House of Representatives

Explanatory Memorandum

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

Chapter 6 - Deductible expenditure and CGT cost bases

Overview

6.1 The amendments contained in Schedule 7 of the Bill will amend the capital gains tax (CGT) cost base provisions in Part IIIA of the Income Tax Assessment Act 1936 (1936 Act) and the Income Tax Assessment Act 1997 (1997 Act). Broadly, the amendments will reduce the cost base and indexed cost base of an asset to the extent of any net revenue deductions allowable for expenditures included in the cost base. Cost base reductions will also apply where a heritage conservation rebate or a landcare and water facility tax offset is obtained in respect of the expenditure as an alternative to claiming a deduction.

6.2 Net revenue deductions are deductions allowable in respect of expenditure incurred on an asset less any amounts included in the taxpayers assessable income which effectively reverse those deductions by inclusion of a balancing adjustment.

Part A: Summary of the amendments to the 1936 Act

Purpose of the amendments

6.3 In principle, an item of expenditure should either be deductible for income tax purposes or included in the cost base of an underlying asset for CGT purposes, but not both.

6.4 The amendments are designed to prevent taxpayers from including an amount of expenditure in the cost base or indexed cost base of an asset to the extent that they would be able to claim a deduction for that expenditure.

Date of effect

6.5 The amendments, announced by the Treasurer in the 1997-98 Budget, will apply to assets acquired after 7.30 pm, by legal time in the Australian Capital Territory, on 13 May 1997. [Subitem 8(1)]

6.6 However, expenditure incurred before 1 July 1999 in respect of underlying land or buildings acquired on or before 7.30 pm, by legal time in the Australian Capital Territory, on 13 May 1997 will not be subject to these amendments. [Subitem 8(2)]

6.7 Further, the amendments will only apply to expenditure to the extent that they relate to the period after 7.30 pm, by legal time in the Australian Capital Territory, on 13 May 1997. [Subitem 8(4)]

6.8 Moreover, CGT cost base or indexed cost base will be reduced for a heritage conservation rebate or a landcare and water facility tax offset is taken as an alternative to a deduction only where the relevant expenditure is incurred on or after this Bill is introduced into Parliament. [Subitem 8(3)]

Background to the legislation

6.9 Part IIIA of the 1936 Act taxes capital gains from disposals of assets acquired on or after 20 September 1985. A capital gain accrues to a taxpayer where the sale proceeds from the disposal of an asset exceeds the assets indexed cost base (or cost base if the asset is held for less than 12 months). A capital loss, however, arises when the sale proceeds are less than the assets reduced cost base.

Cost base

6.10 The cost base of an asset is defined in subsection 160ZH(1) of the 1936 Act. The components of the cost base of an asset are broadly, consideration in respect of acquisition, non-capital costs to the taxpayer of ownership, capital expenditure incurred to enhance the value or to defend the asset and incidental costs of acquisition or disposal.

6.11 Subsections 160ZH(6) and (8) exclude an amount of incidental cost from the cost base of an asset to the extent that the amount has been or is allowable as a deduction to the taxpayer. Similarly, subsection 160ZH(6B) excludes from the cost base, non-capital costs to the extent that the amount has been or is allowable as a deduction to the taxpayer.

6.12 There is, however, nothing in the existing law that prevents an amount of consideration in respect of the acquisition of an asset or expenditure in respect of the asset that is allowable as a deduction to the taxpayer from being included in the cost base.

Indexed cost base

6.13 The indexed cost base of an asset is defined in subsection 160ZH(2) of the 1936 Act. Broadly, the indexed cost base of an asset is the cost base of an asset indexed for inflation.

Reduced cost base

6.14 The reduced cost base of an asset is defined in subsection 160ZH(3) and largely reflects the components of the cost base of the asset.

