2. Building fit-out: a review for non-residential buildings
2.1 In March 2010, Inland Revenue released interpretation statement Residential rental properties – depreciation of items of depreciable property (IS 10/01), which outlined the Commissioner of Inland Revenue’s view that many items in a residential rental property must be depreciated at the building depreciation rate because they are not separate items of depreciable property. Although the statement applies only to residential buildings, its principles could be interpreted to apply more broadly.
2.2 Following this, the Budget 2010 tax changes set the depreciation rate for buildings that have an estimated useful life of 50 years or more to 0% from the beginning of the 2011/12 income year. This has highlighted the question of whether building fit-out is depreciable in a non-residential context.
2.3 The current depreciation rules require taxpayers to consider whether an item of depreciable property is part of a building or, instead, a separate item of depreciable property – such as plant, machinery, or equipment. It would seem that the current practice is for taxpayers to generally claim depreciation deductions for items of non-residential building fit-out separately from the building. This practice has come into focus given the Inland Revenue interpretation statement on residential buildings referred to above.
2.4 For these reasons, we are proposing to clarify the law on when expenditure on non-residential fit-out can be depreciated separately from the building structure. Under this proposal, items of non-residential building fit-out could be separately depreciated if the item is described in the Commissioner’s depreciation determination asset category “Building Fit-out”, or alternatively, if the item is an item of plant. We are also proposing a rule that will allow people who have not separately identified items of fit-out in a non residential building to continue to depreciate a portion of the building’s tax book value at the old building rate.
The appropriate policy setting
2.5 A key goal of the tax system, including depreciation rules, is to tax different forms of investment as neutrally as possible to avoid distortions to investment decisions. Therefore, there are strong grounds for depreciation rates to mirror economic depreciation (how assets fall in market value through time) as closely as possible.
2.6 It is difficult to set depreciation rates to precisely match economic depreciation given incomplete information and variations in depreciation rates between assets. Therefore, current depreciation rates are an attempt to reasonably approximate the average decline in the value of assets over time.
Current practice identifying an item of depreciable property
2.7 For accounting and valuation purposes, many taxpayers separate components of an asset where the component has a cost that is significant in relation to the asset of which it forms part, and where it has a materially different useful life-span. Therefore, components of non-residential building fit-out are generally depreciated separately from the building for accounting purposes.
2.8 Certain aspects of the tax depreciation rules support this practice. Many taxpayers use separate depreciation rates for items of building fit-out (the Commissioner of Inland Revenue has published depreciation rates for approximately 90 general items of building fit-out - including: lifts, internal walls, plumbing, electrical wiring, ceilings, carpets, fitted furniture, air conditioning systems). Currently, the Commissioner determines an asset’s useful life-span after receiving advice from interested parties and a registered valuer. The depreciation rate is then set by using the estimated useful life in the relevant formula. This generally results in higher depreciation rates than would have applied if the asset was depreciated as part of the building.
2.9 Strictly speaking, tax depreciation (according to principles developed by the Courts in cases relating to deductions for repairs and maintenance) generally requires that the relevant item be identified; and that for a component of the item to be considered separately, it must be a distinct physical item capable of operating on its own. It will always be a question of fact and degree whether a particular improvement is considered a separate item of depreciable property.
2.10 Inland Revenue’s interpretation statement IS 10/01 (Residential rental properties – depreciation of items of depreciable property) sets out the Commissioner’s view of the law as it relates to the fit-out of residential buildings. The statement sets out a three-step test that the Commissioner will apply to determine whether an item can be depreciated separately or whether it is properly depreciated as part of the residential building. Although the statement applies only to residential buildings, if its principles were to apply more widely this could result in a number of items of non-residential fit-out, that are currently being depreciated separately, being considered part of the building, and non-depreciable for certain buildings from the beginning of the 2011/12 income year. This could have implications for current practice and could introduce a significant tax bias against fit-out of non-residential buildings.
Different rules for residential and non-residential fit-outs
2.11 We propose that a distinction be made for tax depreciation purposes between non-residential and residential fit-out. We think that a distinction is necessary because building fit-out is likely to constitute a greater portion of the value for non-residential buildings than for residential buildings. In addition, we consider that non-residential fit-out is generally less permanent than residential fit-out due to tenant-specific requirements and changes of use.
