Chapter

17 Depreciation, Amortization, and Depletion

Author(s):
Victor Thuronyi
Published Date:
June 1998
Share
  • ShareShare
Show Summary Details
Author(s)
Richard K. Gordon

Strictly speaking, the calculation of income demands complete revaluation of all assets and obligations at the end of every period. Practically, the question is: How shall the requisite value estimates be obtained?

Henry Simons

I. Introduction

Henry Simons correctly noted that a comprehensive income tax requires the revaluation of all assets and obligations to take into account accumulated gains and losses at the end of every tax period. As a general matter, all income tax systems have accepted that, in many instances at least, the practical question of valuing property for each relevant period can be very difficult to answer. Changes in the value of property will often not be taken into account until some particular moment, such as when ownership of the property is transferred or the property becomes worthless. However, such deferral of accounting for accrued gains and losses may result in either undertaxation, if the value of the property has increased, or overtaxation, if it has decreased.1 Most tax accounting systems allow or require the periodic estimation of gain or loss on certain types of property.2 Depreciation (often called amortization when involving nonphysical property) is one of the most important instances where the taxpayer is allowed to deduct estimations of loss over time.3 The decision to accrue estimated declines in value through depreciation is largely predicated on three points: that the property has a “useful life”4 longer than the taxable year, that absent accrual there would be a substantial likelihood of mismatching current income with unrealized losses, and that reasonable estimates of such losses can be made.

If property has a useful life shorter than the taxable year, its full cost could be completely deducted before the next taxable year, obviating the problem of unaccounted losses.5 For this reason, most jurisdictions deny a full deduction for the cost of any property with a useful life of greater than one year, while at the same time restricting depreciation allowances to such cost.

Because gain in the value of property is not typically recognized until the property is transferred (or until it is scrapped or otherwise becomes worthless), most tax jurisdictions include a counterbalancing or compensating rule not to recognize accrued but unrealized losses.6 Also, many jurisdictions do not tax either the gains or the losses on certain property held by individuals. Finally, many tax systems exempt from tax the income generated by some types of property. However, depreciable property usually generates currently taxable income. If deductions were not allowed for losses in the value of such property, there would be a mismatching of income and loss, and therefore overtaxation.7 For this reason, depreciation deductions are typically limited to property that generates currently taxable income.

Many types of physical property used to produce income are subject to wear and tear, which reduces the property’s value.8 In addition, technological changes may make the property relatively obsolete and therefore also less valuable. Nonphysical property may also lose value, either because the right to possession or use is limited in time (such as with the case of a lease or patent) or because of technological obsolescence. These factors—wear and tear, obsolescence, and, in the case of nonphysical property, a limited term—all tend to cause the value of certain types of property to decrease over time. Although the rules of different jurisdictions vary, as a general matter it is to the costs of such property that depreciation deductions are normally restricted. The most common, and perhaps most important, method of fixing such a restriction is by limiting deductions to types of property that have predictable useful lives.

Of course, the knowledge that property is losing its value as a result of wear and tear or obsolescence over its useful life does not permit the fixing of the value of each intervening yearly reduction.9 In addition to yearly fluctuations in the effects of wear and tear and obsolescence, other factors may cause variation in the value of the property. Various market forces, such as changes in supply or demand for the product produced by the property or in the cost of production or availability of replacement property because of technological innovation or other reasons, will likely result in a corresponding increase or decrease in its value. Generally speaking, these effects are less predictable and may result in increases as well as decreases in value. As a result, there is probably no jurisdiction that generally includes such effects when determining allowable depreciation.10 However, repairs or improvements made to property, or an increase in the term of nonphysical property, may increase its productivity or its productive life and therefore its value. Because these effects are often easier to estimate, they are frequently included in determining depreciation allowances.

