House of Representatives

Treasury Laws Amendment (Housing Tax Integrity) Bill 2017

Foreign Acquisitions and Takeovers Fees Imposition Amendment (Vacancy Fees) Bill 2017

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Scott Morrison MP)

Chapter 2 - Limiting depreciation deductions for assets in residential premises

Outline of chapter

2.1 Schedule 2 to the Bill amends the ITAA 1997 to deny income tax deductions for the decline in value of 'previously used' depreciating assets (plant and equipment) an entity uses in gaining or producing assessable income from the use of residential premises for the purposes of residential accommodation.

2.2 However, the amendments do not affect deductions that arise:

·
in the course of carrying on a business; or
·
for corporate tax entities, superannuation plans (other than self managed superannuation funds), public unit trusts, managed investment trusts, and unit trusts or partnerships, all the members of which are entities listed here.

2.3 The proportion of the decline in value of an asset that cannot be deducted is recognised as a capital loss (or in certain circumstances a capital gain) when the asset ceases to be used.

2.4 All legislative references in this Chapter refer to the ITAA 1997 unless otherwise stated.

Context of amendments

Operation of the existing law

2.5 The ITAA 1997 contains different sets of rules for recognising the cost of different types of capital assets. Deductions for depreciating assets - assets that have a limited effective life and can be reasonably expected to decline in value over their period of use (see section 40-30) - are generally governed by the uniform capital allowance rules in Division 40.

2.6 Under these rules, entities may deduct the amount of the decline in value of a depreciating asset over the period they hold the asset during an income year (see section 40-25).

2.7 However, this deduction is only available to the extent that the decline in value of the asset is not attributable to it being used or installed ready for use for a purpose other than a taxable purpose. Taxable purpose include a purpose of producing assessable income (as well as certain purposes relating to mining and environmental protection) (see subsections 40-25(2) and (3)).

2.8 Depreciating assets means plant and equipment - that is, fixtures and fittings that are associated or used in connection with real property but do not merely function as part of the structure of the property (see section 40-30). However, it does not include certain assets that are dealt with specifically in other provisions of the tax law, such as capital works - see sections 40-45 and 40-50.

2.9 Generally, when an entity permanently ceases to use a depreciating asset, such as by selling the asset, a balancing adjustment event occurs. This requires the entity to make a balancing adjustment to its taxable income if the final value of the asset (its termination value as defined in section 40-300) is greater than the cost of the asset reduced by the decline in value of the asset calculated under Division 40 (its adjustable value). The balancing adjustment effectively ensures that the tax benefits the entity has received for holding the asset are aligned with the final valuation of the asset at the time use ceases.

Budget announcement

2.10 In the 2017-18 Budget, the Government announced a package of measures designed to reduce pressure on housing affordability. As part of this package, the tax law is to be amended to improve the integrity of the tax system in relation to investment properties.

Summary of new law

2.11 Schedule 2 reduces the amount an entity can deduct for a depreciating asset under Division 40 or Subdivision 328-D to the extent that the asset is a previously used asset used for the purposes of gaining or producing assessable income from the use of residential premises for residential accommodation. If a depreciating asset is used wholly for this purpose, no deduction is available.

2.12 This reduction does not apply to a deduction that arises in the course of carrying on a business or for a corporate tax entity, superannuation plan (that is not a self managed superannuation funds), a public unit trust, a managed investment trust, or a unit trust or a partnership, all of the members of which are entities of a type listed here.

2.13 To the extent that an entity's deductions for an asset are reduced because of these amendments, the amount of any balancing adjustment is reduced and the proportion of the decline in value of the asset is recognised as a capital loss (or in certain circumstances a capital gain) when the entity ceases to use the asset.

