House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer,the Hon. Peter Costello, MP)

Chapter 9 - Deduction for capital works

This chapter summarises the rewritten rules allowing deductions for the cost of buildings and other capital works and explains the changes that the Income Tax Assessment Bill 1996 will make to those rules.

Overview of this chapter

This chapter summarises the capital allowance rules for buildings and other capital works.

These rules are contained in Divisions 10C and 10D of Part III of the Income Tax Assessment Act 1936 .

In the rewritten Act they will be contained in Division 43.

This summary is to orient readers to how the new law is structured and expressed. As these provisions have been in the law for some time, there is no need for a detailed exposition. An explanation is given of changes proposed to the capital works provisions.

A. Summary of the new law

Guide to Division 43

What does the Division do?

It allows the capital cost of constructing capital works to be written-off. Capital works are:

•

buildings, structural improvements and environment protection earthworks; and

•

extensions, alterations or improvements to these.

Key operative provisions [Subdivision 43-A]

This Subdivision contains the key provisions that explain how expenditure on capital works can be written-off.

The general rule is

You can deduct an amount for capital works in an income year if:

•

the works have a construction expenditure area ;

•

there is a pool of construction expenditure for that area; and

•

you use your area in the year to produce assessable income.

There can be other uses which apply.

The rate of deduction is

For capital works begun:

•

after 26 February 1992 the rate is 21/2%, or 4% for certain purposes;

•

between 22 August 1984 and 15 September 1987it is4%;

•

for other periods it is 21/2%.

Limit on when you can deduct

You cannot claim a deduction for a period before construction is completed.

Limit on amount of deduction

Your deduction in a year cannot exceed the undeducted construction expenditure for your area .

Balancing deduction on destruction

You can deduct the balance of your construction expenditure in a year in which capital works are destroyed, whether the destruction is voluntary or involuntary.

Establishing the deduction base [Subdivision 43-B]

This Subdivision explains the meaning of the terms construction expenditure , construction expenditure area and pool of construction expenditure . These concepts describe elements central to working out what deductions are available for capital works.

Construction expenditure is

Capital expenditure on constructing capital works, but not on:

•

purchasing land;

•

demolishing existing structures;

•

preparing the construction site;

•

landscaping;

•

plant;

•

property deductible under section 73A, 73B, 75B, 75D, 124F or 124JA or Division 10, 10AAA or 10AA of Part III of the Income Tax Assessment Act 1936 ;

•

heritage conservation expenditure within the meaning of Subdivision AAD of Division 17 of Part III of the Income Tax Assessment Act 1936 ; or

•

property deductible under Division 330.

Construction expenditure area is

•

For capital works begun after 30 June 1996, such part of capital works on which construction expenditure is incurred as is to be owned, leased or held under a quasi-ownership right by the entity who incurred the expenditure.

•

For capital works begun before 1 July 1996, in addition the works (or part) must be intended for use as set out in Table 43-90.

There can be more than one construction expenditure area eg. one for the original construction, another for an extension and a third for a subsequent extension or capital renovation.

Pool of construction expenditure is

The construction expenditure attributable to a construction expenditure area.

Capital works begin

When the first step in their construction phase begins, such as the pouring of foundations.

Your area and your construction expenditure [Subdivision 43-C]

This Subdivision explains the meaning of the terms your area and your construction expenditure . These concepts determine if you have deductible capital works and establish the basis on which your deduction is calculated.

Your area

How your area is determined depends on whether you are an owner, or lessee (or hold a quasi-ownership right).

Your area - owner

If you are an owner, your area is the part of the construction expenditure area you own.

Your area - lessees and holders of quasi-ownership rights

If you lease (or hold quasi-ownership rights) your area is:

•

the part of the area you lease (or hold) on which you have incurred construction expenditure ; or

•

the area you acquired by assignment from the lessee or holder who incurred the expenditure (or one of their successors).

However, the area must have been leased or held continuously since the construction was completed. You would have continuously leased an area even if your original lease had expired provided you have renewed the lease in a timely manner, for example under an option in the lease or by negotiation with the building owner.

Your area - some general comments

Your area may comprise all or part of the construction expenditure area .

