U7

DEDUCTIONS AGAIN

prepared for the course team by

Pe t er F u lch er

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Welcome to Week 7 of AF308.

An income tax is a tax levied on a person with the liability calibrated by reference
to income. In a general income tax the liability is calibrated by reference to the
overall income of the taxpayer. This is the taxpayer’s aggregate net income from
all sources.

In tax law, net income is described as income less deductions. I noted last week
that deductions fall into two broad groups. These are deductions grounded on
principle and deductions grounded on policy. Last week we looked briefly at
concessionary deductions in the ITA 2015 and then made a start on deductions
grounded in principle.

As regards deductions in principle there are two main rules and then a number of
narrower more specific rules.

The first of the main rules is the nexus requirement. There must be a sufficient
nexus between the expenditure (or loss or liability) that the taxpayer seeks to
deduct and the derivation of income. The nexus requirement is often
supplemented by an express prohibition against deduction of personal or
domestic expenses.

The second of the main rules is a prohibition on the deduction of capital

expenditure or loss.

This week we are going to do three things.

First, we look at the prohibition on deduction of capital expenditure.
Second, we look at some of the narrower more specific rules regarding
deductions. We do this looking at the ITA 2015. The rules here are fairly
representative of what is found in most income tax legislation.
Third, we look at the topic of depreciation for tax purposes. Here we focus on the
depreciation rules in the ITA 2015. Additionally there is just a brief mention of
amortization of business intangibles.

Let’s get started.

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Capital Expenditure
Income is gain over a period, but not all gains constitute income. In particular
income does not include gains of a capital character. This is something we
already know. By virtue thereof we surely also know that in determining net
income no account may be taken of capital losses. Nor may account be taken of
sums laid out as capital expenditure.

[Note that to all of this there is one rather large exception. Capital invested in
plant and buildings is lost over time as the plant or building suffers wear, tear and
obsolescence. In the commercial accounts of a business this is recognized by a
charge against income. Tax legislation permits something similar by way of a
depreciation allowance. Deductions for depreciation is our third discrete topic
this week.]

The capital/income distinction is a foundation stone, an axiom of income tax law.

Earlier in the context of income we saw that the distinction is generally not
problematic. But there can be cases where disputes arise. (Think of the
establishment fee in the G.P. International Pipecoaters case or the compensation
payment in the London and Thames Haven Oil Wharfes case.) Borderline
disputes also arise in the expense context. In fact, they arise with rather greater
frequency. In consequence the case law on expenses has developed a rich account
of the income/capital distinction. We look at this shortly. But let’s first consider
some sample fact situations.

Case One:
A company establishes a pension plan for its workers. Workers joining the plan
are to make regular contributions from salary to the trustees of a pension fund.
The company undertakes to make matching contributions equal to one half of the
worker’s contribution. On retirement at 65, a worker is entitled to a pension from
the fund calculated with reference to the number of years of employment with the
company. Workers leaving the company before retirement age receive a lump
sum equal to the worker’s contributions only, plus interest.

The company wishes the pension plan from its inception to apply to existing
workers. This produces an immediate and obvious funding problem. There have
been no contributions to the pension fund by existing workers (nor matching
employer contributions) in the years prior to the creation of the plan.

The problem is addressed by the company making a very large initial

contribution to the fund calculated to make good the deficiency resulting from the
retrospective application of the plan to existing workers.

The company has two objectives in establishing the plan. First, the company has
frequently lost experienced and valuable workers who resign to take up
employment elsewhere. The terms of the pension plan will operate to dissuade
workers from leaving before retirement age. Second, the assurance of a pension
on retirement provides for a more contented workforce and in consequence a
more efficient workforce.

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The tax issue: Is the company’s very large initial contribution to the pension fund
a capital or income expenditure?

Case Two:
The taxpayer, a manufacturing company, manufactures refrigerators. Unhappily a
trade competitor makes superior refrigerators using a patented design. Happily
that patent is due to expire. Once the patent expires the previously patented
design can be utilised by anybody. The taxpayer modifies its production line to
accommodate the new design in anticipation of the expiry of the patent.
Unhappily the trade competitor applies to the patent office for the life of the
patent to be extended for one year. The taxpayer incurs legal expenses in
opposing this application. Happily the application is denied and the taxpayer is
able to proceed with its plan to use the previously patented design.

The tax issue: Are the legal fees incurred by the taxpayer in opposing the patent
extension application capital or income expenditure?

Case Three:
Oil companies competing to obtain outlets for their product offer service station
owners lump sum payments in return for agreeing to ties ranging from three to
twenty years.

The tax issue: Are the lump sum payments made by the oil company a regular
marketing expense or capital expenditure in establishing a distribution network?

Case Four:
Each of Aco, Bco and Cco own and operate a copper mine. All three companies
are owned by Pco. Pco acts as the selling agent for copper produced by all three
subsidiaries. In all other respects Aco, Bco and Cco operate independently of
each other. An oversupply of copper to the world market results in copper
producers around the world agreeing informally to reduce production by 10%.
The Pco group of companies meet to determine how the group as a whole might
best cut production by 10%. Of the operating companies Cco operates the newest,
smallest and most expensive mine.

It is agreed that Cco will cease mining operations for one year; that Aco and Bco
will slightly expand production, the net result being a 10% production cut for the
group; that Aco and Bco will between them pay a sum to Cco to compensate
Cco’s abandoning production for one year. The compensation is split between
Aco and Bco with reference to their share of the aggregate production. The
compensation payment is calculated as a sum sufficient to cover Cco’s interest
expense on existing debt, the cost of development work to bring Cco’s mine up to
its full rated capacity, and the cost of pumping operations in part of the mine
temporarily mothballed. The agreement is implemented. At the conclusion of the
year the problem of oversupply of copper on the world market ceases to exist.
Each of Aco, Bco and Cco resume their independent business operations.

The tax issue: Is the sum paid by Aco (and Bco) to Cco a capital or income
expenditure?
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How are we to think about these issues? No single test or criterion can decide
such varied and novel fact situations as these. Assistance may be gained from the
case law but the case law must be used with care. Lord Morris in Regent Oil Co
Ltd v Strick describes the role and utility of the case law concerning capital
expenditure as follows;
‘The decided cases are to be scanned because they contain pointers
and mention factors and give indications and provide descriptions.
Care must, however, be taken not to take phrases which are uttered in
relation to particular facts and then to promote them to be of universal
application.’

Lord Reid in the same case describes the approach to the question of whether an
expenditure is capital or income in nature in the following terms;
‘The question is ultimately a question of law for the court, but it must
be answered in the light of all the circumstances which it is
reasonable to take into account, and the weight to be given to a
particular circumstance must depend rather on common sense than on
a strict application of any single legal principle.’

With these admonitions in mind we can look at some of the considerations,

factors and images utilized in past cases.

