Issues
Are the repairs made to the electricity poles on Mc Donald’s farm tax deductable? Is it a case of merely a repair or its nature is of restoration or replacement?
What are his tax implications on insurance claims Mc Donald received from damage to electricity poles by natural disaster?
What are his tax implications on Mc Donald for resurfing the road (owned by neighbour Peppa) to access his farm?

Law 1.) Assessable income consists of ordinary income and statutory income as per Income Tax Assessment Act 1997(ITAA97) section 6-1 (1). Section 6-5 of the Income Tax Assessment Act 1997 states that ordinary income is income according to ordinary concepts derived directly or indirectly from all sources whether in or out of Australia. Ordinary income is not defined in statute law; it is determined through case law and can be divided into four categories; income from personal exertion, income from business, income from profit-making schemes & income from property (Barkoczy, 2013, p. 266 - 267). A taxpayer’s accessible income includes not only amounts that are ordinary income but also amounts to that are statutory income (s6-10(1) ITAA97). Statutory income comprises amounts that are deemed by the legislation to the accessible income, But which are not otherwise necessarily income according to ordinary concepts.

2.) Taxpayers subtract deductions from their assessable income to arrive at their taxable income for the financial year. There are two types of deductions, general deductions and statutory deductions. Deductions can be claimed for the cost of fees such as regular management fees or commissions paid to a property agent or real estate agent for managing, inspecting or collecting rent for a rental property on your behalf. You can claim deductions on land tax, insurance, council rates, investment property interest rates and depreciation under of Income Tax Assessment Act 1997(ITAA97) s 8-1.

3.) Statutory, or specific, deductions are for particular kinds of expenditure that may not otherwise be deductable. These include; tax related expenses, repairs, borrowing expenses, losses from profit making undertakings or plans, payments for memberships or association, gifts under ITAA97.

4.) Repairs: Section 25- 10 ITAA97 provides deductions on expenditure on repairs to premises and depreciating assets used or held for the purpose of producing income such as rent. A ‘repair’ involves restoring an asset to its original condition. The object of a repair is to make good the deterioration in an asset through wear and tear without changing its essential character. This can involve “renewal or replacement of subsidiary parts of a whole” but not “reconstruction of the entirety” (Lurcott v Wakely and Wheeler [1911] 1 KB 905, per Buckley LJ at 923). In restoring an asset, it is not necessarily essential that identical materials be used. It is, however, essential that the function of the asset does not change.

5.) A repair should be distinguished from an improvement which involves making an item functionally better than it originally was. Likewise, a repair should be distinguished from a replacement, which involves substitution of an original item with a new item. Although these distinctions may seem obvious, it is not necessarily always clear whether an item has been repaired, improved or replaced. In W Thomas & Co Pty Ltd v FC of T (1965) 115 CLR 58, Kirrto J stated that: The words ‘repair’ and ‘improvement’ may for some purposes connote contrasting concepts, but obviously repairing a thing improves the condition it was in immediately before repair. It may sometimes be convenient for some purposes to contrast a ‘repair’ with a ‘replacement’ or a renewal. But repairs to a whole are often made by the replacement of worn-out parts by new parts. But, in case of a thing considered from the point of view of its use as distinct from its appearance, it is restoration of efficiency in function rather than exact repetition of form or material that is significant. Whether or not work done upon a thing is aptly described as a repair of what thing is thus a question of fact and degree.

6.) A repair often involves the replacement of parts of an asset with new parts. Even the replacement of parts of an asset with new parts. Even the replacement of large portions of an asset can constitute a repair so long as the original asset remains in existence and is not effectively replaced with a new asset. This is illustrated in the case Rhodesia Railways Ltd v CIT Bechuanaland [1933] AC 368, where there owner of a 588 mile long railway lines was allowed deductions for expenditure incurred in renewing some 74 miles of tracks with new sleepers, rails and fastenings. It was held a non-capital repair by Privy Council, as the renewals merely restored the line to its original condition. In contrast, is the case of Lindsay v FC of T (1961) 106 CLR 377, in this which deductions were denied for costs incurred for repairs made to a slipway owned by a partnership of ship repairers. Due to unavailability of certain materials, a substantial proportion of original slipway was demolished and replaced with a slightly longer slipway constructed out of concrete instead of timber. The high court held that the extensive works went beyond a repair and constituted the acquisition of a new capital asset.

7.) When expenditure in relation to an asset leads to a functional improvement rather than a repair, it will typically be of capital nature. This demonstrated in FC of T v Western Suburbs Cinemas Ltd [1952] 86 CLR 102. In this case, a cinema owner was denied deductions on the costs of replacing the existing ceiling in one of his cinemas. The high court held that the expenditure was of capital nature, as a new ceiling would provide a number of advantages over the old ceiling. The initial doctrine, Law Shipping Co Ltd, indicates that making good defects to property, which existed at the time of acquisition, are capital in nature and therefore are not deductable s 25-10 ITAA97. If there is a need to repair that has resulted from wear and tear after purchase, a deduction may be claimable. However, has the repair merely restored the item to its previous state or has the expenditure resulted in an improvement (Western Suburbs Cinemas case). To decide this we consider whether the work has resulted in: the item functioning significantly better, a change in the character of the item, the item having a new and different function, or an additional function. If the answers to these questions are yes, a deduction is not allowed under section 25-10 ITAA97. However, a partial deduction is allowable under Division 43. Division 43 allows a write- off of 2.5% p.a for structural improvements. 8.) If your property is damaged or destroyed, you may receive an insurance payment. How this is treated for tax purposes depends on: a. the type of property – home, other buildings, cars, personal property or work-related items b. whether or not the property is income-producing – for example, a rental property or business premises.(ATO)

Under section 20-20(1) of ITAA97, “an amount is not as assessable recoupment to the extent that it is ordinary income or it is statutory income because of the provision outside the subdivision.
Section 20-20(2) states that, “an amount you have received as recoupment of a loss or outgoing is an assessable recoupment if: a. you received that amount by way of insurance or indemnity; and b. You can deduct an amount for the loss or outgoing for the current year, or you have deducted or can deduct an amount for it for an earlier income year, under any provision of this act. 9.) Capital expenditure is not deductable under the general deduction provision in s 8-1 ITAA97 as it falls within the first negative limb of the section.

