The University of Sydney-    Classic Texts in Australian and International Taxation Law

IV. Depreciation and Amortisation of Fixed Assets

8.71. If the cost of a fixed asset used to produce income is not fairly spread over the period of use, by allowing deductions each year, the tax base will be distorted by the failure to match expenses with income. Criticisms of the present law relate to the unfairness of the spreading for those assets for which the law does allow depreciation and to the absence of any deduction for certain other fixed assets, principally buildings. In addition allowances have been sought for certain expenditure which, though not wholly falling within the usual definition of fixed assets, is nonetheless of a capital nature. This includes costs of acquiring know-how, of company formation and issues of shares, of feasibility studies; it also includes some expenses of moving the site of business operations. The denial of depreciation deductions to a taxpayer who has incurred expenditure on an asset he does not own—for example, improvements to leasehold property—also has been criticised.

8.72. The depreciation provisions of the Act were examined both by the Spooner Committee and, in rather more detail, by the Commonwealth Committee on Rates of Depreciation (the Hulme Committee). The terms of reference of the Ligertwood Committee did not extend to the matters dealt with by the Hulme Committee; but it examined the lease provisions of the Act, including the question of allowances for expenditure by a lessee on improvements to leasehold property.

8.73. Many of the matters raised in submissions are identical with those brought to the attention of the earlier committees, particularly the Hulme Committee: for despite the recommendation of these committees that allowances be available for the recoupment of the cost of certain assets of a capital nature, the law has remained unchanged. Consequently, the differences between net income and accounting profits which arise in relation to depreciation and amortisation continue. In the years that have elapsed since the recommendations of the Hulme Committee, the grounds for the criticism of the differences in treatment have not weakened; rather, they have been strengthened by technological progress and by the now almost general acceptance by business that


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failure to provide adequate depreciation for buildings results in overstatement of profits. The omission to tax capital gains, particularly on land, which it might be thought has mitigated to a degree the absence of depreciation allowances for buildings is now proposed to be rectified.

8.74. The discussion which follows is arranged under four broad categories of assets in respect of which changes in the law are sought. These are plant and equipment, buildings, leasehold improvements and other assets and costs. The questions which arise are considered in relation to the recoupment of the historical cost: the extent to which regard should also be paid to the increased cost of replacement due to inflation is briefly mentioned in Section VII. The special provisions applying to primary production and to the mining and petroleum industries are considered in Chapters 18 and 19.

Plant and Equipment

8.75. Practically all units of property classified in financial accounting as fixed assets and in respect of which depreciation is at present allowed fall under the broad heading of plant and equipment.

8.76. The annual percentage rate of depreciation allowable in respect of each unit of property is determined by the Commissioner on the basis of the estimated effective life of the asset, assuming it is maintained in reasonably good order and condition, and an annual percentage allowance is fixed accordingly. Standard rates of depreciation are determined by the Commissioner in respect of various types of assets. The standard rates make no allowance for obsolescence. Although the Commissioner may allow a variation from the standard rates where special circumstances or conditions relating to a particular unit of property justify such a variation, his determination, it seems, must be made on the physical life of the asset. Australia is one of the few countries which does not have regard for obsolescence in determining rates of depreciation.

8.77. The Hulme Committee considered whether it was practicable and desirable, in determining annual rates of depreciation, to take obsolesence into account and reached the view that it should be recognised as a relevant and material factor. It added, however, that the method of making an allowance for obsolescence and the degree of the allowance had given it some difficulty and concluded that the only feasible approach was to introduce a degree of flexibility by allowing the taxpayer choice of a rate of depreciation within a band of rates.

8.78. The need to make due allowance for the factor of obsolescence has again been pressed in many submissions to the present Committee, including a number from particular industries in which, owing to the speed of technological advances, the matter is of major concern. Where the period of the estimated effective life of any equipment proves, in practice, to have been excessive, a deduction for the cost not covered by allowances in prior years is available when the equipment is scrapped or abandoned. However, this defers a deduction and does not give an even spread of the recoupment of the capital cost over the effective life of the equipment.

8.79. Complaints about the inflexibility of the standard rates continue, though it may well be that a proportion of these are not soundly based. The Commissioner and his officers permit variation from the standard rates where a taxpayer produces satisfactory evidence that, in his particular case, the specified standard rate is inadequate.


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Submissions rarely record whether an application has in fact been made for permission to adopt higher than standard rates.

