Edited version of your private ruling

Authorisation Number: 1012474229702

Ruling

Subject: Repairs

Question 1

Are you entitled to a deduction under section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997) for expenses incurred on the rectification work at the X Shopping Centre?

Answer

No

Question 2

Are you entitled to a deduction under section 8-1 of the ITAA 1997 for expenses incurred on the rectification work at the X Shopping Centre?

Answer

No

This ruling applies for the following periods:

1 July 2011 to 30 June 2012

The scheme commences on:

1 July 2011

Relevant facts and circumstances

Background

You are a property investment company.

You purchased the first building at the X Shopping Centre (Stage 1).

You purchased Stage 2 land at the X Shopping Centre the following year.

You then entered into a development deed with X Company (an unrelated developer) that X Company would develop the site and get tenants while you funded it. You spent further money building Stage 2.

X Company went into administration during the Stage 2 building.

Problems started to emerge on the Stage 1 site soon after you took ownership. Within a number of months most of the tenants had raised concerns.

Building firm Y Pty Ltd was asked to investigate the problems and rectify them.

Y Pty Ltd considered the building and construction of the X Shopping Centre was not in accordance with site plans and relevant building regulations. Y Pty Ltd considered the expenditure would not have been required if the original builders had followed the relevant building regulations.

You acquired the X Shopping Centre expecting to receive a perfectly functional newly built, shopping centre site. You did not expect that any expenditure would be required to repair any part of the site for many years.

You did not purchase the property for a discounted price on the basis that the site did not comply with the relevant building regulations.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

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

Income Tax Assessment Act 1997 section 25-10

Further issues for you to consider

Does Part IVA apply to this ruling?

No

Reasons for decision

Question 1

Summary

The expenses are not deductible under section 25-10 of the ITAA 1997 as the expenditure is considered to be an initial repair and capital in nature.

Detailed reasoning

Section 25-10 of the ITAA 1997 provides that expenditure incurred by you for repairs to any premises, or part of premises, or a depreciating asset that you held or used solely for the purpose of producing assessable income is an allowable deduction. However, a deduction is not allowable if the expenditure is of a capital nature.

The Commissioner's view is provided in Taxation Ruling TR 97/23 Income tax: deductions for repairs (TR 97/23). This ruling explains the circumstances in which expenditure incurred by a taxpayer for repairs is an allowable deduction under section 25-10 of the ITAA 1997.

The word 'repairs' is not defined in the ITAA 1997 and therefore takes on its ordinary meaning. 'Repair' 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.

Initial repair

TR 97/23 provides guidelines on the deductibility of repairs and explains the different types of repairs, one of which is described as initial repairs.

Paragraphs 4 and 5 of TR 97/23 explains that initial repairs relate to the remedying of defects, damage or deterioration to a property that existed at the time of acquisition and did not arise from the operations of the taxpayer who incurs the repair expenditure. 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.

Paragraphs 59 to 62 of TR 97/23 provide guidance as to what is an initial repair. At paragraph 59 it explains that expenditure incurred on an initial repair after the property is acquired is capital expenditure and is not, therefore, deductible under section 25-10 of the ITAA 1997. Such expenditure would include work in remedying defects, damage or deterioration in existence at the date of acquisition. This is so whether the property is purchased or obtained under lease by the taxpayer.

In W Thomas & Co Pty Ltd v. FC of T (1965) 115 CLR 58; 14 ATD 78 (Thomas's case) the taxpayer purchased a building, unaware that extensive repairs were needed for the taxpayer to be able to carry on its business as a flour and grain merchant. The taxpayer carried out those repairs and also altered and enlarged an office and installed a lunch room and other amenities. Windeyer J at CLR p 73 stated:

If a capital asset acquired for use in the taxpayer's business is not in good order nor suitable for use in the way intended the cost of putting it in order suitable for use is part of the cost of acquisition and not a cost of its maintenance.

The principle in the Thomas case was applied in Case 10/98, 98 ATC 171 where work to make good storm damage to the roof of a motor garage that was performed after the taxpayer took ownership of the property was considered to be of a capital nature as it related to the cost of putting into good order a capital asset which was not in good order when it was acquired by the taxpayer's business.

The cost of effecting initial repairs is still not allowable even if some income has been earned before the repair expenditure is incurred - refer to Case W7, 89 ATC 161.

