The cost of a depreciating asset

To work out the decline in value of a depreciating asset, you need to know its cost.

Under the UCA, the cost of a depreciating asset has two elements.

The first element of cost is, generally, amounts you are taken to have paid to hold the asset, such as the purchase price. It also includes amounts incurred after 30 June 2005 that you are taken to have paid in relation to starting to hold the asset. The amounts must be directly connected with holding the asset.

The first element of cost is worked out as at the time you begin to hold the asset.

The second element of cost is, generally, amounts you are taken to have paid after that time to bring the asset to its present condition and location, such as a cost of improving the asset. It also includes expenses incurred after 30 June 2005 in relation to a balancing adjustment event occurring in relation to the asset (that is, costs incurred to stop holding or using the asset) - see What happens if you no longer hold or use a depreciating asset? for information on balancing adjustment events. Such expenses may include advertising or commission expenses or the cost of demolishing the asset.

The first element of a depreciating asset's cost cannot include an amount that forms part of the second element of cost of another depreciating asset. For example, if a depreciating asset is demolished so another depreciating asset can be installed on the same site, the demolition costs will form part of the second element of cost of the asset demolished. The amount is not also included in the first element of cost of the new asset.

Example: First and second elements of cost - ignoring any GST impact

Terry wants to buy a vehicle for his business and the vehicle is not available in Australia. He locates a company in the United States from which he would be able to purchase the vehicle. He travels to the United States for the sole purpose of buying the vehicle and incurs travel costs of $5,000. Terry purchases the vehicle for $45,000.

The first element of cost is $50,000. This amount includes the purchase cost of the vehicle and the travel costs. The travel costs would be included in the first element of cost of the vehicle because they are directly connected with Terry starting to hold the vehicle. If Terry installs an alarm in the vehicle two months later at a cost of $1,500, that amount will be included in the second element of cost of the vehicle as the cost was incurred after he began to hold the vehicle.

For both first and second elements of cost of a depreciating asset, amounts you are taken to have paid include:

• an amount you pay
• the market value of a non-cash benefit you provide
• if you incur or increase a liability to pay an amount - the amount of the liability or increase
• if you incur or increase a liability to provide a non-cash benefit - the market value of the non-cash benefit or the increase
• if all or part of another's liability to pay you an amount is terminated - the amount of the liability or part terminated
• if all or part of another's liability to provide a non-cash benefit (except the depreciating asset) to you is terminated - the market value of the non-cash benefit or part terminated.

The cost of a depreciating asset does not include:

• amounts of input tax credits to which you are or become entitled - see GST input tax credits
• expenditure not of a capital nature, or
• any amount that you can deduct or that is taken into account in working out a deductible amount under provisions outside the UCA.

Example: Expenditure not of a capital nature and deductible outside the UCA

Carolyn uses a motor vehicle for her business. As a result of Carolyn's use of the vehicle, she needs to replace the tyres. The cost of replacing the tyres is not included in the second element of the vehicle's cost because it would ordinarily be deductible under the repair provisions.

There are special rules to work out the cost of depreciating assets in certain circumstances. Some of the common cases are covered below. If you are not sure of the cost of a depreciating asset, contact the ATO or your recognised tax adviser.

GST input tax credits

If the acquisition or importation of a depreciating asset constitutes a creditable acquisition or a creditable importation, the cost of the asset is reduced by any input tax credit you are, or become, entitled to for the acquisition or importation. If you become entitled to the input tax credit in an income year after the one in which the asset's start time occurred, the asset's opening adjustable value is also reduced by the amount of the input tax credit.

If the cost of a depreciating asset is taken to be its market value (such as for assets acquired under a private or domestic arrangement), the market value is reduced by any input tax credit to which you would be entitled had the acquisition been solely for a creditable purpose.

Similarly, any input tax credit you are entitled to claim in relation to the second element of a depreciating asset's cost reduces the cost of the asset. Its opening adjustable value is also reduced if you become entitled to the input tax credit in an income year after the one in which the asset's start time occurred.

Certain adjustments under the GST legislation reduce or increase the cost and, in some cases, the opening adjustable value of the asset. For example, these can commonly arise in the event of a change in price or because of the application of volume discounts. Other adjustments are treated as an outright deduction or income.

Jointly held depreciating assets

If a depreciating asset is held by more than one person, each holder works out their deduction for the decline in value of the asset based on the cost of their interest in the asset and not the cost of the asset itself.

Car limit

Cars designed mainly for carrying passengers are subject to a car limit. If the first element of cost exceeds the car limit for the financial year in which you start to hold it, that first element of cost is reduced to the car limit.

The car limit for 2009-10 is $57,180.

Before applying the car limit you may need to:

• increase the cost of the car if you acquired the car at a discount - see Car acquired at a discount
• reduce the cost of the car by input tax credits - see GST input tax credits.

If a car with a cost exceeding the car limit is held by more than one person, the car limit is applied to the cost of the car and not to each holder's interest in the car. Once the car limit has been applied, the cost of the car (reduced to the car limit) is apportioned between each holder's interest. Each holder then works out their deduction for the decline in value of the car - see Jointly held depreciating assets.

