Private ruling: Income tax – deductions – rental property expenses – repairs and maintenance
Date of advice: 31 August 2018
Published: October 2018
Ruling period: Year ended 30 June 2018 | Year ending 30 June 2019 | Year ending 30 June 2020
Date scheme commenced: 1 July 2017

Ruling: Q1: Will the cost of removing and replacing the external cladding of a commercial high-rise building be treated as a repair under section 25-10 of the Income Tax Assessment Act 1997 due to the existing cladding being classified as combustible? | A1: No. | Q2: Will the cost of removing and replacing the external cladding of a commercial high-rise building be treated as a capital improvement under Division 43 of the Income Tax Assessment Act 1997 due to the existing cladding being classified as combustible? | A2: Yes.

Relevant facts and circumstances: 1. In June 201X, the taxpayer acquired a commercial high-rise property ( the property ). 2. At the time of purchase, the property satisfied the minimum standards required under the Building Code of Australia ( the Building Code ). 3. The property is leased and is solely used for income producing purposes. 4. The property incorporates cladding on the exterior of the building ( the old cladding ). 5. Cladding is used by architects for a number of reasons. Specifically, to: (a) Make the building exterior more attractive, (b) Prevent wind and rain from entering the building, (c) Provide sound and thermal insulation, and (d) Provide fire resistance to the building. 6. In April 201X, Entity A prepared a Technical Due Diligence Report ( the TDD Report ) that outlines the condition of the property following an inspection. (a) On page 9 of the TDD Report, the old cladding is described as being ‘predominantly formed of aluminium composite cladding’. (b) On page 11 of the TDD Report, the old cladding is described as being ‘in good condition’. 7. Aluminium composite cladding: (a) has a polyethylene core, which is a combustible material; (b) is a fire hazard; and, (c) is prone to melting, dripping and collapsing. 8. You were not aware that the aluminium composite cladding had these qualities. 9. Following a specific overseas fire and an inquiry from a tenant, you commenced an investigation into the nature of the old cladding. 10. On XX September 201X, Entity B issued a Fire Engineering Report ( the FE Report ) which advised that the old cladding was combustible under the Building Code. 11. As a result of proposed amendments to the Building Code, you intended to wait until those standards were clarified before commencing replacing the old cladding. 12. In March 201X, the Building Code was amended. The amendments confirmed that the old cladding used on the property was combustible and, therefore, not compliant under the updated Building Code. 13. On XX March 201X, you were advised that the old cladding also failed to pass all tests required in order to be compliant under the Building Code. 14. As a result, you investigated using solid aluminium panels ( the new cladding ). 15. In April 201X, you confirmed that the new cladding was a non-combustible alternative. 16. In a letter dated XX May 201X, you were advised that the ‘new cladding adds no additional functionality to the building apart from the reduction in fire hazard and compliance with the Building Code of Australia’. 17. You intend to replace the old cladding with the new cladding. 18. No regulatory body has approached you to compel you to make the old cladding compliant. 19. The work is expected to commence in 201X. 20. On X August 201X, you applied for a private binding ruling to clarify whether expenditure incurred to replace the old cladding with the new cladding constitutes a repair under section 25-10 of the Income Tax Assessment Act 1997 (ITAA 1997) or a capital improvement under Division 43 of the ITAA 1997.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 25-10 | Income Tax Assessment Act 1997 Division 43

Reasons for decision: Summary: The expenditure incurred to replace the old cladding with the new cladding is an improvement to the efficiency of function of the property. As a result, it is capital expenditure and not deductible under section 25-10 of the ITAA 1997 due to the operation of subsection 25-10(3) of the ITAA 1997. | Detailed Reasoning - Overview: 1. Section 25-10 of the Income Tax Assessment Act 1997 ( ITAA 1997 ) states that: (1) You can deduct expenditure you incur for repairs to premises (or part of premises) or a *depreciating asset that you held or use solely for the *purpose of producing assessable income. (2) If you held or used the property only partly for that purpose, you can deduct so much of the expenditure as is reasonable in the circumstances. (3) You cannot deduct capital expenditure under this section. 2. The word ‘repair’ is not defined within the ITAA 1997. 3. As a result, ‘repair’ bears its ordinary meaning. Definition of ‘repair’ 4. Taxation Ruling TR 97/23 Income tax: deductions for repairs ( TR 97/23 ) outlines the circumstances in which expenditure incurred by a taxpayer for repairs is an allowable deduction under section 25-10 of the ITAA 1997. 5. Paragraph 13 of TR 97/23 states that ‘repairs’ means: …the remedying or making good of defects in, damage to, or deterioration of, property to be repaired (being defects, damage, or deterioration in a mechanical or physical sense) and contemplates the continued existence of the property. 6. Paragraph 15 of TR 97/23 also explains that: Repair for the most part is occasional and partial. It involves restoration of the efficiency of function of the property being repaired without changing its character and may include restoration to its former appearance, form, state or condition. A repair merely replaces a part of something or corrects something that is already there and has become worn out or dilapidated. [emphasis added] 7. Paragraph 14 of TR 97/23 further provides that expenditure incurred to prevent defects, damage or deterioration: …is not in itself a ‘repair’ unless it is done in conjunction with remedying or making good defects in, damage to, or deterioration of, the property. 