Taxation Ruling

TR 2000/18C1

Income tax: depreciation effective life

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FOI status:

may be releasedFOI number: I 1021989

Preamble

What this Ruling is about

1. This Ruling discusses the methodology used by the Commissioner of Taxation in making determinations of the effective life of:

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plant under section 42-110 of the Income Tax Assessment Act 1997 ('the Act'); and

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horticultural plants under section 387-177 of the Act.

2. The effective lives specified by the Commissioner determine the rate at which deductions are calculated under the depreciation and horticultural plants write-off provisions.

3. The Commissioner has made written determinations pursuant to sections 42-110 and 387-177 of the Act which come into effect on 1 January 2001. The effective lives specified by the Commissioner in those determinations are reproduced in Tables A and B of the attached schedule.

4. The new determinations will apply to you if you choose to use the Commissioner's determinations of effective life to work out the amount of your deduction. If you do not use the Commissioner's determinations you must make your own estimate of effective life (see sections 42-100 and 387-175 of the Act). The explanation of the Commissioner's methodology may assist taxpayers who choose to make their own estimate of effective life.

Previous Rulings

5. Taxation Ruling IT 2685 is withdrawn as of 1 January 2001.

Determinations

6. The Commissioner's determination of the effective life of plant set out in the schedule to Taxation Ruling IT 2685 cease to be in force from 1 January 2001. If you are already deducting an amount of depreciation for plant based on the effective life specified in the schedule to Taxation Ruling IT 2685, you continue to use that effective life as the basis for your deduction.

7. The date a determination comes into force is set out in column 4 of Tables A and B.

8. The Government has released a New Business Tax System (Capital Allowances) Bill 2000 as an exposure draft. This draft legislation will, among other things, provide greater certainty for taxpayers ulitising the Commissioner's effective life schedule.

Acquisitions of plant pre 21 September 1999

9. The draft legislation will ensure that if the accelerated rates of depreciation set out in section 42-125 apply because you satisfy the provisions of section 42-118, you may use the effective life for the plant set out in Taxation Ruling IT 2685 regardless of when you first use it or have it installed ready for use.

Acquisitions of plant post 21 September 1999

10. This draft legislation will also ensure that if you start to use plant or have it installed ready for use within three years of the time (the relevant time):

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you entered into the contract to acquire it,

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you started to construct it, or

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you otherwise acquired it,

then the determination that will apply is the one that was in force at the relevant time.

11. It also means that if you do not start to use plant or have it installed ready for use within the required three year period as set out in paragraph 10, then the determination that will apply is the one that is in force at the date you first use it or have it installed ready for use.

Explanations

Context of Commissioner's review

12. The Commissioner advised the Review of Business Taxation chaired by John Ralph AO that the ATO would progressively update and expand the effective life schedule attached to Taxation Ruling IT 2685 to ensure it is as representative as possible. This work will take some time to complete.

13. The Commissioner's new determinations represent the first part of the review. The schedule of effective lives attached to Taxation Ruling IT 2685 has been improved by:

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restructuring it;

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removing duplicate, inappropriate and redundant items;

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reviewing, and, where appropriate, updating the effective lives of a limited range of assets; and

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including new assets.

14. As the initial focus has been on structural changes, there has been a limited review of the effective lives contained in Taxation Ruling IT 2685. Most have been repeated in Tables A and B , although we have eliminated the earlier practice of rounding lives to whole years. We will continue to review the repeated items as part of the ongoing work on the update.

15. The review is based on extensive enquiries made by the Australian Taxation Office ('ATO') and the Australian Valuation Office ('AVO') and, in some instances, on reports prepared by independent consultants.

16. Taxation Ruling IT 2685 applied only to units of plant. Table A of the schedule attached to this Ruling contains the first determinations of effective life for horticultural plants. We explain these later.

Basic Principles of Depreciation

17. From an economic point of view, business income arises from two sources:

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net annual flows from business activities associated with the use of business assets and liabilities; and

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the change in the market value of those business assets and liabilities.

18. Subject to tax timing rules for income recognition, increases in the market value of assets and decreases in the market value of liabilities add to business income while decreases in the market value of assets and increases in the market value of liabilities reduce business income.

