Depreciation

Overview
• Purpose of depreciation
• Relationship with financial accounting
• Identification of depreciable assets
• Determining useful life
• Methods of depreciation
• Disposal of depreciable assets
• Business intangibles
 I. Purpose of Depreciation
• Deduction is allowed for expenditure incurred in
deriving business income
• Issue: is the timing of the deduction
• Distinction made between:
– Expenditure that has a benefit for only a tax year (i.e.
operating expenditure) – revenue in nature and deductible
in the tax year incurred
– Expenditure that has a benefit over a longer period (such
as cost of plant, machinery and equipment) – capital in
nature and deductible over the useful life of the
expenditure (or asset acquired)
 Broad Classes of Expenditure
• Expenditure that has an ascertainable useful life
– Useful life is one year or less – then deducted outright
– Useful life of more than one year – depreciated over
useful life
• Expenditure that does not have an ascertainable
useful life
– Expenditure (asset acquired) may hold its value
– Useful life of asset acquired may not be possible to
ascertain
– In these cases, cost recognised when asset disposed of
II. Relationship With Financial Accounting

• Under financial accounting, depreciation matches a portion

of the cost of a fixed asset to the revenue that it generates
– Matching principle - revenues matched with expenses in the
same reporting period
• The net effect of depreciation is a gradual decline in the
reported carrying amount of fixed assets on the balance
sheet
• Same applies for tax purposes – a portion of the cost of a
fixed asset is allocated to each tax year in the useful life of
the asset
– Tax depreciation may be aligned with accounting depreciation
III. Identification of Depreciable Assets
• Depreciable assets have the following
characteristics
– Tangible movable property (such as plant,
equipment, machinery, computers and fittings)
– The property has a useful life of more than one year
(aligns with the accounting rule)
– The property likely to decline in value as a result of
normal wear and tear, or obsolescence
– Used wholly or partly to derive business income
• Must be in use
 Buildings vs. Land
• Land – not a depreciable asset
– Limited resource with an unlimited life
• Land does not lose value and reduce to a zero base like assets
such as plant and machinery
• Land normally holds its value or, because of demand, it
increases in value
• Building or other structural improvement to land
(such as a fence) does have a limited life and,
therefore, declines in value
• Cost of the building is separated from the cost of
the land and is depreciated
 IV. Determination of Useful Life
• Tax law may follow financial accounting
treatment
• Useful life of assets may be provided for in the
tax law
• Allow taxpayers to self-assess the useful life of
assets
– Consistent with self-assessment
 V. Methods of Depreciation
• Two main accounting methods
– Straight-line - asset declines in value evenly over useful
life
– Declining balance or diminishing value - asset declines
more rapidly in the early years of use
• Not relevant for buildings as assumed to decline in value
evenly over useful life
• Accelerated depreciation – rate of depreciation for
tax purposes is higher than for accounting purposes
• Issue is timing of the deduction
 Straight-line Depreciation
• Asset costs $1m and has an effective life of 5
years, then depreciation rate is 20% per
annum
• Year 1 - $200,000
• Year 2 - $200,000
• Year 3 - $200,000
• Year 4 - $200,000
• Year 5 - $200,000
 Diminishing Value Method
• Assumption is that an asset declines in value at a faster
rate in early years of useful life
• Diminishing value rate is usually 1.5 x straight-line rate
• Same example – depreciation rate is 30% - applied
against the written down value of the asset
• Year 1 $1m x 30% = $300,000
• Year 2 $700,000 x 30% = $210,000
• Year 3 $490,000 x 30% = $150,000
• Year 4 $340,000 x 30% = $105,000
• Year 5 $235,000 x 30% = $70,000 (and so on)
 Apportionment
• Apportion for part year use
– Year of acquisition
– Asset taken out of service for a period during the tax
year
• Apportion if used partly to derive business
income and partly for some other purpose such
as to derive exempt income or a private purpose
– E.g. a sole trader may use a computer partly for
business and partly for private purposes
VI. Disposal of a Depreciable Asset
• Depreciation rate is based on an estimate of the useful
life of the asset
• Estimated useful life may not match the actual wear
and tear of the asset
• Adjustment made on disposal of the asset
– Recaptured depreciation deductions included in business
income
• Decline in value is less than estimated
– Additional deduction if the price received is less than
written down value at time of disposal
• Decline in value greater than estimated
 Disposal of a Depreciable Asset
• What if the price received is greater than the
original cost of the asset?
• Gain above cost included in business income
– Exception when depreciable asset is also a taxable
asset (such as a commercial building)
• Gain above cost taxed under Article 59
• Apportionment if the asset is only partly used
to derive business income
 Disposal of a Depreciable Asset
• Deferral of taxation
– The proceeds of disposal are used to acquire a new depreciable
asset of a similar kind (replacement asset)
– Acquisition of replacement asset must be within 6 months of
disposal of replaced asset or such further time as Authority
allows to acquire replacement asset
• Cost of the replacement asset is the written down value of
the replaced asset at time of disposal
– Increased by any amount paid for the replacement asset in
excess of the price received for the replaced asset
– Reduced by amount that price received for the replaced assets
exceeds the price given for the replacement asset
 VII. Business Intangibles
• Article 25(7)(a) lists four categories of business intangible
– Industrial or intellectual property rights
– Marketing intangibles
– Limited term contractual rights
– Expenditures providing an advantage or benefit for more than
one year
• Expenditure not incurred to acquire movable or immovable property
• Example: preliminary expenditure
• These are business intangibles that lose value through use in
taxpayer’s business
– Goodwill is an intangible but not a business intangible as defined
as it does not lose value
 Business Intangibles
• Straight-line depreciation only
• Based on useful life
– Ceiling on depreciation period for long life
business intangibles
• Same disposal rules apply
 Business Intangibles - Limited Term
Contractual Rights
• Example – Taxpayer paid $90,000 to be the
appointed as exclusive distributor of a product
for 3 years
– Contractual rights = business intangible
– Useful life = 3 years
– Annual deduction = $30,000 straight-line