Chapter 5 – Deductible Expenditure
5.1 - Overview (ITA Part D)
Income tax is payable on your annual gross income less annual allowable deductions and available net losses. Tax deductions put money straight in your pocket. Make sure you take every deduction you can.
The questions of what expenditure is deductible and when, are of prime importance in determining your tax liability. For most expenditure, the question of deductibility is straight forward. However, there are exceptions. This chapter looks at what you may deduct and when.
5.2.1 - General Permission (ITA s DA 1)
5.2.2 - Deductibility of General Expenses
5.2.2.1 - Deduction Test
5.2.2.2 - Capital Expenditure (ITA s DA 2(1))
5.2.2.3 - Repairs and Maintenance (R&M)
5.2.2.4 - Bad Debts (ITA s DB 31, See s CG 3 re: recovery)
5.2.2.5 - Home Office and Private Expenditure (ITA DA 2(2), DB 18AA)
5.2.2.6 - Mixed-Use Assets (ITA Subpart DG)
5.2.2.7 - Failed Software Projects (ITA s DB 40B)
5.2.3 - Specific Expenditure Deductions
5.2.3.1 - Motor Vehicle Expenses for Sole Traders, Partnerships and Close Companies (ITA s CX 17 and Subpart DE)
5.2.3.2 - Motor Vehicle Kilometre Rates
5.2.3.3 - Motor Vehicle Expenses Where Vehicle Provided to Employee (ITA Subpart DE, s CX
17)
5.2.3.4 - Entertainment Expenditure (ITA Subpart DD, s CX 29)
5.2.3.5 - Interest Costs (ITA ss DB 3B & DB 5 - DB 10B)
5.2.3.6 - Expenditure on Leased Assets
5.2.3.7 - Feasibility Expenditure (ITA DA 1, DA 2(1), IS 17/01
5.2.3.8 - Research & Development (R&D) (ITA DA 1, DB 33-DB 40B Subpart LY)
5.2.3.9 - Exit Inducement and Restrictive Covenant Payments (ITA ss CE 1, CE 10 re: income)
5.2.3.10 - Personal Grievance Claims (IRD public binding rulings BR 06/05 & 06/06)
5.2.3.11 - Remuneration Related Provisions and the Sale of Business (ITA s DC 10)
5.2.4 - Timing of Deductions (ITA s BD 4)
5.3.1 - Year-end Shareholder Employee Salaries and Management Fees (ITA ss BD4, CE 1, EA 4)
5.3.2 - Keep Invoices (TAA s 22)
5.3.3 - Employee Expenditure (ITA s DA 2(4))
5.2 - Application
5.2.1 - General Permission (ITA s DA 1)
When is expenditure deductible and when is it not? This is a three-step process.
Step one: Expenditure is deductible (subject to Step two) if:
the expense relates to the production of assessable income for any income year; or
the expense is necessarily incurred in carrying on a business.
This is known as the “general permission”. Expenditure that satisfies the general permission test will be deductible if there is no other reason to disallow it.
Step two: If the expense is deductible under Step one above, then check to see if any restricting provisions or special rules apply. The main items of expenditure not allowed as tax deductions include:
capital expenditure
incurred in deriving exempt income
doubtful debts
payments by one spouse to the other
penalties and interest on taxes owing
private or domestic in nature
incurred in deriving income from employment
Additionally, special rules relate to the deductibility of:
expenditure on capital assets (in most cases, these are depreciated over the life of the asset)
entertainment expenditure
motor vehicle expenditure
salary and wages paid to employees and shareholder/ employees (refer to Chapter 26 “Employment Responsibilities”)
lease costs
expenditure incurred in calculating a taxpayer’s assessable income or GST liability
forestry expenditure (see Chapter 15 “Forestry”)
expenditure arising from financial arrangements
Step three: When is the expenditure deductible? Generally, expenditure is deductible when it is incurred. However, prepaid expenditure (formally “accrual expenditure”) has an ongoing benefit and different rules relating to the timing of the deduction. Prepaid expenses are subject to special rules which are covered in 24.3.6.
5.2.2 - Deductibility of General Expenses
5.2.2.1 - Deduction Test
To be deductible, expenditure must have a close relationship to the production of assessable income or to the conduct of business.
Day to day business expenditure will normally be deductible but subject to specific rules such as those relating to entertainment expenditure
Business expenditure of a capital/asset nature is not immediately deductible
Expenditure of a private or domestic type is non- deductible
5.2.2.2 - Capital Expenditure (ITA s DA 2(1))
Expenditure of a capital nature normally is not deductible immediately.