Four commonly utilised ‘tests’

Past cases give rise to four different ‘tests’ identified by descriptive labels. These
are:
- the once and for all test
- the enduring benefit test
- the fixed and circulating capital test
- the business entity test

We need to look at each ‘test’ in turn.

once and for all test

An obvious feature of many archetypal capital expenditures is that they are not
recurrent in the same way as a wage or rent or repair expense, they are rather one-
off expenditures, once and for all.

A manufacturer builds or purchases a factory. The expenditure is not repeated

unless the business grows and it is necessary to add to or extend the factory or
unless the need arises for the business to relocate. Take another example. Both an
investor and a trader may purchase income producing property, for example,
shares. What largely distinguishes the expenditure of the two is the relative
infrequency of the one and relative frequency of the other.

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This feature of many capital expenditures is famously emphasized in Lord
Dunedin’s judgment in Vallambrosa Rubber Co v Farmer. He said;
‘Now, I don’t say that this consideration is absolutely final or
determinative, but in a rough way I think it is not a bad criterion of
what is capital expenditure as against what is income expenditure to
say that capital expenditure is a thing that is going to be spent once
and for all, and income expenditure is a thing that is going to recur
every year.’

Note, this passage is not to be read literally. The contrast is between infrequent
and frequent expenditures. In Regent Oil (the facts of which were rather like our
Case Three above) a number of the judgments were prepared to regard a payment
tying a service station to a particular oil company and made every three years as
recurrent, the same payment made every twenty years as once and for all.

In the Vallambrosa case the taxpayer had a rubber plantation. Expenditure was
incurred in clearing land, building fences and planting rubber saplings. Thereafter
expenditure was incurred in weeding and tending the young trees until they
reached maturity, a period of six or seven years. The trees could be tapped for
rubber only once they had reached maturity.

The dispute concerned expenses incurred in weeding and tending the young
rubber trees. The taxpayer wins the case. Implicitly the decision recognizes the
company’s plantation business as having commenced when the rubber saplings
are planted rather than when the trees reach maturity. Once the business is
recognized as commencing with the planting, the expenditure in caring for the
young trees is clearly income and not capital expenditure. What we have is six or
seven years of income expenditure without any revenue.

Read Vallambrosa Rubber Co Ltd v Farmer

enduring benefit test

Capital expenditures commonly provide an enduring benefit or advantage. Again
this is easily seen when we look at capital expenditure on business premises and
plant. While different items of plant have different life expectancies, plant usually
endures for some time and while it does, provides an advantage or benefit. By
contrast expenditure on wages or on advertising typically purchases only a short
term benefit.

The enduring benefit test derives from Lord Cave’s majority decision in the
Helsby Cables case. The facts of this case are essentially our Case One above.
Lord Cave finds the enduring benefit obtained by the company’s large initial
contribution to the pension scheme to be decisive. He said:
‘But when an expenditure is made, not only once and for all, but with
a view to bringing into existence an asset or an advantage for the
enduring benefit of a trade, I think that there is very good reason (in
the absence of special circumstances leading to an opposite

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 conclusion) for treating such an expenditure as properly attributable
not to revenue but to capital.’

The Helsby Cables dispute produced a divided House of Lords. The minority
held that no material distinction existed between the company’s initial large
payment to the fund and its later ongoing matching contributions. The two forms
of contributions were not held distinct in the hands of the trustees and both served
the same purpose of funding a worker’s pension entitlement from the fund.
Ongoing contributions were clearly income expenses. The initial contribution
thus too should be on income account. This was in fact the treatment adopted in
the company’s commercial accounts.

The majority reached the opposite conclusion. They held the large initial
contribution must be viewed separately from the later recurrent matching
contributions. The large initial payment would not be repeated. It was once and
for all. Additionally, it established a scheme providing an enduring advantage.

Read British Insulated and Helsby Cables v Atherton

fixed and circulating capital test

In Ammonia Soda Company Limited v Chamberlain (1878) Swinfen Eady L.J.
famously contrasts fixed and circulating capital. Fixed capital is:
‘that which a company retains in the shape of assets upon which the
subscribed capital has been expended, and which assets either
themselves produce income, independent of any further action by the
company or being retained by the company, are made use of to
produce income or gain profits.’
Circulating capital is:
‘a portion of the subscribed capital of the company intended to be
used by being temporarily parted with and circulated in business, in
the form of money, goods or other assets and which, or the proceeds
of which, are intended to return to the company with an increment
and are intended to be used again and again, and to always return
with some accretion.’

Ammonia Soda Company Limited v Chamberlain was not a case concerned in any
way with income tax. However, the distinction it draws between fixed capital and
circulating capital has often been utilized by the tax courts. The distinction
underlies and confirms our common and typically straightforward classification
of expenditure on tangible assets. The distinction is important and may easily
outweigh other considerations.

Hinton v Maden and Ireland Ltd (1959) provides an example. A taxpayer incurred
expenditure in buying knives that were used in the manufacture of shoes. The
knives in fact quickly wore out and had to be replaced. The expenditure was
recurrent and did not provide an enduring benefit. The knives however were

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clearly plant, clearly fixed capital and not circulating capital. The expenditure
was in consequence a capital expenditure.

The fixed/circulating capital distinction is often of little assistance where the

expenditure does not concern tangible assets. In CT v Nchanga Consolidated
Copper Mines Ltd the facts were essentially those in our Case Four above. The
Privy Council said;
‘Judicial decisions have from time to time applied various tests in
seeking to distinguish income from capital. There is the distinction
between fixed and circulating capital resorted to by Lord Haldane in
John Smith & Son v Moore … and so long as the expenditure in
question can be clearly referred to the acquisition of an asset which
satisfied one or other of the accepted categories, as in the ordinary
framework of a manufacturing business or merchanting business,
such a test must be a critical one. But at the same time … there are
many forms of expenditure which, though not falling easily within
these categories, have nevertheless to be allocated to capital or
revenue account … and with regard to all these some other and rather
different distinction has to be looked for.’

business entity test

What is known as the business entity test is the most ambitious of approaches
devised for delineating capital and income in the context of a business. The test
attractively contrasts a business entity, the structure or organization set up or
established for the earning of profit, and the process by which such organization
operates. The contrast may be stated in a number of matched pairs. Contrasted are
the acquisition of the means of production and their use: the implements
employed in work and the work on which they are employed: the enterprize itself
and the sustained effort of those engaged in it.

The fullest statement of the overall conception comes from Dixon J. in the Sun
Newspapers case.
‘The distinction between expenditure and outgoings on revenue
account and on capital account corresponds with the distinction
between the business entity, structure, or organization set up or
established for the earning of profit and the process by which such an
organization operates to obtain regular returns by means of regular
outlay, the difference between the outlay and returns representing
profit or loss. The business structure or entity or organization may
assume any of an almost infinite variety of shapes and it may be
difficult to comprehend under one description all the forms in which
it may be manifest.

