Income Tax Consequences On Rental Property – Case Study

General Expenditure

In the present case apartment was procured by Anna for $595000. In order to pay the amount of house loan of $400000 was taken by her and the remaining was paid by cash from her savings. Consequently, she had listed the property for rent. Further, the apartment was rented for $450 per week for 50 weeks. For the same agent has charged commission of 10% in order to administer property. Along with this, some more expenses were incurred by Anna for maintenance and repairing of apartment since she desires to repair all the things before tenants shift in the house. The legal issue in the present case is to recognise which expenses should not be included in the tax and which are not.

In accordance with assertions of Bankman, et.al, (2018), section 8-1 of Income Tax Assessment Act 1997, the general deduction is defined as a loss which has a connection with activities related to generation of income, and is not considered as personal exertion, private or domestic deduction. In addition to this, it also asserts that expenses which have been incurred for producing assessable income can be deducted from same to the extent it has been applied in order to produce or gain assessable income (Brydges and Yuen, 2018). Further, as per Australian Taxation Office provision expenses which can be claimed as immediate deduction are council rates, insurance, repair and maintenance, property agent fees and commission, etc.

Black (2018) asserts that, a method regarding deduction of capital expenditure incurred is given under the section 43 of ITAA 1997. In accordance with same, deduction is available for constructing, modification or improvement in the building in order to produce income. Further, Bauer and Kourouxous (2017), specifies that, deduction can be availed on the basis of actual cost incurred. Apart from this, it is specified in the section that construction costs can be deducted in some cases that are buildings or expansions, modification or enhancement of building, structural enhancement and modifications to structural upgrading. In present case the camera which has been newly built has been capitalized with the cost of building as same leads to improvement and has been added in order to produce assessable income.

As per assertions of Mumford (2017), section 25 (1) of Income Tax Assessment Act 1997, the expenditures related to borrowing money to the level the money is used with intention of producing reckonable income. In case the estimation of actual cost is not possible than quantity surveyor can or independent specialised individual can be hired. The same is can be observed in present case as the construction costs was recognised by quantity surveyor. Along with this, under this section expenses are specified which are deductible for example expenditures related to taxes, borrowing expenditures, expenses concerning discharging a mortgage and so on. The same will be applied in present case of Anna that is amount paid for loan application as well as the interest will be deducted from the income as immediate deduction on specified expenditure is available to the assessee.

Capital Expenditure deduction

Under the division 40 of Income Tax Assessment Act 1997 the deductions for decrease in value of depreciating assets are accessible. As per study of McCluskey (2018), the decrease in value can be estimated through spreading the cost of asset over its effectual life. Further, depreciation can be calculated either by two methods that are prime cost and diminishing value approach. In present case prime cost method has been applied for ascertainment of depreciation. Furthermore, relating capital expenditure has been added to the cost of house i.e. legal fees, security camera and stamp duty.

In the case law of Lindsay v Federal Commissioner of Taxation , high court, Kitto J embraced that expenses which are incur to renovate a slipway was a restoration of an entirety, as under section 53 of Income Tax Assessment Act 1936 repair was not deductible. As per study of Freebairn (2016), the basis on which the decision is passed considering slipway to be an individually identifiable capital item, preserving its own utility. Significantly whole of the old slipway has been destroyed and substituted by a new one, including all new parts, was a restitution of a separately item and not a repair. Moreover, the same principal will applied in the present case also as the chipped tiles was replaced by Anna. The tiles are capital items which are recognisable individually with their own function and hence an entirety in themselves. Thus, their replacement is considered as replenishment of an entirety. By taking into consideration the same it is concluded that expenses which are incurred through Anna on repairing the house will not be deducted from tax. Hence, with accordance to the section 25-10 of ITAA 1997, this expenditure is not deductible.

Particulars	Note	Amount in $
Rental Income	1	22500
Estate Agent Commission for management		2250
Interest on loan	2	18000
Replacement cost of cupboard due to dishwasher malfunctioned	3	400
Insurance Expenses	4	1153
Depreciation	5	61599.5
Brisbane City council rates		2400
Replacement of chips		990

Per week rental income is $450 and house has been rented for 50 weeks.

Total Income for the year is $450 *50 i.e. 22500

Interest on loan is deductible expenditure whether the property has been rented or not, thus the whole amount will be deducted.

