Introduction

Capital gains tax (CGT) is not a separate tax but a provision to include capital income. It is a

form of statutory income as income of capital nature is not ordinary income. It is important to

correctly calculate the net capital gain or loss for the year in order to work out the assessable

income under s100-10. All sections discussed are being referred to Income Tax Assessment

Act 1997 (Cth), ‘ITAA 1997’, unless stated otherwise.

Purchase of investment property

On 1 February 2007, John purchased an investment property for $630,000. It is important to

determine the nature of this outgoing in order to decide whether a deduction is allowed. In the

case of Sun Newspapers1, Dixon J set out the criteria to draw distinction between an income

earning process and income earning structure:

i. Character of advantage sought,

ii. The manner in which the advantage is to be used, relied upon, enjoyed,

iii. Means used to obtain the advantage.

The first criterion is most important, as the outgoing is to purchase an investment property

that is used to generate income in the future. The outgoing of John provides an everlasting

benefit of rental revenue through a one-off payment of the purchase price, thus it will be an

income earning structure – capital nature. This leads us to conclude that the purchase price of

the investment property is not deductible as set out in the negative limbs of s8-1(2)(a). Under

that section, loss or outgoing of capital, or of capital nature is not deductible2.

Borrowing costs associated with the mortgage loan

Assume that the mortgage is for 20 years.

In order to purchase the investment property, John drew a mortgage loan from Oz Bank on 1

February 2007. He incurred borrowing expenses such as legal fees and mortgage

establishment fees which totalled up to $3,000. Under s25-25, expenditure incurred for

borrowings, where the borrowings are money borrowed in connection with deriving

assessable income (rental revenue in this case) are deductible. The borrowing expenses are

1 Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61CLR 337; 1 AITR 403.2 ITAA 1997 s8-1(2)(a).

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amortised over the period of the loan, which is stated at s25-25(5), the shorter of period of the

loan as specified in contract and a maximum of 5 years. John took a 20-year mortgage, thus

he is allowed to spread the deduction over 5 years. The amount deductible for the year ended

2013 is $353.42. As the borrowing expenses had been deducted, it will be excluded from the

cost base.

Calculations are enclosed in Appendices.

Interest expense of the mortgage loan

John is to pay interest of 5.5% p.a. on the $500,000 mortgage loan drawn to purchase an

investment property. The interest expense for the year ended 2013 is $27,5003. Interest

expenses are not deductible under s25-25 as it is the cost of use of the funds. However, a

general deduction under s8-1 might be allowed. According to the positive limbs, expense

must be incurred to produce assessable income or necessary for the carrying on of business

for it to be deductible. Firstly, it is important to establish that there is sufficient nexus

between interest expense and the rental income by using judicial tests.

The incidental and relevant test4 raises the question of whether the expenditure is ‘incidental

and relevant’ to the production of assessable income. In Herald and Weekly Times Ltd v

FCT, the judges characterized that the payments must be incurred as a result of gaining and

producing assessable income to be incidental to the carrying on of the business, also it must

be an unavoidable loss for the continuation of business. Interest expense paid by John had all

characteristics fulfilled. In addition, as held in Steele v FCT5, interest expense incurred on

loan was deductible because primary purpose of the loan is to purchase property and produce

assessable income. John had incurred the interest expense on a mortgage used to purchase the

investment property, in order to generate rental income. Therefore, the interest expense

would be deductible under s8-1.

3 Interest expense = $500,000 x 5.5% = $27,500.4 test derived from Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113; 2 ATD 169; Amalgamated Zinc (de Bavay's) Ltd v FCT (1935) 54 CLR 295; 3 ATD 288 and W Nevill & Co Ltd v FCT (1937) 56 CLR 290; 1 AITR 67.5 Steele v DCT (1999) 197 CLR 459; 41 ATR 139; 99 ATC 4242.

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Repair and recarpet of the investment property

After the tenant moved out on 1st March 2009, John repaint and recarpet the investment

property. Under s8-1, expenditure must be incurred in gaining or producing assessable

income, or necessarily incurred in carrying on a business. As the expenditure incurred by

John does not relate to income producing activities, it is not deductible under s8-1.

However, the expenditure incurred can be considered as repairs under s25-10, where it is

stated that expenditure incurred for repairs to premises or a depreciating asset held solely for

the purpose of producing assessable income is deductible. A repair is not defined in the Act

but in W Thomas&Co6, a repair involves restoration to a condition it formerly have without

changing its character. Also, a repair involves replacement or renewal of a part of an item and

not the entire item. In the case of Lindsay v FCT7, court emphasized the importance to

determine if the asset is separately identifiable. The wall and carpet are part of the house and

useless on its own, therefore fails the entire item test. Repainting and recarpeting of the

investment property are terminal repairs that are related to the income-producing purposes,

and it did not change the character of the asset. Maintenance due to business, amounting to

$9,0008 is deductible under s25-10 in specific deductions.