Application
The nature of repairs to the electricity poles of Mc Donald’s farm were actually restoration job as opposed to making it functionally better. The expenditure incurred in relation to the electricity poles leaded to an improvement rather than a repair. Although, no greater efficiency of function of electricity is provided by the cables, the asset has not been restored to its original condition under ITAA97. Applying the case law Western Suburbs Cinemas Ltd, where the ‘celotex’ ceiling was replaced with ‘fibro’ ceiling and the high court held that the expenditure was capital in nature. A similar situation can be seen in the case of Mc Donald because he has replaced the electricity poles with underground cables and this will provide a number of advantages over the original poles as there will be low chances damage with protection from future storms and low cost of repairs in future.
Any further argument by Mc Donald that it should be allowed as a deduction for the ‘notion cost’ that it would have incurred even if the asset was repaired to the original point is likely to be rejected as in the case of Western Suburbs Cinemas Ltd, where the judge said that “ when a taxpayer has two courses open to him, one involving an expenditure which will not be an allowable deduction, and for his own reasons he chooses the second , he cannot have his income tax assessed as if he had exercised his choice the opposite way”. Similarly, Mc Donald had a choice to restore the electricity poles to their original condition, but he chose to go the other way and make improvements that are capital in nature. However, a partial deduction is allowable in this case under Division 43 of 2.5% per annum for structural improvements.
In the case of repairs made to the faulty wires and installation of new power points and switchboards to the new shed, the case of Rhodesia Railways Ltd v CIT Bechuanaland is to be applied where it is stated that the replacement of large proportions of an asset can constitute a repair as long as its original asset remains the same. Whereas, in the case of Mc Donald, the replacements have been made to a new asset. Therefore there would be no deductions for the same.
The insurance benefit paid to Mc Donald by AMI Insurance of $40,000 due to damages caused by thunderstorm is an assessable statutory income under Division 15 ITAA97. According to this division the payment received from insurance or indemnity for loss of assessable income is an assessable income under section 15-30. Therefore, the insurance amount received is fully taxable because the shutdown of electricity on Mc Donald’s farm would have caused him loss of income due to ceased operations. And therefore, section 15-30 includes in a taxpayers assessable income, amounts received by way of insurance or indemnity for the loss of amounts that would have been included in accessible income and that are not ordinary income under section 6-5 of ITAA97.
The adjoining road owned by the neighbour (Peppa) resurfaced by Mc Donald to gain access to the farm incurred expenses of $20,000. Capital expenditure is not deductable under the general deduction provision in s 8-1 ITAA97 as it falls within the first negative limb of the section. This means that capital expenditure is therefore only deductable if it satisfies the requirements of a specific deduction provision. However this expenditure is not capital in nature because the asset is not owned by Mc Donald’s and therefore a deduction would not be allowed.

Conclusion
The repairs made to the electricity poles at Mc Donald’s farm is actually a restoration job as opposed to a repair with reference to the case law Western Suburbs Cinemas Ltd .Therefore, it is not deductable from the assessable income under ITAA97. However, a partial deduction of 2.5% is deductible.
The new switchboards added and the faulty wires repaired in the new she are not deductable either under the case law of Rhodesia Railways Ltd v CIT Bechuanaland as the asset is new.
The insurance claim received for the damages by thunderstorm is assessable statutory income under Division 15 and section 15-30 ITAA97. The adjoining road repaired by Mc Donald incurring an amount of$20,000 is not deductable under the provision s8-1 ITAA97 as the asset is not owned by Mc Donald.

References;-
BIBLIOGRAPHY

Barkoczy, S (2013). Core Tax Legislation & Study Guide, 16th ed, North Ryde: McPherson’s Printing Group.

Barkoczy, S (2013). Foundations of Taxation Law, 5th ed, North Ryde: McPherson’s Printing Group.

Websites:

Australian Taxation Office (1992, November 5). Income tax and fringe benefits tax: the difference between an allowance and a reimbursement. Retrieved May 18, 2013 from http://law.ato.gov.au/atolaw/view.htm?Docid=TXR/TR9215/NAT/ATO/00001

Australian Taxation Office (2013, March 13). Withholding from allowances. Retrieved May 18, 2013 from http://www.ato.gov.au/businesses/PrintFriendly.aspx?doc=/content/18499.htm

Case Law

Lurcott v Wakely and Wheeler [1911] 1 KB 905, per Buckley LJ at 923

W Thomas & Co Pty Ltd v FC of T (1965) 115 CLR 58

Rhodesia Railways Ltd v CIT Bechuanaland [1933] AC 368

Lindsay v FC of T (1961) 106 CLR 377

FC of T v Western Suburbs Cinemas Ltd [1952] 86 CLR 102

Legislation:

Income Tax Assessment Act 1936

Income Tax Assessment Act 1997