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28 MARCH 2019
Tax 101 - Deductions and
Losses
What we will cover
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• Overview of the law governing deductions
• General deductions and specific deductions
• Deductions for individuals, including work-related expenses
• Deductions for businesses
• Investment deductions, including rental property expenses
• Substantiating deductions
• Creating and using a loss
• Prepayment rules
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General deductions
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• Section 8-1 ITAA 1007 sets out the general rules for deductibility.
• Most commonly encountered deductions fall within the general deduction provision, such as work-related and business expenses.
• The two positive limbs of the provision are contained in s 8-1(1), which provides that you can deduct from your assessable income any loss or outgoing to the extent that:
• (a) it is incurred in gaining or producing your assessable income, or
• (b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.
• The four negative limbs of the provision are contained in s 8-1(2), which provides that you cannot deduct any loss or outgoing under s 8-1 to the extent that:
• (a) it is a loss or outgoing of capital, or of a capital nature
• (b) it is a loss or outgoing of a private or domestic nature
• (c) it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income, or
• (d) a provision of the Act prevents you from deducting it.
General deductions – positive limbs
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• To claim a deduction under s 8-1 there must be a link or nexus between the loss or outgoing and the production of assessable income (in the case of the first positive limb) or the carrying on of a business for the purpose of producing assessable income (in the case of the second positive limb).
• The necessary link or nexus is sometimes referred to as a “sufficient connection”.
• In the second positive limb, it is necessary that the expense is “necessarily” incurred in carrying on a business. In Taxation Ruling TR 95/33 the Commissioner accepts that “necessarily” does not mean that the outgoing must be unavoidable or logically necessary but, rather, that the outgoing must be clearly appropriate or adapted for the ends of the business. For practical purposes, it is for the person carrying on the business to be the judge of what outgoings are necessarily incurred.
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General deductions
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• Meaning of incurred• TR 1997/7 Income Tax: Section 8-1 – meaning of ‘incurred’ – timing of deductions
• “As a broad guide, you incur an outgoing at the time you owe a present money debt that you cannot escape.”
• Amounts paid have been incurred but in many cases, unpaid expenditure can also be incurred for tax purposes
• Timing of deductions• The expenditure has to be incurred at exactly the same time the taxpayer is gaining
assessable income not just within the income year.
• Bill is a carpenter and buys a hammer in August but is not employed at the time. He gainsemployment in November. He will not be allowed the cost of the hammer as theexpenditure “occurred at a point too soon”.
General deductions – the negative limbs
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• A capital outlay can be defined as the “initial” or basic investment, which makes all future income earning possible
• Example: Purchase of tradies van or purchase of shares, stocks and bonds.
• Note that capital expenditure may be deductible under a specific provision of the law, such as depreciation on the tradies van
• A private expense refers to expenditure incurred by a taxpayer in their everyday life.
• Example: All day to day expenses (food, clothing, etc), travel to and from work (commuting)
• A domestic expense refers to expenditure incurred by a taxpayer as a member of a family unit.
• Example: Household expenses (electricity, etc.), childcare costs
• A provision of the Act prevents a deduction
• Example: Expenses incurred in relation to illegal activities, penalties and fines, bribes to public officials
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General deductions
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• You must be genuinely out-of-pocket. So, you can’t claim an expense which has been or will be reimbursed to you by an employer (or any other person).
• If an expense is incurred that is partly related to work/business and partly private or domestic, a deduction can only be claimed for the work/business related portion of the expense (the expense must be apportioned)
• Example, mobile phone used for work and privately, a tax deduction can only be claimed for the work related part of the bill
Allowances
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• Receiving an allowance from an employer (for a car, travel or work clothing for instance) does not automatically entitle you to a deduction — you must still meet the basic rules listed above to make a claim.
• Example: Raj lives and works on the Gold Coast but is required to work 3 days a week in Brisbane (one hour away) for a three month period to provide cover for an employee who is sick. He is paid a $300 allowance. No deduction is claimable since the journey is home to work travel. The fact that Raj receives an allowance to cover the extra costs and compensate him for the extra travel does not make the travel deductible.
