House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello MP)

Chapter 2 - Business-related costs

Outline of chapter

2.1 Schedule 2 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to:

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allow certain business capital expenditure to be written-off in equal proportions over five income years. The expenditure is deductible only where it is not already taken into account and not denied deductibility for the purposes of the income tax law;

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apply the non-commercial loss provision in certain circumstances to such business capital expenditure;

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increase the range of expenditures that can be included in the cost base of an asset for capital gains tax (CGT) purposes and the cost of a depreciating asset for uniform capital allowances (UCA) purposes; and

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allow deductions for capital expenditure incurred in carrying on or ceasing a business to terminate a lease or licence to be deducted in equal proportions over five income years.

Context of amendments

2.2 Taxpayers may incur business expenditures that fall outside the scope of the various deduction provisions of the income tax law. For example, expenditure may not be deductible under section 8-1 of the ITAA 1997 because it is capital expenditure, but is not included in the cost base of a CGT asset or in the cost of a depreciating asset or there is no other specific capital allowance provision in the income tax law that allows a deduction for the expenditure. Expenditure could also be incurred before a business commences, or after it ceases, therefore a taxpayer may have difficulty in demonstrating the required nexus with the business to enable a deduction under the current law.

2.3 In 1999, the Review of Business Taxation identified a need to address such expenditures, known as 'blackhole' expenditures. The Review of Business Taxation proposed the tax value method as a means of providing recognition for these expenditures. After extensive evaluation of the tax value method, the Board of Taxation recommended against its adoption and the Government accepted the Board's recommendation.

2.4 In 2001, section 40-880 of the ITAA 1997 was introduced to provide a five-year write-off for seven specific types of business capital expenditures, including costs to establish a business structure and costs to cease carrying on a business.

2.5 On 28 August 2002, the Treasurer announced that the Government would develop a systematic solution to business blackhole expenditures by 1 July 2005 (Treasurer's Press Release No. 048 of 28 August 2002). The systematic solution was announced in the 2005-06 Budget (Treasurer's Press Release No. 045 of 10 May 2005).

2.6 By providing deductibility for business capital expenditure, subject to certain criteria to ensure the integrity of the provision, these amendments will recognise such expenditure.

Summary of new law

2.7 Schedule 2 repeals the current section 40-880 and replaces it with a systematic treatment for business-related capital costs. This systematic treatment comprises:

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a five-year straight-line write-off for certain business capital expenditure that:

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permits deductions for capital expenditures incurred in relation to existing businesses that are carried on for a taxable purpose; and

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allows deductions for pre- and post-business expenditures where the business is proposed to be carried on, or was formerly carried on, for a taxable purpose; and

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limitations to ensure these expenditures are deductible where they are not already taken into account, and are not denied a deduction, for the purposes of the income tax law. Therefore, the new provision will be a provision of last resort;

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changes to the cost base of CGT assets, and cost of depreciating assets, so that where expenditures are incurred in relation to the asset, the expenditure is appropriately included in the cost or cost base of the asset for taxation purposes; and

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a five-year, straight-line write-off for capital expenditure incurred to terminate a lease or licence if the expenditure is incurred in the course of carrying on or in ceasing a business.

2.8 In addition, the non-commercial loss provisions apply to pre- and post-business expenditures, by individuals (either alone or in partnership) deductible under section 40-880.

Comparison of key features of new law and current law

Detailed explanation of new law

Business-related costs - overview

2.9 This measure provides treatment for business capital expenditure not recognised in some way elsewhere in the tax law. Taxpayers may deduct capital expenditure incurred in relation to an existing, past or prospective business.

2.10 A key principle in determining the deductibility of business capital expenditure is the relationship between the expenditure and the business. This nexus will be a question of fact and in determining the relationship of the expenditure to the business, the former business or the prospective business, and when the expenditure is incurred, are necessarily considered.

2.11 Where the expenditure is incurred in relation to a business being carried on, or incurred in relation to a business that was formerly carried on, the relationship can be ascertained by considering the business that was actually carried on.

2.12 However, where the expenditure is incurred before the business is carried on, it may be more difficult for the taxpayer to establish the necessary relationship between the expenditure and the business. A key aspect, in order to preserve the integrity of the provision, is that the taxpayer would need to be able to show that, on an objective basis, the business is proposed to be carried on. That is, at the time the expenditure was incurred it can objectively be shown that there is a business that is proposed to commence at some time in the future. [Schedule 2, item 30, subsection 40-880(7)]

2.13 Consistent with general income tax principles, the deduction is available to the taxpayer who incurs the qualifying expenditure. Generally, the taxpayer incurring the expenditure is the same taxpayer that is carrying on, proposes to carry on or used to carry on the business. In some circumstances a taxpayer will incur expenditure in relation to a business that is proposed to be carried on, or that was formerly carried on by another entity. Specific rules apply in these circumstances to ensure that the taxpayer who incurs the expenditure is entitled to the deduction. [Schedule 2, item 30, subsection 40-880(4)]

2.14 Section 40-880 requires that the relevant business is, was or is proposed to be carried on for a taxable purpose. This means that for pre- and post-business expenditure, deductions may be available before and after the gaining or producing of the business's income. The deduction is always limited, however, to the extent the relevant business satisfies this taxable purpose test. The non-commercial loss provisions may also prevent individuals, either alone or in partnership, in certain circumstances, from deducting pre- and post-business expenditures from other assessable income.

2.15 As a provision of last resort, section 40-880 is responsive to subsequent changes in the tax law.

Object

2.16 The object provides that certain business capital expenditure is deductible. The business can be past, current or prospective and must be, was formerly or is proposed to be carried on for a taxable purpose. [Schedule 2, item 30, subsection 40-880(1)]

2.17 There are a number of exceptions which require, in effect, that the expenditure must not be taken into account in some way elsewhere in the income tax law. This means that the expenditure would not already be deductible, capitalised, amortised or capped in some way under another provision. The expenditure must also not be denied a deduction, including by limiting or capping the deduction, elsewhere in the tax law. [Schedule 2, item 30, subsection 40-880(1)]

Capital expenditure

2.18 The provision only applies to business capital expenditure. What this amounts to in the context of an existing, former or prospective business is determined on a case by case basis having regard to the general principles established by the Courts. This includes expenditure that fails the general deduction provision of section 8-1 by reason only of being capital or of a capital nature. [Schedule 2, item 30, subsection 40-880(2)]

2.19 Expenditure on the structure by which an entity carries on (or used to or proposes to carry on) their business and on the profit yielding structure of the business would ordinarily be expected to be of a capital nature. Capital expenditure can also relate to a business's trading operations or the entity that will carry on the business.

2.20 The structure covers the legal entity (such as a company) or the legal relationship (such as a partnership or trust) that is the entity that carries on the business for a taxable purpose and that holds the business assets.

2.21 For pre- and post-business expenditure, it may also provide a deduction for capital expenditure that falls outside the positive business limb of section 8-1. However, the mere fact that the expenditure fails the positive business limb of section 8-1 does not necessarily bring it into this provision.

2.22 Taxpayers can deduct the following specific types of capital expenditure:

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expenditure to establish your business structure;

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expenditure to convert your business structure to a different structure;

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expenditure to raise equity for your business;

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expenditure to defend your business against a takeover;

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costs to your business of unsuccessfully attempting a takeover; and

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costs to stop carrying on your business,

to the extent that they do not fall within the limitations and exclusions. These expenditures were previously deductible under the provision replaced by the measure.

2.23 In addition, shareholders, beneficiaries of trusts and partners can deduct liquidation and deregistration costs where the company, trust or partnership carried on a business. This specific addition to the general principles of deductibility that relate expenditure to a business (past, prospective or current) is to continue, and expand, deductibility for expenditure incurred in the closing-down phase of a business. Shareholders can only deduct their own expenses, and are not entitled to a share in those that the company has incurred. [Schedule 2, item 30, paragraph 40-880(2 )( d)]

2.24 This acknowledges that some of these expenses may be incurred during the closing-down phase of the company, and therefore will be incurred in respect of a current business that may not be the business of the taxpayer for the purposes of paragraph 40-880(2)(a).

