Depreciation & capital contributions

This section of the Budget 2010 Special Tax Report describes the proposed changes to the depreciation rules that, if enacted, will take effect between 21 May 2010 and the beginning of the 2011–12 income year. The Taxation (Budget Measures) Bill 2010, introduced on 20 May 2010, gives effect to these announcements.

The bill changes the depreciation rate of buildings with long estimated useful lives to 0%, and removes depreciation loading on items purchased after 20 May 2010. Additionally, the bill changes the treatment of capital contributions, so that recipients of these payments will have to choose either to treat the contribution as income spread over 10 years, or alternatively, reduce the tax book value of the subsidised assets. Finally, the bill introduces provisions to grandparent the treatment of buildings affected by the release by Inland Revenue of Interpretation Statement 10/02.

Background

The proposed changes are intended to make New Zealand’s tax rules more neutral and non-distortionary. Allowing depreciation on long-lived buildings and the application of depreciation loading on certain assets provides tax depreciation rates in excess of true economic depreciation rates. When this occurs, the tax rules can make an investment profitable when this would not be so in the absence of taxes.

The bill also changes the tax treatment of capital contributions. These contributions are generally not taxed even though businesses may be able to deduct, by way of depreciation, the full cost of any assets that the contributions have been used to pay for. This, in effect, is a tax subsidy.

Building depreciation

Currently, buildings with an estimated useful life of 50 years can be depreciated for tax purposes. However, analysis of New Zealand building price data between 1993 and 2009 shows that, on average, buildings have actually been increasing in value. This suggests that the current depreciation rate of 2% is not appropriate.

To address this concern, the bill sets a 0% depreciation rate for buildings with an estimated useful life of 50 years or more. This new rate will apply to all such buildings regardless of when they were purchased.

Grandparenting existing treatment of some buildings

Inland Revenue’s Public Rulings unit has recently released the interpretation statement Meaning of “building” in the depreciation provisions (IS 10/02). Under this statement, some items that were previously treated as structures will come within the meaning of “building”. This means there will be a change to the way these investments are treated for tax depreciation purposes.

On 30 July 2009, following the release of a draft of this interpretation statement, the Minister of Revenue issued a statement providing that the existing treatment of any affected structure acquired on or before the day of the announcement would be grandparented. To facilitate this grandparenting, the bill specifies that a “building” does not include these affected structures.

Depreciation loading

Under the current rules, depreciation loading increases the depreciation rate by 20% for qualifying items. This concession has been available for items purchased during or after the 1995–96 income year.

Depreciation loading was introduced as an incentive to encourage New Zealand businesses to invest in new capital equipment. However, this concession is inconsistent with a broad-based, low rate tax system, and the bill therefore seeks its removal from items purchased after 20 May 2010.

Capital contributions

A capital contribution is a subsidy or similar payment to a person that compensates them for some capital expenditure. A common example is a payment from a farmer to an electricity lines company towards the cost of connecting their farmhouse to the company’s network.

Currently, capital contributions are not taxable in the hands of the recipient as they are capital in nature. Additionally, the recipient may be able to deduct, by way of depreciation, the cost of the assets acquired with the capital contribution. In other words, the recipient can claim deductions for expenditure they have not borne the financial cost of.

The bill changes the tax treatment of capital contributions so that people who receive capital contributions will, in their tax return in the year the contribution is received, be required to elect either to treat the contribution as income, spread over 10 years, or alternatively reduce the tax value of the assets the contribution has been used to pay for. These new rules apply to capital contributions derived after 20 May 2010.

Key features

0% depreciation rate for certain buildings

• Under the changes in the bill, the annual depreciation rate for buildings will be set to 0% if they have estimated useful lives of 50 years or more, as determined by the Commissioner of Inland Revenue.
• The annual depreciation rate will also be set to 0% for certain buildings that are excluded depreciable property and that are similar to the types of buildings with estimated useful lives of 50 years, as these do not have estimated useful lives.
• This new rate will apply regardless of when a building was acquired.
• Building owners that have previously claimed a depreciation deduction on their buildings will still be required to pay depreciation recovery if they sell a building for more than its tax book value.
• To ensure that the policy works as intended, special depreciation rates will no longer be allowed for buildings and the definition of “temporary building” will also be amended.

Grandparenting existing treatment of some buildings

• Certain buildings that have been treated as structures and were purchased on or before 30 July 2009, will continue to be treated as structures for tax depreciation purposes.
• Any improvements to these buildings made after 30 July 2009 will not receive grandparented treatment.

