Income tax: depreciation effective life

This Ruling discusses the methodology used by the Commissioner of Taxation in making determinations of the effective life of: • plant under section 42-110 of the Income Tax Assessment Act 1997 ('the Act'); and • horticultural plants under section 387-177 of the Act.

The effective lives of these assets determine the rate at which deductions are allowed for them under the depreciation and horticultural plant write-off provisions.

The Commissioner is proposing to make written determinations pursuant to sections 42-110 and 387-177 of the Act. These effective lives to be specified by the Commissioner in those determinations are contained in Tables A and B of the attached schedule.

This Ruling and determinations apply to taxpayers who choose to use the Commissioner's determinations of effective life to work out the amount of their deduction. Taxpayers who do not use the Commissioner's determinations must make their own estimate of effective life (see sections 42-100 and 387-175 of the Act).

This Ruling applies from the date of effect of the proposed determinations of effective life shown in Tables A and B of the attached schedule.

The determinations will apply to: • plant you first use (or install ready for use and hold in reserve) for the purpose of producing assessable income, after 30 June 2000; and • horticultural plants you first use (or hold ready for use) for the purpose of producing assessable income in a horticulture business, after 30 June 2000.

Taxation Ruling IT 2685 is withdrawn as of 1 July 2000.

The effective lives of plant set out in the schedule attached to Taxation Ruling IT 2685 continue to apply to plant you used (or installed ready for use and held in reserve) for the purpose of producing assessable income, prior to 1 July 2000.

The Commissioner advised the Review of Business Taxation chaired by John Ralph AO that we would progressively update and expand the effective life schedule attached to Taxation Ruling IT 2685 to ensure it is as representative as possible.

Whilst we have now completed the first phase of the update, a complete revision will take some time to complete. As a result, we have repeated most of the determinations of effective life in Taxation Ruling IT 2685, although we have eliminated the earlier practice of rounding lives to whole years. We will review these determinations as part of the ongoing work on the update.

The review of Taxation Ruling IT 2685 improves on it by: • restructuring it; • removing duplicate, inappropriate and redundant items; • reviewing, and, where appropriate, updating the effective lives of assets; and • including new assets.

For instance, we have reviewed individual assets such as computers and transport containers and changed their effective lives. We have also considered groups of assets used by the power, gas, dairy, cinema and timber industries. This has resulted in the removal of many redundant items. Further work is continuing on the determination of the effective lives of plant used by these and other industries.

The review is based on extensive enquiries made by the Australian Taxation Office ('ATO'), the Australian Valuation Office ('AVO') (which is now part of the ATO) and, in some instances, reports prepared by independent consultants.

Also, Taxation Ruling IT 2685 applies only to plant. Table A of the schedule attached to this Ruling contains the first determinations of effective life for horticultural plants. We explain these later.

Business income arises from two sources: • net annual flows from business activities associated with the use of business assets and liabilities; and • the change in the market value of those business assets and liabilities.

Subject to tax timing rules for income recognition, increases in the market value of assets and decreases in the market value of liabilities add to business income while decreases in the market value of assets and increases in the market value of liabilities reduce business income.

The current taxation system, as it applies to depreciation deductions, already recognises the change in market value in working out taxable income. In particular, recognising that the loss of market value in most depreciable assets cannot be directly measured, it allows the write off of plant to be based on an estimate of effective life.

Effective life is defined in section 42-105 of the Act for taxpayers who choose to self-assess. It is the estimated period plant can be used by any entity for income-producing purposes, assuming: • it will be subject to wear and tear at a rate that is reasonable to assume; and • will be maintained in reasonably good order and condition.

The estimated period is intended to reflect an appropriate allowance for the diminution of economic value of that asset over its period of use i.e., the consumption of the asset's service potential.

Where the estimate is incorrect, the balancing adjustment provisions ensure, in those cases where depreciable assets are disposed of, that the actual loss in value over the period of use is allowed as a deduction.

For the purposes of section 42-110 of the Act, the Commissioner estimates the effective life of plant on the basis set out in paragraph 18.

The Commissioner's determination involves the consideration of the following factors (which are not intended to be exhaustive). No one factor is necessarily conclusive and the weight given to each factor will vary depending on the nature of the asset. In considering these factors the Commissioner can only take account of normal industry practices.

