What is a prepaid expense?
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A prepaid expense is expenditure you incur for things to be done (in whole or in part) in a later income year. If expenditure is incurred for something to be done in full within the same income year, it is not a prepaid expense to which the prepayment rules apply.
Expenditure not constituting a prepayment
Jasmin is a solicitor. On 1 July 2003, she paid $1,500 annual subscription for the monthly provision of a professional journal. The subscription covers the period 1 July 2003 to 30 June 2004. Because the thing to be done under the agreement - the provision of the professional publication - will be completed wholly within the expenditure year the prepayment rules will not apply.
What are the prepayment rules?
Generally, a prepaid expense is deductible over the eligible service period, or 10 years if that is less, rather than being immediately deductible. However, a prepaid expense may be immediately deductible if:
- it is excluded expenditure
- the 12-month rule applies, or
- it relates to a pre-Review of Business Taxation (RBT) obligation.
The prepayment rules only apply to expenditure deductible under the general deduction provisions or under the research and development provisions.
Special rules apply to prepayments under tax shelter arrangements and for certain prepaid expenditure under plantation forestry managed agreements.
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.
Eligible service period
Mike runs a delicatessen from leased premises. On 1 December 2003, Mike made a lease payment to cover the period 1 December 2003 to 30 November 2004. The eligible service period for this expenditure therefore started on 1 December 2003 and will end on 30 November 2004, a period of 366 days.
Mike's income year ends on 30 June of each year. As the thing to be done under the agreement (the provision of premises by the lessor) is not wholly done within the expenditure year the prepayment rules will apply.
What is excluded expenditure?
Certain types of expenditure are excluded from the prepayment rules. These are:
- amounts of less than $1,000
- amounts required to be paid by a Commonwealth, state or territory law or by a court order
- payments of salary or wages (under a contract of service)
- amounts that are capital, private or domestic in nature, and
- certain amounts incurred by a general insurance company in connection with the issue of policies or the payment of reinsurance premiums.
Amount required to be paid under a state law
John operates a cartage business and paid $1,200 on 31 December 2003 to register his truck for 12 months from 1 January 2004 to 31 December 2004. 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 paid 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 paid.
What is the 12-month rule?
If you are a simplified tax system (STS) taxpayer, or an individual incurring deductible non-business expenditure, you can claim an immediate deduction under the 12-month rule for prepaid expenditure if the payment is incurred for an eligible service period not exceeding 12 months and the eligible service period ends in the next income year. For more information on STS taxpayers, see chapter 5 and on deductible non-business expenditure incurred by individuals, see chapter 4.
Prepaid expenditure incurred under certain managed investments (tax shelter arrangements) is not eligible for the 12-month rule. For more information about tax shelter arrangements, see chapter 2.
Certain prepaid expenditure incurred under an investment in a plantation forestry managed agreement is eligible for the 12-month rule. For more information see chapter 3.
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.
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, and
- cannot be avoided by your own actions.
The rules for deducting prepaid expenses incurred under a pre-RBT obligation are the same as those explained for taxpayers who are in the simplified tax system (STS), see chapter 5.
Expenditure must be deductible under the general deduction provisions or the research and development provisions
The prepayment rules only apply 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 research and development provisions in sections 73B, 73BA, 73BH or 73Y of the Income Tax Assessment Act 1936 (ITAA 1936).
The general deduction provisions generally allow you to deduct from your assessable income any loss or outgoing to the extent that it is either incurred in gaining or producing your assessable income, or is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. Expenditure of a capital, private or domestic nature, or expenditure incurred in gaining exempt income, is specifically excluded from being deductible under these provisions. The prepayment rules do not apply if the expenditure is deductible under a specific deduction provision of the tax law other than those for research and development referred to in the previous paragraph.
Unless specifically stated otherwise, the terms 'expense' and 'expenditure' used throughout this guide refer to expenditure that is only allowable as a deduction under the general deduction provisions of section 8-1 of ITAA 1997 or, for eligible companies, under the research and development provisions in section 73B 73BA, 73BH or 73Y of ITAA 1936.
Transitional rules - residual application
Transitional arrangements apply to certain prepayments that are not immediately deductible under the prepayment rules. The concession treatment available under these arrangements concerned expenditure incurred during the four income years beginning with the income year that included 21 September 1999 (usually the 1999-2000 income year) where the eligible service period ended not more than 13 months after the expenditure was incurred.
The transitional rules automatically expired in the first income year starting after 21 September 2002 (usually the 2002-03 income year).
If under the transitional rules, you were entitled to deduct 20% of the capped later year amount of a prepayment in 2002-03, the balance (80%) of that amount is deductible in 2003-04.
If part of the prepaid expenditure was not deductible as a current year amount in 2002-03 or as a proportion of the later year amount in 2002-03 and 2003-04, that residual (the excess of the later year amount over the upper limit eligible for concessional treatment) is allowed as a deduction proportionately over the eligible service period.
Last modified: 17 Jun 2005QC 27546