The instant asset write-off and temporary full expensing are creating unintended capital gain problems for businesses that haven’t structured correctly
Legislation/Other Material: Income Tax Assessment Act 1936, Income Tax Assessment Act 1997, Income Tax (Transitional Provisions) Act 1997
The instant asset write-off and temporary full expensing has created some significant capital gains anomalies that can be avoided by correct structuring.
In most circumstances the additional capital gains can be avoided by way of converting the debt component to equity using unit trusts to bring about full capitalisation. The strategy discussed in this paper only works using unit trusts. The unit holder may be an individual, discretionary trust, company or a holding unit trust.
If the asset is already being held by a company, then consideration should be given to introducing a unit trust.
Small business entities applying the simplified depreciation rules under Subdivision 328-D of the Income Tax Assessment Act 1997 (ITAA97) are required to immediately deduct the cost of depreciating assets costing less than an applicable threshold (net of GST credits), to the extent that the asset is to be used for tax-deductible purposes.
The threshold is generally $1,000, as set out in s 328-180(1)(b) of the ITAA97. This threshold has been increased and suspended for specified periods by historical amendments to s 328-180 and provisions in the Income Tax (Transitional Provisions) Act 1997 (ITTPA), see table below. The taxable purpose proportion of an asset with a cost less than the applicable threshold must be immediately deducted for the income year in which the asset was first used or installed ready for use for a taxable purpose. Where a threshold applies, depreciating assets that cost an amount equal to or greater than the applicable threshold in the relevant income year are allocated to the general small business pool. Assets that do not satisfy the respective timing requirements continue to be subject to the $1,000 threshold.
Applicable small business instant asset write-off thresholds
* where the relevant purchase date falls between 6 October 2020 and 31 December 2020, full expensing applies.
For a limited period, entities that qualify as "medium sized businesses" can immediately deduct the cost of certain depreciating assets, like the concession available to small business entities under Div 328.
This temporary "instant asset write-off" generally applies to the following 2 instances:
As these rules are within Division 40 of the ITAA97, the deductions are subject to other requirements in Division 40 of the ITAA97 including that a deduction is only available to the extent the asset is used for a taxable purpose.
The second more generous write-off was introduced, and then extended, as part of temporary measures to boost business investment in response to the COVID-19 outbreak.
The taxpayer must satisfy the definition of a “small business entity” in section 328-110 of the ITAA97, except that the permitted aggregated annual turnover is capped at $5 billion (s.40-155 of the ITTPA). This means this measure is available to most businesses, rather than only small or medium businesses like the above instant asset write off measures. Turnover of entities for this purpose includes that of any entities “connected” or “affiliated” with the taxpayer — so for a group of companies with common shareholding, the relevant turnover will be that of the entire group, rather than the entity that purchased the asset, excluding intra-group transactions.
The above has resulted in businesses with a turnover under $50million, $500million and $5billion being granted very generous asset write down allowances and for everyone between 6 October 2020 and 30 June 2023 with a full deduction for the acquisition of depreciating assets.
This has created a very difficult circumstance for those that don’t structure correctly.
The Smith Unit Trust acquires a $5million hotel using money it borrows from a bank. Over the next five years an amount of $2million is claimed pursuant to the instant asset write-off and temporary full expensing. The cost base of the hotel is now $3million. The hotel is sold for $6million. The Smith Unit Trust derives a capital gain of $3million which is distributed to the Smith Family Trust.
If, however, the Smith Family Trust borrowed from the bank and acquired 5 million units in the Smith Unit Trust the situation would be very different.
Upon the sale of the hotel for $6million, a $3million capital gain would arise. This would be distributed to the Smith Family Trust. The Smith Unit Trust would still have $3million in cash remaining after the appointment of the capital gain (see 2. Post-sale).
The Smith Family Trust has 5million units in the Smith Unit Trust which it paid $5million. The redemption of those units for the $3million cash in the Smith Unit Trust would result in a $2million loss to the Smith Family Trust (see 3. Redemption). The $2million loss may be offset against the $3million capital gain leaving a capital gain of $1million (see 4. Capital loss offset).
This example follows the exact same facts however the first option results in a capital gain of $3million and the second option results in a capital gain of $1million. Same purchase and sale price, just some careful debt/equity structuring.
Note: It is important that the capital gain on the sale of the hotel and the redemption take place in the same financial year.