Edited version of private ruling

Authorisation Number: 1011676911199

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Ruling

Subject: Deductibility of costs - business asset - repair or improvements - depreciation of separate asset.

Question 1

Is interest and bank fees incurred on loans, where the loan has been taken out specifically for the repairs to your building only, deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

To the extent that the works carried out on your building are repairs, are costs incurred to repair your building, including electricity and equipment hire costs necessarily incurred in order to make those repairs, deductible under section 25-10 of the ITAA 1997?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 2011

The scheme commenced:

1 July 2010

Relevant facts and circumstances

You purchased property. The property had not been in use for the 12 months prior to your acquisition of the property.

At the time of acquisition the property required substantial repairs to an existing building. However you did not pay any less for the property because of its condition.

You took out loans and began works to repair the building with the intention of operating your business from that building soon after the acquisition time.

You have claimed the GST on costs to date.

Relevant legislative provisions

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)

Income Tax Assessment Act 1997 Division 25

Income Tax Assessment Act 1997 Section 25-10

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

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

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

Income Tax Assessment Act 1997 Section 25-25

Income Tax Assessment Act 1997 Subsection 25-25(5)

Income Tax Assessment Act 1997 Division 43

Income Tax Assessment Act 1997 Section 43-10

Income Tax Assessment Act 1997 Subsection 43-10(1)

Income Tax Assessment Act 1997 Subsection 43-10(2)

Income Tax Assessment Act 1997 Section 43-20

Income Tax Assessment Act 1997 Subsection 43-20(1)

Income Tax Assessment Act 1997 Section 43-140

Income Tax Assessment Act 1997 Subsection 43-140(1)

Further issues for you to consider

We have limited our ruling to the questions raised in your application. There may be related issues that you should consider including:

· whether you may deduct an amount that relates to the costs of establishing your loans (borrowing costs) under section 25-25 of the ITAA 1997

· whether an asset is a depreciating asset for the purposes of Division 40 of the ITAA 1997

· whether an immediate write-off is available for certain low cost tangible assets, and

· whether the Non-commercial losses provisions apply to an individual.

Reasons for decision

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Question 1

Detailed reasoning

Subsection 8-1(1) of the ITAA 1997 provides that you may deduct from your assessable income any loss or outgoing to the extent that:

· it is incurred in gaining or producing your assessable income; or

· is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

However, subsection 8-1(2) of the ITAA 1997 includes a provision that you cannot deduct a loss or outgoing under this section to the extent that it is a loss or outgoing of capital, or of a capital nature.

Taxation Ruling TR 2004/4 considered the decision of the High Court in Steele v. Deputy Commissioner of Taxation (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 (Steele's case) concludes that interest incurred in a period prior to the derivation of relevant assessable income will be incurred in gaining or producing the assessable income in the following circumstances:

· the interest is not incurred 'too soon', is not preliminary to the income earning activities and is not a prelude to those activities;

· the interest is not private or domestic;

· the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost;

· the interest is incurred with one end in view, the gaining or producing of assessable income; and

· continuing efforts are undertaken in pursuit of that end.

Drawing upon Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613, FC of T v. Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52, and Steele's Case, Taxation Ruling TR 2004/4 sets out that the deductibility of interest is typically determined through an examination of the purpose of the borrowing and the use to which the borrowed funds are put.

Further, Steele's Case discussed that outgoings of interest are a recurrent expense. The fact that borrowed funds may be used to purchase a capital asset does not mean the interest outgoings are therefore on capital account.

In addition, Hill J in Kidston Goldmines Limited v. FC of T 91 ATC 4538 at 4545; (1991) 22 ATR 168 at 176 stated that ordinarily '...the purpose of the borrowing will be ascertained from the use to which the borrowed funds were put...'. However, as his Honour later observed in FC of T v. JD Roberts; FC of T v. Smith 92 ATC 4380 at 4388; (1992) 23 ATR 494 at 504, '...a rigid tracing of funds will not always be necessary or appropriate...'.

While Steele's Case deals with the issue of interest, the principles can be applied to other types of expenditure including local council, water and sewage rates, land taxes and emergency services levies.

Steele's Case is also applied in ATO interpretive Decision ATO ID 2001/479, which discusses where a taxpayer can claim a deduction under section 8-1 of the ITAA 1997 for rates and other holding costs incurred on a vacant block of land held for future income producing purposes.

Application of the law

Following the principles outlined within TR 2004/4, in examining the purpose to which you have put the borrowed funds, you have applied those funds to repair property you have acquired for the purpose of producing assessable income.

In addition, that without obtaining a loan to perform those repairs your income producing structure could not operate as intended; this indicates that the interest incurred on your loans, and the ongoing and recurring costs of maintaining your loan accounts (bank fees), is more closely linked to producing your assessable income.

Further, in examining your circumstances and activity it is considered that:

· you hold property that you are repairing in the view of producing assessable income

· your expenses are incurred with regard to property to be used solely for income producing purposes. The expenses are considered not to have been incurred at a point 'too soon' before the commencement of the income producing activity.

