Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 9 - Deducting prepayments
Outline of Chapter
9.1 This Chapter explains changes to the income tax treatment of prepayments. The 13 month rule, which allows immediate deductions of prepayments for things to be done within 13 months, will be removed and the deduction spread over the period the prepayment covers.
9.2 These changes only apply to taxpayers in business and only if they are not small business taxpayers. They generally cover prepayments incurred after 11.45 am AEST on 21 September 1999. They are in Schedule 7 of the Bill and alter Subdivision H of Division 3 of Part III of the ITAA 1936.
What is the current treatment of prepayments?
9.3 Existing section 82KZM of the ITAA 1936 provides special treatment for some prepayments that are allowable deductions under the general deductions provision.
9.4 The prepayment is an allowable deduction in the income year in which it is incurred if it is for something that is to be done wholly within 13 months.
9.5 However, if the prepayment is for more than 13 months, the allowable deduction is spread over the whole period over which the thing is to be done (to a maximum of 10 years).
Why is the prepayments rule being changed?
9.6 The current treatment is inconsistent with accounting practice, which brings prepayments to account as assets at years end. It also creates an inconsistent treatment between people making, and those receiving, the prepayments because the recipients usually only bring to account as income the part of a prepayment attributable to that year.
9.7 The Review considered the tax deferral advantages given by the 13 month rule to be unwarranted for medium and large businesses. Therefore, it recommended that the rule be altered.
Summary of new law
9.8 The new law will remove immediate deductibility for prepayments for the supply of assets or services incurred in carrying on a business, except by small business taxpayers. Instead, the law will spread the deduction over the period for which the assets or services are to be provided. This is the same as the current treatment of prepayments for periods of over 13 months.
9.9 The new law applies to prepayments incurred after 11.45 am AEST on 21 September 1999, except for those incurred pursuant to some contractual obligations existing at that time.
9.10 Because some taxpayers will have made plans based on the 13month rule, there will be transitional arrangements to ensure that they are not unduly disadvantaged by the new treatment. The transitional measure will phase in the initial impact of this measure over a period of 5years.
Comparison of key features of new law and current law
|
|
All taxpayers can receive an immediate deduction for prepayments for things to be done within 13 months. Prepayments for things to be done after that time are deductible over the period the thing is to be done (or 10 years if that is less). |
Detailed explanation of new law
9.11 Business prepayments, other than those by small business taxpayers, for things to be done within 13 months will no longer be immediately deductible. Instead, the deduction will be spread over the period for which the assets or services are to be provided. This is consistent with the current treatment of prepayments for periods over 13months.
9.12 The change applies to prepayments incurred on or after 11.45 am AEST on 21 September 1999, unless they were made pursuant to certain existing contractual obligations.
The existing treatment is preserved for some expenditure
9.13 Section 82KZM of the ITAA 1936 is being modified to limit its application. The modifications will preserve the existing treatment in these situations:
- •
- business expenditure by small business taxpayers;
- •
- non-business expenditure;
- •
- prepayments pursuant to an existing prepayment obligation.
[Items 3 and 4, Schedule 7, paragraph 82KZM(1)(aa)]
What is a small business taxpayer?
9. 14 In broad terms, a small business taxpayer is someone who has an average annual group turnover of less than $1 million from business supplies. The small business taxpayer test is set out in item 22 of Schedule 2 to the New Business Tax System (Capital Allowances) Bill 1999 (refer to Chapter 3 of the Explanatory Memorandum to that Bill). The Bill inserts, into the prepayments rules, a definition of small business taxpayer which refers to that test. [Item 2, Schedule 7, definition of small business taxpayer inserted into subsection 82KZL(1)]
What existing prepayment obligations are covered?
9. 15 The exception for existing prepayment obligations (called pre-RBT obligations ) is designed to avoid penalising taxpayers who have already committed themselves to making a prepayment. There are certain conditions that need to be met for an obligation to be a pre-RBT obligation:
- •
- the taxpayer must be bound by a contract made before 11.45am AEST on 21 September 1999;
- •
- the contract must require the payment in advance of the supply of services or assets; and
- •
- the prepayment must not be avoidable at the discretion of the taxpayer.
[Item 1, Schedule 7, definition of pre-RBT obligation inserted into subsection 82KZL(1)]
The new treatment for business expenditure
How are the new provisions structured?
