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Are the Taxpayers entitled to a deduction under section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997) for expenditure incurred in replacing the plywood cladding with cement fibre cladding, structural features, Sisalation wrap and insulation?

Yes This ruling applies for the following period: 1 July 20XX to 30 June 20XX

Individual A and Individual B (collectively, the Taxpayers) acquired a 50% interest in the Property which settled on XXXX. The Property has been rented out since the date of acquisition. The Property is one of 3 townhouse units that were originally constructed in about XXXX. Prior to the Taxpayer's acquisition of the Property, the body corporate had replaced the external plywood cladding around XXXX. The plywood cladding was meant to have a life expectancy of 30+ years. The plywood cladding, structural items behind the cladding e.g. stud works, timber wall plates, noggins etc., external door and window frames (collectively described as structural features), Sisalation wrap (Sisalation is the brand name for a special type of sarking material), and insulation were not in need of repair at the time the Property was acquired. The Taxpayers have at various times undertaken repairs to the plywood cladding - staining/painting and resealing to address and prevent deterioration caused by water and moisture damage (due to the weather conditions and coastal location).

Due to COVID 19 restrictions it was difficult to undertake building works across the State A/State B border, either by tradespeople or the Taxpayers themselves (the Taxpayers lived in State B). As a result, the plywood cladding deteriorated to such an extent that water and moisture leaking through the damaged sheets affected the structural features, Sisalation wrap and insulation. The Taxpayers made the decision to replace the damaged plywood cladding sheets. All plywood cladding sheets showing signs of damage (the extent of damage to each sheet varied between 10% to 90%) were replaced - 90% of the total outside cladding was replaced. Cladding sheets in areas not exposed to the environmental elements and rain were not replaced. The Taxpayers sought advice and quotes from local builders to replace the damaged plywood cladding and to address any consequential damage to the structure - i.e. to the structural features, Sisalation wrap and insulation (the Works). At this point the extent of this consequential damage would only be fully known once the plywood cladding was removed.

The selected builder, recommended the existing plywood cladding sheets be removed and replaced with a modern equivalent cladding product manufactured by James Hardie Limited in Australia called Axon 133 Grained Cladding Fibre, being a cement fibre sheet with the appearance of timber (cement fibre cladding). The cement fibre cladding has a listed lifespan of 40 years. Permission was sought from the body corporate in XXXX to undertake the Works as it was a 3-unit complex, and permission was granted to use the cement fibre cladding as it was visually indistinguishable from the existing plywood cladding. The visual appearance was a key consideration. The Taxpayers decided on the cement fibre cladding recommended by the builder, and permitted by the body corporate. The Works have in effect restored the efficiency of use and purpose of the cladding in protecting the Property from the elements and retaining the look of the Property to match the other 2 units.

Each cement fibre cladding sheet covers an area of 2700mm x 1200mm and is installed vertically with an overlap at the joints for better water protection. Replacing the damaged sheet in full would be required where there were no studs/noggins/wall plates behind the cladding section to attach the cut outs to replace the damaged area. Given the size of each cladding sheet being removed and installed it was more efficient to replace each damaged sheet completely as opposed to cutting a damaged section out and then replacing it with a smaller piece of a full sheet - patching the cladding carried the increased risk of water leaks. Furthermore, it would have affected the overall appearance of the complex. The Sisalation wrap and insulation behind each damaged plywood sheet were in poor condition and unsalvageable. The Sisalation wrap and insulation were replaced at the same time as the cement fibre cladding sheets were installed. The removal of the plywood cladding revealed damage to the: Sisalation wrap; insulation; and the structural features.

The builder was contracted to install the cement fibre cladding sheets - and to replace the damaged structural features, Sisalation wrap and insulation. The Works also entailed the removal of the damaged plywood cladding, structural features, Sisalation wrap and insulation. The Works: did not entail the re-designing of the wall and other structural features; and involved merely replacing existing cladding, structural features, Sisalation wrap and insulation. The choice of material for the replacement cladding was based on cost (being the least expensive option), function and its appearance. The structural features, Sisalation wrap and insulation were replaced with the like for like. The deposit for the Works was paid to the builders on XXXX for $X and three progress payments of $X each were paid in XXXX, plus $X for Extra Repairs required to the structure discovered post removal of the damaged cladding sheets paid on X. In total, the repairs cost (i.e. with respect to the Works, covering damaged cladding and consequential damage to structural features, Sisalation wrap and insulation) totalled $X. The Taxpayers carried 50% of the costs, being $X each

Income Tax Assessment Act 1936 section 25-10

Summary The cement fibre sheets would not enhance the essential function of the cladding in these circumstances such that this work would be considered an improvement, rather than repairs, for the purposes of section 25-10 of the ITAA 1997. The replacement of the damaged structural features, Sisalation wrap and insulation with like for like constitutes repairs in this context. Consequently, the expenses incurred in replacing plywood cladding with cement fibre cladding, structural features, Sisalation wrap and insulation is deductible in the year in which the expenditure was incurred. Detailed reasoning Section 25-10 of the ITAA 1997 provides that expenditure incurred for repairs to premises held or used solely for the purpose of producing assessable income are deductible in the year in which the expenditure was incurred. The meaning of 'repairs' and the circumstances under which repairs are deductible, as set out in Taxation Ruling TR 97/23 Income tax: deductions for repairs, is applicable.

