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Deductions
P R E PAR E D BY WE S OBS T AND R AMI HANE GBI F OR T HE UNI T T E AM
Contents
Introduction 1
Learning resources 2
Textbooks 2
General deductibility under section 8-1 2
The positive limbs 2
The negative limbs 7
Limitations on deductibility 11
Specific deductions under s. 8-5 13
Introduction 13
Division 25 ITAA 97 specific deductions 14
Other specific deductions under Div. 25 17
Gifts Div. 30 ITAA 97 18
Tax losses Div. 36 ITAA 97 18
Capital allowances Div. 40 ITAA 97 19
Capital works Div. 43 ITAA 97 21
Other capital allowances not covered in this unit 22
Summary 22


Deakin University
P rinciples of I ncome Tax Law
Introducti on
In topics 2 and 3 we have covered the first element of the calculation of taxable
income, i.e. assessable income. In Topic 4 we cover deductions, which is the
second major element of the tax equation as shown in Figure 4.1.
Fi gur e 4. 1 The t ax equat i on


From Figure 4.1 you will be reminded that the calculation of taxable income is
determined by subtracting deductions from assessable income. Figure 4.1 also
shows that deductions are made up of three elements just as assessable income
was. Assessable income was made up of:
ordinary income
statutory income
exempt income.
Following a similar structure, deductions are made up of:
general deductions (s. 8-1(1))
exclusions (s. 8-1(2))
specific deductions (s. 8-5).
It is very important to remember this structure, as these are the three factors that
must be considered each time you determine whether an expense is deductible or
not. Whenever you consider whether an expense is deductible against assessable
income, you must first ascertain whether you are entitled to a general or specific
deduction, and whether any exclusion provisions apply to deny the deduction. This
structure is derived from ITAA 97, ss. 4-15, 8-1 and 8-5. Following this structure,
topic 4 is dealt with under these three major headings.
In a similar manner to s. 6-20, which prevents a receipt being assessable under
more than one provision of the Act, s. 8-10 also prevents an expense being
deductible more than once under different provisions.
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Learni ng resources
Textbooks
Coleman et al., Principles of taxation law 2014, Thomson Reuters, Pyrmont NSW.
Deutsch, RL, Fundamental tax legislation 2014, Thomson Reuters, Pyrmont, NSW,
General deducti bi l i ty under secti on 8-1
The basic structure of the legislation is to provide for general deductions under
section 8-1 ITAA 97 and specific deductions through section 8-5 ITAA 97.
Reading s. 8-1 you will notice that it is divided into two parts, subsections (1) and
(2). The first subsection contains what is known as the two positive limbs. At least
one of these must be proved to apply before any amount is deductible as a general
deduction. The second subsection contains four negative limbs. If any of these
apply the deduction will be denied. The term limbs has been used over the years
by the courts to describe the different tests under s. 8-1, so it is important to
become familiar with the language that is used.
Under the first two positive limbs of s. 8-1(1) a deduction is available from your
assessable income:
(a) [First positive limb] for any loss or outgoing to the extent that it is incurred
in gaining or producing your assessable income
or
(b) [Second positive limb] for any loss or outgoing to the extent that it is
necessarily incurred in carrying on a business for the purpose of gaining or
producing your assessable income.
TEXTBOOK
Please read Coleman et al. 2014, 12.00 12.30.

The posi ti ve l i mbs
The key to obtaining a deduction under either of the two positive limbs is to
establish a connection or nexus between the loss or outgoing and the assessable
income. The nexus test is therefore paramount and must be the first step in
determining whether any expense is deductible or not.
Suffi ci ent nexus
Over the years the courts had established a number of tests to determine whether
there is sufficient nexus between the loss or outgoing and the assessable income.
These tests can best be described as:
the incidental and relevant test
essential character test.

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P rinciples of I ncome Tax Law
EXAMPLE 4. 1
Incidental and relevant test
It might be argued that an employee could show that there is a nexus between
his income and the cost of travelling from home to work. The argument might go:
it is not possible to earn my assessable income without travelling to work, and
therefore travel costs are incidental and relevant to earning assessable income.
However, this is not the correct application of the incidental and relevant test,
which requires that the travel itself is in the course of earning assessable
income. In this example there is no assessable income earned during the travel
from home to work as work only starts once you arrive. In contrast, if the
employee travels because of work, for example to see a client, the nexus test is
proven because the travel is in the course of earning the assessable income.
TEXTBOOK
Please read Coleman et al. 2014, 12.40 12.60.
QUESTI ON 4. 1
Write a brief summary of how the incidental and relevant test and the essential
character test were applied in the Charles Moore and Lunney cases.
QUESTI ON 4. 2
Make a brief summary of the essential requirements necessary to meet the
incidental and relevant test.
Necessari l y i ncurred
The second limb uses the term necessarily incurred in carrying on a business to
qualify the nexus with the assessable income. Over the years the courts have read
down the word necessarily to mean appropriate or adapted for commercial
purposes. This means that the nexus test is proven if the expense is appropriate
for the business rather than is necessary.
EXAMPLE 4. 2
Necessarily incurred
Does an expense have to be necessary before you are allowed a tax deduction
under s. 8-1?
A large newspaper company decides to spend $3 million on an advertising
campaign. After consulting several advertising agencies it decides on a
campaign which it knows is sexist but which the management believes will
increase sales. Only two days after the release of the advertising campaign there
is a public outcry, and the advertising is withdrawn. Market research over the
next few months showed that sales actually declined instead of increasing.
For an expense to be deductible under the second limb of s. 8-1, it must be
necessarily incurred. Although it might be argued that this expense was a waste
of money, it is still appropriate or adapted towards the carrying on of the
business. Therefore, it is still incidental and relevant to the earning of assessable
income and therefore passes the second limb of s. 8-1.
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TEXTBOOK
Please read Coleman et al. 2014, 12.70 12.150.
