Edited version of private advice

Authorisation Number: 1052242187151

Date of advice: 17 April 2024

Ruling

Subject: Commissioner discretion - cost deductions of repairs

Question

Is the expenditure incurred by the Partnership in relation to the renovations deductible under section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997) in the income year ended 30 June 2023?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

DD MM 20XX

Relevant facts and circumstances

The building owned by the Partnership (the Property), was built in 18XX and is listed on the relevant heritage register.

The Partnership purchased the building in 19XX and converted the building to a quality office space in 19XX.

The Partnership has leased the Property to commercial tenants for XX years in which, various repairs have been undertaken to the asset.

The Property has been let to commercial tenants since 19XX and is retained as long-term investment by the Partnership.

The tenant commenced a lease on DD MM 20XX and expires on DD MM 20XX.

The rents were set for the term of the lease with the agreed rental from DD MM 20XX to increase by XX% per annum during the term.

On DD MM 20XX, the tenant has signed to extend the lease from DD MM 20XX until a new expiry date of DD MM 20XX.

The renovations (the Works) were undertaken at the request of the tenant who complained of the poor state of certain areas after XX years of occupancy. The fittings in those areas are XX years old.

Certain areas where the Works were done were demolished and replaced with new.

A spreadsheet showing all expenses incurred for the Works was provided by the Partnership.

The Works were not a condition of the lease extension, but the Partnership has agreed the condition of the relevant areas were not acceptable and had to be replaced.

The Works have no impact on the income potential of the property as tenant has agreed with the annual increase continuing during the period of the lease extension until DD MM 20XX on DD MM 20XX.

The Partnership have provided photos of the areas where the Works have been done. These photos show the condition of the area before and after the Works. The Partnership advised the replaced fittings were similar to the old fittings both in function and quality. The Works replaced all elements in these spaces, including non-damaged items.

The expenditure of the Works was incurred in the 20XX income year.

Relevant legislative provisions

Income tax Assessment Act 1997 section 25-10

Income tax Assessment Act 1997 section 40-25

Income tax Assessment Act 1997 section 43-10

Does IVA apply to this private ruling?

Part IVA of the Income Tax Assessment Act 1936 contains anti-avoidance rules that can apply in certain circumstances where you or another taxpayer obtains a tax benefit, imputation benefit or diverted profits tax benefit in connection with an arrangement.

If Part IVA applies, the tax benefit or imputation benefit can be cancelled (for example, by disallowing a deduction that was otherwise allowable) or you or another taxpayer could be liable to the diverted profits tax.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies, we will need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select 'Part IVA: the general anti-avoidance rule for income tax'.

Reasons for decision

Section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for the cost of repairs to premises used for income producing purposes.

However, subsection 25-10(3) of the ITAA 1997 does not allow a deduction for repairs where the expenditure is of a capital nature.

As such the Commissioner has considered if the Works are repairs or if they are capital in nature and presented from being deducted as repairs.

The Commissioner considers that the Works are capital in nature and you cannot claim a full deduction for the bathroom and kitchen renovations. While small items may be repairs the Works are capital in nature and amount to a substantial improvement of the areas and as such are not repairs. The expense of the Works are not deductible under section 25-10 of the ITAA 1997.

Repairs

The word 'repair' is not defined within the taxation legislation. Accordingly, it takes its ordinary meaning. In W Thomas & Co v. FC of T (1965) 115 CLR 58, it was held that a 'repair' involves a restoration of a thing to a condition it formerly had without changing its character. It is the restoration of efficiency in function rather than the exact repetition of form or material that is significant.

The term 'repair' means the remedying or making good of defects in, damage to, or deterioration of, property to be repaired and contemplates the continued existence of the property. Repair for the most part is occasional and partial. It involves restoration of the efficiency of function of the property being repaired without changing its character and may include restoration to its former appearance, form, state, or condition. A repair merely replaces a part of something or corrects something that is already there and has become worn out or dilapidated.

Taxation Ruling TR 97/23 Income tax: deductions for repairs (TR 97/23) deals with the issue of deductions for repairs.

Paragraphs 15-16 of TR 97/23 states:

•         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.