19. The current taxation system, through the application of the depreciation provisions for example, already recognises the change in market value in working out taxable income. In particular, recognising that the loss of market value in most depreciable assets cannot be directly measured, it allows the write off of plant to be based on an estimate of effective life.

20. Effective life of plant has the meaning given by Subdivision 42-C of the Act. Section 42-105 sets out how you work out the effective life of plant yourself. It is the estimated period plant can be used by any entity for income producing purposes, assuming the plant will be:

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subject to wear and tear at a rate that is reasonable for you to expect when you are working it out having regard to the expected circumstances of your use; and

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maintained in reasonably good order and condition.

21. However, if you conclude that you would be likely to scrap the plant, sell it for scrap or abandon it before the end of the period worked out in paragraph 20, then the effective life will end at the earlier time (subsection 42-105(3)).

22. The deductions based on effective life are intended to reflect an appropriate allowance for the diminution of economic value of an asset over its period of use.

23. Where the estimate is incorrect, the balancing adjustment provisions ensure, in those cases where depreciable assets are disposed of, that the actual loss in value over the period of use is allowed as a deduction.

How does the Commissioner determine the effective life of plant?

24. In making a determination under section 42-110 of the Act, the matters the Commissioner has regard to include, but are not limited to, the same matters you would consider if you worked out effective life yourself under section 42-105, except that the Commissioner considers the application of those matters across a broad range of taxpayers.

25. In conducting a review, the Commissioner considers the factors in paragraph 26 (which are not intended to be exhaustive). Where appropriate, each factor is considered on the basis of historical information and future expectations. No one factor is necessarily conclusive and the weight given to each will vary depending on the nature of the asset. In considering these factors, the Commissioner only takes account of normal industry practices.

26. The factors include:

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the physical life of the asset;

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engineering information;

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the manufacturer's specifications;

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the way in which the asset is used by an industry;

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the past experience of users of the asset;

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the level of repairs and maintenance adopted by users of the asset;

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industry standards;

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the use of the asset by different industries;

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retention periods;

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obsolescence;

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scrapping or abandonment practices;

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if the asset is leased, the period of the lease;

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economic or financial analysis indicating the period over which that asset is intended for use; and

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where the asset is actively traded in a secondary market, conditions in that market.

Physical Life

27. As set out in paragraph 20, subsection 42-105(1) of the Act requires an estimate of the period an unit of plant can be used by any entity for income producing purposes. It is arguable that an asset can be used to produce income while it continues to have a physical existence, that is, until it is physically exhausted.

28. Physical life, therefore, can be seen as the outer limit of an asset's effective life and is a useful starting point for an analysis of all the factors set out in paragraph 26. Historical physical life is best determined by empirical evidence.

Engineering Information/Manufacturer's Specifications

29. An estimate of the physical life of a new asset, however, cannot be based solely on what has occurred in the past. An analysis of engineering information and manufacturer's specifications is important when estimating future physical lives. There is a variety of reasons why the expected life of a new asset may differ from that achieved in the past. These reasons include advances in technology, different construction materials, intensity of use and the levels of repairs and maintenance.

Physical Life/Effective Life

30. It is important to note that we do not consider that the physical life of an asset is necessarily its effective life because, as previously mentioned, all factors must be considered before an estimate of effective life is made. A consideration of these factors may often indicate that an asset's effective life is a period shorter than its physical life.

The way in which an asset is used by an industry/The past experience of users of the asset

31. Just as paragraph 42-105(2)(b) of the Act requires your circumstances of use to be taken into account when you are working out effective life, we also consider circumstances of use of an asset. As mentioned above, intensity of use impacts directly on its life. Where possible, we consult with industry to establish the industry norm for the intensity of use of an asset.

32. Often assets are not used for income producing purposes for the whole of their life. For example, assets may be retired from income producing use but be retained as a source of spare parts. In this instance, their effective life may end at the time they are retired.

Repairs and Maintenance

33. It might be suggested that the life of an asset can be extended indefinitely if there is unlimited expenditure on repairs and maintenance. However, paragraph 42-105(2)(c) of the Act requires you to assume that plant will be maintained only in reasonably good order and condition. Accordingly, the effective life of an asset may end when, from one or more of a variety of causes, it is no longer economic to maintain it, even though it may still be possible to do so. To establish that point in time we consider the industry norm.

