Edited version of private advice

Authorisation Number: 1012626582634

Ruling

Subject: rental property expenses

Foreign rental properties

Client name

Questions and answers

Question 1

Are you carrying on a business in relation to your rental properties?

Answer

No.

Question 2

Are you required to declare your rental income and bank interest derived overseas in your Australian tax return?

Answer

Yes.

Question 3

Are you entitled to a foreign tax offset for tax paid overseas on your rental income?

Answer

Yes.

Question 4

Will the Commissioner allow you to return your overseas foreign sourced income on an overseas income year basis on your Australian income tax return?

Answer

No.

Question 5

Are your travel expenses overseas that are directly related to your rental property income an allowable deduction?

Answer

No.

Question 6

Are you entitled to a capital works deduction for your investment property built after 18 July 1985 from which you derive rental income?

Answer

Yes.

Question 7

Are you entitled to a capital works deduction for your investment property built prior to 18 July 1985 from which you derive rental income?

Answer

No

Question 8

Are you entitled to deduct rental expenses while your investment properties remain unrented?

Answer

No.

Question 9

Are you entitled to deduct the legal costs for evicting non-paying tenants and related losses?

Answer

Yes.

Question 10

Are you entitled to a deduction for expenses relating to a flat overseas, used for carrying on your rental investment business, such as water rates, electricity, building levies, and telephone expenses?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commences on

1 July 2009

Relevant facts and circumstances

You are a resident of Australia for taxation purposes.

You are a foreign resident of Country Y for taxation purposes.

You and your spouse built a number of flats and basement storerooms overseas after 18 July 1985 and own these flats as tenants in common in equal shares.

X flats are rented to tenants, one is owned by your sibling and the remaining flat is used by your spouse when they are overseas.

The basement rooms are used for storage.

You have a flat which was inherited by you and your spouse.

This property is held as tenants in common by you and your spouse in equal shares.

The property was built prior to 18 July 1985.

You have received rent from all of your rental properties for a number of years.

You pay tax on the rental income derived overseas with the country Y tax authorities.

The country Y tax year is a calendar year.

You derive interest on your country Y bank accounts and pay tax on this interest overseas.

Your spouse has made a number of trips overseas in the past few years.

The purpose of the trips was to find tenants for the flats and deal with taxation matters overseas.

The trips were predominantly for the purpose of dealing with the rental properties however, they did see family and friends while on these trips.

You did not accompany your spouse on any of these trips.

Your spouse patiently waits for calls from tenants from your flat overseas and this is a long tedious process given the current rental market overseas.

Your spouse also organised for repairs to be carried out on the properties and carried out some of these repairs themselves.

You and your spouse have previously advertised in the local newspaper for tenants without success.

You and your spouse advertise your flats for rent using self prepared posters in shop windows and other local areas.

Your spouse spends a few weeks a year while in Australia attending to the rental properties.

Your spouse spends some months a year overseas attending to the rental properties.

You and your spouse have incurred legal expenses in relation to the eviction of tenants and the recovery of unpaid rent.

You and your spouse do not have a formal business plan.

You and your spouse have not sought any advice in relation to running a business relating to rental properties.

You and your spouse have a manager overseas who organises and issues the regular monthly levies like cleaner, elevator maintenance, central heating, common areas maintenance and common bills payments.

You and your spouse have a tenant who also communicates with you on a regular basis on matters relating to the properties.

Your spouse's relative inspects the properties daily and reports to you via the phone in the vacant flat.

You and your spouse have not kept any documentation in relation to the properties and your spouse did not keep a travel diary for the trips they made overseas.

You and your spouse claim you are not sophisticated in Australian taxation matters and were not aware of your obligation to declare your worldwide income.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 6-5(2)

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 770-10

Income Tax Assessment Act 1997 Section 770-15

Reasons for decision

Carrying on a business

The Commissioners view on whether the letting of property amounts to the carrying on of a business is found in a number of places. 

