Capital works: destruction - deduction and balancing calculations - reasonable reduction of balancing deduction

Is it reasonable to reduce an amount that would otherwise be deductible for undeducted construction expenditure under step 2 of section 43-250 of the Income Tax Assessment Act 1997 (ITAA 1997) by an amount based upon the period of time the capital works were not used, by any owner, in the way set out in Table 43-140 (current year use) of the ITAA 1997?

Yes. It is reasonable to reduce an amount that would otherwise be deductible for undeducted construction expenditure under step 2 of section 43-250 of the ITAA 1997 by an amount based upon the period of time the capital works were not used, by any owner, in the way set out in Table 43-140 of the ITAA 1997.

The taxpayer acquired a building during the 2003-04 income year. The building was not used for the purpose of producing assessable income prior to its acquisition by the taxpayer. The taxpayer moved into the property and used it as their residence.

During the 2004-05 income year the taxpayer decided to rent the building and listed it with a real estate agent. The taxpayer continued to reside in the building until the commencement of a tenancy agreement that was entered into during the 2005-06 income year.

Soon after the agreement commenced, the tenant, with the approval of the taxpayer, undertook demolition and renovation work to the property. As part of this process, structural features of the building were demolished. Minor electrical and plumbing work was also carried out at this time.

The taxpayer did not receive and was not entitled to receive any amount for the partial destruction of the property.

The building was capital works as set out under subsection 43-20(1) of the ITAA 1997 and was the taxpayer's 'your area' for the purposes of subsection 43-115(1) of the ITAA 1997. There was an amount of undeducted construction expenditure for the building when part of it was destroyed. The taxpayer satisfied the requirements to allow a deduction for the undeducted construction expenditure set out in paragraphs 43-40(1)(a) to 43-40(1)(c) of the ITAA 1997.

Broadly, subsection 43-40(1) of the ITAA 1997 provides that you can deduct an amount if all or a part of your area is destroyed in an income year and that the amount of the deduction is to be calculated under section 43-250 of the ITAA 1997.

The method statement in section 43-250 of the ITAA 1997 contains two steps.

Step 1 is to calculate the amount (if any) by which the undeducted construction expenditure for the part of the taxpayer's capital works that were destroyed exceeds the amounts the taxpayer has received or is entitled to receive for the destruction of that part. The taxpayer did not receive and was not entitled to receive an amount for the partial destruction of the capital works. Accordingly, the Step 1 amount will be the undeducted construction expenditure in respect of the part of the capital works that was destroyed.

Step 2 of the method statement reduces the amount of any deduction that may otherwise be available if, among other things, the taxpayer or another person was not allowed a deduction for the capital works under Division 43 of the ITAA 1997 (see paragraph (b) in Step 2 of the method statement in section 43-250 of the ITAA 1997). The reduction under Step 2 must be reasonable.

A deduction is not allowable under Division 43 of the ITAA 1997 where the capital works is not used in the way set out in Table 43-140 (current year use) of the ITAA 1997 (paragraph 43-10(2)(c) of the ITAA 1997).

The building was not used for the purpose of producing assessable income prior to its acquisition by the taxpayer. The taxpayer used the building as their residence until the commencement of the tenancy agreement. The building was used to produce assessable income (the required use as set out in Table 43-140 (Current year use)) from that time. The previous owners and the taxpayer were therefore not allowed a deduction under Division 43 of the ITAA 1997 in respect of the part of the capital works that was destroyed. Accordingly, Step 2 of the Method statement contained in section 43-250 of the ITAA 1997 requires the taxpayer to reduce the undeducted construction expenditure in Step 1 by a reasonable amount.

Section 43-250 of the ITAA 1997 was amended by the Taxation Laws Amendment Act (No. 1) 1998 in respect to Step 2 of the Method statement to the effect that 'the reduction under this step must be reasonable'. In discussing this amendment, the Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 5) 1997 explains that section 43-250 of the ITAA 1997 was being amended to:

Ensure that the amount of the balancing deduction is reduced to take account of any period during which the capital works were: • not used at all to produce assessable income; • used concurrently for income producing and other purposes.

Accordingly, it is reasonable to reduce an amount that would otherwise be deductible for undeducted construction expenditure under Step 2 of section 43-250 of the ITAA 1997 by an amount based upon the period of time the capital works were not used, by any owner, in the way set out in Table 43-140 of the ITAA 1997.