In relation to

2.25 The provision is concerned with expenditure that has the character of a business expense because it is relevantly related to the business. The concept used to establish this character or requisite relationship between the expenditure incurred by the taxpayer and the business carried on (current, past or prospective) is 'in relation to'. The connector 'in relation to' allows the appropriate latitude to enable the deductibility of qualifying capital expenditure incurred before the business commences or after it has ceased. [Schedule 2, item 30, subsection 40-880(2)]

2.26 There are various pre-business expenses that would be incurred 'in relation to' a proposed business. These include, but are not limited to, expenditures to investigate the viability of the business (eg, feasibility studies or market research), establishment costs (such as the costs of establishing the business structure), or expenses that are a necessary precedent to the business being carried on (costs of market testing or putting in a tender).

2.27 Post-business expenses incurred 'in relation to' a past business include capital expenses incurred for the purpose of ceasing to carry on the business as well as expenses that were incurred as a consequence of the business ceasing.

Used to be

2.28 A business that 'used to be' carried on by a taxpayer would be a business that either the taxpayer had permanently ceased to carry on themselves or that the taxpayer was permanently no longer relevantly associated with. The relevant association is the one described in paragraph 40-880(4)(b). [Schedule 2, item 30, paragraphs 40-880(2 )( b) and (4 )( b)]

2.29 The effect of the requirement for permanence is to ensure the application of the provision to genuine post-business expenses - that is, the taxpayer would have permanently severed their ties with the business or the business no longer operates. If the relationship with the business still exists, even if in abeyance, then the expenditure is not post-business expenditure, and therefore can only be deductible as expenditure in relation to 'your' (ie, the taxpayer) business for the purposes of paragraph 40-880(2)(a).

Proposed to be

2.30 The term 'proposed to be' is an objective purpose test about the relationship between an expenditure in the present and a prospective business. It encapsulates expenditure, the purpose and effect of which is relevantly related to the commencement or operation of that business. Such expenditure would be for the purpose of assessing or advancing, or lead to the commencement of a future business. This phrase will enable the provision to recognise such preliminary expenditures as legitimate business costs in relation to the prospective business activity.

2.31 For a business to be proposed to be carried on for the purposes of this provision, the taxpayer needs to be able to demonstrate a commitment of some substance to commence the business, and sufficient identity about the business that is proposed to be carried on. The deductibility of expenses in advance of the business being carried on will rest on the facts of each case, but this commitment and identity must be tangible: that is, there would need to be some evidence that would enable an objective assessment of the existence of that commitment and identity.

2.32 Further guidance as to the level of commitment required to deduct pre-business expenditure is provided by subsection 40-880(7). In essence, this requires that, having regard to relevant circumstances, it must be reasonable to conclude that the commitment exists. One of these circumstances is that the business be proposed to be carried on within a reasonable time. This may vary according to the industry or the nature of the business and would recognise the long lead times that may be involved. [Schedule 2, item 30, paragraph 40-880(2 )( c), subsection 40-880(7)]

2.33 Such commitment could be shown by, but is not limited to, at least some of the following:

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a business plan;

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the establishment of a business premises;

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research into the likely markets or profitability of the business; and

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capital investment in assets of the business.

Example 2.1

After being retrenched from her job as a graphic designer, Mary decides to investigate starting her own graphic design business. She spends $2,000 on market research, a consultant to put together a business plan, brochures and contacts former clients to compile a client database. On an objective basis, Mary's pre-business activities would be considered indicative of a genuine commitment to carry on a graphic design business. Subject to the non-commercial loss provisions in Division 35, Mary is entitled to deduct the $2,000 over five income years under the new business-related costs provision once she commences her business activity.

2.34 The expenditure would need to relate, in a real sense, to the prospective business. For example, the expenditure could not be for the purpose of pursuing a hobby or other leisure activity of the taxpayer, where the benefit of the expenditure accrues to the taxpayer in the present, rather than to the business in the future.

Example 2.2

Greg plays the drums in a band as a hobby. Greg spends money to investigate the possibility of customising a room in his house for the purposes of rehearsing with the band. The expenditure is not of the type to which a capital works deduction under Division 43 applies. Greg seeks to claim the expenditure as being in relation to a business he proposes to carry on. However, Greg has no evidence that he proposes to carry on a prospective business, so on an objective basis the only benefit of the expenditure is to Greg himself: that is, the expenditure is of a private nature. Greg is not entitled to a deduction as the expenditure is not a business-related cost.

2.35 The deduction will be available before the business is carried on where the requisite purpose is satisfied. However, there must be evidence of a commitment to carry on the business at the time the expenditure was incurred.

Example 2.3

In 2006, Pershing Pty Ltd which carries on a mobile dogwash business, spends $3,100 on research into the market for soft drinks for the purpose of establishing a new business. The research indicates that a new softdrink business is unlikely to be profitable and consequently a new business is not established. As Pershing Pty Ltd proposed to carry on the business for a taxable purpose, a deduction over five years is available for the $3,100 under the new business-related costs provision.

2.36 Where a taxpayer is able to demonstrate that they proposed to carry on a business, the reason why the business did not eventuate would not later be inconsistent with the grounds relied on to support that demonstration. An unforseen change in circumstances for example, would be one such case.

Example 2.4

Ab-one Coy incurs expenditure on due diligence prior to purchasing an existing business that Ab-one Coy proposes to carry on. Before the sale can be finalised, the seller withdraws from the sale. The expenditure is deductible over five years as a business-related cost.

Equal proportions over five income years

2.37 The taxpayer can deduct 20 per cent of the expenditure for the income year in which it is incurred. 'Income year' is a defined term for the purposes of the ITAA 1997. [Schedule 2, item 30, subsection 40-880(2)]

2.38 The taxpayer can then deduct 20 per cent of the expenditure for each of the following four income years.

2.39 This continues the treatment under the current section 40-880.

2.40 Eligibility for deduction is a once only up-front test established as at the time when the expenditure is incurred. This means that, once eligibility is established, the deduction is able to be written-off over the five income years even if the relevant business later ceases or the prospective business does not commence.

Example 2.5

Eleanor and Olivia own a small but successful coffee shop and are seeking to expand their business. They incur qualifying expenditure during the 2006 income year for the purpose of establishing another coffee shop in a newly constructed shopping mall. Eleanor and Olivia deduct 20 per cent of the expenditure for the 2006 income year. The following income year, 2007, Eleanor and Olivia are forced to sell the new coffee shop due to unforseen personal circumstances. They are able to continue to claim the remaining 80 per cent of the expenditure in equal proportions for each of the 2007 to 2010 income years.

2.41 For individual taxpayers, the non-commercial loss provision will also apply so that a deduction otherwise available may be deferred.

Limitations and exceptions

2.42 There are two limitations that link the taxpayer to the business. The first limits the deduction to the extent the relevant business is carried on, was carried on or is proposed to be carried on for a taxable purpose. The second limits the deduction depending on the relationship between the taxpayer and the business.

2.43 The exceptions ensure that deductibility is provided only for business expenditures not elsewhere recognised in some way by the income tax law so that the provision is one of last resort.

2.44 The limitations and exceptions are based on those in the current subsection 40-880(3), with some refinement as a consequence of the broader application of the new law.

Taxable purpose

2.45 Expenditure in relation to a business is only deductible to the extent that the business is, was, or is proposed to be carried on for a taxable purpose. [Schedule 2, item 30, subsection 40-880(3), paragraph 40-880(4 )( a)]

2.46 The definition of 'taxable purpose' is provided by subsection 40-25(7) of the ITAA 1997 and covers various purposes, including the purpose of producing assessable income. The term purpose of producing assessable income is further defined in subsection 995-1(1) of the ITAA 1997 as being something done:

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for the purpose of gaining or producing assessable income; or

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in carrying on a business for the purpose of gaining or producing assessable income.