Comparison of key features of new law and current law

New law Current law
Deducting amounts for depreciating assets for residential premises
Entities may only deduct amounts under Division 40 or Subdivision 328-D for depreciating assets used in gaining or producing assessable income from the use of residential premises for residential accommodation if:

·
the entity is a corporate tax entity - a superannuation plan that is not a self managed superannuation fund, a public unit trust, a managed investment trust, or a unit trust or a partnership, all of the members of which are entities of a type listed here; or
·
the deduction arises in the course of carrying on a business; or
·
the entity:

-
held the asset at the first time it was first used or installed ready for use by any entity (other than as trading stock); and
-
has never used or installed ready for use the asset in a residence of the entity or for a purpose other than a taxable purpose, except for incidental or occasional use; or

·
the entity:

-
first held the asset at a time when it was used or installed ready for use in premises supplied to the entity as new residential premises; and
-
was the first entity to either deduct any amount for the decline in value of the asset or use or install the asset in premises in which any entity resided, other than premises sold within six months of becoming new residential premises; and
-
has never used or installed ready for use the asset in either a residence of the entity or for a purpose other than a taxable purpose, except for occasional use.

Entities may deduct amounts under Division 40 or Subdivision 328-D for depreciating assets used in gaining or producing assessable income from the use of residential premises for residential accommodation.
Balancing adjustments and capital gains
When an entity ceases to use a depreciating asset, a balancing adjustment may need to be made to the entity's taxable income.

The amount of this adjustment is based on the difference between the actual value of the asset at that time and the value based on deductions previously claimed.

If the entity's deductions in respect of an asset have been reduced because the entity used the asset for a purpose other than a taxable purpose or because of these amendments, the amount of this adjustment is reduced. Further, CGT event K7 occurs and may result in a capital gain or loss for the entity to account for the proportion of the change in value of the asset attributable to the use of the asset for a purpose other than a taxable purpose or for which deductions are not available because of these amendments.

When an entity ceases to use a depreciating asset, a balancing adjustment may need to be made to the entity's taxable income.

The amount of this adjustment is based on the difference between the actual value of the asset at that time and the value based on deductions previously claimed.

If the entity's deductions in respect of an asset have been reduced because the entity used the asset for a purpose other than a taxable purpose, the amount of this adjustment is reduced. Further, CGT event K7 occurs and may result in a capital gain or loss for the entity to account for the proportion of the change in value of the asset attributable to the use of the asset for a purpose other than a taxable purpose.

Detailed explanation of new law

Denying deductions for depreciating assets used in residential premises

2.14 Schedule 2 amends Division 40 and Subdivision 328-D to reduce the amount that can be deducted by an entity for the decline in value of a depreciating asset (i.e. plant and equipment) for an income year to the extent that the asset:

·
is used or installed for the purposes of gaining or producing assessable income from the use of residential premises for the purposes of providing residential accommodation; and
·
was 'previously used'.

[Schedule 2, item 4, subsections 40-27(1), (2)]

2.15 This reduction does not apply if the entity is:

·
a corporate tax entity;
·
a superannuation plan that is not a self managed superannuation fund;
·
a public unit trust within the meaning of section 102P of the ITAA 1936;
·
a managed investment trust; or
·
a partnership or unit trust if all of the members of the partnership or unit trust are entities of a type listed here (including under this item).

[Schedule 2, item 4, subsection 40-27(3)]

2.16 The reduction also does not apply if the asset is used in carrying on a business. [Schedule 2, item 4, paragraph 40-27(2)(b)]

2.17 The effect of these amendments is that certain entities can only deduct the decline in value of depreciating assets used in gaining or producing assessable income from residential premises if the asset is acquired new for that purpose. Broadly, the amendments ensure that entities cannot claim excessive deductions relating to rental properties by 'refreshing' the value or effective life of previously used depreciating assets used or installed in those properties.

Gaining or producing assessable income from residential premises

2.18 The reduction only applies to the asset if it is used for the purpose of gaining or producing assessable income from the use of residential premises to provide residential accommodation. [Schedule 2, item 4, paragraph 40-27(2)(a)]

2.19 The term 'residential premises' is defined in the ITAA 1997 as having the same meaning as in the GST Act. The GST Act provides that 'residential premises' means land or a building that:

·
is occupied as a residence or for residential accommodation; or
·
is intended to be occupied, and is capable of being occupied, as a residence or for residential accommodation.

2.20 The definition specifies that land or a building that meets these requirements is residential premises regardless of the term of the occupation or intended occupation. It also specifies that 'residential premises' includes a floating home.

2.21 Due to its use in the GST law, this defined term is already the subject of considerable judicial scrutiny and interpretative guidance. Broadly, land or a building is residential premises if it provides, at a minimum, shelter and basic living facilities and is either occupied by a person (the first limb) or designed for occupation (the second limb).