There are techniques other than depreciation for compensating for accrued decreases (or increases) in the value of property held for the production of income. One technique would, instead of allowing current deductions for depreciation, allow a deduction only when the property is transferred (or scrapped), but also give the taxpayer an additional allowance for the time value of the postponement of the deduction.11 There are a number of problems with this approach. First, whenever interyear tax payments or refunds are involved, circumstances may change, with regard to both the tax system and the taxpayer. Rates may go up or down, taxpayers may go out of business, and, in either case, cash flow is invariably affected. However, as noted, most jurisdictions restrict depreciation in some fashion to property whose decline in value can be predicted through the fixing of a useful life. Nevertheless, property without a known useful life may also depreciate in value. At least in these cases, it might be preferable to allow the taxpayer some allowance for the delay in realizing a tax benefit for incremental reductions in asset value.12

It is also possible to go the other way around, and deduct a portion of the full cost of property in the first year in an amount equal to the discounted value of all future deductions, after which no more deductions would be allowed. This technique, proposed by the economists Alan Auerbach and Dale Jorgenson,13 has a number of advantages, the principal one being that future changes in the inflation rate will not change investment incentives and, therefore, will not create distortions. Again, however, changes in effective tax rates are not automatically compensated for, and it would be necessary to estimate real rates of return and asset lives to determine the discount rate. While the latter is also necessary in other systems of depreciation, errors can be adjusted during the lifetime of the asset.14 This means that if tax or interest rates change, or if the life of the property is miscalculated, while there may be no distortion, there may still may be windfalls, either for the taxpayer or the government.

The author is not aware of any tax system that employs either of these systems.

II. Definition of Depreciable Property

A. Categories of Property

Although all techniques for accounting for the accrued decrease in the value of business property are related, many jurisdictions have different rules for different types of property. Although methods vary, property may be divided into a number of different categories. For physical property,15 categories include (1) buildings other than industrial plant, (2) industrial plant and equipment, (3) depletable property (e.g., minerals), (4) land, and (5) inventory. For nonphysical property, they include (1) term-limited rights (e.g., leases, copyrights), and (2) property without specific time limits on use, such as goodwill. In addition, there are sometimes special provisions regarding the self-creation of otherwise depreciable property and incidental expenses, such as repair relating to depreciable physical property. Depending on the jurisdiction, some systems, for example, the accounting based rules of the French, Germans, and Japanese, tend to rely relatively more on general rules that apply to many categories, while others, particularly those of the Commonwealth, tend to have specific (and sometimes not entirely congruent) rules for each category, or even subcategory, of property.

B. Property the Cost of Which Cannot Be Deducted in One Year

Income tax laws generally allow deductions for the costs of earning or securing current taxable income.16 Income tax laws should, however, prohibit the taking of a current deduction for the purchase of any property that has a useful lifetime longer than a year.17 As a corollary, any of the costs of self-creating such property should be treated in the same fashion as the costs of purchasing it.18 The treatment of the costs of repairing or otherwise extending the life of such property should depend on the effect of the cost. If the effect lasts beyond a taxable year, that cost should also not be deductible. However, if the effect lasts for less than the taxable year, a current deduction is appropriate.19

Depreciation deductions should be permitted only for costs relating to a subcategory of such property. Depreciation deductions should be allowed for all of the related costs that had been disallowed as deductions.

Certain systems, typically those found in civil law countries, base their income tax systems directly on financial accounting.20 The French, German, and Japanese, for example,21 follow the rules noted above fairly clearly and directly. They have a general provision disallowing a current deduction for expenditures for property, both physical and nonphysical, with a useful life longer than a year.22 Contained within this accounting rule is the principle that only such property, including any related costs, may be depreciated, provided that other criteria are also satisfied.23 Indonesia, which adopted a major tax reform in 1984, has a similar rule, although not expressed in terms of financial accounting.24

