Edited version of private advice

Authorisation Number: 1052130196537

Date of advice: 3 July 2023

Ruling

Subject: Deduction for special levy for repairs of rental property

Question 1

Can the Taxpayer claim a deduction in the income year ended 30 June 20XX under section 25-10 of the Income Tax Assessment Act 1997 for the full amount of the special levy they paid in that income year to the body corporate for repairs to their rental property?

Answer

No.

Question 2

If the answer to Question 1 is no, can the Taxpayer claim as a deduction under section 25-10 of the Income Tax Assessment Act 1997 a portion of the special levy amount in the income years in which expenditure was incurred on repairs?

Answer

Yes.

Question 3

If the Taxpayer are not able to claim a deduction under section 25-10 of the Income Tax Assessment Act 1997 for legal expenses incurred by the body corporate can the partnership claim a partial deduction under section 8-1 of the Income Tax Assessment Act 1997 for that portion of the special levy amount that was incurred for legal expenses?

Answer

Yes.

Question 4

If the Taxpayer are not able to claim a deduction under section 25-10 of the Income Tax Assessment Act 1997 for the cost of repairing an air conditioner located at Unit X at Address X can the entity claim a deduction under section 8-1 of the Income Tax Assessment Act 1997 for that portion of the special levy amount that was incurred in repairing this air conditioner?

Answer

Yes.

This private ruling applies for the following periods:

Year ended 30 June 20XX

Year ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

1.         The Taxpayer is an entity for tax purposes.

2.         The Taxpayer purchased a unit in a multi-level apartment building comprised of several residential units, advertised for sale off the plan. The Taxpayer's unit is herein referred to as the Property.

3.         After settlement of the purchase of the Property was finalised a managing agent was engaged, and the Property was leased as soon as possible. It continued to be, leased out to tenants from the date it was purchased to the date it was declared not fit for occupancy.

4.         It was assumed by the Taxpayer that the property was fit for occupancy aside from the minor repairs often required with newly constructed premises.

5.         It then became evident through comments of tenants that the building had drainage issues and water ingress. The unit owners made complaints to the body corporate managers.

6.         Damage to the Building continued to the point where occupancy was deemed to be a health hazard.

7.         A report was commissioned that detailed the extent of the damage and that there were two causes of the damage, being:

•        a construction fault not identified at completion of construction; and

•        damage that was caused by the construction fault.

Special Levy

8.         All of the units were found to have differing amounts of damage, as well as damage to the common areas of the Building. It was to divide the overall expense equally amongst the unit owners.

9.         The Taxpayer paid their contribution in the first income year that this ruling applies for, and work was undertaken over both income years that this ruling applies for.

10.      The funds collected were mainly spent on the repairs to the building which includes the Property and other units. However, some amounts we spent on legal fees in response to a query from one of the unit holders and on the repair of an air-conditioner at one of the units.

11.      Not all of the special levy was spent, and the Taxpayer's share of surplus funds was refunded before the end of the second income year that this ruling applies for.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 25-10

Income Tax Assessment Act 1997 subsection 25-10(1)

Income Tax Assessment Act 1997 subsection 25-10(2)

Income Tax Assessment Act 1997 subsection 25-10(3)

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 subsection 8-1(1)

Income Tax Assessment Act 1997 subsection 8-1(2)

Reasons for decision

All legislative references in this private ruling application are to the ITAA 1997 unless otherwise stated.

Question 1

Can the Taxpayer claim a deduction in the income year ended 30 June 20XX under section 25-10 for the amount of the special levy they paid in that income year to the body corporate for repairs to their rental property?

Summary

No. A deduction for the full amount of the special levy cannot be claimed in the income year which the special levy is paid to the body corporate. The whole of the special levy is not incurred in that income year. Further, it must be determined whether the various expenditures actually incurred were a deductible repair or capital expenditure: The portion of the expenses incurred that relates to deficiencies in the original construction of the building present when it was acquired are an 'initial repair', and initial repairs are expenses that are capital in nature.

Detailed reasoning

12.      Section 25-10 deals with repairs to premises:

(1) You can deduct expenditure you incur for repairs to premises (or part of premises) or a *depreciating asset that you held or used solely for the *purpose of producing assessable income.

(2) If you held or used the property only partly for that purpose, you can deduct so much of the expenditure as is reasonable in the circumstances.

(3) You cannot deduct capital expenditure under this section.

13.      Thus, there are in effect four requirements that must be satisfied in the given circumstances:

You incur the expenditure

(i)        That expenditure is on repairs to premises (or part of premises) or a depreciating asset

(ii)       The premises (or part of a premises) or the depreciating asset must be used solely for the purpose of producing assessable income; and

(iii)      The expenditure cannot be capital in nature.