No depreciation loading for assets acquired after 20 May 2010

• The bill removes depreciation loading for assets purchased after 20 May 2010.
• Depreciation loading will continue to apply to qualifying assets purchased on or before 20 May 2010.
• Any improvements to assets that continue to receive loading made after 20 May 2010 will have to be treated as a separate asset and will not qualify for loading.

New treatment of capital contributions

• The bill requires businesses who receive a capital contribution to choose how to treat the receipt for income tax purposes – either as income or as a reduction in their depreciation base. Different treatments can be elected for each capital contribution; however, once an election is made it may not be changed.
• If a business decides to treat a contribution as income, then it would return 1/10th of the contribution as taxable income every year for 10 years.
• If a business decides to reduce its depreciation base, it would reduce the tax book value of the relevant assets to the extent that they have been funded through the capital contribution.
• This proposed change only affects new capital contribution arrangements. It would not affect contributions derived on or before 20 May 2010.

Application date

The new rules for building depreciation will generally apply from the beginning of the 2011–12 income year. For most people this is 1 April 2011, but if you have had a different income year approved by the Commissioner of Inland Revenue, these would apply from that date. For taxpayers with an early balance date, this may be as soon as 2 October 2010.

Taxpayers will no longer be able to apply for special depreciation rates for buildings from 20 May 2010.

The new rules for depreciation loading will apply to all items for which a binding contract for acquisition or construction was entered into after 20 May 2010.

The new rules for capital contributions will apply to all contributions derived after 20 May 2010.

The rules providing the grandparenting of buildings affected by IS 10/02 will apply retrospectively from 30 July 2009.

Detailed analysis

The depreciation provisions are largely contained in subpart EE of the Income Tax Act 2007. The proposed rules for the new treatment of capital contributions are set out in new sections CG 8 and DB 64 of the Income Tax Act 2007.

Unless otherwise stated, all section references are to the Income Tax Act 2007.

0% depreciation rate for long-lived buildings

Annual rate for buildings with long estimated useful lives (clauses 77, 81, 85 and 86)

The bill amends sections EE 31 and EZ 13 to provide that buildings with an estimated useful life of 50 years or more will have an annual depreciation rate of 0% for tax purposes. This 0% rate is a statutory rate and overrides the rates set by determination.

The changes to section EE 31 apply to buildings acquired during or after the 1995–96 income year, while the changes to section EZ 13 apply to buildings acquired after 1 April 1993 but before the end of the 1994–95 income year.

These buildings will still be depreciable property, but with a 0% annual depreciation rate. This means that the other depreciation provisions, such as those providing for depreciation recovery still apply.

While the depreciation rate for these buildings will be set to 0%, the depreciation rate for items used in, but not part of, these buildings remains unchanged, and they will be able to continue to be depreciated separately from the building itself.

For residential rental properties, the interpretation statement Residential rental properties – depreciation of depreciable assets (IS 10/01) sets out how to determine whether an item is part of a building or separately depreciable.

For non-residential properties, the Government has indicated it will be reviewing which items can be depreciated separately from a building. If necessary, the tax rules will be amended before 1 April 2011 to clarify the law.

Repairs and maintenance

The proposed changes will not affect the deductibility of repairs and maintenance. While this can be a complicated matter, with the correct treatment often being a question of both fact and degree, some general guidance is set out below.

There is a two-stage approach to determine whether certain expenditure is deductible:

1. Identify the relevant asset – that is, is the item being repaired/replaced part of a larger asset (such as the roof of a house), or is it a single asset (for example, a television).
2. Ascertain the nature, extent and cost of the work undertaken. This will involve determining whether the work remedied wear and tear (generally deductible), or whether the asset has been improved or otherwise substantially changed (generally non-deductible).

In relation to step 2, some relevant factors are:

• If the expenditure does no more than restore an asset to its condition on purchase, it is likely to be deductible. This can hold even if the work is carried out over several years.
• This applies even if what is being replaced or repaired is improved – for example, because of new technology or better design, provided the work does not alter a substantial part of the asset.
• Expenditure on the renewal, replacement or reconstruction of a substantial portion of the asset goes beyond repair, and is generally not deductible repairs and maintenance.
• Work that results in a significant increase in an asset’s value, or is unusually expensive, is more likely to be considered capital in nature.

As discussed above, a building can have many different parts. Repairing or replacing something that forms part of a building, provided it does not substantially improve or alter value or function of the building, is likely to be deductible. If, on the other hand, a substantial amount of work is involved, or the building is improved in some way, it is likely that this will be non-deductible capital expenditure. For example, the replacement of a toilet that has fallen into disrepair in a residential house (which is part of the building as per IS 10/01) is likely to be deductible as repairs and maintenance. On the other hand, if the entire bathroom were to be re-designed and completely re-fitted, this is more likely to be a non-deductible capital improvement.