Example
You purchase a new piece of equipment to replace old equipment not worth repairing. The cost of purchasing the new equipment is not immediately deductible (the cost of the new equipment can be depreciated - see Chapter 6). The ongoing maintenance of the equipment and ordinary operating costs are deductible.
It is helpful to consider some other examples of expenditure deduction.
Example
You incur legal fees in purchasing an investment property for rental. These legal fees are a capital expenditure and must be capitalised with the cost of the property (see note below, however). Subsequently you incur legal fees in preparing lease documents for the property or in litigating a dispute with a tenant. These expenses relate to your income earning activities as opposed to your income earning structure and are therefore deductible.
Note
Where your business has legal fees of no more than $10,000 during the course of an income year, you may claim the full amount as a deductible expense. If total legal fees for the year are more than $10,000, then all of your legal costs for that year must be split between capital and deductible expenditure.
5.2.2.3 - Repairs and Maintenance (R&M)
The IRD interpretation statement IS 12/03 sets out the process to establish whether this type of expenditure is deductible or not.
Step 1: Establish whether the general permission applies (See 5.2.1). Is the expenditure incurred in the production of income or necessary in carrying on a business? If not, then it will not be deductible.
Genuine repair work on your vacant rental property will be deductible if you plan to rent out the property once the work is completed as this has a relationship to earning income.
Step 2: Identify the asset involved. This is necessary for the following step and the “entirety test” helps with this process. Consider whether the asset is:
complete in itself and not part of another asset or aggregation of things forming an asset.
physically and functionally distinct from its wider setting.
capable of separate operation as an entirety by itself.
Step 3: Establish the nature and extent of the work done
Reconstruction, replacement or renewal of an asset (or substantially the whole asset) is deemed to be work of a capital nature and not deductible.
So is expenditure that changes the nature of the asset or leads to improvements that could not be achieved via routine repairs and maintenance.
If the work introduces a new asset, then it is likely to be treated as capital. For example, insulating your rental property. This introduces a new asset, changes the nature of the property and leads to improvement. If the dwelling was already insulated, however, the work is likely to be deductible R&M depending on whether the material used was such as to bring it back up to standard or whether the job went further than routine repairs and maintenance to improve the asset. Leaky home repairs are likely to be deductible to the extent that they are bringing the building up to the original intended condition
5.2.2.4 - Bad Debts (ITA s DB 31, See s CG 3 re: recovery)
To be entitled to a bad debt deduction a debt must be:
“bad”, that is where a prudent business person, on the balance of probability, would consider it unlikely the debt would be paid and
“written off” in the income year that the deduction is being claimed - action must be taken in accordance with your accounting systems to treat the debt as bad, for example, reducing your debtors’ ledger by the amount of the bad debt
If your business has a high level of credit sales you should document your attempts to collect the debts and write any bad debts off in your financial accounts before year end. A journal entry made after year end is too late to get the deduction in the year to which it relates.
5.2.2.5 - Home Office and Private Expenditure (ITA DA 2(2), DB 18AA)
Private or domestic expenditure is non-deductible.
If you work from home, you must apportion your costs between business and private expenditure based on the percentage floor area. From 2017-18, you may use an optional ‘square metre rate’ method for calculating deductions for dual use premises. Under this method, you first determine the area of the building (in square metres) that is separately identifiable and used primarily for business purposes. Then multiply the business area by the square metre rate. The IRD set the 2017-18 rate at
$41.10 per square metre. This excludes rent, rates and mortgage interest, referred to as “total premises costs”. These may then be claimed based on the proportion of the premises used primarily for business purposes (“business proportion”). The formula for calculating the total home office deduction is:
(business square metres × square metre rate) + (total premises costs × business proportion)
Beware: The Tax Authorities keep a close eye on private expenditure when auditing small and medium size businesses - they have seen every trick in the book!
5.2.2.6 - Mixed-Use Assets (ITA Subpart DG)
Mixed-used assets are those used for both private and income earning purposes, and include holiday homes,
boats and aircraft.
The apportionment for tax purposes is now based on the actual usage of the asset, ignoring the period when the asset was not being used at all.
For example, if you use your bach for 30 days in the year and rent it out for 20, the private use is 30/50 (60%) and the business use is 20/50 (40%).
Airbnb and other short-term rentals are also taxed and could be subject to GST if the taxpayer is above the GST threshold.