• You can claim only the total amount you actually spent even if the allowance is more.• Example: Bob received a $100 overnight allowance when he was required to stay away
from home for one night whilst on a work assignment. He actually stayed with a relative and spent nothing. He cannot claim a tax deduction for anything.
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Typical work-related deductions for individuals
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• Self-education costs
• Work-related clothing
• Travel expenses• Using private car for work (cents per kilometre or logbook)
• Bridge/tunnel tolls
• Public transport fares
• Airfares
• Car parking
• Taxi fares
• Overnight meals and accommodation
• Home office expenses
Poll: Work-related expenses
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• Ellie is a bank employee and made the following deduction claims:a) Expenses for a briefcase and computer software
b) The cost of a flu injection to protect her from contracting the flu from customers
c) Taxi travel to get to work on four mornings she woke up late
d) Expenditure on comfortable shoes because her work duties require her to stand for long periods during the day
• Q. Which of these costs are tax deductible?1. a) only
2. a) and d)
3. b) and c)
4. a), b), c) and d)
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Example: Work-related deductions
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• Marilyn Murphy is a primary school teacher at a local school. During the year she incurred the following expenses:
• Expenses for car travel from her home to school and also from school to a teachers’ retreat, then from the retreat to her home. Marilyn did not keep a log book. She estimates that the distance travelled from school to the retreat and then to her home was 400 km.
• The cost of a new blouse and skirt which Marilyn wears exclusively for teaching at school. Marilyn also incurred dry-cleaning costs for these clothes.
• Stationery, paper and sundry material costs. These items were purchased by Marilyn for use at work. The cost for each item is less than $10 with total costs being $180.
• Advise Marilyn Murphy whether she is entitled to claim deductions for any of the costs incurred. If the costs are deductible, what are the substantiation requirements?
• (adapted from Australian Practical Tax Examples, CCH Wolters Kluwer, 2018)
Example: work-related deductions
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• Travel and car expenses:
• A deduction should be available for the costs of travel from the school to the conference venue and from the venue to home under the general deduction provisions (ITAA97 s 8-1).
• A deduction is not available for travel from home to the school as this is considered to be private in nature.
• Marilyn can normally choose between the cents/km method and the log book method. No written evidence required for the cents/km method but Marilyn must be able to show that the travel related to income producing activity
• Cents per kilometre method can only be used to claim a maximum of 5000km per vehicle
• She didn’t keep a logbook so she must use the cents/km method
• 400 km x 68 cents per kilometre = $272
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Example: work-related deductions
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• Work-related clothing:
• No deduction – expense is private and domestic in nature and is not protective clothing, an item of work uniform or occupation specific clothing, even though worn in the course of performing her duties. No deduction for dry cleaning costs.
• As the cost is not deductible, no substantiation is required.
• For deductible expenditure, a receipt or invoice would be required to substantiate the clothing
• For claimable dry cleaning, no written evidence is required for deductible laundry expenses up to $150
• Stationery, paper and sundries:
• Deductible under s 8-1 as this is used by Marilyn in the course of producing her assessable income
• Substantiate by keeping receipts or record the relevant information in a diary provided individual items are less than $10 and total costs do not exceed $200
Example: Work-related expenses
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• Dianne manages and owns a hair-dressing salon in a local shopping centre. She travelled to Paris to attend a conference on new developments and products in hair care. Dianne had a few days to spare in Paris before her return flight to Australia.
• Dianne also sees customers for hair-dressing at her home. She has set aside a room in the house and installed hair-dressing equipment. Customers can enter the room via a side door to the house. Dianne, also visits aged-care homes and attends to the hair for residents residing in those premises. She uses her own vehicle for this purpose and has to transport hairdressing equipment in the vehicle.
• In her tax return for 2016/17, Dianne claimed a tax deduction for the total cost of the trip to Paris and conference fees. She also claimed tax deductions for all the expenses in operating her home based hairdressing business and for motor vehicle use for trips to visit clients
• Is she entitled to make these claims?