14.      A taxpayer may be able to claim a deduction for body corporate fees and charges for the rental property to the extent they are incurred in producing assessable income.

15.      Body corporate fees may be incurred to cover costs of day-to-day administration and maintenance or may be applied for a special purpose.

16.      In the given circumstances the Special Levy is a contribution to a special purpose fund, the monies in which are to be applied to carry out work to rectify deficiencies in the construction of the Building and damage in the nature of repairs flowing from construction deficiencies.

17.      The whole of this Special Levy is not deductible in the financial year that it is paid by the Taxpayer to the body corporate as the expenditure on the Building Works was not all incurred in that year. As the body corporate was charged on completion of stages or milestones of the Building Works, as those stages or milestones are completed and the body corporate has a presently existing liability to pay the relevant amount for those partial works, that portion of the fee is deductible.

18.      When an amount is incurred is to be determined from the individual contracts entered into. For example, the expense may be incurred when the invoice for that part of the works is received, or it may be incurred at an earlier time.

19.      It must be determined once the Building Works, or the stage of the works, is completed, and there is a presently existing liability to pay the expense, whether the expenditure from the special levy fund was a repair or capital expenditure.

Question 2

If the answer to Question 1 is no, can the Taxpayer claim as a deduction under section 25-10 a portion of the special levy amount in the income years in which expenditure was incurred on repairs?

Summary

Yes. A deduction can be claimed in the income years which the expense was incurred to the extent which genuine repairs were completed and those repairs are not capital in nature.

Detailed reasoning

20.      As discussed in our reasons for decision for Question 1, section 25-10 deals with repairs to premises and there are in effect four requirements that must be satisfied for the section to apply.

21.      In examining subsection 25-10(1), the Taxpayer leased the Property out, or had it available for lease, since they acquired it, i.e. the Property has been held solely to produce assessable income by way of rent since that date.

22.      The expenditure for repairs to premises can be deductible once it is 'incurred'.

23.      TR 97/7[1]discusses the meaning of both incurred and the timing of deductions under section 8-1. As a broad guide, you incur an outgoing at the time you owe a present money debt that you cannot escape.

24.      With reference to paragraph 6(a) of TR 97/7, an amount does not have to be paid to be incurred. An invoice was issued on behalf of the body corporate to the Taxpayer, with a due date for payment of the same date. However, the special levy amount was not an amount that the Taxpayer became 'completely subjected' at the time this invoice was issued or paid, because the special levy funds not spent are refundable to the unit owners (as in fact subsequently occurred)[2].

25.      The expenditure is incurred by the unit owner at the time the relevant part of Building Works are completed on the property and the body corporate has a presently existing liability to pay the relevant amount.

Common Property

26.      Subsection 25-10(1) states that repair expenditure can be claimed for repair to the premises or part of the premises.

27.      The whole of the Building is common property for the purposes of the relevant state strata law and described as such in the strata plan, and the lot owners hold the Building as tenants in common under the relevant state strata law. The lot owners have agreed the portion of cost of the Building Works that each owner is to bear.

28.      Therefore, the repairs to other units is still a repair to the part of the property held by the particular lot owners.

No deduction for capital expenditure

29.      Under subsection 25-10(3), you cannot deduct capital expenditure.

30.      Therefore, the next step is to determine if all or a part or part of the expenditure is a repair and, if so, whether it is capital expenditure.

Is the expenditure a repair in the ordinary meaning?

31.      Paragraphs 13 to 16 of 97/23[3] set out the Commissioner's view as to the ordinary meaning of repairs:

The word 'repairs' has its ordinary meaning. It ordinarily means the remedying or making good of defects in, damage to, or deterioration of, property to be repaired (being defects, damage, or deterioration in a mechanical and physical sense) and contemplates the continued existence of the property.

32.      Work done to prevent or anticipate defects, damage or deterioration (in a mechanical or physical sense) in property is not in itself a 'repair' unless it is done in conjunction with remedying or making good defects in, damage to, or deterioration of, the property.

33.      Repair for the most part is occasional and partial. It involves restoration of the efficiency of function of the property being repaired without changing its character and may include restoration to its former appearance, form, state or condition. A repair merely replaces a part of something or corrects something that is already there and has become worn out or dilapidated. Works can fairly be described as 'repairs' if they are done to make good damage or deterioration that has occurred by ordinary wear and tear, by accidental or deliberate damage or by the operation of natural causes (whether expected or unexpected) during the passage of time.