Typically, Commonwealth countries do not have financial accounting-based systems. They often do not have express statutory provisions disallowing current deductions for property with a useful life of more than one year or specifically limiting depreciable property to this category. The result is often a confusing set of rules. For example, the British statute denies deductions for costs of “capital.”25 The definition of capital is found not in the statute, but almost entirely in court cases. Unfortunately, the often rather lengthy court definitions are perhaps less clear than the rather succinct accounting system rules. For example, no major British court decision appears to have directly noted that for property to be capital, it must have a useful life of more than a year. Nevertheless, that does seem to be the general implication of existing case law.26

Unlike the accounting-based systems, British law does not have a stated statutory rule restricting depreciation to property that is defined as capital in nature. Instead, further statutory language provides allowances for depreciation only for certain limited classes of both physical and nonphysical property. While each class of physical property has its own separate requirement that the expense be capital in nature, there is no general principle that applies to all property or even to all physical property. While the rules for nonphysical property are more general, only listed types of nonphysical property may be depreciated.27

As under the accounting system jurisdictions, the cost of property that has been manufactured by the taxpayer is a capital cost. However, in the United Kingdom, the treatment of costs of repairs done to maintain property is neither simple nor particularly logical. The statute specifically disallows as a deductible expense costs to improve structures unless the structures constitute manufacturing plant.28 There is no such statutory provision for improvement of equipment. However, court cases suggest that an improvement would be “part of the cost of the income-earning machine” and therefore not deductible.29

Using different logic, court cases have allowed deductions for repairs, with no apparent reference as to how long the repair might last or even to whether the property repaired is itself otherwise eligible for depreciation.30 Courts have disallowed deductions for renewals of structures, apparently meaning something that transcends mere repairs and comes closer to a replacement.31 Naturally, this has required the courts to make nice distinctions among repairs, improvements, and renewals,32 distinctions that are not based on the length of effect of the activity and that therefore do not appear necessary or justified by any theory of depreciation. To add to the confused nature of the system, notwithstanding these cases a deduction will apparently be allowed for renewals if they are of equipment, and apparently even for some plant.33

The confusing and patchwork nature of the U.K. rules appears due, at least in part, to the lack of a coherent theory expressed in statutory form, itself the result, most likely, of the incremental fashion in which the system for allowing for depreciation was created.34 Other Commonwealth countries often rely on British case law, frequently along with their own, often unclear, statutory provisions. The mix may not always be much more systematic than the scheme found in the United Kingdom.35

The U.S. system has two separate, although related, principles. The statute, under a confusingly worded provision entitled “Capital expenditures,” denies a current deduction for “[a]ny amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.”36 A regulation further states that this means physical property with a life of “substantially” longer than the “tax year,” although no such specific rule is applicable to nonphysical property.37 Another section applies this rule to costs of self-constructed property and includes related and “indirect” costs.38 While the capital expenditures rule covers improvements, there is no specific rule concerning costs of repair.39

In a manner analogous to that of the British experience, therefore, an enormous amount of administrative and judicial attention has been devoted to the distinction between nondeductible improvements and deductible repairs.40 As with the U.K. cases, the U.S. courts have paid little or no attention to whether the effect of the improvement or repair was to last for longer than a year. There is no specific rule that limits depreciation to that property that cannot be deducted because of its longevity, although this is implied in another regulation.41 There is also a section that disallows a deduction for costs of property for which a deduction has otherwise been allowed.42 Kazakhstan, which adopted a major reform in 1995, uses phrasing that is clearer than the American.43