Replacement cost of cupboard will not lead to enhancement in quality and will work in same manner as it previously does; hence same has been treated as general expenditure and not capital expenditure.

Depreciation

Estimated Life	10
Total Cost	616595
For present year	616595
Working Note of Cost of House
Purchase Cost of House	595000
Security camera	295
Legal Fees	900
Stamp duty	19800
Loan application fees	600

There are few tests which have to be applied for determining the residency status for the individual taxpayers, which are described below –

• Reside test – If the person resides in Australia, then he/she considered as a resident of Australia for the purpose of tax. Further if the individual fulfils this criterion, then there is no requirement to apply any other test.

However, if the reside test does not satisfied by the individual then the person considered as the resident only if they fulfils at least one of following test, which are described below –

• The domicile test – A person is considered as a resident under this, if he/she has the permanent resident within the Australia.
• The 183 days test – If the person resides in Australia for more than half of the income year either for a continuous period or in part, then he/she is regarded as the resident of Australia.
• The superannuation test – In this case, the individual is considered as the resident even if they do not generally reside in Australia. This test is applicable for the employee who working outside the Australia for the government of Australia.

The board has made the number of observation and recommendation to the government with the view of improving the residency system in the Australia. The residency rules are prepared in the year 1930, since then only few amendments were incorporated. The environment has been changed significantly from the year 1930; therefore the rules underestimate the integrity of the income tax system of the country.

The recommendation of the board in new residency rules is described below –

• Eliminate the obsolete idea such as domicile.
• It must be simple and easy to understand, so that the normal individual can apply the residency rule test.
• It should be as per the current universal work practice.
• It must give the confidence to individual about their residency status.

In the UK the person is considered as the resident in the following situation –

• Automatic residence test  – An individual is automatically considered as a resident of the UK, if

1. They spend at least 183 days in a tax year. or
2. If they have resident home in the UK and spends at least 30 days in the home, or
3. Engaged in the job work in the UK
4. If a person dies in the tax year and in the previous three year he/she is the resident and also had the resident house, then he/she considered as the resident of the UK.

Interest

Further if the person did not satisfy the automatic residence test, then he/she considered as the resident after fulfilling the conditions described under the sufficient ties test.

• The Sufficient ties test – This test is based on the combination of the factors which is connected with the individual of the UK along with the duration spends in the UK.  Country tie, family tie, work tie, accommodation tie, and 90 day tie are some factors, which are taken into account for determining the residency rules.

The residency rules of the Australia already stated above. By comparing the residency rule of Australia and UK, it has been evaluated that both the rules contains a significant difference. The UK residency rules are as per the modern global environment, while the residency rules of the Australia obsolete and not as per the current work practices.

The current residency rules must amend which reflect the modern work pattern of the country. The income tax residency rule must be in such a manner which addresses the goal of simplicity, efficiency, integrity and equity in the taxation system. The definition and the criteria of the residency should start with the number of days by which the individual can determine the residency status easily and also it gives the certainty. The new rule regarding the government servant should include in the act, by which the position regarding the government officials can be effectively determined.

As per the Australian tax law, any person may claim the deduction of the expenses that is directly related with the work. For claiming the work related expenses it is essential that the expenses must be incurred by the individual themselves and not reimbursed by any other person. Along with this, it must directly relate with the income which is earned. The assesse must maintain the record for establishing the fact of incurrence of expenses. Further if the expenses related with the private as well as for working purpose, then the deduction is allowed to the extent which is related with the working purpose. In other words, it can be said that deduction of the personal nature expense is not allowed for computing the assessable income.

In case of employment, all the expenses related with the generating employment income and other income is allowed to the extent it is not reimbursed by the employer or any other person. Further in case of business, an individual can claim the deduction of the expenses incurred for generating the assessable income, or the expenses which are essential for carrying out the business.

A good tax system must contain the system of horizontal and the vertical equity. In case of the horizontal equity the person in the similar economic circumstances should be treated equally. In laymen language, the person who has the same income then same tax rate should be applied.  On the other hand, in case of vertical equity the person who has more money should pay the more tax. The Australian tax system is very complex and inequitable; therefore it is not easily understand by any individual. Many people due to the lack knowledge are not claim the deduction of expenses. Therefore it is concluded that Australia’s deduction regime for individual taxpayer does not satisfies the principle of a good tax system.

