The most common way a taxpayer will be eligible for a deduction on business related expenditure is by satisfying the criteria of section 8-1 of the Income Tax Assessment Act 1997.
That provision provides that a taxpayer can deduct any loss or outgoing to the extent it is:
- incurred in producing assessable income; or
- is necessarily incurred in carrying on a business.
These are referred to as the two positive limbs of section 8-1.
The section also contains four negative limbs. To the extent that any of the negative limbs apply, a deduction should not be available to the taxpayer. For the purposes of this article, the most relevant negative limbs are that a loss or outgoing is:
- of capital, or a capital nature; or
- of private or domestic nature.
The question when it comes to pre commencement and closure related expenses is whether these can be said to have been incurred in producing assessable income or in carrying on a business, or alternatively, whether the required nexus between the expense and the positive limbs is broken.
As established in case law, there are occasions where it can be said that certain outgoings are incurred prior to the production of assessable income or carrying on of a business and should therefore not deductible under section 8-1. Similarly, there are occasions where it can be said that certain outgoings are incurred at a point where there is no production of assessable income or business activity being carried on and should therefore not be deductible under section 8-1.
Simultaneously to answering the above question, there also needs to be an assessment of the character of relevant outgoings to determine if these are capital or private in nature. As established in case law, there are many instances where pre commencement and closure related expenditure is classified as capital or private in nature and therefore not deductible.
This article attempts to shed some light on the tax treatment of certain business pre commencement and closure related outgoings and the opportunity (including opportunities outside of section 8-1 of the ITAA 1997), if any, for an allowable deduction to be obtained.
Pre Commencement Expenditure
The deductibility of pre commencement expenditure is often unclear. However, a few examples of instances where deductibility has been considered are explored below:
- An interest expense incurred on a borrowing to acquire property on capital account before that property was put to income producing use will usually be deductible if it is intended that an income producing use would commence shortly. However, it was suggested that if the period between the interest outgoing being incurred and the derivation of assessable income is too long, a deduction may not be available. See Taxation Ruling 2004/4 for further information on this topic.
- Property expenses incurred prior to the time the property is rented or used to produce other assessable income will usually be deductible, provided the property is being advertised for occupation and is genuinely available for rent or business use or is intended to be made genuinely available for rent but is currently unable to be rented due to circumstances such as renovations.
- The premium expense necessary to obtain an assessable insurance payout (assessable as it replaces future employment related income) will usually be deductible even though, at the time the expense was incurred, the taxpayer may be out of workforce and not producing assessable income.
- An expense incurred which was related to finding employment will usually not be as it considered to be incurred too soon before the production of assessable income.
Note that the vacant land rules of section 26-102 of the ITAA 1997 may apply to limit available deductions during the period of time land (held on capital account) does not contain a substantial and permanent structure.
Note that a temporary pause in business activity will usually not interrupt the nexus between the outgoing and the derivation of assessable income. There is an acceptance that short stints of business inactivity are normal in a commercial context. For example, a business closure over the Christmas holiday period.
Closure Related Expenditure
By closure related expenditure, we refer to expenditure incurred by a business after it has ceased operating in its trade or business.
There is limited scope in section 8-1 to obtain a deduction for the costs of disposing or closing a business as these costs are generally seen as capital in nature. However, such costs may be deductible under the blackhole provisions.
Some examples of closure related expenditure that will generally not be deductible under section 8-1:
- Payment to directors after a company has ceased business operations and is preparing for dissolution.
- Payments as compensation for closure of the business.
Note that interest which accrues after income earning activities have ceased may continue to be deductible. The ATO position on this topic is expressed in Taxation Ruling 2004/4. The ruling provides:
Where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and relevant income earning activities (whether business or non business) have ceased, it is apparent that the interest is not incurred in gaining or producing the assessable income of that period or any future period. However, the outgoing will still have been incurred in gaining or producing the assessable income if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period.
Essentially, interest will generally continue to be deductible after business operations cease if the relevant borrowing (which involves a charge of interest) was in relation to something (e.g. an asset) that was utilised by the business to produce assessable income while the business was actively operating.