Definition of “building”

The bill only affects the depreciation rate of buildings – there is no proposed change to the depreciation rates for structures. What a “building” is, for the purposes of the depreciation provisions, therefore becomes important. The Commissioner of Inland Revenue’s view on this is set out in the recently released interpretation statement Meaning of “building” in the depreciation provisions (IS 10/02).

In essence, a building is a structure that has walls and a roof, is of considerable size, is meant to last a considerable period of time and is generally fixed to the land where it stands. For example, a house has the above features and so would be considered a building; however, a dam does not (it lacks walls and a roof), so would not be considered a building.

For more guidance on this issue, the interpretation statement IS 10/02 is available on Inland Revenue’s website, www.ird.govt.nz.

Interpretation of estimated useful life

An item’s estimated useful life is the estimated useful life for that type of item, as set out in a determination issued by the Commissioner of Inland Revenue. Additionally, when interpreting an item’s estimated useful life, the “whole of life” approach should be taken. For example, if a person purchases a second-hand item with an estimated useful life of 50 years, its estimated useful life will still be 50 years, regardless of how old the item actually is.

No special rate for buildings (clause 78)

The bill amends section EE 35(2) so that special depreciation rates would not be able to be set for buildings, regardless of their estimated useful lives. Special depreciation rates are granted in situations where a specific item’s economic depreciation rate is either faster or slower than the rate set by the Commissioner of Inland Revenue. This change would have effect from 20 May 2010.

The bill removes this ability to apply for special rates for buildings as allowing these would be inconsistent with the general view that buildings, do not on average, decline in value.

However, provisional depreciation rates will still be able to be set for classes of buildings. If the Commissioner of Inland Revenue issues a provisional rate for a class of building stating that it has an estimated useful life of less than 50 years, owners of affected buildings will be able to claim depreciation deductions.

Provisional depreciation rates are granted when there is no applicable rate for the type of item you own, excluding the default class. To have a provisional rate granted, you must satisfy the Commissioner that the building you own does not come within an existing asset category.

Applications for provisional rates can be made using the form IR 260A, available from Inland Revenue’s website at www.ird.govt.nz.

Special excluded depreciable property (clauses 82, 83, 96 and 99)

Section EE 67 will be amended to provide a definition for “special excluded depreciable property”. Special excluded depreciable property will be all buildings not listed in the proposed new schedule 39.

In practice, special excluded depreciable property will be buildings that were excluded depreciable property, and are similar to the current categories of building that have estimated useful lives of 50 years or more.

The asset classes listed in this schedule are from the depreciation rates issued by the Commissioner of Inland Revenue before 1 April 1993. In some cases, the names of these classes differ from those currently used in the depreciation determinations.

This definition of “special excluded depreciable property” is necessary because items of excluded depreciable property do not have estimated useful lives. It is therefore not possible to refer to these buildings using estimated useful lives.

0% annual depreciation rate for special excluded depreciable property (clause 81)

Section EE 61 is being amended with new subsection 7B, which will provide that the annual depreciation rate for items of special excluded depreciable property that are excluded depreciable property is 0%.

This statutory rate will override any depreciation rate issued by the Commissioner of Inland Revenue.

Buildings that are excluded depreciable property but not special excluded depreciable property would continue to be depreciated using the appropriate depreciation rates.

Change to the meaning of “temporary building” (clause 96)

Paragraph (a) in the definition of “temporary building” in section YA 1 will be repealed. This paragraph provides that a “temporary building” includes buildings issued under a permit by a local or public authority that stipulates that the building be removed or demolished at their request.

This will ensure the proposed changes work as intended, as otherwise building owners could claim that their building was a temporary building using this section of the definition.

Grandparenting existing treatment of some buildings

Certain structures purchased on or before 30 July 2009 not buildings (clause 96)

Amendments to section YA 1 will add a definition for buildings, which specifies that, in the depreciation provisions, “building” does not include a grandparented structure. This definition of “building” excludes “grandparented structures” from the common law meaning of “building”. This proposed definition is not intended to detract from the Commissioner’s interpretation statement IS 10/02 Meaning of Building. Instead, the definition is intended to grandparent investments, made before 30 July 2009, in certain types of structures from the depreciation rules applying to buildings.

This means these buildings will continue to be treated as structures for the purposes of the depreciation provisions (notwithstanding that they are buildings under the Commissioner’s interpretation statement IS 10/02). For example, their relevant depreciation rates will still be set using the double-declining balance method, and losses incurred on disposal will remain tax deductible.