Many jurisdictions have de minimis rules, allowing a deduction for costs of acquiring a limited amount of property with a life of longer than a year. The simplification benefits of such a rule depend on the entire system for depreciation. Where a pooling system is used, it is not difficult to depreciate low-cost items: their cost is simply added to the pool in the year they are acquired and there is therefore no need to keep track of the individual assets. In contrast, under a single-asset system, there would be a stronger case for a de minimis rule on simplification grounds. The purpose of such rules is to aid administration, but also sometimes to provide relief to small taxpayers. There are various ways in which such rules can be implemented. For example, the German rule permits an immediate deduction for the costs of a unit of movable property with a value of less than DM 800.44 However, a problem immediately arises as to what constitutes a single unit of property; much property can itself be broken up into smaller pieces. The German solution is to require that the property be “capable of individual use,”45 which effectively limits costs for creation and for repair. A slightly different tack is taken in the Japanese law, although it uses a test similar to that of the Germans to determine what constitutes a separate piece of property.46 With a few minor exceptions, physical property that costs less than ¥10,000 is deductible. The U.S. statute takes a rather different approach, allowing small taxpayers a deduction of up to a total yearly limit on the sum of all costs associated with depreciable physical property of US$17,500.47 Larger taxpayers are not affected by this rule.48

Some jurisdictions have rules of thumb regarding deductibility of repair or maintenance expenses. The Japanese, for example, give the taxpayer a choice of capitalizing such costs or of taking an immediate deduction up to limits set by two rules of thumb. The limits for deductibility are set at either 30 percent of an asset’s total maintenance expense, or 10 percent of the asset’s total acquisition cost, whichever is lower.49 The United States used to have a de minimis rule based on fixed percentages of acquisition costs, but repealed it when accelerated depreciation was introduced in 1981.50 Kazakhstan defines deductible expenses to include repairs on physical property up to 10 percent of the written-down value of the sum of all depreciable property within a particular category of property.51 All other repairs must be depreciated.52

By and large, the accounting-based jurisdictions appear to have the most transparent and coherent rules concerning what costs for acquiring, creating, and sustaining property cannot be deducted because the effective life of such property extends beyond a year, and limiting depreciation to a subclass of such property. The British and other Commonwealth rules are frequently confusing and inconsistent. Nor are the U.S. rules a model of statutory clarity. Whether or not rules based on accounting are used, the statute should be as clear as possible as to the relationship between asset life, deductibility, and depreciability. First, the statute should deny a current deduction for the costs of any property with a useful life of greater than the current tax year. The German rule provides some guidance.53

Another way to do this might be to deny a current deduction for any costs of a capital nature. This could be separately defined to include all property that has a life longer than the current tax year. All costs of self-creation, preparation, repair, or extension that increase the life of the property beyond a single year should be included in “cost.”54 Depreciation allowances should then be limited to those costs for which a deduction was denied. While this can be easily included in accounting-type rules,55 a separate statement could also be added that restricts depreciation allowances for capital costs.

The German de minimis rule makes administrative sense to the extent that it allows taxpayers to avoid keeping separate track of assets with relatively trivial costs. However, if pooling is used to keep track of assets, the argument in favor of such a rule is greatly reduced.56 Also, as noted, once such de minimis rules are adopted, it is necessary to have careful rules regarding what constitutes a single asset. Another possibility would be to adopt the U.S. cumulative de minimis rule, which is restricted to small taxpayers and which obviates the need to determine what is a separate piece of property and allows smaller taxpayers to avoid the trouble of depreciating such property. Some combination of these rules—such as allowing deductibility of costs for assets under a certain amount, but with a total limit on costs so deducted, and perhaps limited to small taxpayers—would also be possible.

Rules of thumb regarding the deduction or capitalization of maintenance costs, while not being true to theory, are probably worth the deviations from theory for purposes of improving ease of administration. Variations on the Japanese, old U.S., and new Kazakh rules may all be reasonable guides.