QUESTI ON 4. 3
From Snowdon and Wilson, who should be the judge of whether an expense is
necessary?
QUESTI ON 4. 4
From the decided cases make a brief summary of whether a nexus can be shown
for a business expense under the second limb that is:
(a) past business income of a continuing business
(b) current business income
(c) future business income which may or may not eventuate
(d) income of a business that ceased three years ago and is not likely to
resume
(e) income of a company that ceased operating for six months and then
resumed operation in an unrelated area of business
(f) income of a business that has been put into liquidation.
Apporti onment
The phrase in s. 8-1 to the extent that clearly contemplates the notion that an
expense may only be partly deductible. It may have to be apportioned between an
amount which is incidental and relevant and an amount that is not.
TEXTBOOK
Please read Coleman et al. 2014, 12.270 12.280.
EXAMPLE 4. 3
Apportionment of expenses
Miss Lee conducts a small photography business which she operates from the
front two rooms of her private home. Her electricity account of $250 is
undissected and applies to both the rooms used for her business and her pri vate
home. Only the proportion of electricity used for her business is incidental and
relevant to earning assessable income, and therefore the total amount of $250 is
not deductible. As the electricity used in the business is not measured
separately, it is necessary to make some reasonable apportionment of the total
account. This may be done by estimating the percentage of the total home that is
occupied by the shop, or some other reasonable method.
The ATO suggests that a rate of 26 cents per hour is reasonable, and the total
number of hours used during the year should be determined by keeping a diary
for four average weeks during each year.
QUESTI ON 4. 5
If a motor vehicle is used for both business and pri vate purposes is any part of
the cost of running the motor vehicle an allowable deduction?
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QUESTI ON 4. 6
The taxpayer incurs a cost of $1500 for an airline ticket to Hong Kong to
investigate the prospects of exporting the companys produce into the Chinese
market. While in Hong Kong the taxpayer spends seven days meeting with trade
and industry representati ves, and five days on an organised bus tour of the local
sites. Is any part of the $1500 airfare deductible, and if so, how could the
deductible proportion be determined?
Amount of deducti on
Up until this stage of our discussion of the positive limbs of s. 8-1, we have
accepted that an expense meets the positive tests if there is a connection between
the expenditure and earning assessable income. This analysis tends to be very
objective, so that in deciding the cases up until the 1980s the courts took the view
that something could be determined as incidental and relevant by looking at the
legal rights that were obtained. However, this approach could be exploited by the
taxpayer by concealing a non-income earning purpose within a legitimate income
earning activity. Consequently, the courts have in more recent times considered the
subjective purpose of the expense, but this approach is only used where the
taxpayer has created a tax loss situation, for example, assessable income is less
than the allowable deductions (see Example 4.4).
EXAMPLE 4. 4
Subjective purpose approach
In the case Ure v. FCT the taxpayer borrowed money at 12% interest which he on
lent to his wife at 1% interest. The taxpayer argued that all of the 12% interest
was deductible because the loan was for the purpose of earning assessable
income the 1% interest.
Applying the legal rights approach it might be concluded that the taxpayer has
shown that the expense of 12% interest is incidental and relevant to earning the
1% interest, which is assessable. However, looking behind this purely objecti ve
approach, the purpose approach would ask whether there is some other purpose
in the borrowing, other than the earning of the 1% interest. In this case it was clear
that the money was ultimately borrowed for the construction of the taxpayers
pri vate home. Therefore, the court only allowed a tax deduction equal to the
amount of interest earned from lending the money to his wife. The remainder of
the interest he incurred was held to be pri vate as it had a pri vate purpose.
TEXTBOOK
Please read Coleman et al. 2014, 12.290 12.320.
SAMPLE PROBLEM
4. 1
Deductions under s. 8-1
Daylee Paper Ltd publishes the UNTRUTH newspaper. In the course of producing
that paper, it printed an article which later was the result of a successful libel
action against Daylee Paper Ltd. Daylee Paper paid compensation of $100 000
and legal fees of $50 000.
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Issue: The compensation and the legal fees will be deductible under s. 8-1 if they
are incidental and relevant to producing assessable income, or are necessarily
incurred in carrying on the newspaper publishing business.
Principle: In answering the above questions it is necessary to determine whether
under the second positive limb of s. 8-1, there is a nexus between the expenses
and the carrying on of the business of newspaper publishing. Whether or not there
is a nexus between the expense and the assessable income can be determined by
applying the incidental and relevant test (Charles Moore v. FC of T 11 ATD 147).
Application: In Herald & Weekly Times Ltd. v. FC of T (1932) 48 CLR 113 it was
decided that an expense is connected with the business if it is appropriate or
adapted to the carrying on of a business. In this case the key issue was whether
the expense of the defence of a libel action was one that was brought about by
the nature of the business.
Conclusion: The expenses of Daylee Paper Ltd for compensation and legal fees
arose because of their business acti vities, and therefore they are incidental and
relevant to carrying on the business. Although these expenses were not foreseen
and unplanned, they are still incurred in relation to the income-earning acti vities
of the business. Therefore both these expenses meet the requirements of the
second positive limb s. 8-1.
QUESTI ON 4. 7
Make a summary of the key elements that must be considered when deciding
whether a loss or outgoing is deductible under either of the two positi ve limbs
of s. 8-1.
QUESTI ON 4. 8
Discuss the deductibility of the following expenses based on each of the two
positive limbs of s. 8-1. (At this stage it is not necessary to consider whether they
may be excluded by some other provision of the Act.)
(a) The traffic and parking fines paid by a taxi dri ver that were incurred while
using the taxi for income-producing purposes.
(b) Interest of $500 paid to the local city council by the owner of a rented
property on monies outstanding to the council for road construction costs.
(c) A sum of $1.4m paid to an advertising agency for the development of an
advertising campaign that was to run for the next two years.
(d) Interest paid on a loan that was borrowed for the purposes of acquiring a
rental property.