2.47 A taxpayer whose business is not carried on for a taxable purpose cannot deduct expenditure to that extent. This limitation is not an annual test: that is, it is not to limit deductions to only the income years in which the business is carried on for a taxable purpose. The test as to the taxable purpose of the business is applied - as at the time the expenditure is incurred - to the taxable purpose of the business by reference to all known and predictable facts in all years.

Example 2.6

In January 2007, Jo incurs qualifying capital expenditure to expand her existing business in an off-shore jurisdiction. The expansion will result in Jo's business deriving 10 per cent of all of its foreseeable future income in an exempt form. Any deduction to which Jo is entitled would be reduced under this provision to the extent the business is not carried on for a taxable purpose.

Business of the taxpayer

2.48 The business to which the expenditure relates is that most relevant to the expenditure. This could be either the activity of the taxpayer entity or various separate activities carried on by the taxpayer. This will depend on the facts under which the expenditure is incurred.

2.49 As the taxpayer that incurs the qualifying expenditure is the only taxpayer entitled to the deduction, whether the business is the taxpayer's business is also relevant. This entitlement may occur in one of two ways.

2.50 First, where the taxpayer who incurs the expenditure carries on an existing business, used to carry on the former business or proposes to carry on a new business, they are entitled to deduct the expenditure. This means that for an existing business, only the taxpayer that carries on the business, and no other taxpayer, is entitled to deduct the expenditure. [Schedule 2, item 30, subsection 40-880(2)]

2.51 Therefore, if the entity that incurs the expenditure is a separate taxpayer from that carrying on an existing business and to which the expenditure relates, then the business is not 'your' business for the purposes of paragraph 40-880(2)(a). [Schedule 2, item 30, paragraph 40-880(2 )( a)]

2.52 Secondly, where a taxpayer incurs expenditure in relation to a prospective or former business, and the taxpayer is not the same entity that will carry on the business, or that formerly carried on the business, special rules apply.

2.53 The deduction is limited to qualifying expenditure in relation to either a former business or a prospective business where the taxpayer that carried on the former business or proposes to carry on the new business (the 'operating entity') is not the same taxpayer who incurred the expenditure (the 'incurring entity'). In both cases, only the incurring entity is entitled to a deduction. For example, pre-business costs such as incorporation fees may be incurred (by an incurring entity) in relation to a business proposed to be carried on by the entity the individual incorporated (the operating entity). [Schedule 2, item 30, subsection 40-880(4)]

2.54 The expenditure must be in connection with the taxpayer deriving their assessable income from the business. [Schedule 2, item 30, paragraph 40-880(4 )( b)]

2.55 This is to provide a proxy for the relationship between the taxpayer and 'their' (ie, the taxpayer) business, where the taxpayer that incurs the expenditure is not the same taxpayer that carries on the business. Deriving assessable income refers to the entitlement to a share in the profits from the business. The way in which the profit is derived can be direct or indirect. The expenditure also needs to be 'in connection with' the business that was carried on or is proposed to be carried on.

2.56 Just because the profit derived is indirect, when taken together with the second requirement, expenditure purely for investment (ie, not business) purposes does not fall for consideration as a business related cost. [Schedule 2, item 30, paragraph 40-880(4 )( b)]

2.57 This means that the expenditure must have some connection with the income so derived, or that is proposed to be derived from the business. The relationship between the taxpayer and the business is relevant. A company employee would not have the requisite connection with the company as they derive their income as a consequence of their employment. However a taxpayer that is seeking to start a new business, and operate it as a company, rather than as a sole trader, would be doing so with the purpose of deriving income from the new entity. Therefore, the nature of the income must be that to which the expenditure contributes in order to incur the expenditure for the purposes of subsection 40-880(4).

2.58 The character of the expenditure must be that connected with the business itself (eg, pertaining to the business structure, or its operations).

2.59 Put another way, the taxpayer would expect a return on that expenditure in the form of profits from the business. The expenditure need not of itself be directly productive of the taxpayer's assessable income.

2.60 The taxpayer does not need to be actually deriving income from the activity at the time the expenditure is incurred to qualify for the deduction.

Example 2.7

Anthea carries on a business of making and selling hand-made shoes as a sole trader from her home. She decides to incorporate her business, so the business will be carried on by the incorporated entity, and Anthea will be the sole shareholder of the company and is entitled to receive all the profits from the business. As the business proposed to be carried on is not, for legal purposes, carried on by Anthea but by the company, the limitation in subsection 40-880(3) does not permit her to deduct the expenditure. However, the expenses to incorporate her existing business are capital business expenditure for the purposes of section 40-880 and subject to the non-commercial loss provision, Anthea has the requisite connection to the company for her to be entitled to deduct the expenditure on incorporation under subsection 40-880(4).

Example 2.8

Dorothy is a director of a company. Upon default by her employer, Dorothy satisfies a personal guarantee provided in respect of the employer. As an employee of the company, the capacity in which Dorothy incurs the expenditure is in connection with deriving her salary income, rather than for the purpose of deriving a profit from the business. Therefore, Dorothy does not have the requisite relationship with the business conducted by the company nor does the expenditure. Dorothy's expenditure does not qualify for a deduction as a business-related cost.

Other excluded expenditure

2.61 Section 40-880 is intended to operate as a provision of last resort. It achieves this by providing that the deduction is only allowed to the extent that the expenditure is not taken into account in some way elsewhere in the income tax law. The ways in which an expenditure can be taken into account are listed in subsections 40-880(5) to (8).

2.62 The exclusions provide guidance on the interaction of the measure with the broader tax law. They are based on those in the current subsection 40-880(3), with some refinement as a consequence of the broader application of the new law.

2.63 The specific exclusions provide that expenditure of the following types do not qualify for a deduction.

Cost of depreciating assets held, formerly held or which will be held

2.64 These expenditures are included in the cost of the depreciating asset which is depreciated for tax purposes under the UCA provisions. For expenditure in relation to starting to hold a depreciating asset to be included in the cost of the asset, the asset must be held, formerly held or will ultimately be held by the taxpayer incurring the expenditure. [Schedule 2, item 30, paragraph 40-880(5 )( a)]

Example 2.9

In April 2006, a poultry company spends $14,000 to demolish an old income producing barn located on its business premises. As the cost of demolition falls within the expanded second element of cost of the barn it is excluded from deductibility under the new business-related costs provision.

2.65 However, where the expenditure is business related and can not be included in the cost of the asset, it may fall for deduction as a business-related cost under section 40-880.

Example 2.10

In November 2005, two companies, O'Keefe Pty Ltd and Hamblen Pty Ltd each incur $5,000 on a pre-acquisition check of one particular depreciating asset they both intend to purchase for their respective business. However, in January 2006 O'Keefe Pty Ltd is successful in purchasing the asset and Hamblen Pty Ltd misses out (ie, the sale falls through). O'Keefe Pty Ltd includes the $5,000 in the first element of cost of the depreciating asset it starts to hold and writes-off the cost over the effective life of the asset. As Hamblen Pty Ltd, did not acquire a depreciating asset, it is able to claim a deduction over five years for the $5,000 pre-acquisition expenditure under the new business-related costs provision.

Expenditure that can be deducted under other provisions of the income tax law

2.66 Expenditure that qualified or qualifies for deduction elsewhere under the income tax law is not deductible. This applies even if the expenditure has not yet been or can no longer be deducted. [Schedule 2, item 30, paragraph 40-880(5 )( b)]

Example 2.11

In October 2006, QOTSA Pty Ltd undertakes a feasibility study directly connected with a project that they propose to operate during the 2008 income year. The expenditure qualifies as a project amount under the project pools provisions. While the expenditure is not yet deductible as the project is only at the preliminary stage, it would not qualify as a business-related cost under section 40-880 as it will be deductible for the 2008 income year when the project starts to operate. Alternatively, a deduction would be available for the income year in which the project was abandoned.