The car limit also applies under the luxury car lease rules - see Leased luxury cars.

The car limit does not apply in certain circumstances to some cars fitted out for transporting disabled people.

When a balancing adjustment event occurs in relation to the car, the termination value must be adjusted under a special formula - see Balancing adjustment rules for cars.

Car acquired at a discount

If a car is acquired at a discount, the first element of its cost may be increased by the discount portion. The discount portion is any part of the discount that is due to the sale of another asset for less than market value - for example, a trade-in.

A car's cost is not affected by a discount obtained for other reasons.

The adjustment is only made if the cost of the car (after GST credits or adjustments) plus the discount portion exceeds the car limit and if you or another entity has deducted or can deduct an amount for the other asset for any income year.

This rule does not apply to some cars fitted out for transporting disabled people.

When a balancing adjustment event occurs in relation to the car, the termination value must be increased by the same discount portion - see Balancing adjustment rules for cars.

Example: Car acquired at a discount - ignoring any GST impact

Kristine arranges to buy a $60,000 sedan for business use from Greg, a car dealer. She offers the station wagon she is using for this purpose, worth $20,000, as a trade-in. Greg agrees to reduce the price of the sedan to below the car limit if Kristine accepts less than market value for the trade-in. Kristine agrees to accept $15,000 for the trade-in and the price of the sedan is reduced to $55,000 (that is, a discount of $5,000).

The cost of the car plus the discount is more than the car limit so the first element of the car's cost is increased by the amount of the discount to $60,000. As the first element of cost then exceeds the car limit, it must be reduced to the car limit for the income year. The termination value of the wagon would be taken to be the market value of $20,000 as Kristine and Greg were not dealing at arm's length - see Termination value.

Non-arm's length and private or domestic arrangements

The first element of a depreciating asset's cost is the market value of the asset at the time you start to hold it if:

• the first element of the asset's cost would otherwise exceed its market value and you do not deal at arm's length with another party to the transaction, or
• you started to hold the asset under a private or domestic arrangement (for example, as a gift from a family member).

Similar rules apply to the second element of a depreciating asset's cost. For example, if something is done to improve your depreciating asset under a private or domestic arrangement, the second element of the asset's cost is the market value of the improvement when it is made.

The market value may need to be reduced for any input tax credits to which you would have been entitled - see GST input tax credits.

Note that there are special rules for working out the effective life and decline in value of a depreciating asset acquired from an associate, such as a spouse or partner - see Depreciating asset acquired from an associate.

Depreciating asset acquired with other property

If you pay an amount for a depreciating asset and something else, only that part of the payment that is reasonably attributable to the depreciating asset is treated as being paid in relation to it. This applies to first and second elements of cost.

We generally accept independent valuations as a basis for this apportionment. However, if there is no independent valuation, you may need to demonstrate that your apportionment of the amount paid is reasonable. Apportionment on the basis of the market values of the various items for which the payment is made will generally be reasonable.

Example: Apportionment of cost

Sam undertakes to pay an upholsterer $800 for a new desk and $300 to re-upholster a chair in a more durable material. He negotiates a trade discount of $100. The $1,000 paid should be apportioned between:

based on the relative market values of the desk and the labour and materials used to upholster the chair.

Hire purchase agreements

For income tax purposes, certain hire purchase agreements entered into after 27 February 1998 are treated as notional sale and loan transactions.

If the goods subject to the hire purchase agreement are depreciating assets and the hirer is the holder of the depreciating assets - see Depreciating assets subject to hire purchase agreements - the hirer may be entitled to deductions for the decline in value. Generally, the cost or value stated in the hire purchase agreement or the arm's length value is taken to be the cost of the depreciating assets.

Death of the holder

If a depreciating asset starts being held by you as a legal personal representative (say, as the executor of an estate) as a result of the death of the former holder, the cost of the asset to you is generally its adjustable value on the day the former holder died.

If the former holder allocated the asset to a low-value pool, the cost of the asset to you is the amount of the closing balance of the pool for the income year in which the former holder died that is reasonably attributable to the asset - see Low-value pools for information about low-value pools.

If you start to hold a depreciating asset because it passes to you as a beneficiary of an estate or as a surviving joint tenant, the cost of the asset to you is its market value when you started to hold it reduced by any capital gain that was ignored when the owner died or when it passed from the legal personal representative. See the Guide to capital gains tax 2010 (NAT 4151) for information about when these gains can be disregarded.

Commercial debt forgiveness

Generally, an amount that you owe is a commercial debt if you can claim a deduction for the interest paid on the debt or you would have been able to claim a deduction for interest if it had been charged. The amount of the commercial debt includes any accrued but unpaid interest.

If a commercial debt is forgiven, you may be required to reduce the expenditure that is deductible under the UCA by all or part of the net forgiven amount. If a reduction of the amount of deductible expenditure is made for a depreciating asset, the asset's cost is reduced. If the reduction is made in a year later than the one in which the asset's start time occurs, the opening adjustable value of the asset is also reduced.

