Edited version of your written advice

Authorisation Number: 1051241481460

Date of advice: 29 June 2017

Ruling

Subject: Repairs

Question 1

Is the replacement of truck engines deductible under section 25-10 of the Income Tax Assessment Act 1997?

Answer

Yes

This ruling applies for the following periods:

1 July 2016 to 30 June 2020

The scheme commences on:

1 July 2016

Relevant facts and circumstances

1. An entity owns a business which has a large fleet of trucks and some of these trucks have been acquired second-hand.

2. The majority of trucks have been purchased new.

3. From time to time, the trucks require repairs and are regularly maintained to ensure they are running at their optimal capacity. Repairs and maintenance includes;

a. Replacement of parts

b. Major repairs to engines

c. Replacement of engines

d. Work on other various components.

4. Decisions for major repairs such as replacement of engines and other major works are made only when these works are required.

5. Where a truck requires a replacement of an engine, the engine is replaced with the same corresponding engine (make and model).

6. Replacement of the engines and any repair work will only be done to restore the trucks back to their original condition.

Relevant legislative provisions

Section 25-10 Income Tax Assessment Act 1997

Reasons for decision

Summary

The entity is entitled to a deduction under 25-10 of the ITAA 1997 for the expenses incurred to carry out repair work on its truck fleet, including expenses to:

● replace truck engine parts

● make truck engine repairs and

● replace truck engines

Detailed reasoning

Repairs

Expenditure incurred by a taxpayer for repairs is an allowable deduction under section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997). The section states:

you can deduct expenditure you incur for repairs to premises (or part of premises) or a depreciating asset that you held or used solely for the purpose of producing assessable income.

The trucks are income producing assets and the entity is entitled to deduct repair costs associated with the trucks.

However, subsection 25-10(3) of the ITAA 1997 states:

You cannot deduct capital expenditure under this section.

Taxation Ruling 97/23 - Income tax: deductions for repairs (TR 97/23) discusses the circumstances in which expenditure incurred for repairs may or may not be an allowable deduction under section 25-10 of the ITAA 1997.

The word 'repair' is not defined within the taxation legislation. Accordingly, it takes its ordinary meaning. Works can fairly be described as 'repairs' if they are done to make good damage or deterioration that has occurred by ordinary wear and tear, by accidental or deliberate damage or by the operation of natural causes (whether expected or unexpected) during the passage of time (paragraph 15 of TR 97/23).

Whereas, work done to prevent or anticipate defects, damage or deterioration (mechanical or physical) in property is not in itself a repair, unless it is done in conjunction with making good of those defects, damage or deterioration (paragraph 14 of TR 97/23).

While some works may be fairly described as repairs, the expenditure will be considered capital in nature in some situations, and therefore not deductible under section 25-10 of the ITAA 97. Expenditure incurred for repairs to property used for income producing purposes is of a capital nature where:

● the works result in a greater efficiency of function in the property, therefore representing an improvement rather than a repair; or

● the extent of the work carried out represents a renewal or reconstruction of the entirety, or

● the work is an initial repair.

What is a 'repair' for the purposes of section 25-10 of the ITAA 1997 is a question of fact and degree in each case having regard to the appearance, form, state and condition of the particular property at the time the expenditure is incurred and to the nature and extent of the work done to the property.

As paragraph 22 of TR97/23 states:

If work done to property goes beyond what is a 'repair' in terms of section 25-10 of the ITAA 1997, any expenditure for the work is not deductible. The work may go beyond 'repairs' in terms of the section if it:

(a) changes the character of the property; or

(b) does more than restore its efficiency of function.

An entirety

Repair involves restoration by the renewal or replacement of subsidiary worn out or defective part. Renewal or reconstruction of a depreciating asset as distinguished from repair is restoration of the entirety (TR 97/23 paragraph 36). An asset is more likely to be an entirety, if it an integral part, but only a part and is capable of providing a useful function without regard to any other part of the asset.

Something that is part of a building, for example, a roof or wall, is just that and no more. The building itself is the entirety (TR 97/23 paragraph 40).

Example 5 in Draft Taxation Ruling TR 2017/D1 Income tax: composite items and identifying the depreciating asset for the purposes of working out capital allowances states:

42. An aircraft and its engine would usually be considered to be a single depreciating asset

Similarly a truck and its engine would be a single depreciating asset.

In your case, replacing truck parts and engines and repairing truck motors would not be considered an entirety as these items alone are not capable of providing a useful function separate from the trucks themselves.

Initial repairs are of a capital nature and not deductible under section 25-10 of the ITAA 1997

If an item of property is in need of repair at the time of acquisition a deduction cannot be claimed for 'initial repairs' under section 25-10 of the ITAA 1997.

Paragraph 5 of TR 97/23 states:

A repair is not an 'initial repair' simply because it is the first repair made after property is acquired. It is an 'initial repair' if repair is due when the property is acquired in the sense that the property has defects, damage or deterioration or is not in good order and suitable for use in the way intended.

For example, replacing a second hand engine in a second hand truck would be an initial repair if it occurred on acquisition. However, if the engine is replaced again at a later period with a second hand engine it would be considered a repair on the second and subsequent occasions.

The 'initial repairs' would not be deductible as they would be repair damage that was in existence at the date that the trucks were acquired.

Capital expenditure

Initial repairs of trucks when first purchased and requiring immediate repairs would not be allowed as repair expenses under section 25-10 of the ITAA 1997. However, a taxpayer may be entitled to a deduction under Division 40 of the ITAA 1997 for any associated depreciation amounts relating to the capital assets.

For example in Taxation Ruling 97/23 states:

164. Elle Bashful uses her truck for income producing purposes. She replaces the truck's worn out petrol engine with a diesel engine with a much greater economy of operation. The engine is not an entirety but a subsidiary part of truck. However, the costs relate to an improvement of the truck because the replacement of the engine involved a significantly greater efficiency in the truck's function. The engine is a major and important part of the truck and is a new and better engine with considerable advantages over the old one, including the advantage that it reduces the likelihood of future repair bills. The costs are of a capital nature and are not deductible under section 25-10: cf (1953) 3 CTBR (NS) Case 82. A deduction for depreciation under section 42-15 may be allowable.

Distinction between a repair and an improvement

An 'improvement' involves bringing a thing or structure into a more valuable or desirable form, state or condition than a mere repair would do. Some factors that point to work done to an asset being an improvement include whether the work will extend the asset’s income producing ability, significantly enhance its saleability or market value or extend the asset’s expected life. (Paragraph 44, TR 97/23)

When considering whether work does more than just restore property to its original function, as a repair would do, the main determinative factor is the actual functionality of the asset and not the functionality of the defective component.

Paragraph 91 of TR 97/23 provides an example of replacing cast-iron pistons in an engine with aluminium-alloy pistons. Although the aluminium-alloy is a more modern material for the construction of pistons, the important question to consider is whether the functionality of the engine has been restored or only enhanced in a minor and incidental way. This expense is deductible as a repair as the engine’s essential efficient of function has not changed, nor has the character of the engine by the use of marginally more efficient pistons.

Paragraph 123, TR 97/23 states:

What is determinative of deductibility under section 25-10 of the ITAA 1997, if different material is used, is whether the work done restores the efficiency of function of the property (without changing its character), not whether the same material as the original is used. We accept that use of different material may result in a minor and incidental degree of improvement in the property but still only restore the efficiency of function of the property. If the degree of improvement is more than minor and incidental, the expenditure is of a capital nature and not deductible under section 25-10 of the ITAA 1997.

Paragraph 124, TR 97/23 further states:

Relevant considerations, consistently with the approach taken by the High Court in the W Thomas & Co case and the Western Suburbs Cinemas case, in distinguishing generally between a repair and an improvement, are:

(a) whether or not the thing replaced or renewed was a major and important part of the structure of the property;

(b) whether the work performed did more than meet the need for restoration of efficiency of function, bearing in mind that 'repair' involves a restoration of a thing to a condition it formerly had without changing its character;

(c) whether the thing was replaced with a new and better one; and

(d) whether the new thing has considerable advantages over the old one, including the advantage that it reduces the likelihood of repair bills in the future.

Apportionment

The “initial repairs” principle may not mean that a deduction is denied for all repairs carried out in the first few months after acquisition.

TR 97/23 states as follows:

138. … After property is acquired by a taxpayer, it may deteriorate more during the period it is held, etc., by the taxpayer for income purposes than it had deteriorated when it was acquired by the taxpayer. The cost of bringing the property back to the state of efficiency of function that it was in when acquired by the taxpayer is deductible as a repair not of a capital nature. In other words, provided that the whole of the expenditure is for repairs, some part of that expenditure may be of a capital nature and some part of it may be deductible.

137. Expenditure for repairs to recently acquired property is fully deductible only if it involves the remedying of defects, damage or deterioration wholly attributable to the period in which the property is held, etc., by the taxpayer for income purposes. If, on the other hand, the expenditure involves putting the property in order suitable for use or the cost of remedying defects, or restoring damage or deterioration existing at the time of purchase, it is of a capital nature and not deductible under the old law. As a general rule of thumb, but subject to the facts in each particular case, repairs effected soon after the purchase of property often rectify defects in, damage to, or deterioration present in the property at the time of purchase.

Conclusion

In your case, replacing truck parts and engines and repairing motors with the same or similar materials would not be considered an improvement if it simply restores the trucks normal function. However, replacing an entire engine on purchase would be a capital expenditure and not deductible under section 25-10 of the ITAA 1997.

Where the materials required to repair an asset are no longer available a modern equivalent can be used which will not constitute an improvement.

As stated in paragraph 21 of TR 97/23 what is a 'repair for the purposes of section 25-10 is a question of fact and degree in each case having regard to the appearance, form, state and condition of the particular property at the time the expenditure is incurred and the nature and extent of the work done to the property.

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