8.80. The essential feature of rates of depreciation is that they are estimates of effective working lives. The allowances flowing from them are in reality estimates also and not precise figures of the portion of an asset's cost relating to a year of income. Considerable clerical recording and effort are frequently involved in computing depreciation allowances, particularly in manufacturing industries, due to the differing rates to be applied to the separate units of property. The clerical effort in checking or reviewing the computations by Departmental officers is also heavy. One method of reducing this would be the adoption of a composite rate to be applied to all depreciable fixed assets of a business, other than motor vehicles and buildings. This method recognises the futility of incurring clerical costs in performing precise calculations of allowances for various categories of property attracting different rates, when approximately the same total allowance can be determined by simple and less expensive procedures and the result under either approach is in any event only an estimate.

8.81. The Committee recommends that the schedules of standard rates of depreciation incorporate composite depreciation rates for specified industries which may be adopted, in lieu of standard rates, for all depreciable assets other than those excluded in fixing the composite rate. It further recommends that, in fixing the composite rate for a particular industry, a loading be added to take account of obsolescence.

Buildings

8.82. The Act allows deductions for depreciation of ‘plant’ used for income-producing purposes but, with certain limited exceptions, not for depreciation of ‘buildings’. The exceptions are income-producing buildings forming an integral part of plant; buildings used only for scientific research related to the business of the taxpayer; structural improvements on land used for the purpose of agricultural or pastoral pursuits; and buildings erected by mining enterprises as part of the development of a mining property.

8.83. One argument that has been used to support the present situation is that land and buildings appreciate in value rather than depreciate. The Hulme Committee, in observing that the Commonwealth income tax law did not allow depreciation on buildings, stated that the reasons which appeared to have previously weighed against the granting of such an allowance were those to be found in the following extract from the Report of the Ferguson Commission (1932-34):

‘We received many requests that depreciation should be allowed in all cases. There are many buildings, however, which with repairs and maintenance, all of which are of course allowed as deductions, will last for hundreds of years. There is the further consideration that many substantial buildings in good localities have not depreciated in value—on the contrary the property as a whole has appreciated owing to an increase in values of the sites on which the buildings stand … We recommend that depreciation on buildings be restricted to buildings forming an integral part of plant …’

8.84. The Hulme Committee reported that in none of the matters which came before it had it encountered more widespread representation, or more unanimity of opinion, than that an allowance should be given for depreciation of buildings. It


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recommended that depreciation be allowed in respect of the cost of all income-producing buildings but drew attention to the practical problems of including existing buildings.

8.85. It recommended that existing buildings be included where, if depreciation using the prime cost method had been available at the time the building was constructed, there would still be some portion of the construction cost unrecouped. However, to overcome the problem of ascertaining the actual construction costs of older buildings, it devised a complex scheme for calculating the cost of existing buildings where actual construction costs were not known. Construction costs of buildings erected between 1939 and 1955 (the year in which the recommendations were made) could, it was thought, be ascertained. It was proposed that buildings erected before 1939, which tended to be more standardised than are buildings erected today, should be given a deemed cost of construction calculated by applying a standard cost for that type of building in 1939 to the building's internal floor area and then relating the result to an index of relative levels of building costs in earlier years. Since the rates of depreciation suggested for brick, stone or concrete buildings assumed a normal life of sixty-seven years, the existing buildings (in 1955) which would still have qualified for depreciation could have been constructed as long ago as 1888.

8.86. Depreciation on industrial and commercial buildings used in the production of income is allowed in many overseas countries including Belgium, Canada, Italy, Japan, Netherlands, New Zealand, South Africa, Sweden, the United States, and West Germany. The United Kingdom is an exception, the deduction being limited to industrial buildings. However, the Millard Tucker Committee on the Taxation of Trading Profits (1951) and the Royal Commission on the Taxation of Profits and Income (1955) both recommended that the depreciation allowance be extended to include commercial buildings.

8.87. In reaching this conclusion, the second of these United Kingdom inquiries reported:

‘380. No doubt commercial buildings involve an ultimate wastage of capital in the same way as industrial buildings do. From that point of view there is no reason to distinguish between them. But we recognise that there are other arguments to be considered. There is an argument that any allowance for capital that is lost in the using up of a fixed asset is anomalous in an income tax system which refrains from treating as taxable a realised capital surplus. This unbalanced treatment, for long confined to plant and machinery, has now been extended to cover other types of assets, in order to stimulate capital investment of a kind desirable in the national interest. It is only in the new context of shortages and high prices combined with a wider range of assets to which capital allowances apply that the anomaly of principle could be of any material importance. But in that context it is not impossible that what is right for industrial buildings is wrong for commercial buildings.