2.22 The courts have found that for both limbs, whether premises are capable of being occupied as a residence or for residential accommodation is to be ascertained by an objective consideration of the character of the property. The purpose for which an entity may hold the property is not relevant.

2.23 Residential premises need only be suitable for occupation, rather than long-term occupation - they include, for example, a hotel room that may only be suitable for short term accommodation. However, it does not include things that people may occupy that are not land or a building, such as a caravan. It also does not include premises that may provide shelter and basic living facilities where it is clear from the design and structure of the premises that this is incidental to the character of the premises.

2.24 For example, while hospitals often have facilities to permit extended occupation by patients, this does not mean that a hospital is occupied or intended for occupation as a residence or as residential accommodation. Similarly, if premises are designed and constructed as a shop, even if they provide shelter and basic living facilities, they generally do not have the character of residential accommodation.

2.25 Additionally, for the reduction to apply, the use of the asset must be related to the use of residential premises to provide residential accommodation. The fact that a tenant may use residential premises to some extent other than as residential accommodation (for example, as a home office) will not generally affect the character of the use of the asset by the landlord. Granting entitlement to use residential premises under a tenancy agreement or similar arrangement is the provision of residential accommodation (whether or not the tenant uses it wholly, partly or at all for that purpose).

2.26 However, if a building is specifically designed, built or modified so that part of the building is suitable for only commercial purposes (such as a doctor's surgery) and part is for residential accommodation then the income from the commercial part will not relate to the use of the premises as residential accommodation (in addition, the commercial part of the building may be separate premises that are not residential premises). Any such distinction needs to be reflected in the physical characteristics of the premises - merely fitting out a room as an office does not change its character.

2.27 Deductions continue to be available for assets that are used for other taxable purposes unrelated to gaining or producing assessable income from residential premises, for example, exploration and prospecting or gaining income from employment.

2.28 This is the case even if an asset may be used in residential premises in the course of this other purpose. For example, a home cleaning service may use depreciating assets in residential premises, but its income does not come from the use of the premises but from its cleaning activities.

2.29 Even where assets are used in income generating activities in residential premises, the deductions continue to be available for the assets if these activities are unrelated to the use of the premises to provide residential accommodation. For example, an entity continues to be entitled to deduct the decline in value of solar panels, or a horse stable, that forms part of the premises to the extent the solar panels are used for the purpose of generating income from the sale of electricity or the stable is used to generate income from agistment fees, separate to the provision of residential accommodation.

Previously used

2.30 The reduction also only applies if the asset has been 'previously used'.

2.31 An asset is 'previously used' for an entity if:

·
the entity is not the first entity that used the asset or installed the asset ready for use (within the meaning of Division 40) other than as trading stock;
·
the asset is used or installed ready for use during any income year in premises that are, at that time, a residence of the entity; or
·
the asset is used or installed ready for use during any income year for a purpose that is not a taxable purpose, other than incidental or occasional use.

[Schedule 2, item 4, paragraphs 40-27(2)(c) and (d)]

2.32 An asset will be previously used if there has been any prior use of the asset by another entity, other than use as trading stock. This includes situations in which another entity used an asset both as trading stock and for some other purpose.

2.33 For example, if a developer installs an asset in premises it intends to sell, this will generally constitute use as trading stock. If the developer rents out the property containing the asset while it seeks to find a purchaser, the property and hence the asset are used, at least in part, for a purpose other than as trading stock and the asset would be previously used in the hands of any subsequent purchaser (subject to the exception outlined below for assets used or installed in certain new residential premises - see paragraphs 2.43 to 2.53).

2.34 An asset will also be previously used for an entity if it has been used or installed ready for use in residential premises that are at that time a residence of the entity.

2.35 For example, if an individual acquires a new apartment and uses it as their residence in an income year before renting it out, any assets used in the premises would generally have been used wholly for personal use or enjoyment during that income year. The individual would not subsequently be able to access any deductions for the decline in value of those assets while it is being rented out.

2.36 In this context, residence is used with its ordinary meaning, of a person's dwelling, similar to the basic concept of main residence in Subdivision 118-B. However, unlike 'main residence', a person may have more than one residence if they commonly occupy, or have available for the purpose of their occupation, two or more residential premises. The mere fact a person does not reside in premises at a particular time does not mean that the premises are not a residence of the person at that time.

