Small business entities should review their depreciation for tax purposes following Government stimulus measures

The Federal Government’s 2020 stimulus measures have provided significant incentives for businesses to undertake capital expenditure on the purchase and improvement of depreciating assets. The stimulus measures have been introduced in stages with different rules applying to small business entities. Therefore, significant complexity now exists in navigating these rules creating both opportunities and traps for small businesses.

Issues for small business entities

Four separate capital allowance stimulus measures apply from 2 April 2019 to 30 June 2022. While these provisions have complex interactions within themselves, depending on the circumstances small business entities have additional interactions to consider as they are specifically excluded from some of these measures. They also have additional opportunities to write-off assets through the general small business pooling rules, which can include older assets first used or installed before any of these measures being announced. It is important to consider how these rules apply to small business entities, as the rules can apply differently to those that are not small business entities.

What are the rules about?

Broadly, the Federal Government stimulus measures enacted since 2019 relating to capital allowances allow:

• For entities with an aggregated turnover of less than $50 million– Full deduction for the cost of depreciating assets first used or installed between 2 April 2019 and 12 March 2020 for assets costing up to $30,000 (the instant asset write-off).
• For entities with an aggregated turnover of less than $500 million– Full deduction for the cost of depreciating assets first used or installed between 12 March 2020 and 30 June 2021 for assets costing up to $150,000 (the expanded instant asset write-off).
• For entities with an aggregated turnover of less than $500 million– Accelerated deduction (50% in the first year) for the cost of depreciating assets first used or installed between 12 March and 30 June 2021 with no limit on the cost of the asset (the 50% backing business investment incentive).
• For entities with an aggregated turnover of less than $5 billion– Full deduction for the cost of depreciating assets first used or installed between 6 October 2020 and 30 June 2022 (the temporary full expensing).

This staggered introduction has resulted in the overlapping application of some of these measures with the temporary full expensing measure generally taking priority for assets first used or installed after 6 October 2020, unless a specific exclusion applies.

Further, each measure has specific rules regarding the time of acquisition, commitments already entered into (e.g. contracts to purchase the asset entered into before the application date), second-hand versus new assets, and whether the asset needs to be used for the principal purpose of carrying on a business.

It may therefore become a complex task to navigate these provisions to determine the correct treatment of capital expenditure for tax purposes.

This article does not seek to outline these interactions in detail. Rather, it seeks to highlight issues relating to small business entities in particular.

What are small business entities?

An entity is a small business entity for an income year if it carries on a business and has an aggregated turnover of less than $10 million in that income year. It can also be a small business entity if it carried on a business in the current and prior income year and had an aggregated turnover of less than $10 million in the prior year.

Aggregated turnover includes the global turnover of all entities that are “connected with” or “affiliates” of the entity, whether or not that turnover is assessable in Australia.

Note that the recent budget measures which increased the aggregated turnover threshold for certain small business entity concessions from $10 million to $50 million did not change the $10 million threshold for the small business depreciation rules (i.e. in terms of defining who is classified as a small business entity for those provisions).

Simplified depreciation rules for small business entities

Subdivision 328-D contains simplified tax depreciation rules for small business entities that have two main features:

• The general small business pool.
• The Instant asset write-off for small business entities.

The pooling rules allow most depreciating assets to be added to a general small business pool with 15% of the asset’s cost deducted in the year the asset is first used or installed and a 30% deduction of the pool balance at the start of an income year (subject to some adjustments).

For assets acquired below a certain cost, instead of allocating the asset to the general small business pool, the full cost may be deducted. This cost threshold has over time been $1,000, $20,000, $25,000, $30,000, $150,000, and unlimited depending on when the asset was first used or installed.

A small business entity also writes off the balance of their pool once it is below a relevant threshold.

For the 30 June 2020 income year, this threshold is $150,000 while the threshold is unlimited for the 30 June 2021 and 30 June 2022 income years. Accordingly, small business entities can obtain access to this write-off for older assets sitting in the pool.

The key thing to note is that a small business entity must elect to use Subdivision 328-D to access the simplified depreciation rules. If it does so, it must apply all of the rules contained in Subdivision 328-D.

That is if it wants to access the instant asset write-off for small business entities it must also adopt small business pooling.

What if a small business entity does not elect to use simplified depreciation?

If the entity elects not to use simplified depreciation, it will use the normal tax depreciation rules applicable to other taxpayers.

However, it is critical to note that the instant asset write-off and expanded instant asset write-off for medium-sized business (for assets costing up to $30,000 or $150,000 as outlined above) is expressly not available for small business entities.

Therefore, if a small business entity did not elect to use simplified depreciation in the 2020 income year (which would require it to adopt the small business general pool that year), it would not be able to access the instant asset write-off under any provision and would instead be required to depreciate the asset for tax purposes over its effective life.

It is therefore critical that a small business entity makes the election to use small business depreciation in the appropriate labels in the relevant tax return to access the instant asset-write off for assets that would not qualify for temporary full expensing (i.e. those first used or installed before 6 October 2020).

Note that the 50% backing business investment incentive and temporary full expensing measures are available to small business entities regardless of whether they elect to use simplified depreciation.

What is the 5-year preclusion rule?

A small business entity does not have to use the simplified depreciation rules. Ordinarily, if the simplified depreciation rules were previously used and the entity is a small business entity in a later year and chooses not to use them, then it is unable to use the simplified depreciation rules for another 5 years. If so, the closing balance of the general small business pool will continue to be written off under the simplified depreciation rules in later years.