The factors are: • where the asset is actively traded in a secondary market, conditions in that market; • where the asset is not actively traded in secondary markets, economic or financial analysis indicating the period over which that asset is intended for use; • obsolescence; • the way in which the asset is used by an industry; • the use of the asset by different industries; • the level of repairs and maintenance commonly adopted by users of the asset; • retention periods; • industry standards; • scrapping or abandonment practices; • the past experience of users of the asset; • the manufacturer's specifications; • engineering information; • if the asset is leased, the period of the lease; and • the physical life of the asset.

The defining character of a wasting asset such as plant is that its market value actually falls, or is expected to fall, over time. An analysis of the market value of an asset class therefore, where there is a deep secondary market, is an important factor in ascertaining the likely future consumption of an asset's service potential. For many depreciable assets, however, the lack of secondary trading requires that their effective lives be approximated less directly.

An obsolete asset is one that is redundant or out of date. This may occur for both commercial and technological reasons. For instance, market demand for the goods produced by the asset may cease through consumer preference or Government regulation. The raw material the asset processes may become unavailable. Technology may advance so that the asset is no longer suitable for the purpose for which it was designed.

The point to note about technological advances, however, is that we do not necessarily consider that the asset's effective life has ended with each technological advance. A taxpayer can still use an asset for income producing purposes even though a newer model has come on to the market. Obsolescence is only relevant if it prevents the continued use of the asset for income producing purposes. This is best evidenced by the scrapping of the asset.

There are two types of obsolescence - that which can be predicted at the time the asset is first used (predictable) and that which emerges later (unpredictable). Clearly the Commissioner can only take account of predictable obsolescence when making an estimate of effective life. Even then, the Commissioner would only take it into account if it can be predicted with a high level of certainty across the majority of users.

Taxpayers faced with predictable obsolescence which impacts only on their business may choose to work out the effective lives of the assets themselves.

In addition, taxpayers can now work out a new effective life under section 42-112 of the Act where facts emerge (unpredictable obsolescence) during the life of the asset that mean it must be scrapped before its originally estimated effective life has ended.

The use of an asset by different industries is an important factor. For example, the effective life of an ordinary car is different from the effective life of a car used as a taxi. This reflects the increased wear and tear experienced by a car used as a taxi. This approach will continue.

The retention period is the period any one taxpayer generally holds an asset. It is only relevant to the Commissioner's determination if, after disposal, the asset can no longer be used by anyone for income producing purposes. That is, the effective life of an asset is its total income producing life.

The total income producing life is not necessarily the period a particular taxpayer expects to hold the asset before replacing it. For example, it is common practice for some businesses to dispose of their cars after the cars have done a fixed number of kilometres. The effective life of the car does not end then because, at that point, the car is still capable of being used for income producing purposes.

Once a taxpayer has scrapped or abandoned an asset there is a presumption it can no longer be used by anyone to produce income. We would expect scrapping to reflect either physical exhaustion or obsolescence. A taxpayer may abandon an asset if it is too difficult or costly to remove from its place of operation at the end of production.

These factors are only relevant to the Commissioner's determination of the effective life of an asset if we can establish a general scrapping or abandonment practice across users of the asset. Evidence that one group of users traditionally scraps an asset while others do not will not be sufficient to establish the asset as one that is generally scrapped for the purpose of the Commissioner's determination. However, taxpayers within the group that scrapped the asset could choose to work out the asset's effective life themselves.

The factors outlined above are essentially the same factors taxpayers should adopt if they choose to work out the effective life of plant themselves rather than adopt the effective life specified by the Commissioner. There is, however, one critical difference.

As mentioned in paragraph 22, the Commissioner can only take account of normal industry practices when estimating the level of use and wear and tear associated with an item of plant. However, taxpayers who choose to self-assess can take account of their own particular circumstances of use.

The Commissioner can only determine the effective life of new assets. The purchaser of a second-hand asset, who decides its second-hand condition justifies a shorter life than that determined by the Commissioner, can self-assess. A taxpayer who self-assesses the effective life of an asset acquired after 11.45 am, by legal time in the ACT, on 21 September 1999 is no longer required to assume that it is new.

