Is It Really Black Hole Expenditure? If so, can we claim it?

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1 Is It Really Black Hole Expenditure? If so, can we claim it? David Zweck FTIA PricewaterhouseCoopers David Zweck FTIA 2008 Disclaimer: The material and opinions in this paper are those of the author and not those of the Taxation Institute of Australia. The Taxation Institute of Australia did not review the contents of this presentation and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests. 1

2 What, if anything, is a black hole? In accounting if you spend it you must show it but not always in tax Many situations where a business spends money but gets no tax benefit; i.e. entertainment But other situations not as a direct result of policy intention; i.e. Capital expenditure but no asset to attach the cost to Expenditure before a business commences, or after it ceases What, if anything, is a black hole? The old section of the ITAA1997 tried to implement the recommendations of the 1999 Review of Business Taxation, but was limited to 7 circumstances As a result, some blackhole expenditure remained 2

3 Business Expenditure Revenue Account? Cost Base CGT Asset? Lease Termination Expenses? Cost Base Depreciating Asset? Sec Business Related Costs? Tax Blackhole Overview of changes As part of the Federal Budget, the Treasurer announced that tax relief will be provided for blackhole expenditures that are otherwise not recognised under the income tax laws The changes were effective from 1 July 2005 or for CGT Events happening on or after that date 3

4 Overview of changes The four main changes were to: 1. Expand the cost base and reduced cost base elements for CGT assets; 2. Expand the elements of cost for depreciating assets 3. Provide a five year write off for certain lease and licence termination payments; and 4. Provide a five year write off for a greater range of business related costs not recognised elsewhere in the tax law Business Expenditure Revenue Account? Cost Base CGT Asset? Lease Termination Expenses? Cost Base Depreciating Asset? Sec Business Related Costs? Tax Blackhole 4

5 The expanded cost base for CGT assets Second element (incidental) costs include Marketing expenses Search fees Conveyancing costs: and Borrowing expenses Example of expenditure now included; Marketing expenses would include furniture hire to help sell a rental property The expanded cost base for CGT assets Third element costs include Costs of owning an asset purchased after 20 August 1991 which are non deductible (e.g. R&M, rates insurance, interest) Note: Only includes costs of owning the asset, not costs of becoming the owner. For example would not include travelling expenses to find an asset suitable for purchase Both capital and non capital items may fall for consideration under the third element 5

6 The expanded cost base for CGT assets Fourth element costs include Expenditure to preserve the asset s value is now included as well as expenditure to increase its value The expenditure need not be reflected in the state or nature of the asset at the time of the CGT event Expenditure that relates to installing or moving the asset; and Capital expenditure incurred in relation to goodwill is excluded Exclusions from cost base- Sec (and reduced cost base Sec ) base include Entertainment, penalties and bribes The expanded cost base for CGT assets Fourth element costs example of expenditure now included: Legal and other expenses incurred to preserve the value of a rental property by opposing a nearby development that would adversely affect the rental property s value. Whether successful or not this expenditure would be included 6

7 Business Expenditure Revenue Account? Cost Base CGT Asset? Lease Termination Expenses? Cost Base Depreciating Asset? Sec Business Related Costs? Tax Blackhole Capital expenditure to terminate lease or licence Five year write off applies for expenditure to terminate a lease or licence now contained in Sec Prior to 1 July 2005 capital expense and no asset hence blackhole Only if incurred in the course of carrying on a business or in connection with ceasing to carry on a business Deductions do not apply until the lease is terminated Only applies to operating style leases not leases which confer all the risks and rewards of ownership (need to look at the accounting standards definition) 7

8 Capital expenditure to terminate lease or licence Five year write off applies for expenditure to terminate a lease or licence now contained in Sec (continued) Market value substitution rule where the parties were not at arms length Deduction denied if the termination payment is made to enter into another lease with the same party and the lease is of the same kind as the original one Deduction denied if the termination payment is for the granting of another lease over the same asset that was the subject of the original lease. Capital expenditure to terminate lease or licence Example 1: Write off allowed Beverly holds a 10-year lease for her jewellery store in a shopping centre. After four years of the term of the lease, she finds larger premises across town. Beverley makes a payment to terminate her current lease. The payment is able to be deducted in equal proportions over five years Example 2: Write off not allowed Same facts as above except her current landlord allows her to expand her shop into the vacant premises next door. She is charged a fee which is described as a 50% termination payment for the current lease and 50% payment for the new lease. None of the payments would be deductible under section , but will be included in the cost base of the new lease 8

9 Business Expenditure Revenue Account? Cost Base CGT Asset? Lease Termination Expenses? Cost Base Depreciating Asset? Sec Business Related Costs? Tax Blackhole Expanding elements of cost for depreciating assets Generally, the first element of cost is the amount paid to hold the asset (e.g. purchase price) From 1 July 2005, the range of costs to be included has been broadened to expenditure incurred in relation to (rather than for holding the asset) to holding the asset (e.g. travel costs for the sole purpose of purchasing an asset) From 1 July 2005 the second element costs includes any amount paid after you hold the asset, and which brings the asset into its present condition and location (including costs of improving the asset) It also includes expenses incurred because of a balancing adjustment event occurring for the asset (e.g. the cost incurred to stop holding an asset, advertising, commission, demolition costs) 9

10 Expanding elements of cost for depreciating assets The changes to the definitions of both the first element and second element of cost reduces the extent of the required nexus to holding the asset. Example first element Laura travels overseas to purchase a purpose built vehicle for use in her trade. The purchase of the vehicle is the sole reason for the trip. Laura incurs expenses for airfares and accommodation. These expenses are included in the cost of the vehicle because they are in relation to starting to hold the vehicle Expanding elements of cost for depreciating assets Example second element Leonie needed to replace one of her old depreciating assets that was fixed to her land with a new, more efficient one. Leonie paid a contractor a fee to demolish and remove the old asset. This resulted in a balancing adjustment event occurring for the old asset, and the fee forms part of the second element of the cost of the old asset that was demolished 10

11 Business Expenditure Revenue Account? Cost Base CGT Asset? Lease Termination Expenses? Cost Base Depreciating Asset? Sec Business Related Costs? Tax Blackhole Business related costs Section provides a five year write off for a range of business related costs not recognised elsewhere in the tax law Deductions may be claimed for business costs in equal portions over five years for certain capital expenditure incurred in relation to: 1. Your existing business 2. Your or another entity s business that used to be carried on; or 3. Your or another entity s business that is proposed to be carried on 11

12 Business related costs Your existing business Expenditure can be deducted in relation to a business being carried on by you; Needs to be a business; Investment costs are not business related Being an employee does not make it your business Example Capital expenditure incurred to restructure your business or defend a takeover of your business Business related costs Your (or another entity s) business that used to be carried on Post business expenses that may be deductible include capital expenses incurred to cease carrying on a business and expenses incurred as a consequence of the business ceasing Example Legal costs to terminate the services of an employee If you incur expenditure in relation to a business that another entity carried on, you can deduct the expenditure only to the extent that the expenditure is connected with you deriving assessable income from the business 12

13 Business related costs Your (or another entity s) business that is proposed to be carried on Pre- business expenses that may be deductible includes: Expenditure to investigate the viability of a business (feasibility study costs, due diligence and market research) Establishment costs (e.g. incorporation costs) Business related costs You can only deduct expenditure if the business is, was or is proposed to be carried on for a taxable purpose: Section Definition; The purpose of producing assessable income The purpose of exploration or prospecting; or The purpose of mining site rehabilitation; or Environmental protection activities 13

14 Business related costs Where expenditure is in relation to a proposed business: You don t need to be actually deriving income from the activity at the time the expenditure was incurred You will need to demonstrate commitment of some substance to commence the business Be able to sufficiently identify the business that is proposed to be carried on e.g. A business plan Establishment of business premises Research Capital investment in assets of the business Business related costs Sec is a section of last resort You cannot claim deductions under Sec for the following expenditure: If it forms part of cost of depreciating assets If a deduction is available under some other provision It forms part of the cost of land (whether or not the land is held by the taxpayer) Used to calculate assessable income or deductions or CGT 14

15 Business related costs Sec is a section of last resort (Continued) You cannot claim deductions under Sec for the following expenditure: It would be specifically non deductible Private or domestic nature or incurred in gaining or producing exempt income or NANE It is a return of capital or a return of a non assessable amount (e.g. dividends or repayment of loan principal) Business related costs Interaction with non commercial loss provisions Division 35 applies to business activities of individuals, operating alone or in partnership Ensures that losses from non commercial business activities cannot be offset against other assessable income unless one of three tests is passed; Assessable income test Profits test Real property test Other assets test 15