The rules don’t apply to:
a residential property used for long-term rental, or
a business asset where the private use is minor, eg once a year, or
a home office, where your expense claim is based on floor area.
The IRD offers a calculator on its website to help calculate income and expenditure for a mixed-use asset.
5.2.2.7 - Failed Software Projects (ITA s DB 40B)
The costs of failed software projects may be deducted immediately for tax purposes.
5.2.3 - Specific Expenditure Deductions
5.2.3.1 - Motor Vehicle Expenses for Sole Traders, Partnerships and Close Companies (ITA s CX 17 and Subpart DE)
If you operate in business as a sole trader, partnership, or are an independent contractor, your motor vehicleexpenditure will be deductible to the extent the expenditure relates to business purposes. When a close company makes a new arrangement allowing private use of a motor vehicle by a shareholder-employee, it may elect to apply subpart DE instead of FBT. If you use a motor vehicle wholly (that is 100%) for business purposes the expenditure will be fully deductible. If the motor vehicle is used partly for business purposes and partly for private purposes, only the business portion of the expenditure will be deductible.
In most cases, the Department will expect motor vehicles to be used for business and private purposes.
If your business operates a motor vehicle for business and private purposes, you must use a vehicle logbook to determine your percentage of business running. Taxpayers can keep a representative logbook for a period rather than every day of the year. This logbook, which must be kept for 90 days, should record accurately for each journey:
the start and end dates and odometer readings of the logbook period
the date and total distance travelled for each journey of the logbook period
reasons for and the distance in the logbook period of each trip undertaken for business purposes
When the trial logbook period ends, you will be able to calculate your percentage of business running. This business running percentage can be applied for up to three years from the day the trial logbook was started.
Example
You are a landscape architect operating as a sole trader or partnership and you own one motor vehicle. This motor vehicle is used for a combination of business and private running. On 1 April, you commence a trial logbook for the motor vehicle. The logbook details all business related trips. This logbook records specific reasons and details of travel. For instance, one entry reads 23 June, 3.30pm, travelled to work site at 42 Luncing Road, 13km. At the end of the 90- day trial period, you calculate your percentage of business running. If total travel was 4,000km and business travel was 3,250km, then the business travel percentage is 81.1%. If your total business running costs for the year 1 April to 31 March was $7,500, then the deductible portion of this expenditure is, $7,500 x 81.1% that equals $6,075.
If the pattern of vehicle use changes to such an extent that the log book is no longer representative of the percentage of business running use, you must start another log book. “Representative” is where the logbook is within 20% of the current actual business use.
5.2.3.2 - Motor Vehicle Kilometre Rates
There is also a provision to claim a per kilometre rate for each business related kilometre. See 26.4.5 in Chapter 26 “Employment Responsibilities”.
5.2.3.3 - Motor Vehicle Expenses Where Vehicle Provided to Employee (ITA Subpart DE, s CX 17)
Where your business provides a motor vehicle to an employee, (or shareholder employee) the motor vehicle expenditure will be fully deductible, regardless of the level of private use of the motor vehicle. However, while the expenses are fully deductible, fringe benefit tax will be payable on the days the motor vehicle is used by or made available to an employee or shareholder/ employee for private use. (See 5.2.3.1 above and Chapter 19 “Fringe Benefit Tax”).
5.2.3.4 - Entertainment Expenditure (ITA Subpart DD, s CX 29)
This is discussed fully in Chapter 7.
5.2.3.5 - Interest Costs (ITA ss DB 3B & DB 5 - DB 10B)
The deductibility of interest costs can be contentious in an income tax audit. You should obtain professional advice prior to entering into any transaction involving substantial interest costs. Large savings can be made by properly structuring your borrowings.
Interest incurred by most companies is fully deductible no matter how the borrowed funds are used.
Interest costs for individuals, qualifying companies and non-resident companies are deductible only if the borrowed funds are used for business purposes or used to purchase assets that produce assessable income.
Example
You borrow $50,000 to acquire a new computer system for your business. The interest costs, say $5,000 per annum, will be fully deductible to your business. Consider another example: a farmer borrows $200,000 to meet obligations under a matrimonial property Act settlement, instead of selling assets which produce assessable income to raise the funds. Inland Revenue is likely to treat the interest as non-deductible.
In some cases it is necessary to allocate interest costs between deductible and non-deductible components.
