Edited version of private ruling

Authorisation Number: 1011850820582

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Ruling

Subject: Works to rental property, legal expenses and GST on settlement sum

Issue 1 - Rental property expenditure

Question 1

Are you entitled to a repairs deduction for the builder's and supervisory fees that you incurred to carry out the following works:

· demolish and rebuild part of building

· demolish and replace brick wall

· replace sky lights

· repair to concrete floor

· painting, and

· plumbing repairs?

Answer

No.

Question 2

Can you claim a capital works deduction for the above works from the date the property was transferred into your name when it was not yet being used for an income producing purpose?

Answer

No.

Question 3

Are you entitled to a capital works deduction for the above works from the date the construction was completed?

Answer

Yes - you can claim a capital works deduction calculated as 2.5% of construction costs over 40 years

Issue 2 - Legal expenses and settlement sum

Question 1

Are you entitled to a deduction for the following:

· the legal expenses you incurred in defending, counterclaiming and entering into a settlement, and

· the payment of the out of court settlement sum?

Answer

No.

Issue 3 - GST on settlement sum

Question 1

Does the out of court settlement amount paid include GST?

Answer

No.

Relevant facts and circumstances

You acquired the property in part from the estate of your parent and in part though a payment to your sibling to purchase their interest in the property from the estate.

Prior to acquiring the property, you assisted your parent with the property and appointed a real estate agent with the intention of leasing the property.

An offer to lease was procured, before you acquired the property, with a potential lessee.

Rental property

The offer to lease required the owner to undertake refurbishment work prior to the lessee taking possession.

You have stated that you commenced and paid for the refurbishment work required by the lessee.

You have stated that the property required substantial work to enable it to be suitable for rent. Due to external factors, you converted the property from a factory space to a retail space.

You also had to complete work on the aged and deteriorated walls, floors and roofing of the property.

The work was commenced before you acquired the property.

You incurred building and supervisor fees.

Included in the following work undertaken on the property were the following (with the builder's quoted price):

· demolish and rebuild part of the building to comply with council permit requirements

· demolish unsafe brick wall and replace with new brick wall

· replace sky lights

· work to concrete floor

· painting, and

· plumbing.

The building works were completed approximately X years later.

A formal lease did not eventuate due to disagreements between you and the prospective lessee.

You began renting the property and received the first rental payment X months after the building works were completed.

GST, legal expenses and settlement

You are registered for GST.

You did not implement a formal lease as the lessee continued to request an extension of the pre-lease renovations on the property.

After you acquired the property, the lessee commenced legal action against you, alleging that you breached your agreement to lease. They claimed that it was entitled to be granted a lease of the property and to compensation for loss of business.

You counterclaimed for possession, damages and mesne profits.

An injunction was put into place by the court, restricting you from leasing the property to another party.

On the advice of your legal representatives, you agreed to enter a settlement with the prospective lessee. You deposited a sum (inclusive of any GST payable) into their solicitors trust account.

The injunction was lifted as part of the consent orders on settling the matter, which were signed on the same day.

In defending the matter, making a counterclaim and entering into a settlement, you incurred legal expenses.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 25-10

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

Income Tax Assessment Act 1997 Division 43

Income Tax Assessment Act 1997 Section 43-10

Income Tax Assessment Act 1997 Subsection 43-25(1)

Income Tax Assessment Act 1997 Section 43-30

Income Tax Assessment Act 1997 Section 43-70

Income Tax Assessment Act 1997 Section 43-115

A New Tax System (Goods and Services Tax) Act 1999 Division 9

Reasons for decision

Issue 1 - Rental property expenditure

Summary

You are not entitled to a repairs deduction under section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997) for the builder's and supervisory fees incurred to carry out the following works:

· demolish and rebuild part of the building to comply with council permit requirements

· demolish unsafe brick wall and replace with new brick wall

· replace sky lights

· repair to concrete floor

· painting, and

· plumbing.

If some or all of these works was done to remedy defects, damage or deterioration, then those expenses would be considered to be 'initial repairs'. This is because the defects, damage or deterioration would have been in existence at the time you acquired the property as the work was carried out shortly after you acquired the property.

Further, if the work done was not to remedy defects, damage or deterioration, but rather to convert the premises from a factory space to a retail space or to meet the requirements of the prospective tenant, then the work does not meet the definition of a 'repair'.

A repairs deduction is not available for these works as they would either be initial repairs and therefore capital in nature or not meet the definition of a repair.

However, you are entitled to a capital works deduction calculated as 2.5% of construction costs over 40 years for the cost of all of the above works.

Please note you are only entitled to start claiming a deduction for these costs once the construction has been completed and the property was available for rent.

Detailed reasoning

Repairs

Section 25-10 of the ITAA 1997 allows a deduction for the cost of repairs to premises or depreciating assets 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.

Taxation Ruling TR 97/23 discusses the circumstances in which expenditure incurred for repairs may or may not be an allowable deduction under section 25-10 of the ITAA 1997.