The government of UK also provides various deductions from the income of the individual. All the expenses which are incurred by the assesse for generating the business income are allowed for the deduction. However the expenses related with the private purpose then the assesse is not allowed to avail the deduction. In case of the employment income, the expenses which are essential for generating the employment income are allowed to the assesse to the extent it is not reimbursed by the employer or any other person. Along with this, in UK government also provide the married couple allowance, pension plan scheme, charitable contribution expenses and so on.

Depreciation

In both UK as well as in Australia, the personal nature expenses are not allowed for computing the assessable income.

Negative gearing refers as a type of the financial leverage, in which the investor borrow money for investment for obtaining the return, however the income generated by that investment is less than the cost of maintaining the investment which includes the payment of interest and the amount of depreciation. In other words it can be said that an investment is regarded as the negatively geared if the income generated from the investment is less than the cost. Negatively geared property results in the net rental losses.

The treatment of the negatively geared investment is described as below –

• Interest on the loan is deductible from the investment income. If the income falls short then the interest may be deducted from income of other sources.
• The maintenance and petty expenses are also fully deductible.
• Deprecation is allowed as a deduction over the useful life of the asset and at the time of sale the difference between written dawn value and sale price treated as income or further deduction.

In case of the negative geared investment, assesse is allowed to avail the whole deduction even if the income of investment is less than the cost of expenses incurred. The negative gearing significantly impact on the saving as well as the investment decisions. If the assesse carefully choose the investment that is probable for the capital growth then the negative gearing may be the good strategy for creating the asset. Negative gearing motivates the people with tax avoidance by setting of the expenses from the income of other sources.

One of the big perks of United Kingdom has over the Australia is the lower rate of interest; it is believed that the Australia will proceed to be much more costly as compared to UK. Cost of living in Australia is high, it is because the Australia’s salaries are approx 30% more on an average,  but it is not true in reality. However, the UK is comparatively cheap, due to the main rationales of low prices of housing.Both the countries have their different rules when it comes to permanent residency, employment, visa, cost of living, housing and tax rules. In addition, the tax dollars differs between the two countries, the UK has VAT, while the Australia has GST. In Australia, the pros is of indirect taxes like GST, is amid lowest in the world. On the other hand, one pros that UK have in context with taxes, is that their National Health Service (NHS), is highly extensive as compared to the Medicare of Australia.

A negative geared property might turn out to be more neutral or geared in a positive manner as there is increment in rent, yet the crucial aspect that negative gearing benefits inline if the value of property increases from the viewpoint of investors. In Australia, the capital gain is not eligible tax till the time the property is sold, and then it will be eligible for tax, once again inducing the claim that it is in favour of rich landlords. Indeed, the negative gearing is more productive for taxpayers who are capable to earn higher incomes. Of course, the negative gearing deform housing market as a whole. It gives rise to over-investment as well as over leveraging within the real estate industry of Australia. Thus, the housing market of Australia can be made more fair and sustainable if these are mixed with changes held with capital gain tax thereby reforming the negative gearing. 

Repair and Maintenance Cost

Small businesses are eligible for the following capital gains tax (CGT) concessions on assets that are applied to carry out the business, these are mostly referred as active assets. The small business tax concessions are accessible of or if not a business runs sole proprietorship, partnership, trust or corporation, the main things to be considered is that business is principally categorized as small business and the activities they undertake. For the purpose of tax, the businesses are categorized as a small business enterprise, if they meet the criteria of operating a business for each or part of the income year or not more than aggregated turnover of $10 million.Additionally, to the Capital Gain Tax exemptions and, rollovers as well as exemptions are highly accessible. There is presence of key four concession that enable the small business entity to either disregard or defer certain or all capital gain from the active assets employed in small business namely; 15-year exemption, 50% active asset reduction, Retirement exemption and Rollover. The small business CGT concessions are technically developed to enable business owners of eligible assets to full or in a partial manner decrease the tax to be paid on the sale of the specified asset.