The proposed definition of “grandparented structure” is an item on the following list, provided its owner acquired it, or entered into a binding contract for its acquisition or construction, on or before 30 July 2009:

(a) barns, including barns (drying)
(b) carparks (buildings)
(c) chemical works
(d) fertiliser works
(e) powder drying buildings
(f) site huts.

More detail on the types of items covered by the definition of “grandparented structure” can be found in IS 10/02, available on Inland Revenue’s website. For example, carparks (buildings) does not include a commercial building that contains carparks.

Some carparking buildings continue to depreciate

The proposed grandparenting of carparking buildings, described above, will mean that carparking buildings purchased on or before 30 July 2009 will not be subject to a 0% annual depreciation rate.

Improvements to grandparented structures building (clause 79)

Changes to section EE 37 provide that if a person owns a grandparented structure, and they make the improvements, or enter into a binding contract to make them, after 30 July 2009, then the improvement must be treated as a separate item.

This effect of this proposed amendment is that any new improvements to grandparented structures will be treated as buildings. This will mean, for example, losses on disposal on the improvements will not be available. In the case of carparking buildings, this will mean the annual depreciation rate of any improvements will be 0%.

Removal of depreciation loading

No depreciation loading for items purchased after 20 May 2010 (clauses 77 and 81)

The bill amends EE 31 with new subsection (3). This subsection will apply when a binding contract for an asset’s acquisition or construction is entered into after 20 May 2010, and provide that an asset’s annual depreciation rate is just its applicable economic, special or provisional rate, unless the item is a long-lived building or international aircraft.

This contrasts with existing subsection (2), which applies to assets for which a binding contract for acquisition existed on or before 20 May 2010. Under this section, many assets have an annual rate of their applicable economic, special or provisional depreciation rates multiplied by 1.2. This acceleration of depreciation rates is often referred to as depreciation loading.

Treatment of improvements (clause 79)

Amendments to section EE 37 apply if a person owns an asset that will continue to receive loading after 20 May 2010. It provides that if they make improvements to it, or enter into a binding contract to make improvements to it, then they must treat the improvements as separate items. Therefore, the annual depreciation rate for these improvements would be set by the proposed subsection EE 31(3) (Rate for item acquired after 20 May 2010).

The effect of this is that any improvements made to existing assets will not be eligible for depreciation loading. Such improvements will depreciate for tax purposes at the appropriate rate as set by the Commissioner of Inland Revenue.

New treatment of capital contributions

Capital contributions either income or non-deductible (clauses 75, 76 and 96)

New sections CG 8 and DB 64 set out a new tax treatment for capital contributions.

The bill amends the definition of “capital contribution” in section YA 1. Outside of section HG 11, a capital contribution would mean an amount that:

(i) is paid to a person (the payer) to a person (the recipient) under an agreement between them that is not a contract of insurance;
(ii) is paid by the payer other than in their capacity of settler, partner or shareholder of the recipient;
(iii) is not income of the recipient, ignoring section CG 8;
(iv) is paid, under the express terms and conditions of the agreement, as a contribution for depreciable property owned or to be acquired by the recipient.

Part (i) of this definition ensures that insurance pay-outs to cover the replacement of damaged assets do not fall within this definition, as they are not capital contributions. Part (ii) ensures that payments by settlers, partners or shareholders who are introducing capital into their own businesses in their capacity as owners are not included.

The proposed new section CG 8 provides that a capital contribution that a person receives is treated as income in the income year it is received and the nine following income years. The formula for calculating the amount that is income in each income year is set out in section CG 8(2). This is simply the amount of the contribution divided by 10.

Section CG 8 provides the default treatment. However, if a person elects, they could instead use the treatment in section DB 64. This election is provided because it was recognised that some businesses would have difficultly implementing section DB 64.

Section DB 64, applies when a person derives a capital contribution and would be allowed an amount of depreciation loss for the acquired assets. Subsection (2) provides that the amount of the capital contribution would be excluded from the item’s adjusted tax value, base value, cost, or value, as applicable, for the purposes of part EE (Depreciation). Essentially, this means the recipient would not be able to claim depreciation deductions to the extent that any acquired assets have been paid for by capital contributions.

Any election must be made in the recipient’s tax return for the income year in which the relevant capital contribution is derived. Each new capital contribution would require a new election, and the recipient can elect to treat different contributions differently. Once an election has been made in respect of a contribution, it would be unchangeable.

Effect on disposal (clause 80)

The bill amends section EE 48 so that, if a person has elected to apply proposed section DB 64, then the amount of the capital contribution is added to the calculation of subsection (1)(b) for the purposes of calculating depreciation recovery income.