Expenditure that is part of the cost of land

2.67 Expenditure that forms part of the cost of land, whether or not the land is held by the taxpayer, is not deductible. This exclusion is transferred from the repealed section 40-880. [Schedule 2, item 30, paragraph 40-880(5 )( c)]

Expenditure in relation to a lease or other legal or equitable right

2.68 This exclusion replicates that found in the repealed section 40-880, having been added in 2002 in the context of the Government's review of the treatment of expenditure incurred on leases or other legal or equitable rights. The 2005-06 Budget announced that the Government would take a case-by-case approach in relation to the taxation of rights. [Schedule 2, item 30, paragraph 40-880(5 )( d)]

Example 2.12

In January 2006, AORT Pty Ltd was seeking to obtain a prospecting right over a particular tract of land. It undertakes an investigation to determine if there are any other rights held over that land. The investigation finds that a farmer holds a right of access over the land, and AORT Pty Ltd agrees to pay the farmer compensation to access the land. As the taxpayer's expenditure is in relation to a right (being compensation for the right to access the land) it is not deductible under the business-related costs provision.

However, the expenses would be included in the expanded first element of cost of a depreciating asset the taxpayer starts to hold as being in relation to starting to hold that asset, being the exploration right.

2.69 This exclusion does not apply to intra-group assets or transactions within a consolidated group, as these are not recognised as leases, or other legal or equitable rights for income tax purposes. Further information on the operation of the exclusion in relation to consolidations is provided in paragraph 2.82 and Example 2.16.

2.70 Expenditure is deductible where it is incurred in relation to a lease or other legal or equitable right, and the value of the expenditure to the taxpayer arises solely from the effect that the right has in preserving, but not enhancing, the value of goodwill. For example, capital expenditure may be incurred in relation to a right that is both unlimited in duration, and which merely prevents goodwill from being damaged. Such a right has no distinct value in itself. Its value lies in the effect its existence has upon the value of the goodwill. Such expenditure represents in substance a blackhole expense even though it is in relation to an asset. [Schedule 2, item 30, subsection 40-880(6)]

2.71 Where a taxpayer incurs an expense in relation to a right and that right enhances the value of the goodwill, or has an inherent value in itself then it would not be appropriate to allow a deduction as a business related cost as the expenditure does not represent a loss to the taxpayer.

Expenditure that would be taken into account in working out a profit or a loss

2.72 Expenditure that has been used to calculate a profit included in the taxpayer is assessable income, or that has been included in working out a loss that can be deducted, is excluded as it has already been taken into account for the purposes of the income tax law. This replicates the exclusion in the repealed section 40-880. [Schedule 2, item 30, paragraph 40-880(5 )( e)]

Expenditure that could be taken into account in working out a capital gain or loss

2.73 Where an amount can be taken into account in working out a capital gain or loss from a CGT event, it is not deductible. A capital gain or loss that has not yet been realised or where the capital gain or loss is disregarded (eg, because it is a pre-CGT asset) or reduced is excluded from deduction under section 40-880 by paragraph 40-880(5)(f). An amount is not taken into account in working out a capital gain or loss if the expenditure cannot be included in the cost base or reduced cost base of the asset (eg, expenses related to the sale of a CGT asset that falls through). In relation to non-residents, this provision excludes a capital gain or loss from an asset that does not have the necessary connection with Australia or any other kind of capital gain or loss that an Australian resident can make but a non-resident cannot. This exclusion has been transferred from the repealed section 40-880 with minor modification to reflect the broader application of the law. [Schedule 2, item 30, paragraph 40-880(5 )( f)]

Example 2.13

On 1 May 2006, Chooks Pty Ltd, a restaurateur, enters into a franchise agreement under which it pays $100,000 for the right to use the franchisee's name. Therefore, Chooks has acquired a CGT asset, that is, the right, with a cost base of $100,000. The cost will ultimately be recognised at the time of a subsequent CGT event, for example, were Chooks to dispose of the right.

The expenditure is expressly made non-deductible under another provision

2.74 Where expenditure is made non-deductible by an express provision of the tax law (including where it is limited or capped), it is also non-deductible under section 40-880. This ensures that if a particular type of expenditure is specifically denied a deduction for the purposes of the income tax law, then the expenditure should not be considered under this provision. This exclusion maintains the non-deductibility even if the expenditure is capital, or capital in nature. Expenditure that fails under section 8-1 of the ITAA 1997 is not excluded for the purposes of this paragraph as it is not considered to be expressly excluded for the purposes of the income tax law. However, the expenditure would need to satisfy the requirements of the provision to be deductible. [Schedule 2, item 30, paragraph 40-880(2 )( g)]

Expenditure excluded but not necessarily capital in nature

2.75 This excludes expenditure that is denied a deduction, for example, entertainment expenses. Paragraph 40-880(5)(h) specifically excludes such expenditures where they are of a capital nature. Put another way, if the excluded item was of a revenue nature, this provision does not make it deductible merely because it is capital. [Schedule 2, item 30, paragraph 40-880(5 )( h)]

Private or domestic expenditure

2.76 If capital expenditure is of a private or domestic nature it is not deductible under section 40-880. [Schedule 2, item 30, paragraph 40-880(5 )( i)]

Example 2.14

In May 2007, Shirley, a wage and salary earner, travels to the Whitsundays for a holiday. In June 2007, after considering the business opportunities that her visit alerted her to, Shirley decides to establish a tourism venture in the Whitsundays, and seeks to deduct her travel and accommodation expenses as pre-business expenses in relation to the tourism venture she proposes to carry on. As the expenditure was of a private nature when it was incurred, Shirley is not entitled, with the benefit of hindsight, to the deduction under the business-related costs provision. This would remain the case even if Shirley decided to establish her tourism venture while on her holiday because the costs were not incurred in relation to a business she proposed to carry on at the time those costs were incurred.

Non-assessable, non-exempt income

2.77 Expenditure incurred in gaining or producing 'non-assessable, non-exempt income' (a defined term), or exempt income (also a defined term), is not deductible under section 40-880. [Schedule 2, item 30, paragraph 40-880(5 )( j)]

Market value substitution rules

2.78 This applies where the market value substitution rules in the UCA or CGT regimes have prescribed an amount to be included in the cost or cost base of the asset respectively. The prescription of market value in these cases, in effect substitutes market value for the amount that would otherwise have been included under the operation of the general cost and cost base rules. Under this exclusion, the other amount (generally being capital expenditure) is considered to have already been taken into account for the purposes of section 40-880. [Schedule 2, item 30, subsection 40-880(8)]

Returns of capital

2.79 Some capital amounts are not considered legitimate blackhole expenditures as they comprise the transfer or distribution of funds, repayments, or do not give rise to any income tax consequences. As such, the expenditure does not represent an economic loss to the taxpayer and is not deductible. [Schedule 2, item 30, subsection 40-880(9)]

2.80 Expenditures excluded by this provision include, but are not limited to:

•

dividends paid by companies;

•

distributions by trustees;

•

margin calls;

•

payments made by a company to buy back its own shares; and

•

repayments of loan principal.

2.81 This exclusion does not preclude deductibility for fees and charges related to these transactions.

Interaction with the consolidation regime

2.82 Under the consolidation regime, intra-group assets and intra-group transactions are ignored for income tax purposes. Consequently, under the current law, business-related capital expenses that are incurred by a head company to a third party in relation to intra-group transactions may not be appropriately recognised for income tax purposes (if at all). For example, capital costs in relation to the transfer of a non-intra-group asset between members of a consolidated group may not be deductible under section 8-1 of the ITAA 1997 (because they are capital in nature) and may not be included in the cost base and reduced cost base of the asset (because the head company may not have acquired a CGT asset and/or there is no CGT event).

2.83 The amendments will ensure that third party expenditure in relation to intra-group transactions is appropriately recognised.

Expenditure included in the cost base

2.84 If the third party expenditure is incurred by the head company and reasonably relates to a CGT asset held by the head company, it will be an incidental cost that is included in the second element of the cost base and reduced cost base of the asset. [Schedule 2, items 39 and 41, subsections 110-35(1) and (10)]

2.85 The head company of a consolidated group can only 'hold' a CGT asset if the asset is recognised for income tax purposes (ie, if it is a non-intra-group asset). As intra-group assets are ignored under the single entity rule a head company does not 'hold' these assets.