Furthermore, paragraph 61 of TR 97/23 advises that it is immaterial whether or not you were aware of the need for the repairs at the time of acquisition or if the purchase price (or lease rentals) reflected the need for repairs.

Whether, in your circumstance, the expenses incurred are deductible under section 25-10 of the ITAA 1997 is a question of fact and degree having regard to the condition of the property when you acquired it and whether the defect, damage or deterioration arose from your business operations.

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

You have stated that problems started to emerge on the Stage 1 site soon after you took ownership. Within a number of months most of the tenants had raised concerns.

The building firm that you engaged to investigate the problem considered the building and construction of the X Shopping Centre was not in accordance with site plans and relevant building regulations. They also considered the expenditure incurred to rectify this would not have been required if the original builders had followed the relevant building regulations.

It is considered you undertook remedial work to remedy defects which existed at the time of purchase and these defects did not arise from your business operations. It is immaterial that at this time you were not aware of the condition of the property or that the purchase price did not reflect the need for repairs.

Further, it is considered immaterial if the relevant asset is a new asset or second-hand. TR 97/23 makes it clear that the critical issue with respect to initial repairs is the condition of the property when it is acquired, not whether the property is new or second hand. Initial repair expenditure is essentially an additional cost of acquiring the property or an improvement in the quality of the property acquired and relates to the establishment of the profit - yielding structure.

Therefore, the rectification work is considered to be an initial repair and capital in nature and not deductible under section 25-10 of the ITAA 1997.

Regulatory body

Paragraph 96 of TR 97/23 states that to constitute a repair for the purposes of section 25-10 of the ITAA 1997, work done to meet requirements of regulatory bodies must satisfy the general principles and the various factors discussed in the Ruling. Work done to repair property that also happens to meet the requirements of regulatory bodies is deductible under the section. However, work done solely to meet requirements of regulatory bodies is not a 'repair' for the purposes of the section.

As discussed above, the expenditure incurred is considered to be an initial repair and capital in nature, therefore, the work done to meet the requirements of regulatory bodies does not satisfy the general principles and the various factors discussed in TR 97/23 to constitute a repair.

Conclusion

The expenses incurred on the rectification work at the X Shopping Centre are considered to be initial repairs and capital in nature. Therefore, you are not entitled to a deduction under section 25-10 of the ITAA 1997.

Question 2

Summary

The expenses are not deductible under section 8-1 of the ITAA 1997 as they are considered to be expenditure of a capital nature.

Detailed reasoning

Section 8-1 of the ITAA 1997 states that you can deduct from your assessable income any loss or outgoing to the extent that it is incurred in gaining or producing your assessable income or 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 states that you cannot deduct a loss or outgoing under this section to the extent it is a loss or outgoing of capital or of a capital nature.

The guidelines to distinguish between capital and revenue outgoing were laid down in the Sun Newspapers Ltd. and Associated Newspapers Ltd. v Federal Commissioner of Taxation (1938) 5 ATD 87; [1939] ALR 10; (1938) 61 CLR 337 (the Sun Newspaper case). It was pointed out that expenditure in establishing, replacing and enlarging the profit-yielding structure itself is capital and is to be contrasted with working or operating expenses. An expenditure incurred with a view to bringing into existence an asset or an advantage for the enduring benefit of the business will be capital in nature (British Insulated & Helsby Cables v Atherton (1926) A.C.205).

The expenditure incurred on the X Shopping Centre to bring the X Shopping Centre up to the standard required by the relevant building regulations is considered to relate to the establishment of the profit-yielding structure. The expenditure will extend the X Shopping Centre's income producing ability, significantly enhance its saleability or market value and extend the X Shopping Centre's expected life, all factors that indicate expenditure of a capital nature.

The fact the standard of the brand new centre was of such poor workmanship in a number of areas and such significant expenditure needed to be incurred to rectify this does not alter the nature of the expenditure.

Also, the fact the expenditure is required to comply with legal requirements does not, of itself, alter the nature of the expenditure.

Further, the expenditure was not necessarily incurred in your day to day business operation of being a shopping centre landlord, it was incurred in establishing your profit-yielding asset.

Accordingly, the expenses are not deductible under section 8-1 of the ITAA 1997 as they are considered to be expenditure of a capital nature.