In a trade or pursuit where little or no plant is required, it may be

represented by no more than the intangible elements constituting what
is commonly called goodwill, that is, widespread or general
reputation, habitual patronage by clients and an organized method of
serving their needs. At the other extreme it may consist in a great
aggregate of buildings, machinery and plant all assembled and
systematized as the material means by which an organized body of
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 men produce and disseminate commodities or perform services. But
in spite of the entirely different forms, material or immaterial, in
which it may be expressed, such sources of income contain or consist
in what has been called a ‘profit yielding subject’. …. As general
conceptions it may not be difficult to distinguish between the profit
yielding subject and the process of operating it. In the same way
expenditure and outlay upon establishing, replacing and enlarging the
profit yielding subject may in a general way appear to be of a nature
entirely different from the continual flow of working expenses which
are or ought to be supplied continually out of the returns or revenue.’

In Australia, the business entity test is established as the principal framework to

be used in determining capital/income issues in a business context. The test has
had a more mixed reception before the English courts.

While conceptually attractive, in difficult cases the business entity test may do no
more than restate the problem for solution. Parties can be agreed that expenditure
concerning the profit yielding subject is on capital account, expenditure in
operations of the entity on income account, but disagree as to where the structure
ends and operations commence. Is a tie securing a monopoly outlet for one’s oil
products for a number of years simply a long term trading contract or a
development of the business entity itself? In the oil tie cases (our Case Three
above) judicial opinion was split 50/50 on such arrangements.

Read Sun Newspapers Ltd v FCT

Other features
Aside from the four ‘tests’ there may be other features potentially of relevance
when judging on which side of the capital/income divide a particular expenditure
falls. Let me deal briefly with some other possible considerations.

size
The size of an expenditure of itself cannot determine the character of an
expenditure. But it may be a factor to be given some small weight. In the Helsby
Cables story one obvious feature of the expenditure held to be capital was its
size. On the other hand, the very large donation in the Fiji Sugar Corporation
case was not seen as any reason to regard the expenditure in that case as on
capital account.

misstating profits
Tax law typically permits income expenditure to be deducted in full in the year in
which the expenditure is made notwithstanding that the benefit obtained may not

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be exhausted within the year. This rule has the effect of understating profit in the
year of expenditure (and overstating profit in later years.)

Meanwhile, there can be no deduction of capital expenditure. Absent provision

for depreciation or amortisation the prohibition of deduction for capital
expenditure risks overstating profit where the asset or benefit gained by the
expenditure wastes over time.

The impact on the measure of profit in a year or over a series of years may be a
factor in the characterization of expenditure as capital or income.

Lord Reid in Regent Oil describes the problem of over statement of profits in the
following passage.
‘The purpose of any commercial account must be to give as fair and
accurate a picture as possible of the trader’s financial position; but the
provisions of the Act of 1952, as they have been interpreted, make
that difficult where a wasting asset has been acquired. As explained in
Kauri Timber Co Ltd v TC, it had long been settled that if capital has
been expended in acquiring or producing a wasting asset, it is not
permissible to bring into the profit and loss account for tax purposes a
part of that capital corresponding to the wasting or depreciation of the
asset during the year; no part of the expenditure can be set against
income in any year. These old cases were dealing with expenditure
made to acquire or improve tangible assets and as regards a great
many of them, such as machinery, plant, buildings and mines, the
severity of this rule has been relaxed by statutory provision for annual
depreciation and other allowances; but the rule still stands as regards
matters not particularly dealt with by the Act.

If a trader acquires a rapidly wasting asset not covered by these

statutory provisions, he would not generally strike his balance of
profits and gains without taking account of the annual wasting or
diminution of value of that asset; but if his expenditure in acquiring it
has to be regarded as capital expenditure he cannot do that for income
tax purposes.’

Commenting on the same issue the Privy Council in the B.P. Australia Ltd case
said;
‘It is of commercial importance that profits should not be inflated for
tax purposes by the artificial withdrawal from the profit and loss
account of expenditure directly incurred in earning them unless it is
of a truly capital nature. There is force in the observation of the Lord
President in the Vallambrosa case; “The Crown will not really be
prejudiced by this because when the tree comes to bear, the whole
produce will go to the credit side … The only deduction will be the
amount which has been spent on the tree in that year; they will not be
allowed to deduct what has been deducted before.’

The latter half of this quotation is a reference to the second of the concerns: an
expenditure classified as income may be deducted in full in the year in which it is
made notwithstanding it may be in part matched to income derived in later years.
Commenting on this concern, Lord Reid again in Regent Oil said;
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 ‘One reason at least for refusing to allow a lump sum payment as a
debit against incomings and therefore treating it as a capital outlay is
that to allow it as a debit would distort the profit and loss account.
Counsel agreed that a taxpayer is always permitted to bring the whole
of any item of revenue expenditure in to the profit and loss account of
the year in which the money was spent. Counsel for the Crown
suggested that the taxpayer might be permitted to spread it over more
than one year, but certainly the Revenue cannot insist on that. So, if
the whole of a payment made to cover several years is brought into
one year’s account, the profit for that year will be unduly diminished.
The effect of that, however, will be rather different according to the
length of time covered by the lump sum payment. Suppose that in
order to achieve a continuing advantage like a tie, the taxpayer makes
a series of agreements each for three years and each for a lump sum.
Then, if the lump sum payments are allowed as revenue expenses, the
effect will be that in the first year of each agreement the profit will be
too small, but in the next two years it will be rather too large and so
on. So over each period of three years there will be a fair result.
Suppose on the other hand that the taxpayer makes an agreement for a
tie for twenty years or more, then the lump sum will presumably be
much larger, and the distortion in the first year much greater if the
payment is allowed as a revenue expense; and, even if one could
assume fairly constant conditions for so long a period it would be
only after twenty years that a fair result would be reached. That
would seem to justify refusing to treat a payment covering so long a
period as a revenue expense; and on more general grounds I must say
that I would have great difficulty in regarding a payment to cover
twenty years as anything other than a capital outlay.

Ever since the Vallambrosa case in 1910 recurrence as against a

payment once and for all has been accepted as one of the criteria in a
question of capital or income. I would regard a payment which has to
be made every three years to retain an advantage as a recurrent
payment, whereas for practical purposes I would not think that the
fact that another payment will have to be made after twenty years if
the situation does not change in that time would prevent the first
payment from being regarded as made once and for all.’

The facts in the Regent Oil and BP Australia cases are essentially the same facts
as in our Case Three above,

Read B.P. Australia Ltd v FCT

commercial and legal advantage

Both the business entity test and enduring benefit test look to the benefit or
advantage gained from the expenditure. In each instance it is important to
correctly identify the advantage and the manner in which it serves the business.

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Attention must focus on the advantage gained in a commercial sense rather than a
strictly legal sense.

