The myriad of tax depreciation incentives are designed to boost cash flow and encourage capital investment but they are overly complex and can leave businesses with unexpected tax liabilities. This article considers the key traps with applying the measures.
Traps with tax depreciation incentives
Overview of IAWO
The increase in the instant asset write-off (IAWO) threshold from $1,000 to $20,000 in 2015 was explained by the Federal Government in the explanatory memorandum to the amending bill as follows:
By allowing small businesses to write off more assets early, the increase in the threshold will boost small businesses cash flow, particularly for new businesses, reducing their vulnerability. The measure will also encourage additional capital investment by small businesses…
The policy to allow small business entities (SBEs) (aggregated turnover of less than $10 million) a full deduction for the cost of eligible depreciating assets in the year of purchase rather than depreciating them over their effective lives is commendable. The merit of the policy is evidenced by its extension and expansion six times since 2015, most recently as an economic stimulus response to support businesses through the COVID-19 pandemic.
The IAWO threshold in s 328-180 of the Income Tax Assessment Act 1997 (ITAA 1997) and s 328-180 of the Income Tax (Transitional Provisions) Act 1997 (IT(TP)A) has been increased for assets first used or installed ready for use (IRFU):
- from 7:30pm on 12 May 2015 to before 29 January 2019 — from $1,000 to $20,000;
- from 29 January 2019 to before 7:30pm on 2 April 2019 — from $20,000 to $25,000;
- from 7:30pm on 2 April 2019 to before 12 March 2020 — from $25,000 to $30,000;
- from 12 March 2020 to 30 June 2021 — from $30,000 to $150,000.
The IAWO measure was expanded through the insertion of s 40-82 into the ITAA 1997 to include:
- Medium-sized businesses (aggregated turnover of $10 million to less than $50 million) for assets first used or IRFU from 7:30pm on 2 April 2019; and
- Medium-large businesses (aggregated turnover of $50 million to less than $500 million) for assets first used or IRFU from 12 March 2020.
The threshold for SBEs reverted to $1,000 for assets acquired on or after 1 January 2021, or for assets acquired before 1 January 2021 that were first used or IRFU after 30 June 2021. However, the reversion of the threshold to $1,000 will have no practical effect until after 30 June 2023, when the temporary full expensing measure (TFE) is proposed to end. Under the current law, TFE ends on 30 June 2022, but the Federal Government announced in the Federal Budget 2021–22 that it will extend the measure by 12 months so it will end on 30 June 2023.
As an aside, the car limit still applies to limit the deduction allowed for luxury cars ($60,733 for 2021–22 and $59,136 for 2020–21).
Balancing adjustment events
Where an asset that has been fully deducted under the IAWO for SBEs ceases to be held by the entity, or is no longer used for any purpose, a balancing adjustment event (BAE) occurs. The taxable purpose proportion of the asset’s termination value is required to be included in the entity’s assessable income. Accordingly, an SBE that fully deducts an asset under the IAWO when it is purchased is assessed on the proceeds when it is sold, adjusted for any non-taxable use.
Where a non-SBE fully deducts an asset, its adjustable value is taken to be nil. So when a BAE happens to an asset that was fully deducted by a non-SBE, the entity has an assessable balancing adjustment equal to its termination value. Akin to an SBE, a non-SBE that fully deducts an asset under the IAWO in s 40-82 when it is purchased is assessed on the proceeds when it is sold, adjusted for any non-taxable use.
What if the taxable use of the asset changes after it was fully deducted?
If an entity fully deducts an asset under the IAWO, and the taxable use of the asset later reduces, or the asset starts to be used wholly for a private purpose, there is no tax consequence at the time of the change in use.
However, the eventual balancing adjustment — when the entity ceases to hold the asset or use it for any purpose — takes into account any non-taxable use when the IAWO was claimed. For example, if an entity fully deducted the cost of an asset, and the taxable use later changes to zero, the balancing adjustment assesses 100% of the sale proceeds, or the market value of the asset if it ceases to be used for any purpose.
Taxing the proceeds on the sale of an asset that was fully deducted but subsequently used wholly for a private purpose may not be apparent and can leave many businesses with unexpected future tax liabilities.
Low pool value
The low pool value is the closing balance of the general small business pool excluding the decline in value deduction for the year. For the income years ending 30 June 2021, 30 June 2022 and 30 June 2023, SBEs must fully deduct their low pool value where it exceeds zero.
SBEs cannot choose not to fully deduct their pool balances on 30 June 2021. The December 2020 amendments to the TFE rules allow larger entities to choose whether they apply TFE on per asset basis, but this flexibility does not extend to SBEs. Being required to fully deduct the pool balance may result in unwanted losses.
Choosing to exit the simplified depreciation rules does not overcome this, as entities must continue to apply Subdiv 328-D of the ITAA 1997 to the pool, and therefore must still fully deduct their pool balance on 30 June 2021, even if the entity is not an SBE or does not choose to use Subdiv 328-D for that income year.
