Farmers to face increased compliance costs
Tax Alert - November 2016
By Susan Wynne and Brad Bowman
Farmhouses are the administrative base for most farms. Throughout the country they are often the boardroom for business meetings, an office for meeting professional advisers, a bathroom and kitchen for employees, and even a space for mixing livestock formula. Since the 1960s, Inland Revenue has allowed a deduction of 25% of farmhouse expenses without any evidentiary support where a farmhouse is part of a farming business. This is in contrast to the limitation on claiming private expenditure as a business expense that applies to other taxpayers.
Fifty plus years later, a review of historical Public Information Bulletins and Taxation Information Bulletins has prompted Inland Revenue to reconsider a number of long-standing policies that allowed some farmers to claim deductions for what would otherwise be non-deductible private expenditure.
Inland Revenue released a draft interpretation statement on the deductibility of farmhouse expenditure for public consultation on 14 October 2016. In the draft interpretation statement, Inland Revenue has largely moved away from allowing expenses as deductions without the need to substantiate the claim. This position has been taken as Inland Revenue’s “main concern is to allow farmers to deduct farmhouse expenses that are business related, while ensuring that deductions are not claimed for expenses that are private in nature”. Instead farmers should generally determine the deductions of farmhouse expenditure under the ordinary deductibility principles (including the general permission, general limitations and specific deductibility provisions under Part D of the Income Tax Act 2007 (“ITA 2007”)).
It is important to note that the draft interpretation statement only applies to farming businesses, so its discussion focuses on determining the deductible expenses to this kind of business.
A factor in determining if farmhouse expenses are deductible is who is living in the farmhouse. The draft interpretation statement identifies a number of scenarios and discusses the deductibility of farmhouse costs in each of those situations. In general if the farmhouse is provided to an employee or rented at market value then mortgage interest and other expenses related to that property should be fully deductible to the farming business (note, you should be separately considering if there are any tax issues from the provision of accommodation to employees; refer to our July 2014 Alert for further information). If the farmhouse is provided to someone who is not an employee or not paying rent then no deduction for expenses related to that property may be allowed. The exception would be mortgage interest may be deductible if a company owned and operated the farm. If a sole trader or partnership owns or leases and operates the farm then apportionment of expenses would be required.
Where apportionment is required, the draft interpretation statement discusses dissecting or separating expenses into those that are clearly related to the farming business and those that may relate to the farmhouse and have a non-deductible private element. Where expenses relate to the farm as a whole, including the farmhouse, apportionment based on the cost or value of the farmhouse compared to the farm as a whole is suggested. The traditional apportionment methods used for home office expenses based on area used and time usage is not considered appropriate given a farmhouse may represent a small area of the farm but a high proportion of the farm cost or value.
As a concession to minimise compliance costs a distinction is made between farming businesses where the cost of the farmhouse including curtilage and improvements is 20% or less (Type 1 farms) of the total cost of the farm compared to those where the value is more than 20% (Type 2 farms) of the total cost of the farm. It is proposed that the cost of the farmhouse and farm would be used for this calculation but if this was unknown then a valuation, either a formal valuation or a reasonable estimate, could be used instead. The draft interpretation statement also suggests that the Type 1/Type 2 calculation should only be required once unless circumstances changed. The example given in the draft interpretation statement was if private use improvements were made to the farmhouse, but potentially there could be a number of scenarios which could require this calculation to be updated.
For farmers who live in Type 1 farms, which are considered to have a low private use element, the draft interpretation statement provides the following concessions:
- 15% of general farmhouse expenditure (including rates) is deductible without evidentiary support. This percentage is suggested to be a more realistic amount than the previously used 25%. Type 1 taxpayers may claim a higher deduction if the deduction can be substantiated and they wish to undertake the calculations required.
- 100% of interest expenditure in relation to Type 1 farmhouses is deductible.