The rates listed in Taxation Ruling IT 2685 were accelerated. Accelerated rates now only apply to small business taxpayers who satisfy the conditions in Subdivision 42-K. Those rates will continue to apply until the proposed Simplified Tax System for small business taxpayers takes effect from 1 July 2001.

For all other taxpayers, for plant they acquire or commence to construct after 11.45 am, by legal time in the ACT, on 21 September 1999, accelerated rates have been removed and the amount of the depreciation deduction is determined by the effective life of the plant: see section 42-118 and subsections 42-160(3) and 42-165(2A) of the Act. Taxpayers work out the rate as part of calculating their deduction under subsection 42-160(3) if they are using the diminishing value method and subsection 42-165(2A) if they are using the prime cost method.

The tables in the schedule attached to this Ruling contain only effective lives. Rates have not been included. Working out a rate is no longer a separate step in the process, but has been incorporated into the calculation formulas.

Table A of the attached schedule is an industry table which contains assets under industry headings that have, where possible, been drawn from the Australian New Zealand Standard Industry Classification (ANZSIC) subject categories. It lists assets that are peculiar to particular industries or for which a special effective life is justified because of the use to which those assets are put by a particular industry. Table B is an asset table which contains generic assets which may be used by more than one industry.

We have set out the Commissioner's estimate of effective life against each listed asset. Adopting this new structure allows the removal of many duplicated items. For example, in Taxation Ruling IT 2685, we have listed motor vehicles both individually and under various industry headings. In this schedule we have only included them in the asset list. We would only include them in an industry list if we were to give them a different rate for use in that industry.

We have marked new items and items we have reviewed with an asterisk *.

If we have listed a specific asset under a relevant industry heading in the industry table and also in the asset table, then you should use the industry table if you are a member of that industry.

Under some industry headings there is a listing for 'general plant'. These listings cover groups of assets. They usually apply to manufacturing plant and represent an average for the group. You should only use them for your manufacturing assets that are not specifically listed for your industry or in the asset table.

We inserted most of the listings for general plant a number of years ago and we will, therefore, be progressively reviewing them as part of updating the Commissioner's determinations.

If you cannot find an asset under your relevant industry heading or in the asset table, you will need to work out its effective life yourself.

Many of the items that appear in Taxation Ruling IT 2685 do not appear in the attached schedule. Generally, we have removed them because no effective life is set for them or the asset is no longer used for income producing purposes.

We have listed all items that we have removed in Tables C to F of the schedule attached to this ruling. For easy identification, we have listed them exactly as they appear in Taxation Ruling IT 2685. These tables do not contain determinations made by the Commissioner. We have divided assets that we have removed into four categories: • non-depreciable assets; • assets for which a deduction was allowed using the replacements method; • assets for which there were previously statutory rates; and • redundant assets.

There are approximately 50 assets listed in Taxation Ruling IT 2685 for which no effective life is set. Most were listed for the purpose of advising that no depreciation is available for them because they are not plant (e.g., they are livestock governed by the trading stock provisions or buildings or structures) or, in one case, because the taxpayer leased the plant (see boot and shoe-making machinery leased by taxpayer).

We have removed these assets because their listing in a Commissioner's determination of the effective lives of assets is inappropriate. The schedule is confined to the determinations the Commissioner is authorised to make under sections 42-110 and 387-177 of the Act i.e., determinations specifying the effective life of assets.

Table C of the attached schedule lists the assets we have removed because no effective life is set for them.

It has been a longstanding practice to permit taxpayers to treat the initial purchase of certain assets as not depreciable but to claim an immediate deduction for the cost of their replacement. The practice principally relates to low cost items that have very long or indeterminate lives, are difficult to keep track of, and are subject to frequent replacement through loss or breakage e.g., crockery.

Taxation Ruling IT 2685 contains approximately 100 entries for assets the cost of which is only deductible on a replacements basis. There are a further 17 assets where we offer the replacements basis as an alternative to an effective life write-off.

In 1991 an immediate write-off was introduced for assets costing $300 or less or having an effective life of less than 3 years. We considered that the replacements arrangement for assets in this category was no longer appropriate (see paragraph 63 of Taxation Ruling IT 2685).

