Tax deduction guide for small and medium business

I’ve already talked about some year end tax planning issues, but it might be worth reminding SMEs of some of the tax deductions they may be able to claim. By TERRY HAYES

By Terry Hayes

I’ve already talked about some year end tax planning issues, but it might be worth reminding SMEs of some of the tax deductions they may be able to claim.

For small and medium sized businesses, this can sometimes be a complicated task. The general principle under Australia’s tax laws for businesses is that an expense is tax deductible if it is incurred in carrying on the business. That is, the expense must be related to the conduct of the business.

Every business is different, so an exhaustive list of what is tax deductible will vary. But here are some pointers as to what is deductible.

Repairs

Expenditure incurred by an SME for repairs to its premises, part of premises or a depreciating asset (including plant) held or used solely for the purpose of producing assessable income is deductible.

Some care is needed however, because the word “repair” is not defined in the tax law and therefore takes its ordinary meaning of restoration by renewal or replacement of subsidiary parts of a whole.

So, the essential question is whether the particular work is the renewal or replacement of defective parts or the renewal or replacement of substantially the whole of the asset.

Where the asset repaired is only partly used for income-producing purposes, the cost of any repairs has to be apportioned between the income-producing and non-income-producing uses of the asset.

Initial repairs to a newly acquired asset, the replacement of the entire item and improvements are not deductible, but may qualify for a periodic write-off under the capital allowance provisions.

Trading stock

The valuation of trading stock is an important tax planning issue. This is particularly relevant if you are trading as a sole proprietor, partnership, or trust. If the value of closing trading stock on hand at the end of the year exceeds opening stock, the excess amount will be included in the assessable income of the business. Therefore, a reduction of closing stock on hand will reduce assessable income.

There are several methods for valuing trading stock – at cost, market selling value or replacement value – although there is no requirement to adopt permanently any of the three valuation methods.

Bad debts

A debt that is written off as “bad” in an income year is an allowable deduction, provided:

• The amount was either previously brought to account as assessable income in the current or a former income year.
• There must be a debt in existence at the time of writing off.
• The debt must be bad.
• The debt must in fact be written off as bad during the income year in which the deduction is claimed.

SMEs should review their debtors before the year-end and assess which debts may be written off as bad debts.

Borrowing expenses

The tax law allows a deduction for expenditure incurred by an SME in borrowing money to the extent that the borrowed money is used for the purpose of producing assessable income.

Note that this is a year-by-year test, allowing for changes in the use of the borrowed funds, rather than a test applied only at the time of borrowing. Borrowing expenses can include legal costs, search, valuation, survey and registration fees, fees paid for guaranteeing an overdraft, and commission paid to brokers.

The interest on loans used for income-producing purposes is also generally deductible.

Superannuation

As 30 June 2008 will mark the end of the first year of operation for the Government’s Simplified Superannuation reforms, it is worth reflecting on some of the 30 June year-end implications.

For 2007-08 and later income years, superannuation contributions are subject to annual limits. Contributions above the annual contributions caps are subject to excess contributions tax levied on the individual who can, and in some cases must, withdraw from their superannuation fund an amount to meet the excess contributions tax liability.

Therefore, it is vital to check an individual’s level of concessional contributions and non-concessional contributions for the financial year to ensure that any last-minute additional contributions will not exceed the individual’s annual “caps”.

The tax treatment and annual contribution limits for 2007-08 (that is, the year ending 30 June 2008) are summarised in a table below.

Concessional contributions are essentially tax deductible contributions, which are included in the assessable income of the receiving superannuation fund. For example, employer contributions for superannuation guarantee purposes, salary sacrifice contributions and personal contributions for which the eligible person (that is, a self employed person) intends to claim a tax deduction.

Non-concessional contributions include contributions that are not included in the assessable income of the receiving superannuation fund, such as non-deductible personal contributions made from the fund member’s after-tax income.

While superannuation has been “simplified”, there are still many traps to be wary of, and it is important SMEs consult their accountant and/or financial adviser.

Legal expenses

As noted above, legal expenses connected with borrowing money to use to derive assessable income are deductible. Legal expenses incurred by an SME in defending its business practices are generally deductible.

Over the years, case law has also held certain legal expenses to be deductible (although each case must be considered on its merits) for example, a nursery business opposing an application by a neighbour to begin quarrying activities, obtaining a renewal of planning permission to carry on quarrying activities, and opposing a rezoning application by a neighbour of a business.

FBT issues

A change announced in the 2008-09 federal budget could also affect tax deductions concerning work-related items like laptop computers in the year to end on 30 June 2008 (and, of course, later years). The Government announced that the FBT exemption for eligible work-related items such as laptop computers and mobile phones would be limited.

The Government said the FBT exemption will only apply where these items are used primarily for work purposes and will be limited to one item of each type (per employee, per FBT year) unless it is a replacement item. With the exception of mobile phones, computer software and protective clothing, the current FBT exemption for work-related items is available without any requirement that their actual use be work-related.

These changes have been introduced in a bill before Federal Parliament, but as at the time of writing, had not been passed. Your accountant should be able to advise you about this deduction.

Recruitment costs

Employers are entitled to a tax deduction for costs associated with seeking to obtain employees, such as advertising costs and agency fees.

Insurance

Premiums paid by a business for workers compensation insurance are deductible. Insurance paid for fire, theft, public liability, loss of profits and motor vehicle insurance (for cars used in the business) are also deductible.

Some taxes are deductible

Taxes other than income tax are generally deductible provided there is a sufficient connection to the SME’s income-producing activities and provided they are not of a capital or private nature. Taxes that are deductible include payroll tax, land tax and debits tax.

Tax advice costs

A wide range of deductions for tax advice and tax compliance costs is available under the tax law, including the costs of preparing income tax returns, preparing objections to tax office assessments or answering tax office queries, obtaining valuations required under tax laws, creating and maintaining records as required under tax laws, and tax planning advice.

Work-in-progress payments

An amount paid in respect of work-in-progress is deductible under the tax law. Conversely, the receipt of a work-in-progress payment is assessable income.

Other expenses

The range of expenses incurred by SMEs can be large, so determining their tax deductibility will often require professional advice. In addition to claiming a straight-out tax deduction, reducing taxable income can also be achieved by taking advantage of the various concessions in the tax law, most notably the capital gains tax (CGT) small business concessions.

Note that the rules to access these concessions have changed since last year. There is now a standard eligibility criterion that applies across the small business tax concessions. In essence, entities that satisfy an aggregated turnover test of $2 million a year are able to access those concessions.

The 2008 federal budget also announced a change re access to the CGT small business concessions. The Government said that, with effect from the 2007-08 income year (from 1 July 2007), it will increase access to the concessions via the $2 million aggregated turnover test for taxpayers owning a CGT asset used in a business by a related entity, and for partners owning a CGT asset used in the partnership business. Unfortunately, this useful change has not yet been legislated, so SMEs should check with their accountant.

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Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions.