Tax Deductible Business Expenses
What we Can and Cannot claim
With income tax rates as high as 33%, tax majorly impacts nearly all our business transactions. So, while we should be making business decisions for commercial reasons, it is vital to understand what their tax impact them will be. Yet, business operators regularly make decisions on business expenses based on false assumptions and misunderstandings, resulting in a drastically different tax outcome than they expect.
Take Pete, an owner of a rapidly growing IT Consultancy. At the start of March, with one month left in the tax year, his income is almost double the previous year’s and his bank balance is looking healthy. However, he is worrying about his inevitably growing tax bill. After some creative thinking, he decides he can finally justify upgrading his business vehicle, before 31 March, cleaning out much of this year’s surplus and surely saving a pile of tax.
So, Pete, who dislikes debt, pays a car dealer $55,000 plus GST for a late model Lexus. What he doesn’t count on is it cutting only $454 from the year’s tax. We will see why below.
What makes an expense tax deductible?
Most people understand that business expenses are tax-deductible. This means that when they “claim” a business expense, it is deducted from their taxable profit, reducing the profit and therefore reducing the tax calculated on that profit.
But we can’t always fully deduct what we spend, and we can’t always claim a deduction when we spend the money. So, let’s look at what we can deduct and when.
The General Tax Deduction Rule
Understanding one simple rule will clarify whether an expense is tax deductible or not in nearly all cases:
Expenses are tax deductible to the extent they are incurred to either:
- generate taxable income, or
- run a business that generates taxable income.
A computer retailer buys a computer to resell for a profit. The profit is taxable income, so the computer is bought to generate taxable income and therefore the cost is tax deductible.
The same business needs somewhere to operate so it rents a shop. The rent is paid to run the income generating business, so is tax deductible.
But it is not always so clear cut, especially as business owner-operators where our expenses often benefit both us and the business.
Expenses we can Fully Deduct
The following examples are generally 100% business expenses, and therefore fully tax deductible.
- Cost of Sales – Buying a product, or paying for a service, for resale
- Rent – Business premises or equipment
- Wages or Subcontractors – Including related costs such as Kiwisaver contributions and ACC levies.
- Interest – Paid on money borrowed and used for business purposes. NB, repayments of loans are often a combination of interest and principal. Only the interest portion is tax deductible.
- IRD Interest – IRD charge Use of Money Interest on underpaid tax. NB, Interest that IRD pay you on overpaid tax (at a much lower rate than they charge you) is taxable income.
Travel and Accommodation – On business trips. Entertaining customers while away will come under the entertainment rules below.
- Professional Development – Ongoing training to help with your current business is deductible. A degree or diploma to become a professional is not.
- Telecommunications – Business telephones and internet.
- Depreciation – As explained below, we can deduct for the cost of business assets such as business tools, equipment and vehicles, but the cost is spread over the asset’s life.
Expenses we can Partly Deduct
These expenses usually provide a business and a private benefit, so we can deduct the business portion.
- Home Office – When we live and work at the same place, we can deduct the business portion of shared expenses such as electricity, rates, insurance, rent or interest on mortgage payments, and maintenance on the overall property. The business percentage is generally calculated on a floor area basis.
- Motor Vehicle –If used for both business and private purposes, we must apportion ownership and running costs. The business percentage is usually calculated by keeping a log book of business travel.
- Travel and Accommodation – When combining a business trip with a holiday, we must apportion costs that relate to the whole trip, such as air fares, usually based on time spent on each.
- Telephone – Telephone rental and data used for both business and privately.
- Entertainment – When entertaining staff or business contacts, the tax deduction is limited to 50% of the cost. This includes costs of functions, events, food and drink, holiday accommodation and pleasure craft. Limited exceptions allow a 100% deduction for overseas entertainment, promotional functions open to the public, and food and drink at seminars and training sessions
Expenses we Cannot Deduct
Tax deductions are denied on some expenses even if we feel they benefit our business.
- Clothes – Even if we buy a suit solely for work, we cannot claim it. Only protective clothing or uniforms are deductible.
- Health Costs – Doctor visits, gym memberships, glasses, hearing aids or massages. Even if they restore our health so we can work they are not deductible.
- Life Insurance – But income protection insurance is deductible.
- Fines and bribes – Whether incurred while doing business or not, most fines and bribes cannot be claimed.
- Income Tax – No deduction for tax payments. Income tax is the government’s share of our income, not a cost of earning the income.
- GST – For GST registered businesses, GST paid to suppliers, collected from clients and paid to IRD all fall outside our income tax calculations. GST is a tax collected by business on behalf of the government. For non-GST registered businesses, however, GST inclusive expenses are deductible as the GST forms part of the final cost.
- Tax Penalties – As with fines, tax penalties are non-deductible.
Timing of Tax Deductions
Why did Pete’s $55,000 Lexus only save him $454 tax? Assuming it was a 100% business vehicle, the cost is fully deductible. The problem is not if he can deduct it, but when he can deduct it.
Tax laws follow the “matching principle”, meaning expenses are matched to the income they are used to generate. Pete’s Lexus should last for several years but is only used briefly in the tax year he purchased it, so he can only deduct a small portion in that year.
While most business expenses are used up in the short-term and can be fully deducted when incurred, or invoiced, here are two examples where deductions are delayed.
Fixed assets, such as vehicles and business equipment, benefit our business over more than one year. We do not deduct the cost when we buy them but “depreciate” them by deducting a portion each year, thus spreading the cost over its expected useful life.
Pete’s Lexus cost $55,000. IRD allow us to deduct 30% of a vehicle cost in the first year, $16,500 for Pete ($55,000 x 30%). However, Pete purchased the Lexus in the last month of the year so can deduct for that month only. He deducts depreciation of $1,375 ($16,500 / 12). If Pete is paying 33% tax, he saves $454 tax ($1,375 x 33%). Not the greatest immediate return on $55K.
Cost of Sales
In another attempt to tame a tax bill, a reseller may make a big stock order just before year end. The problem is, we can only deduct the cost of goods sold when we sell them. The cost of stock unsold at year end is carried forward to the following year.
Here’s a simple cost of sales calculation for the tax year ended 31/3/17:
The $24,000 of stock remaining becomes the next year’s “opening stock” and will be deducted in that year.
Bad business decisions are usually uninformed business decisions. While the outcome of many decisions involves some guesswork, the tax impact of our spending decisions does not have to be one of them. If unsure, get some advice before spending your money.
Contact us with your business questions.