34.      To repair property improves to some extent the condition it was in immediately before repair. A minor and incidental degree of improvement, addition or alteration may be done to property and still be a repair. If the work amounts to a substantial improvement, addition, or alteration, it is not a repair and is not deductible under section 25-10.

35.      In the given circumstances, if the works were not carried out on the Building, the Property was not able to be rented out as it had become hazardous.

36.      With reference to the above paragraphs and the Scope of Works, the removal and replacement of the flooring and grout, plaster, floor joists, downlight fittings, and doors, is making good the deterioration of those items, which is a repair.

37.      Taxation Ruling TR 97/23 provides the Commissioner's view on repairs that are allowable under section 25-10 and indicates that expenditure for repairs to property is of a capital nature where:

•        the extent of the work carried out represents a renewal or reconstruction of the entirety, or

•        the work results in a greater efficiency of function in the property, therefore representing an 'improvement' rather than a 'repair', or

the work is an initial repair.

Use of different materials

38.      Under the Scope of Works, light fittings, tiles and grout, plaster ceiling, carpet, cement flooring, floor joists are damaged and were to be removed and replaced, thus restoring them to their original functionality.

39.      Some of the Scope of Works includes the provision of better materials which may be waterproof or more durable, i.e. waterproof membrane, rust kill paint. There was also added technology to reduce future water damage to the structure, i.e. stainless steel tray flashing, leak control flanges.

40.      Paragraphs 48 to 52 of TR 97/23 discuss the use of different materials:

48. If expenditure is incurred in replacing or renewing a part of property with a material of a different type from the original, the work done may either repair the property, or be an improvement to it. The use of different materials is not in itself determinative of the issue.

49. Whether the use of a more modern material to replace the original material qualifies as a repair is a question determined on the facts of each case. It is restoration of a thing's efficiency of function (without changing its character) rather than exact repetition of form or material that is significant.

50. If the work done restores a previous function to the property, or restores the efficiency of the previous function, it does not matter that a different material is used. Even if the work done using different material enables the property to perform its function marginally more efficiently, the work may still constitute a deductible repair. However, the greater the work enhances the efficient functioning of the property, the more likely it is that the work constitutes an improvement.

51. The test is whether there is a sufficient degree of improvement to justify characterising the expenditure as capital and therefore excluding it from deductibility under section 25-10.

52. If the work produces a new and different function, or an additional function, it is likely to constitute a capital improvement.

Expenditure to remedy defects, damage or deterioration in existence at the date of acquisition (initial repairs)

41.      It is contended by the taxpayer that no improvements were made to the Building in excess of what was 'regarded to be in situ at the time the property was acquired'.

42.      A contribution to the special levy was received by the builders and plumbing contractors as an acknowledgement of deficiencies in construction, which shows that upon construction of the Building it was not properly performing its function.

43.      Therefore, consideration must be given to whether any part of the Building was deficient at the time of purchase, as this will be considered an initial repair, which is a capital expense and not deductible under section 25-10.

44.      Paragraphs 59 to 60 and 125 to 134 of TR 97/23 discuss initial repairs:

59. Expenditure incurred on an initial repair after property is acquired, if the expenditure is incurred in remedying defects, damage or deterioration in existence at the date of acquisition, is capital expenditure and is not, therefore, deductible under section 25-10. This is so whether the property is purchased or obtained under lease or licence by the taxpayer. The cost of effecting an initial repair is still not deductible even if some income happens to be earned after acquisition but before the repair expenditure is incurred: but see paragraphs 63 to 66 of this Ruling in relation to dissecting or apportioning initial repair costs.

60. The main consideration in relation to initial repairs is the appearance, form, state and condition of the property and its functional efficiency when it is acquired. Expenditure that remedies some defect or damage to, or deterioration of, property is capital expenditure if the defect, damage or deterioration:

(a) existed at the time of acquisition of the property; and

(b) did not arise from the operations of the person who incurs the expenditure.

61. It is immaterial whether at the time of acquisition the taxpayer was aware of the condition of the property, including its need for repair. It is also immaterial whether the purchase price (or lease rentals) reflected the need for repairs. We consider that the English Court of Appeal decision in Odeon Associated Theatres Ltd v Jones (Inspector of Taxes) [1972] 1 All ER 681 is not authority in Australia for a contrary view. An initial repair expense is not the type of repair expenditure ordinarily incurred as a working or operating expense in producing assessable income or in carrying on a business. This is because it lacks a connection with the conduct or operations of the taxpayer that produce the taxpayer's assessable income. It is essentially an additional cost of acquiring the property or an improvement in the quality of the property acquired. Initial repair expenditure relates to the establishment of the profit - yielding structure. It is capital expenditure and is not deductible under section 25-10.