(e) Expenditure incurred by an airline company in defending against the
right of other airlines to fly similar routes.
(f) A lecturer at Deakin Uni versity incurred expenditure of $1200 in moving
to Sydney to take up a position at the Uni versity of NSW.
(g) The taxpayer incurs travel expenditure of $1300 for the use of his own
car. He manages two farming properties which are some distance apart.
His employer requires him to live at one property and supervise both. He
does not recei ve any travel allowance.
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(h) T Smart li ves in Melbourne and has two children attending Deakin
Uni versitys Warrnambool campus. In an attempt to reduce the cost of
accommodation for his children, he purchases a small house in
Warrnambool at a cost of $360 000 for his children to li ve in. To do this he
borrowed money at 8% per annum and charged his children $5 per week
rent and gave them the responsibility of maintaining the house. T Smart
also pays each child an allowance of $180.00 per week.
(i) A Scribe is a freelance TV scriptwriter who has a room in her house
where she does most of her work, even though she has been given an
office at the television studio. On most days she rises at 5.00 am and
begins work on either the television scripts or her freelance acti vities. At
about lunch time she travels to the studio to discuss progress with the
program director. Her costs include:
electricity for lighting and heating
rates on her home
interest on a housing loan
travel to and from the television studio.
(j) A law/accounting student spends $1000 on postage trying to find a job.
(k) The following expenses are incurred by a company that manufactures
shoes for the surf-wear market:
company formation expenses
employee wages
factory rent
purchase of trading stock
repairs to production plant
telephone and administration costs
insurance on factor and plant
childcare expenses of an employee.
QUESTI ON 4. 9
Coleman et al. 2014, Question 12.1
The negati ve l i mbs
The first step in determining whether an expense is a general deduction under s. 8-
1 is to determine whether or not either of the two positive limbs allow a deduction.
Once this is proved, the next step is to ascertain whether the expense will be
excluded from deductibility by one of the four negative limbs. Section 8-1(2)
excludes from deductibility losses and outgoings that are:
(a) [First negative limb] capital: or
(b) [Second negative limb] private or domestic; or
(c) [Third negative limb] incurred in earning exempt income; or
(d) [Fourth negative limb] excluded under specific provisions of the
Act.

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The first two of these exclusions from deductibility are the most important and need
to be considered in some detail. The third negative limb is self explanatory, and the
fourth negative limb is covered in the last part of this topic as it applies to both
general and specific deductions.
Fi rst negati ve l i mb capi tal expenses
The exclusion of capital expenses from deductibility produces a symmetry
between deductions and assessable income. In topics 2 and 3 we saw that capital
receipts are not ordinary income and are only assessable because of their specific
inclusion under the capital gains provisions. A similar approach operates for
deductions. Capital expenses are excluded from general deductibility, but the
specific deductions do allow some capital expenses such as depreciation (see
later discussion in this topic).
Capital expenses are not defined in the legislation, giving rise to the same
difficulties that occurred with defining ordinary income. When considering the
meaning of capital, in the context of income, we needed to resort to case
decisions. Although there are some similarities between the courts approach to
defining capital for income and expenses, it is important not to confuse the two.
The leading decision on the deduction side is Sun Newspapers Ltd v. FCT (1938)
61 CLR 337 in which Dixon J drew a distinction between structural expenses,
being capital, and process expenses, being deductible. The analysis used by Dixon
J has become known as the business entity test but is also referred to as the
profit yielding structure test.
Even though the business entity test has become the most significant test of
capital in Australia, it is still important to recognise that the once and for all and the
enduring benefit tests should still be considered when deciding whether an
expense is capital or not.
EXAMPLE 4. 5
Capital expenditure
Simple examples of capital expenditure will include obvious expenses such as
the construction of a new factory and the acquisition of new manufacturing plant.
It is the intangible expenses such as legal fees and the cost of undertaking a
feasibility study that are more difficult to distinguish.
In Sun Newspapers Dixon J contrasts capital expenses which alter the way in
which business is done, with non-capital expenses which simply allow the
business to operate. This difference can be seen using the example of a
business loan acquired to purchase new business premises. The cost of the new
premises is clearly capital as it has an enduring benefit, is once-off and alters the
way in which the business is carried out. However, the interest on the loan used
to acquire the capital item is not capital.
This is because the interest payments enable the loan to continue, and so are
part of the process of operating the business rather than changing it. A similar
example can be gi ven with insurance. Insurance on a capital item may be thought
to be capital, but if you apply the tests of capital you will see that it is not. The
insurance does not show an enduring benefit, is not once-off and does not alter
the way in which the business is carried out. It simply protects the asset so that
the business can continue free of risk.
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You should note in this example that it is important to consider all three tests,
although more emphasis should be given to the business entity test, especially
if the other tests gi ve conflicting conclusions.
TEXTBOOK
Please read Coleman et al. 2014, 12.160 12.210.
READI NG
Please read the Justice Dixons Judgment in Sun Newspapers case -
http://law.ato.gov.au/atolaw/view.htm?dbwidetocone=05%3ALRP%3AHigh%20Co
urt%3A1938%3ASun%20Newspapers%20Ltd%20%26%20%20Anor%20v%20Fede
ral %20Commissioner%20of%20Taxation%3A%2303%23Judgment%20by%20Dixo
n%20J%3B
SAMPLE PROBLEM
4. 2
Capital exclusion under s. 8-1
FreeFlight Pty Ltd airlines incurred an expense in connection with the
unsuccessful application for variation in the companys air traffic rights. This
was an attempt to increase the number of routes available to the company.
Issue: Is the expenditure capital in nature or not?
Principle: Outgoings of a capital nature are specifically excluded from
deductibility under s. 8-1(2). Following Sun Newspapers Ltd. & Associated
Newspapers Ltd. v FC of T (1938) 661 CLR 337 the expense will be capital if it
alters the business entity rather than simply operating it. An expense is also more
likely to be capital if it has an enduring benefit or is incurred once and for all.