You can have more than one area (each separately referred to as your area ) in relation to capital works, eg. if there is more than one construction expenditure area .

This can happen where:

•

you own, lease or hold part of a construction expenditure area in an income year and you acquire, lease or the hold another part during the year; or

•

during an income year you dispose of some but retain some of a construction expenditure area .

Your construction expenditure is

The portion of the pool of construction expenditure that is attributable to your area .

Deductible uses of capital works [Subdivision 43-D]

How your area must be used for you to claim a deduction depends on when the capital works were begun and what type of works they are.

If you use your area in the way set out in the first table following, for capital works begun after 26 February 1992, you will be entitled to a deduction calculated at the rate of 21/2%.

For works begun earlier the rate can be either 2 1/2% or 4%.

If you use your area in the way set out in the second table you will be entitled to a deduction calculated at the rate of 4%. This table only applies to capital works begun after 26 February 1992.

Special rules about uses [Subdivision 43-E]

This Subdivision contains some rules which modify the uses described in the tables above and in Table 43-90 of the Bill. Some examples are discussed below.

Use for any purpose or manner

Your area will be taken to be used for a particular purpose or manner if:

•

it is maintained ready for that use, is not used for another purpose and its use has not been abandoned; or

•

its use has temporarily ceased because of construction, repairs etc., or for seasonal or climatic conditions.

Taken not to be used to produce assessable income

Your area will not be accepted as being used to produce assessable income if:

•

it is used for display and is part of a building (other than a hotel or apartment building) begun before 1 July 1996;

•

it is used for residential accommodation (other than in a hotel or apartment building) and the building began before 18 July 1985;

•

you use it for residential accommodation (and it is not a hotel or apartment building).

Use for residential accommodation

Your area will be taken to be used as residential accommodation if:

•

it is part of an individual's home (other than a hotel or apartment building);

•

it is used as a hotel, motel or guest house but does not satisfy the definition of a hotel building.

Calculation of deduction [Subdivision 43-F]

This Subdivision shows how to calculate the amount of your deduction. There are two separate calculation provisions: one for capital works begun before 27 February 1992 and the other for capital works begun after 26 February 1992.

Capital works begun before 27 February 1992

The deduction is calculated separately for each part that meets the description of your area .

Your construction expenditure is multiplied by the applicable rate (2 1/2% or 4%) and by the number of days in the income year in which you owned, leased or held your area and used it in a relevant way. That amount is divided by the number of days in the year.

You apportion the amount if your area is used only partly to produce assessable income.

You also take out any part of a hotel or apartment complex not used as a hotel or for short-term traveller accommodation.

The amount you arrive at as a deduction cannot exceed the undeducted construction expenditure .

Capital works begun after 26 February 1992

Again, the deduction is calculated separately for each part of capital works that meets the description of your area .

Different parts of your area can be used in ways which attract different rates of deduction. If this is the case you will have to make separate calculations for the parts attracting the 2 1/2% and 4% rates respectively.

Undeducted construction expenditure [Subdivision 43-G]

This Subdivision explains how to calculate the undeducted construction expenditure .

Capital works begun before 27 February 1992

The undeducted construction expenditure for your area is the amount of your construction expenditure that remains available for deduction. It is calculated on the assumption that your area has been used in a deductible way throughout the period since it was first used for any purpose.

Capital works begun after 26 February 1992

The undeducted construction expenditure calculation for capital works begun after 26 February 1992 is different from that for earlier capital works. You first reduce your construction expenditure for parts used in a manner attracting the 4% rate. For the rest, it is assumed to have been used in a deductible manner ever since it was first used for any purpose.

Balancing deduction on destruction [Subdivision 43-H]

This Subdivision explains how to calculate a balancing deduction on destruction of your area .

You are entitled to a deduction for the excess (if any) of the undeducted construction expenditure for the destroyed part of your area over any amounts you are entitled to receive for the destruction (such as insurance receipts).

B. Discussion of Changes

Division 43 Deductions for capital works

This Division will set out the rules for obtaining deductions for capital expenditure on the construction of buildings and certain other capital works.

1. Change

The Bill will bring together, in new Division 43, the rules about deductions for traveller accommodation and other income-producing buildings.

