The attraction of prepaid expenditure is that eligible taxpayers can claim a deduction this financial year, for expenditure that actually relates to next year.
For example, you pay 12 month’s rent in June 2020, this will be deductible in your 2019/2020 tax return, even though most of the expense relates to 2020/2021. By prepaying this expenditure, you effectively get to bring forward a tax deduction and therefore improve your tax position this year.
However, this tax planning opportunity is only available to some taxpayers.
Small Business Entity
SBE prepaid expenditure is deductible in the year it is incurred if:
- The eligible service period of the expenditure is 12 months or less, and
- The period to which the expenditure relates ends no later than June 30 the following year.
Example
Create Pty Ltd is a law firm with a prior year turnover of less than $1.5 million. In May 2020, it prepays $28,000 in rent to cover the period 1 June 2020 to 31 May 2021. Is Create eligible for the deduction?
Answer
Create can claim a $27,000 deduction in 2019/2020 because:
- It is an SBE (has turnover of less than $10 million)
- The eligible service period is 12 months or less (1 June 2020 to 31 May 2021), and
- The period to which the expenditure relates ends no later than 30 June 2021 (end of the following financial year).
If Create did not take advantage of this tax planning opportunity and rather paid its rent on a monthly basis, then it would only be able to claim a deduction of $2250 (the rent for the month of June 2020).
Instead by using the prepayment strategy, Create has improved its 2019/2020 tax position by claiming an extra $24,750 in deductions ($27000 – $2250). Using the corporate tax rate of 27.5%, the cash position of the business has been improved by $6806.
If the eligible service period had been more than 12 months or the period ended later than 30 June in the following, then you cannot claim an immediate deduction. Instead you must apportion the deduction over the period to which it relates or 10 years (whichever is less), using this formula:
Example
Assume that instead Create Pty Ltd prepaid two years rent totalling $44,000 in advance. Despite being in SBE, Create would not get a deduction for the entire amount of the prepayment in the 2019/2020 year because the service is more than 12 months (it is 2 years). Create’s 2019/2020 deduction would instead be $2219.
Using the formula: $54000 x 30 / 730
Therefore, if you wish to claim the whole of your prepaid expenditure in 2019/2020, limit your prepayment period to no more than 12 months.
Given the tax advantages of this strategy, if your business is an SBE and you have the spare cash at your disposal, you should consider the types of expenditure that you can prepay before 30 June 2020 such as:
- Insurance
- WorkCover
- Rent
- Subscriptions
- Advertising
- Memberships
- Maintenance contracts (e.g. for photocopiers), and
- Service contracts.
Non-SBE
Businesses that are not SBEs (have an turnover of more than $10 million) are not eligible for the prepayment deduction in relation to business expenditure. Instead they must apportion the deduction for prepaid business expenditure over the lesser of the eligible service period or 10 years by using the same formula as above.
Individuals
SBEs are not the only taxpayers he can take advantage of the prepayment deduction rule individuals can too! Non-business prepaid expenditure incurred by individuals is also eligible for an immediate deduction in the year in which it is incurred provided the same rules are followed:
- The eligible service for the expenditure is 12 months or less, and
- The period ends no later than June 30 of the year following when the expenditure was incurred.
Non-business expenditure for an individual is any expenditure you incur in earning assessable income from activities that do not relate to carrying on a business. This includes expenditure in relation to earning:
- Salary and wages, for example:
- subscriptions to professional trade journals
- memberships to professional associations
- Union fees.
- Rental income (even if your property is not earning income, provided it is available for rent), for example:
- maintenance fees (e.g. gardening)
- Body corporate fees
- Interest on your loan.
- Dividends on shares, for example interest on your loan taken out to purchase those shares.
So is Prepaid Expenditure worth it?
In deciding whether to employ the prepayment strategy you need to take stock of your cash flow and also whether it is advantageous to bring the deduction forward or delay it until the following year (this will depend on your current year and following year income).
Example
Tim is a plumber who also owns a rental property with a loan of $150,000, currently subject to a 3.5% interest rate. He expects the rental property to incur a net rental loss for the income year ending 30 June 2019. Tim has had a slow 2018/2019 year work-wise, he only earned $38,000 from his job during the year. However, he expects his earnings will rebound to his normal $96,000 in 2019/2020. In May, Tim makes a call to his banker about prepaying 12 months interest from 30 June 2019 to 29 June 2020 on his rental property and is quoted a rate of 3% equalling an amount of $4500. Should Tim prepay his interest?
Answer
2018/2019
Tim is eligible for the prepayment deduction because:
- He is not running a business but merely owns a single rental property
- The eligible service is for 12 months or less (30 June 2019 to 29 June 2020), and
- The period to which the prepayment relates ends no later than 30 June 2020 (being the last day of the following financial year).
Therefore, Tim can deduct the full $4500, reducing his income from $37,000 to $32,500 and will save $855 in tax compared to not prepaying the amount.
2019/2020
If Tim chooses to wait and not prepay the 12 months of interest he will now be able to reduce his anticipated 2019/2020 income of $96,000 down to $91,500 and save $1665 in tax. This would save an extra $810 compared to prepaying the amount in 2018/2019.
Tim, with his financial advisor, needs to weigh up whether he wants the immediate tax saving of $855 or the bigger tax saving of $1665 but the longer wait until 2019/2020.
If you are an SBE or an individual not in business, prepaid expenditure can bring forward a significant tax benefit to the current financial year. However, as we can see from the last example, sometimes the prepayment option is not always best if you anticipate having a significantly higher income in the following year. By contrast, if you desire cash flow benefit in the current year, or if you are income is expected to be significantly less next year then consider getting in quick and prepaying before 30 June!
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