Application: The expenditure was incurred in an attempt to obtain rights to air
routes presently unavailable to the company. As the company earns income from
conducting flights on the various air routes available to it, the right to fly a
particular air route may be viewed as part of the business structure which
generates the income. Asking the question that Dixon J. posed what is the
character of the advantage sought?, it would be concluded that the airline
company sought to increase the size of its business, rather than simply
operating the business.
This expense also has an enduring benefit because if the application is successful
the benefits will last for some time. The fact that the application was unsuccessful
is irrelevant because the intention was to alter the way the business was done.
Although this expense may occur on a number of occasions it is nevertheless
once off, unless the airline is in the business of trading in air traffic rights.
Conclusion: As there is no indication that the company is in the business of
trading in air traffic rights, the fact suggest that this expenditure is capital in
nature and therefore excluded from deductibility under the first negati ve limb of
s. 8-1. This expense goes towards the structure of the business rather than the
process of its operation.
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QUESTI ON 4. 10
(a) In Sun Newspapers, what three considerations did Dixon J use to
determine whether an expense alters the taxpayers business entity?
(b) To what extent do these three matters incorporate the earlier tests
adopted by the courts?
(c) How would Dixon J treat advertising?
QUESTI ON 4. 11
How would you characterise a feasibility study undertaken by a gold mining
company as to whether it should also mine for nickel on some of its existing
mining leases?
QUESTI ON 4. 12
Explain how the following expenses would be treated under the business entity
test. Note the different taxation effects of the different forms of holding assets.
(a) Costs of purchasing a new shop to operate a retail business.
(b) Interest paid on the money borrowed to purchase the new shop.
(c) Costs of leasing a shop to operate a retail business.
(d) Costs of leasing a motor vehicle that will be used for business purposes
only and can be acquired at the end of the lease for a fraction of its
market value.
QUESTI ON 4. 13
Discuss the deductibility of the following items for taxation purposes,
gi ving reasons.
(a) A bonus of $10 000 paid to a building contractor by the owner of the
building, for the early completion of an income producing building.
This bonus represents a share of the extra income recei ved due to
early completion.
(b) The taxpayer is a large pharmaceutical firm and conducts continuous
research on a cure for the common cold.
(c) A retail business borrowed $500 000 to expand its business by building a
new shop. The loan was for 10 years. When borrowing these funds the
business incurred expenses of $2000 to arrange and establish the loan.
(d) A large beer manufacturer operates a system whereby it pays hotels a fee
of $50 000 for entering an agreement that requires the hotel to only sell
the manufacturers brand of beer. This practice has been undertaken for
the last 2 years and hundreds of hotels throughout Australia have taken
up the offer. During the current year the company paid $1m to hotels
under these arrangements.
(e) The taxpayer is in the business of gas exploration and spends $2m
investigating the viability of commencing a business of laying gas
pipelines.
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(f) A company has spent $50 000 advertising against a government proposal
to remove taxation concessions currently enjoyed by the business.
Second negati ve l i mb pri vate or domesti c expenses
Section 8-1(2)(b) denies a deduction for loss or outgoing that is private or domestic
in nature. Consequently, personal expenditure is specifically excluded from
deductibility. It is interesting to note that there is no equivalent notion of private
transactions in relation to income.
Part of the difficulty with private and domestic expenses revolves around the fact
that many expenses that could easily be described as private or domestic, could
also be business or employment related. For example, clothing might be normally a
private expense but how would we treat a business suit or a barristers wig? What
about business lunches where deals are struck or child minding fees incurred to
allow an employee to be able to attend work?
When considering this exclusion it is important to consider whether or not passing
one of the positive limbs of s. 8-1, excludes the possibility of the expense being
private or domestic. This would seem a reasonable argument, because if you can
show that an expense is incidental and irrelevant to earning assessable income, then
by that very nature it is not private. However, in FCT v. Forsyth (1981) 148 CLR 203
and Handley v. FCT (1981) 148 CLR 182, the High Court indicated that expenditure
of a domestic nature may nevertheless satisfy one or either of the positive limbs.
TEXTBOOK
Please read Coleman et al. 2014, 12.220.
Thi rd negati ve l i mb l osses or outgoi ngs i n rel ati on to exempt
i ncome
Because exempt income is not assessable income (s. 6-20), expenses incurred to
gain such non-assessable income should not be deductible. The third negative limb
of s. 8-1 confirms that proposition.
Li mi tati ons on deducti bi l i ty
Fourth negati ve l i mb excl uded by the Act
The fourth negative limb (s. 8-1(2)(c)) limits a deduction where a provision of the
Act (both ITAA 97 and ITAA 36) prevents a taxpayer from obtaining such a
deduction. Some of the more important exclusions are dealt with in this topic.
As already discussed, s. 8-1 has three general exclusion provisions which deny a
deduction for capital expenditure, private or domestic expenditure, or expenditure
incurred in earning exempt income. The fourth negative limb excludes expenditure
that is specifically excluded under the Act.
In addition to these specific exclusion provisions it is also important to note that a
deduction may also be denied because adequate records are not kept, or because
the deduction was part of a tax avoidance scheme. These issues are covered in topic
8. Also, in April 2005 the Federal Government introduced legislation (s. 26-54) to
deny the deduction of expenses associated with the earning of income from illegal
activities. This amendment resulted from the courts allowing a deduction of $220 000
to a taxpayer involved in an illegal drug-dealing business (La Rosa (2003)).
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In this unit we will cover the following more important exclusion provisions:
GST credits
provisions for employee leave
fines and penalties
payments to related entities
leisure facilities and club memberships
non-commercial losses
expenses relating to illegal activities
leisure facilities and club memberships
HECS and self-education expenses
entertainment expenses.
TEXTBOOK
Please read Coleman et al. 2014, 12.240 12.260.