Explanation

The existing law deals separately with deductions for expenditure on traveller accommodation (Division 10C of Part III of the Act) and on other buildings and structural improvements (Division 10D). However, the principles underlying these Divisions are essentially the same, and there is much unnecessary duplication of text.

2. Change

Replace a number of discretions given to the Commissioner under the existing law.

Explanation

One of the aims of this rewrite of the law is to replace with objective criteria many of the discretions that the Commissioner of Taxation may exercise under the existing law, to more fully reflect the introduction of the self-assessment system.

Most of the discretions in this part of the existing law require the Commissioner to determine an amount of expenditure attributable to a particular part of a building. The proposed legislation allows this attribution to be made by the taxpayer.

In other cases, a Commissioner's discretion based on his finding of reasonableness will be replaced with a simple objective test of reasonableness, see clauses 43-170 and 43-260.

One Commissioner discretion remains, that being part of an anti-avoidance provision which will be limited in its application - see the discussion below on clause 43-55.

Clause 43-2 Key concepts used in this Division

This clause will provide an illustration of the main concepts in this Division and the relationships between them.

Change

The proposed Division includes a graphic to illustrate the concepts and their relationships.

Explanation

This Division is constructed upon several linked concepts which need to be understood by readers. They fall into two main categories, areas of capital works and expenditure amounts relating to those areas. The graphic gives a visual insight into the workings of the Division as part of the introductory Guide. The graphic does not have operative status but is provided as an illustrative introduction to the main concepts.

Subdivision 43-A Key operative provisions

This Subdivision will contain all the key operative provisions.

Change

The structure is presented and the main operative provisions are brought together in Division 43.

Explanation

The structure and main concepts of the existing law are difficult to locate and follow.

Subdivision 43-A will set out the main provisions of the new law, explaining:

•

the key elements of an entitlement to a deduction [clause 43-10] ;

•

the type of capital works that can be deducted, and the relevance of when their construction began [clause 43-15] ;

•

the rate at which particular capital works can be deducted [clause 43-20] ;

•

that deductions commence only once construction is completed [clause 43-25] ;

•

what limits apply to the amount deductible in a year [clause 43-30] ;

•

what happens if property is destroyed [clause 43-40] ;

•

the operation of capital allowance common rules [clause 43-45] ;

•

the special anti-avoidance rules [clause 43-55] .

The remainder of the Division, Subdivisions B to H, contains material that will amplify the meaning of these main provisions.

Clause 43-10 Deductions for capital works

This clause will identify the key elements for determining an entitlement to a deduction for expenditure on capital works.

1. Change

The term capital works covers the range of structures and improvements to which this Division applies.

Explanation

The existing law refers to buildings and extensions, alterations or improvements to buildings. A building is also taken as an umbrella term to include a structural improvement and an environment protection earthwork. This can be quite misleading so the more generic term capital works has been adopted in the rewrite.

2. Change

Key concepts will be given labels more indicative of the operative rules.

Explanation

Some key terms used in the existing law do not readily convey their meaning. This does not assist in understanding how the law works.

The new terms, and their counterparts in the existing law, are set out in the following table.

Clause 43-15 Capital works to which this Division applies

This clause will identify the types of capital works to which the Division applies.

Change

The clause gives an example of the kinds of earthworks that can qualify for deduction as structural improvements.

Explanation

The existing law allows a deduction for expenditure on structural improvements. The example will clarify that earthworks integral to the construction of a structural improvement can also qualify.

Clause 43-55 Anti-avoidance arrangements with tax-exempt entity

This clause contains an anti-avoidance rule to disallow deductions if certain arrangements have been entered into.

Change

The provision will be limited to hotel and apartment buildings begun before 1 July 1996.

Explanation

This provision was introduced in 1980, in response to arrangements that transferred, to tax exempt entities, the benefit of deductions for traveller accommodation buildings. The general anti-avoidance provisions in Part IVA of the Income Tax Assessment Act 1936 would now apply to arrangements of this kind.

Clause 43-70 What is construction expenditure?

This clause will spell out clearly the types of expenditure that are excluded from construction expenditure .

Change

The clause will spell out more clearly the types of expenditure that can be construction expenditure .