Industry Standards

34. There may be industry standards/regulations which set the level of repairs and maintenance that must be carried out. In addition, these standards/regulations may dictate the time at which a particular asset must be retired from use by an industry. We consider these factors when building up a complete picture of the effective life for an asset.

Use of the asset by different industries

35. The use of an asset by different industries is another important factor. The use may be parallel or consecutive. An example of parallel use is the use of a car as a taxi compared to the use of a car for income producing purposes generally. In these circumstances, the Commissioner has determined that the effective lives are different. This reflects the increased wear and tear experienced by a car used as a taxi.

36. The consecutive use of an asset arises where it is used by different taxpayers for different purposes during its physical life. In determining the effective life of some assets, we have estimated the period for which it can be used by any taxpayer for its intended purpose, without regard to the possible subsequent use of the asset by another taxpayer for an entirely different purpose. However, we have taken that approach only where the subsequent change in use is significant and the proceeds received on disposal are small relative to its original cost. An example of this is a shipping container which, at the end of its effective life as a shipping container, may be used for a variety of other purposes, including as a storage shed. In that situation, the container would, nevertheless, have an effective life in the hands of the purchaser when it commences to be used as a storage shed.

Retention period

37. The retention period is the period any one taxpayer generally holds an asset. Subject to paragraph 36, the effective life of an asset is its total income producing life which is not necessarily the period a particular taxpayer expects to hold it before replacing it. For example, it is common practice for some businesses to dispose of a car after it has done a fixed number of kilometres. The effective life of the car does not end at that time if it can still be effectively used as a car for income producing purposes.

Obsolescence

38. If you are working out the effective life of plant yourself, subsection 42-105(3) of the Act allows you to take into account whether you would be likely to scrap it, sell it for scrap or abandon it before the end of the period it might otherwise be capable of being used for income producing purposes by any entity.

39. This subsection clearly recognises your ability to factor in obsolescence. The Commissioner also considers obsolescence when determining the effective life of an asset.

40. An asset may become obsolete for both commercial and technological reasons.

41. Commercial obsolescence may occur if, for instance, market demand for the goods produced by the asset ceases through consumer preference or Government regulation. It may also occur if the raw material the asset processes becomes unavailable.

42. Technology may advance so that another asset is better suited for the income producing activity for which an existing asset is used. The point to note about technological advances, however, is that we do not necessarily consider that an asset's effective life has ended with each technological advance. A taxpayer can still use an asset for income producing purposes even though a newer model has come on to the market.

43. We consider obsolescence is only relevant when it prevents the continued use of the asset for income producing purposes. This is best evidenced by scrapping practices.

44. There are two types of obsolescence - that which can be predicted at the time the asset is first used (predictable) and that which emerges later (unpredictable). Clearly, we can only take account of predictable obsolescence when making an estimate of effective life. Even then, we would only take it into account if it can be predicted with a high level of certainty across the majority of users.

45. Taxpayers faced with predictable obsolescence which impacts only on their business may choose to work out the effective lives of the assets themselves rather than adopt the effective life specified by the Commissioner.

46. In addition, taxpayers can now work out a new effective life under section 42-112 of the Act where facts emerge (eg unpredictable obsolescence) during the life of the asset that mean it must be scrapped before its originally estimated effective life has ended.

Scrapping or abandoning practices

47. Once a taxpayer has scrapped or abandoned an asset there is a presumption it can no longer be used by anyone to produce income. We would expect scrapping to reflect the fact that the asset is either physically exhausted or obsolete. A taxpayer may abandon an asset if it is too difficult or costly to remove from its place of operation.

48. This factor is only relevant to the Commissioner's determination of the effective life of an asset if we can establish a general scrapping or abandonment practice across users of the asset. Evidence that one group of users traditionally scraps an asset while others do not will not be sufficient to establish the asset as one that is generally scrapped for the purpose of the Commissioner's determination. However, taxpayers within the group that scrapped the asset could choose to work out the asset's effective life themselves.

Lease periods

49. Because effective life is, among other things, the period plant can be used for income producing purposes, it is unlikely that an asset would be leased for a period greater than its effective life. Consideration of this factor will, in many instances, suggest that the effective life is no shorter than the period of the lease.

