Clarifying that certain building fit-out is depreciable property

Sections DB 65, EE 47(2) and YA 1 of the Income Tax Act 2007

Changes have been made to the Income Tax Act 2007 to clarify that fit-out of commercial and industrial buildings remains depreciable. The changes also clarify the meaning of "plant" and "building" for the purposes of the tax depreciation rules. A transitional rule has been included, allowing certain building owners to claim a deduction for an amount of building fit-out embedded in the tax book value of their building.

A key goal of the tax system, including the depreciation rules, is to tax different forms of investment as neutrally as possible to avoid distorting investment decisions. There are strong grounds, therefore, for depreciation rates to mirror economic depreciation (how assets fall in market value through time) as closely as possible. In this context, a distinction between the tax treatment of residential and non-residential building fit-out is justified on the grounds that building fit-out is likely to constitute a greater portion of the value of non-residential buildings than it is for residential buildings. Generally, non-residential fit-out is also less permanent than residential fit-out because of tenant-specific requirements and changes of use.

The new rules ensure that the fit-out of a non-residential premises remains depreciable property. The fit-out of residential premises remains generally non-depreciable. This is in line with the Commissioner's recently released interpretation statement, IS 10/01 "Residential rental properties - depreciation of items of depreciable property".

The depreciation treatment of fit-out in a building that has both residential and non-residential premises is determined by the dominant purpose of the building. If the dominant purpose of the building is non-residential, items that are shared for both purposes will be depreciable as commercial fit-out. If the dominant purpose of the building is one of providing private residential accommodation, the items of shared fit-out generally will be non-depreciable.

A consequential change has been made to clarify that the change-of-use rules are triggered when the dominant purpose of a building or premises changes between residential and non-residential purposes.

A transitional rule has also been introduced to enable certain building owners to claim a deduction for building fit-out that is embedded in the value of their building and when the building depreciation rate has been set at 0% as a consequence of Budget 2010.

Background

Following changes to the tax treatment of buildings in Budget 2010, it was considered timely for a review of the depreciation rules around fit-outs of commercial and industrial buildings.

The review was intended to bring greater clarity on the distinction between a building and building fit-out in the depreciation rules, given:

• The release of interpretation statement, IS 10/01, "Residential rental properties - depreciation of items of depreciable property", that discusses items that are part of a residential building. While the statement only applies to residential buildings, many of the principles are also likely to apply to commercial and industrial buildings.
• It may be uncertain when taxpayers can choose to apply depreciation rates that differ from the rate that applies to a non-residential building, particularly when in the residential context the Commissioner's view is that many of these items will be part of the building.

Application date

The changes apply from the 2011-12 and later income years.

Detailed analysis

Definition of "building"

The definition of "building", in subpart YA 1, has been amended for the purpose of the tax depreciation rules. The change is intended to ensure that the value of items of commercial fit-out do not form part of the value of a building for the purposes of the tax depreciation rules. The amended definition of building means that a building does not include commercial fit-out for the purposes of subparts EE and EZ.

Definition of "commercial fit-out"

A definition of "commercial fit-out" has been introduced in subpart YA 1. The definition clarifies that plant attached to a commercial building is generally an item of commercial fit-out and therefore can be depreciated separately from the building. An exception is when the item of plant is used inside a dwelling within the commercial building. The intention is for plant to be depreciable unless the item is used in residential premises.

The second limb of the definition of commercial fit-out is intended to exclude items holding up the building or used to weather-proof the building ("building core") from being a commercial fit-out. This makes the building core of certain buildings non-depreciable. For a building with an estimated life of 50 years or more, the non-depreciable building core includes foundations, the building frame, floors, external walls, cladding, windows, external doors, internal stairways, the roof and load-bearing structures associated with the building such as pillars and load-bearing internal walls. Further, under the new definition of commercial fit-out, items attached to the building used within residential premises are not commercial fit-out. However, attached items used in relation to a residential dwelling are commercial fit-out if the building is a commercial building.

Definition of "commercial building"

A definition of "commercial building" has been inserted in section YA 1. The definition is important to the definition of "commercial fit-out". A commercial building is one where the main use is for non-residential premises and any residential premises within the building are of a secondary and minor use. In most instances it will be obvious whether the main use of a building is to provide residential premises. However, if it is not clear what the main use of a building is, taxpayers will need to take a position based on their particular circumstances. One method for determining the building's main use could be to compare the area of the building that is used or set aside exclusively for residential accommodation with the remaining area of the building. In making this assessment, the taxpayer would need to consider how to allocate the shared areas (for example, lobbies, hallways and entranceways that commercial and residential tenants can normally access). If commercial and residential tenants have equal access to shared areas, one approach would be to count the shared areas as appurtenant to the residential accommodation and again as part of the rest of the building. However, in working out the most appropriate apportionment approach the particular circumstances of each building will be important.