The immediate deduction will not apply to plant acquired on or after 1 July 2000 except for small business taxpayers. For all other taxpayers, for plant acquired after 1 July 2000, it will be removed and replaced with a system that allows assets costing less than $1,000 to be pooled and written off over an effective life of 4 years using the diminishing value method (see Subdivision 42-M).

The Government has announced a Simplified Tax System for small business taxpayers to apply from 1 July 2001. That system will remove previous accelerated rates and the $300 immediate deduction. It will also allow eligible taxpayers who decide to use it an immediate write-off for any tangible depreciable asset which costs less than $1,000, and a pooling arrangement for tangible depreciable assets which have effective lives of less than 25 years (which can be depreciated at the rate of 30%).

For these reasons, the replacement basis for deductions will not be available for assets you first use (or install ready for use and held in reserve) for the purpose of producing assessable income after 30 June 2000.

We have completely removed replacement only assets. For those assets for which replacements are offered as an alternative, the effective life remains but we have removed the replacement option. A list of assets for which replacements used to apply appears in Table D of the attached schedule.

In Taxation Ruling IT 2685, under the 'building and construction industry' heading, we give loose tools an effective life of 5 years, with the option of using the replacement basis. Elsewhere, we simply list them as replacements and do not suggest an effective life.

In the schedule attached to this Ruling, we list loose tools in all cases as having an effective life of 5 years.

There are two asset categories for which statutory rates have applied automatically without having to ascertain effective life. They are employee amenities and assets used for scientific research. For the reasons discussed below, these rates now have little or no application and we have, therefore, removed from the schedule the items to which they pertain. We have listed those items in Table E .

Employee amenities are plant used mainly for providing clothing cupboards, first aid, rest-room or recreational facilities, meals or facilities for meals for employees or their children. Their depreciation rate is 33% prime cost and 50% diminishing value (see section 42-150 of the Act).

These rates are not linked to the effective life of the plant and they are clearly set out in the Act. They now only apply to small business taxpayers. For all other taxpayers, for plant they acquire or commence to construct after 11.45 am, by legal time in the ACT, on 21 September 1999, these rates have been removed and the depreciation rate is determined by the effective life of the plant.

For both of the reasons above, we have removed the entries relating to employee amenities. Taxpayers will need to work out the effective life of plant that is no longer covered by the statutory rate.

For plant used only for scientific research in the fields of natural or applied science the prime cost rate is 33% and diminishing value rate is 50% (see section 42-145 of the Act). However, these rates only apply to plant acquired before 1 July 1995. Therefore, we have also removed entries in the schedule relating to them.

We have listed in Table F , which is for information purposes only, those assets in Taxation Ruling IT 2685 which we have so far identified as redundant.

We consider an asset is redundant if it is: • no longer used for income producing purposes (e.g., accounting machines, drays, wagons, buggies); • no longer manufactured (e.g., radiograms); or • in the process of being overtaken by technology (e.g., gramophone records, which have been largely replaced by compact discs).

If a taxpayer requires an effective life for an asset that we have removed on the basis that it is redundant, they can work out the effective life themselves.

A special write-off of the capital expenditure attributable to the establishment of a horticultural plant is available under Subdivision 387-C. The write-off rate depends on the plant's effective life.

Taxpayers have the choice of using the Commissioner's determination of effective life or of working out their own effective life (see section 387-175 of the Act). Prior to this Ruling, the Commissioner had not made any determinations of the effective lives of horticultural plants.

In determining the effective lives specified in the schedule attached to this Ruling, the Commissioner has used the definition of effective life prescribed for taxpayers who self-assess. That is, the effective life of a horticultural plant is the period for which the plant could reasonably be expected to be used for the purpose of producing assessable income in a horticulture business (see sections 387-170 and 387-175).

The attached schedule specifies the effective life for some of the most common commercially grown horticultural plants. An effective life has been specified for: • apples; • avocados; • citrus fruit; • mangoes; and • pears.

The methodology used to establish the effective life of horticultural plants involved the formulation of a questionnaire that went to establishing both the physical life of the plant and factors affecting the length of commercial production.

The questionnaire was sent to horticulturalists employed by relevant State Government Departments, industry/grower associations and individual growers.