2.12 We consider that these differences justify residential and non-residential building fit-out being treated differently for income tax purposes. Under this approach whether an item of residential fit-out qualifies as a separate depreciable item will be governed by current law – guided by the Commissioner of Inland Revenue’s interpretation statement IS10/01 (Residential rental properties – depreciation of items of depreciable property). A separate set of rules would govern whether commercial and industrial fit-out is able to be depreciated separately from the building. A proposal outlining a new set of rules is discussed below.
The proposal for non-residential building fit-out
2.13 The proposal is to clarify the law to allow expenditure on non-residential fit-out to be separately depreciable from the building structure.
2.14 We consider that the building structure includes: the foundations; the building frame; floors; external walls, cladding, windows, and doors; stairs; the roof; and load-bearing structures such as pillars and load-bearing internal walls. Expenditure on these components of a building would be non-depreciable for buildings with an estimated useful life of 50 years or more from the beginning of the 2011/12 income year.
2.15 The law would be changed to clarify that fit-out associated with commercial, industrial, recreational and certain short-term accommodation (for example: motels, hotels, rest homes, and hospitals) would be able to be separately depreciated. The items of fit-out that would be separately depreciable are described in the Commissioner’s “Building Fit-out” asset category. The rates of depreciation for these items would not change as a result of this review. A list of the items in this category is contained in Appendix A. Items that are not contained in this list that are not part of the non-depreciable building structure (described above) would continue to be depreciable at the default rate.
2.16 In addition to the general building fit-out category, officials also propose to clarify that plant, where the plant is integrated into the fabric of the building, can also be separately depreciated at the appropriate depreciation rate. For example, wool scouring plant might be so integrated into the fabric of the building housing the plant that it would be part of the building under the Commissioner’s 3 step test (described in footnote 2). Specifically allowing an item of plant to be depreciated separately from the building would ensure that the law aligns with current practice for depreciating items of non-residential building fit-out.
The boundary between residential and non-residential
2.17 Under the approach described above, it is necessary to define the boundary between residential and non-residential. We propose to base the boundary on a legislative concept of “dwelling”. The depreciation status of an item of fit-out for a building meeting the definition of “dwelling” would be treated under the current law, while the depreciation status of an item of fit-out for a building that does not meet this definition would be treated under the separate rules for commercial and industrial fit-out.
2.18 The key aspects of the proposed definition of “dwelling” are that:
- it would include any building, premises, structure including any parts of these items; and
- it must be used predominantly as a place of residence or abode for any individual; and
- it does not include a commercial dwelling.
2.19 As described above, a dwelling would be defined broadly and would be concerned with the functional aspects of the structure. That is, the structure must be predominantly used as a place of accommodation, but it would not be limited to buildings that are a person’s primary place of residence or home. There would be no requirement for any degree of permanency of occupation in order for particular premises to fall within the ambit of ‘dwelling’. Nor would the concept of “dwelling” require full time use. However, the definition will specifically exclude commercial dwellings such as hotels, motels, rest homes and hospitals.
2.20 Under this approach second homes that taxpayers use predominantly for themselves but are rented out infrequently or sporadically (these can be described as “holiday homes”) and timeshare apartments would fall within the definition of “dwelling” and would not, therefore, qualify for the separate commercial and industrial fit-out rules. This is because the provision of accommodation in these situations cannot be described as commercial in nature.
Mixed purpose building fit-out
2.21 For mixed purpose buildings, certain items of fit-out are typically shared between non-residential and residential spaces. Examples of these kinds of items include lifts, electrical cabling, fire protection, and sewerage and water reticulation.