Taxation Ruling TR 97/11, which is about whether a taxpayer is carrying on a business, states the question of whether a person is carrying on a business is determined by the facts in each individual case. This is done by considering the following indicators that have been used in court cases: 

• the nature of the activities, particularly whether they have the potential of profit making;  

• the repetition and regularity of the activities; 

• organisation in a business-like manner, including whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade

• in that line of business and the keeping of books or records;  

• the volume of the operations; and  

• the amount of capital employed. 

TR 97/11 states the indicators must be considered in combination and as a whole and whether a business is being carried on depends on the 'large or general impression gained' from looking at all the indicators. The weighting to be given to each indicator may vary from case to case. 

The intention of profit making is not a salient indicator. Paragraph 17 of TR 97/11 holds the intention of profit making is a determinative indicator where an activity does not have the potential to produce a profit. For example, where numerous rental properties are negatively geared, that activity may be disqualified as one of carrying on a business given its nature will be one of investment activity where profit is produced from capital gains.

Regarding the indicator of repetition and regularity of the activities, A person who simply co-owns an investment property or several investment properties is usually regarded as an investor who is not carrying on a rental property business, either alone or with the other co-owners. This is because of the limited scope of the rental property activities and the limited degree to which a co-owner actively participates in rental property activities. 

Similarly, in Taxation Ruling TR 93/32, which is about rental property and division of net income or loss between co-owners, the indicator of repetition and regularity of the activities is mentioned in quotes from Federal Commissioner of Taxation v McDonald (1987) 18 ATR 957; 87 ATC 4541, where Beaumont J said at ATR p 968; ATC p 4550 and at ATR page 969; ATC page 4552:  

The reference to "business" . . . indicates a "commercial enterprise as a going concern": see Hope v Bathurst City Council (1980) 144 CLR 1 at 8; 12 ATR 231 at 236 per Mason J. Purely domestic transactions are thus excluded from the definition: see Fletcher, op cit p 28. The "business" must be "carried on". This suggests some active occupation or profession: see IRC v The Marine Steam Turbine Co Ltd (1919) 12 TC 174 per Rowlatt J at 179.' . . . 'On the other hand, in the case of a private individual as distinct from a company, "it may well be that the mere receipt of rents from properties that he owns raises no presumption that he is carrying on a business." see American Leaf Blending Co Sdn Bhd v Director-General of Inland Revenue (1979) AC 676 per Lord Diplock at 684.  

In the present case, a number of indications point to the conclusion that the parties were not carrying on a business, with the consequence that their relationship was that of co-ownership rather than partnership. Their investment involved little, if any, active participation from either party ... This was not a case of the active joint participation by the parties in a business activity. Rather, it was a case of a renting out of premises without the provision of other services of the kind discussed in Wertman, supra. In my view, there was here a mere investment in property rather than a partnership in the properties or their profits.  

Paragraph 55 of TR 97/11 states about the indicator of repetition and regularity activities:

It is often a feature of a business that similar sorts of activities are repeated on a regular basis. The repetition of activities by the same person over a period of time on a regular basis helps to determine whether there is the 'carrying on' of a business. For example, in Hope the 'transactions were entered into on a continuous and repetitive basis', such that the taxpayer's activities 'manifested the essential characteristics required of a business'.

Regarding the indicator of the scale of operations, Taxation Ruling. IT 2423, which is about whether rental income constitutes proceeds of business (for withholding tax purposes), states:

A conclusion that an individual is carrying on a business of letting property would depend largely upon the scale of operations. An individual who derives income from the rent of one or two residential properties would not normally be thought of as carrying on a business. On the other hand if rent was derived from a number of properties or from a block of apartments, that may indicate the existence of a business.  

In brief, the legal cases and the views of the Commissioner listed above hold that even though the number of properties held may support the existence of a business, the repetition and regularity of or active participation in the activities is the salient indicator.  

In your case, the Commissioner considers you and your spouse are not carrying on a business of rental properties. Whilst you and your spouse have a number of properties which may support the existence of a business, you and your spouse do not have the repetition and regularity of or active participation in the activities to indicate you and your spouse are carrying on a business. The facts supporting this view are your spouse spends 2 weeks a year while they are in Australia carrying out tasks relating to the rental properties overseas such as monitoring the bank account for rental income deposits.

