Taxation keeping business owners awake
Prepaid expenses & how it works.
The topic of prepaid expenses is one that offers a kaleidoscope of complications. It can more confusing than a crypto-head trying to explain blockchain to .. well, to anyone really. We all know that stuff doesn’t make any sense!
But still. Why pre-pay expenses, right? When most times, it is better to pay for something afterwards. Even better if you can get 90 days after end of month terms. But, as a business owner, it is inevitable that you will pay for something ahead.
When that happens, you’ll wish you knew the following rules.
What do the prepayment rules entail?
Prepayment rules dictate a shift in the timing of deductions for specific prepaid expenses. They are applicable to those expenses that would typically be fully deductible in the year they are initially incurred.
Prepaid expenses are usually deductible over the “eligible service period,” which is limited to a maximum of 10 years. However, there are circumstances in which a prepaid expense can be immediately deductible. These circumstances include:
- **Excluded Expenditure**: If the expense falls under the category of “excluded expenditure,” it may be immediately deductible.
- **The 12-Month Rule**: Prepaid expenses can be immediately deductible if they meet the criteria outlined in the “12-month rule.” This rule allows for immediate deduction if the expense pertains to a service that will be provided within a 12-month period.
- **Relating to a Pre-RBT (Review of Business Taxation) Obligation**: If the prepaid expense is associated with a “pre-RBT obligation,” it may also be eligible for immediate deduction.
In summary, while prepaid expenses are generally deductible over the eligible service period, certain exceptions, such as excluded expenditure, the 12-month rule, and expenses related to pre-RBT obligations, can allow for immediate deduction. These rules help determine when and how prepaid expenses can be claimed as deductions for tax purposes.
How to apply the rules of prepayment leading to taxation of things.
The prepayment rules have specific criteria for their application. They are relevant to amounts that would typically be deductible under the general deductions or certain research and development (R&D) provisions. However, it’s important to note that special rules come into play for prepayments made within tax shelter arrangements.
The ‘eligible service period’ refers to the duration during which a specific activity or service is to be carried out as outlined in an agreement in exchange for the associated expenditure. The eligible service period commences on either of the following two dates, depending on which is later:
- The day when the activity or service specified in the agreement actually commences.
- The day when the expenditure is incurred.
The eligible service period extends until the conclusion of the last day that the activity specified in the agreement ceases to be performed, or for a maximum of 10 years, whichever of these events occurs first.
For instance, if we consider the example provided (derived from the ATO’s website):
Napoleon, who operates a delicatessen, makes a lease payment on 1 December 2022, covering the period from 1 December 2022 to 31 December 2023. In this case, the eligible service period begins on 1 December 2022 (the day when the lease agreement commences) and concludes on 31 December 2023 (the last day the lease agreement is in effect), resulting in a total eligible service period of 396 days. However, if this period were to exceed 10 years, the eligible service period would be capped at 10 years.
‘Excluded expenditure’ refers to specific categories of expenses that are not subject to the prepayment rules and can typically be immediately deductible for tax purposes. These excluded expenditures include:
- **Amounts of Less than $1,000 (excluding input tax credits)**: Expenditures that are less than $1,000 in total, excluding any input tax credits, are not subject to the prepayment rules.
- **Amounts Required to be Incurred by Court Order or Law**: Expenditures that are mandated to be incurred by a court order or by the laws of the Commonwealth, state, or territory are excluded from the prepayment rules.
- **Payments of Salary or Wages (Under a Contract of Service)**: Payments of salary or wages made under a contract of service are not subject to the prepayment rules.
- **Amounts that are Capital, Private, or Domestic in Nature (except certain research and development amounts)**: Expenditures of a capital, private, or domestic nature, with certain exceptions related to research and development amounts, are excluded from the prepayment rules.
- **Certain Amounts Incurred by a General Insurance Company**: Specific expenses incurred by a general insurance company in connection with the issuance of policies or the payment of reinsurance premiums are also exempt from the prepayment rules.
These exclusions ensure that certain types of expenses are not subject to the rules governing the timing of deductions for prepaid expenditures and can be claimed as deductions in the year they are incurred. It’s essential to consult the tax regulations and guidelines in your jurisdiction. That’ll help you determine how these exclusions apply to your specific situation.
Expenditure accrued by a registered GST entity:
(Derived from the ATO’s website again) Beetojoos, who is a registered GST entity, made a prepayment on June 30, 2023, for services that will be rendered by another registered entity from July 1, 2023, to June 30, 2025. These services qualify as a taxable supply, and Beetojoos acquired them exclusively for a creditable purpose. The total prepaid expenditure amounts to $1,045, which includes a GST component of $95.
Beetojoos’s prepayment is eligible for a tax deduction, characterized as a deductible expense. Beetojoos has fulfilled the conditions to qualify for an input tax credit. The prepaid expense will be reduced by the input tax credit of $95, resulting in a final prepaid expenditure of $950. Since the $950 prepaid expense falls below the $1,000 threshold, it qualifies as excluded expenditure and can be claimed as a deduction in the 2022–23 fiscal year.
The “12-month rule” is a tax provision that allows small business entities or individuals incurring deductible non-business expenditures to claim an immediate tax deduction. Under this rule, you can claim a deduction for prepaid expenditures if the following conditions are met:
- The payment is made for an eligible service period that does not exceed 12 months.
- The eligible service period ends in the next income year.
In essence, this rule allows for the immediate deduction of prepaid expenses for services that are consumed within a relatively short period and cross over into the next financial year. This helps taxpayers in small businesses or incurring non-business expenses to manage their tax liabilities.
A “pre-RBT obligation” typically refers to obligations or commitments that were established or incurred before the implementation of certain tax-related changes, particularly those related to tax shelter arrangements or managed investments. RBT, in this context, may stand for “Revenue Budgetary Test” or another tax-related acronym that signifies a change in tax rules or regulations.
In the passage you provided, it mentions that prepaid expenditure under certain managed investments (tax shelter arrangements) is not eligible for the 12-month rule. If the 12-month rule doesn’t apply, the deduction for prepaid expenditure is apportioned over the eligible service period or 10 years, whichever is less.
The reference to “pre-RBT obligations” likely means that this apportionment rule may apply to obligations or commitments established prior to the introduction of specific tax changes (the RBT), and the treatment of these obligations may differ from those established after the change. The exact meaning and implications may vary depending on the specific tax regulations and context.
A “pre-RBT obligation” is defined as any contractual commitment that fulfills the following criteria:
- It was in existence under an agreement on or before 11:45 am (by legal time in the ACT) on 21 September 1999, which is the date when the government released the Review of Business Taxation (RBT).
- It requires you to make a prepayment in exchange for something to be carried out under the agreement.
- It cannot be avoided through your own actions.
For prepaid expenses incurred under a pre-RBT obligation, specific rules apply for tax deductions. These rules align with those governing small business entities or entities that would meet the criteria of small business entities (if the aggregated turnover threshold was $50 million) and have chosen to claim an immediate deduction. In other words, the treatment of prepaid expenses for entities with pre-RBT obligations follows the same principles as small businesses regarding tax deductions.
Feeling confused by taxes? Most people do. Don’t feel too bad. But, you need to do something about it. Now.
He who hesitates is lost – If you need tax help for your business,