'Repairs' for the purposes of section 25-10 of the ITAA 1997 relates to the making good of defects, damage or deterioration that has occurred by ordinary wear and tear, by accidental or deliberate damage or by the operation of natural causes, to restore the efficiency of function of the premises (or part of premises), without changing its character. Repair is restoration by renewal or replacement of subsidiary parts of a whole. Renewal or reconstruction of the whole, as distinguished from repair, is restoration of the entirety. Relevantly, the Commissioner accepts, as determined in W Thomas and Co Pty Ltd v. FC of T 155 CLR 58, the roof of a building is not considered an entirety: 117. In the W Thomas & Co case , where the High Court considered deductions claimed for repairs to guttering, the roof, walls and two floors of a building, the view was taken that the whole building was the entirety. Windeyer J said (at 115 CLR 66; 14 ATD 83) that the relevant question is not:

' ... whether the roof or the floor or some other part of the building, looked at by itself, was repaired as distinct from being reconstructed or replaced. It is whether what was done to the roof or the floor or some other part was a repair of the building.' Whether the work undertaken constitutes repair is a question of fact and degree and an exercise of judgement. This involves a process of evaluating and weighing a range of factors for the particular circumstance. Factors that may be relevant in determining whether the work is repair include: •       The condition of the building at the time of acquisition. •       The purpose of the work - for example: -      whether it is to restore the building to its former appearance, form, state or condition; -      whether it is to prevent future defects in, damage to, or deterioration of a building; or -      whether it is to remedy or make good a defect in, damage to, or deterioration of a building that existed at the time of acquisition. •       The outcome of the work - for example: -      whether the work changes the character of the building; or -      whether the work affects the efficiency of function of the building.

The key consideration is whether the work does more than restore the character or function of the building - as per TR 97/23, the use of different materials and improved technology will not in themselves cause the work to be considered an improvement: Restoration of efficiency of function of the property 88. The High Court of Australia (Windeyer J) said in W Thomas & Co Pty Ltd v. FC of T (1965) 115 CLR 58 at 72; (1965) 14 ATD 78 at 87: 'The words "repair" and "improvement" may for some purposes connote contrasting concepts; but obviously repairing a thing improves the condition it was in immediately before repair. It may sometimes be convenient for some purposes to contrast a "repair" with a "replacement" or a "renewal". But repairs to a whole are often made by the replacement of worn-out parts by new parts. Repair involves a restoration of a thing to a condition it formerly had without changing its character. But in the case of a thing considered from the point of view of its use as distinct from its appearance, it is restoration of efficiency of function rather than exact repetition of form or material that is significant.

Whether or not work done upon a thing is aptly described as a repair of that thing is thus a question of fact and degree.' (emphasis added) 89. It is therefore more significant in applying the word 'repairs' in its context in section 25-10, to consider whether the work restores the efficiency of function of the property for income purposes (without changing its character) than it is to consider whether the appearance, form, state or condition of the property is exactly restored. Use of different materials 48. If expenditure is incurred in replacing or renewing a part of property with a material of a different type from the original, the work done may either repair the property, or be an improvement to it. The use of different materials is not in itself determinative of the issue. 49. Whether the use of a more modern material to replace the original material qualifies as a repair is a question determined on the facts of each case. It is restoration of a thing's efficiency of function (without changing its character) rather than exact repetition of form or material that is significant.

50. If the work done restores a previous function to the property, or restores the efficiency of the previous function, it does not matter that a different material is used. Even if the work done using different material enables the property to perform its function marginally more efficiently, the work may still constitute a deductible repair. However, the greater the work enhances the efficient functioning of the property, the more likely it is that the work constitutes an improvement. 51. The test is whether there is a sufficient degree of improvement to justify characterising the expenditure as capital and therefore excluding it from deductibility under section 25-10. 52. If the work produces a new and different function, or an additional function, it is likely to constitute a capital improvement. Technological advances or enhancements

53. As a general proposition, the greater the degree of technological advancement involved in work done to property, the more it is likely the work goes beyond a 'repair'. This is so because it is more likely the work does more than restore the property to its original efficiency of function. If it does, the cost of the work is not deductible under section 25-10. (It might be deductible under section 8-1 if the cost is a working or operating expense and it is not of a capital nature.) 54. If, however: a)    the work done to property involves: (i)    a degree of technological advancement that results in only a minor and incidental improvement to the property; or (ii)   an enhancement arising from the use of more modern materials and component parts (often where original materials and parts are no longer available) that adds in only a minor and incidental way to the overall efficiency of function of the property; and b)    the work done does not change the property's character; this does not in itself preclude the expenditure from being characterised as repair expenditure deductible under section 25-10.