6.15 Section 160ZK, however, provides that in calculating the reduced cost base of an asset, an amount of any consideration, incidental cost or expenditure in respect of an asset is reduced by any deductions allowable in respect of those amounts. Section 160ZK equally provides for such a reduction in the reduced cost base where a heritage conservation rebate or a landcare and water facility tax offset is obtained in respect of the expenditure as an alternative to claiming a deduction.

6.16 The existing law does not required similar adjustments to be made in respect of such amounts in working out the cost base or indexed cost base of an asset. These amendments will rectify this anomaly by requiring the relevant adjustments to be made when working out the cost base or indexed cost base of an asset.

Explanation of the amendments

Adjustments to the 'cost base' and 'indexed cost base'

Cost base

6.17 New subsection 160ZJA(1) will reduce the amount of consideration and expenditure to be included in the cost base of an asset under subsection 160ZH(1). The amount of consideration and expenditure will be reduced to the extent of any deductions that are allowable to the taxpayer in respect of those amounts.

6.18 Deductions that are allowable to a taxpayer include a situation where the taxpayer receives a heritage conservation rebate or a landcare and water facility tax offset in respect of the expenditure as an alternative to claiming a deduction.

Indexed Cost base

6.19 New subsection 160ZJB(1) will mirror the amendments as discussed in relation to the cost base. Below is an example of how the amendments would affect the current calculation of the indexed cost base of an asset.

Example

6.20 Building acquired 1 July 1999 for consideration of $100,000

Building write off at 2.5% per year (therefore $2,500 for 2 years = $5,000)

CPI 5%

Expenditure incurred by another taxpayer

6.21 In certain circumstances, a taxpayer is entitled to a deduction for capital expenditure incurred by another taxpayer. The new sections 160ZJA and 160ZJB will ensure that such deductible expenditure also reduces the amount of consideration and expenditure in respect of the cost base or indexed cost base of an asset owned by the taxpayer entitled to the deduction.

For example, expenditure incurred by a former owner of a building may be deductible as a building write-off to the new owner under Division 10C and 10D of Part III of the 1936 Act (or Division 43 of the 1997 Act). The new owner will need to reduce the cost base of the asset by such deductible expenditure even though the new owner did not incur that expenditure.

Deemed acquisition of an asset

6.22 Where an asset has been deemed to be acquired after 13 May 1997 the asset is subject to the measures in this Bill. New paragraphs 160ZJA(1)(d) and 160ZJB(1)(d) ensure that the new measures only apply to deductions allowed or allowable to the taxpayer after the deemed acquisition of the asset.

6.23 An example of such a deemed acquisition is if there is a change in the majority underlying ownership of an asset. The asset is deemed to have been acquired at the time of change in the majority underlying ownership of the asset (section 160ZZS and related provisions of the 1936 Act).

Rebates and tax offsets

6.24 The heritage conservation rebate and the landcare and water facility tax offset allows a taxpayer to obtain a rebate or a tax offset from tax for expenditure incurred on an asset. The rebate or tax offset is already taken into account under section 160ZK of the 1936 Act as a reduction to the reduced cost base of an asset. New paragraphs 160ZJA(1)(d) and 160ZJB(1)(d) ensure that the cost base and indexed cost base rules are consistent with the reduced cost base rules.

Assessable income

6.25 New paragraphs 160ZJA(1)(b) and 160ZJB(1)(b) will ensure that the consideration and expenditure in respect of an asset is included in the cost base to the extent the allowable deduction is effectively reversed by an amount being included in the taxpayers assessable income.

6.26 For example, an amount of assessable income equal to the excess of sale proceeds over the written down value of depreciable plant is required to be included in assessable income under subsection 59(2) of the 1936 Act or its equivalent in subsection 42-190(2) of the 1997 Act. This effectively reverses depreciation deductions allowable in respect of expenditure incurred on the plant where the expenditure is recouped upon disposal.

6.27 In working out the cost base of the depreciable plant, new paragraph 160ZJA(1)(b) will include the balancing adjustment in the cost base as the balancing adjustment is effectively reversing a previously allowable deduction. Similarly, new paragraph 160ZJB(1)(b) will have the same effect for indexed cost base.