Example 2.15

A consolidated group comprises Head Co, A Co and B Co. A Co transfers a building to B Co and incurs legal costs and stamp duty in association with the transfer. As these costs reasonably relate to a CGT asset that is held by Head Co they will be included in the second element of the cost base and reduced cost base of the building.

Expenditure deductible under section 40-880

2.86 If the third party expenditure is incurred in connection with an asset that the head company does not hold (such as intra-group assets), it will be a business-related cost that is deductible over five income years (provided all of the requirements of section 40-880 are satisfied).

2.87 In order to determine whether business capital expenditure incurred by a head company is deductible under section 40-880, the nature of the expenditure must be characterised in the hands of the head company, taking into account the effect of the single entity rule.

2.88 The expenditure must be characterised at the time it is incurred by the head company. That is, a head company is not required to anticipate whether or not the expenditure is related to an asset that may become recognised for tax purposes at some time in the future. For example, expenditure incurred by a head company in relation to membership interests in a subsidiary member will be deductible under section 40-880 despite the fact that the expenditure is in relation to an asset that may at some point in the future become recognised for tax purposes (eg, immediately before the subsidiary member exits the consolidated group).

Example 2.16

A Co, from the previous example, leases some plant and equipment to B Co and incurs capital expenditure in relation to the lease. Intra-group assets are ignored for income tax purposes under the single entity rule. As the expenditure does not relate to a CGT asset that is held by the head company it is not included in the cost base and reduced cost base of the intra-group asset. As the expenses are incurred by Head Co in relation to carrying on its business, they will be a business-related cost under section 40-880 that is deductible over five income years.

Expenditure in relation to contractual or equitable rights between members of a consolidated group are not excluded by paragraph 40-880(5)(d), as such a right is treated as an arrangement between divisions of one company, and is therefore not treated as a lease or other equitable right for the purposes of working out the head company's income tax liability.

Example 2.17

A consolidated group incorporates a new subsidiary company, which becomes a subsidiary member of the consolidated group. The capital expenditure the head company incurs in doing so is deductible under paragraph 40-880(2)(a) as it does not relate to an asset that is held by the head company. Under the single entity rule, shares in a subsidiary member would be ignored for income tax purposes. If the subsidiary member is later sold by the group, the subsidiary cannot deduct amounts for that expenditure.

Non-commercial loss provision

2.89 The non-commercial loss provisions in Division 35 of the ITAA 1997 aim to improve the integrity of the tax system by preventing losses from non-commercial activities that are carried on as businesses being offset against other assessable income such as wages and salaries.

2.90 The provisions apply to the business activities of individuals, operating alone or in partnership.

2.91 Under the provisions, a taxpayer can offset a loss from a business activity carried on in an income year against other income if at least one of the four objective tests is satisfied for that year. The four tests are the assessable income test (section 35-30), the profits test (section 35-35), the real property test (section 35-40) or the other assets test (section 35-45). Where a taxpayer does not satisfy one of the four tests, the Commissioner may exercise a discretion to allow any losses to be offset against other income in certain circumstances.

2.92 If a loss is unable to be offset against other income in the year that it arises, it is not lost altogether, but can be deferred and offset in a future year when there is a profit from the same activity, or a like activity, or against other income when the taxpayer satisfies one of the tests for that activity.

2.93 The definition of the term 'business' means that the non-commercial loss provisions do not currently apply to pre-business or post-business expenditures.

2.94 As pre- and post-business expenditures deductible under the amended section 40-880 are related to the business activity (forming the basis for deductibility), it is consistent to apply the non-commercial loss provisions to these expenditures.

2.95 Therefore, pre- and post-business expenditures deductible under section 40-880 will not be generally prevented from being deducted against other assessable income where the pre- and post-business expenditures relates to a business activity that satisfies one of the tests in Division 35, or where the Commissioner exercises a discretion.

2.96 The amendments to Division 35 only apply to pre- and post-business expenditure deductible under section 40-880.

2.97 The amendments improve the integrity of the tax system by preventing pre-business and post-business expenditure by individuals (alone or in partnership) in relation to non-commercial activities being deductible under section 40-880 unless certain exceptions apply. [Schedule 2, item 3, subsection 35-5(1)]

2.98 A taxpayer cannot deduct an amount under section 40-880 for post-business expenditure, in relation to a business activity that the taxpayer used to carry on (either alone or in partnership, whether or not some other entity is a member of the partnership), unless:

•

the business activity satisfied one of the four tests (set out in sections 35-30 to 35-45);

•

the Commissioner exercised the discretion under section 35-55 for the business activity which the taxpayer used to carry on; or

•

the business activity was a primary production business or professional arts business and the income from other sources was less than $40,000,

for the income year in which the business activity ceased to be carried on or an earlier income year. [Schedule 2, item 5, subsection 35-10(2A)]

2.99 This ensures that a deduction for post-business expenditure is not denied where the business activity in the current or an earlier income year was not subject to the non-commercial loss provisions.

2.100 A taxpayer cannot deduct an amount under section 40-880 for pre-business expenditure in relation to a business activity that the taxpayer proposes to carry on (either alone or in partnership, whether or not some other entity is a member of the partnership) in an income year before the one in which the business activity starts to be carried on. [Schedule 2, item 5, paragraph 35-10(2B )( a)]

Example 2.18

Anupam, a wage and salary earner, incurs expenditure otherwise deductible under section 40-880 during the 2006 income year for the purpose of establishing a supermarket business in the 2008 income year. Subsection 35-10(2B) prevents Anupam from deducting the amounts arising from the pre-business expenditure prior to the business commencing.

2.101 Subsection 35-10(2C) deems the amount, prevented from deduction under paragraph 35-10(2B)(a) as an amount in relation to a business activity carried on by the taxpayer (either alone or in partnership) otherwise deductible under section 40-880, as if it were an amount attributable to the business activity that the taxpayer can deduct from assessable income from the activity for the income year in which the activity starts to be carried on.

2.102 This amount, deemed under subsection 35-10(2C) as if it were attributable to the business activity in the income year the activity starts to be carried on, by the taxpayer (either alone or in partnership), is subject to the operation of the quarantining rule in subsection 35-10(2). [Schedule 2, item 5, subsection 35-10(2C)]

2.103 That is, in the income year a business activity starts to be carried on, a taxpayer can only offset a loss (calculated inclusive of the amounts that could have been deducted apart from paragraph 35-10(2B)(a)) from the business activity carried on against other income if:

•

the business activity satisfies one of the four tests (set out in sections 35-30 to 35-45);

•

the Commission exercised the discretion under section 35-55 for the business activity; or

•

the business activity was a primary production business or professional arts business and the income from other sources was less than $40,000.

2.104 Where this loss (calculated inclusive of the amounts that could have been deducted apart from paragraph 35-10(2B)(a)) cannot be offset against other income in the income year that it arises, it is not lost altogether, but can be deferred and offset in a future year when there is a profit from the same activity, or a like activity, or against other income when the taxpayer satisfies one of the tests for that activity.

Example 2.19

Naomi, a wage and salary earner, incurs a $1,000 expenditure during the 2006 income year (otherwise deductible under section 40-880 in equal proportions for the 2006 to 2010 income years apart from Division 35) for the purpose of establishing an ice-cream shop in the 2008 income year.

Subsection 35-10(2B) prevents Naomi from deducting the amounts arising from the pre-business expenditure in the 2006 and 2007 income years. Therefore, the deductions under section 40-880 from those two income years ($200 + $200) are quarantined until the business commences in 2008.

The ice-cream business passes the assessable income test in Division 35 for the 2008 income year. Under section 35-10, Naomi can offset the two amounts ($200 + $200) quarantined from the 2006 and 2007 income years against the income from her ice-cream business and against her wage and salary income in the 2008 income year.