Tax concessions for taxpayers of small business are considered as a significant aspect of the Australian Taxation System. There are multiple policy reasons that underpin these concessions, some of them aims at decreasing the burden of tax compliance, while some offer tax relief to support the success of business or to provide business higher accessibility of funds during retirement, and the remaining are meant to satisfy the mixture of these objectives. Preferably, the tax policy of small business in Australia will show a holistic approach, wherein small business policies are established and are considered as independent, thereby supporting the overall public policy in the favour of small businesses, in which one of essential elements is tax.  The current regime meets the objectives of targeting the concessions with affordability, tax concessions generally engage a considerable commitment of community expects and public funds, and these does not surpass the limits of policy objectives. These also reduce complexity and eliminate distortions that come with inconsistencies in the broader policy objectives.

It can be concluded that the proposed changes and amendments are based on integrity rule developed to avoid the taxpayers from using the concessions for those assets which are not related with their small business, for example the arrangement of affairs so that their interest in ownership with larger business do not add up to the tests of identifying the eligibility meant for concessions. These further amendments are necessary to avoid the SBCGT Concessions used by taxpayers with considerable wealth which is not consistent with the policy intention.The solution of considering reliable CGT assets that is adequately linked with the viable small business conducted by taxpayer can result in integrity improvisation and provide opportunity to government for simplifying rules and thereby decrease the tax costs as well as compliance.  There must be integration of three further basic conditions that are; a further technical concern of the capital gain tax small business entity test, application of a modified CGT small business entity version with the test of $2 million turnover or modified $6 million greatest net asset value test at the value of company and calculation of the test of active asset once again by making use of modified rules.

In the Australia, it is stated that the income shifts by the multinational companies is a considerable consideration that is required to be addressed by tax reform. The non capability of internal tax rules to keep up with the changes in the worldwide business scenario place an important risk to the corporate tax base of Australia. In addition, rapid increase in the digital economy and the rise in the significance of intangible assets pose challenges to the tax base of corporations for all jurisdictions inclusive of Australia. The Parliament of Australia has passed the legislation in the past three years to restrict the transfer pricing rules regarding the cross-border transfer pricing in regards with income tax law. Further, these rules aim to need multinational companies to consider pricing of intra-group products and services among the associated parties to showcase the contribution towards economy of their Australian operations effectively by implementing the arm’s length principle. The Government of Australia and tax administrators have tightened up the Thin Capitalisation rules, and the existing tax system of Australia is continuing to be robust globally in the prevention of tax avoidance.

In Australia, the methods of transactional profits seems to be preferred by most of the multinational companies and most of the companies tend to consider the Advanced Pricing Arrangements (APAs) from the Australian Taxation Office to assist the identification of transfer prices on fixed time period. The implementation of transactional profits methods as well as Advanced Pricing Arrangements have come up with concerns in the committee regarding the comparatively less profitability level and related tax to be paid by the subsidiaries of Australia. Although, a profit based method was believed to the most suitable method to use the arm’s length principle, particularly a Transaction Net Margin Method. The tax reduction methods applied by MNC are recognized very well for decades these are inclusive of transfer pricing, lower-tax jurisdiction use, over-charging business entities in countries to decrease taxable profit and finishing a transaction legally. These actions and methods have been considerably facilitated the digital economy and an increase in the intangible asset value.

The current strategy adopted by the Australian Government for tax avoidance is the requirement of proper public disclosure of tax affairs and potential tax avoidance.  This strategy needs the public disclosure ofcountry by country reporting of company tax affairs (CbCR), this crucial aspect came from the action plan of OCED based on Base Erosion and Profit Shifting (BEPS). It will make increment in the tax transparency by needing the company to consider particular disclosure on the payable tax in different countries. It will enable any of the party to examine and interpret how the companies transfer profit from the jurisdictions of high to low tax. In doing so, it will be complex for corporations to cover their tax affairs and avoidance while offering jurisdictions and movement for the public to the force tax avoiders.  This strategy was highly not in favour multinational firms based on the commercial sensitivity of the information, the tax burden and compliance and that it may the perceptions of the true economic contribution by the company. Constantly, the government is improvising the tax information disclosure to the ATO and is considering the development of new rules to need tax advisors to make reporting to possibly aggressive tax planning schemes. Thus, these rules will offer the ATO a further strategy to mitigate the usage of aggressive tax planning schemes.

References

Books and Journals

Bajada, Christopher. Australia’s Cash Economy: A Troubling Issue for Policymakers: A Troubling Issue for Policymakers. (Routledge, 2017).

Bankman, Joseph, Daniel N. Shaviro, Kirk J. Stark, and Edward D. Kleinbard. Federal Income Taxation. (Aspen Casebook, 2018).