Advertising expense

John had incurred advertising expenses amounted to $3,300, second element of the cost base

under s110-25(3) incidental costs. As mentioned above, in order for the advertising expense

to be deductible and excluded from cost base, it must have a strong relation to deriving

assessable income9. The temporal nexus was relaxed in the case of AGC(Advances) Ltd v

FCT10, when it was held that the expense need not to be related to the assessable income

produced in the current year, it can be former or future years. Part of the advertising expense

of $1,00011 had not allowed John to find new tenants but it was an unavoidable cost that is

‘incidental and relevant’ to the production of rental income in the future. It is also important

6 W Thomas & Co Pty Ltd v. FC of T (1965) 115 CLR 58.7 Lindsay v FCT (1960) 106 CLR 37. 8 Repairs = $6,000 repaint + $3,000 recarpet = $9,000.9 ITAA 1997 s8-1.10 AGC(Advances) Ltd v FCT (1975) 132 CLR 175; 5 ATR 243; 75 ATC 4057.11 $1,000 in March 2009.

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to note in Steele v FCT12, the court allowed deduction on considerable interest expense

incurred due to unsuccessful ventures, because the sole purpose of expense was to produce

assessable income.

The remaining advertising expenses of $2,30013 are allowed under general deductions14 as

they are costs incurred by John in search for new tenants to earn rental. Applying the

incidental and relevance test, the advertising expense was necessarily incurred in producing

his assessable income thus deductible.

Cost of in-ground swimming pool

Due to the difficulties faced in securing tenants, John spent $17,500 to construct an in-ground

swimming pool on 15th May 2009 to attract new tenants. This had enhanced the efficiency of

the property, which constitutes an improvement. Considering that it is a capital repair, it is

not deductible under s25-1015. Under the capital allowances regimes, capital works

allowances is relevant for John as the property is not a plant. In order for a deduction, basic

conditions under s43-10 must be fulfilled:

i. John was the owner of the property at time of construction

ii. Expenditures of the construction were incurred by John

iii. John had derived rental as assessable income using the property

Furthermore, it was a structural improvement16 that was done after 26th February 1992, and

was completed17 on 30th June 2009, thus deduction will be allowed for post 1992

constructions. As the property is not in operation of hotel, motel, guesthouses or short-term

accommodation for travellers, it is entitled to a rate of deduction of 2.5% under s43-25. Using

the formula stated in s43-210, the amount deductible for the installation is $1555.82. The

amount included in the cost base will be $15,944.18 to avoid double deduction because

improvements are included in the calculation of CGT as the fourth element of the cost base.

Calculations are enclosed in Appendices.

12 Steele v DCT (1999) 197 CLR 459; 41 ATR 139; 99 ATC 4242.13 $300 in July 2009 + $2000 in Dec 2012 = $2,300.14 ITAA 1997 s8-1.15 ITAA 1997 s25-10(3).16 ITAA 1997 s43-20.17 ITAA 1997 s43-30.

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Legal fees and Agent commission

John incurred $31,000 in legal fees and agent commission in the course of the sale of

property. Decisions in Amalgamated Zinc (de Bavay’s) Ltd v FCT18 established that expenses

are deductible if they are incurred in the course of gaining or producing assessable income –

carrying on of a business. It extends beyond the scope of income-producing activities to

initial outgoings that are essential for the derivation of income. Legal fees and agent

commission are costs that were unavoidable for John, ‘incidental and relevant’19 to the

production of assessable income. John is entitled to a deduction under s8-1 for the year ended

2013.

Sale of investment property

John sold the investment property on 20th January 2013 at $880,000. The property was

bought on 1st February for $630,000. An investment property is a capital gains tax (CGT)

asset under s108-5(1) and liable for CGT. The disposal of CGT asset is ruled under s104-10

where the ownership of property changed from John to another entity. To calculate the capital

gain/loss, cost base is subtracted from capital proceeds. s110-25 states that there are 5

elements of the cost base. The purchasing price of $630,000 is the first element, while the

second element is made up of the borrowing costs, agent commission, advertising costs and

legal fees associated with the sale of property. As part of the borrowing costs had already

been deducted, the cost base will include the remaining. Lastly, the fourth element which

includes the cost of in-ground swimming pool because it had increased the property value.

However, capital works allowances had allowed deductions for John and the amount

deducted is not included in the cost base. Since capital proceeds are greater than cost base,

there is a net capital gain of $174,089.90.

Calculations are enclosed in Appendices.

Sale of shares in ABC Ltd

18 Amalgamated Zinc (de Bavay’s) Ltd v FCT (1972) 128 CLR 171.19 test derived from Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113; 2 ATD 169; Amalgamated Zinc (de Bavay's) Ltd v FCT (1935) 54 CLR 295; 3 ATD 288 and W Nevill & Co Ltd v FCT (1937) 56 CLR 290; 1 AITR 67.

