Depreciation changes require fresh thinking

Milking sheds retain a degree of depreciability. Photo / Supplied

Changes to the taxation of property were widely anticipated to be part of the Government's 2010 Budget and changes were certainly delivered.

Specifically, from the 2011/12 income tax year, the depreciation of buildings will no longer be allowable for tax purposes as the rate will be zero per cent. This zero rate will apply to existing buildings owned and new buildings acquired after this date. The presumption here is that all buildings have an estimated useful life of 50 years.

Where taxpayers consider particular buildings have an estimated useful life of less than 50 years, they cannot automatically claim depreciation, but will need to apply to the Inland Revenue Department (IRD) for a provisional depreciation rate for "classes of buildings" considered to have an less than 50 years estimated useful life.

Current indications are the IRD will require a high onus of proof on applicants to establish the estimated useful lives for classes of buildings of less than 50 years.

This then begs the question: Just what is a building?

Earlier this year, the IRD issued an "interpretation statement" on the meaning of "building", implying that a building is to be defined by its ordinary or conventional meaning noting the following characteristics:

A building is a structure of considerable size.

A building is "permanent" in the sense that is intended to last a considerable time.

A building is enclosed by walls and a roof.

As a consequence of this statement, the IRD has tightened up on the category of "structures" that they consider to be "buildings".

The Budget tax legislation means that these particular structures, if acquired on or before July 30, 2009, by a taxpayer, remain depreciable at the original depreciation rates, with losses on disposal deductible.

Buildings of this nature acquired after July 30, 2009, remain depreciable at the applicable depreciation rates even when the zero per cent depreciation rate generally begins to apply. These buildings include: barns, including drying barns, with an estimated useful life of 20 years; chemical works with an estimated useful life of 33.3 years; fertiliser works with an estimated useful life of 33.3 years; powder-drying buildings with an estimated useful life of 15.5 years; and site huts with an estimated useful life of 12.5 years.

The Budget tax legislation also listed a number of buildings that continue to be depreciable at a rate of higher than zero per cent regardless of when acquired. These are carports hired out to householders, portable huts, cool-stores and freezing chambers, slaughterhouses on farms, fowl houses, plastic hothouses and PVC tunnel houses, glasshouses, structures affected by acid, milking sheds, roofed livestock yards, wintering barns and simple loading barns, and temporary structures.

For most property owners however, the "structures" on their property will fall within the new, non-depreciable, "building" category.

The big question for commercial and industrial property owners is: What is the split between the core building structure and fit-out, and what will the Government's position be on depreciating fit-out?

Ultimately the question revolves around estimated useful life.

But it is an important question since the answer is the difference between receiving no depreciation allowance and no tax benefit, or receiving an allowable depreciation claim and a corresponding benefit.

The IRD plans to review the boundary between buildings and depreciable fit-out for commercial buildings and any changes in this regard will apply from the same date that the zero per cent depreciation rate kicks in.

If there are to be few provisional depreciation rates issued for classes of buildings with estimated useful lives of less than 50 years, there is a real expectation that the definition of a depreciable fit-out should be broad.

On this, the IRD recently issued its guidelines for what constitutes separately depreciable fit-out in a residential rental property.

The overriding criteria used the following three-step process:

1. Whether an item is attached or connected to the building (the "Attachment" test).

2. Whether an item is an integral part of the building such that it would be incomplete or unable to function without the item (the "Integral" test).

3. Whether an item is built in or attached or connected to the building as part of the "fabric" of the building (the "Fabric" test).

The document included a number of examples with the following being designated as part of the building: plumbing and piping, electrical wiring, internal walls, door, fitted furniture, kitchen cupboards, bathroom fittings and furniture, lino, and tiles on the wall and floor. Examples given of fit-out were: wardrobes and cupboards not built in, carpet, curtains and blinds, water heaters and hot water cylinders, and heating and air conditioning.

It is yet to be seen how much the above work on residential property fit-out will influence policy on commercial property fit-out.

Undoubtedly there will be considerable pressure for the fit-out categorisation to be more extensive for commercial and industrial buildings where the estimated useful life is 50 years.

If we take the example of a hotel, the estimated useful life of fitted furniture and bathroom fittings (which based on the residential building interpretation would be part of the building) is significantly less than 50 years.

In a commercial office context, there is no doubt that much of the fit-out does not have a useful life anywhere near 50 years. Of real note here is the example of the complete refurbishment of the early 70s building at 21 Queen Street, which was "gutted" back to the concrete framing and completely refitted.

Given it will no longer be possible to apply for special depreciation rates for specific buildings, much work needs to be completed to ensure fair allocation of fit-out components for commercial and industrial buildings.

Application of the fit-out position for residential rental property to commercial and industrial buildings is clearly inappropriate.

An emerging financial reporting issue, with huge surprises for certain owners of buildings which will no longer be tax-depreciable, involves a significant one-off tax charge against profit.

Finally, we would expect that pressure will mount from owners of commercial and industrial buildings for the broadening and increased certainty of what is regarded as tax-deductible repairs and maintenance.

Hanley is a corporate tax partner, and Schellekens a real estate advisory partner at Ernst & Young