2.37 Whether residential premises are a person's residence at a particular time is a question of fact requiring an examination of the person's connection with and use of the premises. A dwelling an entity owns that is currently being rented out to a tenant is not generally a residence of the entity at that time, even if it had previously been a residence of the entity. On the other hand, a holiday home that is principally held available and ready for the use of an entity may well be the entity's residence at that time.

2.38 An asset is also previously used for an entity if it is used or installed ready for use for a purpose that is not a taxable purpose unless the use for that purpose is occasional.

2.39 Use or installation ready for use and a purpose that is not a taxable purpose are existing concepts in Division 40 and are used in these amendments with the same meaning. Use for a purpose generally includes use that is incidental to a purpose. Use is incidental if it is minor in the context of the overall use and arises in connection with another non-incidental use - for example staying at the property for one evening while carrying out maintenance activities would generally be incidental use.

2.40 In this context, use for a purpose is occasional where that use is infrequent, minor and irregular. Use of assets in different ways for the same purpose must be considered together in determining if use for that purpose is occasional.

2.41 For example, spending a weekend in a holiday home or allowing relatives to stay for one weekend in the holiday home free of charge that is usually used for rent would generally be occasional use.

2.42 The requirement that assets must have been previously used in one of the three ways outlined in paragraph 2.31 ensures that the reduction is targeted to situations in which there is a particular risk of the overvaluation of previously used depreciating assets. When assets are purchased new, there is generally little ambiguity about their value. If they are purchased after being used by another entity or applied to a taxable purpose after private use, their value is less clear and there is more scope for the entity holding the asset to adopt a 'refreshed' or unrealistic valuation or extended effective life that increases the amount deductible.

Example 2.1 : 'Previously used' assets Craig has acquired an apartment that he intends to offer for rent. This apartment is three years old and has been used as a residence for most of this time.Craig acquires a number of depreciating assets together with the apartment, including carpet that was installed by the previous owner. He also acquires a number of depreciating assets to install in the apartment immediately prior to renting it out, including:

·
curtains, which he purchases new from Retailer Co; and
·
a washing machine, that he purchases used from a friend, Jo.

Craig also purchases a new fridge, but rather than place this in the apartment, he uses it to replace his personal fridge, that he acquired a number of years ago for use in his residence. He instead places his old fridge in the new apartment.The amendments do not permit Craig to deduct an amount under Division 40 for the decline in value of the carpet, washing machine or fridge for their use in generating assessable income from the use of his apartment as a rental property as both are previously used. The carpet and washing machine are previously used as the previous owner or Jo rather than Craig first used or installed the assets (other than as trading stock). The fridge is previously used as while Craig first used or installed the fridge, he has used it in premises that were his residence at that time.The amendments do not affect Craig's entitlement to deduct an amount under Division 40 for the decline in value of the curtains. They are not 'previously used' under either limb of the definition.

Assets acquired in a supply of new residential premises

2.43 A qualification applies to the requirement that the asset must not have been first used or installed ready for use (other than as trading stock) by another entity.

2.44 Often developers will acquire and install various depreciating assets in the course of constructing or substantially renovating residential premises. In some cases the property may already have an owner, but in others, the developer or another entity may hold the land and it will not be sold until after construction and installation.

2.45 In these situations, in which a new asset is installed in new and unoccupied residential premises, the value of the asset has not yet declined and there is no risk of the valuation of the asset for the purposes of depreciation being refreshed.

2.46 Accordingly, even if an entity did not hold an asset when it was first used or installed ready for use, the amendments do not apply to an asset held by that entity that was installed in premises supplied as new residential premises (including substantially renovated premises) if:

·
no entity has previously been entitled to any deduction for the decline in value of the asset; and
·
either:

-
no one resided in residential premises in which the asset has been used before it was held by the current owner; or
-
the asset was used or installed in new residential premises (or related real property) that were supplied to the entity within six months of the premises becoming new residential premises, and the asset had not been used or installed in a residence before that use or installation.