Explanation

The existing law does not detail what capital expenditure qualifies for the deduction. This clause will do so by listing items included in the Explanatory Memorandums to Act No. 57 of 1980 and Act No. 14 of 1983 which inserted Divisions 10C and 10D respectively.

The clause also incorporates matters set out in the then Treasurer's Press Release (No. 135 of 1979), which outlined the Government's proposed operation of the traveller accommodation building deduction prior to the introduction of legislation for Division 10C.

Specifically, construction expenditure will not include expenditure on:

•

acquiring land, demolishing existing structures or on landscaping; or

•

clearing, levelling, filling, draining or otherwise preparing the construction site prior to carrying out excavation work.

This does not change the practical effect of the law.

Clause 43-75 Construction expenditure area

This clause will explain the meaning of the term construction expenditure area . Capital works must relate to a construction expenditure area before a person can get a deduction under Division 43.

1. Change

This clause will allow a deduction for the cost of capital works to be based on their current use only (without also requiring regard to their original intended use as the present law does). This change will apply to capital works begun after 30 June 1996.

Explanation

The existing law does not allow a deduction for capital works unless:

•

their current use is for an eligible purpose; and

•

their originally intended use, on construction, was also for an eligible purpose.

If the works were not originally intended for an eligible purpose, neither the person who constructed them nor any subsequent person can obtain deductions.

Entitlement to a deduction in any given year will in future be based only on how the current owner, lessee or holder uses the building.

This change will apply to capital works begun after 30 June 1996.

2. Change

The clause will allow a person who acquires a building from a speculative builder and all subsequent purchasers of the building to claim a deduction for the cost of construction.

Explanation

The existing law allows a deduction only for capital construction costs. This would literally exclude the construction costs of a speculative builder or property developer whose costs are of a revenue nature. However, the original intention was to allow a deduction for that type of expenditure (in the hands of building purchasers). The Commissioner has administered the law to give effect to that intention and this change will align the law with that practice and intent.

Clause 43-80 When capital works begin?

This clause establishes when construction begins.

Change

It will be made clear that the construction of capital works begins when the first step in the construction phase starts.

Explanation

The existing law is silent on this issue but the change is consistent with the way in which the law has been administered by the Commissioner.

The time when construction of capital works begins is critical for several reasons, including:

•

whether particular capital works qualify for deduction;

•

the rate of deduction; and

•

the method used to calculate the deduction.

The fact that expenditure is incurred before capital works begin does not preclude it from deduction. For example, architects and engineers fees and the cost of excavating foundations are construction expenditure.

Construction is not taken to start simply because preliminary work such as site preparation has commenced. It requires a physical start, eg. pouring of foundations.

Clause 43-95 Meaning of hotel building and apartment building

This clause will explain the meaning of the terms hotel building and apartment building .

Change

These terms will be defined by reference to the use of the buildings and when their construction began.

Explanation

Hotel and apartment buildings will be defined by reference to:

•

their intended use when construction finished (for buildings begun after 21 August 1979 and before 18 July 1985 or after 26 February 1992 and before 1 July 1996); and

•

their use in the current year (for buildings begun after 30 June 1996).

There is no concept of a hotel or apartment building for buildings begun after 17 July 1985 and before 27 February 1992. Buildings of all kinds constructed in this period are treated on the same basis.

Clause 43-120 Your area and your construction expenditure - lessees and quasi-ownership right holders

This clause will explain the meaning of your area and your construction expenditure area in the context of property that is:

•

leased; or

•

held under a right granted by certain government agencies.

Change

These situations will be dealt with explicitly in the new law.

Explanation

The existing law deems such lessees (and holders) to be the owners of the areas they lease, or hold by a quasi-ownership right.

The new law avoids this kind of deeming device which can be confusing to readers.

Clause 43-140 Using your area in a deductible way

Clause 43-145 Using your area in the 4% manner

These clauses will set out how capital works must be used in order to qualify for deduction.

Change

In order to bring these use tests together in one place, they will be set out in tables in the new law.

Explanation

Under the existing law for capital works begun after 26 February 1992:

•

traveller accommodation buildings (Division 10C) can be deducted at the rate of 4% if they are used in the prescribed manner (ie. to provide traveller accommodation). If not used in the prescribed manner but, nonetheless, used to produce assessable income, they attract a deduction at 2 1/2%.