SAMPLE PROBLEM
4. 3
Excluded deductions
Harris runs an overnight deli very service and he employs six dri vers to deli ver in
all areas of the city. After leaving school Harriss daughter Emil y could not get a
job so he employed her to gi ve her something to do. Because Emily had no other
income Harris decided to pay her twice as much per hour as his other employees.
Issue: Is Emilys wage incidental and relevant to earning assessable income or is
it excluded by a specific provision?
Principle: Under the second limb of s. 8-1, an expense will be deductible if there
is a nexus between the expense and the carrying on of the business. Whether or
not there is a nexus between the expense and the assessable income can be
determined by applying the incidental and relevant test (Charles Moore v. FC of
T 11 ATD 147). The courts generally do not consider whether the expense is
commercially justifiable (Cecil Bros Pty Ltd v. FC of T (1964) 111 CLR 430)
unless it can be shown that there is another purpose for the expense (Ure v. FC
of T 81 ATC 4100). However, the expense may not be deductible in part or in full
if s. 26-35 applies.
Application: In Herald & Weekly Times Ltd. v. FC of T (1932) 48 CLR 113 it was
decided that an expense is connected with the business if it is appropriate or
adapted to the carrying on of a business. In this case the expense is clearly
part of the cost of operating the business that gives rise to assessable income,
albeit an unnecessary expense. The decision in Cecil Bros shows that a
payment is not denied deductibility under the positive limbs of s. 8-1 just
because it is unnecessary.
However, s. 26-35 limits the deductibility of a payment to a related entity to an
amount considered reasonable by the Commissioner. Section 26-35(2)(a) defines
a related entity as including a relati ve and s. 995-1(1) defines a relati ve as
including a lineal descendant which would include Harriss daughter.
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Conclusion: Although the daughters wage is incidental and relevant under the
second limb of s. 8-1, the deduction will be limited to a reasonable amount as
determined by the Commissioner.
QUESTI ON 4. 14
Discuss the deductibility of the following items for taxation purposes,
gi ving reasons.
(a) Lim Emporium Pty Ltd is a large distributor of Asian foods. Much of the
business of the company is negotiated at sporting clubs and football
matches. As a result Lim Emporium pays one sporting club membership
per person for each of its top employees.
(b) A fine of $10 000 imposed by a national sporting tribunal on a sports star
who breached the organisations rules of conduct.
QUESTI ON 4. 15
Redo Question 4.8 now considering any possible effect of the exclusion
provisions.
QUESTI ON 4. 16
Coleman et al. 2014, Question 12.3

TEXTBOOK
Please read Coleman et al. 12.330 12.450, 12.580 12.850.
Speci fi c deducti ons under s. 8-5
Introducti on
You will recall from the introduction of this topic, that to determine whether an
expense is deductible against assessable income, you must first ascertain whether
you are entitled to a general or specific deduction, and whether any exclusion
provisions apply to deny the deduction. The general deductibility provision s. 8-1
applies to all expenditure and should be considered in all cases. On the other
hand, specific deductions are only relevant to particular situations and have been
included in the Act for two major purposes:
to clarify the application of s. 8-1
or
to make deductible expenditure that does not fall under s. 8-1.
EXAMPLE 4. 6
Specific deductions
Graphics Ltd publishes magazines. During the year the company purchases a
printing press at a cost of $1 000 000. The machine has an estimated life of 10
years. In accounting terms the cost of the machine will need to be charged
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against the revenue earned from the use of this income-producing asset over the
life of the printing press.
Logically the same should be true in tax law, but if you apply the tests in s. 8-1
you would conclude that, while the cost of the machine is an outgoing incurred in
earning assessable income, a deduction would be denied because the outgoing
is of a capital nature (s. 8-1(2)(a)). Is this fair?
Graphics Ltd also has a visit from the Environment Protection Authority (EPA).
Apparently the filters on the machine are inadequate and undesirable waste is
being discharged into the local ri ver.
As a result Graphics Ltd has to replace the filters with new filters which have a
greater capacity. The cost of the new filters, including installation is $100 000. For
accounting purposes the $100 000 would probably be treated as an expense.
Alternati vel y, the cost may be capitalised and depreciated over the life of the
asset. But how would the expense be treated under tax law? If you apply the
general deduction tests in s. 8-1, the issue would be whether the cost of the
filters is incurred in the production of assessable income, or do they add to the
value of the printing press and hence are capital?

To overcome some of the inequities that would apply if the tests for deductibility
were confined to s. 8-1, the Act provides for a number of specific deductions. In
some cases a deduction would be allowed under either s. 8-1 or under a specific
provision; for example, non-capital expenditure on repairs would be deductible
under either s. 8-1 or s. 25-10. When more than one provision is applicable, s. 8-10
provides that the deduction is made under the provision that is the most
appropriate.
Section 12-5 provides a very good index to the specific deductions available under
both the ITAA 36 and the ITAA 97, but please notes that this section is not an
operative provision and must never be cited as authority for a deduction. Division
25, ITAA 97 contains many of the specific deduction provisions but there are many
others spread throughout the Act.
For this unit the following specific deductions are dealt with:
ITAA 97 Div. 25
Gifts ITAA, Div. 30
Tax losses ITAA 97, Div. 36
Capital allowances ITAA 97, Div. 40
Capital works ITAA 97, Div. 43.
TEXTBOOK
Please read Coleman et al. 2014, 13.00 13.20.
Di vi si on 25 ITAA 97 speci fi c deducti ons
Before beginning your study of specific deductions under Div. 25 you should look
through the list of deductions covered by this division which is contained in s. 25-1.
Although we do not cover all of these provisions it is valuable to have an overview
of the type of expenses that are specifically covered.
14
P rinciples of I ncome Tax Law
Tax-rel at ed expenses (s. 25-5)
Costs associated with the preparation of an income tax return do not meet the
general requirements of s. 8-1 as there is no nexus with the production of
assessable income or carrying on a business. As a result the only source of
deduction for these expenses is s. 25-5.
