Edited version of private ruling

Authorisation Number: 1011879046433

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Ruling

Subject: Foreign rental property deductions

This ruling applies for the following periods:

Year ended 30 June 2010

Year ended 30 June 2011

Year ending 30 June 2012

The scheme commenced on:

30 June 2009

Question 1:

Is the cost of cyclical repairs undertaken on your rental property in Country A an allowable deduction under section 8-1 of the ITAA 1997?

Answer 1:

No.

Facts:

You are an Australian resident for tax purposes.

You are a citizen of both Australia and Country A.

Your spouse is a citizen of both Australia and Country B.

You acquired a residential flat located in Country B on a specific date during the financial year ended 30 June 20XX from the estate of your late relative. Prior to the date of acquisition, the property was under probate from a specific date during the financial year ended 30 June 2009.

The property was built on a specific date and is between XX-XX years old.

The property is jointly owned by yourself, your spouse, your relative and your relative's spouse, with each of you holding a 25% share in the property.

The property was available for lease from a specific date during the financial year ended 30 June 20XX, however you were unable to secure a tenant until a specific date during the financial year ended 30 June 20XX.

The flat required internal repairs before it was suitable for leasing, and these repairs were undertaken from a specific date during the financial year ended 30 June 20XX and completed on a specific date during the financial year ended 30 June 20XX.

The internal repairs did not effect an improvement to the flat, but were undertaken to remedy defects, damage and deterioration in existence at the time the flat was acquired by you.

You consider the cost of internal repairs as capital works, and are therefore claiming a 2.5% deduction over a period of 40 years in your income tax return for the financial year ended 20XX, and for your future income tax returns.

Your flat is one of a specific number of flats that are contained within a single building (the entire property).

The managing agent for the entire property is Agent A, which acts for a local government organisation located in Country B.

You were advised by the agent on a specific date during the financial year ended 30 June 2009 that cyclical repairs were required on the entire property for a total cost in a specific foreign currency of a particular amount.

The repairs to the entire property include:

· renewals to the roof

· external painting and decorating

· repairs to balconies and windows

· repairs to communal doors and screens

· repairs to concrete and brickwork

Your agent advised that that they were unable to determine when repairs were previously undertaken on the property.

The cyclical repairs were necessary to remedy defects, damage and deterioration of the property, including a leaking roof.

The cyclical repairs to the entire property were commenced a specific date during the financial year ended 30 June 20XX and completed on a specific date during the financial year ended 30 June 2011.

Your agent advised that the repairs are expected to ensure the good condition of the entire property for a period of a specific number of years, with the next cyclical repairs being scheduled for a date during the financial year ending 30 June 2016 or 30 June 2017.

Your share of the cost of the repairs to the entire property is for a specific amount which you have opted to pay to your agent in a specific number of monthly instalments of a specific amount commencing on a specific date during the financial year ended 30 June 20XX and ceasing on a specific date during the financial year ended 30 June 2013.

The entire property is known as a particular type of building and lies within a conservation area.

The property is subject to regulations that require that any repairs undertaken are consistent with maintaining its original style and character, and that consent is required from several specific government regulatory bodies before work can be performed.

You have advised that where there is any replacement of damaged items to the entire property, they are required to be replaced on a like-for-like basis.

The repairs that were undertaken to the entire building were required by a specific local governmental organisation, to perform cyclical maintenance and urgent necessary works.

The repairs that were undertaken to the entire building comprised of major capital works to deal with deterioration, and they did not produce a new and different function for the property that it did not previously have.

There is a Tax Treaty with Country B.

Reasons for decision

Rental income

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Rental income is ordinary income for the purposes of subsection 6-5(2) of the ITAA 1997.

Country A Tax Treaty

In determining liability to Australian tax on foreign sourced income, it is necessary to consider not only the income tax laws but also any applicable tax treaty, contained in the International Tax Agreements Act 1953 (Agreements Act).

Section 4 of the Agreements Act incorporates that Act with the Income Tax Assessment Act 1936 (ITAA1936) and the ITAA 1997 so that those Acts are read as one.

