Taxation Ruling

TR 2000/18C5

Income tax: effective life of depreciating assets

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FOI status:

may be released

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 depreciating assets under section 40-100 of the Income Tax Assessment Act 1997 ('the Act').

2. The effective life of a depreciating asset is used to work out the asset's decline in value. To the extent the asset is used for a taxable purpose, a deduction is available, under Division 40 of the Act, for its decline in value.

3. Determinations of the effective life of depreciating assets made by the Commissioner are reproduced in Tables A and B of the attached schedule.

4. You may choose to use the Commissioner's determination of the effective life of a depreciating asset or you may make your own estimate (see section 40-95 of the Act). The explanation of the methodology used by the Commissioner in making determinations 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 Taxation Ruling IT 2685 is withdrawn as of 1 January 2001.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 ceases to be in force from 1 January 2001. If you were using an effective life from Taxation Ruling IT 2685 for the purpose of calculating your deduction for an asset under Division 42 of the Act you can continue to use that effective life for the purpose of calculating your deduction under Division 40 for the asset.

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

Acquisitions of plant pre 21 September 1999

8. For plant:

•

you entered into a contract to acquire,

•

you otherwise acquired, or

•

you started to construct,

before 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999, 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/depreciating assets post 21 September 1999

9. If you start to use other plant or a depreciating asset or have it installed ready for use within five years of the time (the relevant time):

•

you entered into the contract to acquire it,

•

you started to construct it, or

•

you otherwise acquired it,

then the determination of effective life that will apply is the one that was in force at the relevant time (see section 40-95 of the Act).

10. If you do not start to use the plant or depreciating asset or have it installed ready for use within the required five year period as set out in paragraph 9, 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 for any purpose (see section 40-95 of the Act).

Explanations

Context of Commissioner's review

11. 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. The first tranche of the review is contained in the version of this ruling which issued on 21 December 2000. The review is continuing and will take some time to complete.

12. The schedule of effective lives attached to Taxation Ruling IT 2685 was improved by:

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restructuring it;

•

removing duplicate, inappropriate and redundant items;

•

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

•

including new assets.

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

Basic Principles of Depreciation

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

•

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

•

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

15. 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.

16. The current taxation system, through the application of the capital allowances rules in Division 40, for example, already recognises the change in market value of depreciating assets in working out taxable income. In particular, recognising that the loss of market value in most depreciating assets cannot be directly measured, it allows the write off of those assets to be based on an estimate of effective life.

17. 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.

18. Where the estimate is incorrect, the balancing adjustment provisions ensure, in those cases where the depreciating asset has stopped being held or used, 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 a depreciating asset?

19. The Commissioner makes a determination of the effective life of a depreciating asset by estimating the period (in years, including fractions of years) it can be used by any entity for a taxable purpose or for the purpose of producing exempt income (the relevant purposes):

(a)

assuming it will be subject to wear and tear at a rate that is reasonable for the Commissioner to assume; and

(b)

assuming it will be maintained in reasonably good order and condition; and

(c)

having regard to the period within which it is likely to be scrapped, sold for no more than scrap or abandoned (see section 40-100 of the Act).

20. In making a determination, the Commissioner considers the factors in paragraph 21 (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 relative importance of each will vary depending on the nature of the asset. In considering these factors, the Commissioner only takes account of normal industry practices.

21. The factors include:

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the physical life of the asset;

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engineering information;

•

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;

•

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

•

industry standards;

•

the use of the asset by different industries;

•

retention periods;

•

obsolescence;

•

scrapping or abandonment practices;

•

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

•

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

•

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

Physical Life

22. As set out in paragraph 19, subsection 40-100(4) of the Act requires an estimate of the period a depreciating asset can be used by any entity for the relevant purposes. It is arguable that an asset can be used for these purposes while it continues to have a physical existence, that is, until it is physically exhausted.

23. 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 21. Historical physical life is best determined by empirical evidence.

Engineering Information/Manufacturer's Specifications

24. 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 are various 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

25. It is important to note that the Commissioner does not consider that the physical life of an asset is necessarily its effective life because, as previously mentioned, all the 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

26. How intensive an industry uses an asset may impact directly on the asset's effective life. To establish what is the industry norm, industry is consulted wherever possible.

27. Often assets are not used for the relevant purposes for the whole of their life. For example, assets may be retired from use for the relevant purposes 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

28. 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 40-100(4)(b) of the Act requires the Commissioner to assume that an asset will be maintained only in reasonably good order and condition. Accordingly, the effective life of an asset may end when it is no longer economic to maintain it, even though it may still be possible to do so. To establish that point in time the industry norm is considered.