The Helsby Cables case presents a striking example of this. The monies paid
away to the trustees of the pension fund did not acquire for the company any
legal rights. The funds were held by the trustees for the benefit of workers. The
company was not in any circumstance a beneficiary. From an accounting
perspective the expenditure produced no fixed asset that might appear in the
company’s balance sheet. Notwithstanding the absence of any legal or accounting
asset the expenditure was of a capital nature. It obtained a clear and valuable
enduring commercial advantage for the company.

form and substance

A constant theme in tax law is the need to look to the substance of a transaction
rather than its legal form. On the other hand, the legal form of a transaction may
sometimes be of considerable significance. This opposition of form and substance
can appear in questions concerning the character of expenditure. The legal form
of a transaction may occasionally assume significance. In Regent Oil the
substantive object of the oil company was to obtain a tie with the service station
owner. The actual legal mechanism adopted involved the owner granting a lease
to the oil company and the company immediately subletting the service station
premises back to the owner. A lump sum was paid as a premium for the head
lease. While the court held the substance of the transaction, a lump sum payment
for a twenty year tie marked the payment as a capital expense, the court also held
that the form of the payment, a premium paid for a lease, by itself required the
same result.

On occasions the form of the transaction alone may be decisive. This was the
situation in IRC v Adams. The taxpayer, a carting contractor, required a site for
the disposal of waste soil removed from building sites. The taxpayer acquired the
right to deposit soil on a defined area for eight years in return for a stated sum,
payable in instalments every six months. The expenditure was held to be capital
in nature. At the same time the court said that had the money been paid as a semi-
annual rent it would have been deductible as an income expense.

analogy
Reasoning by analogy is common in the application of rules to hard cases. In CT
v Nchanga Consolidated Copper Mines Ltd (1964) the Privy Council recognized
that reasoning by analogy may obtain a particularly prominent role in the
classification of expenditure. The court said;
‘In considering allocations of expenditure between the capital and
income accounts, it is almost unavoidable to argue from analogy. An
instance is taken which seems to fall beyond dispute on one or other
side of the line and it is argued that the case under review is in
substance more akin to that than any comparable instance which falls
beyond argument on the other side.’

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The facts of Nchanga Consolidated Copper are essentially the facts of our Case
Four above. The passage above continues with the court relying on analogy to
classify the payment to Cco.
‘Applying this method, their Lordships think that Aco’s expenditure
has no true analogy with expenditure for the purposes of acquiring a
business or the benefit of a long-term or “enduring” contract. On the
other hand, it does bear a fair comparison with a monetary levy on the
production of a given year. What Aco did was to charge its 1958/59
production with the payment of this money in order to settle its share
of the group’s production programme in the way that suited it best.
The payment was wholly related to and an incident of its output of the
year, and it is of no moment for this purpose that the factors of the
calculation that produced the sum were certain financial requirements
of Cco itself. Nor does it matter whether the sum is treated as a
charge on the gross proceeds of the copper sales of the year, as it was
in Aco’s accounts, or as an extra charge on the additional production,
as the Chief Justice described it in the Federal Supreme Court. Some
of the year’s production, he said, was produced “at very high cost.”
The point in either case is the same. Aco’s arrangement with [Bco and
Cco] out of which the expenditure arose, made it a cost incidental to
the production and sale of the output of the mine. As such its true
analogy is with an operating cost.’

fact specific
As in other areas of tax law, a judgment as to the character of an expenditure can
only be made after a careful survey of all the facts. This is perhaps especially true
when dealing with common forms of expenditure. Interest and salary are two
common expenditures. They generally constitute expenditure on income account.
However, this classification does not always hold true. The Privy Council
decision in Wharf Properties Ltd v CIR (1997) provides an example.

The taxpayer purchased an old tram depot in Hong Kong, redeveloped the site as
a commercial complex and leased it out. By agreement the tram company
continued to use the site for a period of 18 months following the sale. The
purchase and sale was on a cash basis and funded by borrowed monies. The tax
issue concerned the deductibility of the taxpayer’s interest expense over this
period (and by implication during construction thereafter.) The interest was held
to be capital expenditure. While interest always has a revenue character in the
hands of the recipient its character as regards the borrower depends on the
purposes for which the loan is used.

The Privy Council said;

‘Wages and rent are income in the hands of their recipients; periodic
payments, in return for services or the use of land or chattels
respectively. But whether such payments are of a capital or revenue
nature depends on their purpose. The wages of an electrician
employed in the construction of a building by an owner who intends
to retain the building as a capital investment are part of its capital
cost. The wages of the same electrician employed by a construction

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 company, or by the building owner in maintaining the building when
it is completed and let, are a revenue expense.’

This same reasoning applies to an interest expense. Interest incurred during the
development process and before the building becomes an income producing asset
is a capital expenditure. Once development is complete and the building let,
interest becomes an income expense. Failure to attend to the precise factual
circumstances of a taxpayer’s situation may easily result in the capital character
of particular salary and interest expenditure being overlooked.

Note that in the Wharf Properties case there was a discrete borrowing by the
taxpayer for the particular acquisition. Where a taxpayer has borrowed “for
general corporate purposes” with the borrowed funds utilized generally in the
business it will be much more difficult to attribute interest to a particular
transaction as in the Wharf Properties case. In this situation interest is treated as
an income expense.

summary
What expenses may we take account of in determining net income? The general
answer is those expenses that we would normally take account of. The more
specific answer is that attention must be given to ss.21 and 22. In every case an
expense must satisfy the nexus requirement. In every case the expenditure must
be a matter of income and not capital. Beyond this there may in a particular case
be more specific concerns. We look at some of the narrower more specific rules
regarding deductions as our second topic this week.

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Other rules concerning deductions
Expenses and exempt income
Should a taxpayer be permitted to deduct expenses incurred in deriving exempt
income? No. Of course not. A situation in which the taxpayer deducts expenses in
deriving income and then omits the income from taxable income would be too
good to be true. As we know, when something is too good to be true, generally it
is not true.

The old Act contained an express prohibition on deducting expenses incurred in

deriving exempt income. Curiously there is no similar express prohibition in the
new Act.

However, there is an implication in the general nexus rule in s.21(1)(a). Here is

the provision:
‘(1) Subject to this Act, a person is allowed a deduction for a tax year
for –
(a) an expenditure or loss on revenue account to the extent
incurred by the person during the tax year in deriving income
included in gross income;’

What is authorized is the deduction of expenditure incurred in ‘deriving income

included in gross income’. By implication what is not authorized is deduction of
expenditure in deriving income that is not included in gross income. Inter alia,
this would include exempt income. It would also include income omitted from
gross income by virtue of s.12(a) and s.14(2)(b).

illegality and deduction

Students commonly presume that there can be no deduction for sums paid as
bribes, or other illegal or morally offensive expenditure. Wrong, wrong, wrong.
Income tax law knows no such general prohibition against deduction.

The matter in issue is functional and not moral. Was the expenditure for the
purposes of carrying on the trade? Is the expenditure on income rather than
capital account? If the answer to each question is yes, then prima facie the
expenditure is deductible in determining the profits of the trade etc.