C. Property Held to Generate Current Taxable Income

No deduction should be allowed that represents personal consumption. Therefore, any decrease in the value of any property resulting from personal consumption should not be deductible through depreciation. While perhaps this rule could be subsumed under the general requirement that deductions be limited to the costs of earning current taxable income, the denial of deductions for capital costs found in many laws sometimes appears to require a separate statement of this condition with regard to depreciation.57 Also, because one of the purposes of depreciation is to prevent mismatching of income and expenses, it should apply only to property that generates currently taxable income.58 As noted above, the French, German, and Japanese rules are closely related to the financial accounting treatment given assets, which means that only property used to generate business income may qualify for depreciation.59 Indonesia makes a similar provision through a general statutory rule.60

Reminiscent of the capital requirement discussed above, the British statute does not include a general rule restricting depreciation to property held to generate currently taxable income. Instead, a separate limit is included for each class of depreciable physical property, while another statutory provision relates to nonphysical property.61 Other Commonwealth countries, however, may use a smaller number of more general rules, although typically they have separate sections for physical and for nonphysical assets.62 Kazakhstan does so as well.63 The U.S. statute, however, includes a general rule that restricts depreciation for both physical and nonphysical property to that “used in the trade or business” or “held for the production of income.”64

Some jurisdictions with accounting-based systems, such as France and Japan,65 and the Commonwealth jurisdictions of Australia and Lesotho66 as well as the United States67 explicitly allow for apportionment of costs of property used partly for the generation of taxable income and partly not, and allow depreciation attributable to the costs of the former. Other jurisdictions, such as the United Kingdom, do not do so explicitly, but have so allowed through case law.68 The German rule is quite different. If more than 50 percent of movable depreciable property is used for business purposes, the entire asset is depreciable. If more than 10 percent is not, none of it is. If the business use lies between those two percentages, the taxpayer may choose.69 Understandably, according to at least one commentary, this rule makes little sense.70

It is an essential requirement that to qualify for depreciation, the property, regardless of its type, must be held or used for the production of currently taxable income. While apportionment in the case of “dual use” property seems to make theoretical sense, it may make tax administration that much more difficult. However, the German rule seems unnecessarily favorable to the taxpayer as far as depreciation is concerned.71

D. Wear, Tear, Obsolescence, and Useful Life

Depreciation is an estimate of a decline in the value of property. Therefore, property that does not decline in value, or whose decline cannot be reasonably estimated, should not be eligible for depreciation. Generally speaking, it would be possible to allow depreciation for the costs of any property that declines in value. As noted earlier, property can be expected to decline in value for many reasons, including wear and tear, obsolescence, or time-limited rights of use. A number of jurisdictions predicate depreciation first on the existence of these attributes. However, while reductions in value resulting solely from limited terms of use are simple to estimate, it may be quite difficult to do so for those reductions that result from wear and tear and obsolescence. Most jurisdictions therefore greatly restrict how depreciation may be computed. For example, land may be subject to wear and tear, but because it has no fixed useful life, the decrease in value owing to such wear and tear might be difficult to estimate, and a deduction for depreciation of land as such is not generally allowed.

Most jurisdictions rely to some extent, either explicitly or implicitly, on the concept of “useful life,” to determine whether the costs of a property are eligible for depreciation treatment at all (i.e., it must have a determinable useful life), as well as what amount of depreciation will be permitted (i.e., annual rate of depreciation is fixed by reference to that determinable useful life). In essence, a useful life analysis extends the concept of limited term of use (so often applicable for analysis of the decline in value of nonphysical property) to physical property. A variation of the useful life analysis is to assign useful life rules of thumb to property by type. These assume that a particular kind of property always has an ascertainable useful life and fixes that life. The necessary result of the first function of useful life is that certain types of property are excluded entirely from depreciation. The second function, using useful lives to fix annual depreciation deductions, will be discussed below.72

Some systems do not base their analysis for some, or even all, property either on wear and tear or obsolescence or on a useful-life analysis. Instead, they simply provide specific rules for the depreciation of particular properties or classes of properties. Still other systems may provide apparent rules of thumb that are so arbitrary as to suggest that they are not based on any useful life analysis or on any readily available theory of depreciation. However, two major problems can arise if neither the “subject to wear and tear and obsolescence” nor the “determinable useful life” rule exists. First, if the rules refer only to specific properties or classes of property, certain types of property, which according to theory should be subject to depreciation allowances, may be excluded, perhaps even unintentionally. Second, if the rules are too general, some property, which according to theory should not be subject to depreciation allowances, may slip through the cracks and be included.