Renewals/Rebuilds

29. Another reason why the level of repairs and maintenance is considered is to see if it is possible to ascertain a point in time when an asset has been wholly or substantially physically replaced. A renewal may be carried out at one point in time or it may be incremental. If an asset has been wholly or substantially physically replaced then it is considered its effective life has ended as it is, in fact, a new asset.

Industry Standards

30. 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. These factors are considered when building up a complete picture of the effective life of an asset.

Use of the asset by different industries

31. 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 relevant 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.

32. 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, the period for which a particular asset can be used by any taxpayer for its intended purpose has been estimated, without regard to the possible subsequent use of the asset by another taxpayer for an entirely different purpose. However, that approach has only been taken where the subsequent change in use is significant and the proceeds received on disposal are small relative to the asset's 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

33. The retention period is the period any one taxpayer generally holds an asset. Subject to paragraph 32, the effective life of an asset is the total period it can be used by any entity for the relevant purposes. That may not necessarily be 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 pre-determined 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 the relevant purposes.

Obsolescence

34. The Commissioner considers obsolescence when determining the effective life of an asset.

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

36. 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.

37. Technology may advance so that another asset is better suited for the relevant purpose for which an existing asset is used. The point to note about technological advances, however, is that an asset's effective life does not necessarily end with each technological advance. A taxpayer can still use an asset for the relevant purposes even though a newer model has come on to the market.

38. Obsolescence is only considered when it prevents the continued use of the asset for the relevant purposes. This is best evidenced by scrapping practices.

39. 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, unpredictable obsolescence cannot be taken into account when making an estimate of effective life. The Commissioner would only take obsolescence into account if it can be predicted with a high level of certainty across a majority of users.

40. Taxpayers faced with predictable obsolescence that impacts only on their business may choose to work out the effective lives of the assets themselves rather than adopt the effective lives determined by the Commissioner.

41. In addition, taxpayers can work out a new effective life under section 40-110 of the Act where facts emerge (e.g. unpredictable obsolescence) during the life of the asset that mean it must be scrapped before its originally estimated effective life has ended.

Scrapping or abandonment practices

42. Once a taxpayer has scrapped or abandoned an asset, there is a presumption it can no longer be used by anyone for the relevant purposes. The scrapping of an asset demonstrates 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.

43. This factor is only relevant to the Commissioner's determination of the effective life of an asset if a general scrapping or abandonment practice can be established 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

44. Because effective life is, among other things, the period a depreciating asset can be used for the relevant 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 of an asset is no shorter than the period it is leased.

Financial Analysis

45. As with lease periods, 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 the relevant purposes by any entity for a much longer time.

Market Value

46. The defining character of a depreciating 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

47. The factors outlined above are essentially the same factors the Commissioner considers you would use if you worked out the effective life of an asset yourself. There is, however, one critical difference.

48. As mentioned in paragraph 20, 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 subsection 40-105(1) of the Act).

49. The Commissioner only makes determinations of 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 or a depreciating asset 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

50. The rates listed in Taxation Ruling IT 2685 were accelerated. Accelerated rates were removed for plant that was acquired or commenced to be constructed after 11.45 am, by legal time in the ACT, on 21 September 1999, except for small business taxpayers who were able to use them until the Simplified Tax System took effect from 1 July 2001.

51. The tables in the schedule attached to this ruling contain only effective lives. Rates have not been included. Working out a rate is not a separate step in the process, but has been incorporated into the calculation formulas: see subsections 40-70(1) (diminishing value) and 40-75(1) (prime cost) of the Act.

Structure

52. 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 and 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.

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

54. The Commissioner's estimate of effective life is set out against each listed asset. Adopting this new structure allows the removal of many duplicated items. For example, in Taxation Ruling IT 2685, motor vehicles are listed both individually and under various industry headings. In the attached schedule they are included only in the asset list. Whilst some assets are included in both tables with the same effective life, this is the exception rather than the norm. Generally, an asset would be included in an industry list only if the Commissioner determined a different effective life for use in that industry.

New and Reviewed Items

55. New and reviewed items have been marked with an asterisk (*) in column 3 of Tables A and B .

Statutory Caps

56. Taxation Laws Amendment Act (No.4) 2002 introduced statutory caps on the Commissioner's determined effective lives for certain assets. Where the Commissioner has determined effective lives for assets in excess of the statutory caps for those assets, they have been marked with a hash (#) in column 3 of Tables A and B .