Here is an example. A sales manager for a manufacturing company wishes to

boost sales. How can this be achieved? One means may be to bribe the
purchasing manager of a supermarket company to make larger orders and to place
the goods purchased in a more prominent position within the supermarket.

Here is another example. A corner store sells alcohol without a liquor license.
Trade is good, particularly after hours. All the store’s customers know about this
facility. Indeed, it seems everybody knows. Everybody, except for the local
police post. How is it that the police never seem to spot the illegal trade?

15
Everybody knows the answer to that question also. The store owner pays the
police to look the other way.

In each story the expenditure is a true cost of carrying on and earning the profits
of the trade. If we were to refuse deduction of the expenditure then we would
overstate the profits.

Of course in the accounts the particular outlays are not likely to be identified as
bribes. Likely there will be a more generic innocent expression. In the first
example, marketing expense and in the second, security expense.

In the modern world we condemn such practices. Yet even governments engage
in them. Here are two cases concerning the Australian Government. Following
the removal of Saddam Hussein from power in Iraq a UN investigation revealed
that the Australian Wheat Board had paid bribes to Iraqi officials to obtain wheat
sales to the Iraqi government. In Malaysia an Australian Government entity, the
Australian Mint, was caught paying bribes to Malaysian central bank officials to
obtain orders for the printing of banknotes.

In the private sector, many large corporate ‘citizens’ often breach the law in the
pursuit of profit. The UK’s largest export industry is defence equipment. BAE,
the country’s largest weapons company, is forever mired in bribery scandals.
HSBC, at times the world’s most profitable bank, has paid billions in fines for
providing cash services to Mexican drug gangs. Real expenses were incurred in
performing those services.

Why is there no general principle that a taxpayer cannot deduct expenditure on

payments that may be illegal or morally offensive? Why is tax law so permissive?

Consider this story. X, a sole trader carries on a farming business. The business is
run very professionally with complete accounting records, quality control of
produce and excellent marketing. In consequence the business is highly
profitable. Business profit constitutes income of the owner X and enters the
calculation of X’s taxable income. X files true returns of his income for tax
purposes. X’s tax liability is correctly assessed and the tax liability paid in full in
a timely fashion. Everything in this story is as it should be.

To all of this let me add one further fact. X’s farming business has a single cash
crop. This crop is marihuana.

Does this further fact change the story? Will the State say that in consequence of
this further fact X has no income tax liability? This is unlikely. It is also
undesirable. If the State taxes persons on their income, it would be very odd if
one could escape tax liability by arguing: ‘I am not liable for tax because my
business is illegal.’ Accepting that argument would seem to reward people for
carrying on illegal businesses. In short, if those who carry on legal businesses are
subject to tax on profit, then surely those who carry on illegal businesses should
also be subject to tax.

In fact this has been the traditional position in income tax law. The State wants its
share of the taxpayer’s income regardless of how it was earned. However, once
the State takes a share of the tainted income of the taxpayer it becomes difficult
16
for the law to refuse deduction of expenses incurred in deriving that income.
What is sauce for the goose is sauce for the gander. We are back at an initial point
that I made. The matter in issue (taxable income) is functional and not moral.
Business is business.

I want you to read FCT v La Rosa. This is a relatively recent case that sets out the
traditional position under income tax law.

Read FCT v La Rosa

Fiji’s new Act qualifies the traditional position regarding expenditures that are
illegal themselves or incurred in carrying on an illegal trade. Deduction is denied
for bribes paid to public officials. Section 22(1)(k) provides:
‘(1) Except as provided in this Act, no deduction is allowed for the
following –
(k) subject to subsection (3), an inducement paid or provided by a
person to a public officer, including a foreign public officer, if the
inducement is intended to influence the public officer to act or to
fail to act, in his or her official capacity in order to –
(i) obtain or retain business for the person or an associate; or
(ii) obtain an improper advantage for the person or an associate
in the conduct of business.’

This is not a new provision. Something similar was introduced into the old Act in
2006.

It is important to notice the designed narrowness of s.22(1)(k), It is limited to

bribes or inducements to ‘public officials’. The law remains unchanged as
regards a bribe paid to a private sector actor.

Should we have a provision denying deduction for bribes paid to public officers?
Arguments can be made either way. On the one hand, corruption in government
is such an important issue we need to bring all guns to bear, including if
necessary our tax law. Advancing the goal of a government free from corruption
outweighs all else. On the other hand, denying deduction results in business profit
being overstated with the consequence that the taxpayer is assessed for additional
tax. We already have criminal law to prosecute parties bribing government.
Shouldn’t that suffice without the penalty of additional tax? As you might guess
the debate could be lengthy.

Let me make one final point. The inclusion of profits illegally obtained in
chargeable income has implications for tax administration. Under s.104 a
taxpayer must file an annual return disclosing income from all sources.
Taxpayers are required to report income, even knowing this will result in a tax
liability. This is a tough ask, but we find that taxpayers do largely comply
(encouraged, of course, by the threat of penalties if found not to be complying).
However, taxpayers are unlikely to report income tainted by illegality if
disclosure will result in not just a tax assessment but also a criminal prosecution.
In consequence, effective tax administration requires that the tax authority keep
17
confidential from other arms of the state (notably the police) its knowledge of an
illegal trade, illegal income and illegal expenditure.

loss or expense covered by insurance

Section 22(1)(g) provides:
‘(1) Except as provided in this Act, no deduction is allowed for the
following –
(g) an expenditure or loss to the extent recoverable or recovered
under a contract of insurance, guarantee, surety, or indemnity;’

Paragraph (g) establishes a technical rule that attempts to address anomalies that
may result from application of regular tax rules. The classic example is the
‘profitable accident’.

Suppose a taxpayer owns a truck utilized as plant in the taxpayer’s business. The
truck is damaged in a traffic accident and under an insurance policy held by the
taxpayer the taxpayer receives an insurance payment equivalent to the cost of
repairing the vehicle. The taxpayer does in fact have the truck repaired and incurs
a repair expense. This is a story of a receipt and expenditure. The two sums are
not necessarily identical in amount but are likely to be roughly equivalent.

What is the tax treatment of each sum? The insurance monies are a capital
receipt, being compensation for physical injury to the capital asset. Meanwhile
money laid out in repair of the item of plant is an income expense. From a tax
viewpoint the whole incident is a profitable accident. The true cost of the repairs
is close to zero while the actual sum spent on repairs goes to reduce profit for tax
purposes generating tax savings of 20% of the repair bill (if we presume the
taxpayer to be a company with 2016 Income Tax rates).

