a food manufacturing company, decide in July 2021 to expand its operations and buy a new milling machine. Unexpected disruptions to global trade routes mean that the milling machine ordered from overseas will not arrive until April 2023. Fleur’s Flour relies on being able to fully expense the cost of the milling machine, to lower the cost of investing in expanding. Without the extension of temporary full expensing to 30 June 2023, Fleur’s Flour would not be able to benefit from the full expensing.