How to use this schedule

57. 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 .

58. 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 .

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

60. Many of the items that appeared in Taxation Ruling IT 2685 do not appear in Tables A or B . Generally, they have been removed because no effective life was determined for them or the asset is no longer used for relevant purposes.

61. All items that have been removed are listed in Tables C to F of the schedule attached to this Ruling. These tables do not represent re-determinations made by the Commissioner. For easy identification, removed items have been listed exactly as they appeared in Taxation Ruling IT 2685. Removed items fall into four categories:

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no effective life determined;

•

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

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assets for which there were previously statutory rates; and

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redundant assets.

No effective life determined

62. There were approximately 50 assets listed in Taxation Ruling IT 2685 for which no effective life was determined. Most were listed for the purpose of advising that no depreciation was available for them because they were not plant (e.g. 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).

63. These assets have been removed because their listing in tables setting out the Commissioner's determinations of the effective lives of assets is inappropriate. Tables A and B are confined to the determinations the Commissioner is authorised to make under section 40-100 of the Act - i.e. determinations specifying the effective life of depreciating assets.

64. Table C lists the assets that have been removed because no effective life was determined for them.

Replacements

65. 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).

66. Taxation Ruling IT 2685 contained approximately 100 entries for assets the cost of which was only deductible on a replacements basis. There were a further 17 assets where the replacements basis was an alternative to an effective life write-off.

67. In 1991, the law was amended to allow an immediate write-off for plant costing $300 or less or having an effective life of less than three years. At that time, the administrative practice of allowing a deduction on a replacements basis for plant that was otherwise immediately deductible because of those provisions was no longer relevant (see paragraph 63 of Taxation Ruling IT 2685).

68. For some taxpayers, the $300 immediate write-off provisions were replaced with a new system which applied from 1 July 2000 (see Subdivision 42-M of the Act). Division 40 introduced a similar system from 1 July 2001 for depreciating assets. It allows certain taxpayers to pool assets costing less than $1,000 each and to write off the assets under the diminishing value method using an effective life of four years (see Subdivision 40-E of the Act).

69. The Simplified Tax System (the STS) is available to small business taxpayers from 1 July 2001. The STS allows 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.

70. The $300 immediate write-off provision was retained for assets used by taxpayers predominantly in deriving non-business income.

71. For these reasons, the replacement basis for deductions is not available for assets you first use (or have installed ready for use) for relevant purposes after 30 June 2000.

72. Replacement only assets have been removed. For those assets for which replacements were an alternative in the schedule attached to Taxation Ruling IT 2685, the effective life remains but the replacement option is no longer available. A list of assets for which replacements used to apply appears in Table D . That table is for information purposes only.

73. In Taxation Ruling IT 2685, under the 'building and construction industry' heading, loose tools had an effective life of five years, with the option of using the replacement basis. Elsewhere, they were listed as replacements and no effective life was specified.

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

Division 42 statutory rates

75. There were two asset categories for which statutory rates applied automatically without having to ascertain effective life. They were employee amenities and assets used for scientific research. These rates have no application now and they have been removed from the schedule. Those items are listed in Table E .

Redundant assets

76. Table F , which is for information purposes only, provides a list of those items which have been identified as redundant.

77. An asset is redundant if it is:

•

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

•

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

•

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

78. If a taxpayer requires an effective life for a depreciating asset that has been removed on the basis that it is redundant, they can work out the effective life themselves.

Horticultural plants

79. Horticultural plants are depreciating assets. The deduction for a horticultural plant is also based on its effective life and is available under Subdivision 40-F of the Act.

80. The methodology used to establish the effective life of a horticultural plant involves a consideration of the factors set out in paragraph 21 to the extent that they are relevant. 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, have been canvassed. Consumer demand for new varieties may cause commercial obsolescence and, therefore, is a major factor in determining the effective life of horticultural plants.

81. 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 will be based on the effective life of the new plant.

Consultation

82. Industry bodies and interested taxpayers have been consulted during the course of the reviews. In addition, the items marked with an asterisk in Tables A and B have been reviewed by an independent panel presently comprising a representative from CPA Australia, the Corporate Tax Association, The Treasury, The Australian Valuation Office and the Australian Taxation Office.

Detailed contents list

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

Commissioner of Taxation
Consolidated as at 1 January 2003

Table A - Effective lives (Industry Categories) - as at 1 January 2003

Table B - Effective lives (Asset Categories) - as at 1 January 2003

Table F - Redundancies - as at 1 January 2003