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TAX MATTERS: It pays to know what are deductible so as to reduce your taxes on rental income
Classification: This article covers the latest developments on tax treatment for rental income from real property under the Public Ruling No. 4/2011, effective for the year of assessment 2011. In particular, we will focus on the classification of rental income as business source or non-business source, the grouping of business source and non-business source when computing the statutory income, the commencement date of letting of real property, and allowable and non-allowable expenses.
A. Advantages of rent as a business source
The advantages of treating the rent as a business source are as follows:
• It can claim capital allowance.
• Business source losses can be carried forward to the next period.
• Current year business source losses can be utilised to set off all sources of income.
To treat rent as a business source, section 4(a) of Income Tax Act 1967 (ITA) requires the tax person to provide “maintenance services or support services” in relation to the real property.
Maintenance or support services: Where, in conjunction with the letting of a property, a person also provides “maintenance services or support services”, the letting of the property can be considered a business source of income under section 4(a) of ITA. The maintenance or support services should be “comprehensively” and “actively” provided.
‘Comprehensively provided’: Maintenance services or support services comprehensively provided means services which include:
(a) doing generally all things necessary (e.g. cleaning services or repairs) for the maintenance and management of the real property such as the structural elements of the building, stairways, fire escapes, entrances and exists, lobbies, corridors, lifts/escalators, compounds, drains, water tanks, sewers, pipes, wires, cables or other fixtures and fittings; and
(b) doing generally all things necessary for the maintenance and management of the exterior parts of the real property such as playing fields, recreational areas, driveways, car parks, open spaces, landscape areas, walls and fences, exterior lighting or other external fixtures and fittings.
However, if a person only provides security services or other facilities, it should not be considered as providing maintenance services or support services comprehensively.
Services ‘actively provided’: Services actively provided means the person who owns or lets out the real property:
(a) provides them himself; or
(b) hires another person or another firm to provide the maintenance services or support services.
Maintenance services or support services: The following examples in Table 1 show where the letting of property is treated as a business source: See Table 1
Rent as a non-business source: If a person lets out the real property without providing maintenance or support services comprehensively and actively, the rental income is regarded as a non-business source of income and is charged to income tax under section 4(d) of ITA.
Passive maintenance or support services: If a person lets out the real property and the maintenance or support services are passively derived from the ownership of the real property, the rental income is treated as non-business income under s4(d) of ITA.
Table 2 shows examples where the letting of property is treated as non-business source: See Table 2
B. Letting of property to related parties
Letting of property between related parties can be considered as a business source as long as maintenance services or support services are comprehensively and actively provided. The rental charged must be at arm’s length. However, if the rental charged to the related parties is not at arm’s length basis, the Inland Revenue Board would adjust the rental payment accordingly.
Meaning of related parties and related company: The related parties include individuals or companies; meaning one of the parties is in a position to influence or control the other party. Related company means where one company holds not less than 20 per cent of the ordinary shares or preference shares of the other.
C. Commencement date of letting of real property for the first time
The commencement date the real property is rented out for the first time, where the source is treated under s 4(d) of the ITA is “the date of letting”. However, the commencement date of letting of real property where the source is treated under s 4(a) of the ITA is on the date “the real property is made available for letting”, that is, when the real property is ready to be occupied by tenants. Expenses incurred before the commencement date are not allowable, therefore considered as pre-commencement expenses.
D. All real properties grouped as a single source
If a person lets out several real properties in a YA (Year of Assessment) and the letting of real properties can be grouped as one source:
(a) all real properties is a business source, all the real properties can be grouped as one business source under s 4(a) of the ITA (see Example 1);
(b) all real properties is a non-business source, all the real properties can be grouped as one non-business source under s 4(d) of the ITA (see Example 2); and
(c) some of the real properties is a business source and some is a non-business source, income from both sources shall be assessed separately under s 4(a) and (d) respectively (see Example 3).
E. Expense relating to income of letting real property
Expense ‘wholly and exclusively incurred’: An expense wholly and exclusively incurred in the production of income under section 33(1) of ITA and which does not fall under section 39(1) of the ITA is allowed as a deduction from income of business of letting of real property charged under s 4(a) of the ITA.
Deduction of direct expenses from income under s 4(d): Expense which is allowed a deduction from income under s 4(d) is direct expense that is wholly and exclusively incurred in the production of income under s 33(1) of the ITA.
Examples of direct expenses:
a) Assessment and quit rent paid to the local authority and land office respectively;
b) Interest on loan taken to finance the purchase of real property which is rented out;
c) Fire insurance premium paid in relation to the real property which is rented out;
d) Expense on rent collection fee and legal expense incurred to enforce rent collection
e) Expenses on rent renewal incurred on tenancy agreement or to change tenant; and
f) Expense on ordinary repair to maintain the real property in its existing state.
Initial or pre-commencement expenses to obtain first tenant: Initial expense is not allowed as a deduction from rental income assessed under s 4(a) or (d) of the ITA, as the expense is incurred to create a source of rental income and not incurred in the production of rental income. An example of such expenses is the cost to obtain the first tenant such as advertising cost.
Expenses during a period the real property is not rented out: Generally, expenses incurred in relation to a real property during a period it is not rented out are not allowable as a deduction. However, if the period the real property is not rented out occurs after it has been let out and it is clear that it is ready to be let out, then expenses during that period are allowable.
Letting ceases temporarily: If the letting ceases temporarily due to the following circumstances:
a) repair or renovation of the building;
b) absence of tenants for a period of 2 years ( 24-month period) after termination of tenancy;
c) legal injunction or other official sanction; or
d) other circumstances beyond the control of the person who lets out the real property,
then expenses for the period the real property is not let out are allowable provided that the real property is maintained in good condition and is ready to be let out.
Replacement cost of furnishings for non-business source: If the letting of real property is a non-business source, the replacement cost of furnishings, such as furniture and air conditioner can be claimed as deduction from gross income from letting.
Rental income received in advance: Rental received in advance is treated as gross income for the basis period in which it is received, any expense incurred in relation to that rental income after that basis period is allowable in the basis period in which the income is assessed. Therefore amendment has to be made to the assessment for the YA concerned.
Where there is more than one real property and rental from one or more properties is received in advance, expenses related to that source is deductible from other rental income in the basis period in which the expenses are incurred.
Capital allowances for rental under business source: If the letting of property is treated as a business source, capital allowances can be claimed on expenditure incurred on plant and machinery. The provisions in Schedule 3 of the ITA shall apply.
If the letting of property ceases temporarily, capital allowances can still be claimed provided the real property is maintained in good condition and is made available for letting.