However, this restriction has been suspended from the 30 June 2015 year until the 30 June 2022 year such that a small business entity can elect back in to access the instant asset write-off and the general small business pooling rules where it otherwise would not be able to (e.g. if a small business entity chose not to use the simplified depreciation rules in the 2019 income year after previously using them, it will still be able to do so in the 2020 income year).

Transitioning to simplified depreciation for small business entities

If a small business entity elects into the simplified depreciation rules to access the instant asset write-off, the adjustable values (i.e. the tax written down values) of its existing depreciating assets at the start of the income year will be included in its opening pool balance allowing a 30% deduction to be claimed that year.

Importantly, this may create an opportunity to write off the total tax written down values of all depreciating assets brought into the general small business pool on 1 July 2019 for small business entities electing into simplified depreciation in the 2020 income year. This will be the case if those tax written down values and the cost of any new asset brought into the pool during the year (less the sale price of any depreciating assets sold during the year) is less than $150,000.

In the 2021 income year, as the threshold for the write-off of the general small business pool is unlimited, small business entities that elect into the simplified depreciation rules will essentially be able to write off the balance of their entire tax fixed asset register as at 1 July 2020, even if this is several million dollars.

Therefore, while the measures in the October Federal Budget were aimed at stimulating the purchase of new assets, the changes made for small business entities effectively for the acceleration of the tax depreciation for older assets purchased previously as well as the ability to fully write-off certain capital improvements made to older depreciating assets.

While there may be some compliance costs associated with updating the tax fixed asset register in order to adopt simplified depreciation for the first time, there may be substantial tax savings available by doing so.

Exclusions from simplified depreciation including leased assets

Leased asset arrangements

Some depreciating assets are excluded from the simplified depreciation rules for small business entities.

These include capital works, existing low-value or software development pools, assets for which R&D tax incentives have been claimed, certain second-hand assets used in residential property, certain primary production assets, and assets that are being let (or might reasonably be expected to be let predominantly) on a depreciating asset lease.

“Depreciating asset lease” is a broadly defined concept. It essentially covers any arrangement under which a right to use or possess the asset is granted to another entity (related or unrelated). The only exclusions are those for hire purchase agreements and short-term hire agreements (i.e. for the intermittent hire on an hourly, daily, weekly or monthly basis where there is no substantial continuity of hiring to the same or related entities for longer than a short-term basis). The rule applies to all lease arrangements, not only related party ones. Accordingly, a “fit-out” under a property lease undertaken by a lessor that is a small business entity that may otherwise qualify for Division 40 depreciation could fall into this exclusion.

Policy reason for the exclusion?

For small business entities that lease depreciating assets, this exclusion may create a significant trap. Effectively, for those assets first used or installed before 5 October 2020 (that the small business entity leases to another entity), the instant asset write-off will not be available to a small business entity under any provision. This is because the $30,000 and $150,000 instant asset write-offs for medium-sized businesses are not available for small business entities.

This may be an unintended outcome as there is no clear policy for allowing an entity with an aggregated turnover of $499 million to instantly write off the full cost of a particular asset that is leased while an entity with an aggregated turnover of $200,000 will not be able to do so in the same situation.

Interaction with the temporary full expensing and the 50% allowance

However, a small business entity can access the temporary full expensing measure such that this issue does not arise for assets first used or installed after 6 October 2020 if they are leased. Further, a small business entity can utilise the 50% backing business investment incentive for leased assets first used or installed between 12 March 2020 and 6 October 2020 to access some form of accelerated depreciation for leased assets.

What are some other differences between the various measures?

Second-hand assets

The 50% backing business investment incentive and temporary full expensing measures contain exclusions for second-hand assets which the instant asset write-off measures do not.

However, for entities with an aggregated turnover of less than $50 million (which will include small business entities), temporary full expensing will be available for second-hand assets, but the 50% backing business investment incentive will not.

Pre-commitment exclusion

For entities with less than a $50 million aggregated turnover, the “pre-commitment” rule will not apply for the temporary full expensing measure such that assets for which a contract to purchase was entered into before 6 October 2020 will still be able to be written off fully if the asset was acquired after 6 October 2020 (and it is first used or installed before 30 June 2022).

Carrying on a business requirement

While depreciation is generally available for tax purposes when an asset is held for a taxable purpose (e.g. to produce assessable income), the 50% backing business investment incentive and the temporary full expensing rules contain a “principal purpose of carrying on a business” requirement. Therefore, these measures may not be available for assets used predominantly for a non-business purpose. This may include certain passive investments (e.g. depreciating assets within a residential property) as well as assets with a large private use component (e.g. a car that will be used 40% for business purposes and 60% for private purposes).

However, the instant asset write-off is available for such assets as these do not have such a “business use” rule, at least to the extent that the asset used for a taxable purpose and not privately. That is, while a small business entity does need to be one that carries on a business, the depreciating asset does not need to be used in that business to qualify for the simplified depreciation measures (i.e. it merely needs to be used for a taxable purpose, a lower threshold than used in carrying on a business).

What are the next steps?

The rapid evolution of the tax depreciation rules over the last year have resulted in a complex maze of provisions that are difficult to navigate and contain traps as well as opportunities.

Critically, small business entities should consider how these rules affect them and whether they will need to elect into the simplified depreciation rules and adopt small business pooling to take advantage of accelerated deductions for their depreciating assets.

Contact your Pitcher Partners representative to review their situation and determine what action is required.