9. 16 The new rules for prepaid business expenditure (other than that incurred by small business taxpayers) are organised into 4 sections. In broad terms, new section 82KZMA sets out when the new treatment will apply while new section 82KZMD explains how the deduction for prepaid expenditure is to be spread over the period to which the prepayment relates. New sections 82KZMB and 82KZMC set out the rules for prepayments, incurred in the transitional period, for things to be done wholly within 13 months. [F1] [Item 5, Schedule 7, sections 82KZMA, 82KZMB, 82KZMC and 82KZMD]
When does the new treatment apply?
9. 17 The new treatment applies to expenditure meeting the following requirements, except where that expenditure is incurred by a small business taxpayer. The expenditure must be:
- •
- deductible under the general deductions provision (section 8-1 of the ITAA 1997);
- •
- incurred in carrying on a business; and
- •
- incurred under an agreement in return for the doing of a thing that is not to be done wholly within the income year in which the expenditure was incurred.
[Subsections 82KZMA(1), (2) and (3)]
9. 18 However, some prepayments are excluded from the new treatment, as they are under the existing section 82KZM. These prepayments will continue to be immediately deductible regardless of the period they are for:
- •
- prepayments that are less than $1,000; and
- •
- prepayments that are required to be paid by law or court order.
9. 19 Expenditure incurred under a pre-RBT obligation is not covered by the new treatment [subsection 82KZMA(5)] . Such expenditure continues to get the existing treatment (refer to paragraphs 9.13 and 9.15).
How is the deduction for prepayments spread over the service period?
9. 20 The fraction of the amount subject to the new treatment that taxpayers can deduct in an income year is worked out by dividing the number of days the prepayment covers in the income year by the total number of days it covers [subsections 82KZMB(3), 82KZMC(5) and 82KZMD(2)] . The formula illustrates this:
current year deduction = expenditure * (number of days the prepayment covers in the current income year / total number of days the prepayment covers)
(The period the prepayment covers is called the eligible service period in the legislation.)
Garden Goods Ltd, who is not a small business taxpayer, signs a contract on 17 June 2006 for supply of garden gnomes for twelve months from 1 January 2007 to 31 December 2007. It pays $365,000 for the gnomes on the date it signs the contract.
- •
- In the income year 1 July 2005 to 30 June 2006, Garden Goods Ltd cannot claim any deduction for the garden gnomes.
- •
- In the income year 1 July 2006 to 30 June 2007, Garden Goods Ltd has used 181 days of the 365 day period covered by the contract. It can claim a deduction for $181,000 - that is:- 181/365 * $365,000.
- •
- In the income year 1 July 2007 to 30 June 2008, Garden Goods Ltd can claim the rest of the payment as a deduction; $184,000.
Prepayments are still subject to the commercial debt forgiveness rules
9. 21 The provisions operate subject to Division 245 of Schedule 2C of the ITAA 1936, which deals with forgiveness of commercial debts [paragraph 82KZMA(6)(b)] . Broadly speaking, this means a taxpayer who has a commercial debt that is forgiven may have to reduce some of their deductions, including those for prepayments covered by the rules discussed in this Chapter.
Application and transitional provisions
9.22 The transitional rules are intended to alleviate the effect of the new prepayments treatment. They do that by, in effect, spreading over 5years the increase in tax that comes from denying an immediate deduction for prepayments incurred in the first year of the change. Taxpayers only obtain the full transitional effect if they have even, or increasing, prepayments in those years. If their prepayments decline, the increase will be spread over a shorter period.
9.23 Prepayments incurred before 11.45 am AEST on 21September1999 will not be subject to the new treatment of prepayments, nor will those made afterwards pursuant to a contractual obligation that meets certain requirements existing at that time (refer to paragraphs 9.13 and 9.15).
Transitional treatment of expenditure incurred in the first year of change
9.24 Other prepayments incurred in the income year that includes 21September 1999 (usually 1999-2000 [F2] ), that would previously have fallen within the 13 month rule, will be eligible for transitional treatment [subsection 82KZMB(1)] . That treatment isolates the part of the prepayment that relates to future years (usually 2000-2001 and 2001-2002). The part so isolated is called the later year amount [subsection 82KZMB(6)] . The treatment allows a deduction for 80% of that part in the current income year [subsections 82KZMB(2) and (5)] . The remaining 20% will be deductible in the next year (usually 2000-2001) [subsections 82KZMB(4) and (5)] .