If an asset's opening adjustable value is reduced and you use the prime cost method to work out the asset's decline in value, you need to use the adjusted prime cost formula for the income year that the change is made and in later years - see Methods of working out decline in value.

Recoupment of cost

If you recoup an amount that you had previously included in the cost of a depreciating asset, you may need to include that recouped amount in your assessable income. An amount you receive for the sale of a depreciating asset at market value is not an assessable recoupment.

Foreign currency gains and losses

If you purchased a depreciating asset in foreign currency, the first element of the asset's cost is converted to Australian currency at the exchange rate applicable when you began to hold the asset, or when the obligation was satisfied, whichever occurred first. From 1 July 2003, if the foreign currency amount became due for payment within the 24-month period that began 12 months before the time when you began to hold the depreciating asset, any realised foreign currency gain or loss (referred to as a forex realisation gain or a forex realisation loss) can modify the asset's cost, the opening adjustable value, or the opening balance of your low-value pool (as the case may be). Otherwise, that gain or loss is included in assessable income or allowed as a deduction, respectively.

If the foreign currency amount relates to the second element of the cost of a depreciating asset, the translation to Australian currency is made at the exchange rate applicable at the time you incurred the relevant expenditure, and the 12-month rule applies instead of the 24-month rule. The 12-month rule requires that the foreign currency became due for payment within 12 months after the time you incurred the relevant expenditure. In some circumstances you may be able to elect that forex gains and losses do not modify the asset's cost, the opening adjustable value or the opening balance of your low-value pool. For more information, see the publication Forex: election out of the 12 month rule (NAT 9344).

TOFA and the cost of a depreciating assets

If the TOFA rules apply to your financial arrangement and you start or cease to have a financial arrangement (or part) as consideration for acquiring a depreciating asset, the TOFA rules will operate to determine the first element of cost. In general the rules operate to ensure the first element of cost is the market value of the depreciating asset at the time of acquisition.

In the same way, the TOFA rules can also affect the second element of a depreciating asset's cost when the financial arrangement represents consideration for something obtained which is relevant to the second element of cost, for example, capital improvements.

Example: TOFA and the cost of a depreciating asset

Aus Co's financial arrangements are subject to the TOFA rules and it has elected to have these rules apply early, The TOFA rules apply for its income year commencing on 1 July 2009.

Aus Co enters into a contract on 1 July 2009 to buy a depreciating asset from ABC Co for $100,000. Under the terms of the contract, the depreciating asset will be delivered in 6 months time on 1 January 2010 and payment is required on 1 July 2011 (that is, 18 months after delivery). The market value of the depreciating asset on 1 January 2010 is $90,000.

On 1 January 2010 when Aus Co receives the depreciating asset it will start to have a financial arrangement as its only subsisting right or obligation under the contract is a cash settlable obligation to pay for the acquisition of the depreciating asset. The TOFA rules will operate so that Aus Co is taken to have provided an amount equal to the market value of the depreciating asset when it is acquired. Therefore, Aus Co's first element of cost of the depreciating asset will be $90,000. This will also be the 'cost' of Aus Co's financial arrangement under which it makes a loss of $10,000. This loss does not form part of the first element of cost of the depreciating asset.

The TOFA rules also provide for a hedging tax-timing method that allows gains and losses from certain hedging financial arrangements to be recognised and characterised in accordance with the tax treatment of the underlying item being hedged. For example, where a hedging financial arrangement election is in force, gains or losses from a hedging financial arrangement used to hedge against risks in relation to a depreciating asset will be separately recognised when the decline in value is recognised.

Note however that the gain or loss on the hedging financial arrangement will not form part of the cost of the depreciating asset.

Example: TOFA and hedging financial arrangements

XYZ Co's financial arrangements are subject to the TOFA rules and it has elected to have these rules apply early. The TOFA rules apply for its income year commencing on 1 July 2009. In addition, XYZ Co has elected to apply the hedging tax-timing method, and all record-keeping requirements are satisfied including additional tax documentation.

XYZ Co enters into a contract on 1 July 2009 to buy machinery for US$10 million. The parties agree that the machinery will be delivered and paid for on 1 January 2010.

At the time of entering into the contract on 1 July 2009, US$10 million is the equivalent of A$12 million. XYZ Co hedges against the foreign currency risk by entering into a foreign currency forward contract. The forward contract will be settled at the delivery and payment date of the machinery on 1 January 2010.

In accordance with the TOFA rules, XYZ Co determines that the gain or loss on the forward contract will be allocated on the same basis that the cost of the machinery is treated for income tax purposes (that is, in the same way as the decline in value is recognised).

On 1 January 2010, US$10 million is the equivalent of A$13 million. The first element of the cost of the machinery to XYZ Co is A$13 million (the applicable value in Australian dollars when the payment is made). XYZ Co also settles the forward contract at this time, and makes a A$1 million gain on this hedging financial arrangement.

The A$1 million gain does not reduce the cost of the machinery. However this amount will be recognised as assessable income in the same way and over the same period that the decline in value of the depreciating asset is recognised.