Your spouse returns overseas when required to interview for tenants. They have spent anywhere from 1-7 months overseas dealing with the rental properties. You and your spouse have a property manager overseas who organises and issues the regular monthly levies like cleaner, elevator maintenance, central heating, common areas maintenance and common bills payments. Your spouse's relative inspects the flats on a weekly basis and communicates with you and your spouse from the phone line in the vacant flat. You and your spouse also have a trusted tenant who also deals with some of the day to day operations of the flats and communicates with you and your spouse on a regular basis. You and your spouse do not have a formal business plan and have not sought advice in relation to the rental properties. You and your spouse have not kept comprehensive records in relation to the rental properties as this is not required for the country Y tax office and you were not aware you were required to keep records for the Australian tax office.

The Commissioner considers you and your spouse are not carrying on a business of rental properties as you have a manager who deals with the day to day running of the rental properties and your spouse's sibling and another tenant also assist in communication with you on matters concerning the properties. Although you and your spouse have a number of properties you are more of an investor rather than carrying on a business in relation to the properties.

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that here you are a resident of Australia for taxation purposes, your assessable income includes income gained from all sources, whether in or out of Australia. Rental income and bank interest is ordinary income assessable under section 6-5 of the ITAA 1997.

As a resident of Australia you are required to declare the income derived from your rental properties in Country Y in your Australian tax return according to your ownership. You own the properties as tenants in common in equal shares with your spouse and therefore you are required to declare 50% of the rental income derived and received from the rental properties in country Y in your Australian tax return along with the interest earn on your Country Y bank accounts.

Foreign Income Tax Offset (FITO)

To qualify for a foreign income tax offset under section 770-10 of the ITAA 1997 you must meet all the following criteria:

• You must have paid the foreign tax on the foreign income,

• The foreign tax must be a tax which you were personally liable for, and

• The income or gain that the foreign tax was paid must be included in your assessable income for Australian income tax purposes.

Foreign income tax is a tax imposed by a law other than an Australian law, on income profits or gains (subsection 770-15(1)(a) of the ITAA 1997.

You have paid tax on your rental income in country Y. You are entitled to claim a foreign Income tax offset for the tax paid on the income derived in Country Y subject to the FITO limits.

Adoption of foreign income year basis for returning foreign income

The general rule is that for income tax purposes an individual taxpayer will be required to disclose in his or her Australian tax return the amount of foreign income derived during the Australian financial year.

It has been recognised in the past that where an individual taxpayer's foreign source accounts have been prepared on a basis other than the year ended 30 June, difficulty can be experienced in dissecting the income for the purposes of returning on a strict Australian income year basis.

The Commissioner has issued Taxation Ruling IT 2498 Income Tax: foreign tax credit system: currency translation of foreign income: trading stock and depreciable plant: basis of returning foreign income: capital gains/losses which addresses the issue of foreign income and expenses to be returned for an Australian year of income where foreign accounts and/or tax apply on a different basis.

Specifically, paragraph 39 of IT 2498 states:

… individual taxpayers who are required to prepare foreign source income accounts on a basis other than a year ending 30 June and who can demonstrate difficulties in dissecting the income/expenses for the purposes of returning on a strict Australian income year basis in relation to a year of income, may be permitted to return the foreign source income in his or her Australian return for that year of income on the relevant foreign income year basis. …

You are in receipt of Country Y foreign source income. You argue that for practical purposes you believe the Commissioner should allow you to return your country Y sourced income on a country Y financial year basis due to the fact that it is very difficult and a long process to reconcile the country Y Tax with the Australian Tax rules in attempting to consolidate and declare world income and expect to arrive at an equitable and fair outcome.

From the information provided the Commissioner does not accept that your circumstances fall within those outlined in IT 2498 and will not allow you to return the foreign sourced income on a country Y income year basis on your Australian tax return.