The definition of "commercial building" helps to define the boundary for the tax treatment of items of fit-out that are used for both commercial and residential purposes ("shared fit-out"). The dominant purpose of the building determines the tax treatment of items of shared fit-out, as illustrated by the following examples.

Definition of "plant"

Plant does not include an item that is structural in relation to a building. This definition has been introduced in section YA 1 to clarify that if an item, or part of an item, of plant is integrated into the structure of a building then the item or part of the item will be non-depreciable if the building has an estimated useful life of 50 years or more. Without this definition, it would be possible to argue that parts of a building's structure are also within the meaning of "commercial fit-out", as they are items of plant, and therefore depreciable.

Items holding up the building or used to weather-proof the building are non-depreciable if the building has an estimated useful life of 50 years or more. In certain buildings some of these items may be specially constructed or strengthened to support, for instance, an item of plant. The definition of "plant" ensures for example, that a lift shaft is not treated as being part of the lift, as lifts are depreciable property and have an estimated useful life of 25 years. The definition of plant makes it clear that the estimated useful life of a lift shaft is not 25 years, but is the estimated useful life of the associated building or structure.

Change of use

In the unlikely event that a building changes its dominant use, section EE 47 has been amended to clarify that the normal depreciation change-of-use rules apply to the items of shared fit-out. Thus, if the dominant purpose of a building changes from commercial to residential, the items of shared fit-out will be deemed to have been disposed of at their market value. The reverse applies when the dominant purpose of a building changes from residential to commercial. That is, the items of shared fit-out will be deemed to have been acquired for their market value. In these instances the normal depreciation recovery or loss-on-disposal rules apply to the items of shared fit-out. In this instance the change of use is treated as occurring on the first day of the next income year. Therefore, taxpayers need to have a view on the dominant use of their building throughout the income year.

Definition of "dwelling"

A definition of "dwelling" has been added to section YA 1 to help set the boundary between commercial and residential premises. The first limb of the definition is very broad and means any place used predominantly as a place of residence or abode. However, paragraph (b) of the definition excludes certain premises and types of activities that are more commercial in nature and the fit-out of these premises is more likely to depreciate when used in an income earning process. The new rules recognise that there are commercial buildings that provide residential-type accommodation by excluding a number of these types of buildings from the meaning of "dwelling". This ensures that fit-outs associated with these buildings will continue to be depreciable. The types of buildings that are specifically excluded from the meaning of "dwelling" are:

• hospitals;
• hotels, motels, inns, hostels, or boarding houses;
• certain serviced apartments, where additional services are provided and where the resident does not have quiet enjoyment;
• convalescent homes, nursing homes, or hospices;
• rest homes or retirement villages, except places that are characterised as places of residence for independent living; and
• camping grounds.

Definition of "independent living"

A definition of "independent living" has also been included in section YA 1. In relation to rest homes and retirement villages a distinction has been drawn between serviced apartments and premises that provide residents with independent living arrangements. Fit-out associated with rest homes, hospitals, community centres and serviced apartments will generally continue to be depreciable whereas fit-out associated with premises that provide for independent living will generally be non-depreciable. Serviced apartments are generally distinguishable from premises providing for independent living because the occupancy arrangements typically require the resident to purchase a bundle of care services (such as medical supplies, nursing care, meals, cleaning, provision of linen and laundry) in addition to a right of occupancy in order to be entitled to occupy the premises. In this situation, the fit-out of the serviced apartment will continue to be depreciable property. However, if the only compulsory services supplied to the resident are merely incidental to the occupancy (such as gardening, maintenance, management and security services) the fit-out of the serviced apartment will not be depreciable.

Transitional rule

A transitional rule, new section DB 65, allows a deduction for building fit-out that is embedded in the tax book value of certain buildings. The transitional rule applies to building owners that acquired a commercial building in the 2010-11 or earlier income years and who have not itemised the items of commercial building fit-out, acquired at the same time as the building, separately from the building in their tax asset register. Any subsequent commercial fit-out acquired and separately depreciated after the date that the building was acquired reduces the amount of the deduction allowed under section DB 65.

The amount of the deduction is the lesser of 2% of the starting pool value or the residual value of the pool - taking into account all previous deductions taken under this provision. The opening value of the pool is 15% of the building's adjusted tax book at the end of the 2010-11 income year less the adjusted tax book value, at the end of the 2010-11 income year, of any fit-out associated with the building that has been separately depreciated for income tax purposes.

To reduce complexity and compliance costs there are no loss or recovery rules applying to the value of the pool when the relevant building or fit-out is disposed of. In the above example, the taxpayer is entitled to a deduction of up to $640 a year provided they own the commercial building. However, if the dominant purpose of a building changes from commercial to residential, no deduction is allowed under section DB 65, as subsection (1)(a) no longer applies to the building. However, the deductions would begin again if the building subsequently reverts to being a commercial building - provided the building ownership has been maintained.