Income tax – deductibility of repairs and maintenance expenditure 
Repairs vs Maintenance – What’s Deductible? 

 
Introduction 

Approach to deductibility of repairs and maintenance expenditure 

• Commissioner’s views on the general principles governing the deductibility of repairs and maintenance expenditure.

• Usually, this type of expenditure is used on tangible assets that may be depreciated.

• “Repairs and maintenance expenditure” is a general tax-neutral term in this statement.

• The approach the statement takes is that the asset must be deductible under the general permission (s DA 1) before any repairs and maintenance expenditure can be deducted. The statement informs you on how to know whether the deduction is allowed under the general permission is denied because of capital limitations (s DA 2(1)). To decide, you must identify if the asset and apply the principles derived from the case law to identify if the cost of the work done is of capital or revenue in nature.

• If the nature of the cost of the work done is capital, the deduction will be denied (This is assuming that there are no other specific provisions that allow a deduction) 

• If the nature of the cost of the work done is revenue, the deduction will be allowed, subject to the satisfaction of any other legislative requirements.

• The distinction between capital and revenue depends on the facts and circumstances.

  • Must carefully apply principles derived from case law.

• The statement’s approach is mainly concerned about the capital limitation in s DA 2(1).

  • The general permission may have other limitations that may deny the deduction for repairs and maintenance expenditure, but are not considered in the statement. 

• Capital expenditure can be considered under the rules of depreciation or the rules of investment boot. Capital expenditure can have a deduction for depreciation loss or an investment boot if the rules are satisfied. 

Summary of analytical approach

• Does the expenditure qualify to be deductible under the general permission (s DA 1)?

  • Is there a clear relationship between the expenditure and a business or income-earning activity?

    • If no, no deduction is permitted.

• If yes, apply capital limitation to determine whether a deduction is permitted.

• Apply the two-step approach

  • Step 1 – Identify the relevant asset.

    • Apply entirety test to determine the totality or entirety of a tangible asset that satisfies a specific notion.

  • Step 2 – What is the nature and the work done to the asset.

    • You should consider:

    • What was the work that was done, not hypothetical “notional repairs”

    • What the scale, extent and nature of the work and the to the asset.

    • Are there any changes to the useful life, function, value, earning capacity, operating capacity and cost of work of the asset. 

• Simple framework:

  • Does the work change the asset in any substantial way?

  • Does the work change the asset’s character?

  • Was the work from one overall capital project?

  • Was the work needed to make a recently acquired capital asset appropriate for long-term use?

• If any of these were a yes, it is not permitted to have a deduction

• If all of these were a no, it is likely to be deducted. 

Is the expenditure deductible under the general permission?

• Does the expenditure meet the general permission in s DA 1.

• Section DA 1:

  • A deduction for an expenditure or loss, and depreciation loss is allowed if the expenditure or loss is:

    • Created by them from deriving:

      • Assessable income 

      • Excluded income 

      • Both of their assessable and excluded incomes

    • Created by them in the course from carrying on a business for the purpose of deriving.

      • Assessable income 

      • Excluded income 

      • Both of their assessable and excluded incomes

Connection or nexus with income

• To determine whether an adequate nexus or connection exists, the true character of the expenditure and the relation to the taxpayer’s income-earning activities must be considered.  This should be considered at the time of the expenditure that was incurred. The income-earning process that the expenditure is connected to must be ongoing, and the ingoing nature must be determined as a matter of fact and degree.

• The degree of nexus or connection must satisfy two limbs of deductibility simultaneously. (s DA (1)(a), s DA (1)(b)).

  • The difference between the two limbs is the what the relevant expenditure must have sufficient connection with.

  • (b) only applies to business taxpayers, which allows for a wider approach than (a)

  • The expenditure under (b) may still be deductible even if the expenditure is not directly liked to earning income.

• The general permission allows a deduction for expenditure “to the extent to which” the provision’s requirements are met. The apportion expenditure can be split into deductible and non-deductible portions. 

Key point on the general permission 

• The expenditure of repairs and maintenance must have a sufficient relationship, connection or nexus with carrying on a business or an income-earning activity to be permissible to have a deduction. 

Does the capital limitation deny deduction? 

General principles for distinguishing capital or revenue 

• After deciding whether a deduction is available for repairs and maintenance expenditure under the general permission, capital limitation is the next step to deciding whether a deduction is denied. Under capital limitation, an expenditure gets denied if an amount of the expenditure is found to be capital in nature. 

• The distinction between the to natures are the acquisition of the means of production and the use of them, establishing and extending a business organization and carrying on the business, the asset employed and the regular performance of the asset which they are employed, an enterprise itself and the sustained effort of that are engaged in it. 