Type 2 farms are given no such concessions and must calculate the actual business use of the farmhouse to claim any farmhouse deductions, including interest.
Another long standing concession allowed farmers to claim 100% of the costs of telephone rental where the farm business phone was based at home. It is proposed that this policy is also modified and that all farming businesses may claim only 50% of fixed line telephone charges as deductible, unless they can show actual business use is greater. This is consistent with the operational position for other taxpayers running businesses from home.
Taxpayers need to be aware of the new concession levels, as they amount to a change in a policy that has been in place for well over 50 years.
Once finalised, Inland Revenue are expected to apply the new interpretation statement from the beginning of the 2017-18 income year.
There is no doubt that the proposed changes are intended to level the playing field so that farming businesses operate under the same rules as other taxpayers when it comes to the deductibility of private expenses. The difficulty is that this comes with a compliance cost to farming businesses compared to the current approach which is straightforward to apply. Inland Revenue has acknowledged the need to balance the strict application of the law, equity between taxpayers and protecting the integrity of the tax system against compliance costs and has attempted to provide a practical approach for those farming taxpayers considered low risk, being Type 1 farms. Inland Revenue has also provided some useful commentary on the approach to apportioning expenses as well as giving a number of examples in the draft interpretation statement which are always useful guidance.
Taxpayers with Type 1 farms may still be able to apply a flat rate of 15% to determine deductible farmhouse expenditure. However, this is not without its compliance costs, as establishing and tracking the cost or value of the farmhouse and improvements compared to the total farm may be difficult in some cases. The concession does not apply to taxpayers whose farms will qualify as Type 2 and those taxpayers will be required to apportion actual farmhouse expenditure between business and private use. This exercise would likely add compliance costs to the preparation of a tax return for a farming business. In reality this will be more of an issue for smaller operations that are benefiting under the current approach compared to the larger scale farming operations where the expenses concerned and the impact of the change in available percentage from 25% to 15% is less material.
As noted above, Inland Revenue’s main concern is to ensure that taxpayers are deducting farmhouse expenditure in accordance with ordinary deductibility principles and not simply applying an arbitrary rate defined by historic policy. This aim has merit. Ironically, the draft interpretation statement still provides for a flat rate (albeit lower) and includes an additional arbitrary threshold (i.e. distinguishing Type 1 farms based on a 20% or less cost threshold). The draft interpretation statement is also silent on any evidence which suggests that 15% is more representative of a farmhouse’s business use than the previous 25%. So although it has good intentions, we consider that the new policy continues to be arbitrary in some respects.
Finally, we note that the draft interpretation statement does not consider relevant proposals included in the Taxation (Business Tax, Exchange of Information, and Remedial Matters) Bill (“the Bill”). The Bill proposes to insert a new section into the ITA 2007 providing an optional alternative method for calculating the deductions for premises that are used for both business and private purposes (which would include farmhouses). The proposed new section would allow taxpayers to apportion any interest, rates and/or rent in accordance with the business portion of the premises. Additionally, taxpayers would be allowed a notional deduction based on a rate prescribed by Inland Revenue for every square metre of business use. Like the draft interpretation statement’s application date, the proposed section would apply from the beginning of the 2017-18 income year. We consider that taxpayers would benefit if the draft interpretation statement was updated to include comments in relation to the proposed section’s application, as the draft interpretation statement would not otherwise be entirely complete and representative of the law at the time of its application.
Inland Revenue are looking for comments in relation to the draft interpretation statement. Submissions close on 22 December 2016.
If you have any questions in relation to the draft interpretation statement, please don’t hesitate to contact your usual Deloitte advisor.
November 2016 Tax Alert contents
- Compliance Focus for Multinational Enterprises
- Australian GST to apply to low value goods from 1 July 2017
- PAYE Reporting proposals finalised
- Farmers to face increased compliance costs
- Facts and figures as Inland Revenue reports on its performance
- A snapshot of recent developments