What is a prepaid expense?
A prepaid expense is expenditure you incur for things to be done (in whole or in part) in a later income year.
If you incur expenditure for something to be done in full within the same income year, it is not a prepaid expense and the prepayment rules do not apply.
Example:Expenditure that is not a prepaid expense
Jasmin is a solicitor. On 1 July 2011, she paid $1,500 for an annual subscription for the monthly provision of a professional journal. The subscription covers the period 1 July 2011 to 30 June 2012. Because what the agreement covers (the provision of the professional publication) will be completed wholly within the expenditure year, the prepayment rules will not apply.
What are the prepayment rules?
Generally, a prepaid expense is deductible over the eligible service period, or 10 years if that is less, rather than being immediately deductible. However, a prepaid expense may be immediately deductible if:
- it is excluded expenditure
- the 12-month rule applies, or
- it relates to a pre-Review of Business Taxation (RBT) obligation.
The prepayment rules only apply to general deduction provisions or under the research and development (R&D) provisions.
Special rules apply to prepayments under tax shelter arrangements.
What is the eligible service period?
The eligible service period is the period during which the thing is to be done under the agreement in return for the expenditure.
The eligible service period begins on the day the thing under the agreement begins to be done or on the day the expenditure is incurred, whichever is later. The eligible service period continues until the end of the last day the thing under the agreement ceases to be done or 10 years, whichever is earlier.
Example: Eligible service period
Mike runs a delicatessen from leased premises. On 1 December 2011, Mike made a lease payment to cover the period 1 December 2011 to 31 December 2012. The eligible service period for this expenditure therefore started on 1 December 2011 and will end on 31 December 2012, a period of 397 days.
Mike's income year ends on 30 June of each year. As the thing to be done under the agreement (the provision of premises by the lessor) is not wholly done within the expenditure year, the prepayment rules will apply.
What is excluded expenditure?
Certain types of expenditure are excluded from the prepayment rules. These are:
- amounts of less than $1,000
- amounts required to be incurred by a court order or law of the Commonwealth, state or territory
- payments of salary or wages (under a contract of service)
- amounts that are capital, private or domestic in nature, and
- certain amounts incurred by a general insurance company in connection with the issue of policies or the payment of reinsurance premiums.
Example: Amount required to be incurred under a state law
John operates a cartage business and paid $1,200 on 31 December 2011 to register his truck for 12 months from 1 January 2012 to 31 December 2012. The truck is used exclusively for business purposes. Although the registration fee is over $1,000 and it covers a period spreading across more than one income year, it is excluded expenditure. This is because it is required to be incurred under a state or territory law. The prepayment rules do not apply to this type of expenditure and the fee is deductible in the year it is incurred.
What is the 12-month rule?
If you are a small business entity, or an individual incurring deductible non-business expenditure, you can claim an immediate deduction under the 12-month rule for prepaid expenditure if the payment is incurred for an eligible service period not exceeding 12 months and the eligible service period ends in the next income year. For more information on small business entities, see Small business entities, and on deductible non-business expenditure incurred by individuals, see Individual taxpayers incurring deductible non-business expenditure.
Prepaid expenditure incurred under certain managed investments (tax shelter arrangements) is not eligible for the 12-month rule. For information about tax shelter arrangements, see Investments in tax shelter arrangements.
If the 12-month rule does not apply, your deduction for prepaid expenditure is apportioned over the eligible service period or 10 years, whichever is less.
What is a pre-RBT obligation?
A pre-RBT obligation is any contractual obligation that:
- exists under an agreement at or before 11.45am (by legal time in the ACT) on 21 September 1999, the date of the Government's release of the RBT
- requires you to make a prepayment in return for something to be done under the agreement, and
- cannot be avoided by your own actions.
The rules for deducting prepaid expenses incurred under a pre-RBT obligation are the same as those for small business entities that have chosen to claim an immediate deduction, see Small business entities.
General deduction provisions and the research and development provisions
The prepayment rules apply only to expenditure which would otherwise qualify for immediate deduction:
- under the general deduction provisions of section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), or
- for eligible companies, under the R&D provisions in sections 355-205 (R&D expenditure) or 355-480 (earlier year associate R&D expenditure) of the ITAA 1997.
The general deduction provisions generally allow you to deduct from your assessable income any loss or outgoing incurred in gaining or producing your assessable income, or incurred in carrying on a business.
You cannot claim a deduction under these provisions for expenditure of a capital, private or domestic nature, or expenditure incurred in gaining exempt income.
If the expenditure is deductible under a specific deduction provision of the tax law other than those for R&D (that is, other than sections 355-205 or 355-480 of the ITAA 1997), the prepayment rules do not apply.
Unless specifically stated otherwise, the terms 'expense' and 'expenditure' used throughout this guide refer to expenditure that is only allowable as a deduction under the general deduction provisions of section 8-1 of the ITAA 1997 or, for eligible companies, under the R&D provisions in sections 355-205 or 355-480 of the ITAA 1997.
R&D expenditure prepaid in years beginning prior to 1 July 2011:
Sections 355-205 and 355-480 of the ITAA 1997 apply to R&D expenditure incurred in income years beginning on or after 1 July 2011. Undeducted amounts of prepaid expenditure incurred in an income year beginning prior to 1 July 2011, but taken by section 82KZMD of the ITAA 1936 to be incurred over the eligible service period to which they relate, may be a deduction under the transitional rules for the R&D tax incentive for years beginning on or after 1 July 2011. The expenditure must be incurred on activities that the company has registered under section 27A of the Industry Research and Development Act 1986 for the relevant year.
Unless specifically stated otherwise, the terms 'expense' and 'expenditure' used throughout this guide refer to expenditure that is only allowable as a deduction under the general deduction provisions of section 8-1 of the ITAA 1997 or, for eligible companies, under the research and development provisions in sections 73B, 73BA, 73BH, 73QA, 73QB or former section 73Y of the ITAA 1936.