125. A repair after acquisition of property is an 'initial repair' if repair was due when the property was acquired, in the sense that there was a need for repair to restore or maintain the property's efficiency of function. In other words, the property was neither in good order when it was acquired nor suitable for use for income purposes in the way intended.

126. The leading Australian case in this area is the High Court decision in the Thomas case. There, Windeyer J held that the costs of repairing a roof, guttering, wall, basement floor and wooden floor and painting a building in the year of income it was acquired was expenditure of a capital nature.

127. His Honour said (at 115 CLR 72; 14 ATD 87):

'Expenditure upon repairs is properly attributable to revenue account when the repairs are for the maintenance of an income-producing capital asset. Maintenance involves the periodic repair of defects that are the result of normal wear and tear in operation. It is an expense of a revenue nature when it is to repair defects arising from the operations of the person who incurs it. But if when a thing is bought for use as a capital asset in the buyer's business it is not in good order and suitable for use in the way intended, the cost of putting it in order suitable for use is part of the cost of its acquisition, not a cost of its maintenance. The decision of the Court of Session in Law Shipping Co. Ltd. v. Inland Revenue Commissioners, [(1923) 12 TC 621] is commonly cited as authority for that proposition. The principle is obvious without the need for any supporting authority.' (emphasis added)

128. His Honour made it clear that it is immaterial whether the taxpayer knew of the defects or whether the purchase price was affected by them. Windeyer J said (at 115 CLR 74; 14 ATD 88):

'It seems to me immaterial that when the taxpayer acquired the building it did not know of some of its defects.... That means only that the cost of obtaining an asset suitable for its purpose was greater than had been expected.'

45.      The report received by the body corporate found that the Building had at least two issues that existed immediately post-construction, and thus prior to the date of acquisition by the Taxpayer.

46.      It was also the opinion of the report's author that these issues should be addressed as a matter of urgency before significant damage occurs because of these defects.

47.      This information in the report provided by an industry expert illustrates there were issues present from construction, as well as damage to the building which arose post-construction

48.      Therefore, the works to fix the initial building defects that were in place at the building's completion will be considered a capital improvement and thus not deductible under section 25-10.

49.      The rectification of issues which arose post-construction are non-capital repairs and deductible under section 25-10.

50.      The expenses must be apportioned to the extent they are deductible and non-deductible.

Other expenditure

51.      The Legal Expenses related to a query from one of the unit owners and are not directly in respect of the repairs themselves regarding the building works. They were not incurred for repairs to the Building, and therefore are not deductible under section 25-10.

52.      With reference to the air conditioner, it as a separate asset from the building was not used by the Taxpayer to produce income and therefore that expenditure is not deductible under section 25-10.

Conclusion

53.      The special levy expenditure incurred by the Taxpayer included amounts for both deductible repairs and initial capital repairs.

54.      The expenses incurred must be apportioned between deductible and non-deductible amounts as .expenses incurred on Initial Repairs are capital and not deductible under section 25-10.

Question 3

Where the Taxpayer are not able to claim a deduction under section 25-10 for legal expenses incurred by the body corporate, can they claim a partial deduction under section 8-1 for that portion of the special levy amount that was incurred for legal expenses?

Summary

Yes. The legal expenses arose as a consequence of the income earning activity. The advantage sought by the Building Works included both non-capital repairs and capital improvements. Therefore, at least a portion of the legal fees are in relation to the body corporate being in a position to undertake to repairs and maintenance, and thus those legal fees are partly allowable deductions under section 8-1.

Detailed reasoning

55.      In relation to the Legal Expenses paid by the body corporate from the special levy, these expenses are not deductible under section 25-10 as they are not for a repair to premises, but they may be deductible under section 8-1

56.      Section 8-1 allows a deduction for any loss or outgoing to the extent that it is incurred in gaining or producing assessable income, providing the loss or outgoing is not of a capital, private or domestic nature.

57.      For legal expenses to be an allowable deduction under section 8-1, it must be shown that they are incidental or relevant to the income earning activity.

58.      The purpose of the Legal Expenses was to resolve an issue raised by one of the unit owners regarding the planned repairs. Once the dispute was resolved, the contract was signed by all Owners, and the Building works could be undertaken, Taxpayer could then continue producing rental income from their interest in Unit X.