6.28 In certain circumstances, an election to offset what would have been a balancing adjustment against the cost of either a replacement plant or other depreciable plant can be made. In this case, the balancing adjustment is not required to be included in the taxpayer's assessable income.

6.29 The effect of new subsections 160ZJA(2) and 160ZJB(2) is to treat an amount of balancing adjustment offset as if it were included in the assessable income of the taxpayer. The new provisions recognise that although such a balancing adjustment is not actually included in assessable income at the time of disposal, the amount is effectively assessed over the life of the replacement plant, or where relevant, other depreciable plant. This is because depreciation deductions in respect of the replacement plant or depreciable assets are based on the cost of the plant or depreciable assets as reduced by the balancing adjustment.

6.30 In certain circumstances a balancing adjustment may be deferred from being included in a taxpayers assessable income. This is known as a balancing adjustment rollover relief. New paragraphs 160ZJA(2)(d) and 160ZJB(2)(d) prevent potential double taxation arising from the interaction of the mechanism of the balancing adjustment rollover relief and the cost base adjustment provisions of this Bill. These provisions ensure that the deferred balancing adjustments does not reduce the cost base or indexed cost base of an asset at the time of the balancing adjustment rollover.

Partnerships

6.31 New subsections 160ZJA(3), (4) and 160ZJB(3), (4) apply where a partner in a partnership disposes of an interest in a partnership asset. These subsections mirror the effect of subsections 160ZJA(1), (2) and 160ZJB(1), (2) on the cost base and indexed cost base of an asset as discussed above.

6.32 These new provisions recognise that some deductions are allowable to the partnership while others are allowable to the individual partners. Some examples of expenditure that are taken into account in working out the net income or loss of a partnership are:

•

expenditure in establishment of grape vines (section 75AA); and

•

expenditure eligible for building write off (Division 10C and 10D of Part III of the 1936 Act or Division 43 of the 1997 Act).

6.33 The effect of the provisions is that the cost base or indexed cost base of the partners interest in the partnership asset will be reduced by that partners share of the partnerships allowable deduction.

Date of effect

6.34 The amendments made by Schedule 7 apply to assets acquired after 7.30 pm, by legal time in the Australian Capital Territory, on 13 May 1997. [Subitem 8(1)] The acquisition date of assets is determined by section 160U of the 1936 Act.

Transitional rule

6.35 However, the amendments made by Schedule 7 do not apply to expenditure incurred before 1 July 1999 where certain conditions are met. The conditions of this transitional rule are satisfied where:

•

that expenditure gives rise to a separate asset (deemed asset) from the underlying asset by virtue of section 160P;

•

the underlying asset is land or a building acquired by the taxpayer at or before 7.30 pm, by legal time in the Australian Capital Territory, on 13 May 1997; and

•

the deemed asset is acquired by the taxpayer after 7.30 pm, by legal time in the Australian Capital Territory, on 13 May 1997 but before 1 July 1999.

6.36 Where a taxpayer satisfies the above conditions, this measure will not apply to adjust the cost base or indexed cost base of the asset by any allowable deductions in respect of the expenditure. [Subitem 8(2)]

Example 1

6.37 A taxpayer acquires land in 1990. In March 1998 the taxpayer signs a contract for a building to be constructed on their land. By December 1998, the building is completed and at that time, the taxpayer incurs the expenditure for the building's construction. The taxpayer's expenditure on the building is eligible for building write off under Division 43 of the 1997 Act. The new building is deemed to be a separate asset by virtue of section 160P.

6.38 The deductions for building write off will not be deducted from the cost base or indexed cost base of the building. This is because the taxpayer's expenditure on the building satisfies the conditions of the transitional rule.