•

other buildings (Division 10D) can be deducted at the rate of 2 1/2% if they are used in the prescribed manner (ie. to produce assessable income or for research and development). If a building is also used for eligible industrial activities the rate increases to 4%.

Clause 43-140 will establish a basic entitlement to a deduction at the rate of 2 1/2%. Clause 43-145 establishes the higher rate of 4% equivalent to use in the prescribed manner in Division 10C and use in an eligible industrial manner in Division 10D.

The circumstances in which a deduction will be available at either the 2 1/2% or 4% rate have not been changed.

These rules apply to buildings begun after 26 February 1992.

Clause 43-150 Meaning of industrial activities

This clause defines the meaning of the expression industrial activities .

Change

The definitions of goods and manufactured goods used in the original provisions have been omitted.

Explanation

The existing law uses definitions of the terms goods and manufactured goods . These definitions are unnecessary as they do no more than explain the ordinary meaning of the expressions. The omission of these definitions is not considered to alter the meaning of the provisions in any way.

Clause 43-160 Your area is used for a purpose if it is maintained ready for use for the purpose

This clause will treat your area as being used for a particular purpose, or in a particular manner, if it is maintained for that use and is not used in any other way.

Change

This clause will apply to all capital works.

Explanation

Under the existing law, this rule applies only to general income producing buildings (Division 10D) and not to traveller accommodation buildings (Division 10C).

The change will:

•

standardise the treatment of buildings to which this Division applies; and

•

apply only to the use of capital works in the 1996-97 income year and subsequent years (regardless of when construction began).

Clause 43-165 Temporary cessation of use

This clause will allow a temporary cessation of use to be ignored.

Change

The clause will apply to all capital works.

Explanation

Under the existing law, this relieving rule applies only to traveller accommodation (Division 10C) and not to general income producing buildings (Division 10D).

The change will:

•

standardise the treatment of buildings to which the Division applies; and

•

apply in its extended operation only in the 1996-97 income year and subsequent years (regardless of when the capital works began).

Clause 43-170 Own use - capital works other than hotel and apartment buildings

This clause will exclude certain buildings (other than hotel and apartment buildings) that are used for residential accommodation from deduction.

Change

The adoption of a broader definition of the word associate may mean that a deduction that is allowable under the current law will be denied under the new law.

Explanation

As the notes on clause 995-1 explain, the definition of associate provided in the dictionary is broader than the definition provided in the existing provisions of Division 10D. Therefore the provision potentially denies the deduction in more cases than is possible under the present law.

However, the number of cases in which the deduction will actually be denied should be very limited, because:

•

the provision can only affect an associate who is a natural person;

•

the provision only denies a deduction if the building owner and the associate aren't dealing at arm's length; and

•

it is arguable that the Commissioner could disallow the deduction under the existing law by applying general law principles on the derivation of assessable income.

Clause 43-185 Residential or display use

This clause will treat certain buildings used for residential or display purposes as not being used for assessable income producing purposes, and therefore ineligible for deductions.

Change

A deduction will be extended to income-producing buildings, begun after 30 June 1996, that are used for display purposes.

Explanation

Under the existing law, a deduction is not allowed for income-producing buildings used for the purpose of display (such as a display home). This restriction will be limited to buildings begun before 1 July 1996.

Clause 43-210 Deduction for capital works begun after 26 February 1992

This clause explains how to calculate a deduction for capital works begun after 26 February 1992.

Change

Two apportionment provisions are amalgamated.

Explanation

Under the existing law, you are required to:

•

calculate your gross deduction;

•

consider, and where appropriate, apply two separate apportionment provisions to reduce the deduction; and

•

ensure that your net deduction does not exceed the residual capital expenditure (now called undeducted construction expenditure ).

Amendments to the law in 1992 changed the calculation of the gross deduction for capital works begun after 26 February 1992. For works begun after that date the gross deduction is based on the portion of your construction expenditure for the part of your area used in the relevant way. For works begun before 27 February 1992 the gross deduction is based on your construction expenditure .