Financial Analysis

50. As with lease periods, we consider that economic or financial analysis indicating the period over which an asset is intended for use gives guidance that the effective life is no shorter than that period. In many instances, the analysis may only reflect the capital cost recovery period or the term of a contract when in fact the asset may be used for income producing purposes by any entity for a much longer time.

Market Value

51. The defining character of a wasting asset is that its market value actually falls, or is expected to fall, over time. An analysis of the decline of market values of an asset class, therefore, is an important factor together with those set out above to ensure that a determination of effective life provides appropriate deductions.

Working out your own effective life

52. The factors outlined above are essentially the same factors that we consider you would use if you worked out the effective life of an asset yourself rather than adopt the effective life specified by the Commissioner. There is, however, one critical difference.

53. As mentioned in paragraph 25, the Commissioner only takes account of normal industry practices when estimating effective life. However, taxpayers who choose to self-assess can take account of their own particular circumstances of use: see paragraph 42-105(2)(b) of the Act.

54. The Commissioner only determines the effective life of new assets. The purchaser of a second-hand asset, who decides its second-hand condition justifies a shorter life than that determined by the Commissioner, can self-assess. A taxpayer who self-assesses the effective life of plant acquired after 11.45 am, by legal time in the ACT, on 21 September 1999 is no longer required to assume that it is new.

Rates

55. The rates listed in Taxation Ruling IT 2685 were accelerated. The accelerated rates, which are set out in Subdivision 42-D of the Act, now only apply to small business taxpayers who satisfy the conditions in Subdivision 42-K. Those rates will continue to apply for small business taxpayers until the proposed Simplified Tax System takes effect from 1 July 2001.

56. For all other taxpayers, for plant they acquire or commence to construct after 11.45 am, by legal time in the ACT, on 21 September 1999, accelerated rates have been removed: see section 42-118 of the Act.

57. The tables in the schedule attached to this Ruling contain only effective lives. Rates have not been included. Working out a rate is no longer a separate step in the process, but has been incorporated into the calculation formulas: see subsections 42-160(3) (diminishing value) and 42-165(2A) (prime cost) of the Act.

Structure

58. Table A of the attached schedule is an industry table which contains assets under industry headings that have, where possible, been drawn from the Australian New Zealand Standard Industry Classification (ANZSIC) subject categories. The table lists, under each industry heading, specific assets that are peculiar to that industry or for which a special effective life is justified because of the use to which those assets are put by the industry. Under some industry headings, the list of assets also contains a general grouping or class of assets that is identified by reference to the specific industry function or process for which the assets are employed.

59. Table B is an asset table which contains generic assets which may be used by more than one industry.

60. We have set out the Commissioner's estimate of effective life against each listed asset. Adopting this new structure allows the removal of many duplicated items. For example, in Taxation Ruling IT 2685, we have listed motor vehicles both individually and under various industry headings. In the attached schedule we have included them only in the asset list. We would include them in an industry list only if we were to give them a different effective life for use in that industry.

61. We have marked new items and items we have reviewed with an asterisk (*).

How to use this schedule

62. The entries for the effective life of assets listed under a particular industry in Table A must only be used by members of that industry. If an asset is listed in Table A under a particular industry heading and also in Table B , then you must use the industry table if you are a member of that industry. Taxpayers not in that industry must use Table B .

63. If an asset used by an industry member is not listed under its industry heading, either specifically or under the general functional group/class, then the member should use the effective life of the asset listed in Table B .

64. If an asset is not listed in either Table A or B then the Commissioner has not determined its effective life and you will need to work out its effective life yourself.

Removal of items listed in Taxation Ruling IT 2685

65. Many of the items that appear in Taxation Ruling IT 2685 do not appear in the attached schedule. Generally, we have removed them because no effective life is set for them or the asset is no longer used for income producing purposes.

66. We have listed all items that we have removed in Tables C to F of the schedule attached to this ruling. For easy identification, we have listed them exactly as they appear in Taxation Ruling IT 2685. These tables do not represent re-determinations made by the Commissioner. We have divided assets that we have removed into four categories:

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non-depreciable assets;

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assets for which a deduction was allowed using the replacements method;

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assets for which there were previously statutory rates; and

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redundant assets.