Exclusion for depreciating asset lease assets
The exclusions from being able to depreciate or fully deduct an asset under the simplified depreciation rules for SBEs include an asset that is being, or might reasonably be expected to be, let predominantly on a depreciating asset lease (DAL).
A DAL is an agreement under which an entity that holds the depreciating asset grants a right to use the asset to another entity. However, a DAL does not include a hire purchase agreement
or a short-term hire agreement.
Leasing arrangements between related entities may be affected, as there is generally a substantial continuity of hiring which would not constitute short-term hire agreements. Larger businesses can fully deduct an asset let predominantly on a DAL but SBEs that lease an asset to a related entity that carries on the business cannot depreciate the asset under Subdiv 328-D.
Temporary full expensing
Overview of TFE
TFE is available for eligible assets that start to be held at or after 7:30pm on 6 October 2020 and are first used or IRFU by 30 June 2022 (to be extended to 30 June 2023).
An entity is eligible to apply TFE to an eligible asset for an income year if:
- its aggregated turnover is less than $5 billion; or
- it is a corporate tax entity and satisfies the alternative income test (broadly, its total ordinary and statutory income is less than $5 billion and its investment in depreciating assets over three years exceeds $100 million); and
- it does not choose to not apply Subdiv 40-BB of the IT(TP)A to the asset for that income year — such a choice must be notified to the ATO and is irrevocable; and
- a BAE does not happen to the asset in the income year (see below).
Only entities with an aggregated turnover of less than $50 million can fully expense eligible second-hand assets and assets that started to be held under contractual arrangements entered into before 7:30pm on 6 October 2020.
The car limit applies to luxury cars.
Balancing adjustment events in the same income year
Caution must be taken when seeking to use TFE for an asset where a BAE occurs in the same income year as TFE would otherwise apply.
For example, let’s assume that a partnership acquired a depreciating asset on 1 January 2021.
- If a partner joins the partnership on 1 July 2020, this causes a BAE to occur to the partnership assets. However, as the introduction of the partner pre-dates the acquisition of the asset, the BAE did not happen to the asset, so TFE is available for the asset.
- If a different partner exits the partnership on 30 June 2020, this causes a BAE to occur to the asset when the partner exits. Accordingly, TFE is not available for the asset because the BAE happens to the asset in the same income year in which TFE would otherwise be available.
- If that same partner instead exited the partnership on 1 July 2021, while a BAE still happens to the asset, it occurs in a later income year, so TFE is available for the asset.
Interaction of TFE with loss carry back
Fully expensing a depreciating asset may give rise to a tax loss in a corporate tax entity (i.e. a company). ATO web guidance advises:
You might make a tax loss in an income year as a result of claiming an immediate deduction under temporary full expensing. If you are a corporate tax entity, instead of carrying the tax loss forward and using it to offset your future income, you can consider if you are eligible for a refundable tax offset under loss carry back.
Additional labels in income tax return
There are several new labels in the 2021 income tax returns which are required to be completed by taxpayers (including SBEs) claiming IAWO, TFE and BBI (see below), including their aggregated turnover range. This is the case even where the tax return software does not prompt a validation error on non-completion of a label.
Low-cost assets and low-value pools
Non-SBEs can choose to allocate a low-cost asset (costing less than $1,000) to a low-value pool (LVP). Although the IAWO under Subdiv 328-D and s 40-82 takes priority over a LVP, assets allocated to a LVP are excluded from TFE. Once an entity allocates a low-cost asset to a LVP, it must allocate all future low-cost assets to that pool.
An entity with an aggregated turnover of $10 million to less than $5 billion that has previously allocated an asset to a LVP can fully expense an asset that costs, say, $1 million, but it cannot fully expense an asset that costs under $1,000 — it will have to be pooled. This seems an incongruent outcome.
Backing Business Investment
The Backing Business Investment — accelerated depreciation (BBI) measure was available to businesses that had an aggregated turnover of less than $500 million, and first held and used an asset, or installed it ready for use, between 12 March 2020 and 30 June 2021.
The measure has now ended, but it is important to understand its interaction with the other measures.
By way of a roadmap, businesses and their advisers should consider:
- whether an asset purchased during 2020–21 can be fully expensed — the priority of application of the measures is firstly TFE, then IAWO, then BBI, then the general depreciation rules;
- the opting out rules where available;
- what information is needed to make this determination, such as the business’ aggregated turnover, the date the asset was first acquired or held and first used or IRFU, and the asset’s GST-exclusive cost; and
- the tax consequences when a BAE occurs.
To reiterate, the merit of the full expensing policy is commendable, and it should remain a permanent fixture of the law; however the execution of the policy intent has left the provisions in disarray. Layers of legislative amendments across multiple divisions and statutes, the raft of exclusions and myriad of application dates — merely for a timing difference — has made what should be a straight-forward area of the tax law unnecessarily complex and inelegant.
Stay well everyone.
Robyn Jacobson, senior advocate, The Tax Institute