Jimco makes a $36,600 prepayment for the 2000 calendar year on 1January 2000. Jimco uses the standard income year, so it can deduct the $18,200 attributable to the 1999-2000 year immediately that is: 182/366 * $36,600. It can also deduct 80% of the remainder ($14,720) in the 1999-2000 year, because of the transitional rule. It can deduct the remaining $3,680 in 2000-2001.
Transitional treatment of expenditure incurred in the next 3 years of change
9. 25 Similar transitional deductions are available for prepayments incurred in the next 3 years (usually 2000-2001, 2001-2002 and 2002-2003) but with different percentages. Table 9.2 sets out the percentages for each of the transitional years [subsections 82KZMB(2), (4) and (5)] .
| Year including 21-09-1999 | 80% | 20% |
| Year including 21-09-2000 | 60% | 40% |
| Year including 21-09-2001 | 40% | 60% |
| Year including 21-09-2002 | 20% | 80% |
Cap on amount eligible for transitional treatment
9.26 There is a cap on the amount of a taxpayers future years expenditure that is eligible for the transitional rule in the years including 21 September 2000, 2001 and 2002. That cap is the total amount that was eligible for the transitional treatment for that taxpayer in the year including 21 September 1999. [Section 82KZMC]
9.27 If the amount that would otherwise be eligible in those later years does exceed the cap, the excess is deductible proportionately over the years the prepayment covers after the year it was incurred (refer to paragraph 9.20). [Subsections 82KZMC(4) and (5)]
9.28 The cap is a limit on the total amount eligible for transitional treatment in those later years. However, taxpayers are free to choose how much of the amount of each particular expenditure that would otherwise be eligible for that treatment will contribute to that total [subsections 82KZMC(2) and (3)] . To maximise the benefit, taxpayers would usually want to choose to make up the capped amount for the transitional treatment from the longest term prepayments.
Example 9.3: Transitional treatment for prepayments
Clock Ltd, who is not a small business taxpayer, buys broken Swiss clocks and restores them. In order to make sure it can receive the clocks, its makes prepayments for 12 months in each of the transitional income years. This table sets out details of the prepayments and the amounts Clock Ltd can deduct in each income year. [F3]
| 1999-2000 | 2000-2001 | 2001-2002 | 2002-2003 | 2003-2004 | |
|---|---|---|---|---|---|
| Amount of prepayment incurred. | $100,000 | $130,000 | $100,000 | $110,000 | Nil |
| Amount relating to current income year (deductible in the current year) [paragraph 82KZMB(2)(a) and subsection 82KZMB(3)] . | $20,000 | $30,000 | $10,000 | $20,000 | |
| Amount relating to later income years. | $80,000 | $100,000 | $90,000 | $90,000 | |
| Part of the expenditure eligible for transitional treatment (after capping). This is the later year amount. | $80,000 | $80,000 | $80,000 | $80,000 | |
| Part of later year amount deductible in current income year under transitional rule [paragraph 82KZMB(2)(b) and subsection 82KZMB(5)] . | $64,000 (80%) | $48,000 (60%) | $32,000 (40%) | $16,000 (20%) | |
| Deduction for part of previous years later year amount not deductible in previous year [subsections 82KZMB(4) and (5)] . | $16,000 (20%) | $32,000 (40%) | $48,000 (60%) | $64,000 (80%) | |
| Deduction for part of previous years expenditure in excess of capped amount [subsections 82KZMC(4) and (5)] . | Nil | $20,000 | $10,000 | $10,000 | |
| Total amount deductible. | $84,000 | $94,000 | $94,000 | $94,000 | $74,000 |
9.29 The prepayments changes apply to prepayments incurred after 11:45 am AEST on 21 September 1999. [Subitem 12(1), Schedule 7]
9.30 Once the transitional changes have expired, in the income year starting after 21 September 2002, the transitional provisions will automatically be removed from the ITAA 1936. Section 82KZMD will then be the operational provision for business prepayments made by someone who is not a small business taxpayer. [Items 6, 7, 8, 9 and subitem 12(2), Schedule7; clause 2]
9.31 The prepayments changes will only commence once Subdivision960-Q of the ITAA 1997 commences. This is because subdivision 960-Q defines small business taxpayer. [Clause 2]
Consequential amendments
9. 32 References in the ITAA 1936 and the ITAA 1997 are being altered to reflect the changes to section numbering caused by the new prepayments treatment. [Items 10 and 11 of Schedule 7]