We canvassed issues such as the varieties and location of plants grown, the age planted out, the years required to come into production and the number of years production was anticipated.

We also investigated crop management techniques. Two of the most important factors we considered were the processes of topworking and reworking which mean that trees are cut back to the stump. In both these cases we consider the effective life of the tree has ended. With reworking, where a new variety is grafted onto the old root system, we consider that a new plant has been established and a taxpayer is entitled to claim a deduction for the costs involved in that process on the basis that a new plant has been established with a new effective life.

Other factors which we considered, and which are reflected in the effective lives specified for horticultural plants, are the impact of consumer demand for new varieties and the move to higher density planting. Both of the factors have the ability to shorten commercial lives.

The effective lives specified in the schedule attached to this Ruling apply to plant you first use (or install ready for use and hold in reserve) for the purpose of producing assessable income after 30 June 2000.

We chose this date of effect for two reasons: first, it matches the time when a depreciation deduction is first allowable (see sections 42-15, 42-100(2) and 42-110(2) of the Act) and secondly, it prevents taxpayers from gaining an advantage through bringing forward the purchase of capital assets under review.

It is important to understand how the date of acquisition of plant and its date of first use may each, independently, affect the amount of the deduction.

In the following examples, all the taxpayers chose to use the effective life specified by the Commissioner and none are small business taxpayers as defined in Subdivision 960-Q.

John acquires an asset for $10,000 after 30 June 2000 and commences to use it for income producing purposes. If he chooses to adopt the effective life specified by the Commissioner, he must use the appropriate effective life specified in the schedule attached to this Ruling (and not the effective life specified in the determination attached to Taxation Ruling IT 2685).

His deduction is based on the effective life of the asset. It is worked out in accordance with the calculation formula in either subsection 42-160(3) (if he is using the diminishing value method) or subsection 42-165(2A) of the Act (if he is using the prime cost method).

Betty acquired an asset on 10 September 1999. She uses it for private purposes prior to 30 June 2000 and then commences to use it for the purpose of producing assessable income for the first time after that date.

If she chooses to adopt the effective life specified by the Commissioner, she must use the effective life specified in the schedule attached to this Ruling (and not the effective life specified in the determination attached to Taxation Ruling IT 2685). She should then work out her deduction using the accelerated rates and calculation process that applied at the time of acquisition, 10 September 1999.

We have consulted industry bodies and interested taxpayers during the course of the review. In addition, the items marked with an asterisk in the attached schedule have been reviewed by an independent panel comprising a representative from the Taxation Institute of Australia, the Corporate Taxpayers Association, The Treasury, The Australian Valuation Office and the Australian Taxation Office.

Below is a detailed table of contents for this draft Ruling: Paragraph What this Ruling is about 1 Class of persons/arrangement 4 Date of effect 5 Previous Rulings 7 Explanations 9 Context of Commissioner's review 9 Basic Principles of Depreciation 15 How does the Commissioner determine the effective life of plant? 21 Market Value 24 Obsolescence 25 Use of the asset by different industries 30 Retention period 31 Scrapping or abandoning the asset 33 Working out your own effective life 35 Rates 38 Structure 41 How to use this schedule 44 Removal of items listed in Taxation Ruling IT 2685 48 Non depreciable assets 50 Replacements 53 Loose tools 60 Division 42 statutory rates 62 Employee amenities 63 Scientific research 66 Redundant assets 67 Horticultural plants 70 Date of effect of determinations for plant 79 Consultation 87 Detailed contents list 88 Your comments 89 Attachments page 16 Table A - Effective lives (Industry Categories) page 16 Table B - Effective lives (Asset Categories) page 39 Table C - No effective life set page 49 Table D - Replacements page 52 Table E - Statutory rates page 57 Table F - Redundancies page 58

We invite you to comment on this draft Taxation Ruling. We are allowing 3 weeks for comments before we finalise the Ruling. Comments by Date: 9 June 2000 Contact Officer: Helen Duffy E-Mail Address: Helen.Duffy@ato.gov.au Telephone: (07) 32135085 Facsimile: (07) 32136300 Address: Box 10284 Adelaide St P.O. Brisbane QLD 4000