The word 'repair' is not defined within the taxation legislation.  Accordingly, it takes its ordinary meaning. 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 (paragraph 15 of TR 97/23).

TR 97/23 explains (at paragraph 16) that to repair property improves to some extent the condition it was in immediately before the 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 of the ITAA 1997.

Repair costs are deductible where they are incurred during the period the property is held for income purposes and are attributed either to damage that occurs during that time.

While some works may be fairly described as repairs, the expenditure will be considered capital in nature in some situations, and therefore not deductible under section 25-10 of the ITAA 97. Expenditure incurred for repairs to property used for income producing purposes is of a capital nature where:

· the works result in a greater efficiency of function in the property, therefore representing an improvement rather than a repair; or

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

· the work is an initial repair.

An improvement

An 'improvement' involves bringing a thing or structure into a more valuable or desirable form, state or condition than a mere repair would do. Some factors that point to work done to asset being an improvement include whether the work will extend the asset's income producing ability, significantly enhance its saleability or market value or extend the asset's expected life.

When considering whether work does more than just restore property to its original function, as a repair would do, the main determinative factor is the actual functionality of the asset and not the functionality of the defective component.

An entirety

Taxation Ruling 97/23 states that a thing or structure is more likely to be an entirety if it is an integral part, but only a part, of entire premises and is capable of providing a useful function without regard to any other part of the premises or asset. The Ruling states that something that is part of a building, for example, a roof or wall, is just that and no more. The building itself is the entirety.

Initial repair

According to paragraph 125 of the TR 97/23, a repair after acquisition of property is an 'initial repair' if the 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.

Capital works

Division 43 of the Income Tax Assessment Act 1997 (ITAA 1997) provides a deduction for capital works attributable to a construction expenditure area that is owned or leased by the taxpayer and used during the income year for the purposes of producing assessable income.

Your rental property is a building to which Division 43 of the ITAA 1997 applies.

Subsection 43-25(1) of the ITAA 1997 provides that for structural improvements the annual special building write-off allowable is 2.5% of the construction expenditure for a period of 40 years. However, a deduction cannot be made prior to the completion of the capital works (section 43-30 of the ITAA 1997).

Capital works includes buildings and structural improvements and also extensions, alterations or improvements to buildings and structural improvements.

Section 43-70 of the ITAA 1997 defines construction expenditure as capital expenditure in respect of the construction of capital works.

Construction expenditure includes:

· preliminary expenses such as architect fees, engineering fees, foundation excavation expenses and costs of building permits;

· cost of structural features that are an integral part of the income producing buildings or income producing structural improvements, such as atriums and lift wells; and

· some portion of indirect costs.

Section 43-115 of the ITAA 1997 states that you are entitled to claim a deduction for capital works to the extent that you are the owner of the capital works.

Further, the 'use' test must be satisfied before a capital works deduction is available. That is, the capital works must actually be used in a deductible way in the income year in which the deduction is claimed. If the capital works started after 30 June 1997, they are used in a deductible way if used for the purpose of producing assessable income.

Application to your case

In your case, the following work was conducted on your property:

· demolition and rebuilding part of the building

· demolition and replacement of brick wall

· replacement of sky lights

· work to concrete floor

· painting, and

· plumbing.

We do not consider these expenses to be deductible repairs under section 25-10 of the ITAA 1997 for the following reasons:

If some or all of these works was done to remedy defects, damage or deterioration, then those expenses would be considered to be 'initial repairs'. This is because the defects, damage or deterioration would have been in existence at the time you acquired the property as the work was carried out shortly after you acquired the property.

If the work done was not to remedy defects, damage or deterioration, but rather to convert the premises from a factory space to a retail space or to meet the requirements of the prospective tenant, then the work does not meet the definition of a 'repair'.

In either case, these works are not deductible as repairs under section 25-10 of the ITAA 1997.

However these works are considered to be capital works for the purposes of Division 43 of the ITAA 1997.

Therefore, you are entitled to claim a capital expenditure deduction at a rate of 2.5% of eligible construction costs of the property, apportioned for the period it was used or available for income producing purposes.

However, any deductions that are allowable to you only arise upon the completion of the construction and apply for any income year during which you use the area for the purpose of producing assessable income.

Please note

When calculating the deduction under section 43-10 of the ITAA 1997, the construction expenditure is reduced to the extent that it includes any input tax credits allowed to the owner of the capital works.

Issue 2 - Legal expenses and settlement

Summary

You are not entitled to a deduction for the costs incurred to

· legally defend, counterclaim and entering into a settlement, and

· make the payment of the settlement sum.

We consider the legal expenses you have incurred to be capital in nature. The settlement sum follows the nature of the legal expenses and is also not deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

Section 8-1 of the 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.

For legal expenses and settlement sums to be considered as allowable deductions, it must be shown that they were incidental or relevant to the production of the taxpayer's assessable income (Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).

The nature of the expenditure must also be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 8 ATD 190; (1946) 3 AITR 436 per Dixon J). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses.