Paragraph (g) overcomes the anomaly by denying deduction of the repair

expense. Deduction is denied to the extent the expense is ‘recoverable or
recovered under a contract of insurance, guarantee, surety, or indemnity:’

taxation levied on incomes

Section 22(1)(h) provides:
‘(1) Except as provided in this Act, no deduction is allowed for the
following –
(h) Income Tax, Social Responsibility Tax, Capital Gains Tax or
Fringe Benefits Tax payable in Fiji or elsewhere, including any
penalty, additional tax, or interest payable in respect of Income
Tax, Social Responsibility Tax, Capital Gains Tax or Fringe
Benefits Tax due;’

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From a business perspective income tax is a cost of doing business. From a tax
viewpoint, income tax is not an expense in deriving income. It is rather the
State’s share of the taxpayer’s net income. This is not just one more principle of
income tax law, it is a foundational principle, or, in other words, an axiom.

Paragraph (h) states the axiom. Does it do anything further? Yes. Deduction is
denied for any Income Tax, be it that of the taxpayer or (and this is the additional
bit) a third party. On general principles an employer who meets the tax liability of
his worker or a borrower who meets the tax liability of his lender has an
additional employment expense or additional borrowing expense. (Note also that
in such situations the worker will have a fringe benefit and the lender an
additional reward in the amount of the liability satisfied by the employer or
borrower.) This expense by virtue of para(h) is not deductible.

Occasionally parties overlook para(h) and we find an employer undertaking to

meet the Income Tax liability of the worker. Or a borrower undertaking to meet
the tax liability of his lender. Such arrangements are not illegal but they are sub-
optimal from a taxpayer’s viewpoint. Parties who wish to contract to provide a
specified tax free figure should rather contract to provide such remuneration as
will after tax is paid provide the specified figure. Under such an arrangement the
worker or lender in fact pays their tax in a regular fashion while the employer or
borrower may recognize all of the additional sum paid as salary or interest as an
expense in deriving income.

Paragraph (h) contains a rather elementary drafting error. The intention is to deny
deduction not only for Fiji Income Tax, but also for any similar tax imposed by a
foreign State. As regards the later, the reference should be to ‘income tax’, the
generic expression rather than to ‘Income Tax’ the proper name of the tax
imposed by s.8 of the ITA 2015. Both s.2 and s.8 define ‘Income Tax’ as the tax
levied by Fiji on chargeable income. Any tax imposed by a foreign State will
never be ‘Income Tax’.

The same criticism applies to the other capitalized terms, all of which are taxes
created and imposed by the Fiji Act.

A similar schoolboy error is seen in s.60(1).

Note that para(h) only concerns Income Tax, SRT, CGT and FBT. There is no
reference to other forms of tax; for example, land tax or stamp duty. Unlike
income tax itself, there is no reason in principle to deny deduction of such taxes
as expenses in deriving income. An annual land tax paid by a landlord on a rental
property is just as much an expense in deriving the rental income as sums
expended on repairs, maintenance and the pursuit of delinquent tenants for
unpaid rental monies. Stamp duty paid by a borrower on security documentation
is as much a cost of the financing as any sum paid as interest to the financier.
And so on. Provided there is a sufficient nexus and the expenditure is not capital
expenditure (for example, stamp duty paid by a purchaser on the purchase of
plant) other forms of tax liability incurred by the taxpayer will be a deductible
expense in determining chargeable income.

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no reserve
Section 22(1)(f) provides:
‘(1) Except as provided in this Act, no deduction is allowed for the
following –
(f) an amount carried to a reserve fund, a provision for expected
expenditures or losses, or an amount capitalised in any way;’

Tax law concerns itself with the actual facts of a case and not hypotheticals. We
already know this. We already know, for example, that tax law rejects arguments
of economic equivalence. In consequence two situations that are economically
equivalent but factually different may receive quite different tax treatments.
Paragraph (f) is a further application of the general principle; facts not
hypotheticals. We recognize expenses actually incurred in deriving income, we
do not recognize expenses that might be incurred in the future. A conservative
management may out of profits for a year set aside a reserve to address future
possible eventualities. This may be good management practice but it cannot
generate a deduction where none presently in fact exists. Paragraph (f) reminds us
of this.

Some care needs to be taken in the application of para(f). The prohibition only
concerns a provision or reserve for future possible expenses. It does not preclude
deduction of an estimated sum for an expense already incurred but for which no
precise dollar figure is presently available. Nor does it deny the deduction of an
estimated sum for contingent liabilities, some of which are bound to mature,
where the liability is a true cost of the present year’s trading. We will look at
several such examples in week 9.

The Act creates a specific exception to s.22(1)(f) in s.28. Section 28 concerns

‘self insurance’.

Businesses in Fiji face the risk of cyclone, flood etc damage. Commonly one
guards against this risk by taking out insurance from any one of a number of
casualty insurance companies. The cost of such protection is the annual insurance
premium. This expenditure is deductible in determining chargeable income.

An alternative to regular commercial insurance is what is known as ‘self

insurance’. This may take one of two forms. In its more sophisticated form a
company group, composed typically of large dollar value companies, may
establish a subsidiary whose sole function is to act as an insurer to group
members. The subsidiary is said to be a ‘captive insurer’. Group members
purchase insurance coverage from the captive in regular fashion. The captive
insurer may retain all risk or may engage in re-insurance like a regular
commercial insurance company. The advantage gained is that any profits on the
insurance activity remain within the group rather than going to some unrelated
third party insurance company. (Of course, on the downside, if the insurance
activity makes a loss this is a loss for the group rather than the more usual
unrelated third party commercial insurer.)

[Tax authorities commonly view captive insurance arrangements with suspicion.

A captive insurer will typically be established in a low tax jurisdiction. Group

20
members may then pay excessive premiums for their insurance coverage. By this
means profits are shifted to the low tax jurisdiction.]

In its less sophisticated form self insurance takes the form detailed in s.28. The
taxpayer pays regular sums to its own dedicated bank account with the intention
that the fund accumulated over time shall only be used to make good actual
damage that results from a cyclone, flood etc.

Insurance premiums are regarded as an income expense and sums paid by way of
premiums for casualty insurance satisfy the nexus requirement in s.21(1)(a). Thus
premiums paid to a regular insurance company or to a captive insurer are a
deductible expense. However, the less sophisticated form of self insurance
involves no payment to a third party. It is actually a case of a reserve created to
provide for a possible future expense. It is thus not deductible on general
principles and more specifically under s.22(1)(f). This is what necessitates the
express provision for deduction in s.28.

Note, that any deduction obtained under s.28 must be added back to gross income
if the monies set aside in the dedicated account are actually used for other
purposes (see s.28(4)).

Note that the deduction granted under s.28 may give rise to an anomaly where
dedicated funds are actually used to effect repairs. Section 22(1)(g) will not be
attracted because there is no contract of insurance. Thus there may be a double
dipping by the taxpayer. First, a deduction under s.28 when funds are deposited
to the dedicated account, and second, a deduction for repairs when the same
funds are applied in repairing cyclone etc damage. The anomaly is addressed by
s.28(3).

repair expenses
Repair work undertaken on plant or buildings used in deriving income satisfies
the nexus requirement and is expenditure on income account. Repair expenditure
is thus deductible in full in the year of repair.