The French accounting-type rule makes no reference to physical wear and tear or to obsolescence. However, only physical and nonphysical property, with reasonably ascertainable useful lives, may be depreciated.73 However, if the useful life of property cannot be fixed beforehand, and then “extraordinary depreciation” occurs, a deductible provision, similar in effect to depreciation, is allowed.74 The German rule specifically limits depreciation to property that suffers from wear and tear and depletion, as well as extraordinary technical or financial depreciation.75 The German regulations also state that only property with a determinable “limited” life may qualify.76 The Japanese rule is somewhat different, although the effect is largely the same.77 Under the French rule, depreciation of goodwill is not generally allowed because it has no ascertainable useful life.78 However, the Germans and Japanese have special rules for the amortization of goodwill.79 The Indonesian statute has recently switched to an accounting-type model for depreciation. Although the wording is different, the treatment of the costs of physical assets is broadly similar in effect.80 While the costs of nonphysical property are depreciated, broadly speaking, on the basis of expected useful life, there is no specific restriction requiring that a useful life be ascertainable.81

The U.K. statute has no general rule restricting the depreciation of property to wear and tear or obsolescence or to property with determinable useful lives. For certain types of both physical and nonphysical property, there are, however, individual provisions allowing a fixed yearly amount of depreciation for each of a number of different classes. These categories are fixed by type of property and have only two different rates of depreciation; at least in cases other than certain buildings, these categories and rates appear not to be based on useful lives, even as a rule of thumb.82 A major exception exists in that there is no provision for the depreciation of structures other than industrial buildings or plant and hotels, even if the structure (such as an office building) is used to generate current income.83 Goodwill is not included as depreciable property.

The Australian statute is in some ways quite similar to the U.K. law, while in others it departs radically. Although it does not specify that a useful life must be determinable, depreciation for the costs of physical property is based on the effective life of the unit.84 As with the United Kingdom, no depreciation is allowed for the cost of buildings other than plant. Goodwill is also not included. The Lesotho statute starts out by limiting depreciation for physical property to that which “is likely to lose value because of wear and tear or obsolescence.”85 However, the statute makes no reference to useful lives for physical property; there, depreciation is allowed by type of property, although a catchall category allows the depreciation of any depreciable physical property (other than nonindustrial buildings, which are specifically excluded).86 Intangible assets are depreciated on the basis of useful life.87

The U.S. statute begins with a general rule that restricts depreciation for the costs of property, both physical and nonphysical, that is due to “exhaustion, wear, and tear (including a reasonable allowance for obsolescence).”88 As with the Australian statute, in the case of physical property there is no explicit reference to useful lives.89 However, also as with the Australian statute, the standard method of determining annual depreciation allowances for the costs of physical property is based on the estimated useful life of that property; there are also a number of rules of thumb that appear to assume consistent useful lives for a few additional classes of property.90 Regulations permit depreciation for nonphysical property only when its useful life is limited and its length “can be estimated with reasonable accuracy.”91 Explicitly excluded in this rule is goodwill, presumably because it has no accurately determinable useful life.92 However, a separate statutory provision permits depreciation of purchased goodwill and certain other nonphysical property.93

In a manner somewhat similar to the U.S. and Lesotho statutes, the Kazakh statute first limits depreciation to physical property that is liable to wear and tear.94 It then assigns physical property to a small number of classes, the apparent assumption being that the property in each category has roughly comparable useful lives.95 However, there is a residual class covering all physical property liable to wear and tear (other than land) that is not listed in the other classes. This means that it is possible for different types of physical property that might have radically different useful lives to be depreciated at the same rate. There is no requirement that nonphysical property be subject to obsolescence, but it must have an ascertainable useful life. Nevertheless, a single depreciation rate is fixed for all nonphysical property.96