However, the deductibility of such interest may be compromised in certain circumstances. For example:
- where the taxpayer keeps the loan on foot for reasons not associated with the former income earning activities; or
- where the taxpayer makes a decision to extend the loan in such a way that there is an ongoing commercial advantage to be derived from the extension which is unrelated to earning assessable income.
Remember that interest incurred on a loan to acquire land (on capital account) without a substantial and permanent structure may also be required to satisfy the vacant land rules in section 26-102 of the ITAA 1997 before a deduction is allowable.
Specific Deductions
It is important to keep in mind that ineligibility for a deduction under section 8-1 of the ITAA 1997 will not prevent the taxpayer from obtaining a deduction pursuant to another provision in the tax law that applies and expressly grants the right to a deduction.
For example, take section 25-5 of the ITAA 1997 which enables the taxpayer to claim a deduction for tax related expenses. If the criteria of section 25-5 are satisfied and a deduction is expressly available, the taxpayer’s failure to satisfy section 8-1 of the ITAA 1997 will not matter (for example, if tax related expenditure relates to the structure of the business and is therefore considered capital in nature).
Note that section 25-5 does not enable a deduction for capital expenditure. However, the scope of tax related expenditure that is considered capital in nature is specifically narrowed in the wording of the section.
The narrowed definition of capital in nature does not appear in section 8-1.
Therefore, it is commonly the case that certain tax related expenditure achieves deductibility under section 25-5 despite the fact that such expenditure would theoretically not be deductible under section 8-1.
Blackhole Expenditure
If a deduction is not available under section 8-1 of the ITAA 1997 or another provision of the tax law, section 40-880 of the ITAA 1997 (dealing with blackhole expenditure) may provide the taxpayer with an alternative avenue for claiming a deduction.
The main requirements to obtain a deduction under section 40-880 are set out below:
- The expenditure is capital expenditure; and
- The expenditure is incurred in relation to a business; or
- The expenditure is incurred in relation to a business that used to be carried on; or
- The expenditure is incurred in relation to a business proposed to be carried on and, if so, commencement must occur within a reasonable time; or
- The expenditure is incurred in winding up a trust and the taxpayer is a beneficiary of the trust; or
- The expenditure is incurred winding up a partnership and the taxpayer is a partner of the trust; or
- The expenditure is incurred in liquidating or deregistering a company and the taxpayer is a member of the company.
- A deduction is not available under another section of the ITAA; and
- The expenditure does not form part of the cost of a depreciating asset; and
- The expenditure does not form part of the calculation of the net gain under a profit making scheme; and
- The expenditure does not form part of the cost base of a CGT asset; and
- There is no section of the ITAA which specifically disallows a deduction for the outgoing (other than section 8-1); and
- The expenditure is not private or domestic in nature; and
- The expenditure is not incurred in relation to gaining or producing exempt income or non assessable non exempt income.
Please see section 40-880 for a description of the eligibility criteria. The above list describes the main eligibility criteria only.
If these criteria are satisfied, the expenditure may be deducted over the course of 5 years on a straight line basis.
However, a small business entity will be entitled to an immediate deduction for certain types of blackhole expenditure.
Small Business Entity Immediate Deduction
A small business entity in the context of section 40-880 broadly refers to an entity which has an aggregated annual turnover of less than $50m.
Eligible expenditure includes:
- expenditure incurred for a business that is proposed to be carried on; and
- which involves obtaining advice or engaging services related to the proposed structure or the operation of the business; or
- which involves payment to an Australian government agency to discharge fees, taxes or other charges which are related to establishing the business operating structure.
Examples could include:
- The payment of an ASIC fee related to setting up a company.
- Transfer duty or land title registration fees payable on assets acquired for utilisation in the proposed business.
- Costs related to raising debt or equity funding for the business.
- Costs of professional fees to obtain assistance with setting up a business structure, assessing the feasibility of a proposed business and / or obtaining advice on business matters related to commencement.
Remember these expenses would only be deductible under s 40-880 if they were not already deductible under another section of the tax law, such as section 8-1 of the ITAA 1997.
Please note that this article does not address the tax rules relevant to liquidation or the sale of a business.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.