2.105 An individual taxpayer is prevented from deducting an amount that is otherwise deductible under subsection 40-880(4) for expenditure in relation to a business activity another entity, other than an individual (either alone or in partnership), proposes to carry on until the income year the activity starts to be carried on. The individual taxpayer can deduct amounts, quarantined during the income years before the business activity starts to be carried on by the other entity (other than an individual either alone or in partnership), in the income year the business activity starts to be carried on by the other entity. [Schedule 2, item 5, paragraph 35-10(2B )( b), subsection 35-10(2D)]

2.106 In the event that the business activity ceases, amounts otherwise deductible after this event under section 40-880 would be prevented if the business activity, which was carried on by the individual (either alone or in partnership), failed to pass one of the tests and if the Commissioner does not exercise a discretion and if the primary production business or professional arts business exclusions are not met prior to the business ceasing. [Schedule 2, item 5, subsection 35-10(2A)]

Example 2.20

Jenny-Lee, a wage and salary earner, incurs a $1,000 expenditure - otherwise deductible under section 40-880 - during the 2006 income year for the purpose of establishing a supermarket business in the 2007 income year. She intends to carry on the business activity as a sole trader. Apart from Division 35, section 40-880 would provide deductions in equal proportions for the $1,000 expenditure for the 2006 to 2010 income years.

Her business ceases at the end of the 2008 income year and the supermarket business did not pass any of the tests in Division 35 and the Commissioner did not exercise his discretion while the business activity was carried on. As a result, subsection 35-10(2A) prevents Jenny-Lee from deducting the amounts arising from the pre-business expenditure in the 2009 and 2010 income years.

2.107 A consequential amendment is made to subsection 35-10(4) to ensure that the non-commercial loss provisions do not apply to pre-business expenditure or post-business expenditure where the associated business activity is a primary production business or professional arts business and the income from other sources is less than $40,000. [Schedule 2, item 6, subsection 35-10(4)]

2.108 Section 35-20 currently ensures that losses from non-commercial business activities, which were incurred prior to the date of a business becoming bankrupt and were deferred under Division 35, cannot be offset after the date of bankruptcy. Consistent with this principle, where an amount arising from an expenditure (otherwise deductible under section 40-880) that has not been deducted before the date of bankruptcy due to the operation of Division 35, a deduction should not be available after the date of bankruptcy if the business activity subsequently satisfies one of the tests under Division 35. [Schedule 2, item 8, subsection 35-20(1)]

2.109 Consequential amendments are also made to the four tests in sections 35-30 to 35-45 to ensure that they apply for the purposes of subsections 35-10(2A) to (2C). In particular, section 35-35 is amended so that quarantined amounts from previous years, otherwise deductible under section 40-880 apart from the operation of Division 35, do not affect the operation of the profits test in the current year. A consequential amendment is also made to subsection 35-15(1) to ensure that it only applies in relation to subsection 35-10(2). [Schedule 2, items 7, 9 to 16 ]

2.110 The Commissioner's discretion in section 35-55 is amended to enable the Commissioner to exercise a discretion to allow a taxpayer to deduct pre-business expenditure under section 40-880 where the Commissioner is satisfied that it would be unreasonable to defer a deduction for the pre-business expenditure because special circumstances prevented the business activity from being carried on.

2.111 Consistent with the existing Commissioner's discretion, special circumstances are those circumstances which are outside of the control of the operators of the business activity, including drought, flood, bushfire or some other natural disaster. Consequently, if a taxpayer incurs pre-business expenditure in relation to a business activity which the taxpayer proposes to carry on, but due to special circumstances the business activity is prevented from starting, the Commissioner may decide that subsection 35-10(2B) does not apply to defer a deduction for the pre-business expenditure. This is intended to provide for a case where a business activity would have begun to be carried on and satisfied one of the tests if it were not for the special circumstances. [Schedule 2, item 18, subsection 35-55(2)]

Capital expenditure to terminate lease

2.112 Taxpayers can deduct capital expenditure incurred to terminate a lease or licence (including an authority, permit or quota) that results in the termination of the lease or licence if the expenditure is incurred in the course of carrying on a business or in ceasing a business. [Schedule 2, item 2, subsection 25-110(1)]

2.113 In part, the deduction will provide a write-off for expenditure that would otherwise be blackhole in nature, as lease surrender payments by a lessee to a lessor are not currently recognised under the income tax law as deductible or for write-off. Other lease and licence surrender payments are provided with the same treatment for income tax purposes. There are many business reasons why a lease may be terminated.

2.114 The taxpayer can deduct 20 per cent of the capital expenditure in the income year in which the lease or licence is terminated. The taxpayer can then deduct 20 per cent of the expenditure in each of the four following income years. [Schedule 2, item 2, subsection 25-110(2)]

2.115 This provision applies to a payment or payments, to include those made in instalments. However the expenditure must result in the termination of the lease. Therefore, the deduction will not be allowed until the lease is terminated and payments will be quarantined until such time.

2.116 The parties that qualify for a deduction can include a lessee or licensee, a lessor or licensor but may also include additional parties wanting to induce the surrender of a lease or licence, for example, where there is third party involvement.

2.117 If a payment is made to terminate a lease or licence but does not result in the termination of the lease or licence, a deduction under Division 25 is not allowed.

2.118 The write-off is available for expenditure incurred to terminate leases and licences. For this purpose, licence includes, but would not be limited to, an authority, permit or quota.

Example 2.21

Beverley holds a 10-year lease over premises for her jewellery store in a shopping centre. After four years of the term of the lease, she finds cheaper premises to lease across town which are also more suitable for her business. Beverley makes a payment to terminate her current lease. The payment is able to be deducted in equal proportions over five years under the new provision.

2.119 This provision is only intended to allow deductions for lease payments where the lease provides the right to use an asset for a determined period or term, such as operating leases. It will not allow deductions for payments which, in effect, confer all the risks and rewards of ownership of the asset. Capital expenditure incurred to terminate a lease that is, in accordance with accounting standards, or statements of accounting concepts made by the Australian Accounting Standards Board (AASB), is classified as a finance lease, is specifically excluded from this provision. The Accounting Standard AASB 117 as at July 2004, defines a finance lease as:

'...a lease that transfers substantially all the risks and rewards incidental to ownership of an asset.'

[Schedule 2, item 2, subsection 25-110(3)]

2.120 A market value substitution rule will apply to this provision to prevent deductions for inflated lease and licence termination payments. The rule will ensure the amount of expenditure taken into account is the market value of the lease or licence. The market value will be equal to the value arrived at as if the termination did not occur and was never proposed to occur (ie, the value of the lease immediately prior to termination). It will apply where the expenditure is incurred under an arrangement and there is at least one other party to the arrangement with whom the taxpayer did not deal at arm's length; and the amount of expenditure is more than the market value of what it was for. [Schedule 2, item 2, subsection 25-110(4)]

2.121 A deduction will be denied under this provision for a termination payment that is made to enter into another lease or licence with the same party; and where the lease or licence is of the same kind as the original one. 'Of the same kind' refers to a lease or licence agreement in which the term and/or cost of the payments associated with the lease or licence do not vary significantly, and it cannot be demonstrated that there is a need to have a new lease or licence. This exclusion has been applied to prevent payments being brought forward simply to gain a five-year deduction. [Schedule 2, item 2, subsection 25-110(5)]

2.122 Where capital expenditure is incurred to terminate a lease or licence for the granting of another lease or licence in relation to the asset that was the subject of the original lease or licence, it will be specifically excluded from this provision. This is because, rather than the removal of an onerous obligation, the payment is to acquire a new lease. The expenditure may form part of the cost base of the new lease, a CGT asset. [Schedule 2, item 2, subsection 25-110(6)]

Example 2.22

Nicholas holds a lease over a suburban office space with the office building manager, Tim. James has been looking for a suitable office in that area, and approaches Tim to negotiate taking over the lease. Tim agrees, subject to the payment of a lease surrender payment. James makes the payment. As the payment is for the purpose of James taking over the lease and gives rise to a new lease, it is expenditure for the granting of a new lease so is not deductible under this provision.