Example
You purchase a residential dwelling for homestay purposes. Half of the house is your residential home and the other half is used for homestays. In this case, part of the interest expenditure relates to your private or domestic establishment. Accordingly, you should apportion the interest costs between the private and income earning components. If the interest costs are say $20,000 per annum, you would apportion interest costs between private expenditure $10,000 and business expenditure $10,000.
5.2.3.6 - Expenditure on Leased Assets
The income tax deductions available for lease expenditure depend upon which type of lease you have entered into. An operating lease is essentially a rental agreement for the use of property.
The lease continues until such time as you cancel it and return the property. Operating lease (rental) costs are fully deductible. You are paying for the use of property.
Example
Your business enters into an operating lease for a motor vehicle. You will not acquire ownership of the motor vehicle at the end of the lease period. These lease payments are fully deductible to your business.
A finance lease is a financing transaction as a result of which you acquire, or have an option to acquire the asset (typically lower than the market value) at the end of the lease term, or where the lease term is more than 75% of the useful life of the asset.
Example
Your business leases a computer on a financing lease basis. You will acquire ownership of the computer at the end of a three-year period. Because you are acquiring ownership at the end of the lease period, this lease constitutes a financing lease. You will be entitled to a deduction for the interest component of the finance lease but no deduction will be available in respect of the principal (debt repayment) amounts. The split between the interest and principal components is normally shown in the lease contract.
An asset acquired on a finance lease may be depreciated for tax purposes. (The amount to be depreciated is the cost of the asset exclusive of interest costs). You may depreciate the asset from the date you entered into the finance lease.
5.2.3.7 - Feasibility Expenditure (ITA DA 1, DA 2(1), IS 17/01
This was reviewed in light of the 2016 Supreme Court decision in Trustpower Ltd v CIR. The expenditure is deductible if incurred in deriving assessable income, as an ordinary incident of business. It is non-deductible if it relates to starting a business or income-earning activity; or it is capital in nature. Early feasibility expenditure of a general nature may be allowed, but once it is clearly associated with a specific capital project or an identified asset having enduring benefit, it is likely to be treated as capital and disallowed. The deductibility is determined at the time the expense is incurred and does not depend on the acquisition of an asset or success of the project to which it relates.
5.2.3.8 - Research & Development (R&D) (ITA DA 1, DB 33-DB 40B Subpart LY)
From the 2019-2020 income year, a tax credit of 15% on eligible business R&D expenditure may be claimed. To qualify, in-house R&D expenditure must exceed $50,000, but this does not apply if your R&D is conducted by anapproved research provider. From the 2020-21 income year, tax credits may be cashed out, subject to a payroll based limit. Callaghan Innovation grants will be phased out.
For full details, download R&D tax incentive: Guidance, from the IRD website.
Expenditure on scientific research for the purpose of deriving assessable income is deductible (DB 33) unless it relates to a depreciable asset not created by the research.
A tax deduction is allowed for R&D expenditure if the taxpayer recognises the expenditure as an expense for financial reporting purposes.
For financial reporting purposes, research expenditure is always written off, while development expenditure is written off unless all of the following criteria are met:
the product or process is clearly defined and the costs attributable (to the product or process) can be identified separately and measured reliably.
the technical feasibility of the product or process can be demonstrated
the entity intends to produce and market, or use, the product or process
the existence of a market for the product or process or its usefulness to the entity, if it is to be used internally, can be demonstrated
adequate resource exists, or their availability can be demonstrated to complete the project and market or use the product process
Regardless of the above, taxpayers are allowed an immediate deduction if total R&D expenditure for an income year is $10,000 or less (unless the expenditure is treated as material for the taxpayer concerned).
Note, no deduction is allowed for property that is used in carrying out R&D. Also, research and development expenditure incurred in devising a patented invention is deductible when the patent is sold.
Under certain circumstances the legislation allows for deferment of R&D deductions to subsequent income years thus resulting these deductions not being lost. Advice should be sought from your tax advisor in this regard.
The R&D Loss Tax Credit (Subpart LH and CX 48D)
For the 2018/19 tax year, innovative start-up companies can also claim a cash refund of 28% on a loss of up to $1.4 million of R&D, with the loss cap rising by $300,000 each year to an eventual $2 million ($560,000 refund at 28%), from 2020/21. Instead of carrying forward the losses, the start up will get a timing benefit of early tax payments from the IRD. If a company subsequently makes a capital gain from the innovation, or sale of its shares, or is liquidated or becomes non-resident, then the cashed-out loss is clawed back. To qualify for the benefit, at least 20% of wages and salaries must be on eligible R&D as defined in relevant accounting standards.