Travel expenses

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.  You have made a number of trips to country Y in relation to your rental properties. You and your spouse have incurred expenses relating to airfares to and from country.

Substantiation Provisions 

Special substantiation rules apply to expenses in relation to overseas travel under Division 900 of the ITAA 1997. The effect of the substantiation provisions is that overseas travel expenses are not deductible unless the following two conditions are satisfied: 

(a) Written evidence must be obtained by the taxpayer in respect of expenses relating to travel;

(b) Travel records (i.e. a travel diary or similar document) must be kept by the taxpayer where the taxpayer was away from the ordinary place of residence for six or more consecutive nights. The diary should stipulate:

• The nature of the activity,

• The day and approximate time it began,

• How long it lasted,

• Where the activity took place.  

You and your spouse did not maintain a travel diary for your trips to country Y. As mentioned, a travel diary is required where you are away from your ordinary place of Residence for six or more consecutive nights.  Your spouse was away from their ordinary place of residence for each of the trips they made to Country Y. Consequently, the airfares are not an allowable deduction under section 8-1 of the ITAA 1997.

Capital works deduction

A deduction is allowable for capital expenditure incurred on certain income-producing buildings for:

• The construction of; or

• An extension, alteration or improvement. 

For 1998 and future years the deduction is allowable under section 43-10 of the Income Tax Assessment Act 1997 (ITAA 1997). For 1997 and prior years, sections 124ZG and 124ZH of the Income Tax Assessment Act 1936 (ITAA 1936) apply.  

The deduction is either 2.5% or 4% of the construction expenditure, depending on when construction started and how the capital works are used. 

In the case of residential rental properties, you can deduct certain kinds of construction expenditure and the deduction would generally be spread over a period of 25 or 40 years. A deduction is allowable only for the period that the property is rented or is available for rent. 

The following rules apply for residential rental properties:

• if construction of the building started before 18 July 1985, you cannot claim a capital works deduction. 

• if construction of the building started between 18 July 1985 and 15 September 1987, the annual capital works deduction allowable is 4% of the construction expenditure. 

• if construction of the building started after 15 September 1987, the annual capital works deduction allowable is 2.5% of the construction expenditure. 

The deduction can be claimed for 40 years from the date of construction. However the deduction is only allowable from the day the building is first used for income producing purposes.

You and your spouse obtained development approval for the flats Country Y after 18 July 1985 and you commenced construction of the rental properties soon after the approval was given. The flats were available for rent in 1996/97.

You can only claim a capital works deduction for the flats Country Y from the time the flats became income producing.

A capital works deduction is not available for the property in country Y as it was built prior to 18 July 1985.

Deduction for vacant rental property

To claim expenses that relate to your rental property, you must be holding the property for the purpose of gaining or producing assessable income. Generally, a property is considered to be held for the purpose of gaining or producing assessable income where it is either tenanted, listed with an agent as being available for tenancy or where the owner is making active and bona fide efforts to let the property. 

Paragraph 25 of Income Tax Ruling IT 2167 states that when determining whether the property was available for rent, only the periods of vacancy should be taken into account where it is established that active and bona fide efforts were made to let the property at a commercial rate. 

Unless active and bona fide efforts are being made to attract new tenants during periods of vacancy, it is considered that the property is not available for rent for the full year and not wholly used for producing assessable income. The losses and outgoings are therefore limited or apportioned. 

Various court cases have considered whether active and bona fide efforts were made to let a property. In Inglis v. Federal Commissioner of Taxation (1979) 28 ALR 425; 10 ATR 493; 80 ATC 4001 (Inglis case), a rental property located in a NSW beach resort was only leased for part of the year during the school holidays and at Easter. The Administrative Appeals Tribunal considered whether expenses relating to a rental property should be apportioned to reflect only the period which the property was let.

