What is a prepaid expense?
A prepaid expense is expenditure you incur under an agreement for something to be done (in whole or in part) in a later income year.
If you incurred expenditure for something that was to be done in full within this income year, that is, 1 July 2019 to 30 June 2020, it is not a prepaid expense and the prepayment rules do not apply.
Example: Expenditure that is not a prepaid expense
Jasmin is a solicitor. On 1 July 2019, she paid $1,500 for an annual subscription for the monthly provision of a professional journal. The subscription covers the period 1 July 2019 to 30 June 2020. The prepayment rules will not apply because the provision of the professional publication will be completed in 2019–20.End of example
What are the prepayment rules?
The prepayment rules alter the timing of deductions for certain prepaid expenses. These rules apply to prepaid expenses that would ordinarily be immediately deductible in full in the year in which they are incurred.
Generally, a prepaid expense is deductible over the ‘eligible service period’. The ‘eligible service period’ cannot exceed 10 years.
A prepaid expense may be immediately deductible if:
- it is ‘excluded expenditure’
- ‘the 12-month rule’ applies
- it relates to a ‘pre-RBT (Review of Business Taxation) obligation’.
The prepayment rules only apply to amounts that would be deductible under the general deduction provision or certain research and development (R&D) provisions.
Special rules apply to prepayments under tax shelter arrangements.
What is the ‘eligible service period’?
The eligible service period is the period during which the thing is to be done under the agreement in return for the expenditure.
The eligible service period begins on:
- the day the thing under the agreement begins to be done, or
- on the day the expenditure is incurred, whichever is later.
The eligible service period continues until the end of the last day the thing under the agreement ceases to be done or 10 years, whichever is earlier.
Example: Eligible service period
Mike runs a delicatessen from leased premises. On 1 December 2019, Mike makes a lease payment to cover the period 1 December 2019 to 31 December 2020. The eligible service period for this expenditure therefore starts on 1 December 2019 and ends on 31 December 2020, a period of 397 days.
Mike’s income year ends on 30 June of each year. The prepayment rules will apply as the provision of premises by the lessor is not wholly done within the expenditure year.End of example
What is ‘excluded expenditure’?
Certain types of expenditure are excluded from the prepayment rules. These are:
- amounts of less than $1,000 (excluding input tax credits)
- amounts required to be incurred by a court order or law of the Commonwealth, state or territory
- payments of salary or wages (under a contract of service)
- amounts that are capital, private or domestic in nature (except certain research and development amounts)
- certain amounts incurred by a general insurance company in connection with the issue of policies or the payment of reinsurance premiums.
Example: Expenditure required to be incurred under a state law
John operates a cartage business and pays $1,200 on 31 December 2019 to register his truck for 12 months from 1 January 2020 – 31 December 2020. The truck is used exclusively for business purposes. Although the registration fee is over $1,000 and it covers a period spreading across more than one income year, it is excluded expenditure. This is because it is required to be incurred under a state or territory law. The prepayment rules do not apply to this type of expenditure and the fee is deductible in the year it is incurred.End of example
Example: Expenditure incurred by an entity that is registered for GST
Maree is registered for GST. On 30 June 2020 she prepays expenditure for services to be provided by another registered entity over the period 1 July 2020 – 30 June 2022.
The services to be provided are a taxable supply and Maree has acquired the services solely for a creditable purpose. The amount of the prepaid expenditure is $1,045, which includes GST of $95.
Maree’s prepaid expenditure is tax deductible (a deductible loss or outgoing). Maree has met the requirements to be entitled to an input tax credit. The prepaid expenditure will be reduced by the input tax credit of $95 so the prepaid expenditure amount is $950. As the $950 prepaid expenditure is less than $1,000, it is excluded expenditure and deductible in the year ended 30 June 2020.End of example
What is ‘the 12-month rule’?
If you are a small business entity, or an individual incurring deductible non-business expenditure you can claim an immediate deduction. You can claim the deduction under the 12-month rule for prepaid expenditure if:
- the payment is incurred for an eligible service period not exceeding 12 months
- the eligible service period ends in the next income year.
Prepaid expenditure incurred under certain managed investments (tax shelter arrangements) is not eligible for the 12-month rule. If the 12-month rule does not apply, your deduction for prepaid expenditure is apportioned over the eligible service period or 10 years, whichever is less.
- Small business entities
- Individual taxpayers incurring deductible non-business expenditure
- Investments in tax shelter arrangements
What is a ‘pre-RBT obligation’?
A pre-RBT obligation is any contractual obligation that:
- exists under an agreement at or before 11.45am (by legal time in the ACT) on 21 September 1999, the date of the government’s release of the Review of Business Taxation (RBT)
- requires you to make a prepayment in return for something to be done under the agreement
- cannot be avoided by your own actions.
There are rules for deducting prepaid expenses incurred under a pre-RBT obligation. The rules are the same as those for small business entities that have chosen to claim an immediate deduction.
The prepayment rules apply only to expenditure which would otherwise qualify for immediate deduction:
- under the general deduction provisions of section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), or
- for eligible companies, under the R&D provisions in sections 355-205 (R&D expenditure) or 355-480 (earlier year associate R&D expenditure) of the ITAA 1997.
The prepayment rules do not apply where the expenditure is deductible under a specific deduction provision of the tax law other than those for R&D (that is, other than sections 355-205 or 355-480 of the ITAA 1997).
The general deduction provisions generally allow you to deduct from your assessable income any loss or outgoing incurred in:
- gaining or producing your assessable income, or
- carrying on a business.
You cannot claim a deduction under these provisions for expenditure:
- of a capital, private or domestic nature, or
- incurred in gaining exempt income.
Unless specifically stated otherwise, expense and expenditure refer to expenditure that is only allowable as a deduction under the general deduction provisions of section 8-1 of the ITAA 1997 or, for eligible companies, under the R&D provisions in sections 355-205 or 355-480 of the ITAA 1997.
R&D expenditure prepaid before 1 July 2011
Sections 355-205 and 355-480 of the ITAA 1997 apply to R&D expenditure incurred since 1 July 2011. Undeducted amounts of prepaid expenditure incurred prior to 1 July 2011, but taken to be incurred over the eligible service period to which they relate, may be a deduction under the transitional rules for the R&D tax incentive for income years beginning on or after 1 July 2011. The expenditure must be incurred on activities that the company has registered under section 27A of the Industry Research and Development Act 1986 for the relevant year.