•         To repair property improves to some extent the condition it was in immediately before repair. A minor and incidental degree of improvement, addition or alteration may be done to property and still be a repair. If the work amounts to a substantial improvement, addition or alteration, it is not a repair and is not deductible section 25-10 of the ITAA 1997.

•         TR 97/23 provides that expenditure for repairs to property is of a capital nature where the extent of the work carried out represents a renewal or reconstruction of the entirety (paragraphs 36-42), or the works result in a greater efficiency of function in the property, therefore representing an 'improvement' rather than a 'repair' (paragraphs 44-58).

The following are examples of expenses which are capital or of a capital nature:

•         replacement of an entire structure or unit of property (such as a complete fence or building, a stove, kitchen cupboards or refrigerator)

•         improvements, renovations, extensions and alterations, and

•         initial repairs, for example, in remedying defects, damage or deterioration that existed at the date you acquired the property

TR 97/23 clarifies what repairs are in the context of section 25-10 of ITAA 1997:

22. ... 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.

...

32. Expenditure for repairs to property is capital expenditure if any of the following subparagraphs applies:

...

(c)           The expenditure, rather than being for work done to restore the property by renewal or replacement of subsidy parts of a whole, is for work that is a renewal in the sense of reconstruction of the entirety...

TR 97/23 gives the Commissioner's views on the meaning of 'entirety':

37. The term "entirety" is used by the courts in repair cases to refer to something "separately identifiable as a principal item of capital equipment" (Lindsay v FCT (1960) 106 CLR 377 at 385; (1960) 12 ATD 197 at 201), "a physical thing which satisfies a particular notion" (the Lindsay case at 106 CLR 384; 12 ATD 201) and "not necessarily the whole but substantially the whole of the [property] under discussion" (the Lindsay case at 106 CLR 383-4; 12 ATD 200). There is no one correct test for what is a subsidiary part and what is an entirety. Which approach to adopt depends on the facts in each particular case and, even then, the question is one to be answered in the light of all the circumstances it is reasonable to take into account ...

38. Property is more likely to be an entirety if:

•         the property is separately identifiable as a principal item of capital equipment; or

•         the thing or structure is an integral part, but only a part, of entire premises and is capable of providing a useful function without regard to any other part of the premises; or

•         the thing or structure is a separate and distinct item of plant in itself from the thing or structure which it serves; or

•         the thing or structure is a "unit of property" as that expression is used in the depreciation deduction provisions of the income tax law.

39. Property is more likely to be a subsidiary part rather than an entirety if:

•         it is an integral part of some larger item of plant; or

•         the property is physically, commercially and functionally an inseparable part of something else.

...

Improvement

Paragraphs 44 to 47 of TR 97/23 discuss improvements. An improvement provides a greater efficiency of function in the property. It 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 property being an improvement include whether the work will extend the property's income producing ability, significantly enhance its saleability or market value or extend the property's expected life.

Paragraph 46 states:

If the work entails the replacement or restoration of some defective, damaged or deteriorated part of the property, one does not focus on the effect the work has on the efficiency of function of the part. That is not determinative of whether the property is repaired or improved. It is a relevant factor to consider, however, in considering the effect of the work on the property's efficiency of function. It is possible, for instance, that the replacement of a subsidiary part of property with a part better in some ways than the original is a repair to the property without the work being an improvement to the property.

•         Repairing property means fixing something that is broken or damaged. It does not necessarily make the property better than it was before, but it does make it function the way it is supposed to.

•         Improving property means making it better than it was before. This could mean adding new features, making it more efficient, or making it more valuable.

Decline in value (Capital allowances)

Section 40-25 of the ITAA 1997 allows deductions for the decline in value of depreciating assets to the extent the asset's decline in value is attributable to its use, or it being installed ready for use, for a taxable purpose.

Subsection 40-30(1) provides that a depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over time it is used.

Depreciating assets are those items that can be described as plant, which do not form part of the premises. These items are usually:

•         separately identifiable;

•         not likely to be permanent and expected to be replaced within a relatively short period and not part of the structure.

Examples of assets that deductions for decline in value can be applied to include timber flooring, carpets, curtains, appliances like a washing machine or fridge and furniture.

Where a depreciating asset cost less than $300 you are able to claim an immediate deduction rather than depreciate the asset over a period of time where the asset has been used for income producing activity.

