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The art of deduction

Tax Telegraph, December 2012

The art of deductionYou are a suburban accountant.

A client of yours, Ricky Martin, is the owner of a small Mexican restaurant which is going through some tough times attracting new customers.

In a bid to attract new customers, Ricky decides to “re-vamp” the ambience of the restaurant. Ricky incurs the following expenditure:

  • Red “mood” lights, to give the restaurant an authentic Mexican feel
  • New signs
  • A new entry in the shape of a Mexican hat
  • Standard shopfront glass door
  • Standard shopfront glass windows
  • Painting of walls in yellow and red to fit in with the Mexican theme
  • A new awning outside the shop front.

Ricky comes to you and asks you how he should treat these items of expenditure.

Since the expenditure incurred is capital in nature, it will not be deductible under the general deduction provided in section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

Therefore, a deduction should be available under either Division 40 (for depreciating assets) or under Division 43 (as capital works) of the ITAA 1997. Deductions for the decline in value for fit-outs which are considered depreciating assets are based on the effective life of that asset. Fit-outs which are considered to be capital works are generally deducted over 40 years on a straight line basis (i.e. effective rate of 2.5% per annum

Generally, as deductions under Division 40 will be at a more accelerated rate than under Division 43, most taxpayers prefer that the expenditure they incur be deducted under Division 40 rather than Division 43.

First, we look at what constitutes capital works.

What are capital works?

Works to buildings or structural improvements and to extensions, alterations or improvements to those buildings or its structural improvements are generally referred to as capital works.

Whether a fit-out is considered to be capital works depends on whether it “has formed part of the premises”. The following factors are relevant matters to consider in determining whether an item of fit-out forms part of the premises:

  • Whether the item appears visually to retain a separate identity from the rest of the premises
  • The degree of permanence with which it has been attached to the premises (e.g. stapled, nailed, glued, cemented etc.)
  • The incompleteness of the structure without it
  • The extent to which it was intended to be permanent or whether it was likely to be replaced within a relatively short period (i.e. duration/time).

None of the above factors are necessarily conclusive and the importance of each will vary depending on the nature of the item. Once the above matters are considered and appropriately weighted, a conclusion should be made as to whether the item forms part of the premises and if in the affirmative, then deductible under Division 43.

So therefore, broadly speaking, items which are “fixed” to the structure and form part of the structure of the premises would generally be deducted under Division 43.

But is that really the case? Keep reading.

What are depreciating assets?

A depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used.

Each separately identifiable depreciable item of fit-out with its own function should be considered a separate depreciating asset. For example, tiling is a separate functional item to the sauce racks and they are not specifically designed to be used in conjunction with each other. Therefore, the tiling and sauce racks will be separate assets and should be depreciated according to their respective effective life.

“Plant” as depreciating assets

Items of “plant” can also be considered to be depreciating assets. Taxation Ruling 1999/2 (which considers depreciation of plant in a different industry) provides the following overview of the ordinary meaning of plant at paragraph 20:

20. '[Plant] in its ordinary sense...includes whatever apparatus is used by a business man for carrying on his business, - not his stock-in-trade which he buys or makes for sale; but all goods and chattels, fixed or moveable, live or dead, which he keeps for permanent employment in his business': Lindley LJ in Yarmouth v. France (1887) 19 QBD 647 at 658.

In determining whether an item is plant, regard is had to its function. Where its function is primarily to provide a setting or environment from which assessable income earning activities are conducted, the item would not generally qualify as plant. For example, a building is generally the “setting” for the income earning activities.

Where an item does not form part of the premises like discussed above, it may be considered “plant” if the “function performed by the item is so related to the particular taxpayer’s income earning activities” that it falls within the ordinary meaning of plant. In the case Scottish & Newcastle Breweries [1982] 2 All ER 230, the Court held that items used to create a particular atmosphere or ambience for premises used in certain businesses may come within the ordinary meaning of plant. Lord Lowry stated:

…Now the creation of the right atmosphere is a means to an end in the carrying on of such a trade … The mere fact that some of the ornaments are freestanding on the floor or on shelves or tables and that others are suspended from or affixed to walls or ceilings is quite beside the point. They are all part of the hotelier's plant…

Interestingly, the Commissioner of Taxation considers that an item used to create a particular atmosphere or ambience for a restaurant constitutes plant in certain circumstances. Taxation Ruling 2007/9 provides the following at paragraphs 11 and 12 (emphasis added):

11. An item used to create a particular atmosphere or ambience for premises used in a cafe, restaurant, licensed club, hotel, motel or retail shopping business performs a function that is so related to that business to warrant the item being held to come within the ordinary meaning of plant for that business where that atmosphere or ambience is [1] intended to attract customers and is a [2] definable element in the service which the business provides and [3] for which its customers are prepared to pay.

12. Describing an item as decor does not of itself mean that the item comes within the ordinary meaning of plant for one of these businesses. An item used to create a particular atmosphere or ambience for premises used in one of these businesses must not form part of those premises and must satisfy paragraph 11 of this Ruling to come within the ordinary meaning of plant for that business.

So therefore, under this Ruling even where items are “fixed” or form part of the structure of a business, they can be considered plant and depreciated under Division 40. The key is –

  • does the fixture add to the atmosphere, ambience or identity of the business?
  • does it help in attracting customers

If items are deductible under Division 40, they will not be deductible under Division 43.

Conclusion

In light of the discussion above, the treatment of the items of expenditure incurred may be as follows:

Items which are considered unique and create a special ambience for the restaurant, form part of the visual identity of the restaurant and therefore are deductible under Division 40 as “plant”

  • Red “mood” lights, to give the restaurant an authentic Mexican feel
  • New signs
  • A new entry in the shape of a Mexican hat
  • Painting of walls in yellow and red to fit in with the Mexican theme.

Items which are considered to be part of the premises and treated as capital works under Division 43:

  • Standard shopfront glass door
  • Standard shopfront glass windows
  • New awning outside the shop front.

If you have any confusion as to how expenditure you have incurred should be treated, contact your local Deloitte Private tax advisor.

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