[Schedule 2, item 4, subsections 40-27(4) and 40-27(5)]

2.47 Combined, these requirements only allow access to this exception in circumstances where the asset is substantially new - no entity has been entitled to any deduction for the decline in value of the asset and it has not been used in any person's residence for a substantial period of time. Allowing entities to access the exception for assets only used or installed in new residential premises supplied within six months of the premises becoming new residential premises ensures that entities acquiring tenanted apartments are not disadvantaged. In such cases there is limited time for the assets to decline in value through use or age and the integrity risks are relatively low.

2.48 The amendments also do not apply to a depreciating asset used or installed in property that is not residential premises, but is supplied as part of a supply of new residential premises, if no entity has previously been entitled to any deduction for the decline in value of the asset. This is the case even if an entity is not the entity that held the asset when it was first used or installed ready for use (other than as trading stock). [Schedule 2, item 4, subparagraph 40-27(4)(c)(ii)]

2.49 This ensures that the amendments apply appropriately when an entity acquires assets provided in connection with residential premises, such as assets installed in the common property of apartment complexes. In this situation, as the asset is not used in residential premises, the question of whether any entity has resided in the premises does not arise. As a result, the entity may deduct amounts for the decline in value of such assets reflecting the extent of their ownership of the asset unless:

·
a previous owner of the same unit or apartment deducted amounts related to depreciation of the asset; or
·
the asset has been previously used or installed ready for use in residential premises that were being used as a residence.

2.50 It should be noted that this exception does not prevent the amendments applying to an entity in relation to an asset if the asset is ever used or installed ready for use in a residence of the entity or used, by the entity, for a non-taxable purpose - see paragraphs 2.30 to 2.42.

2.51 The term 'new residential premises' has, for the purposes of the amendments, the same meaning as in the GST law. Section 40-75 of the GST Act defines new residential premises as, broadly, premises that have not been previously sold or subject to a long-term lease as residential premises, or have been subject to a substantial renovation or replacement of existing premises.

2.52 'Substantial renovations' is also defined in the GST law as, broadly, renovations in which substantially all of a building is removed and replaced (though it does not always need to involve structural alterations). For example, the installation of a new kitchen and bathroom in an existing home is not, on its own, 'substantial renovations'.

2.53 Interpretative guidance has been issued in relation to the meaning of 'new residential premises', 'substantial renovations' and other related concepts - see for example GST Ruling GSTR 2003/3 'Goods and services tax: when is a sale of real property a sale of new residential premises?'.

Example 2.2 : Assets installed in new residential premises Hannah purchases two apartments off the plan from Developer Co. The apartments are supplied three months after completion - one is already tenanted and the other is vacant.In addition to the construction of the apartments, Developer Co has fitted out the apartments, installing ready for use depreciating assets including curtains and furniture prior to settlement and the transfer of the title to Hannah. Developer Co has also fitted out the shared areas of the complex in which the apartment is located, installing ready for use a range of deprecating assets that are the joint property of the apartment owners.All of these assets are new at the time of installation. As these assets were first installed by Developer Co, not Hannah, they are previously used and a deduction would not be available under the general rules established by these amendments.However, a deduction is still available to Hannah for the depreciating assets (including Hannah's share of the assets installed in the shared areas of the apartment) for the period she holds the assets as:

·
the assets have been installed ready for use in premises that were supplied to Hannah as new residential premises or in other real property supplied as part of the supply of residential premises;
·
Developer Co has not claimed any deduction for the decline in value of the assets (and nor has any other entity); and
·
either (excluding assets installed in the common property):

-
for assets in the first apartment, the assets were only used or installed in the apartment, which was supplied to Hannah as new residential premises within six months of the apartment first becoming residential premises; or
-
for assets in the second apartment, no entity has resided in residential premises in which the assets have been installed before Hannah held the assets.

Exception for certain entities

2.54 The reduction in the amount that can be deducted also does not apply to deductions incurred by an entity for an income year in which the entity is:

·
a corporate tax entity;
·
a superannuation plan that is not a self managed superannuation fund;
·
a public unit trust (within the meaning of section 102P of the ITAA 1936);
·
a managed investment trust; or
·
a partnership or unit trust if all of the members of the partnership or trust are entities included on this list (including this item).