Repai rs (s. 25-10)
Section 25-10 specifically allows a deduction for non-capital repairs that are carried
out for the purposes of producing assessable income. Clearly s. 8-1 would also
allow a deduction for repairs, however, because there is a specific provision this
must be considered first (s. 8-10).
When studying the readings covering the deductibility of repairs, you need to make
certain that you understand the following basic issues:
the definition of repair
the distinction between non-capital and capital repairs
apportionment of repairs where the item is only partly used for the
production of assessable income.
TEXTBOOK
Please read Coleman et al. 2014, 13.30 13.80.
READI NG
Please read from eReadings Lindsays case or (http://www.austlii.edu.au/cgi-
bin/sinodisp/au/cases/cth/HCA/1961/93.html?query)
EXAMPLE 4. 7
Repairs the carpenters hammer
When a carpenter purchases a new hammer to use in his trade, it is clearly
capital and not deductible under either s. 8-1 or 25-10. On the other hand, if he
damages the head of the hammer and pays for repairs to fix it, then this is clearly
a repair under s. 25-10 as it restores it to its useful state.
But what about this situation? On Monday the builder goes to work and during
the day he breaks the handle of the hammer so he sends his apprentice to the
hardware store to buy a new handle. Is this a repair? Most people will say yes as
the carpenter does not have a new hammer, he has simply fixed it so that it is
useful again. On the very next day the apprentice borrows the builders favourite
hammer and uses it to chip concrete, damaging the head. The builder is furious
and again he sends the apprentice down to the hardware shop to buy a new
head. Is this a repair, or does the builder now have a new hammer as both the
handle and head are now new?
The distinction between a repair and a replacement is quite a difficult one. When
approaching this problem you must first decide what is the entirety, and then
decide whether the work done is a replacement of a subsidiary part or a
substantial part of the entirety.

15
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QUESTI ON 4. 17
Discuss whether there is a repair under s. 25-10 in the following situations:
(a) A rotten wooden floor in a shop is replaced with a cheaper concrete floor.
(b) The front brick fence in a rental property is badly cracked, it is removed
and a new brick fence is built. The rest of the property is surrounded by a
wooden fence.
(c) A brick letter box in a rental property is moved two metres to the right to
avoid damage to a tenants car.
QUESTI ON 4. 18
A repair involves the replacement or renewal of a part but not of the entirety. Are
the following entireties or parts? What additional facts are needed to make a
more accurate determination?
(a) A factory chimney into which the steam of a processing plant is
discharged.
(b) External lavatories of a hotel.
(c) Foundations of a building.
(d) The front brick fence of a rental property.
(e) Floor coverings.
(f) A timber staircase to provide internal access to the second floor
of a building.
QUESTI ON 4. 19
Coleman et al. 2014, Question 13.2
Lease document expenses (s. 25-20)
Section 25-20 allows a deduction for expenditure incurred by a taxpayer for the
preparation, registration and stamping of a lease or of an assignment or surrender
of a lease of property that has been, or will be, used by the taxpayer for the
purpose of producing assessable income. Where the property is only used partly
for income producing purposes, the deduction is apportioned (s. 25-20(2)). These
expenses would not normally be deductible under s. 8-1 as they would usually be
capital in nature.
Borrowi ng expenses (s. 25-25)
Section 25-25 allows a deduction for expenditure incurred in borrowing money, where
the money is used by the taxpayer for the purpose of producing assessable income.
It is important to distinguish between the cost of borrowing and the cost of the
money. For example, expenditure on legal expenses, valuation fees, survey fees,
stamp duty, prospectus advertising, printing and other costs relating to a debenture
issue are costs of borrowing; while interest payable represents a cost of money.
Interest is therefore not deductible under s. 25-25 but would need to be considered
for deductibility under s. 8-1.
16
P rinciples of I ncome Tax Law
Expense of di schargi ng a mortgage (s. 25-30)
Section 25-30 allows a deduction for expenditure (excluding principal and interest
payments) in connection with the discharge of a mortgage given as security for the
repayment of a loan. The deduction is limited to the extent that the money borrowed
or property bought was used for the purpose of producing assessable income.
Bad debts (s. 25-35)
Where a taxpayer is assessed on the accruals basis, the taxpayer pays tax on the
income in the year it is derived, which will not necessarily be in the same year it is
received. Therefore if a debt is not paid, the taxpayer should be entitled to a
deduction for the resulting bad debt which has already been taxed at the time the
sale was made. Section 25-35 specifically provides for such a deduction.
TEXTBOOK
Please read Coleman et al. 2014, 13.80 13.90.
QUESTI ON 4. 20
An analysis of debtors as at 30 June provided by the firms accounts clerk showed:
$
Accounts recei vable 103 000
Estimated bad debts 3 560
Estimated doubtful debts 12 500
Debts written off during the year 4 000
What amount(s) can be claimed as a deduction for the year?
Other speci fi c deducti ons under Di v. 25
Travel between work pl aces (s. 25-100)
Expenses t o termi nate a l ease (s. 25-110)
Section 25-110 allows a deduction for expenditure that terminates a lease. Under
this section, the expenditure is deductible over 5 years. This section only allows a
deduction where the payment was in the course of business or in connection with
ceasing to carry on a business.
TEXTBOOK
Please read Coleman et al. 2014, 13.110.
QUESTI ON 4. 21
During the current year the taxpayer conducted a manufacturing business and
incurred the following expenses:
(a) On 20 July: $350 in discharge of a mortgage on the taxpayers pri vate
home. The mortgage was used to acquire a loan that funded the
purchase of business assets.
(b) On 1 June: $7000 to establish a three-year loan that was used to fund
working capital. Interest for the remainder of the tax year was $3000.
17
TOP I C 4
(c) During the current tax year the taxpayer incurred $1000 in travel from his
pri vate home where he runs a business of trading in shares, to his main
office where he conducts his manufacturing business.
What deductions can be claimed for the year ended 30 June?