On the other hand, expenditure on improving capital assets is capital expenditure.

So too is expenditure on replacing capital assets. And capital expenditure is not
deductible.

All of this is straightforward and unexceptional. The legal rules are clear.

In practice we find disputes arise over the factual issue: Does the work
undertaken constitute a repair? Disputes of this character have pushed the courts
to develop a definition of ‘repair’.

The leading decision concerning the concept of repair is Lurcott v Wakely &
Wheeler. This is not a tax case. Rather it is a dispute between a landlord and
tenant. The case has been adopted in tax disputes.

21
In the Lurcott case one entire wall of a building was in a dangerous condition and
needed to be replaced. The lease placed the onus for repairs on the tenant. A
dispute arose between the landlord and tenant as to whether the work required to
replace the wall constituted repair.

Buckley L.J. defined repair as follows:

‘Repair and renew are not words expressive of a clear contrast. …
Repair is restoration by renewal or replacement of subsidiary parts of
a whole. Renewal, as distinguished from repair, is reconstruction of
the entirety, meaning by the entirety not necessarily the whole but
substantially the whole subject-manner under discussion.’

The landlord wins the case. The whole is held to be the building. The wall is a
part of this larger whole. Hence replacement of the defective wall is a repair.

Read Lurcott v Wakely & Wheeler

whole and part

What is a whole and what is a part? Suppose we have a motor vehicle in which
the clutch breaks. One can go to the dealer and buy an entire new clutch to
replace the broken clutch. Is the clutch a ‘whole’, an entirety? Or is a clutch a part
of the larger whole known as the transmission? Is the transmission a whole? Or is
the transmission part of a larger whole called the car? Is the car a whole? Or is
the car a part of the larger whole the company fleet of vehicles? What is the
relevant whole and what is the relevant part?

In identifying the relevant ‘whole’ attention is focused on physical discreteness.

A car engine once attached and in place is not physically discreet from the
remainder of the car. The car is the whole and the engine is a part.

Attention is also focused on functional discreteness. While an engine viewed

alone has a discrete function, a car without an engine does not. This would be an
incomplete car. Again the car is the whole and the engine is a part.

By way of contrast consider a work station. The PC and monitor function

together to form the complete work station but the two are physically discrete,
joined only by a wire. If the monitor failed and was replaced this is best viewed
as not a repair. This is a replacement of the ‘whole’, the monitor being an entirety
or whole within itself.

repair and improvement

Repair involves a restoration. If work goes beyond restoration and improves the
capital asset the work will constitute capital expenditure and not be deductible.

This point requires a little elaboration. Any repair (or at least any successful
repair) involves an improvement. A repair that didn’t improve the object would
only be an attempted but unsuccessful repair. A repair restores an object to a
condition comparable to that which existed before the object fell into dis-repair.

22
Improvement or repair plus improvement?
Suppose the ceiling of a theatre is in disrepair and needs to be replaced. (A
ceiling is just a part of the whole the building.) The taxpayer has an option to
replace the ceiling with materials and a design substantially like that already in
place or alternatively a new style of ceiling that is a clear improvement on the
present ceiling. Whichever of the two options is chosen, the same work and
expenditure must be incurred in removing the present ceiling. Option two
constitutes an improvement, but may the taxpayer claim that the work common to
both options is deductible as a repair expense. The taxpayer argues: ‘If I had
taken option one there would only be a repair. The expenditure deductible would
include the cost of removal. I incur the same cost of removal in option two and
this too should be deductible. In option two I have undertaken first repair work
followed by work on improvement.’ This is substantially the facts and argument
of the taxpayer in the Australian High Court case FCT v Western Suburbs
Cinemas Ltd (1952). The court rejected the taxpayer’s analysis. The work on
completion constituted an improvement. That characterization then applied to
everything done from the commencement of the work. The work could not be
divided into two stages. While there is clearly a logic to the taxpayer’s analysis it
involves an argument by reference to what might have been done rather than
what was actually done. Tax law almost invariably rejects an appeal to a
hypothetical alternative rather than the real facts of the case.

Property acquired in a state of dis-repair

The general classification of a repair of a capital asset as a deductible expenditure
rests on the idea that repairs are an expense in deriving income and more
specifically an expense on income account, being a recurrent (and almost
inevitable) expense. As we use a capital asset in earning income the need for
repair arises and this must be taken account of if we are to obtain a true measure
of net income.

Suppose, however, a second hand asset is acquired in a state of dis-repair and

expenditure is required to fix the asset before it may be put to use in deriving
income. The purchase price for the capital asset is capital expenditure. However,
the real cost of acquiring the asset also includes the expenditure in putting it in
working order. What might otherwise be a repair expense is in this circumstance
a capital expenditure.

This conclusion might be reached in several other ways.

- For the new owner, the work of ‘repair’ is actually an improvement since it
places the object in better condition than when acquired.
- For the new owner this is not a repair of defects resulting from his use of the
asset in deriving income but from the previous owner’s use of the asset.

Thus work done in fixing defects that existed at the time of acquisition will not
(usually) be deductible as a repair expense. The leading authority on this issue is
The Law Shipping Co case. I want you to read that case.

Read The Law Shipping Co Ltd v CIR

23
There is one qualification to the general rule above concerning expenditure to
remedy defects that exist in a capital asset at the time of acquisition.

Expenditure that repairs a state of dis-repair that existed at the time of acquisition
will be deductible where:
- the asset although worn was in working condition when acquired
- the asset was in fact used in its worn condition, and
- the repair work was only undertaken some considerable time after acquisition
and then only as part of what might be regarded as usual repair work.

Common examples of this are the replacement of carpets, the painting of a

building or the replacement of a part in a secondhand machine, in each case the
repair work being undertaken some considerable time after acquisition. In each of
these cases one might technically trace the emerging dis-repair in part to use by
the previous owner and in part to use by the present owner. The law, however, in
line with commercial accounting practice, does not countenance such a technical
analysis. Rather the full repair expenditure is a deductible expense on income
account.

This concludes our examination of some of the more particular rules concerning
deductions.

24
Depreciation
Deprecation is our third and final particular topic for this week.

Capital invested in physical assets used in the production of income is gradually

eroded as the assets suffer wear, tear and obsolescence. In commercial accounting
we recognize this by means of a charge against income. Income tax law in similar
fashion recognizes that capital assets may be subject to waste (to use an old legal
term) and that account needs to be taken of this in order to arrive at a true net
income figure. In an income tax this is commonly achieved by means of an
annual depreciation allowance.

[The term waste in its most common sense refers to a failure to use a resource
efficiently. A second meaning is to waste away. Where a broken leg is placed in a
cast the legs unused muscle is subject to wastage; it wastes away. The legal term
waste has this second meaning.]

In what follows I will focus on the scheme for depreciation in the ITA 2015.