381. The Board are opposed to this recommendation. We summarise their reasons:

• (1) Commercial buildings last a very long time; they are not nearly as much subject to obsolescence as factories are.
• (2) Over very long periods they tend to appreciate rather than depreciate in value, so that if allowances were given they would very often have to be withdrawn when a sale took place.
• (3) At the present time there is no economic importance in stimulating the construction of commercial buildings.
• (4) The proposal would involve drawing a line between commercial buildings and dwelling-houses that would inevitably be regarded as unsatisfactory, particularly in the common case of the house over the shop. Complicated provisions would, moreover, be required to deal with changes of user.



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• (5) The proposal would add considerably to the work of the Department.

382. Although these arguments must be taken into account we do not believe that in the long run they can be decisive. So far as they are not concerned with administration they amount to saying that businesses would not find it worth while to claim the allowance, or that there would be no economic reason for a Chancellor to implement the recommendation. That may well be so, and we should agree to this extent that we do not regard a change from the present system as in any sense an urgent requirement. But we could find no fiscal justification for distinguishing between commercial and industrial buildings and we think both should get the allowance. Accordingly, we endorse the recommendation of the first Tucker Committee.’

8.88. The Institute of Chartered Accountants in Australia and the Australian Society of Accountants, in a joint statement, ‘Depreciation of Non-current Assets’, issued in April 1974, recommended as follows:

‘Buildings. For the purposes of calculating depreciation, the historical cost of a freehold property (or other value substituted for historical cost in the accounting records) should be apportioned between the land itself and the building(s) erected on the land. The resultant depreciable amount attributable to the building(s) should be written off as an expense by means of periodical depreciation charges over the estimated useful life (lives) of the building(s).’

8.89. The experience of this Committee is very similar to that reported by the Hulme Committee and referred to in paragraph 8.84. Numerous submissions have been received which are unanimous in condemning the present restriction of the allowances to buildings to the extent that they form integral parts of manufacturing plant. The representatives of various kinds of business have urged that at least their own particular class of buildings should qualify for relief.

8.90. The basic arguments in favour of allowing depreciation on buildings as a taxation deduction stem from a recognition that a material asset has a finite useful life which may be shorter than the physical life of the asset. All buildings and other structures on land are just as subject to the need for eventual replacement as is working plant, and with the rapid rate of technological change the effective working life of these items is becoming shorter. This fact is reflected in a practical manner in the continual demolition of existing buildings to make room for new ones, usually of increased capacity and more suitably designed for modern conditions.

8.91. The argument which persuaded the Ferguson Commission to recommend against an allowance for building depreciation—that any loss in value of a building tends to be offset by appreciation in the value of land—has, in general, long since been rejected. A further argument—that the imposition of a capital gains tax on profits arising from the realisation of real property is a necessary counterpart to the allowance of building depreciation—has also been rejected. The reasons for the rejection of both these arguments were stated in the Hulme Committee report and have been dealt with at some length in pronouncements by the major professional accounting bodies in Australia and overseas. The principal reason is that they overlook the fact that buildings are consumed and replaced in the course of business operations unrelated in any way to changes in the value of the underlying land. Many business activities are conducted on land owned for very long periods. Rarely is industry carried on efficiently in buildings erected more than fifty years previously. Commercial buildings of the same vintage originally used for offices or accommodation are seldom now suitable for that purpose without expenditure of a capital nature on reconstruction.

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8.92. In the Committee's view allowances for depreciation of buildings are called for. Their introduction, however, raises certain problems:

• (a) For what classes of building should depreciation be allowed?
• (b) Should all buildings be included or only those completed after a certain date or after the proposal is introduced?
• (c) How should changes in the ownership of depreciating buildings subject to depreciation be treated?
• (d) How should the demolition and destruction or damage of buildings be treated?
• (e) Is a phasing-in period necessary to cushion the effect on tax revenue?

8.93. Classes of buildings which should qualify. The Committee sees no valid reason for excluding particular classes of buildings from the allowances and therefore recommends that depreciation be allowable in respect of all income-producing buildings whether they be industrial or commercial. In this context commercial would include residential accommodation. While the case for allowances may be stronger for industrial buildings, which generally have a shorter effective life than other buildings, and possibly also for accommodation buildings such as hotels and motels for the same reason, allowances are justified whenever a building is used in producing income. Moreover, real difficulties would arise in identifying industrial buildings if the allowances were confined to such buildings, or in identifying accommodation buildings if allowances extended only to industrial and accommodation buildings.