59.      The taxpayer incurred the liability to pay the Legal Expenses in its capacity as a property owner. There is the necessary connection between the legal fees incurred and the gaining or producing of your assessable income. Therefore, the first limb of subsection 8-1(1) is satisfied.

60.      In determining whether a deduction for legal expenses is allowable, the nature of the expenditure must be considered. The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

61.      ATO ID 2002/938[4] provides the Commissioner's views on this: Where legal expenses arise as a consequence of the day-to-day activities of a business, the object of the expenditure is devoted towards a revenue end and the legal expenses are deductible (Herald & Weekly Times v Federal Commissioner of Taxation (1932) 48 CLR 113). However, where the expenditure is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337) (Sun Newspapers Ltd).

62.      Where an expense relates to multiple purposes, the expense must be apportioned between the purposes on a fair and reasonable basis (Ronpibon Tin NL & Tongkah Compound NL v Federal Commissioner of Taxation (1949) 78 CLR 47).

63.      Expenditure is capital in nature where it is made with a view to bring into existence an asset or advantage that is of enduring benefit. Capital expenditure is characterised by the fact that it is usually a one-off payment and establishes, replaces or enlarges the income producing asset.

64.      The advantage sought by the Building works included both non-capital repairs and capital improvements.

65.      Therefore at least a portion of the legal fees are to be attributed to repairs and maintenance which are allowable deductions not excluded by the negative limb under subsection 8-1(2) whereas other expenses are capital in nature.

Question 4

Where the Taxpayer is not able to claim a deduction under section 25-10 for the cost of repairing an air conditioner, can it claim a deduction under section 8-1 of the for its portion of the special levy amount that was incurred repairing this air conditioner?

Summary

Yes. The repair of the Unit 9 air conditioner arose because of the income earning activity. The air conditioner does not provide you an enduring benefit, therefore it is not capital in nature, and the expenditure incurred by the Taxpayer on the air conditioner is deductible under section 8-1.

Detailed reasoning

66.      The Project Budget Spreadsheet and the expenditure 'on the air conditioner' shows that this air conditioning unit was repaired as a result of water damage.

67.      As outlined in answer to Question 2, as the Taxpayer does not use the air conditioner to produce its assessable income, that outgoing is not deductible under section 25-10.

68.      Section 8-1 allows a deduction for any loss or outgoing to the extent that it is incurred in gaining or producing your assessable income providing the loss or outgoing is not of a capital, private or domestic nature.

69.      The Taxpayer contributed to the special levy whereby it was agreed that all tenants in common would share the expenditure equally.

70.      The initial inspection did not include the damage to the air conditioner and, following a further inspection, it was identified that the air conditioner on one of the units was damaged because of the water ingress. The body corporate managers agreed to pay for the costs of the repairs to that air conditioner.

71.      The result is that the expenditure incurred by by the Taxpayer to repair that air conditioner.

72.      Had the body corporate managers not agreed to this, the owner of that air conditioner would have had to meet the full cost of the repair themselves or take legal action against the body corporate to seek compensation for damage to their property caused by defects in the Building.

73.      The body corporate has a statutory obligation to the unit owners to maintain and repair the Building. By agreeing to pay for the cost of the repairs of the air conditioner, the body corporate was compensating the owner of the air conditioner for damage sustained to their air conditioner because the Building was not appropriately maintained.

74.      Therefore, the expense the Taxpayer has incurred in respect of the air conditioner is a share of the cost of repair of the air conditioner.

75.      The expense arose in relation to the income earning activity of the Taxpayer in their capacity as property owner. Therefore, the first limb of subsection 8-1(1) is satisfied.

Is it excluded because it is capital in nature?

76.      Under subsection 8-1(2) a deduction is not allowed if the loss or outgoing is capital in nature.

77.      The case of Sun Newspapers Ltd provides the test of whether a loss or outgoing is of a capital nature is whether it relates to the "profit yielding structure", which requires an enquiry as to whether the expenditure relates to the structure within which the profits are earned.

78.      The air conditioner is an asset of the relevant unit owner, i.e., there is no future or enduring benefit to any other owners of units in the Building.

79.      The air conditioner does not contribute to the profit yielding structure of the Taxpayer, and therefore it is not capital in nature, and the portion of the expense paid by the Taxpayer is deductible under section 8-1.

[1] Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions.

[2] Contributions refunded are also not assessable income of a unit owner, see para 71 of TR 2015/3.

[3] Taxation Ruling TR 97/23 Income tax: deductions for repairs.

[4] ATO Interpretative Decision ATO ID 2002/938 Income Tax Legal expenses incurred to preserve a financing arrangement.

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