2006 legislation amends the previous tax depreciation rules. The most significant changes are to the way that economic rates are set by the Commissioner.
Sections EE 25, EE 25B, EE 25C, EE 25D, EE 25E, EE 26B, EE 31, EE 37, EE 58, EZ 21B, GC 6, and Schedule 11B of the Income Tax Act 2004, sections 91 AAF(1) and 91 AAG of the Tax Administration Act 1994 and section EG 16 of the Income Tax Act 1994
The Taxation (Depreciation, Payment Dates Alignment, FBT, and Miscellaneous Provisions) Act 2006 amends the previous tax depreciation rules. The most significant changes are to the way that economic rates are set by the Commissioner.
Economic rates are part of the process that the Commissioner must use when setting depreciation rates for items of plant or equipment and buildings. Economic rates for buildings are now worked out using a straightline method, with a diminishing value equivalent. For most items of plant or equipment, economic rates are now calculated used the double declining balance method, with a straight-line equivalent.
There has also been a change to the value at which capital purchases can be expensed. To reduce business compliance costs, the low-value asset thresholds increase from $200 to $500. The higher thresholds are intended to reduce the number of low-value purchases that must be capitalised and depreciated.
Depreciation is an allowance to take account of the fact that assets used in a business eventually wear out or become out of date, even though they are maintained and repaired. This decline in value is recognised for tax purposes by allowing a deduction against income for each income year that the asset is used in the business.
A 2004 issues paper, Repairs and maintenance of the tax depreciation rules, examined a number of issues relating to the tax depreciation rules. The issues paper concluded that while the depreciation rules were generally sound, a number of changes would make the depreciation rules more neutral. A key change was to the method used to calculate economic rates because of concerns that it created an unintended investment bias favouring investment in longer-lived assets.
New methods for calculating economic rates apply to depreciable assets from the beginning of the 2005-06 income year. The new methods apply to plant and equipment acquired on or after 1 April 2005 and to buildings acquired on or after 19 May 2005.
There is no change to the way depreciation rates are calculated for fixed-life intangible property or excluded depreciable property. The changes only apply to plant or equipment and buildings.
Plant and equipment
Economic rates for short-lived plant and equipment are now more consistent with those applying to longer-lived plant and equipment. Rates for shorter-lived equipment are calculated using the double declining balance method. The result is higher economic rates for shorter-lived plant and equipment, with no increase in rates for longer-lived assets.
The new double declining balance method does not apply to some types of aircraft, cars, taxis, and minibuses, unless the motor vehicle is used for short-term hire. The double declining balance method also does not apply to plant and equipment that is expected to have a scrap or residual value greater than 13.5% of cost. Economic rates for these assets are set under separate rules.
The new methods of calculating the economic rate applies to plant and equipment acquired on or after 1 April 2005 and from 2005-06 onwards.
Economic rates for buildings are calculated using the straight-line method. An equivalent diminishing value rate can also be used. These rules apply to buildings acquired on or after 19 May 2005 and from the 2005-06 and subsequent income years.
Low-value asset thresholds
To reduce some of the compliance costs to business having to maintain fixed-asset registers, the low-value asset thresholds increase from $200 to $500. Purchases of capital assets that cost equal to or less than $500 will be able to be expensed in the year in that the expenditure is incurred. The idea is to reduce the number of assets that businesses must annually account for on their fixed-asset registers. The increase applies to assets acquired on or after 19 May 2005.
The amendments alter the way that economic rates are calculated rather than changing the basic structure of the tax depreciation rules. The changes do not change the way that tax depreciation rates are calculated for fixed-life intangible property.
Application dates - section EE 25
The changes do not alter economic rates for assets acquired before 1 April 2005, in the case of plant or equipment, and before 19 May 2005 in the case of buildings. The changes apply from 1 April 2005 for plant or equipment and after 19 May 2005 for a building and from the 2005-06 year onwards. A number of limited concessions have been provided in the legislation that affect the general application dates. These relate to an election to use the old rates for plant and equipment purchased before the 2006-07 year and to building purchases and transfers in certain circumstances.