8. As stated by Windeyer J in W Thomas & Co Pty Ltd v. Federal Commissioner of Taxation (1965) 115 CLR 58 at 72, and which is reflected in paragraph 88 of TR 97/23: Whether or not work done upon a thing is aptly described as a repair of a thing is…a question of fact and degree. 9. Paragraph 18 of TR 97/23 further states that: [This questioning] requires a careful weighing of the various factors discussed in this Ruling and exercising judgment in light of decided case law and practical commercial experience. 10. Paragraph 21 of TR 97/23 provides that factors can include: (a) Form, state and condition of the particular property, (b) The functional efficiency of the property when expenditure is incurred, and (c) The nature and extent of the work done. Expenditure that is not considered to be a ‘repair’ 11. As seen in subsection 25-10(3) of the ITAA 1997, capital expenditure cannot be deducted under this section. 12. Expenditure incurred for repairs to property used for income producing purposes may be of a capital nature where: (a) The work provides a greater efficiency of function in the property, representing an improvement rather than a repair; (b) The expenditure is incurred in establishing, replacing or enlarging the profit-yielding structure rather than being a working or operating expense: as described in Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337 and Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (c) The extent of the work carried out represents a renewal or reconstruction of the entirety; or, (d) The work is an initial repair. Repair versus improvement 13. As highlighted by paragraph 44 of TR 97/23, a repair generally involves restoring the efficiency of function of a property without changing its character. Conversely, an improvement brings a thing or structure into a more valuable or desirable form, state or condition than a mere repair would do. 14. The determinative test involves considering the effect that the work done on the property has on its efficiency of function: pursuant to paragraph 45 of TR 97/23. 15. If the work is completed with materials different to the original, the work may either be a repair or an improvement: pursuant to paragraph 48 of TR 97/23. 16. Relevantly here, as highlighted by paragraph 50 of TR 97/23: If the work done restores a previous function to the property, or restores the efficiency of the previous function, it does not matter that a different material is used… However, the greater the work enhances the efficient functioning of the property; the more likely it is that the work constitutes an improvement. [emphasis added] 17. Additionally, paragraph 52 of TR 97/23 provides that work which produces a new and different function, or an additional function, is likely to constitute a capital improvement. Expenditure incurred in establishing, replacing or enlarging profit-yielding structure 18. For the purpose of this ruling, this provision does not apply. Renewal or reconstruction of the entirety 19. As highlighted by paragraph 36 of TR 97/23, a repair is restoration by renewal or replacement of subsidiary parts of a whole. This is distinguished from renewal or reconstruction of the entirety. 20. Paragraph 37 of TR 97/23 states that there is no one correct test for what is a subsidiary part or an entirety. The question depends on the facts of each case and is considered in light of all the circumstances reasonable to take into account: pursuant to Regent Oil Co Ltd v. Strick Inspector of Taxes [1965] 3 All ER 174. 21. Paragraph 38 of TR 97/23 provides that: Property is more likely to be an entirety if: ● The property is separately identifiable as a principal item of capital equipment; or ● The thing or structure is an integral part, but only a part, of entire premises and is capable of providing a useful function without regard to any other part of the premises; or ● The thing or structure is a separate and distinct item of plant in itself from the thing or structure which is serves; or ● The thing or structure is a ‘unit of property’ as that expression is used in the depreciation deduction provisions of the income tax law. 22. Comparatively, paragraph 39 of TR 97/23 considers that: Property is more likely to be a subsidiary part rather than an entirety if: ● It is an integral part of some larger item of plant; or ● The property is physically, commercially and functionally an inseparable part of something else. 23. The High Court in WG Thomas & Co Pty Ltd v. Federal Commissioner of Taxation (1965) 115 CLR 58 considered that deductions claimed for repairs to guttering, the roof, walls and two floors of a building were repairs of a subsidiary of a whole, where the building was treated as the entirety. 24. Specifically, Windeyer J stated that the relevant question was not: …whether the roof or the floor or some other part of the building, looked at by itself, was repaired as distinct from being reconstructed or replaced. It is whether what was done to the roof or the floor or some other part was a repair of the building. Initial repairs 25. Paragraph 59 of TR 97/23 states: Expenditure incurred on an initial repair after property is acquired, if the expenditure is incurred in remedying defects, damage or deterioration in existence at the date of acquisition, is capital expenditure and is not…deductible under section 25-10. 