8.94. The inclusion of existing buildings. Some restriction on the scope of buildings entitled to allowances, related to time of erection, would seem to be inescapable. The broad alternatives are to give allowances in relation to (i) all existing buildings, together with all new buildings and additions to buildings; or (ii) buildings and additions erected after a specified day (say 1960); or (iii) buildings and additions erected after a very recent date (say 1974). The problems involved in giving allowances in respect of all existing buildings are immense, especially when it is proposed that all income-producing buildings should qualify. On the other hand, the restriction of the allowance to relatively new structures must give rise to inequity: for example, a rented house finished in 1975 would qualify but one next door completed in 1973 would not. The exclusion of existing buildings would also distort the property market.

8.95. Choosing between the alternatives is not easy. The major reason why nothing has been done in this area for so long, despite the recommendations of earlier committees, is probably the administrative difficulties associated with the proposals that have been made. Hence, administrative feasibility must be the major consideration, even though some inequities may result. The Committee therefore recommends that all buildings which were completed, and were used or were available for use, in the production of assessable income after 30 June 1974 (referred to hereafter as the ‘qualifying date’) and any additions to buildings where the additions were completed and used or available for use after that date, should qualify for depreciation. The rates should be based on their estimated effective lives as determined by the Commissioner. Contractual completion date rather than cost incurred to a specified date should be more readily ascertainable in the case of most buildings and a modestly retrospective date, coinciding with the end of a fiscal year, is proposed.

8.96. There will be formidable problems in determining the apportionment of the cost of a building to individual home units, own-your-own units and strata titles to property. An official study will be needed to work out special provisions for these


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cases, and initially it may be appropriate to defer granting allowances for buildings to which the title is held in one of those forms.

8.97. There is evidence in the published reports of a number of public companies that some taxpayers hold the view that because of the purpose for which a property is held, the value attributed to a building, or some other reason, depreciation of the building does not need recognition. There could be little merit in introducing a difference between tax accounting and financial accounting in these instances. In some overseas countries certain allowances are available only to the extent that the costs concerned have been recognised in a taxpayer's financial records. A similar provision might well be appropriate in relation to allowances for building depreciation proposed by the Committee, at least in respect of companies.

8.98. Treatment on change of ownership. The segregation of the proceeds of the sale of a building from the proceeds of the sale of the land on which it is erected gives rise to special difficulty. This was recognised by the Hulme Committee in its proposal that there be no balancing charge in respect of depreciation on the sale of a building, but not, however, in its proposal that there be a balancing allowance on such a sale.

8.99. In the view of this Committee, the difficulty of ensuring a fair and realistic segregation, within the proceeds from the sale of a property, of that part of those proceeds applicable to a building dictates that there be neither a balancing charge nor a balancing allowance. Segregation within sale proceeds would give rise to added complications if it were necessary to dissect further the sum allocated to buildings, so as to identify that part of the sum applicable to a building erected prior to the qualifying date and that part applicable to additions to it made subsequently.

8.100. Accordingly, the Committee recommends that in the event of the disposal of a building, the new owner should be entitled to depreciation on the basis that he succeeds to the unrecouped amount of the original cost of the structure. His annual allowances would be in accordance with the depreciation schedule for that property applying at the date of purchase. The purchase price of the property would be irrelevant in regard to depreciation allowances, the sale proceeds of the building being deemed to be its written-down value. Where there has been non-income-producing use in any year, the written-down value will have been reduced by a ‘notional’ depreciation allowance in that year.

8.101. Implicit in these proposals is the principle that all proceeds received on the sale of a property which are in excess of the written-down value of the building must represent the value of the land on which the building stands. The total of depreciation previously allowed to the vendor will, however, diminish the cost base of property for capital gains tax purposes. Where property is sold for less than the written-down value of the building—an unlikely event, no doubt—the assumption that the building was sold for its written-down value is of course contradicted by the facts, and there may be a case in this circumstance for the application of a balancing allowance. The buyer would be treated as having acquired the building at the price he paid for the property. If this is not done, the seller will be allowed only a capital loss in respect of what should be an income deduction.

8.102. It should be noted that these proposals are not intended to vary the present treatment of depreciation of buildings under the special provisions of the Act relating to mining, petroleum, primary production and forestry operations.