The methods of setting economic rates - sections EE 25B to EE 25E
There are now four methods of calculating the economic rate. The new rates apply from the beginning of the 2005-06 income year. The new methods apply to plant and equipment purchased on or after 1 April 2005 and buildings acquired after 19 May 2005. Each method and the assets to which it applies are discussed in more detail below.
Economic rates for plant or equipment - section EE 25B
Section EE 25B sets the economic rate for an item of plant or equipment with a residual value of less than or equal to 13.5% of cost. Taxpayers should not use this section to work out economic depreciation rates for items of depreciable property that are: aeroplanes (excluding aeroplanes used for top-dressing or spraying); fixedlife intangible property; excluded depreciable property; buildings; cars, taxis, and minibuses (unless it is not available for short-term hire of less than one month); or plant or equipment that has a residual value greater than 13.5% of cost.
The rate that the Commissioner initially calculates is a diminishing value rate, which is rounded to the nearest banded rate. The banded diminishing value rate and the equivalent straight-line rate are set out in Schedule 11B.
A taxpayer acquiring an item of plant and equipment on or after 1 April 2005 and in their 2005-06 or subsequent income year, must use the economic depreciation rate calculated by the formula in section EE 25B(5). To work out this rate a taxpayer enters the estimated useful life of the asset into the double declining balance formula. The formula is expressed as 2/estimated useful life. The Commissioner's assessment of an asset's useful life, and any residual value, should be contained in determinations on depreciable assets.
The estimated useful life of a helicopter is 20 years and 4 years for a laptop computer. Both have residual values of 13.5% or less. The diminishing value economic rate for each type of asset will be 2/20 = 10% and 2/4 = 50% respectively. The corresponding straight-line equivalent rates given by Schedule 11B are 7% and 40%.
Depreciation loading is added to the economic rate to work out the annual depreciation rate for a new item of plant and equipment. Assets that do not qualify for depreciation loading are items that have previously been held or used as depreciable property in New Zealand, buildings, imported used cars and international aircraft. For these assets, the banded economic rate equals the depreciation rate. For assets with estimated useful lives of less than two years, the total depreciation deduction is limited to the assets' cost because of sections EE 14(1) and EE 15.
Economic rates for buildings - section EE 25C
Section EE 25C sets the economic rate for an item of depreciable property that is a building.
"Building" is not a defined term in the Income Tax Act 2004. Guidance on whether a structure is considered a building is given in Inland Revenue's depreciation guides. The Commissioner is undertaking a project to more clearly define a building.
The Commissioner initially calculates the straight-line economic rate for a building. This is rounded to the nearest banded straight-line rate for buildings and the equivalent diminishing value rate is set out in Schedule 11B.
Generally, a taxpayer acquiring a building after 19 May 2005 must in their 2005-06 and subsequent income years use the economic rate calculated by the formula in section EE 25C(4). However, there are two exceptions to this rule. These relate to contracts to purchase buildings signed before 19 May 2005 and transfers of buildings between associated persons. These are discussed in more detail below in Exceptions to the general application dates.
The formula for the straight-line economic rate is 1/estimated useful life. The Commissioner has worked out an estimate of the useful life for each type of building. Again, these are contained in Determination DEP 1.
The estimated useful life of a rental property is 50 years. The straight-line economic rate for this building will be 1/50 = 2%. Schedule 11B provides the corresponding diminishing value equivalent rate of 3%.
Economic rates for certain aircraft and types of motor vehicle - section EE 25D
Section EE 25D sets the economic rate for items of depreciable property that are types of aircraft or types of motor vehicle. This section arose out of concerns that applying the double declining balance method to these types of assets would result in overly generous economic rates.