16 Business related costs Interaction with non commercial loss provisions (continued) Div 35 applies to both pre-business and post-business expenditure Cannot claim an amount under Section in an income year before the year in which the business activity starts to be carried on May offset quarantined amounts in year when one of the tests is passed Cessation of business without ever meeting one of the tests mean amounts not being deductible at all Lease or other legal or equitable right Review of Business Taxation discussion paper stated; Leases and rights are essentially arrangements for transferring some or all of the benefits of ownership of an asset from the owner to the recipient of the lease or right. The following kinds of rights contracts are covered by the discussion: Leasing and similar contracts which provide rights over physical assets, e.g. leases of equipment Contracts giving rights over intangible assets, such as spectrum licences and rights in films. Patents, copyright, and industrial design Indefeasible rights of use over assets Profits a prendre, that is a right to take a product such as standing timber Contracts for services Restrictive covenants Rights to receivables arising from rights contracts, for example, lease receivables 16

17 Lease or other legal or equitable right Expenditure is excluded from deduction Sec (5) (d) But: Exclusion does not apply to intra-group assets within a consolidated group May be deductible (sec (6)) if merely preserving (not enhancing) the value of goodwill In ATO ID 2007/93 narrow interpretation of exclusion is taken Exclusion does not apply to capital expenditure in relation to a demerger Shares held in relation to the demerger could be a bundle of rights Shares are not the type of rights contemplated in the Review of Business Taxation Goodwill Note the distinction drawn between goodwill preservation and enhancement in Sec (6) in respect of capital expenditure relating to lease or other equitable right and CGT calculations; For CGT all capital expenditure relating to goodwill is excluded from the 4 th element of CGT cost base Capital expenditure that preserves goodwill may attract 20%pa write off Capital expenditure that enhances goodwill may be Blackhole! 17

18 Goodwill Preservation Example Drinkco is a drinks manufacturer only has one product superfizz. Recently their product was tampered with in a supermarket, which has led to a dramatic loss of sales. Drinkco, embarks on a major advertising campaign to restore confidence in their product Firstly, is this expenditure deductible under Sec 8(1)? If not; If capital, excluded from fourth element of cost base as incurred in relation to goodwill Not excluded under Sec as expenditure is to preserve goodwill not to enhance it Road-testing certain transactions- Building Demolition Costs Aco owns land with a building including depreciating assets. Aco incurs $1 million to demolish the current building structure, and incurs $20 million in constructing a new building Consider a claim for undeducted construction expenditure under section Cost of demolition that is attributable to the depreciating assets should fall within the expanded second element of cost (expenditure reasonably attributable to a balancing adjustment event occurring for the asset). This effectively allows a portion of the demolition costs to be taken into account in working out the balancing adjustment Balance of demolition costs will form part of the cost base (fourth element) of the land. One would expect that the purpose of the demolition of the building would be at least maintain the value of the land if not to increase the value of land 18

19 Road-testing certain transactions- Travel costs Aco travels interstate to inspect a number property which is subsequently purchased and incurs travel and accommodation costs Travel and accommodation costs are not included in the expanded list of incidental costs contained in Sec As a result, they are not taken into account in calculating a capital gain or capital loss from a CGT event for the purposes of Sec (5) (f) Should be able to claim over 5 years in expenditure incurred in relation to business If costs related to purchase of depreciating assets, will form part of the first element of cost base for Division 40 purposes Road-testing certain transactions- Make good expenses Aco leases a building from Bco. On termination of the agreement, Aco is required to incur $20,000 of expenditure in restoring the premises to their original condition. In accordance with ATOID 2003/738 (now withdrawn), expenditure undertaken to be in relation to restoring the building and not in relation to the lease of premises Sec does not apply as the expenditure does not result in the termination of the lease As such, the expenditure should not be excluded from Sec by virtue of paragraph (5)(d) (in relation to a lease or other legal or equitable right) ATO have stated they do not consider it appropriate to comment as they have sought clarification from Treasury of policy intent as to the nature of leases and rights covered by Sec (5)(d) 19

20 Business Expenditure Revenue Account? Cost Base CGT Asset? Lease Termination Expenses? Cost Base Depreciating Asset? Sec Business Related Costs? Tax Blackhole Summary Can the expenditure be deducted under some provision of the Act or is it specifically non deductible? Can the expenditure be included in the expanded elements of cost base of an asset? Is it expenditure to terminate a lease or a licence? Is it expenditure incurred in relation to holding a depreciating asset? Is there a business that is, was or proposed to be carried on for a taxable purpose? If you are an individual (operating alone or in partnership) do the non commercial loss provisions apply? Do any of the exclusions apply to the expenditure? Do you still have blackhole expenditure? 20