A particular schedule to the Agreements Act contains the tax treaty between Australia and Country B and the Notes to the agreement (the Country B Convention). The Country B Convention operates to avoid double taxation of income received by Australian and Country B residents.

A particular article of the Country B Convention provides that income derived by a resident of Australia from real property may be taxed by the country in which the real property is situated.

Paragraph 23 of Taxation Ruling TR 2001/13 states that the phrase 'may be taxed' normally means the source country has a non-exclusive entitlement to tax the income. However, the country of residence of the taxpayer may also tax the income subject to the laws of that country, unless the tax treaty explicitly prevents it.

A particular article of the Country B Convention provides that, subject to the provisions of the laws of Australia, a credit against Australian tax payable shall be allowed for Country B tax paid (in accordance with the law of Australia) where tax has been paid under Country B law and in accordance with the Country B Convention.

In your case:

As you are a resident of Australia who owns real property situated in Country B, the rental income derived by you may be taxed in Australia and in Country B.

Consequently the rental income received by you from real property located in Country B is assessable under subsection 6-5(2) of the ITAA 1997.

Rental property expenses

Section 8-1 of the ITAA 1997 provides that expenses incurred relating to a rental property are deductible if the property is rented, or available for rent, in the income year in which a deduction is claimed. A deduction is allowable for expenses incurred in gaining or producing assessable income provided those expenses are not capital, private or domestic in nature. In addition, to be eligible to claim expenses that relate to your property, you must be holding the property for the purpose of gaining or producing assessable income.

A property will be considered to be held for income-producing purposes if the property is:

· being rented, or

· available for rent, or

· temporarily unable to be rented due to the carrying out of repair work.

Repairs and maintenance expenses

Section 25-10 of the ITAA 1997 allows for a deduction of the cost of repairs to premises used for income producing purposes, with the exception of where the expenditure is of a capital nature. In addition, the repairs must relate directly to wear and tear or other damage that occurred as a result of you renting out the property.

Some kinds of maintenance work are 'repairs' in terms of section 25-10 of the ITAA 1997; for example, painting plant or business premises to rectify existing deterioration and to prevent further deterioration.

However, Taxation Ruling 97/23 indicates that expenditure incurred in remedying defects, damage or deterioration that was in existence at the date that the property was acquired are deemed to be "initial repairs" and would therefore be of a capital nature. This ruling also indicates that it is immaterial whether at the time of acquisition a person was aware of the condition of the property, including its need for repair.

In your case:

· you became a beneficial owner of the property on a specific date during the financial year ended 30 June 2009, this being the date when probate was granted

· the managing agent advised you of the need for repairs to the entire property on a specific date during the financial year ended 30 June 2009

· these repairs commenced a specific date during the financial year ended 30 June 20XX and were completed a specific date during the financial year ended 30 June 2011

· the property was constructed on a specific date between 50-60 years ago and requires cyclical repairs every specific number of years to maintain it in good condition

Given the age of the property, the cyclical nature of the repairs and the relatively short period of your ownership, it is reasonable to assume that the property would have been in need of repairs at the time you acquired it.

As a result, the repairs would be deemed to be initial repairs and therefore of a capital nature. Consequently, no deduction is allowable under section 25-10 of the ITAA 1997.

Deduction for capital expenditure

Taxation Ruling TR 97/25 - Property development: deduction for capital expenditure on construction of income producing capital works, including buildings and structural improvements - discusses the deductibility of capital expenditure.

Where a capital work is used in the production of your assessable income, Division 43 of the ITAA 1997 allows you to claim a progressive deduction for the cost of the capital work, and provides for a deduction for certain types of construction expenditure.