Non-depreciable assets

67. There are approximately 50 assets listed in Taxation Ruling IT 2685 for which no effective life is set. Most were listed for the purpose of advising that no depreciation is available for them because they are not plant (e.g., they are livestock governed by the trading stock provisions or buildings or structures) or, in one case, because the taxpayer leased the plant (see boot and shoe-making machinery leased by taxpayer).

68. We have removed these assets because their listing in a Commissioner's determination of the effective lives of assets is inappropriate. The schedule is confined to the determinations the Commissioner is authorised to make under sections 42-110 and 387-177 of the Act - i.e., determinations specifying the effective life of assets.

69. Table C of the attached schedule lists the assets we have removed because no effective life is set for them.

Replacements

70. It had been a longstanding practice to permit taxpayers to treat the initial purchase of certain assets as not depreciable but to claim an immediate deduction for the cost of their replacement. The practice principally related to low cost items that had very long or indeterminate lives, were difficult to keep track of, and were subject to frequent replacement through loss or breakage (e.g., crockery).

71. Taxation Ruling IT 2685 contains approximately 100 entries for assets the cost of which is only deductible on a replacements basis. There are a further 17 assets where we offer the replacements basis as an alternative to an effective life write-off.

72. In 1991, the law was amended to allow an immediate write-off for assets costing $300 or less or having an effective life of less than three years. At that time, we discontinued our administrative practice of allowing a deduction on a replacements basis for plant that was otherwise immediately deductible because of those provisions (see paragraph 63 of Taxation Ruling IT 2685).

73. For some taxpayers, the $300 immediate write-off provisions have been replaced with a new system which applies from 1 July 2000. That system allows certain taxpayers to pool units of plant costing less than $1,000 each and to write off the pool under the diminishing value method using an effective life of four years. (see Subdivision 42-M of the Act).

74. The Government is proposing Simplified Tax System ( the STS) for small business taxpayers to apply from 1 July 2001. The STS will remove both the previous accelerated rates and the $300 immediate write-off which remained available for those taxpayers. The STS will also allow eligible taxpayers who decide to use it an immediate write-off for depreciating assets costing less than $1,000, and pooling arrangements for other depreciating assets.

75. The Government has also announced that the $300 write off for depreciating assets used by taxpayers predominantly in deriving non-business income will be reinstated with effect from 1 July 2000.

76. For these reasons, the replacement basis for deductions will not be available for assets you first use (or have installed ready for use) for the purpose of producing assessable income after 30 June 2000.

77. We have completely removed replacement only assets. For those assets for which replacements are offered as an alternative in the schedule attached to IT 2685, the effective life remains but we have removed the replacement option. A list of assets for which replacements used to apply appears in Table D of the attached schedule.

Loose tools

78. In Taxation Ruling IT 2685, under the 'building and construction industry' heading, we give loose tools an effective life of five years, with the option of using the replacement basis. Elsewhere, we simply list them as replacements and do not suggest an effective life.

79. The Commissioner's new determination specifies that the effective life of all loose tools is five years.

Division 42 statutory rates

80. There are two asset categories for which statutory rates have applied automatically without having to ascertain effective life. They are employee amenities and assets used for scientific research. For the reasons discussed below, these rates now have little or no application and we have, therefore, removed from the schedule the items to which they pertain. We have listed those items in Table E .

Employee amenities

81. Employee amenities are plant used mainly for providing clothing cupboards, first aid, rest-room or recreational facilities, meals or facilities for meals for employees or their children. Their depreciation rate is 33% prime cost and 50% diminishing value (see section 42-150 of the Act).

82. These rates are not linked to the effective life of the plant and they are clearly set out in the Act. They now only apply to small business taxpayers. For all other taxpayers, for plant they acquire or commence to construct after 11.45 am, by legal time in the ACT, on 21 September 1999, these rates have been removed and the depreciation rate is determined by the effective life of the plant.

83. For these reasons, we have removed the entries relating to employee amenities. Taxpayers will need to work out the effective life of plant that is no longer covered by the statutory rate.

Scientific research

84. For plant used only for scientific research in the fields of natural or applied science the prime cost rate is 33% and diminishing value rate is 50% (see section 42-145 of the Act). However, these rates only apply to plant acquired before 1 July 1995. Therefore, we have also removed entries in the schedule relating to them.