[Schedule 2, item 4, subsection 40-27(3)]

2.55 As discussed in paragraph 2.17, these amendments are intended to address incentives to obtain excessive deductions. These incentives primarily exist for individuals, who are most likely to be in a position to apply such deductions to reduce tax payable on income from employment and other unrelated activities and receive favourable tax treatment for capital gains. The incentives also exist for entities that individuals can control and which either can pass income (including capital gains) or deductions through to individuals or receive similar tax concessions.

2.56 The same incentives do not arise for corporate tax entities, superannuation plans (that are not self managed superannuation funds), public unit trusts, managed investment trusts and unit trusts or partnerships that are ultimately held by these entities. They are either outside the control of an individual, do not receive tax concessions or both. Given this, the amendments do not apply to these entities.

2.57 Corporate tax entity is defined in section 960-115. It includes entities that are companies, corporate limited partnerships, corporate unit trusts and public trading trusts at the relevant time. It does not include a trust merely because the trustee of the trust is a corporate tax entity.

2.58 'Superannuation plan' and 'self managed superannuation fund' are similarly defined in subsection 995-1(1).

2.59 Public unit trust is defined in section 102P of the ITAA 1936. Broadly, a unit trust will be a public unit trust if the units in the trust are listed for quotation in the official list of a stock exchange, offered to the public in a public offer, held by more than 50 people or where a tax exempt investment vehicle, such as a foreign superannuation fund, is a substantial unitholder (see subsections 102P(1) and (2) of the ITAA 1936). However, a trust will not be a public unit trust if 20 or fewer people hold beneficial interests in 75 per cent or more of the income or property of the trust, or if other integrity rules are not satisfied (see section 102P of the ITAA 1936).

2.60 Trusts are also excluded if they are managed investment trusts within the meaning of section 275-10. As part of its Housing Affordability package, the Government announced amendments to the tax law to enable managed investment trusts to invest in dwellings used to provide affordable housing and for investors to benefit, for example, from reduced rates of withholding tax. Excluding managed investment trusts removes any doubt that such trusts that comply with the widely held rules for managed investment trusts and engage in institutional investment in affordable housing are permitted depreciation deductions.

2.61 In all cases these requirements ensure that trusts must be widely held and genuinely free from the control of any one member to benefit from this exclusion.

2.62 The final exclusion is for unit trusts or partnerships if all of the members of the entity (i.e. the unit holders or partners) are listed as excluded entities. This exclusion ensures that where all the benefit of deductions goes to excluded entities, the deductions continue to be available. This includes situations where the excluded entities receive the benefit of deductions through a chain of unit trusts or partnerships.

2.63 For example, a unit trust that owns residential premises is entitled to deduct the decline in value of those assets for an income year if all of the units in the trust are held by another unit trust and all of the units in that unit trust are owned by excluded entities, such as companies.

Carrying on a business

2.64 Similarly, deductions also continue to be available to the extent that an asset is used in the course of carrying on a business, even if that business is carried on for the purpose of gaining or producing income from the use of residential premises for residential accommodation. For example, an entity operating a hotel continues to be entitled to deduct the decline in value of the depreciating assets used for the purposes of the business in the hotel premises. [Schedule 2, item 4, paragraph 40-27(2)(b)]

2.65 Whether a business is being carried on depends on the facts of the particular case. For example, some indicators that the courts have considered relevant are whether the activity:

·
has a significant commercial purpose or character;
·
is repeated and regular; and
·
is better characterised as a hobby or recreational pastime.

Application to small business entities

2.66 Small business entities may choose to calculate their deductions for the decline in value of depreciating assets they hold using Subdivision 328-D rather than Division 40.

2.67 These amendments have limited application to the assets of small business entities. Small business entities must, among other things, carry on a business. The assets used in carrying on their business are excluded - see paragraphs 2.64 to 2.65 above.

2.68 However, while an entity must be a small business entity to apply Subdivision 328-D, the application of the Subdivision is not limited to assets used in carrying on the business. Small business entities that choose to apply Subdivision 328-D generally must apply it in respect of all depreciating assets they hold, even those that are not used in carrying on a business - see section 328-175.

2.69 This means that while it is unusual, it is possible for depreciating assets to which these amendments would generally apply - assets used in gaining or producing assessable income from the use of residential premises to provide residential accommodation other than in the course of carrying on a business - to be subject to the small business depreciation rules in Subdivision 328-D.