QUESTI ON 4. 22
Bob and his brother Fred have been operating their wholesale business in
partnership for 10 years. During the current tax year the business incurred the
following expenses.
$
(a) Taxation advice about restructuring
the current partnership into a company 1600
(b) Cost of lodging last years partnership tax return 1500
(c) GST advice 1700
(d) Cost of successfully defending Bob in a tax audit 3000
(e) Interest on overdue tax 800
Explain the taxation implications of each of the expenses above, indicating
whether or not each expense is deductible and, if deductible, under what section
of the Income Tax Assessment Act.
Gi fts Di v. 30 ITAA 97
Gifts to charity would normally be a private and domestic expense and therefore
excluded from deductibility under s. 8-1. However, Div. 30 allows a deduction for
gifts or contributions over $2 to certain nominated funds or institutions. The Division
mainly sets out the organisations that have been approved for tax deductible gifts.
You should scan this Division to obtain an overview of the type of entities that are
eligible for gift deductibility. It is not necessary to have an in-depth understanding of
this division.
QUESTI ON 4. 23
A review of the records of Mary Lyon showed that during the current tax year she
had given the following gifts.
(a) $500 in cash as Christmas presents to her grandchildren
(b) $50 to the Royal Childrens Hospital appeal
(c) $2600 to her Church (assume it is a recognised religious body)
(d) A compulsory payment of $4000 made to a non-profit pri vate school
building fund.
What is the amount that Mary could claim as a gift in her income tax return for
the year? Explain how you deri ved your answer.
Tax l osses Di v. 36 ITAA 97
A tax loss will arise for the year if deductions exceed total assessable income. For
example, if a taxpayer has $70 000 of assessable income and deductions totalling
$100 000, the tax loss would be $30 000. Division 36 allows this tax loss to be
carried forward indefinitely to be used as a tax deduction against future taxable
income. Without Div. 36 the excess tax deduction of $30 000 would be wasted.
18
P rinciples of I ncome Tax Law
TEXTBOOK
Please read Coleman et al. 2014, 13.130 - 13.210.
Capi tal al l owances Di v. 40 ITAA 97
Under s. 8-1(2)(a) a taxpayer is denied an immediate deduction for an outgoing
of capital or of a capital nature. Therefore, there are no deductions under the
general provision for the depreciation of capital items or the loss in value of any
wasting asset.
To overcome this problem Div. 40 allows the taxpayer a deduction for the write-off
of certain depreciating assets used for income-producing purposes. Effectively, this
division introduces the notion of depreciation into the income tax system, but it is
important to remember that the taxation depreciation system is not the same as
depreciation for accounting purposes.
Section 40-25 allows the taxpayer to claim a deduction for the decline in value for the
income year of depreciating assets that are used for producing assessable income.
The key elements of Div. 40 are:
the asset must be a depreciating asset
the depreciating asset must be used or held ready for use for the
production of assessable income during the income year
the depreciation deduction is calculated using the assets cost and its
effective life
the taxpayer may choose between the prime cost and diminishing value
methods of depreciation
the amount of the deduction may be apportioned if the asset is used for
non-income earning activities or is not held for all of the income year.
TEXTBOOK
Please read Coleman et al. 2014, 14.00 14.100.
EXAMPLE 4. 8
Depreciation calculations
Item 1 Machinery: opening value $5000, cost $10 000, effecti ve life 10 yrs,
depreciation method prime cost.
Depreciation = 10 000 x (365/365) x (100%/10) = $1000
Item 2 Equipment: opening value $6400, effective life 10 yrs, cost $8000,
depreciation method diminishing value.
Depreciation = 6400 x (365/365) x (200%/10) = $1280
Item 3 Motor vehicle: opening value $22 000, 30% pri vate use, cost $30 000,
effective life 5 yrs, depreciation method prime cost.
Depreciation = 30 000 x (365/365) x (100%/5) = $6000
Depreciation deduction = 6000 x 70% = $4200
Item 4 Motor vehicle: purchased 1st January, effecti ve life 12 yrs, cost
$30 000, depreciation method prime cost or diminishing value.
19
TOP I C 4
Prime cost depreciation = 30 000 x (181/365) x (100%/12) = $1240
Diminishing value depreciation = 30 000 x (181/365) x (200%/12) = $2479
Bal anci ng adj ustments
When tax depreciated assets are disposed of, lost or destroyed during a year of
income, there will be a tax adjustment to correct for under or over depreciation.
This correction is known as a balancing adjustment.
The effect of s. 40-285 is that where an asset is sold for more than its depreciated
value, the excess is assessable. Conversely, where the depreciable asset is sold
for less than its depreciated value, the loss is deductible.
TEXTBOOK
Please read Coleman et al. 2014, 14.110 14.120.
EXAMPLE 4. 9
Balancing adjustment
The taxpayer has held a depreciable asset for the last fi ve years. Over the life of
the asset capital allowances of $5000 have been deducted from the original
purchase price of $12 000. Therefore, the asset has an adjustable value (cost
less depreciation) of $7000. The balancing adjustment for a range of sale prices
is as follows:
Sale price Balancing adjustments Calculations
7000 0 7000 7000
4000 3000 deduction 4000 7000
9000 2000 assessable 9000 7000
13000 6000 assessable 13000 7000
QUESTI ON 4. 24
A part-time student purchases a new computer on 1 March to use in his course of
study. The dealer estimates the effective life of the computer at four years.
The costs associated with the acquisition of the computer were:
$
Computer 2100
Installation fee 50
Computer software not an integral part of the computer 600
Extended maintenance warranty 300
Assuming that there is a direct connection between the students employment
and the course of study so that the student is entitled to claim self-education
expenses, determine what deductions may be claimed for the income year
ending 30 June.


