The Treasury has asked the House of Representatives Economics Committee to conduct a short review of
work-related deduction expenses (WRE) and report back its findings and recommendations. Any changes to the current treatment could have adverse implications for both taxpayers and the tax practitioner community. Changes could be announced as early as the Federal Budget on 10 May 2016.
Fundamental entitlement
A fundamental principle behind our self-assessment tax system is the right to deduct expenses
against assessable income. The expenditure must meet the eligibility rules for deductibility: there must
be a nexus between the outgoing and the assessable income; and the outgoings must not be of a capital
nature. If it meets these rules, the expenses can be deducted from assessable income to arrive at a taxpayer’s taxable income.
This right is contained in subsection 8-1 of the Income Tax Assessment Act, which states: ‘You can deduct from your assessable income any loss or outgoing to the extent that:
- it is incurred in gaining or producing your assessable income; or
- it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.’
The principle behind allowing tax deductions for income expenses is essentially one of fairness. Some taxpayers incur greater expenses in earning their income than others, and the tax system accounts for this by allowing certain expenses to be claimed as a tax deduction.
Current system
Three quarters of net taxpayers in Australia claim WREs for items including tools of trade, equipment,
technical and trade books, travel, self-education and home office costs. The claimable amount is not capped, and the total claimed has grown substantially over time.
The Australian tax system is relatively generous when compared with other tax jurisdictions, however. In fact, comparable countries – including New Zealand, the United Kingdom, the United States and
Canada – either have limited deductions for WREs or do not allow them to be claimed at all.
New Zealand ‘cashed out’ WRE deductions in the late 1980s, providing income tax cuts in exchange for disallowing WRE deductions. This has been a major driver behind reducing the number of people needing to file a tax return in that country. In the 2012 tax year, around 1.25 million individual
tax returns were filed in New Zealand out of an estimated 3.3 million individual taxpayers.
Australia has an extensive framework of deductions for WREs. Australia’s Future Tax System Review (the Henry Review) noted that the WRE framework is also highly complex. It both creates a significant compliance burden for individuals and adds to administration costs for the ATO. The Henry Review commented that the law for WREs is complex, stating: ‘While the general principles are simple, many tax rulings, court rulings and legislative provisions underpin their application.’
The Henry Review also noted that under the current framework there are significant difficulties in correctly quantifying work-related costs, in apportioning expenses between income-earning purposes and private purposes, and in defining and claiming the deductions. It stated: ‘These complex arrangements constitute one of the impediments to further prefilling of tax returns and, ultimately, removing the need to complete a tax return for a large number of employees.’
Individuals are required to document and retain for five years proof of claims of $300 or more in WREs.
The Henry Review made the following three findings in relation to WRE deductions:
- the scope of work-related expenses for which a tax deduction can be claimed is broad by international standards.
- deductibility for work-related expenses adds a great deal of complexity to the personal income tax system and imposes high compliance costs on taxpayers.
- the scope and number of claims significantly limits opportunities for fully automating the preparation of tax returns using pre-filling.
The Henry Review did, however, acknowledge the role of the deductibility of self-education
expenses. To encourage further education and training, it recommended that tuition fees for education related to current employment should be excluded from any standard deduction reform (whilst other deductible self-education expenses would be included in the standard deduction) and should be deductible from the first dollar, with full substantiation.
Other issues with the current system
Our current system has also been criticised for the following reasons:
1. WREs that were not actually incurred: Some employees feel entitled to claim up to the full amount of work-related allowances received from their employer, even if the expenditure has not been incurred; for example, claims may be made against a travel or meal allowance. Some taxpayers simply invent fictitious claims, often involving small amounts, hoping to fly below the ATO’s radar.
2. WREs that do not meet the deductibility tests: The expenditure may essentially be private or domestic in nature, such as clothing.
3. WREs do not satisfy income tax substantiation rules: There are no receipts, log book or travel diary to
substantiate the expenditure, even though the taxpayer may assert otherwise to the tax agent or the ATO.
It is estimated that WREs are overstated by 10 per cent to 15 per cent, which equates to $2 to $3 billion dollars. As part of its tax gap analysis, the ATO is currently attempting to quantify the extent of overclaiming.
Arguments for retaining deductions
There are a range of arguments in support of retaining personal tax deductions, which caution against making any changes that are not part of a comprehensive reform of tax deduction arrangements. These include:
- equity concerns and the potential effects these may have on individuals and employees, particularly in sectors that rely on certain WRE deductions
- how the removal of deductions may influence the behaviours of individuals and lead to unintended consequences
- self-education deductions provide support for individuals to undertake work-related education.
Particularly with regards to the final point, Research Australia acknowledged the significance of education to the Australian economy, stating:
”It is increasingly recognised by the Australian government that Australia’s future is dependent on a highly educated and productive workforce, and that the rapid rate of technological change means that Australians need a lifelong approach to learning if we are to prosper in the 21st century. In this context, it makes sense for the government to provide incentives for individuals to invest in their own ongoing education. Providing a tax deduction for self-education expenses encourages individuals to take responsibility for their own ongoing education while assisting them to meet the cost of doing so.
Removing the deductibility of selfeducation expenses to fund a lower tax rate would remove this incentive for continuing education.”
Possible reform options
1) do nothing and maintain status quo
2) eliminate WREs altogether and lower personal tax rates
3) tighten the required nexus for WREs to reduce the scope of expenses claimable
4) introduce a universal deduction cap
5) introduce a tailored cap which takes into account specific industry and/or income level
6) introduce a threshold under which no WREs should be claimed byindividuals. Above the threshold claims can be made on proof of expenditure but subject to a maximum cap amount
7) introduce a threshold under which no WREs should be claimed by individuals. Above the threshold claims can be made on proof of expenditure only for expenditure in excess of this amount with no upper limit
The IPA has argued that a universal deduction cap is a blunt instrument, as it rewards taxpayers with little or no deductions and penalises those who are required to incur legitimate work related deductions. Whilst a deduction cap simplifies the personal tax system and makes pre-filled returns one step closer to reality, it fails the equity and fairness test.
The IPA represented members at the House of Representatives Economics Committee public hearings in Canberra as part of the committee’s consultation process. As stated in the introduction, the principle behind allowing tax deductions is essentially one of fairness, as no two individuals are the same. In the event that a cap is introduced, we also argued that selfeducation should be excluded from such an amount.
The government is actively looking at ways to address bracket creep. It needs to find savings in order to lower personal tax rates. Reforming WREs is one option under consideration. Any potential savings could evaporate if the costs of work related items are transferred to the employer. A more damaging consequence will be if employees forgo essential WREs, thereby damaging our nation’s productivity. The government will also face some opposition from the electorate if substantial carrots are not forthcoming in return for any loss of entitlements.
There is a strong community attachment, or sense of entitlement, to certain personal tax deductions and politicians need to be mindful of this when contemplating possible changes.