This section sets the economic rate for fixed-wing aircraft used in New Zealand, excluding aircraft used for topdressing or spraying, gliders (as aircraft must be selfpropelled), international aircraft and helicopters. It also applies to motor vehicles designed exclusively or mainly to carry 12 or fewer people. This includes cars, minibuses and taxis. It does not include motor vehicles used for short-term hire (less than one month) which have their economic rates worked out under section EE 25B.
The economic rates for domestic aircraft are 10% diminishing value and 7% straight-line. For passengercarrying motor vehicles, the rates are 30% diminishing value and 21% straight-line.
Since the legislation was passed, the Minister of Revenue has announced that amendments will be made to the section EE 25D to clarify those assets that have their economic rates set under this section. These changes are proposed to apply from the 2005-06 year.
Economic rates for plant or equipment with residual values greater than 13.5% of cost - section EE 25E
Section EE 25E sets the diminishing value economic rate for items of plant or equipment that are estimated to have residual values greater than 13.5% of cost. This section allows the Commissioner to avoid setting overly generous economic rates for such plant or equipment.
The Commissioner estimates that international oceangoing yachts have an estimated useful life of six years. They are typically sold at the end of six years for an amount equal to 40% of original cost. Applying this formula in section EE 25E (1 - (40/100)1/6 = 14%) the economic rate is 15% when rounded to the nearest banded diminishing value rate in Schedule 11. The straight-line equivalent rate is 10%.
If the section EE 25B formula had been applied, the diminishing value economic rate would have been 30%, which is out of line with the reduction in value suffered by the business.
Exceptions to the general application dates
There are a number of exceptions to the general application dates. Each of these exceptions is discussed below.
Election to calculate economic rates in accordance with the old rules - section EE 26B
The legislation was not enacted until April 2006. This section allows a taxpayer to elect to apply the old depreciation rates to plant or equipment purchased on or after 1 April 2005 and before the beginning of their 2006-07 income year. Under this section, a taxpayer can avoid the cost of having to adjust tax depreciation rates for these assets if they have used the earlier method of setting the economic rate to calculate tax depreciation deductions for the 2005-06 income year. Requiring all taxpayers to go back and adjust depreciation rates on these assets could impose a significant compliance cost.
Therefore, section EE 26B allows a taxpayer to elect in their 2005-06 return the old method of calculating the economic rates for plant or equipment purchased on or after 1 April 2005 and before the beginning of their 2006-07 income year. Using this election results in economic rates for these assets being calculated in accordance with section EZ 21B and not sections EE 25B, EE 25D, or EE 25E. If such an election has been made, these assets must continue to be depreciated according to the old economic rates until they are sold, scrapped or are no longer used by the business.
A standard balance taxpayer purchases $1 million worth of plant and equipment during the 2005-06 income year. At the end of each month, new purchases are entered into the firm's asset register and the then current law applied to work out depreciation deductions. To avoid the cost of having to go back and re-calculate economic rates for all the plant and equipment purchased during the 2005-06 year, the taxpayer elects to continue to use the old method of calculating economic rates for these assets and must continue to depreciate these assets on this basis for subsequent income years.
Purchases of plant or equipment made on or after the start of a taxpayer's 2006-07 income year must have their economic rate worked out under either sections EE 25B, EE 25D or EE 25E.
Binding contracts to purchase a building signed before 19 May 2005 - section EE 25C
The old economic rate method in section EZ 21B is used if a binding contract to purchase or construct a building was entered into before 19 May 2005. However, if the building or the ownership interest in a building yet to be built is subsequently on-sold, section EE 25C applies because the building would be a new acquisition.
As at 18 May 2005, Bravo Limited has a binding contract with Building Co Limited to build a new 10,000 sq metre head office. The building is scheduled to be finished in May 2006. Because the contract was entered into before 19 May 2005, the earlier method of working out the economic rate applies once the building is available for use. In April 2006, Bravo Limited sells the nearly completed building. The new building owner must calculate the building's economic rate according to the formula in section EE 25C.
