A prepaid expense describes a payment made in advance of the benefit of a service or receipt of something. The potential advantage of a prepaid expense is the opportunity for a taxpayer to bring forward the recognition of a deduction into a sooner income year and thereby reduce taxable income in that particular income year.
The technique is particularly effective with respect to sole traders, trusts and partnerships where the expense is brought forward into an income year where there is a higher expected taxable income for the underlying individual or individuals being taxed. This is because the ‘strength’ of a deduction is greater in an income year where applicable tax rates are higher.
Take Thomas who earns $200,000 as an employee in the 2022-23 income year. Thomas is planning to take a long holiday from work for most of the 2023-24 financial year and will therefore only earn $18,000 for that financial year. Thomas is considering paying in advance a subscription for two years’ worth of deductible professional development courses. Is there any tax advantage for Thomas in prepaying this expense? Well in the 2022-23 financial year, all of his taxable income in excess of $180,000 is being taxed at the rate of 45% plus a 2% Medicare levy. Therefore, any deductions (up to $20,000) will result in a tax saving of 45c per $1 plus 2c per $1. However, in the 2023-24 financial year, he will be below the tax-free threshold. Therefore, any deductions (including the prepayment of the course) in 2023-24 will not result in any tax savings or benefits. In this scenario, Thomas would be eligible for significant tax benefits by prepaying the costs of the training course to bring forward an allowable deduction.
In response and anticipation of these forms of behaviours, there are now some limitations on the immediate recognition of deductions in respect of prepaid expenses. These rules are known as the ‘prepayment rules’.
The prepayment rules
The prepayment rules govern the timing of deductions available in respect of prepaid expenses that relate to something being done wholly or partially in a future income year. Essentially, the deductible amount allowable in respect of the prepaid expense will be evenly spread out over the ‘eligible service period’. The eligible service period commences on the day the thing begins being provided or the day the expense is incurred (the later of these two dates) and ends on the completion of the thing to be done or 10 years (the earlier of these two dates). Note that a prepaid expense will generally be considered to have been incurred on the date paid.
Thomas is a sole trader of a taxi driving business. To bring forward the recognition of a deduction on 31 August 2023, he purchases 5-years’ worth of defensive driving classes (from 1 October 2023 – 31 August 2028) for $10,000 to improve his driving for work purposes. Assume these costs are deductible. The deduction must be spread evenly over the eligible service period which will run from 1 October 2023 (being the later of (i) the date the thing commences to be provided and (ii) the date the expense is incurred) to 31 August 2023 (being the earlier of (i) the date the thing ends and (ii) 10 years).
The annual deduction for the prepaid expense should be calculated as follows:
Prepaid expense amount / number of days in eligible service period x number of days in respective income year that are within the eligible service period.
$10,000 / 1,796 total days in eligible service period x number of days in respective income year (273 days in first year, 366 days in the second year, 365 days in the third, fourth and fifth years and 62 days in the sixth year).
Deductions over the eligible service period will be as follows:
Year ending 30 June 2024: $10,000 / 1,796 x 273 = $1,520.04.
Year ending 30 June 2025: $10,000 / 1,796 x 366 = $2,037.86.
Year ending 30 June 2026: $10,000 / 1,796 x 365 = $2,032.29.
Year ending 30 June 2027: $10,000 / 1,796 x 365 = $2,032.29.
Year ending 30 June 2028: $10,000 / 1,796 x 365 = $2,032.29.
Year ending 30 June 2029: $10,000 / 1,796 x 62 = $345.21.
- The prepaid expense is ‘excluded expenditure’
- The ‘12-month’ rule applies
- A prepayment is in respect of an obligation that existed prior to the release of review of business taxation report on 21 September 1999 (not considered further in this article).
- Expenses less than $1,000 (not including the value of claimable input tax credits)
- Expenses that are compulsory to incur due to a court order or as legal requirement e.g. legally required insurances. Note that an unlegislated industry requirement would not be likely be sufficient.
- Expenses being salary or wages under a contract of service e.g. employee salary and wages.
- Expenses that are of a character that is capital or private in nature.
- Certain other niche expenses.
The 12-month rule
This rule is only available for small business entities or an individual incurring the expense in employment (e.g. purchase of work laptop) or in a non-business income-producing context (e.g. prepayments relating to investment property expenses).
In the context of the prepayment rules a ‘small business entity’ is an entity with an aggregated turnover of less than $50 million. Remember that ‘aggregated turnover’ is a reference to annual turnover, plus the annual turnover of associates and connected entities (with some exclusions). ‘Annual turnover’ is a reference to ordinary income. It is not restricted to current year turnover but can include prior year turnover and projected turnover in certain circumstances.
The 12-month rule allows the taxpayer to claim an immediate deduction for the prepaid expense if the thing being acquired has an ‘eligible service period’ of 12 months or less and where the eligible service period will end no later than the end of the following income year i.e. by 30 June of the financial year following the year of the prepayment.
Thomas is a sole trader of a taxi driving business. To bring forward the recognition of a deduction on 31 August 2023 he prepays vehicle insurance to cover the period of 15 July 2024 to 14 July 2025.
- The eligible service period is 12 months i.e. from 15 July 2024 (being the later of (i) the date the expense was incurred on 31 August 2023 and (ii) the date the thing / service commenced being 15 July 2024) to 14 July 2025 (being the earlier of (i) the date the thing ends and (ii) 10 years).
- However, the eligible service period extends past the end of the financial year following the incurred expense. The prepaid expense is incurred in the financial year ending 30 June 2024 but the eligible service period goes past the end of the following financial year ending 30 June 2025 and into the financial year ending 30 June 2026.
- Therefore, the taxpayer is not eligible for an immediate deduction for the prepaid expense under the 12-month rule.
Note that if the vehicle insurance was legal required to be obtained, the related prepaid expense would be an ‘excluded expense’ and the entire prepayment would be immediately deductible.
Continued opportunities with prepaid expenses
- Prepaying excluded expenditure such as legally required expenses, staff salaries or outgoings less than $1,000 (GST-exclusive).
- Prepaying expenses with an eligible service period less than 12-months and that ends no later than the end of the following income year (provided you are an eligible person to access this concession).
- Prepaying for depreciable capital assets or trading stock. These may be fully depreciable (deductible) in the year of purchase or at least over a lesser period than is representative of the benefit of the use of the assets. For example, a taxi vehicle can be depreciated over 4 years under the Commissioner’s effective life table despite the car having a business-use lifespan (akin to an eligible service period) of 10 plus years. Even better, the car (or any other depreciable capital asset) may be immediately depreciable under the instant asset write-off. Remember that the immediate write-off under the instant asset write-off is only available where the asset is installed and ready for use. An immediate deduction would also be available for trading stock which is purchased and on hand by the end of the financial year.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.