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Ruling

Subject: Rental property expenses

Question 1

Is the cost of replacing a retaining wall located on your rental property an allowable deduction as a repair?

Answer:

No

This ruling applies for the following period

Year ended 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts and circumstances

You have owned a property which has been rented for several years.

At one boundary of the property was a retaining wall which is integral with the fence on that boundary.

The fence fell down and had to be entirely rebuilt.

In the course of replacing the fence, it was found that the retaining wall underneath the fence was faulty and had to be replaced in its entirety at the same time.

The property was rented during the income year in which the fence and retaining wall were replaced.

There was no insurance payment available for the costs incurred.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 25-10

Reasons for decision

Section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997) generally allows a deduction for expenditure incurred on repairs to premises or plant held or used by a taxpayer for the purpose of producing assessable income. However, capital expenditure is not deductible under section 25-10.

Taxation Ruling TR 97/23 explains the circumstances in which expenditure incurred by a taxpayer for repairs is an allowable deduction under section 25-10.

TR 97/23 states that in its context in section 25-10, 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 and contemplates the continued existence of the property. Repair for the most part is occasional and partial. It involves restoration of the efficiency of function of the property being repaired without changing it's 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.

Expenditure incurred for repairs is not deductible under section 25-10 if the expenditure is of a capital nature. TR 97/23 states that expenditure for repairs to property is capital expenditure if the expenditure, rather than being for work done to restore the property by renewal or replacement of subsidiary parts of a whole, is for work that is a renewal in the sense of a reconstruction of the entirety.

The term 'entirety' is used by the courts in repair cases to refer to something 'separately identifiable as a principal item of capital equipment' (Lindsay v FC of T (1960) 106 CLR 377 at 385; (1960) 12 ATD 197 at 201). In Lindsay's case, the taxpayer company was a slip proprietor and ship repairer. It claimed a deduction for the cost of reconstructing one of two slipways. In finding that the work was not repairs, Kitto J rejected the taxpayer's submission that either the whole slip (comprising the slipway, hauling machines, cradles and winches by which vessels were manoeuvred on to it) or the whole of the business premises containing the slipway should be regarded as the relevant entirety. His Honour decided that the slipway was an entirety by itself and not a subsidiary part of a larger whole.

Property is more likely to be an entirety, as distinct from a subsidiary part, if (TR 97/23):

· the property is separately identifiable as a principal item of capital equipment; or

· the thing or structure 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

· the thing or structure is a separate and distinct item of plant in itself from the thing or structure which it serves; or

· the thing or structure is a 'unit of property' as that expression is used in the depreciation deduction provisions of the income tax law.

TR 97/23 states that a reconstruction of the whole of property (eg., fencing or a railway) is not a deductible repair. The ruling states:

Replacement or substantial reconstruction of the entirety, as distinct from the subsidiary parts of the whole, is an improvement."

The following example from TR 97/23 illustrates the distinction between a repair and either renewal or reconstruction - what constitutes the 'entirety'.

Example

Mr Fermier and Mr Agricola are neighbouring farmers affected by a severe bushfire. Mr Fermier restores his existing fencing to good condition by mending it and replacing damaged sections, e.g., the fence on the northern boundary. Mr Agricola replaces the entire fencing surrounding his property.

Mr Fermier is entitled to claim a deduction for the cost of repairing his fencing under section 25-10. The entirety is the total fencing so replacing the fences on the northern boundary is a replacement of a subsidiary part of the whole fencing.

However, Mr Agricola's expenditure is not deductible under section 25-10 because the whole fencing was replaced, making it a reconstruction of the entirety. The total fencing is not a subsidiary part of the rural property or of anything else. To replace entire fencing with new fencing is to replace one capital asset with another capital asset. The cost is therefore of a capital nature.

The issue of repairs to retaining walls has been considered in a number of cases, including Case S13, 85 ATC 171 and Mt Isa Mines Ltd v FC of T 90 ATC 4267.

In Case S13, two retaining walls built on a rental property to prevent soil erosion were each held to be an 'entirety'. The replacement following storm damage, with two new retaining walls which were higher, stronger and of different material, was held to be an improvement to a fixed capital asset and not repairs.

In Mt Isa Mines Ltd v Federal Commissioner of Taxation, a mining company constructed a retaining wall to create a tailings dam on a mine site. The retaining wall was intended to be the first stage of a much larger development. Following seepage through the retaining wall a new retaining wall, or embankment, was constructed with the result that the old retaining wall was submerged. The Federal Court held that the expenditure incurred in building the new retaining wall was not deductible because it was an outgoing of capital or of a capital nature and did not constitute repairs to the old retaining wall or to the dam.

In your case, your expenditure is not a deductible repair under section 25-10 ITAA 1997 because the whole retaining wall was replaced, making it a reconstruction of the entirety. The cost of replacing an entire retaining wall with a new retaining wall is of a capital nature.