Part B: Summary of the amendments to the 1997 Act

Overview

6.39

Summary of the new law

Division 110

What the Division does

Division 110 sets out the general rules for working out the cost base or reduced cost base of a CGT asset. These are key components determining whether a taxpayer makes a capital gain or capital loss. There are also special rules about cost base and reduced cost base in Division 112.

Costs not included in cost base for assets acquired before 7.30 pm, by legal time in the Australian Capital Territory, on 13 May 1997.

Some costs are not included in the cost base. These are:

•

expenditure in elements 2 and 3 which is an allowable deduction;

•

any expenditure recouped that is not included in assessable income.

[Sections 110-40 and 110-43]

Costs not included in cost base for assets acquired on or after 7.30 pm, by legal time in the Australian Capital Territory, on 13 May 1997.

Some costs are not included in the cost base. These are:

•

expenditure in any element which are allowable deductions;

•

any expenditure recouped that is not included in assessable income;

•

heritage conservation expenditure giving rise to a tax offset;

•

landcare and water facilities expenditure giving rise to a tax offset.

This section reflects the amendments to the cost base rules announced by the Treasurer in the 1997-98 Budget. [Sections 110-45, 110-50 and 110-55]

Generally, the measure will apply to CGT assets acquired on or after 7.30 pm, by legal time in the Australian Capital Territory, on 13 May 1997. [Sections 110-45 and 110-50]

Special application rule for tax offsets

Amendments affecting expenditure that qualifies for the heritage conservation rebate and landcare and water facility tax offset apply only to such expenditure incurred on or after the day on which these amendments are introduced into Parliament. [Subsection 110-53(2) and subitem 14(2)]

Special application rule for the period from 7.30 pm, by legal time in the Australian Capital Territory, on 13 May 1997 to 30 June 1999

Certain expenditure on capital improvements on land and building treated as separate assets. Generally, such separate assets are treated as having been acquired when the expenditure was incurred.

A special application rule ensures that the amendments do not apply to expenditure incurred before 1 July 1999 in respect of underlying land or a building acquired before the Budget even though the expenditure is deemed to give rise to a separate asset acquired after the Budget. [Subsection 110-53(3)]

Finding Table - New Law to Old Law

Finding Table Old Law to New Law

Finding Table - 1997 Act to amended 1997 Act

Regulation Impact Statement

Policy objective

6.40 As part of the 1997-98 Budget, the Government announced that amounts of expenditure included in the cost base of assets for capital gains tax (CGT) purposes would be adjusted to take into account net revenue deductions allowable in respect of those expenditures.

6.41 The principle underlying this measure is that an item of expenditure should be either deductible for income tax purposes, or included in the CGT cost base of an underlying asset, but not both.

6.42 According to the Government's announcement, the amendments are to apply to the disposal of assets acquired after the Budget at 7.30 pm AEST on 13 May 1997.

Implementation option

Budget measure

6.43 Only one implementation option was considered for the implementation of the Budget measure. This option involves reducing the cost base and indexed cost base of assets to the extent of any net revenue deductions that result from expenditure in respect of those assets. A taxpayer would obtain a net revenue deduction in respect of a particular expenditure if the sum of the allowable deductions in respect of the expenditure exceed the sum of any amounts required to be included in assessable income. These amounts of assessable income are limited to those included in a taxpayer's assessable income, which effectively seek to reverse the deductions previously allowed.

Transitional rule for the Budget measure

6.44 Subsequent to the Budget announcement the Government has decided that certain expenditure incurred after 13 May 1997 but before 1 July 1999 will not be subject to the Budget measure.

6.45 This is because under the existing CGT provisions, expenditures qualifying for some of the various capital allowances covered by the measure can be treated as creating assets that are separate from the underlying land or building they seek to improve or modify. Consequently, expenditure incurred after the Budget on underlying land or a building acquired before the Budget (pre-Budget land or building) might be subject to the measure.

6.46 Whilst such expenditures give rise to the double deductions sought to be removed by this measure, it has been argued that the expenditures may generally be perceived as being in respect of the pre-Budget land or building.