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John disposed 5,000 shares in ABC Ltd on 1 March 2013. The shares were purchased on 1

July 2001 at $7,500 and he had received $18,000, thus giving rise to a gain of $10,500. As

defined in s108-5, shares are a proprietary right that is classified as an intangible property,

thus considered as a CGT asset. According to s104-10, a change of ownership from one

entity to another is a disposal of CGT asset under CGT event A1. Firstly, the cost base of the

shares would include the first element, s110-25(2) money paid in respect of acquiring and the

second element, s110-25(3) incidental costs. The s110-35 states that incidental costs include

brokerage fees associated with the purchase and sale of the asset, of which is a total of $25520.

Capital gain of John is calculated by subtracting cost base from the capital proceeds, which is

$10,245. Under s102-5, this amount will be assessed as net capital gain.

Sale of “antique” mirror

The mirror was purchased on 1 September 2005 at $15,000. Under s108-10(2)(a) an antique

is regarded as collectables. However, according to TD1999/40, ‘an antique is an object of

artistic historical significance, that is of an age exceeding 100 years’. As the antique mirror is

made in 1925, it is only 88 years old, therefore cannot be classified as an antique.

Consequently, the mirror is a personal use asset under s108-20(2) where it is used or kept for

personal use. As it is a CGT asset, it is subject to CGT and special rules. The cost base of the

mirror under s110-25 includes the first and second element, cost of acquisition and incidental

costs associated with the sale, $50 advertising expenses. The net capital loss from the sale of

artwork is $6,95021. As the special rules of personal use asset apply, the capital loss is

disregarded under 108-20(1).

Sale of car

20 Capital proceeds – Cost base = $18,000 – ($7,500 money paid + $75 brokerage fees at acquisition + $180 brokerage fees at sale) = $10,245 net capital gain.21 Capital proceeds – Cost base = $8,000 – ($15,000 money paid + $50 advertising expenses) = $6,950 net capital loss.

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John gave the car to his nephew during the year without receiving any consideration. The

cost base of the car includes only the cost of acquisition as described in s110-25(2). Although

he received no capital proceeds, capital proceeds modifications rules under Division 116

apply. According to s116-30 market value substitution rule, transactions that are not dealt at

arm’s length where the taxpayer received no capital proceeds, the market value of the asset

will be used. The capital proceeds is the market value of the car at the time of disposal,

$11,000. The net capital loss of this disposal is $11,00022. However, this will be disregarded

under s118-5 as car is one of the exempt assets.

Conclusion: Net Capital Gain/Loss for the year

For the year ended 30th June 2013 there are two CGT events that happened for John. Both of

the events had amounted to a total capital gain of $184,334.923. John, as an individual is

entitled to a 50% discount under s115-10. However, there are circumstances that discount is

not available. For example, gains from CGT event D1 at s115-25(3) and assets that acquired

less than 12 months at CGT event at s115-25(1). Furthermore it must be made after 21

September 199924. In John’s case, both the sale of shares and rental property are acquired for

more than 12 months and they are CGT event A1, therefore entitled to the discount. Since

there are no prior year losses, no capital gains are used to offset the losses25. Consequently,

the capital gain for the year ended 2013 is $92,167.4526, assessable under s102-5.

Appendices

Calculation of Deduction for Borrowing Costs

22 Capital proceeds – Cost base = $11,000 – $22,000 cost of purchasing = $11,000 capital loss.23 Capital gain = $174,089.90 sale of house + $10,245 sale of shares.24 ITAA 1997 s115-5.25 ITAA 1997 s102-15.26 Net capital gain = $184334.9 x 50% = $92167.45.

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Year 1 (1 Feb 2007 – 30 June 2008) $3,000 x 150/1825 = $246.57

Year 2 (I July 2008 – 30 June 2009) $2753.42 x 365/1675 = $600

Year 3 (1 July 2009 – 30 June 2010) $2153.42 x 365/1310 = $600

Year 4 (1 July 2010 – 30 June 2011) $1553.42 x 365/945 = $600

Year 5 (1 July 2011 – 30 June 2012) $953.42 x 365/580 = $600

Year 6 (1 July 2012 – 30 June 2013) $353.42 x 215/215 = $353.42

Calculations of Deductions for Capital Works

Annual deduction: $ 17,500 * 2.5% = $437.50

Year 1 1 July 2009 – 30 June 2010 = $437.50

Year 2 1 July 2010 – 30 June 2011 = $437.50

Year 3 1 July 2011 – 30 June 2012 = $437.50

Year 4 1 July 2012 – 20 January 2013 = (203 days * $ 437.50) / 365 days = $243.32

Total amount eligible for deduction = $437.50 + $437.50 + $437.50 + $243.32= $1555.82

Calculation of Net Capital Gain of Investment Property

Sales proceeds $880,000

Cost base:

1st element: Purchase price $630,000

Plus

2nd element:

Agent commission

Stamp duty

$28,000

$24,000

Advertising costs $3,300

Legal fees $3,000

Borrowing costs $353.42

Plus

4th element: Major improvement

Less: capital works allowances

$17,500

($243.32)

Total cost base $705,910.10

Capital gain $174,089.90

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