  • Whether the expenditure is a need or occasion

    • Why the expenditure is needed

  • Whether the expenditure is reoccurring

    • Determine whether the expenditure is one off or reoccurring.

    • Reoccurring expenditure means ongoing demands, which is part of the cost of ordinary business, which shows revenue characteristics.

    • One off expenditure is likely to be capital expenditure. 

  • Whether an enduring benefit is given when the expenditure is one and for all producing assets or advantages. 

    • Under this, expenditure is considered capital.

    • Difficult to apply this to repair and maintenance as there is usually an enduring benefit when repairing. 

  • Whether the expenditure is on the business process or business structure.

    • Is the asset that is being worked on going to be part of the business structure?

  • Whether an identifiable asset is created by the expenditure.

    • The expenditure on a capital account where the nature of the asset is capital is obtained; or

    • The money is spent for improving the asset. 

• • Whether fixed or circulating capital creates a source of payment. 

    • Where the money came from.

    • It is likely that money coming from circulating capital is of revenue nature. 

    • Less relevant for repairs and maintenance because the funds of work do not reliably indicate the nature. 

  • How the ordinary principles of commercial accounting treats the expenditure. 

    • Tax and accounting have different aims and treatments can be different.

    • The results and treatments for repairs and maintenance can be very different for some businesses. 

Step 1: Identify the asset being worked on

Introduction

• Must determine and identify the asset that is being worked on before determining the nature of the repair and maintenance expenditure.

• Identifying assets being worked on involves the degree and impression.

The “entirety test” 

• The identification of assets being worked on involves:

  • Determining what the relevant “entirety” is.

  • Identifying “a physical thing which satisfied a particular notion”.

  • Identifying “the totality or entirety of the physical asset”.

How the courts have applied the entirety test

• The principles for determining assets for repairs and maintenance purposes are the same as the principles for determining depreciation purposes.

• For repairs and maintenance, expenditure is for work done and the entirety test is used to identify the asset. 

• For depreciation, expenditure is for work done and could be more due to the nature of the acquisition costs. 

• Both contexts are led by the expenditure and what it aims to achieve in a practical business perspective. 

• Generally tangible assets that are considered for repairs and maintenance purposes are the same as the item subject to depreciation. 

  • Assuming that the other conditions in relation to when an asset is subject to depreciation property is met. 

    • One of the conditions relating to this is that the taxpayer must own the property. 

    • If the taxpayer does not own the property, the rules may differ, leading to the differentiation of repairs and maintenance and depreciation. 

• Factors to determine the relative asset in repair and maintenance in relation to depreciation:

  • Factors that may determine the item under consideration is a relevant asset:

    • Must be physically distinct from assets which the item may be part of. 

    • Functionally finished.

    • The function of the item must differentiate between others.

  • Factors that may determine the item under consideration is not a relevant asset:

    • Other items are physically connected.

    • Part of a system that is integrated.

    • Needed to complete something else. 

Items attached to a building and commercial fit outs

• In the context of repairs and maintenance for buildings, the main question will be whether the object of the work building proper, separate, or chattel not forming part of the building. 

• Three-step test to differentiate between buildings and items attached to the building. 

  • Attachment: Whether the item is attached or a part of the building. If not, it’s a separate asset. 

  • Integral part: Is the part essential that if it will be uncomplete or unfunctional without it? If yes, the item is part of the building. 

  • Fabric: is the item incorporated or attached in a way that makes it part of the “fabric” of the building? If yes, the item is part of the building. If not, it’s a separate item. 

• Commercial fit-out items:

  • A part of a commercial building that are not for structure, and not for the purpose of weatherproofing. 

  • Cannot be used for the dwelling within a commercial building 

  • Plant attached to commercial building, without the purpose of being for structure.

  • Shared spaces outside dwellings in commercial buildings.

Step 2: Consider the nature and extent of the work done to the asset

Two key questions arise for consideration under step 2

• Did the work lead to the asset’s reconstruction, replacement or renewal, either entirely or substantially? If the answer is yes, the cost is considered capital expenditure.

• Did the work go beyond the repairs and altered the asset’s character, even if it doesn’t involve the asset’s entire or substantial reconstruction, replacement or renewal? If the answer is yes, the cost is considered capital in nature. 

• Step 2 encompasses the overlapping aspects of the work, being its extent and nature. 

  •  The extent of the work, mainly to help identify whether it was led to the asset’s reconstruction, replacement or renewal, by entirely or substantially.