Construction expenditure is defined in subsection 43-70(1) of the ITAA 1997 as capital expenditure incurred 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

· a portion of indirect costs, such as the cost of facilities for construction workers

An item is more likely to be considered a capital work where it: 

· forms part of the fabric of the building

· does not perform a function which is independent from the general function of the building

· has the purpose of making the building or structure complete

The following factors need to be considered together when determining whether an item is part of the premises or setting:

· whether the item appears visually to retain a separate identity

· the degree of permanence with which it is attached to the premises

· the incompleteness of the structure without it

· the extent to which it was intended to be permanent or

· whether it was likely to be replaced within a relatively short period.

Examples

· Wall and floor tiles are generally fixed to the premises, not freestanding, and intended to remain in place for a substantial period of time. They will generally form part of the premises. Expenditure on these items falls under capital works.

· Kitchens are fixed to the premises, are intended to remain in place indefinitely and are necessary to complete the premises. Any separate visual identity they have is outweighed by the other factors. They are therefore part of the premises. Clothes hoists are also part of the premises for similar reasons.

· Insulation batts, although generally not fixed, are intended to remain in place indefinitely, do not have a separate visual identity and add to the completeness of the structure. They are also part of the premises.

In the case of residential rental properties, the capital expenditure deduction is:

· generally spread over a period of 25 or 40 years

· limited to 100% of the construction expenditure

· not allowable until the construction is completed

· may only be claimed for the period during the year a property is rented or available for rent

Where the capital work is undertaken on residential rental properties after 15 September 1987, the cost of the capital work will be spread over a period of 40 years at a flat rate of 2.5% per year.

In your case:

You have supplied a list of the repairs that were undertaken on the entire property, these being:

· roofing

· windows

· external wall insulation

· lightning protection

· balcony waterproofing

· communal doors and screens

· concrete

· brickwork

· painting and decorating

· site establishment costs (e.g. scaffolding, hoists, temporary protection, site set-up, accommodation)

The majority of these repairs would fall under the definition of a capital work, with the exception of the costs of painting and decorating.

However, as previously stated, since the repairs to the entire property are deemed to be of a capital nature, no deduction is allowable under section 25-10 of the ITAA 1997.

Consequently, a 2.5% per year capital works deduction is allowed under Division 43 of the ITAA 1997 over a 40 year period commencing a specific date during the financial year ended 30 June 2011, this being the date that the repairs were completed.

Note

Foreign income tax offset

Division 770 of the ITAA 1997 allows a foreign income tax offset for foreign tax that a taxpayer has paid on income that is included in the taxpayer's assessable income. If Country B tax has been imposed and paid on the rental income which is included in your assessable income in Australia, you may be entitled to a foreign income tax offset.

Capital gains tax

Capital works expenses you incur form part of the cost base of your property for capital gains tax purposes. If you claim a capital works deduction, you will need to take this into account when you work out your capital gain or loss.

More information on rental properties including claiming capital works deductions and avoiding common mistakes is available from the Australian Taxation Office website at www.ato.gov.au.

The ATO annual publication Rental Properties 2010-11 (NAT1729) provides more information on how to treat rental income and expenses.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5
Income Tax Assessment Act 1997 subsection 6-5(2)
Income Tax Assessment Act 1997 subsection 6-15(2)
Income Tax Assessment Act 1997 section 8-1
Income Tax Assessment Act 1997 section 11-15
Income Tax Assessment Act 1997 section 25-10
Income Tax Assessment Act 1997 section 43-10
Income Tax Assessment Act 1997 division 43
Income Tax Assessment Act 1997 division 770
Income Tax Assessment Act 1997 division 770-10
Income Tax Assessment Act 1997 division 770-130
International Tax Agreements Act 1953 section 4

Other references

TaxPack Supplement (2011)
Rental Properties (NAT1729-06.2011)
Explanatory Memorandum, Tax Laws Amendment (2009 Budget Measures No.1) Act 2009
ATO view documents
ATO ID 2009/93
Taxation Ruling IT 2650
Taxation Ruling TR 97/23
Taxation Ruling TR 2001/13
Taxation Ruling TR 93/32

Keywords
Foreign income
Foreign rental property
Foreign income tax offset
Rental expenses
Rental property income
Initial repairs
Capital works deductions
Tax treaty