z3421738 LEGT2751 1

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 Newspapers
1
, 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 deductible
2
.

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 $27,500
3
. 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 test
4
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 FCT
5
, 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 1
st
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&Co
6
, 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 FCT
7
, 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
$9,000
8
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 income
9
. The temporal nexus was relaxed in the case of AGC(Advances) Ltd v
FCT
10
, 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 $1,000
11
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 FCT
12
, 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 $2,300
13
are allowed under general deductions
14
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 15
th
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 s25-10
15
. 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 improvement
16
that was done after 26
th
February 1992, and
was completed
17
on 30
th
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 Bavays) Ltd v FCT
18
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 20
th
January 2013 at $880,000. The property was
bought on 1
st
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.




18
Amalgamated Zinc (de Bavays) 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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Sale of shares in ABC Ltd

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
$255
20
. 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 $6,950
21
. As the special rules of personal use asset apply, the capital loss is
disregarded under 108-20(1).






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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Sale of car

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
arms 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 $11,000
22
. 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 30
th
June 2013 there are two CGT events that happened for John. Both of
the events had amounted to a total capital gain of $184,334.9
23
. 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 1999
24
. In Johns 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 losses
25
. Consequently,
the capital gain for the year ended 2013 is $92,167.45
26
, assessable under s102-5.









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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Appendices
Calculation of Deduction for Borrowing Costs
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