  • The nature of the work, mainly to help determine its probable effect on the asset and if it has gone past repairs and alters the asset’s character. 

Step 2 is applied to the work actually carried out.

• The analysis for the nature and extent of the work that is carried out is applied to the expenditure that was actually incurred. 

• Repairs and maintenance cover many things:

  • Resorting an asset to its new condition 

  • Replacing substantial parts

  • Reconstructing with new materials 

• The expenditure’s ability to be deducted depends on what issues were resolved. 

• No deductions can be made on any hypothetical notational amounts. 

Work that entirely or substantially reconstructs, replaces or renews the asset

• Work involving the reconstruction, replacement or renewal of the asset entirely or substantially, is considered an expenditure with a capital nature.

• You must consider the work done to the asset in its entirety when deciding whether the whole or a substantial amount of the asset is being reconstructed, replaced or renewed. 

Work that goes beyond repairs and changes the asset’s character. 

• If the work done changes the character of the asset, it is capital in nature. 

• It’s important to consider the nature and extent of the work to determine if the work changes the asset’s character.

• Most repair work will improve the asset. 

  • It is considered capital nature if the restoration changes the asset’s character by going beyond the former condition of the asset.

• If the work done to the asset does not change the character of the asset and does not a replacement, reconstruction, or renewal of the whole or substantially of the whole asset, it would be revenue in nature and deductible. 

Factors the courts have considered relevant under step 2

• Scale of the work done 

  • The extent and the scale of the work done should be considered. 

  • Extent is the degree, range or scope of something. 

  • Scale is the relative size or level of something. 

• Significance of the work to the asset

  • The more essential part of the asset being worked on the more likely the expenditure to be considered capital. 

• Use of different materials 

  • Using different materials from the original for the work done on the asset may mean a change in character. 

  • An asset may not be improved if the original material used is no longer usable. 

    • But if the change of material makes the asset more useful or performs better, it may mean the character has changed.

    • Choosing to use better other materials over the original material, can result in a change in character, making it a capital expenditure. 

Factors that are rarely determinative on their own 

• Increase in value

  • The increase in an assets value after the repair by itself is not considered a main element in determining whether the nature is capital.

• Income-earning capacity

  • The income-earning capacity of an asset isn’t enough to determine whether the nature is capital. 

• Useful life, function and operating capacity 

  • If the work changes the character of the asset, it is capital in nature, despite the asset’s lifespan, operating function or capacity is no more than it just being repaired. 

• Cost of the work done 

  • The cost of the repair alone might not affect the nature of the work from revenue expenditure to capital expenditure. 

• Unsought benefits

  • If an unexpected benefit occurs when repairing the asset, it will still be considered a capital expenditure as the character has changed, regardless of the intention. 

Specific situations to consider under step 2 

Different scenarios in which may affect the analysis of the nature and extent of the work:

• Deferred and then completed all at once or spread out over many years

  • When deferring then completing all repairs all at once, the nature and scale of the work done can cover the whole or substantially, reconstructing, replacing or renewing the asset. 

  • The question regarding the nature of the work due to scale and timing may occur. 

  • Timing alone does not affect the nature of the work.

  • The costs because of deferred repairs will remain deductible, if the nature of the work stays within repairs. 

  • If the work of the deferred repairs’ reconstruction, replacement, or renewal of the whole or substantially changes the character of the asset, the expenditure will be considered capital. 

• Part of one overall project 

  • The court must consider all the repairs, instead of individually.

  • It is important to define the scope of the repair and the overall capital project.

    • The work done at the same time as the project may be outside of its scope. 

    • If there is proof that the work done is no part of the project, it can be considered separate. 

    • If repair work was done during the project, it may not necessarily be considered part of the project. If the work is truly repairs, and can be differentiated from the project.

• For a recently acquired asset 

  • In some cases, the cost of repairs may be considered inherit costs if the repair is part of the acquisition.

  • Initial repairs are repairs taxpayers do when they have recently acquired an asset, where the expenditure is capital in nature and is not deductible. 

• The result of a significant event 

  • The effect of the work is more focused on, rather than they timing or cause. 

  • The results of significant events and normal wear and tear have the same considerations. 

• Remedying an inherent defect and leaky buildings 

  • Inherent defects are defects that were sold along with the asset.

  • These defects require routine repairs and maintenance. 

  • Repairs revolve around the reconstruction, replacement, or renewal of a thing to its former condition. 

    • In the case of inherent defects and leaky buildings, it will likely be the condition of “as constructed”. 

    • If the repair work done to restore the inherit defect improves or enhances the building, it is considered a capital expenditure.