Transfer of buildings and limited concessions - section EZ 21B
Section EZ 21B saves the old method for calculating an asset's economic rate for assets purchased before these changes were made. It also provides a number of concessions that preserve the old higher economic rates in certain limited circumstances for building transfers.
The transfer of a building to another person that takes place on or after 19 May 2005 will generally mean that the new owner has a lower economic rate for the building that the previous owner. However, the law provides for two exceptions to this general principle.
The first is in the case of transfers between companies where there is 100% common ownership. In the case of a building that is transferred from one company within a wholly-owned group to another company within the same group, the economic rate is worked out in accordance with section EZ 21B. The result is no change in the building depreciation rate.
Bravo Limited wholly owns four other companies, Alpha, Charlie, Delta, and Echo. They are planning to re-organise the group and create a new company, Foxtrot Limited, to manage and administer the group's properties. The restructuring is set to occur at the beginning of the 2008 income year. Because section EZ 21B applies to buildings transferred within a wholly owned group of companies, the previous method of calculating economic rates applies. The result is no change to the building's depreciation rate.
The savings provision also applies to individuals when the building transferred is relationship property. This means that the economic rate for a building transferred between wives and husbands, de facto partners or same-sex partners is worked out according to EZ 21B.
In 2004, Ben and Jen purchased a one-bedroom apartment and rented this out. Ben is killed in an accident in early 2006. Jen receives Ben's interest in the rental property. Under the savings provision, Jen can still use the earlier economic rate, meaning no change to the building depreciation rate for the one-bedroom apartment.
Deductions for low-value assets - section EE 31 and section EG 16(1)
New sections EE 31(1) and (1B) have been inserted to give effect to the increase in the low-value asset threshold from $200 to $500. The new $500 threshold applies for the cost of assets acquired on or after 19 May 2005. There are no other changes to the previous low-value asset rules.
Taxpayers can claim a deduction for the cost of assets purchased for $500 or less provided that:
- they are not purchased from the same supplier at the same time as other assets to which the same depreciation rate applies, unless the entire purchase costs is equal to or less than $500; and
- the assets will not become part of a larger item of depreciable property - for example, expenditure on material to build a new wall in the taxpayer's factory; and
- the costs of those assets are not deductible under another provision of the Act.
Section EG 16 in the Income Tax Act 1994 has also been amended so that late-balance date taxpayers can take advantage of the increased thresholds.
Commissioner's power to deny a deduction - section GC 6
Section GC 6 denies a depreciation deduction if the Commissioner is of the opinion that certain arrangements have been entered into to allow a taxpayer to obtain a depreciation deduction contrary to the intent of the Act. This section could be applied when taxpayers sell and reacquire assets in order to obtain the benefit of the higher depreciation rates.
Sections 91 AAF and 91 AAG of the Tax Administration Act 1994 have been amended to reflect the changes to the methods used to calculate economic rates. These changes allow the Commissioner to consider and select the most appropriate method of calculating an asset's economic rate when making a determination about an asset's depreciation rate.
Section EE 38 has been amended so that nil or negative consideration is allowed for the purpose of sections EE 41 to EE 44. Inserting subsection (1B) in section EE 38 means that all asset disposal costs are deductible in full. These costs can be significant if an asset has no scrap value. For example, Resource Management Act consents sometimes require demolition costs to be incurred when the asset is no longer used. Allowing a deduction for the cost of demolition and disposal is the economically correct outcome. This change may remove an artificial impediment to more environmentally friendly asset disposal practices. This change applies to asset disposals from the 2005-06 income year.
Section EE 58 is amended to include references to the new sections EE 25B to EE 25E in the definition of "economic rate".
An error in section EE 41(3), which excluded buildings from the depreciation claw-back provisions in section EE 41(1), has been corrected by replacing the reference to "section" in EE 41(3) to "subsection (2)". This has effect from the 2005-06 and later tax years.