The immediate deduction is available if all of the following tests are met in relation to the asset:

•         it cost $300 or less and you used it mainly for the purpose of producing assessable income that was not income from carrying on a business (for example, rental income where your rental activities did not amount to the carrying on of a business of letting rental properties)

•         it was not part of a set of assets costing more than $300 that you started to hold in the income year, and

•         it was not one of a number of identical, or substantially identical, assets that you started to hold in the income year that together cost more than $300.

Capital works

Division 43 of the ITAA 1997 provides a deduction for capital works. Capital works includes buildings and structural improvements, and also extensions, alterations or improvements to building and structural improvements where a residential property is used for income producing purposes pursuant to section 43-20 of the ITAA 1997.

TR 97/23 indicates that expenditure for repairs to property is of a capital nature where:

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

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

•         the work is an initial repair.

Section 43-10 of the ITAA 1997 provides that a taxpayer can only claim a capital works deduction if:

(a) the capital works have a construction expenditure area; and

(b) there is a pool of construction expenditure for that area, and

(c) the taxpayer uses the area in the income year in the way set out in the table in section 43-140 of the ITAA 1997. Broadly, this requires the area to be used to produce assessable income.

In addition, a taxpayer is required to have completed the construction of the capital works before claiming a deduction under Division 43 of the ITAA 1997. Under section 43-30 of the ITAA 1997, a taxpayer is denied a deduction for capital works until construction of the capital works is completed. This is notwithstanding that a taxpayer may use the capital works or part of them before completion.

Apportionment

Paragraph 55 to 57 of TR 97/23 covers repairs done at the same time as improvements. The character of a repair does not necessarily change because it is carried out at the same time as an improvement. It is necessary to examine separately the individual parts of the total project to determine whether any part, if considered in isolation, is a repair. If individual parts of the total project can be separated and characterised as repairs, and if their cost can be segregated and accurately quantified, their cost is deductible. It must be possible to segregate the cost of the repairs actually affected from the capital cost of the improvements.

57. For example, if work normally regarded as a repair, such as painting, is done to property as part of, or in conjunction with, a reconstruction and modernisation of the property, and it cannot be segregated and its cost separately quantified, it may not be deductible. It is again a question of fact and degree.

Application to your circumstances

While the Works may have incorporated to some extent repairs for damage and also for fair wear and tear the Works undertaken to the relevant areas have replaced everything and modernised these areas.

In similar cases where works significantly modernise premises it has been found that the work is not in the nature of a repair. See Case 30 (1951) 2 CTBR (NS) in relation to premises and Case 58 (1956) 6 CTBR (NS) in relation to shop fronts.

As the Works significantly alters and improve the property beyond restoring its original functionality. This suggests an improvement rather than just a repair.

That is, while some parts of the Works might be considered repairs (e.g., replacing faulty fixtures), the Commissioner has considered the extent of the Works and the supporting photos and determined that the overall scope and focus on modernisation lean towards the Works being an improvement.

You should consider if you have separate records of repairs that have been done as part of or in conjunction with the Works that can be segregated and its cost separately quantified. If this is the case these repairs would still be able to be claimed as a repair.

The remainder of the Works will be capital in nature and we have included commentary above to help you determine from these any deductions for the decline in value of depreciating assets under section 40-25 of the ITAA 1997 and any capital works under section 43-20 of the ITAA 1997.

Conclusion

Section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for the cost of repairs to premises used for income producing purposes.

However, subsection 25-10(3) of the ITAA 1997 does not allow a deduction for repairs where the expenditure is of a capital nature.

As such the Commissioner has considered if the Works are repairs or if they are capital in nature and presented from being deducted as repairs.

The Commissioner considers that the Works are capital in nature and the Partnership cannot claim a full deduction for the Works. While small items may be repairs the Works are capital in nature and amount to a substantial improvement of the areas and as such are not repairs. The expenses of the Works are not deductible under section 25-10 of the ITAA 1997.

You should consider if you have separate records of repairs that have been done as part of or in conjunction with the Works that can be segregated and its cost separately quantified. If this is the case these repairs would still be able to be claimed as a repair.

The remainder of the Works will be capital in nature and we have included commentary above to help you determine from these any deductions for the decline in value of depreciating assets under section 40-25 of the ITAA 1997 and any capital works under section 43-20 of the ITAA 1997.

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