2.70 To address this, the amendments prevent an entity deducting amounts under Subdivision 328-D for an asset to the extent that the entity could not deduct amounts under section 40-25 for that asset because of these amendments. [Schedule 2, item 11, subsection 328-175(9A)]

Application to low value pools

2.71 Entities may choose to allocate certain assets (generally assets with a value of less than $1,000 in the year in which the asset is first used by the entity for a taxable purpose) to a low value pool for an income year (see section 40-425).

2.72 The decline in value of assets placed in a low value pool is calculated on a fixed basis for the whole pool - see section 40-440. The amount that can be deducted is not reduced for the use of the assets for a purpose that is not a taxable purpose (see subsection 40-25(5)).

2.73 Instead, an entity must make a reasonable estimate of the percentage of its total use of an asset that will be used for a taxable purpose when the asset is first allocated to a low value pool. Only this percentage of the value of the asset will be placed in the pool - see section 40-440.

2.74 The amendments provide that the amount an entity can deduct for assets is similarly not specifically reduced as described in paragraph 2.14 above. However, to the extent an asset is estimated to be put to a use for which the amendments prevent a deduction from being available, this use is treated as being use for a purpose that is not a taxable purpose. [Schedule 2, item 7, subsection 40-435(2)]

2.75 This reduces the taxable purpose proportion for such assets and hence the amount that is included in the low value pool to be deducted. It results in an equivalent outcome for these assets that is consistent with the operation of the low value pool rules.

Subsequent implications of denied deductions

2.76 Schedule 2 also amends the rules in the ITAA 1997 to modify the consequences if an entity sells or otherwise ceases to use an asset.

2.77 As a result of the amendments:

·
any balancing adjustment the entity must make is adjusted to account for any reductions in the amount the entity can deduct; and
·
to the extent that the amendments prevent an entity deducting the decline in value of the asset, the change in value of the asset is recognised as a capital loss (or gain if the asset has appreciated rather than declined in value).

[Schedule 2, items 5, 8 and 9, section 40-291, paragraph 104-235(1)(b) and paragraph (a) of the definition of sum of reductions in subsection 104-240(1)]

Balancing adjustments

2.78 First, when a depreciating asset is sold or permanently ceases being used, if the termination value of the asset (the value of the asset when it was sold or otherwise ceased to be used) differs from its adjusted value (its cost less its decline in value), the entity must make a balancing adjustment. The entity makes this adjustment by including the amount of the difference in its assessable income or deducting the amount.

2.79 The balancing adjustment ensures that the entity is only able to deduct the amount by which the value of the asset has actually declined over the period it has been used by the entity (and brings to account any gain if the asset has appreciated).

2.80 The amount of the balancing adjustment is normally reduced to the extent an entity has not been able to deduct amounts for the decline in value of an asset, for example because of private use.

2.81 The amendments reduce the amount of the balancing adjustment to account for the proportion of the decline in value of the asset that the entity has not been entitled to deduct because of these amendments. [Schedule 2, item 5, section 40-291]

2.82 This is consistent with the treatment of balancing adjustments for assets for which an entity has not been able to deduct amounts because the asset has been used for a purpose other than a taxable purpose. It ensures that, when an entity ceases to use an asset, the total amount they are entitled to deduct for the decline in value of the asset (or required to pay if the asset has appreciated) is consistent with the final value of the asset.

CGT event K7

2.83 Second, if a balancing adjustment event occurs in relation to a depreciating asset that has not been wholly used for a taxable purpose, CGT event K7 will also occur, resulting in a capital gain or loss for that entity.

2.84 The amount of this capital gain or loss is broadly equal to the proportion of the decline in value of the asset (the difference between the termination value of the asset and its adjusted value) that the entity has not been able to deduct - see sections 104-235, 104-240 and 104-245. For example, if an entity sells a depreciating asset it has used for wholly private purposes, CGT event K7 results in the entity having a capital loss equal to the difference between the cost of the asset and its sale price.

2.85 Unlike most other CGT events, a gain or loss from CGT event K7 is not disregarded if it happens in relation to a depreciating asset an entity holds.

