Deductions, Trading Stock and the Borderline Repairs
Ravi owns a small manufacturing business, Ravi's Widgets Pty Ltd, which is a resident small business entity with aggregated turnover of AUD 8 million. In the 2024 income year, the company incurred the following expenses: (1) AUD 120,000 to replace the roof of its factory, which was leaking and causing damage to machinery. The new roof is made of a different material with a longer life than the original. (2) AUD 15,000 to repair a machine that broke down due to a faulty part; the repair restored the machine to its original condition. (3) AUD 200,000 to purchase a new widget-making machine, which is expected to last 10 years. (4) AUD 50,000 for trading stock purchased during the year; opening stock was AUD 30,000 and closing stock is AUD 40,000. (5) AUD 10,000 in legal fees to defend a patent infringement claim. (6) AUD 5,000 in fines for breaching environmental regulations. Ravi also received a government grant of AUD 20,000 to assist with the purchase of the new machine. The company uses the accruals basis and is not a small business entity for the simplified depreciation rules? Actually it is a small business entity with turnover under AUD 10 million, so it can use simplified depreciation. Ravi is unsure whether the roof replacement is a repair or a capital improvement, and whether the grant is assessable income.
1. Classify each of the six expenses as deductible or not, and explain the reasoning, including the treatment of the government grant.
Read the worked answer
(1) Roof replacement: The cost of replacing the entire roof with a different material and longer life is likely a capital expense, not a repair, because it improves the asset beyond its original condition and is not merely restoring it (s 25-10 ITAA 1997). The fact that the roof was leaking and causing damage does not change the capital nature; it is a replacement of a capital asset. It may be deductible as a depreciation expense over the effective life of the roof under Div 40, but not as a repair. (2) Machine repair: Deductible under s 25-10 as a repair, as it restores the machine to its original condition and does not improve it. (3) New machine: Capital, deductible under Div 40 depreciation over its effective life (10 years), or immediately under the simplified depreciation rules if the company qualifies as a small business entity (turnover under AUD 10 million). Since turnover is AUD 8 million, it is a small business entity and can use the simplified depreciation rules: assets costing less than the instant asset write-off threshold (currently AUD 20,000 for 2024? Actually the threshold for 2023-24 is AUD 20,000, but for small business entities, the instant asset write-off threshold is AUD 20,000 for 2023-24, and AUD 20,000 for 2024-25? The threshold changes. The machine costs AUD 200,000, so it exceeds the instant write-off threshold; it goes into the small business pool and is depreciated at 15% in the first year and 30% thereafter, unless the company chooses to use Div 40. The grant of AUD 20,000 may reduce the cost for depreciation purposes? Under s 40-45? Actually a government grant that is assessable income may be included in assessable income, and the asset's cost is not reduced unless the grant is non-assessable non-exempt. If the grant is assessable, the cost is not reduced. If the grant is non-assessable, the cost is reduced. The grant is likely assessable under s 6-5 as ordinary income or under s 15-10 as a bounty or subsidy? It is a grant to assist with purchase, likely assessable as ordinary income if it is a business receipt, or under s 15-10. (4) Trading stock: The purchase of trading stock is deductible under s 8-1, but the value of trading stock at year-end must be accounted for under Div 70. The deduction for purchases is adjusted by the change in stock: opening stock AUD 30,000, closing stock AUD 40,000, so the deduction for purchases is AUD 50,000, but the increase in stock of AUD 10,000 is included in assessable income (or reduces the deduction). Effectively, the deduction is AUD 40,000. (5) Legal fees to defend patent infringement: Deductible under s 8-1 as a business expense, or under s 40-880? It is a revenue expense incurred in defending the business's intellectual property, so deductible. (6) Fines for environmental breaches: Not deductible under s 26-5 because they are penalties for breaches of the law. The government grant: likely assessable under s 6-5 as a business receipt, or under s 15-10 if it is a bounty or subsidy. It is not a gift because it is for a specific purpose. If it is assessable, it is included in assessable income. If it is non-assessable, it would reduce the cost of the machine. The better view is that it is assessable under s 6-5 as a receipt in the ordinary course of business, or under s 15-10. So it is included in assessable income, and the machine's cost is not reduced. The company can claim depreciation on the full cost.
2. Calculate the net effect on taxable income from the trading stock and the new machine, assuming the company uses the simplified depreciation rules and the grant is assessable. State any assumptions about the instant asset write-off threshold.
Read the worked answer
Trading stock: Opening stock AUD 30,000, purchases AUD 50,000, closing stock AUD 40,000. Under Div 70, the deduction for purchases is adjusted: cost of goods sold = opening stock + purchases - closing stock = 30,000 + 50,000 - 40,000 = AUD 40,000. So the net deduction for trading stock is AUD 40,000 (instead of AUD 50,000). Alternatively, the purchases are deductible under s 8-1, and the closing stock is assessable under s 70-35, and opening stock is deductible under s 70-35. The net effect is a deduction of AUD 40,000. New machine: Cost AUD 200,000. The grant of AUD 20,000 is assessable income, so it is included in assessable income. The machine is a depreciating asset. As a small business entity, the company can use the simplified depreciation rules in Subdiv 328-D. The instant asset write-off threshold for 2023-24 is AUD 20,000 (or AUD 20,000 for 2024-25? The threshold is AUD 20,000 for 2023-24 and AUD 20,000 for 2024-25, but for 2024-25 it is AUD 20,000? Actually the instant asset write-off threshold was AUD 20,000 for 2023-24, and for 2024-25 it is AUD 20,000? The 2024-25 budget proposed AUD 20,000. Let's assume the threshold is AUD 20,000, so the machine does not qualify for instant write-off. It is allocated to the small business general pool. The pool is depreciated at 15% in the first year, regardless of when acquired. So depreciation deduction = 15% of AUD 200,000 = AUD 30,000. The grant is assessable income of AUD 20,000. Net effect on taxable income: deduction for trading stock AUD 40,000, deduction for depreciation AUD 30,000, assessable grant AUD 20,000. Net deduction = 40,000 + 30,000 - 20,000 = AUD 50,000. But the grant may be non-assessable if it is a gift? No, it is a government grant for purchase of an asset, likely assessable. If the grant were non-assessable, the cost of the machine would be reduced by AUD 20,000 to AUD 180,000, and depreciation would be 15% of AUD 180,000 = AUD 27,000, and no assessable income. Net deduction = 40,000 + 27,000 = AUD 67,000. The question assumes the grant is assessable, so the first calculation applies. Also, the machine may qualify for the instant asset write-off if the threshold is higher (e.g., AUD 20,000 for 2023-24, but the machine is AUD 200,000, so no). If the company is a small business entity, it can also choose to use Div 40 instead of the simplified rules, but the question says it uses the simplified rules. Assumptions: the instant asset write-off threshold is AUD 20,000, so the machine is not immediately deductible. The pool rate is 15% in the first year. The grant is assessable under s 6-5. The net effect is a deduction of AUD 50,000. The roof replacement is capital and depreciated separately, but not included in this calculation.