2.123 Lease and licence-related termination payments will generally be assessable income in the hands of the recipients under section 6-5 of the ITAA 1997, if received in the circumstances set out in Australian Taxation Office Ruling TR 2005/6.

Changes to elements of cost of a depreciating asset under the uniform capital allowances regime

2.124 The expanded concept of cost of a depreciating asset under the UCA regime increases the range of expenditures included as part of both the first and second elements of cost of a depreciating asset.

2.125 Presently, expenditure to hold a depreciating asset is included in the first element of cost - this requires a direct relationship between the expenditure and starting to hold the asset. The meaning of 'hold' a depreciating asset is covered by section 40-40. In the most common situation, a taxpayer is taken to hold an asset if he or she owns the asset. [Schedule 2, item 20, subsection 40-180(3)]

Example 2.23

Russ wishes to buy a computer for his business that is not available in Australia. After adequate research he concludes he would be able to obtain the computer from a company in Silicon Valley in the United States. Russ travels to Silicon Valley for the sole purpose of purchasing the computer. The travel costs would be included as part of the first element of cost of the computer because they are directed to and result in the purchase of the computer.

2.126 A broader range of costs, those incurred in relation to starting to hold - owning in the most common situation - a depreciable asset will now be included in the cost of that asset.

2.127 The first element of cost of a depreciating asset does not include any amount that forms part of the second element of cost of any other depreciating asset. [Schedule 2, item 20, subsection 40-180(4)]

2.128 A consequential amendment has been made to paragraph 40-185(1)(b) to change the wording from 'for holding the asset or receiving the benefit' to 'in relation to holding the asset or receiving the benefit'. This will ensure consistency with section 40-180. [Schedule 2, item 21, paragraph 40-185(1 )( b)]

2.129 The second element of cost includes expenditure incurred that is reasonably attributable to a balancing adjustment event occurring for a depreciating asset. Expanding the second element of cost will allow all costs reasonably attributable to a balancing adjustment event to be taken into account in working out a balancing adjustment rather than such costs reducing the termination value of the asset as is currently the case in section 40-315. Expansion of the second element of cost in this way will allow all such costs to be taken into account in working out a balancing adjustment rather than such costs being taken into account to the extent only of the termination value. [Schedule 2, item 24, subsection 40-190(2)]

2.130 The combination of the current splitting a depreciating asset rules (section 40-115) and the amendments to the elements of cost together will provide that expenditure incurred in selling part of a depreciating asset will be wholly attributed to the sold part of the asset.

2.131 The amendments to the second element of cost now incorporate subsection 40-315(1). Subsection 40-315(2) was an exclusion to subsection 40-315(1) and as such it has been relocated so paragraph 40-190(2)(b) does not apply to specified items of the termination table in subsection 40-300(2). [Schedule 2, item 27, subsection 40-190(3)]

CGT amendments

2.132 The amendments expand the coverage of the cost base and reduced cost base provisions for CGT purposes. Cost base is used to calculate a capital gain, while reduced cost base is used to calculate a capital loss. The proposed provisions affected are those for the second element (incidental costs) of cost base and reduced cost base, the third element (ownership costs) of cost base, and the fourth element (improvement expenditure) of cost base and reduced cost base.

2.133 The CGT changes apply both to taxpayers carrying on a business and those not carrying on a business.

Second element

2.134 The second element of cost base and reduced cost base comprises various specified incidental costs incurred to acquire the CGT asset or dispose of it. Section 110-35 lists the costs. They include stamp duty and the remuneration of a legal adviser or other consultant.

2.135 The additional qualifying costs now being included are marketing expenses, search fees relating to a CGT asset, the cost of a conveyancing kit (or a similar cost), borrowing expenses (such as loan application fees and mortgage discharge fees) and certain expenses incurred by a head company of a consolidated group or multiple entry consolidated group (MEC group).

2.136 An example of marketing expenses is furniture hire to help sell a rental property.

2.137 Search fees essentially relate to fees payable in checking land titles and similar fees and would not include costs such as travelling expenses to find an asset suitable for purchase.

2.138 An additional ninth incidental cost has been added to ensure that certain expenses incurred by a head company of a consolidated group or MEC group are appropriately included in the second element of cost base and reduced cost base. This additional cost need not relate to the acquisition or disposal of a CGT asset. Paragraphs 2.84 to 2.85 contain further information on the operation of the new rule. [Schedule 2, items 34, 39 to 41 and 49, subsection 110-25(3), section 110-35 and definition of 'incidental costs' in subsection 995-1(1)]

Third element

2.139 At present, the third element of cost base comprises non-capital costs of ownership of assets acquired after 20 August 1991. The amendments remove the requirement that the costs be non-capital in nature. They also clarify that only costs of owning the asset (as distinct from costs of becoming the owner) are recognised. The taxpayer still needs to acquire the asset after 20 August 1991. [Schedule 2, items 31, 32, 35, 46 and 48, sections 108-17 and 108-30, subsection 110-25(4), section 114-1, note 3 and subsection 960-275(4)]

Fourth element

2.140 At present, the fourth element of cost base and reduced cost base is capital expenditure incurred to increase the asset's value (subsection 110-25(5)). There is also at present a requirement that the expenditure be reflected in the state or nature of the asset at the time of the CGT event. The amendments make four changes to the fourth element.

2.141 The first change is that it is no longer necessary that the purpose of the expenditure be to increase the asset's value. Instead, it is now sufficient that the purpose or expected effect be to increase or preserve the asset's value. An example of expenditure that would now qualify for inclusion in the fourth element would be legal and other expenses incurred to preserve the value of a rental property by opposing a nearby development that would adversely affect the rental property's value. Another example would be the costs incurred in unsuccessfully applying for zoning changes.

2.142 The second change is that there is no longer a requirement that the expenditure be reflected in the state or nature of the asset at the time of the CGT event.

2.143 The third change is that the element now includes capital expenditure that relates to installing or moving the asset.

2.144 The fourth change is that the element does not apply to capital expenditure incurred in relation to goodwill. A consequence of this exclusion is that expenditure in relation to goodwill already attracting deductibility over five years does not receive less generous CGT treatment by reason of the enlargement of the fourth element. [Schedule 2, items 36 and 38, subsections 110-25(5) and (5A) and subsection 110-25(1), note 1 ]

Exclusions from cost base and reduced cost base

2.145 The amendments include provisions to prevent expenditure on entertainment, penalties and bribes from being included in cost base or reduced cost base. This mirrors the approach taken in provisions that prevent income tax deductions for this kind of expenditure. At present, bribes are excluded from cost base but not from reduced cost base. There is at present no exclusion from either cost base or reduced cost base of entertainment expenses or penalties. [Schedule 2, items 33, 37, 42 to 45 and 47, subsections 110-25(1), (7) to (11), sections 110-36 and 110-38, subsections 110-55(9A), 114-5(2) and (3)]

Application and transitional provisions

2.146 The amendments in relation to the new business-related costs provision (Part 1 of the Schedule) apply to expenditure incurred on or after 1 July 2005, as announced by the Treasurer in the 2005-06 Budget.

2.147 The amended CGT provisions (Part 2 of the Schedule) will apply to CGT events happening on or after 1 July 2005.

REGULATION IMPACT STATEMENT

Specification of the policy objective

2.148 The objective of this measure is to provide recognition in the income tax laws for business blackhole expenditures, that is, business capital expenses not elsewhere recognised within the taxation laws.

Background

2.149 Blackhole expenditures are currently dealt with under section 40-880 of the ITAA 1997 which specifies certain business-related costs that have a straight-line write-off over five years. It is a provision of last resort that only applies if expenditures are not deductible elsewhere under the tax law.

2.150 Such blackhole expenditures can be grouped broadly into the following categories:

•

expenditure in relation to a non-depreciating or depreciating asset that is not incorporated into its cost base for CGT purposes, or the cost of a depreciating asset for UCA purposes (an example is some demolition costs, where expenditure is incurred to demolish an asset and there is no new asset for the cost to be attributed to);

•

costs of ceasing a business (some costs to stop carrying on a business are deductible under paragraph 40-880(1)(g) of the ITAA 1997);

•

preliminary (pre-business) costs (these are not generally deductible under the ITAA 1997 as they require a nexus between the income earned and the expenditure incurred. Some specified pre-business capital costs are deductible, for example business start-up costs under section 40-880 of the ITAA 1997); and

•

costs incurred after a business has ceased.