Three questions
Any income tax law making provision for depreciation must address three
questions or issues.
- What assets attract an allowance for depreciation?
- How do we calculate (value) the annual depreciation allowance?
- What are the tax consequences (if any) when an asset subject to depreciation is
disposed of?

What can be depreciated?

Section 2 defines the term ‘depreciable asset’.

A depreciable asset is tangible personal property or ‘structural improvement’ to

real property having three qualities.

The property has:

- a useful life exceeding one year;
- is likely to lose value as a result of normal wear and tear, or obsolescence
- is used wholly or partly to derive income included in gross income.

A deduction for depreciation is available to a taxpayer who owns and uses a

depreciable asset in producing income (see s.31(1)).

Section 41 creates special rules that govern assets subject to a finance lease. For
the purposes of the Act, the lessee in a finance lease is treated as the owner of the
property under lease. In consequence, it is the lessee who claims a deduction for
depreciation.

25
Calculating the depreciation deduction
Section 31(2) establishes a choice. The taxpayer may depreciate their depreciable
asset on a straight-line basis or diminishing value basis.

The choice offered by the Act is subject to two constraints:

- all assets must be depreciated on the same basis (s.31(2)).
- structural improvements to land (e.g. buildings) may only be depreciated on a
straight line basis (s.31(3)).

Whichever alternative is selected, the annual depreciation in the initial year is

calculated as a percentage of the cost of the asset. In subsequent years a taxpayer
depreciating on a diminishing value basis will calculate depreciation on the
asset’s written down value (s.33(1)).

Section 85 elaborates on cost. Section 85(2) provides:

‘(2) Subject to this section, the cost of an asset of a person, other than
an intangible asset, is the sum of the following amounts –
(a) the total consideration given by the person for the asset,
including the fair market value of any consideration in kind
determined at the time the asset is acquired and, if the asset is
constructed, produced or developed, the cost of construction,
production or development;
(b) any incidental expenditure incurred by the person in acquiring
or disposing of the asset;
(c) any expenditure incurred by the person to install, alter, renew,
reconstruct or improve the asset.’

A depreciation deduction is calculated using the rate prescribed by Regulations.

These are the Income Tax (Depreciation Rates) Regulations 2016. The
Regulations provide for four categories of assets. For each category there is a
stipulated rate for depreciation on a straight-line basis or diminishing value basis.

In calculating the annual depreciation deduction one may need to attend to three
more particular rules.

(i) depreciable asset acquired during the tax year

A full year depreciation deduction requires that an asset is a depreciable asset of
the taxpayer for the entire year. Section 31(6) divides the year into days. The
deduction for an asset that is depreciable for less than the full year is calculated as
number of days depreciable over number of days in the tax year.

(ii) mixed use assets

A deduction is available notwithstanding that an asset is in part used in deriving
income and in part used for personal purposes. In this situation the deduction
allowed is ‘the fair proportional part’ of a full depreciation deduction (s.31(5)).

The written down value of a mixed use asset is calculated on the basis that the
asset is used solely in deriving income (see s.34(8)). (And see also s.33(3) re
diminishing value depreciation).

26
(iii) inherited assets
Where the taxpayer inherits an asset and subsequently utilizes the inherited asset
in deriving income, a problem arises as regards cost. Per s.85(2) the cost of the
asset is zero. In this situation a special rule applies. The cost of the asset for the
taxpayer is the cost of the asset to the deceased (see s.87(1)(b) and (3)(b)(i),(ii)).

Tax consequences on disposition

On disposition of a depreciable asset one needs to consider two different matters.
First, what are the tax consequences on general principle?
Second, what are the consequences for the purposes of depreciation?
These two matters are unrelated.

As regards the first, the situation is straightforward. A depreciable asset is held by

the taxpayer as a capital asset. The sale of a capital asset produces (usually) a
capital receipt. Any gain or loss realized is a capital gain or loss.

As regards the second, the situation is a little more complex. On disposition there
may be a final deduction or there may be a nominal receipt. It all depends.

Here is the theory. The annual depreciation deduction is an estimate. It is an

estimate of the value exhausted in the year through wear, tear and obsolescence.
Estimates are … well they are estimates. Estimates reliably over or under
estimate. In particular, this must be the case where the depreciation rate is
specified by Regulation. Disposal reveals the reliability of the estimate. The sale
of a depreciable asset for a figure less than the wdv suggests depreciation has
been under-estimated. The sale of a depreciable asset for a figure greater than the
wdv suggests depreciation has been over-estimated. Whichever the case,
correction is needed. In the former case this is a final deduction. In the latter case
this is what might be called a ‘balancing charge’, a sum to be included in gross
income to counter the excessive deductions allowed in earlier years.

Here are the essential rules. Section 34(1)(b) provides:

‘(1) Subject to this section, if a person disposes of a depreciable asset
in a tax year, the person is not allowed a depreciation deduction for
the year and –
(b) if the written down value of the asset at the time of the disposal
exceeds the consideration for the asset, the person is allowed a
deduction in that year for the amount of the excess.’

Section 34(1)(a) provides:

‘(1) Subject to this section, if a person disposes of a depreciable asset
in a tax year, the person is not allowed a depreciation deduction for
the year and –
(a) if the consideration for the disposal of the asset exceeds the
written down value of the asset at the time of disposal, the amount of
the excess is income included in the gross income of the person for
that year;’

27
The basic rules seen in s.34(1) are subject to refinement where the asset disposed
of is a mixed use asset (see s.34(2) and 34(3)(a)).

What is a disposal?
Commonly the disposal of a depreciable asset will take the form of a sale.
However, the term ‘disposal’ is not limited to a sale. Disposal is defined as any
event by which the taxpayer ceases to own or have the asset. It includes the loss
or theft or destruction of the asset (see s.84(1)). A disposal in these circumstances
will commonly produce a consideration of zero. If the asset which is lost or stolen
or destroyed is insured, the consideration on disposal will be a sum equal to the
insurance pay-out.

Disposal and the rollover option

Where a depreciable asset is disposed of for a figure in excess of the wdv, the
excess over the wdv rather than being included in gross income may be rolled
over against the cost of a replacement asset. In essence the excess reduces the
cost base of the replacement asset. The Act refers to this as ‘deferred recognition’
(see s.34(4)).

The Act provides two alternative means of calculating the cost base of a
replacement asset where the taxpayer elects for a roll-over (see s.34(5) and (6)).

In this week’s moodle section you can find a video in which I discuss the ITA
2015 depreciation rules in a little more detail.

28
Amortisation
Historically income tax legislation has made no general provision for
amortization of intangible assets.

Fiji’s new Act parts with tradition. A taxpayer may now deduct from gross
income an (annual) amortization deduction for business intangibles (see
s.21(1)(d)). ‘Business intangibles’ is a defined term in s.2. The rules governing
amortization are found in s.35.

This concludes this week’s examination of deductions.

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