Blunden, Hazel. “Discourses around negative gearing of investment properties in Australia.” Housing Studies 31, no. 3 (2016): 340-357.

Braithwaite, Valerie. Taxing democracy: Understanding tax avoidance and evasion. (Routledge, 2017).

Chardon, Toni, Brett Freudenberg, and Mark Brimble. “Tax literacy in Australia: not knowing your deduction from your offset.” Austl. Tax F. 31 (2016): 321.

Davidson, Peter, and Ro Evans. “Fuel on the fire: Negative gearing, capital gains tax & housing affordability.” ACOSS Papers (2015): 29.

Gastwirth, Joseph L. “Measures of Economic Inequality Focusing on the Status of the Lower and Middle Income Groups.” Statistics and Public Policy 3, no. 1 (2016): 1-9.

Herbert, Tanja, Pia Olligs, and Michael Overesch. “Public Disclosure of Foreign Subsidiaries and International Tax Avoidance.” (2016).

King, David. Fiscal Tiers (Routledge Revivals): The Economics of Multi-Level Government. (Routledge, 2016).

Long, Brendan. “A taxing issue: Reflections of Christian economists on tax reform in Australia.” St Mark’s Review 235 (2016): v.

Marian, Omri. “The state administration of international tax avoidance.” Harv. Bus. L. Rev. 7 (2017): 1.

McMillan, Kate. “‘Affective integration’and access to the rights of permanent residency: New Zealanders resident in Australia post-2001.” Ethnicities 17, no. 1 (2017): 103-127.

Pawson, Isla. “Reframing Australia’s housing affordability problem: The politics and economics of negative gearing.” Journal of Australian Political Economy, The 81 (2018): 121.

Saad, Natrah. “Tax knowledge, tax complexity and tax compliance: Taxpayers’ view.” Procedia-Social and Behavioral Sciences 109 (2014): 1069-1075.

Sadiq, Kerrie, and Stephen Marsden. “The small business CGT concessions: Evidence from the perspective of the tax practitioner.” Revenue Law Journal 24, no. 1 (2015): 6743.

Sharkey, Nolan. “Coming to Australia: Cross border and Australian income tax complexities with a focus on dual residence and DTAs and those from China, Singapore and Hong Kong-Part 1.” Brief 42, no. 10 (2015): 10.

Sheridan, Naomi, and Elaine Lee. “Tax changes on the horizon for expatriates working in Australia.” Governance Directions 67, no. 7 (2015): 428.

Steen, Adam, and Victoria Peel. “Economic and social consequences of changing taxation arrangements to working holiday makers.” J. Austl. Tax’n 17 (2015): 225.

Yuan, Helena. “Mid market focus: The sharing economy and taxation.” Taxation in Australia 51, no. 6 (2016): 293.

Online

Chapter 3 – Parliament Of Australia 2018.  Aph.gov.au <https://www.aph.gov.au/Parliamentary_Business/Committees/Senate/Economics/Corporate_Tax_Avoidance/Report%20part%201/c03>

Proposed Amendments To Small Business CGT Concessions – Throwing Out The Minnows To Catch The Whale – Too Much “Collateral Damage” 2018. Hall & Wilcox <https://hallandwilcox.com.au/proposed-amendments-small-business-cgt-concessions-throwing-minnows-catch-whale-much-collateral-damage/>

Residency Tests 2018. Ato.gov.au <https://www.ato.gov.au/Individuals/International-tax-for-individuals/Work-out-your-tax-residency/Residency-tests/>

Small Business CGT Concessions 2018. Ato.gov.au <https://www.ato.gov.au/General/Capital-gains-tax/Small-business-CGT-concessions/>

Tax Avoidance By Multinational Companies: Methods, Policies, And Ethics (Updated On August 29, 2018) 2018. Global Business – Economic & Cultural Commentaries <https://globalbusiness.blog/2016/05/05/tax-avoidance-by-multinational-companies-methods-policies-and-ethics/>

Tax Avoidance By Multinational Enterprises—Australian Government Initiatives To Avoid Erosion Of Corporate Tax Base – Parliament Of Australia 2018. Aph.gov.au https://www.aph.gov.au/About_Parliament/Parliamentary_Departments/Parliamentary_Library/pubs/BriefingBook44p/TaxAvoidance