General Deduction rules
The term deduction should bring a smile to business owner’s face. Deductions can be used against taxable income and is controlled by legislation Part D of the ITA 2007.
The key to claiming deductions is as long as you are claiming expenses that have incurred as a result of generating income in your business. These can be treated as deductions and hence allowed.
Deductions are allowed when expenditure or loss has incurred when deriving gross income for example rental income, dividends or interest income. Deductions can be claimed when expenses or loss has incurred during the course of carrying on a business for example manufacturing company, retail business or an accounting business.
Section DA1 of ITA 2007 An amount is allowable deduction of the taxpayer to the extent that it is an expenditure or loss -
- Incurred by taxpayer in deriving the taxpayers assessable income or
- Incurred by the taxpayer in the course of carrying on a business for the purpose of deriving the taxpayers assessable income
In most cases all expenditure can fall into three categories. An outgoing will be an ordinary income deduction if it results from a transaction entered into by a taxpayer :
1. With the purpose or intention of making a profit or gain (Ordinary income concept)
2. With the purpose or intention of creating enhancing or disposing of the setting or structure which enables the profit or gain to arise (Capital expenditure)
3. With the purpose of none of the above two (Private expenditure)
Tax residence is a critical element for deduction of expense. Only those amounts of gross income (and associated allowable deductions) which are derived (incurred) by a taxpayer who is resident or which have a source in New Zealand are to be included in assessment of tax.
1. General permission (DA1)
A person is allowed a deduction for an amount of expenditure or loss, including an amount of depreciation loss, to the extent to which the expenditure or loss is incurred by them (can be in the course of carrying on a business) in deriving—
- their assessable income; or
- their excluded income; or
- a combination of their assessable income and excluded income;
There are some notices when define whether a deduction is allowed. They are:
Whether expenditure is incurred?
A deduction is allowed only if the expenditure is incurred. Expenditure is incurred when the taxpayer is committed to it. There is no requirement for actual payment to be made first. For example, a taxpayer placed an order for supplies on 10th March. The supplier invoiced the taxpayer on 15th March and delivered the goods on 20th March. On 20th March, the payment was made. We can say the expenditure was incurred on 15th March.
Further, if convincing evidence is provided, a taxpayer can claim deduction on anticipated expenditure (Refer to Commissioner of Inland Revenue v Mitsubishi Motors NZ Ltd). However, a contingent liability is not allowed for deduction.
Expenditure and loss are deductible if they are related to business operation:
Business related expenditure is deductible no matter it is directly related to deriving income or it is indirectly related. For example, advertisement is not directly related to deriving income, but it is necessary for a business, so it is deductible.
Loss occurs without the anticipation of deriving income. If it is related to business operation, it is deductible. For example, the robbed monies on its way to bank are deductible. Refer to case Charles Moore & Co (WA) Pty Ltd v Federal Commissioner of Taxation.
2. General limitation (DA2)
Each of the general permission is overridden by the general limitations below, unless it is specifically addressed by any other sections in Part D.
1) Capital limitation
A person is denied a deduction for an amount of expenditure or loss to the extent to which it is of a capital nature.
Determining whether expenditure is of a capital nature or revenue nature is quite complicated. Many cases may apply for that issue. Refer to case Auckland Gas Co Ltd v Commissioner of Inland Revenue (2000).
There are also some guiding principles to assist in determining whether an expenditure or loss is capital or revenue in nature:
- The need or occasion, which called for the expenditure: This test considers the surrounding circumstances and ultimate objective of the expenditure indicate a capital or revenue characterisation.
- Whether the expenditure is recurrent in nature : Recurrent expenditure is often of revenue nature and one-off expenditure is often of capital nature.
- Does the expenditure create an identifiable asset?: If an identifiable asset was acquired by the expenditure, the expenditure is more likely to be a capital item. For example, the legal fees incurred in acquiring real property will be capital expenditure.
- Does the expenditure create an asset or advantage, which is of enduring benefit to the business? :It focus on whether an enduring asset or advantage was acquitted by the expenditure. If it was, it is more likely to be a capital expenditure.
- Whether the expenditure is on the taxpayer's business (profit-making) structure or income-earning process? : If it is related to business structure, it is more likely to be a capital expenditure.
- Whether the source of the payment is from fixed or circulating capital: Expenditure made from fixed capital is more likely to be a capital expense. Expenditure made from circulating capital (capital which returns to the business as a result of the business' operation) is more likely to be a revenue expense.
- The treatment of the expenditure according to the ordinary principles of commercial accounting: The accounting treatment of expenditure or loss may support for the classification.
Notice: capital limitation is overridden by other specific deduction rules like depreciation and amortisation outlined in ITA .
2) Private limitation
A person is denied a deduction for an amount of expenditure or loss to the extent to which it is of a private or domestic nature.
For example, expenditure on musician’s performance clothing is deductible (on the condition that the musician is not an employer of the band, otherwise it is subject to Employment limitation. The expenditure is not deductible.) (Refer to TRA Case F46 (1983)). The expenditure on a suit of an accountant is not deductible, because the suit is an ordinary outfit and it is not specific for accountants.
3) Exempt income limitation
A person is denied a deduction for an amount of expenditure or loss to the extent to which it is incurred in deriving exempt income.
4) Employment limitation
A person is denied a deduction for an amount of expenditure or loss to the extent to which it is incurred in deriving income from employment.
Refer to TRA case E20 (1981).
5) Withholding tax limitation
A person is denied a deduction for an amount of expenditure or loss to the extent to which it is incurred in deriving non-resident passive income. Refer to RF2(3) (Non-resident passive income).
6) Non-residents’ foreign-sourced income limitation
A person is denied a deduction for an amount of expenditure or loss to the extent to which it is incurred in deriving non-residents’ foreign-sourced income.