In accordance with TR 97/23, the Commissioner accepts that 'repair' in this context contemplates a minor and incidental, and not a substantial, degree of improvement - in the sense that the improvement happens in fortuitous or subordinate conjunction with the repair work and it is inconsequential: Functionality of the property on which the work is done 90. In considering whether work does more than restore property to its original efficiency of function, what is determinative is the functionality of the property on which the work is being done and not the functionality of the defective component or part. That is not to say, however, that the effect of the work on the functionality of the defective component or part is not relevant. It is a relevant factor to take into account in considering the extent of change made to the functionality of the property.

91. To illustrate, if cast-iron pistons in an engine are replaced with aluminium-alloy pistons, being a more modern material for the construction of pistons, the determining question is whether the functionality of the engine has been restored or has only been enhanced in a minor and incidental way. However, any greater efficiency of function of the pistons is a relevant consideration in deciding that question. Expenditure in replacing the pistons is deductible under section 25-10. The engine's essential efficiency of function has not changed. Nor has the character of the engine changed by the use of marginally more efficient pistons. The aluminium-alloy pistons are marginally more efficient because they are lighter, hardier and are machined differently to produce less friction. FC of T v. Western Suburbs Cinemas Ltd (1952) 86 CLR 102 (Western Suburbs Cinema) illustrates the circumstances in which the work to the subsidiary can be taken to be an improvement that is capital in nature, as referenced in TR 97/23: 110. In the Western Suburbs Cinemas

case, the ceiling of a motion picture theatre was in a state of disrepair. To restore the ceiling to its original condition would have cost #603. The company instead replaced the ceiling with a new one of a different design and better material for a cost of more than #3,000. The High Court (Kitto J) concluded that the new ceiling was an improvement to a fixed capital asset and that its cost was a capital charge. His Honour said at 86 CLR 105; 9 ATD 454: ... In this case, the work done consisted of the replacement of the entire ceiling, a major and important part of the structure of the theatre, with a new and better ceiling. The operation seems to me different, not only in degree, but in kind, from the type of repairs which are properly allowed for in the working expenses of a theatre business. It did much more than meet a need for restoration; it provided a ceiling having considerable advantages over the old one, including the advantage that it reduced the likelihood of repair bills in the future ... . The truth is, I think, that the new ceiling was an improvement to a fixed capital asset and that its cost was a capital charge.'

In making this finding, the court observed that the nature of the work involved more than merely replacing the ceiling material: The architect came to the conclusion that it was really impossible to repair the ceiling at all. Ten Test was not available, but it does not appear that celotex, which was the Australian rival to Ten Test, or another material of a similar kind, caneite, was unobtainable. However, the architect would not use any material of this type for the ceiling, because experience had satisfied him that it was unsatisfactory for that kind of work. He employed, not fibro, but fibrous plaster, and with that he covered the whole area formerly covered by Ten Test and lattice. The fibrous plaster was affixed to new battens, which in turn were fixed to new ceiling joists: and the result was an entirely new ceiling. Fibrous plaster has a much longer life than the celotex type of material; it is harder, and it also lends itself better to decorative treatment and can be moulded. The new ceiling cost more than 3,000 pounds.

The advantage of reducing the likelihood of future repair bills is to be viewed in the context that only part of the ceiling was in need of repair but the taxpayer chose to replace the entirety. The new battens, joists and material significantly enhanced the performance of the ceiling and reduced the likelihood of repairs being required Application in these circumstances. The Taxpayers have incurred expenses in undertaking the Works, that is, in replacing the plywood cladding with cement fibre cladding, structural features, Sisalation wrap and insulation. The Commissioner accepts that 'repair' in this context contemplates a minor and incidental, and not a substantial, degree of improvement.

The replacement of plywood cladding with cement fibre cladding (a different material and technology), may result in some improvement over a plywood cladding. However, there is an insufficient degree of improvement to justify the characterisation of the expenditure as capital. Any improvement happens in a fortuitous or subordinate conjunction with the repair work and it is inconsequential. Cement fibre sheets would not enhance the essential function of the cladding in these circumstances (which is to prevent damage to the interior caused by exposure to the elements) to such a degree over and above that which may be expected of plywood cladding such that this work may be considered an improvement rather than repairs for the purposes of section 25-10 of the ITAA 1997. The work will not amount to an improvement: •       The damaged plywood sheets are being replaced in such a way to ensure the efficacy of the cladding and with regard to the overall appearance of the cladding. •       The cement fibre cladding did not require the installation of new supporting structural components (beams etc.)

•       Whereas cement fibre sheeting maybe a minor improvement in terms of reducing repairs, it costs no more over the life of the cladding and does not require any significant changes to the structure/design. •       Cladding sheets in areas not exposed to the environmental elements and rain were not replaced. In these circumstances any reduced likelihood of future repair bills (as the cement fibre sheeting may be better suited for the environment) is not determinative and would not apply to render what is otherwise repairs, capital in nature. The replacement of the damaged structural features, Sisalation wrap and insulation with like for like are repairs for the purposes of section 25-10 of the ITAA 1997 as they merely make good the damaged existing structural features, Sisalation wrap and insulation. Consequently, the Taxpayer is entitled to a deduction under section 25-10 if the ITAA 1997 for the Works, being expenses incurred in replacing the plywood cladding with cement fibre cladding, structural features, Sisalation wrap and insulation.