2.86 The amendments provide that CGT event K7 also occurs if a balancing adjustment event occurs for a depreciating asset where some or all of the decline in value has not been deductible because of these amendments. [Schedule 2, items 8 and 9, paragraph 104-235(1)(b) and paragraph (a) of the definition of sum of reductions in subsection 104-240(1)]

2.87 The amendments also change the amount of the capital gain or loss that occurs as a result of CGT event K7 so that it includes the amount of the decline in value of the asset that an entity has not been able to deduct due to these amendments. [Schedule 2, items 8 and 9, paragraph 104-235(1)(b) and paragraph (a) of the definition of sum of reductions in subsection 104-240(1)]

Example 2.3 : Resale of a property including depreciating assets Gunther purchases a two year old property for $500,000 on 10 July 2017. Part of the purchase price relates to six previously used depreciating assets that are included with the residential premises. The assets are worth $1,000, $3,000, $4,000, $6,000, $7,000 and $9,000, respectively, for a total of $30,000.Gunther rents out the property. He is unable to deduct the decline in value of any of the depreciating assets he acquired with the property as they are previously used. On 10 May 2021, Gunther sells the property, including these depreciating assets, for $700,000. At the time of sale, the six depreciating assets have a value of $0, $1,000, $3,000, $4,000, $5,000 and $7,000, respectively, so in total $20,000 of the sale price relates to the depreciating assets.The sale of the property is a balancing adjustment event.As Gunther has not been able to deduct any amount of the decline in value of the depreciating assets, Gunther does not need to make any adjustment to his assessable income for the income year.However, as a balancing adjustment event occurs in relation to depreciating assets for which the available deduction has been reduced by these amendments, CGT event K7 occurs.As a result of CGT event K7 occurring, Gunther has a capital loss equal to the proportion of the decline in value of the assets that Gunther has not been able to deduct either because of these amendments or because the amount deductible was reduced under section 40-25.In this case, the difference between the total termination value of the assets ($20,000) and the total cost of the assets ($30,000) is $10,000 and all deductions for the decline in value have been denied (so the proportion of total deductions denied is 10,000/10,000 or 1). Therefore the amount of Gunther's total capital loss because of the disposal of all of the assets is $10,000 ((30,000 - 20,000)*1 = $10,000).

Consequential amendments

2.88 Schedule 2 also makes a number of minor consequential amendments to the ITAA 1997 to reflect the principal amendments, including updating guidance material. [Schedule 2, items 1 to 3, 6, 10 and 12, the item headed capital allowances in the table in section 12-5, subsection 25-47(4A), the note to subsection 40-25(2), subsection 40-435(1), paragraph 250-290(2)(c) and the definition of new residential premises in subsection 995-1(1)]

Application and transitional provisions

2.89 Schedule 2 to this Bill commences on the first day of the next quarter following the day of Royal Assent. [Clause 2]

2.90 The amendments apply to income years starting on or after 1 July 2017 to assets acquired at or after the time the measure was publicly announced (7.30 pm on 9 May 2017) unless the asset was acquired under a contract entered into before this time. [Schedule 2, subitem 13(1)]

2.91 The amendments also apply to assets acquired before this time if the assets were first used or installed ready for use by an entity during or prior to the income year in which this measure was publicly announced (generally the 2016-17 income year), but the asset was not used at all for a taxable purpose in that income year. [Schedule 2, subitem 13(2)]

2.92 These application rules are intended to limit the effect of the measure to assets being newly used after Budget night for purposes that permit deductions for the decline in value of the asset, whether this is because the asset is newly acquired or newly applied for a purpose that allows its decline in value to be deducted.

2.93 The application to assets used for wholly non-taxable purposes in the income year in which this measure was announced avoids creating unintended incentives for:

·
individuals to move personal assets into rental properties; and
·
the value of these assets or effective life of these assets to not properly account for the decline in value of the assets during the period in which this decline was not deductible.

2.94 The retrospective application to assets newly applied for use in residential investment properties after the measure was announced is consistent with the Budget announcement by the Government. This is necessary to ensure taxpayers cannot avoid the operation of the amendments by acquiring new assets or applying existing assets between the time of announcement and application in order to take advantage of the limitations in the existing law. Any adverse impact is expected to be minor, given the retrospective application was included in the Budget announcement and has been widely publicised.


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