Expenses as a result of legal action are generally deductible if the expenses arise out of the day to day activities of the taxpayer's business (Herald & Weekly Times v FC of T 48 CLR 113; 2 ATD 169) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v. FC of T 80 ATC 4542; (1980) 11 ATR 276).

Generally, the treatment of a settlement sum will follow the treatment of the other legal costs incurred in relation to a particular matter.

However, where the expenditure is devoted to a structural purpose or to gain an enduring benefit, rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd v. FC of T (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403).

In your case, you incurred legal expenses in defending, counterclaiming and entering into a settlement with the prospective lessee in relation to the proposed lease on your property.

As you incurred these legal expenses at a time where there was no lease agreement in place, we consider that the expenses were incurred at a point too soon to be considered as being incurred in the production of assessable income. Defending or pursuing action to ensure that a lease agreement is entered into forms an enduring benefit and is therefore capital in nature.

As mentioned above, the treatment of the settlement sum that you incurred to settle the legal matter will follow the treatment of the related legal costs. We therefore consider the settlement sum to be capital in nature.

For this reason, the legal expenses and the payment of the settlement sum are not deductible under section 8-1 of the ITAA 1997.

Issue 3 - GST on settlement sum

Summary

The payment made to the prospective lessee is in the nature of a damages payment and is not consideration for a supply made to you by the prospective lessee. Therefore, GST will not apply to the payment as there is no taxable supply according to Division 9 of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act).

Detailed reasoning

The Goods and Services Tax Ruling GSTR 2001/4 sets out the Commissioner's view on the GST consequences of an out-of-court settlement.

The GST treatment will depend on whether the payment made under the settlement is characterised as consideration for a supply, and if so, whether that supply is in the nature of a taxable, input taxed, or GST-free supply.

Section 9-5 of the GST Act states:

You make a taxable supply if:

· you make the supply for *consideration; and

· the supply is made in the course or furtherance of an *enterprise that you *carry on; and

· the supply is *connected with Australia; and

· you are *registered, or *required to be registered.

However, the supply is not a *taxable supply to the extent that it is *GST-free or *input-taxed.

Note: *asterisk denotes a term defined in the GST Act.

Paragraph 21 of GSTR 2001/4 states:

A 'supply for consideration' is the first step towards there being a taxable supply. However, for there to be a supply for consideration, three fundamental criteria must be met:

(i) there must be a supply …

(ii) there must be a payment …

(iii) there must be a sufficient nexus between the supply and the payment for it to be a supply for consideration …

A payment will be consideration for a supply if the payment is in connection with, in response to or for the inducement of a supply. Therefore, there must be a sufficient nexus or connection between a particular supply and particular payment, act or forbearance that is provided for that supply.

In determining whether a sufficient link or nexus exists between the supply and consideration, regard needs to be made to the true character of the transaction. An arrangement between parties will be characterised not merely by the description the parties give to the arrangement, but by looking at all of the transactions entered into and the circumstances in which the transactions are made.

Supply

Under subsection 9-10(1) of the GST Act, the term 'supply' includes any form of supply whatsoever. GSTR 2001/4 explains that supplies that are related to an out-of-court settlement fall into 3 categories:

· earlier supply;

· current supply; or

· discontinuance supply.

Discontinuance supplies may be characterised as:

· surrendering a right to pursue further legal action,

· entering into an obligation to refrain from further legal action,

· releasing another party from further obligations in relation to the dispute.

Based on the facts of this case, the settlement did not involve earlier supplies or current supplies. It is however, considered to give rise to a discontinuance supply.

Paragraph 106 of GSTR 2001/4 states:

Where the only supply in relation to an out-of-court settlement is a 'discontinuance supply', it will typically be because the subject of the dispute is a damages claim. In such a case, the payment under the settlement would be in respect of that claim and not have a sufficient nexus with the discontinuance supply.

Paragraph 107 of GSTR 2001/4 adds:

In most instances, a 'discontinuance' supply will not have a separately ascribed value and will merely be an inherent part of the legal machinery to add finality to a dispute which does not give rise to additional payment in its own right. They are in the nature of a term or condition of the settlement, rather than being the subject of the settlement.

The payment that you have made to the prospective lessee is considered to be in the nature of a damages payment.

Paragraph 73 of GSTR 2001/4 explains that:

The most common form of remedy is a claim for damages arising out of the termination or breach of a contract or for some wrong or injury suffered. This damage, loss or injury, being the substance of the dispute, cannot in itself be characterised as a supply made by the aggrieved party. This is because the damage, loss, or injury, in itself does not constitute a supply under section 9-10 of the GST Act.

Paragraph 111 of GSTR 2001/4 goes on to say:

If a payment is made under an out-of-court settlement to resolve a damages claim and there is no earlier or current supply, the payment will be treated as payment of the damages claim and will not be consideration for a supply at all, regardless of whether there is an identifiable discontinuance supply under the settlement.

Therefore, it is considered that the payment that you made to the prospective lessee was not consideration for a supply made to you and GST will not apply to the payment.