Identification of implementation options

Systematic tax treatment

2.151 The Treasurer has previously announced that the Government will develop, in consultation with the business community, a systematic tax treatment of such blackhole expenditures, with a view to implementing these changes by July 2005. ^[F1]

2.152 The Treasurer announced the systematic treatment for blackhole expenditures in the 2005-06 Budget. ^[F2]

2.153 This was developed having regard to the parameters set out by the then Minister for Revenue and Assistant Treasurer, including that reform will be confined to business-related expenditures and will take into account any risks to tax law integrity and the Government's overall fiscal strategy. ^[F3]

2.154 Blackhole expenditures are proposed to be recognised as follows:

•

amending the CGT provisions to enhance the incorporation of certain expenditures into the cost base. This will cover expenditures identified in the first dot point of paragraph 2.150;

•

introducing a third element of cost for UCA assets to enhance the incorporation of certain expenditures into the cost of depreciating assets. This will also cover expenditures identified in the first dot point of paragraph 2.150;

•

introducing a new provision that allows a straight-line write-off for business capital expenditures where these expenditures are not currently recognised by the income tax laws. This will capture expenditures identified in the second to fourth dot points of paragraph 2.150; to the extent that the business is carried on for a taxable purpose. It is also intended to include those expenditures specified in the current section 40-880 of the ITAA 1997.

2.155 Under this proposal, section 40-880 of the ITAA 1997 will be repealed and replaced by the new provision outlined above. The integrity measures in subsection 40-880(3) will be transferred to the new provision to ensure that it is a provision of last resort.

2.156 Transitional provisions are not required as the provision allows for expenditures that are currently deductible under section 40-880 of the ITAA 1997, to continue to be deductible under the new provision.

2.157 The proposed amendments to the ITAA 1997 will not require the Australian Taxation Office (ATO) to adopt alternative administrative arrangements. Options for ensuring taxpayer compliance, both administrative and integrity measures, will be considered in consultations with taxpayers.

2.158 As part of the integrity measures, it is proposed that the non-commercial loss provisions (in Division 35 of the ITAA 1997) be amended so that individuals (whether alone or in partnership) cannot offset against other assessable income deductions for pre-and post-business expenses under the proposed section 40-880, unless they satisfy one of the relevant tests in the non-commercial loss provisions.

Tax value method

2.159 In 1999, the Review of Business Tax proposed the tax value method as a means of capturing blackhole expenditure. After extensive evaluation of the tax value method, the Board of Taxation recommended against its adoption and the Government accepted the Board's recommendation. ^[F4]

Assessment of impacts (benefits and costs) of implementation

2.160 As the proposal treats only business expenditure, small and large businesses who seek to deduct blackhole business expenditure will be able to utilise the proposed new provisions. There is not expected to be any disproportionate impact on small business.

2.161 While there is insufficient information to quantify the number of businesses that will be directly affected by the proposal, submissions to the Treasury represented a significant number of taxpayers.

2.162 Submissions to the Treasury have not identified any obvious impacts on different geographical areas.

2.163 There will be implications for the ATO in terms of ensuring taxpayer compliance.

Assessment of benefits

2.164 Blackholes place a burden on taxpayers through increased compliance costs. These arise from:

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seeking to construct complex arrangements to achieve deductions for legitimate business expenditures; and

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uncertainty as to what expenditures can be deducted, leading to unnecessary record-keeping and an ongoing requirement to consult the ATO on its interpretation of the tax laws.

2.165 Businesses have raised concerns about the burden placed on them by the existing treatment of blackhole expenditures.

2.166 Therefore, the main impacts on business from adopting a systematic approach are anticipated to be:

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permitting business to seek deductions where there is no existing tax treatment, providing a financial benefit to the taxpayer;

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providing greater certainty for business as to what is deductible thus removing delays in decision making and reducing unnecessary record-keeping; and

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reducing the need for businesses to seek ATO guidance on what falls within section 40-880 or other provisions (eg, project pools), reducing costs and time delays for business.

2.167 The new provision will be a provision of last resort which minimises the potential for arbitrage as deductions will only be possible where the expenditures are not already recognised under the income tax laws.

2.168 The ATO has formally advised that the current uncertainty and non-deductibility in relation to blackhole expenditures causes taxpayers to challenge aspects of the law and seek the ATO's views in relation to the expenditure and its deductibility under provisions that were not intended to apply, or at least where the application of the law is uncertain.

2.169 Hence moving to a regime that provides greater certainty and deductibility should provide an associated reduction in costs.

2.170 Whilst it is expected that the new legislation will have an overall positive outcome, some benefits for both taxpayers and the ATO cannot be quantified.

Economic impact

2.171 The anticipated reduction in distortions from taxpayers seeking to construct complex arrangements will improve resource allocation for businesses and for the economy generally.

Assessment of costs

Administration costs

2.172 There may be some implementation costs for the ATO in terms of staff training and business education. However the new provision is an extension of an established area of the law, thus the ATO already has arrangements in place to draw on which will help to minimise these costs.

2.173 Administration costs for the ATO have not been able to be quantified.

Compliance costs

2.174 As is standard with new measures, groups affected by them will need to incur a small up-front cost in either familiarising themselves with the new law or having advisers familiarise themselves with the new law and, if necessary, communicating the necessary information to taxpayers affected.

2.175 The provision will require businesses to seek a straight line write-off over a period to be prescribed in the statute. This methodology is already utilised by the current section 40-880 of the ITAA 1997, therefore business familiarisation costs are expected to be small.

2.176 Individual taxpayers claiming deductions arising from pre- and post-business costs (under the proposed amendments) against other income will need to become familiar with the amended non-commercial loss provisions. These taxpayers will need to determine whether the tests apply to them and if so whether they satisfy any one of the tests, in order to be able to offset losses from a particular business activity (or a like activity) against their other income.

2.177 Individuals who fail to satisfy any of the tests for a particular business activity (or a like activity) will need to maintain records of those loss amounts in order to defer them to a future year in which they pass any of the tests. These records will need to separately identify the deductions from each activity which were not previously permitted to be claimed.

2.178 Compliance costs have not been able to be quantified.

Revenue costs

2.179 The expected revenue cost over the forward estimates for the taxation treatment of business 'blackhole' expenditure is shown in Table 2.1:

Consultation

2.180 Relevant stakeholders have provided their views on the treatment of blackhole expenditures. Initial consultation was in respect to a call for submissions by the then Minister for Revenue and Assistant Treasurer on expenditures considered to be blackholes for taxation purposes. The Government received 10 formal submissions from peak industry and tax bodies representing a substantial number of taxpayers.

2.181 The views expressed in these submissions were taken into account in developing the proposal. Not all types of blackhole expenditures identified by taxpayers were considered to be genuine blackhole expenditures.

2.182 Further confidential targeted consultation was undertaken subsequent to the Treasurer's Press Release of 10 May 2005. ^[F5] The consultation applied the details of the proposal and:

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considered expenditures that will be covered by the new provision;

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integrity measures; and

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compliance and administration matters,

through the release of Treasury discussion papers and draft legislation.

2.183 The legislation has incorporated proposals which were raised in discussions by key stakeholders.

Conclusion and preferred option

2.184 The proposed systematic tax treatment meets the parameters set out previously by the Treasurer and the then Minister for Revenue and Assistant Treasurer. ^[F6]

2.185 It is expected to provide net benefits for businesses and the ATO by increasing certainty, reducing complexity and minimising the risk of arbitrage. Ongoing compliance costs are expected to be lower.

2.186 Further, the proposal is broadly in line with taxpayer views as expressed in submissions.

2.187 The Treasury and the ATO will monitor this taxation measure as part of the whole taxation system on an ongoing basis.