The gross deduction for capital works begun after 26 February 1992 is an amount attributable only to the part of your area that you use in the relevant way. This achieves the same result as one of the two apportionment provisions which is now being omitted as unnecessary.

Clause 43-215 Deduction for capital works begun before 27 February 1992

This clause explains how to calculate a deduction for capital works begun before 27 February 1992.

1. Change

Separate rules in Divisions 10C and 10D about reducing deductions are being combined.

Explanation

Under the existing law, you are required to:

•

calculate a gross deduction;

•

consider, and where appropriate, apply two separate apportionment provisions to reduce the deduction; and

•

ensure that your net deduction does not exceed the residual capital expenditure (now called the undeducted construction expenditure ).

The gross deduction is calculated as if the whole of a building was used in a deductible manner. Apportionment rules then apply if necessary to reduce the deduction to an amount referable to the part actually used. However, the apportionment rules differed in each Division.

Under Division 10C, the deduction for traveller accommodation buildings is reduced if:

•

any part of the building was not used to operate a hotel or for short-term traveller accommodation; or

•

the building was used only partly to produce assessable income.

Under Division 10D, the deduction is reduced if:

•

any part of the building is not used to produce assessable income; or

•

the building is used only partly to produce assessable income.

Two separate reductions are appropriate to the calculation of the Division 10C deduction because there are two separate use tests which must be satisfied for hotel and apartment buildings, but Division 10D has only one use test.

Step 2 of clause 43-215 contains the reduction that is specific to hotel and apartment buildings. Step 3 contains the further reduction for any building that is used only partly to produce assessable income.

2. Change

The mechanism used to determine the total period over which deductions may be claimed has been made uniform for all capital works, irrespective of when they began.

Explanation

Under the existing law, two different mechanisms are used. For capital works begun before 27 February 1992 the time limit is either 25 or 40 years. For capital works begun after 26 February 1992 the limit is based on not deducting more than the residual capital expenditure (to be called undeducted construction expenditure ).

The rewrite uses only one mechanism to determine the period for deduction. Undeducted construction expenditure is used because it is effective for all capital works.

C. Date of effect

Proposed Division 43

New Division 43 will apply to all capital works deductions claimed in the 1996-97 income year regardless of when capital works began.

D. Transitional arrangements

Special transitional provision - quasi-ownership rights [clause 43-100]

Division 10D of Part III of the Income Tax Assessment Act 1936 allows a deduction to holders of Crown leases (as defined for the purposes of section 54AA of that Act). That definition extends the ordinary meaning of Crown lease to include easements and rights, powers and privileges over land. However, the extended meaning of Crown lease:

•

only applies to buildings begun after 26 February 1992;

•

does not apply to traveller accommodation buildings (Division 10C).

The extended meaning of Crown lease is covered by the new terms quasi-ownership right , exempt Australian government agency and exempt foreign government agency . These terms are explained in Chapter 11.

In so far as the extended meaning of Crown lease applies to hotel and apartment buildings it will only apply to buildings begun after 30 June 1996.

Special transitional provision - exclusive deduction provision [clause 43-105]

Division 10D of Part III of the Income Tax Assessment Act 1936 contains a provision ensuring that construction expenditure is only deductible to the owner, or subsequent owner, under that division.

It also prevents a subsequent owner from claiming a deduction for expenditure incurred in acquiring the part of the building that the construction expenditure relates to.

These rules will apply to all capital works under Division 43 [subclauses 43-50(1) and (2)] . However, a transitional provision will ensure that they only apply to hotel buildings and apartment buildings begun after 30 June 1996.

E. Consequential amendments to the Income Tax Assessment Act 1936 and other Commonwealth legislation

Consequential amendments - record keeping [clause 264]

A new subsection 262A(4AJA) will be inserted in the Income Tax Assessment Act 1936 to impose the same record keeping obligations for Division 43 as exist in subsections 262A(4AF) to (4AJ) for Divisions 10C and 10D of Part III of the 1936 Act. This is needed to reflect the merger of Divisions 10C and 10D into proposed Division 43.

Proposed subsection 262A(4AJA) will apply to disposals of capital works for which deductions have been allowed under Division 43, or under Divisions 10C or 10D, that occur in the 1996-97 or subsequent income years.