• (adapted from Australian Practical Tax Examples, CCH Wolters Kluwer, 2017)
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Example: Work-related expenses
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• Home business costs
• Dianne satisfies the criteria for claiming deductions for both the occupancy and running costs attributable to her hair-dressing business. A room is set aside and set up for hair-dressing and is not available for private or domestic use. She attends to customers at home and they enter via a side door separate from the normal residential entry.
• Dianne would be entitled to claim occupancy expenses for home loan interest or rent, insurance, council and water rates and land tax, apportioned on the basis of floor area for the room relative to the home as a whole.
• Dianne would also be entitled to claim running expenses directly attributable to the business, such as, heating, lighting, cleaning and insurance. She could also claim for repairs and depreciation of the hairdressing equipment.
• Dianne’s use of motor vehicle
• Dianne is entitled to claim car expenses relating to the use of her motor vehicle when attending to the hair of customers in aged-care premises, including travel to and from the premises, on the basis that her home is her place of business and she is travelling on business.
Example: Work-related expenses
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• Dianne’s trip to Paris
• The expenses incurred in travelling to Paris and attending the hair-dressing conference are deductible.
• The costs incurred were for the purpose of improving her knowledge and skills and keeping up-to-date in her current hair-dressing trade, and therefore has a relevant connection to her current income-earning activity.
• The deductions would relate to conference fees, books and materials and the cost of travel, meals and accommodation
• The expenses would be deductible in full provided the additional days spent in Paris were only incidental to the main purpose of travelling to Paris or if it was not possible to catch an earlier flight back to Australia.
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Reminder: Is an expense an allowable deduction?
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• The answers to the following must be YES• Has the expense been incurred?
• Does the expense have a direct relationship to the occupation?
• The answers to the following must be NO• Was it capital?
• Was it private or domestic?
• Did it produce exempt or non-assessable income?
• Was a deduction prohibited by another part of the Act?
Specific deductions
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• Section 8-5 defines what is meant by a “specific deduction”.
• In effect, a specific deduction is an amount which is deductible under a provision other than the general deduction provision, in s8-1.
• For example, tax losses of earlier income years which are deductible under sec 36-15 are specific deductions
• Other examples of specific deductions include:• Cost of managing tax affairs
• Gifts and donations
• Interest, dividend and other investment income deductions
• Personal super contributions
• Bad debt expenses
• Repairs and maintenance expenses
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Substantiation
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• See TR 2005/7
• You must be able to substantiate deduction claims with written evidence if the total claimed for expenses, not including claims for car, meal allowance, award transport payments allowance and travel allowance expenses, is greater than $300.
• Substantiation includes:
• a receipt or invoice.
• bank or credit card statements will be accepted if the statement contains enough information to support the claim
• electronic copies will suffice.
• The document must show:
• Date of purchase
• Item purchased
• Date the document was prepared
• Name of supplier
• Value of item
Substantiation
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• If the total claimed is $300 or less, you need to be able to show how the claim was calculated but you do not need written evidence.
• If total claims are greater than $300, you need to be able to substantiate the whole claim, not just the bit over $300.
• Substantiation must be kept for 5 years after the later of 31 October in the year the return has been lodged or from the date of lodgement.
• Where the Commissioner considers that it would be unreasonable to expect the taxpayer to have obtained documentary evidence due to the nature of the expense (e.g. parking meters or vending machines) the taxpayer may record the necessary details in a diary.
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Investment deductions
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• A taxpayer who derives assessable income from investments (ie dividends and interest) can claim various deductions for costs incurred in earning that income including:
• interest on borrowed funds where an investment portfolio has been financed using those funds
• Borrowing costs incurred in arranging finance, such as legal expenses, loan establishment fees, etc(deductible over five years or the term of the loan, whichever is shorter, unless the amount is $100 or less in which case its immediately deductible)
• bank charges for bank accounts to manage investment income and expenses
• management fees or retainers paid to a financial planner (but not the initial costs of drawing up an investment plan)
• the cost of running a home office to manage investments (including telephone, computer and internet expenses),
• the cost of investment-related journals and subscriptions
• costs of obtaining tax advice
• travel costs associated with investments, such as trips to see a financial planner or stockbroker, or the cost of attending AGMs
Investment deductions – property investors
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• A deduction can be claimed for expenses incurred for the period the property is rented or is available for rent. However, expenses of a capital or private nature cannot be claimed. Sometimes expenses may need to be apportioned:
• If the property is not available for rent for the full year, apportion expenses on a time basis.