6.47 The following implementation options were considered to limit the effect of the separate asset treatment under the existing law:

Option A: an open-ended transitional rule that would exclude from the measure all expenditure incurred in respect of pre-Budget land or buildings;

Option B: a transitional rule that would exclude from the measure expenditure incurred on pre-Budget land or buildings only if the expenditure was incurred before 1 July 1999.

Assessment of impacts (costs and benefits) of each implementation option

Impact group identification

6.48 Taxpayers who are allowed net revenue deductions in respect of expenditure included in the cost base or indexed cost base of an asset acquired after the Budget.

6.49 Taxpayers acquiring income producing assets after the Budget that are eligible for building write off will be the main group subject to the measure. However, other taxpayers claiming various capital allowances and deductions in respect of assets may also be subject to the Budget measure.

6.50 The Australian Taxation (ATO) will be responsible for administering the measure.

Analysis of costs and benefits associated with each implementation option

Compliance costs

6.51 The Budget measure will increase taxpayers' compliance costs marginally as taxpayers will need to keep records of deductions claimed in respect of expenditure until at least five years after the asset is disposed of. Records in relation to the expenditure itself are already required to be kept, as the expenditure is relevant to the cost base of the underlying asset. The compliance costs of the Budget measure have not been quantified.

Administration costs

6.52 The revenue estimates of the budget measure above do not take into account the costs to the Australian Taxation Office of administering the Budget measure. However, these costs are likely to be small. The administrative costs of the Budget measure have not been quantified.

Transitional rule for the Budget measure

6.53 Option A would open up a potential loophole through which certain taxpayers could avoid the measure. Moreover, the option would be difficult to justify on equity grounds as it is unlikely that a taxpayer who incurs relevant expenditure on their pre-Budget land or building in, say, five to ten years' time, actually intended at the time of the Budget to incur such expenditure. Finally, the option may introduce distortions by providing an incentive for taxpayers to retain pre-Budget underlying land or buildings in order to claim double deductions in respect of those assets.

6.54 Option B runs the risk that it would rule out some expenditure that was genuinely in train at the time of the Budget announcement but was not incurred until after 1 July 1999. However, advice from the construction industry on the delays typically involved in obtaining building and zoning approvals for substantial redevelopment suggests that a transitional rule of two years is reasonable. Hence, Option B would ensure such projects are unaffected.

6.55 Taxpayer compliance costs will be further increased as a result of the Government's decision to implement a transitional rule. However, it is considered that the increased compliance cost will be limited to the small group of taxpayers who satisfy the conditions of the transitional rule.

6.56 Likewise the additional administrative costs arising from administering the transitional rule will be small as the affected group of taxpayers is small.

Taxation revenue

6.57 The CGT cost base adjustment measure is expected to provide a gain to the revenue over the five years 1997-98 to 2001-02 of $325 million. This is down from the original Budget estimate of $460 million over the same period. This reduction represents the estimated cost of proceeding with Option B. Option A was not costed, but its cost was considered to be prohibitive.

Consultation

6.58 The Government has received representations from the building and property industries to the effect that it would be unfair for the measures to apply to expenditures incurred in respect of pre-Budget assets. The transitional provisions contained in the proposed legislation are a result of those representations.

Conclusion

Budget measure

6.59 The Budget measure will be implemented as announced on Budget night.

Transitional rule for the Budget measure

6.60 Both Options A and B would deal with the perceived anomaly that arises because certain expenditure in respect of pre-Budget underlying land or buildings could be treated as giving rise to separate assets.

6.61 However, Option B is preferred because it provides for a reasonable transitional period to protect expenditure genuinely intended at the time of the Budget announcement. In contrast, Option A is inequitable, open to abuse and would cause economic distortions.

6.62 The Treasury and the ATO will monitor this taxation measure, as part of the whole taxation system, on an ongoing basis. In addition, the ATO has consultative arrangements in place to obtain feedback from professional associations and through other taxpayer consultative forums.