Redundant assets

85. We have listed in Table F , which is for information purposes only, those items of plant in Taxation Ruling IT 2685 which we have so far identified as redundant.

86. We consider an asset is redundant if it is:

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no longer used for income producing purposes (e.g., accounting machines, drays, wagons, buggies);

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no longer manufactured (e.g., radiograms); or

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in the process of being overtaken by technology (e.g., gramophone records, which have been largely replaced by compact discs).

87. If a taxpayer requires an effective life for an item of plant that we have removed on the basis that it is redundant, they can work out the effective life themselves.

Horticultural plants

88. A special write-off of the capital expenditure attributable to the establishment of a horticultural plant is available under Subdivision 387-C of the Act. The write-off rate depends on the plant's effective life.

89. Taxpayers have the choice of using the Commissioner's determination of effective life or of working out their own effective life (see section 387-175 of the Act). Prior to this ruling, the Commissioner had not made any determinations of the effective lives of horticultural plants.

90. The Commissioner has made his determination of the effective life of horticultural plants specified in the attached schedule by estimating the period for which the plant could reasonably be expected to be used for the purpose of producing assessable income in a horticulture business (see sections 387-170 and 387-175 of the Act).

91. The methodology we use to establish the effective life of a horticultural plant involves a consideration of the factors set out in paragraph 26 to the extent that they are relevant. We canvass issues such as the varieties and location of plants grown, the age planted out, the years required to come into production and the number of years production was anticipated. Consumer demand for new varieties may cause commercial obsolescence and, therefore, is a major factor in determining the effective life of horticultural plants.

92. Crop management techniques, such as regeneration and topworking/reworking, where trees are cut back to the stump, have also been taken into account in determining the effective life of horticultural plants. Where topworking/reworking involves grafting a new variety onto the old root system, with the result that a new plant has been established, deductions for capital expenditure incurred in establishing the new plant will be based on the effective life of the new plant.

Date of effect of determinations for plant

93. In each of the following examples, we have assumed that the taxpayer has decided to use the effective life specified by the Commissioner, none are small business taxpayers as defined in Subdivision 960-Q of the Act and the assets are not able to be pooled.

Example 1

94. XXX Ltd constructed a unit of plant and construction started on 19 September 1999. Regardless of when the plant is first used or installed ready for use, XXX Ltd will be able to apply the general (accelerated) rates set out in section 42-125 of the Act for that plant based on the effective life specified in Taxation Ruling IT 2685. This is because XXX Ltd started to construct that plant before 21 September 1999 (paragraph 42-118(1)(b)).

Example 2

95. XXX Ltd constructed a unit of plant and construction started on 1 May 2000. If the company uses the plant within three years of the date construction started it must use the effective life for that plant set out in Taxation Ruling IT 2685. If the plant is not used within three years it must use the effective life specified in the Commissioner's determination that is in force when the plant is first used or installed ready for use.

Example 3

96. John acquires an asset after 1 January 2001 and commences to use it immediately for income producing purposes. He must use the appropriate effective life specified in the schedule attached to this Ruling (and not the effective life specified in the schedule attached to Taxation Ruling IT 2685).

97. His deduction is based on the effective life of the asset. It is worked out in accordance with the calculation formula in either subsection 42-160(3) of the Act (if he is using the diminishing value method) or subsection 42-165(2A) (if he is using the prime cost method).

Consultation

98. We have consulted industry bodies and interested taxpayers during the course of the review. In addition, the items marked with an asterisk in the attached schedule have been reviewed by an independent panel comprising a representative from the Taxation Institute of Australia, the Corporate Tax Association, The Treasury, The Australian Valuation Office and the Australian Taxation Office.

Detailed contents list

99. Below is a detailed table of contents for this Ruling:

This is the last Taxation Ruling for the 2000 calendar year. The next Ruling will be Taxation Ruling TR 2001/1.

Commissioner of Taxation
21 December 2000

Table A - Effective lives (Industry Categories)

Table B - Effective lives (Asset Categories)

Table C - No effective life set

Table D - Replacements

Table E - Statutory rates

Table F - Redundancies