Capitalised development expenditure on a patent, patent application or plant variety rights, will be added to the depreciable cost of the asset. There will also be a one-off deduction available for capitalised development expenditure that does not result in a depreciable intangible asset.
Application costs for a registered design will be deductible in the current-year if the application fails, and registered design costs will be depreciable over 15 years. Copyright in industrial artwork will be depreciable over 16 years for product designs and casting moulds and 25 years for works of craftsmanship. Computer software developed for the taxpayer’s own business use will also be deductible. To learn more about the R&D tax credit, register and apply for it, go to the IRD site and search for “research development”.
5.2.3.9 - Exit Inducement and Restrictive Covenant Payments (ITA ss CE 1, CE 10 re: income)
Exit inducement payments made to prospective employees will be deductible if they are taxable income to the recipient. Restrictive covenant or restraint of trade payments are also deductible provided that the payment is gross income to the recipient.
You should consult your tax advisor on these transactions, as in some instances the deduction may be limited!
5.2.3.10 - Personal Grievance Claims (IRD public binding rulings BR 06/05 & 06/06)
Are compensation payments for humiliation, loss of dignity and injury to feelings of the employee, and loss of benefits under the Employment Relations Act deductible? In most cases, the compensation expense is incurred as part of the employment of employees and is “reasonably incidental” to the earning of business income. Therefore, such payments would often be tax deductible. Note, however, that genuine compensation for humiliation, loss of dignity, or injury to feelings is not taxable in the hands of the employee.
5.2.3.11 - Remuneration Related Provisions and the Sale of Business (ITA s DC 10)
A vendor selling a business can be entitled to a deduction for various accrued “monetary remuneration” amounts that are unpaid at the time of sale. This applies where employees are being transferred as part of the business sale and various accruals for holiday pay, long service leave and other allowances exist at the date of sale. The vendor and purchaser must agree in writing as to the amount of the monetary remuneration related provisions and the amount must be part of the calculation of the sale and purchase price.
The purchaser of the business is not entitled to a deduction for these provisions. That is, as the purchaser pays out these provisions no deduction is available for these costs.
5.2.4 - Timing of Deductions (ITA s BD 4)
In most cases, expenditure is deductible in the year in which it is incurred. However, certain types of expenditure yield ongoing benefits to more than one income year. Expenditure of this kind is termed “accrual expenditure” and it is wholly deductible in the income year it is incurred, although the unexpired portion relating to future income years is added back to income as a timing difference. A number of exceptions apply relating to items which can be excluded from the accrual expenditure rules. These are discussed in the section for year-end planning. See 22.3.6.
5.3 - PRACTICAL HINTS
5.3.1 - Year-end Shareholder Employee Salaries and Management Fees (ITA ss BD4, CE 1, EA 4)
In many companies, the owner of the business waits until the financial results are calculated (some time after year end) before deciding on the level of final shareholder employee salary. Likewise, business owners may choose to wait until after year end before quantifying the level of management fees to be charged by related companies.
Don’t fall into a technical tax trap. In all cases, (whether shareholder employee salaries or management fees) it is important that the business seeking a deduction “incurs” the expenditure before year end. That is, a legally binding arrangement (recorded in contract or directors minutes) should bind the company to making the payment. If the expenditure is not “incurred” by year end, the Department can deny a deduction to the business.
(Note, expenditure can be legally incurred notwithstanding the fact that the actual amount has not been quantified until after year end. Further, the requirement to “incur” salary expenditure remains notwithstanding rules in the Income Tax Act which regulate the timing and receipt of salary payments).
5.3.2 - Keep Invoices (TAA s 22)
Expenditure will only be deductible if you maintain invoices as proof of payments and document your reasons for apportionment where appropriate. These documents must be maintained for seven years. It is extremely important that you comply with these record-keeping requirements. This is especially important if your financial affairs are subject to a tax investigation. If you have not received an invoice, bank statements (for auto payments) and visa chits (with explanatory notes) may suffice but remember the need for GST purposes to have a valid GST tax invoice.
5.3.3 - Employee Expenditure (ITA s DA 2(4))
Employees are unable to obtain tax deductions for costs incurred in generating employment income. However, a business is able to obtain a tax deduction for the costs of reimbursing expenses paid by employees for work related purposes. These amounts received by the employee are non-assessable.
In some cases, employers may be able to substitute modest amounts of assessable salary and wages with non-assessable reimbursements. This topic is further discussed in Chapter 26 “Employment Responsibilities”.