· there is no private or domestic purpose for holding the property, your intention was always to repair the building to a state suitable for producing an income

· the length of time between purchase of the property and commencement of repairs is not considered to be so long that the necessary connection between the outgoings and the assessable income is lost. You intend to complete works soon after the acquisition of the property.

Therefore it is considered that interest and bank fees incurred on loans, where the loan has been taken out specifically for the repairs to your building only, is deductible under section 8-1.of the ITAA 1997.

Question 2

Detailed reasoning

General discussion of law

Division 25 of the ITAA 1997 provides certain particular amounts that you may deduct, including repairs.

Section 25-10 of the ITAA 1997 allows a deduction for the cost of repairs to premises used for income producing purposes. However, subsection 25-10(3) of the ITAA 1997 does not allow a deduction for repairs where the expenditure is of a capital nature.

Section 43-10 of the ITAA 1997 provides that you may deduct certain amounts relating to capital works. Where subsection 43-10(1) repairs where the expenditure is of a capital nature.

Section 43-10 of the ITAA 1997 provides that you may deduct certain amounts relating to capital works; where subsection 43-10(1) states that you can deduct an amount for capital works for an income year.

Subsection 43-10(2) states that you can only deduct the amount if:

(a) the capital works have a construction expenditure area; and

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

(c) you use your area in the income year in the way set out in Table 43-140 (Current year use).

Subsection 43-20(1) This Division applies to capital works being a building, or an extension, alteration or improvement to a building:

(a) begun in Australia after 21 August 1979; or

(b) begun outside Australia after 21 August 1990.

Section 43-140 repairs where the expenditure is of a capital nature.

Section 43-10 of the ITAA 1997 states that you must use your area in a deductible way. Specifically, the table under subsection 43-140(1) repairs where the expenditure is of a capital nature.

Section 43-10 of the ITAA 1997 sets out the way you must use your area in an income year for a deduction to be allowed under section 43-10 (the main deduction provision). The relevant use depends on the time when the capital works began, the type of capital works and how you use that area.

Generally, you must use the area for the purpose of gaining or producing your assessable income. This typically means that the building is being used, or is available for use, in operating your business.

Repairs or improvement?

Taxation Ruling TR 97/23 advises that repairs are of a capital nature where the work undertaken facilitates a greater efficiency of function in the property, therefore representing an 'improvement' rather than a 'repair'. With this in mind, it is necessary to determine if the work undertaken on your property is a repair or an improvement.

To constitute a repair, the work must not amount to a substantial improvement, addition or alteration. A repair merely replaces a part of something or corrects something that is already there and has become worn out or dilapidated. If the work amounts to a substantial improvement, addition or alteration, it is not a repair and is not deductible under section 25-10 of the ITAA 1997.

Some of the factors which indicate an improvement as opposed to a repair include:

· the modification work has effected an improvement to the asset,

· there is greater efficiency of function of the property,

· there is an increase in the value of the asset, and

· the expenditure provides considerable advantages and reduces the likelihood of future repairs.

In accordance with paragraph 55 of TR 97/23, it is necessary to examine separately the individual parts of the work to determine whether it is a repair or an improvement/initial repair.

The main consideration in relation to initial repairs is the appearance, form, state and condition of the property and its functional efficiency when it was acquired.

The Commissioner's view as expressed in TR 97/23 is that an initial repair refers to that which remedies some defect in property or makes good damage to, or deterioration of, property being a defect, damage or deterioration:

· existing when the property was acquired from another person; and

· not arising from the operation of the taxpayer who incurs the repair expenditure.

A repair is not an 'initial repair' simply because it is the first repair made after property is acquired. It is an 'initial repair' if repair is due when the property is acquired in the sense that the property has defects, damage or deterioration or is not in good order and suitable for use in the way intended.

TR 97/23 further highlights that initial repairs are of a capital nature and are not deductible under section 25-10, as they are an additional cost of acquiring the property.

TR 97/23 states that it is irrelevant whether, at the time of buying the property, the taxpayer was aware of the condition of the property, including its need for repair. Further, it is not necessary that the condition of the property be reflected in the price paid by the taxpayer to acquire the property.

Application of the law

In your case you purchased property with existing defects, damage and deterioration of the building located upon that property. You began works required to bring the building into a suitable condition to commence operating your business. You have not yet commenced operating your business, nor is the building available for operating your business.

In accordance with TR 97/23, the works you have undertaken are considered to be initial repairs, which are capital in nature and are an additional cost of acquiring the property.

Further, as the works carried on in respect of the building are considered to be initial repairs and you are not currently operating your business, those works are not improvements such that Division 43 would apply.

Therefore it is considered that to the extent that the works carried out on your building are repairs, costs incurred to repair your building, including costs necessarily incurred in order to make those repairs, are not deductible under section 25-10 of the ITAA 1997.