• If only part of the property is used to earn rent, only the part of the expenses that relate to the rental income is claimable. Apportionment would generally be made on a floor area basis - that is, by reference to the floor area of the part of the residence solely occupied by the tenant, together with a reasonable figure for tenant access to the general living areas, including garage and outdoor areas.
• Deductions may be claimed from the date the property first became available for rent. Note that the property may be vacant but still available for rent.
• Per TR 2004/4 some deductions can be claimed (e.g. interest, rates and insurance) before the property is actually built (eg, interest, rates and insurance) provided the property is intended to be used for income producing purposes.
• Deductions can also be claimed for expenses incurred when a property ceases to be an investment property (e.g. repairs and maintenance) provided the expenses relate to the period of rental and they are paid before the end of the financial year in which the property ceases to be an investment property.
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Investment deductions – property investors
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• Typical property deductions:
• advertising for tenants
• bank charges
• body corporate fees
• cleaning
• council rates
• electricity, gas and water
• gardening and lawn mowing
• insurance – building, contents, public liability, landlord insurance
• interest on loans and mortgages
• land tax
• Some legal expenses
• lease costs – preparation, registration, stamp duty
• property agent's fees and commission
• repairs and maintenance
• phone and internet
Poll
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• Bill acquired a rental property on 28 August 2017 and incurred the following costs in relation to this property in the year ended 30 June 2018:
1. 15 September 2017: roof repairs, cost $3,800
2. 28 September 2017: travel costs incurred in attending Owners Corporation meeting, $760
3. 6 February 218: legal costs in relation to a dispute with a neighbour about the location of a border fence
4. 4 April 2018: repair to leaky toilet, cost $320
• Q. Which costs are deductible against his rental income for the year?a) 1, 2 and 4
b) 3 only
c) 4 only
d) 1,2,3 and 4
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Deductions – planning points
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• Increasing allowable deductions reduces tax liability. “Accelerating” deductions so as to incur them in the current year is particularly beneficial especially if a higher marginal tax rate applies in the current year
• Deductions against salary or non-salary income reduces current year tax and possibly the PAYG withholding instalment rate for the following year
• If the general deduction provision is not satisfied (eg capital outgoings) check whether the outgoing is recognised under other provisions (eg depreciation rules)
• A high rate taxpayer can pay deductible amounts to an associated low rate taxpayer as a way of diverting income (eg secretarial fees), provided payment is commercially justifiable and the overall tax savings are incidental (and also subject to anti-avoidance rules such as Personal Services Income rules)
Tax losses
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• A tax loss arises when a taxpayer’s allowable deductions for a year exceed their assessable income and net exempt income in a year
• Some deductions that would usually be allowable cannot be claimed as deductions where they would give rise to a tax loss. They are:
• payments of pensions, gratuities or retirement allowances to employees, former employees, or their dependents
• gifts or contributions made to deductible gift recipients
• payments made under conservation covenants
• personal superannuation contributions.
• Individuals can generally carry forward a tax loss indefinitely, but must claim a tax loss at the first opportunity. Losses cannot be retained to offset them against future income if they can be offset against the current year’s income.
• Carried-forward tax losses are offset first against net exempt income and only then against assessable income.
• Losses must be claimed in the order in which they were incurred.
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Tax losses
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• Example 1
• Ian incurred a loss of $7,000 in Year 1. In Year 2 he has assessable business income ($18,000), allowable business deductions ($13,000) and net exempt income ($300). His Year 1 loss brought forward is offset as to $300 against the net exempt income and as to $5,000 against the taxable income of $5,000 ($18,000 − $13,000). The Year 1 loss unrecouped as at the end of Year 2 ($7,000 − $5,300), ie $1,700, may be carried forward for deduction against income of Year 3 and so on.