8.103. Demolition and damage. There would need to be exceptions, in the case of demolition or damage to a depreciated building, to the general rule that balancing


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adjustments are not made. Problems of segregating amounts received between land and buildings would not arise here (though segregation would need to be made between a building erected prior to the qualifying date and additions made subsequently). In the case of demolition or destruction, the difference between the written-down value of the building and the salvage or insurance proceeds would be allowed as a deduction in the year of demolition. If the proceeds exceeded the written-down value, the excess, up to the sum of the depreciation deductions previously allowed to the taxpayer, would be a balancing charge. Any amount of the excess not then treated as a balancing charge would reduce the cost base of the land for purposes of capital gains tax, unless the taxpayer elected to apply it in reduction of the cost of a building erected in replacement. Where there is only partial damage, any insurance recoveries would be offset against the cost of any restoration not deductible as a repair. Any amount not so absorbed would be treated as a balancing charge to the extent of depreciation previously allowed to the taxpayer and thereafter applied to reduce the cost base of the property for purposes of capital gains tax. Insurance recoveries in respect of restoration amounting to repair are income under existing law and the repair cost deductible. Balancing deductions would not be allowed, since depreciation will continue to be available on the original schedule.

8.104. Effect on revenue. The loss of tax revenue that would result if income-producing buildings were to qualify for allowances has been a major factor in postponing the introduction of such allowances. But this factor should not be permitted to override the correction of an inequity in the form of an overstatement of net income by a large body of taxpayers. Some phasing-in of the allowances is nevertheless called for. If, contrary to the Committee's proposal, a major portion of existing buildings were to qualify, phasing-in could be achieved by commencing with a low rate which would increase to a realistic figure over a period of five to ten years. A phasing-in is automatically achieved under the Committee's proposal that the allowances be restricted to buildings completed after the qualifying date.

Leasehold Improvements

8.105. Brief reference is made in Section VIII to leases in general. Here discussion is limited to leasehold improvements carried out by a taxpayer at his own expense in connection with his business activities and for which an allowance, either by way of depreciation or amortisation, is not available. A number of submissions have been received on this point.

8.106. A taxpayer sometimes has no option but to incur costs in erecting buildings on leasehold, and it has been claimed that an allowance should be available which recoups the costs over a reasonable period. Buildings erected at an airport by an airline to service passengers, cargo and aircraft are one example.

8.107. The Ligertwood Committee made a series of recommendations relating to a deduction for part of the cost of improvements carried out by a lessee on leased property used for the production of assessable income and for the inclusion of an equivalent sum in the assessable income of the lessor. The effect of these recommendations would have been to allow the lessee a deduction, spread over the period of the lease subsequent to making the improvements, of an amount agreed by the parties as being the estimated residual value of the improvements at the end of the term of the lease. There would have been corresponding inclusions in the assessable income of the lessor. However, that Committee was mainly concerned with overcoming the abuse of the then provisions of Division 4 of Part III of the Act. The recommendations of the Ligertwood Committee were not acted upon but the abuses were ended by the


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termination in 1964 of the operation of Division 4 in respect of new improvements. Whatever merit there may have been in the recommendations of the Ligertwood Committee they do not seem to be appropriate in the context of the general allowance of depreciation on buildings which this Committee recommends.

8.108. At least when the lessee has erected the building at his own expense on Crown land or on land of a public authority or a body not subject to taxation, it would be reasonable to deem him to be the owner of the building in question and to provide that he should receive the depreciation allowances. However, this approach would exclude any allowance to a lessee where the leasehold improvements have been carried out on privately owned land and accordingly may be thought to be unduly restrictive.

8.109. The Committee recommends that, for the purpose of allowances for depreciation of buildings, a lessee should be deemed to be the owner of any leasehold improvements carried out at his own expense if he uses the property for income-producing purposes. He should be entitled, during the period of his possession as lessee, to allowances to recover the costs he has incurred at the same rate as would apply to equivalent expenditure by the owner. It is not proposed that on his ceasing to have possession as a lessee he should obtain a balancing allowance as to do so would possibly open the way for abuse of the allowance. The treatment of any unrecouped cost for capital gains tax purposes would be a matter of detail of that legislation.

Other Assets and Costs of a Capital Nature

8.110. The existing law has been criticised for its failure to make allowances available for the cost of assets not falling within the ambit of the depreciation provisions and for the costs of a capital nature incurred in business operation but having limited enduring value. The items include costs of acquiring know-how and trade rights, some expenses of moving the site of operations, feasibility studies and costs of capital-raising.

8.111. With the introduction of capital gains tax, thought would need to be given to whether some of these costs should qualify for amortisation allowances, similar to those available to primary producers under section 75A (paragraphs 18.23–18.25). Alternatively, losses arising from expenditure of this nature could be made to fall within the definition of capital losses for capital gains tax purposes, though there would often be problems in fixing the time when losses of this nature are to be treated as having been incurred.

8.112. The Committee is inclined to the view that at least some of these costs could be conveniently dealt with by a provision similar to section 75A, which would make the costs allowable, over a period of years, against income.