2.22 The issue arises whether the depreciation status of items of fit-out that serve both the residential and non-residential areas of a building should be subject to the current law or the proposed new rules for commercial and industrial fit-out. We propose a dominant purpose test whereby a taxpayer will be entitled to depreciate, as an item of fit-out separate from the building, these shared items of fit-out if the dominant purpose of the building is to provide non-residential space. However, if the building provides mainly residential space, then the depreciation status of the shared components of the building will be determined by the current law as it applies to residential property. The following are examples of how this test would apply in practice:
A four storey building has three floors of commercial space and a penthouse apartment on the top floor. A lift serves all 4 floors. As the dominant purpose of the building is to provide commercial space, the depreciation status of the lift would be determined under the proposed new rules for commercial and industrial fit-out. This means that the lift would be a separate item of depreciable property and the costs associated with the lift would be spread over 25 years. The lift would be an item of depreciable fit-out because the dominant purpose of the building is to provide commercial space. However, the depreciation status of the fit-out of the penthouse apartment would be determined under current law.
A 10 storey residential apartment block has a commercial café on the top floor and a bicycle shop on the ground floor. A lift serves all 10 floors. As the dominant purpose of the building is the provision of residential accommodation, the depreciation status of the lift would be determined under the current law. However, the depreciation status of the fit-out associated exclusively with the café and the bicycle shop would be determined under the proposed new rules for commercial and industrial fit-out.
Implications for repairs and maintenance
2.23 The cost of repairing or maintaining assets is generally treated as a deductible expense in the year such expenditure is incurred. However, if the work adds to or improves the asset, this may constitute capital expenditure, with the cost having to be capitalised and, if it is associated with a depreciable asset, depreciated over future years. The application of these general principles to particular circumstances has been the subject of numerous court cases. Therefore, defining the boundary between repairs and maintenance (R&M) and capital expenditure precisely is very difficult. Ultimately, as with other issues associated with the capital/revenue boundary, it will be a question of fact. We do not propose to alter this boundary as part of this review.
Transitional rule – a non-residential fit-out pool
2.24 During the course of this review, we have been advised that a number of taxpayers have not separately identified and depreciated items of building fit-out. This is likely to have occurred where taxpayers have sought to minimise tax compliance costs – particularly where the value of the fit-out component was sufficiently low to make its separate identification uneconomic. There was nothing wrong with the choice these taxpayers made. The issue arises as to how to treat the fit-out once building depreciation is removed on these buildings from the 2011/12 income year.
2.25 While the fit-out should continue to be depreciable, in practice it will be difficult to work out how much of the building’s value is attributable to the fit-out. Taxpayers could in theory sell and reacquire the fit-out and then depreciate each item separately. An alternative approach would be for the tax rules to deem a sale and immediate reacquisition at market value. However, this would impose significant compliance costs on these taxpayers.
2.26 Instead, we propose a transitional rule that would allow a one-off adjustment. Under this approach, taxpayers that are currently depreciating commercial and industrial fit-out as part of the building, would create a building fit-out depreciation pool of 15 percent of the building’s adjusted tax book value. The pool would be depreciated at 2% straight line (equivalent to the current building depreciation rate). Taxpayers would only be permitted to elect to create a fit-out pool once - from the start of the 2011/12 income year.
2.27 Under this proposal there would be no deduction allowed for losses on the value of the pool when the pool is sold or scrapped. Also, it is proposed that there be no depreciation recovery on the pool when the building is sold. This reduces the need for more complex and arbitrary judgements to assign disposal proceeds between building and building fit-out pool.
2.28 Draft legislation that attempts to reflect the policy outlined above is contained in Appendix B.
2Step 1: Determine whether the item is in some way attached or connected to the building. If the item is completely unattached, then it will not form a part of the building. An item will not be considered attached for these purposes, if its only means of attachment is being plugged or wired into an electrical outlet (such as a freestanding oven), or attached to a water or gas outlet. If the item is attached to the building, go to step 2.
Step 2: Determine whether the item is an integral part of the building, such that the building would be considered incomplete or unable to function without the item. If the item is an integral part of the building, then the item will be a part of the building. If the item is not an integral part of the residential rental property, go to step 3.
Step 3: Determine whether the item is built-in or attached or connected to the building in such a way that it is part of the “fabric” of the building. Consider factors such as the nature and degree of attachment, the difficulty involved in the item’s removal, and whether there would be any significant damage to the item or the building if the item were removed. If the item is part of the fabric of the building, then it is part of the building for depreciation purposes.