20
P rinciples of I ncome Tax Law
Other capi t al al l owance provi si ons
Division 40 (discussed previously) provides the general rules for capital allowance
deductions. However, there are several special rules that relate to small
businesses and for low-cost items:
Under s. 40-425 items costing less than $1000 may be pooled so that
separate records do not need to be kept for each item. This low value pool
is depreciated at a diminishing value rate of 37.5% per year.
Items costing $300 or less can be written off in full in the year of acquisition
(s. 40-80(2)) provided the asset is used for the production of assessable
income and the income is not income from carrying on a business. For
example; deductions relating to income from a rental property.
Section 40-880 allows for the write-off of some so called black hole
expenses that are not deductible under any other provision of the Act,
e.g. business formation expenses.
Subdivision 328-D provides special rules for eligible small business
taxpayers, i.e. businesses that have a turnover of less than $2m.
QUESTI ON 4. 25
Coleman et al. 2014, Question 14.2
Capi tal works Di v. 43 ITAA 97
Prior to the introduction of Div. 40, the depreciation provisions did not allow
depreciation of buildings and other structural improvements. To overcome this
problem Div. 43 was introduced which allows the write-off of new structural
improvements over either 25 or 40 years.
Division 43 provides for a system for deducting construction expenditure on
capital works used to produce assessable income or carry on research and
development activities. The term capital works is defined in s. 43-20 to include
buildings, structural improvements and environmental protection earthworks; and
any extensions, alterations and improvements to them.
The term structural improvements is not specifically defined although sealed
roads, retaining walls, fences and earthworks integral to the construction of a
structural improvement are listed among the examples given in s. 43-20(3).
Earthworks that affect the general usefulness of the land and are not integral to the
installation or construction of another structure, such as excavating an artificial lake
and contouring earth for golf courses and recreational facilities, are excluded
(s. 43-20(4)). Earthworks carried out as part of environmental protection activities
would qualify (s. 43-20(5)).

21
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Other capi tal al l owances not covered i n thi s uni t
Subdiv. 40-F water facilities, horticulture and grapevines
Subdiv. 40-G landcare, electricity and telephone
Subdiv. 40-H mining
s. 73B scientific research
s. 40-880 some black hole (not deductible, not depreciable) business
expenses may be written-off over 5 years e.g. Business establishment
costs.
290-60 employer superannuation contributions
290-150 self-employed superannuation contributions.
Summary
In Topic 4 we covered deductions, which is the final element in determining taxable
income. Deductions are subtracted from assessable income to determine taxable
income as shown in Figure 4.2.
Fi gur e 4. 2 The t ax equat i on


Figure 4.2 also shows that deductions are made up of three elements:
general deductions, s. 8-1(1)
specific deductions, s. 8-5
exclusions, s. 8-1(2).
Each of these essential components of the determination of deductibility can be
further broken down into their essential elements.
A general deduction is available under s. 8-1 if the expense meets one of the two
positive limbs and is not excluded by any of the four negative limbs. General
deductibility is applicable to all expenses and is only not relevant if a specific
provision allows the deduction.
Specific provisions have been included in the Act to clarify the application of s. 8-1
(e.g. s. 25-10 repairs and s. 25-35 bad debts) or to allow deductions for
expenses that are not covered by s. 8-1. Specific provisions therefore allow some
22
P rinciples of I ncome Tax Law
capital expenses as deductions even though they would be excluded by the first
negative limb of s. 8-1, e.g. capital allowances (Div. 40) and capital works (Div. 43).
It is also important to remember to consider whether any of the specific exclusion
provisions will deny a deduction that is otherwise allowable. Most of these
exclusion provisions have been introduced to limit deductibility of expenses that
have been exploited as dubious tax deductions, e.g. payments to relatives and
entertainment expenses.
A final point that must be emphasised is the importance to putting all the aspects of
deductibility together, and remember to follow all avenues for a deduction before
concluding as to the tax effect of an expense. The following questions reinforce how
each of the three key elements of deductibility must be considered for all expenses.
QUESTI ON 4. 26
Felicity operates a chain of clothing stores and is in the process of building a
new retail shop in an outer suburb of Melbourne. Her original plan was to open
the store before the Christmas period to capitalise on Christmas sales. However,
there have been several delays to the construction project and it is not envisaged
that it will be completed on time. In an attempt to get the shop open as planned
Felicity offered a bonus of $30 000 to the building contractor if he completes on
time. Ultimately the building is finished on time and Felicity happily pays the
bonus which she based on the extra income recei ved due to early completion.
In preparing to answer this question the following points need to be considered.
(a) Is the expense incidental and relevant to the production of assessable
income under either of the two positive limbs of s. 8-1?
(b) Is the expense excluded from deduction by the first negative limb of s. 8-1?
(c) If the expense is capital and excluded from s. 8-1 is a specific deduction
available under Di v. 40 or Di v. 43?
(d) If neither Di v. 40 or 43 apply can the cost be added to the cost base of
a CGT asset?
Prepare an answer to this problem considering each of the questions above.
QUESTI ON 4. 27
Consider the deductibility of the following transactions taking into account the
possible application of s. 8-1, any specific deduction available and any
exclusions that may apply. Some of these questions have been considered
before but now need to be reconsidered using all aspects of deductibility.
(a) A successful Australian retailing company sells its trade name and logo
to its overseas parent company for $2m. The contract of sale states that
the parent company will allow the Australian company exclusi ve use of
the name and logo at a cost of $1m per year.
(b) Legal costs incurred in defending a challenge against a company patent
that forms the basis of the companys business.
(c) A feasibility study conducted by a large bank to determine the
profitability of entering the insurance business. The feasibility study
showed it was not profitable and the bank did not proceed with the new
business venture.
23
TOP I C 4
(d) A forestry business spends $20 000 per year controlling weeds in a
timber plantation there will be no income for 15 years.
(e) Legal expenses of a business in relation to:
purchase of a business
advice on whether to form a company
action taken to prevent a competitor from breaching the
companys patent
advice on whether they could enter an agreement with a competitor
not to compete in the local area.
24