26. This is clarified in paragraph 125 of TR 97/23, which states that: A repair after acquisition of property is an ‘initial repair’ if repair was due when the property was acquired, in the sense that there was a need for repair to restore or maintain the property’s efficiency of function. In other words, the property was neither in good order when it was acquired nor suitable for use for income purposes in the way intended. Expenditure done solely to meet requirements of regulatory bodies 27. Paragraph 24 of TR 97/23 provides that: Expenditure on work that modifies property to satisfy regulatory requirements is allowable under section 25-10 as repair expenditure only if the work: (a) Remedies or makes good a defect in, damage to, or deterioration (in a mechanical or physical sense) of, property; and (b) Restores the efficiency of function of the property; and (c) Does not produce a new and different function for the property nor add to the property a function that it did not previously have. 28. Additionally, pursuant to subsection 25-10(3) of the ITAA 1997, the expenditure must not be capital in nature (as outlined above). Expenditure to control health risks from dangerous substances 29. In relation to work done to property to control health risks associated with the use of dangerous substances, paragraph 26 of TR 97/23 provides that these repairs: [do] not qualify as a ‘repair’ for the purposes of section 25-10 unless the work remedies or makes good defects in, damage to, or deterioration (in a mechanical or physical sense) of, the property. 30. Paragraph 27 of TR 97/23 includes an example where expenditure incurred to replace insulation from factory walls (which contained asbestos) with a modern insulation material was not considered to be a rectification of a defect as required by section 25-10 of ITAA 1997. 31. The insulation was not, itself, in need of repair and functioned efficiently as insulation. The purpose of replacing the insulation was due to the health risks posed to factory occupants. This distinction meant that the replacement was not a ‘repair’ in the ordinary sense of the word. | Detailed Reasoning - Applying the law to your circumstances: 32. It must be determined whether the expenditure incurred to replace the old cladding with the new cladding is a ‘repair’ under section 25-10 of the ITAA 1997. 33. As highlighted by paragraph 21 of TR 97/23, the main factors (among others) in determining whether work done is a repair include: (a) The form, state and condition of the particular property, (b) The functional efficiency of the property when expenditure is incurred, and (c) The nature and extent of the work done. Form, state and condition of the property 34. The property includes a commercial high-rise building which hosts three types of tenants. 35. The building incorporates external cladding composed of aluminium composite cladding ( the old cladding ) to prevent wind and rain from entering the building, as well as provide sound and thermal insulation. 36. When the property was initially purchased, you received a TDD Report about the condition of the property. The TDD Report described the old cladding as being in good condition. 37. The old cladding also met the then requirements under the Building Code for high-rise commercial buildings. 38. The old cladding was also intended to also provide fire resistance but, due to the polyethylene core, it is actually a fire hazard (as it is a combustible material) and prone to melting, dripping and collapsing. 39. From March 201X, the old cladding no longer meets the requirements under the Building Code. Functional efficiency of the property when expenditure is incurred 40. As highlighted above, the old cladding functioned to prevent wind and rain from entering the building. It also provided sound and thermal insulation. 41. In subsequent testing of the old cladding, you found that it did not provide fire resistance and was considered to be a fire hazard. 42. As a result, the Commissioner does not consider that the old cladding was defective in a mechanical or physical sense. 43. This is because the old cladding and, by extension, the property did not originally possess the quality of being non-combustible or fire resistant. Due to the nature of the polyethylene core which formed part of the aluminium composite cladding, the old cladding was always combustible and posed a fire hazard. The old cladding performed as it is designed to, even though that design has unintended or adverse consequences. Nature and extent of the work done 44. No regulatory body has approached you to compel you to make the old cladding compliant under the amended Building Code. 45. Instead, you intend to proactively replace all of the old cladding with solid aluminium panels ( the new cladding ), which have been confirmed to be non-combustible. 46. A representative Fire Safety Engineer has stated that the new cladding ‘adds no additional functionality to the building apart from the reduction in fire hazard and compliance with the Building Code of Australia’. Replacement of old cladding is a capital improvement 47. As stated above, the old cladding was capable of preventing wind and rain from entering the building, among other qualities. But it did not have the function of being fire resistant or non-combustible. 48. Pursuant to paragraph 50 and 52 of TR 97/23, the replacement of the old cladding with the new cladding produces a new function: making the building’s exterior non-combustible and fire resistant. 49. As a result, the replacement of the old cladding with the new cladding is a capital improvement to the property. 50. Therefore, the expenditure incurred to replace the old cladding is capital expenditure and not deductible under section 25-10 of the ITAA 1997 due to the operation of subsection 25-10(3) of the ITAA 1997. | Detailed Reasoning - Question 2: 51. Pursuant to the reasoning above, the replacement of the old cladding with the new cladding is a capital improvement for the purpose of Division 43 of the ITAA 1997.