• Example 2
• In Year 1, Lisa incurs a loss of $7,000. In Year 2, Lisa has assessable income ($20,000), allowable business deductions ($23,000) and net exempt income ($15,000). The excess of deductions over assessable income ($3,000) is subtracted from net exempt income, resulting in a balance of $12,000. The tax loss from Year 1 is deducted from that balance, reducing it to $5,000. The tax loss is now exhausted.
• Example 3
• Lee has a loss of $25,000 in Year 1. In Year 2, his total assessable income is $20,000 and deductions (other than for the tax loss) are $3,000, thus resulting in an excess of $17,000. As there is no net exempt income in Year 2, the $25,000 is carried forward so as to reduce the amount of $17,000 to nil. The balance of the loss ($8,000) is available to be carried forward to Year 3 or subsequent income years.
Losses: Application of the non-commercial loss rules
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• You can't claim a loss for a business that is little more than a hobby or lifestyle choice. Even if it has business-like characteristics, if it is unlikely to ever make a profit and doesn't have a significant commercial purpose or character, you can't offset the loss against your other income. In this case, you can defer the loss until you make a profit from the business.
• Normal rules:
• Loss immediately deductible (not deferred) if both the following are met:
• Adjusted taxable income is less than $250,000
• At least one of the following four tests are passed:
• Assessable income from the business activity is at least $20,000
• Business has produced a tax profit for at least three of the past five income years
• Market value of real property is at least $500,000
• Other assets used continuously in the business are at least $100,000
• Commissioner can exercise discretion not to defer the loss where the tests are failed where:
• The activity was affected by special circumstances outside the taxpayer’s control (eg, fire, flood, drought, illness, or crop infestations) or
• Because of its nature, the activity is not expected to become commercially viable until some time after it has commenced (long ‘lead time’ for the industry, eg olive growers)
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Losses: Application of the non-commercial loss rules
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• Special rules for primary producers:
• If an individual makes a loss from carrying on a primary production business, the loss can be claimed immediately if the individual’s assessable income (excluding capital gains) from other sources is less than $40,000
• The four tests are not relevant
Prepayment rules
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• For individuals who are not in business, and for small businesses certain prepaid expenses can be deducted.
• Prepaid expenditure is apportioned over the eligible service period or 10 years, whichever is less.
• For an individual, prepaid non-business expenditure is immediately deductible under the 12-month rule if
• the eligible service period for the expenditure is 12 months or less
• the period ends no later than the last day of the income year following the year in which the expenditure was incurred.
• If you are an individual, a deduction is apportioned for prepaid non-business expenditure over the eligible service period or 10 years, whichever is less, if the eligible service period is more than 12 months or it ends after the last day of the next income year.
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Prepayment rules
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• Example – Deduction available immediately:• On 1 June 2018, Jasmin, an employed solicitor, paid $1,750 for a subscription for a
monthly professional journal for the period 1 June 2018 to 31 May 2019. Because the period of subscription is wholly within a 12-month period ending before the last day of the next income year, Jasmin can claim a deduction for the expenditure in 2017–18.
• Example – Deduction spread over “eligible service period”:• On 1 January 2018, Martin, a senior clerk employed by a legal firm, paid $1,250 for a
subscription for a professional journal to cover the period 1 January 2018 to 31 January 2019 (396 days). As the eligible service period is more than 12 months, Martin must apportion his deduction over the 2017-18 and 2018-19 income years. Martin’s deductions are:
• 2017–18 (1 January 2018 to 30 June 2018) - $1,250 × 181 ÷ 396 = $571
• 2018–19 (1 July 2018 to 31 January 2019) - $1,250 × 215 ÷ 396 = $679
• For the 2017–18 and 2018–19 income years combibned , Martin gets a total deduction of $1,250.
Questions?
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• You can type them in the “Questions” box now
• Or contact me via:
• Mark Chapman
• Director of Tax Communications, H&R Block
• 0415 844 388