The taxpayers efforts to attract tenants were limited to an advertisement in the Canberra Times and word of mouth. The Tribunal concluded the method of advertising the property only made the property available to people from Canberra and limited the potential to attract tenants. Even though the property was vacant and theoretically available at all times, it could not be said that the property had been genuinely available for rent for the whole year. On this basis, the rental property expenses were apportioned to reflect periods when the property was actually let.

On the other hand, the efforts made by the taxpayers in Case V133 88 ATC 847 (Case V133), were considered to be active and bona fide. Their efforts involved extensive advertising and promotion of their property including advertisements in daily newspapers, specialised journals and other newspapers, writing letters to various companies, and listing the property with several real estate agents. The primary purpose of having the property was for gaining assessable income and the gaining of a return on their investment.

In your case you and your spouse do not advertise your properties for rent in local newspapers as you believe this is not affective in attracting tenants due to no responses from an advert placed previously for one of your properties.

You and your spouse place posters with your contact details in shop windows and other places in the local area. Your spouse also patiently waits for phone calls from tenants and then shows them around the flat. If your spouse is not in country Y when a tenant commences inquiries about a flat you and your spouse rely on your spouse's sibling to show them through the flat etc.

We do not believe that the flats are genuinely available for rent and that you are doing all that is possible to attract new tenants. Therefore the periods that the flats are vacant you are not able to have a deduction for the expenses associated with them.

Legal expenses

Generally, legal expenses have been held to be deductible if the expenses have arisen as a consequence of the taxpayer's income earning activities provided that the legal expenses are not of a capital, private or domestic nature (Herald & Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; 2 ATD 169 (Herald & Weekly Times ), Putnin v. Federal Commissioner of Taxation (1991) 27 FCR 508; 91 ATC 4097; (1991) 21 ATR 1245 (Putnin's Case) and Federal Commissioner of Taxation v. Snowden & Willson Pty Ltd (1958) 99 CLR 431; 11 ATD 463; (1958) 7 AITR 308 (Snowden's Case )).

The principles established in Herald & Weekly Times are not confined to recurring or common expenses (Putnin's Case and Snowden's Case). Legal expenses can be characterised as an outgoing on revenue account or an outgoing of a capital nature depending on the cause or purpose for which the legal expenses were incurred (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; 8 ATD 190).

The principles espoused in Herald & Weekly Times were applied in Case C12 (1952) 3 TBRD 100 (Case C12). That case dealt with the trustees of a deceased estate, who let a city property to a number of tenants. A tenant's injured employee claimed damages against the trustees in respect of injuries she sustained on the rental premises. The Board, in allowing the trustees a deduction for the amount that they paid to settle the claim, stated that:

[the trustees] became liable... because they had let rooms to tenants...It was in the capacity of landlord that the outgoing was incurred...the expense incurred resulted from a risk which, to a landlord, is ever present...the expense claimed as a deduction was one which arose out of the letting of the building to tenants for the purpose of producing assessable income, and that it can properly be regarded as having been incurred 'in the course of' gaining or producing that assessable income...I cannot see that the outgoing produced "an enduring benefit" of any sort. I can see no justification ...for capitalising the expense. It seems to me to be one which should properly be set against revenue account.

You and your spouse incurred the legal expenses in your capacity as landlords of the rental property. The expenses arose out of the letting of the premises to a tenant for the purposes of producing assessable income. There is a clear connection between your legal expenses and your rental income such that the expenses are incidental and relevant to the generation of your assessable rental income. Therefore, you and your spouse are entitled to a deduction under section 8-1 of the ITAA 1997 for legal expenses incurred in recovering the rental income.

Vacant flat

As already stated a deduction under section 8-1 of the ITAA 1997 is available to the extent that is incurred in gaining or producing assessable income, or is necessarily incurred in carrying on a business. You and your spouse have a flat in country Y which remains vacant at all times other than when your spouse is in Country Y. your spouse stays at this property for the duration of their stay in country Y.

As already determined the commissioner is not satisfied that you and your spouse are carrying on a business in relation to rental properties and you do not derive any income from this flat in Country Y , therefore no deduction in relation to the expenses relating to this flat are deductable under 8-1 of the ITAA 1997.

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