As noted, a large number of different techniques exist for restricting depreciation to property whose decline in value can be reasonably estimated. For both physical and nonphysical property, either a “subject to wear and tear and obsolescence” or a “determinable useful life” rule would be necessary. In part because a determinable useful life can provide a basis for determining reasonable depreciation allowances, this rule should probably be included.97 If for administrative reasons it is preferred that various types of property be listed with their assumed useful lives, such lists can be seen as guidelines in specific applications of the general rule. However, in such cases, rather than have catchall rules, it might be better to require the taxpayer to declare a fixed useful life. This would avoid any ambiguity regarding such assets as financial securities.

A French-type rule that allows for a special after-the-fact allowance when a useful life cannot be determined—provided that a reasonable estimate of a reduction in value can be found—makes theoretical sense, although it could prove difficult to administer. One possibility would be to permit such an allowance only if there was clear evidence, such as a recent price for identical property. Another would be to follow the French rule that any additional allowances be reflected in financial statements; however, this would probably be a less effective tool with unquoted companies or in jurisdictions where financial reporting is relatively unimportant. A third possibility would be not to permit deductions or allowances for property without determinable useful lives, but instead, when the property is transferred or is rendered worthless, to impute the time value of the lost deductions. This, however, might be too much of an administrative burden for developing and transition countries.

E. Exclusions of Particular Property

1. Land

As a general matter, costs for acquiring land would be excluded from depreciation through the operation of either the wear-and-tear or determinable life rule. However, land can be prepared or developed in a way that increases its value, but that preparation or development may itself have a limited useful life. If the value of the preparation or development can be separated from the rest of the land, a reduction in value of this separate amount can be estimated. If the development or preparation is itself part of otherwise depreciable property, those costs can be included and depreciated together.98 However, if there is a specific statutory exclusion of land, it should be drafted so as not to cover the preparation or development of land that itself may have a determinable useful life. Depletion, an issue related to but different from other matters concerning land, is discussed below.99

The French statute does not explicitly exclude the cost of land from depreciation; it only excludes property with no determinable useful life. Therefore, preparations of land that are part of the costs of another depreciable property should not be excluded, nor would other land workings that themselves have a determinable useful life.100 The German rule is similar,101 as is the Japanese.102 Indonesia specifically excludes land and makes no specific reference to whether the workings of land can be depreciated as part of the cost of other property.103 The same is true of Kazakhstan104 and the United States.105 The U.K. law has no specific rule allowing land to be depreciated. As noted earlier, the costs of nonindustrial buildings are generally not subject to depreciation. However, a provision allowing depreciation of certain buildings includes the cost of land preparation.106 Australia has a more restrictive rule.107

If a statute includes a general rule limiting depreciation to property with a fixed useful life, there would appear to be no specific reason to exclude land, nor would there then be a reason to provide a special rule for the workings of land. However, an additional rule, perhaps more appropriate for a regulation than a statute, could spell out that the costs of working land that are related to construction of otherwise depreciable assets must be included as costs and that other workings are depreciable provided that they have a determinable life.

2. Goodwill

What exactly constitutes goodwill may not be entirely self-evident. It is generally thought to include the value, based on reputation, that the relevant public attaches to a particular product or service and the undertaking that provides it. It can be created through the provision of a good product or service and can be enhanced through such things as advertising. It can often be transferred through the sale of a trademark and can constitute part of the value of the transfer of a copyright, a patent, or an entire business.

As noted earlier, some jurisdictions disallow depreciation for goodwill because it has no ascertainable useful life, making it difficult to estimate a decline in its value.108 Also as noted, it might be possible to impute the value of lost deductions at the point when goodwill is transferred or becomes worthless. However, there are other justifications for disallowing any deductions for a decline in the value of goodwill in certain circumstances. These circumstances exist when costs that relate to the creation or maintenance of goodwill are not disallowed, but are deductible; as a compensating distortion, losses in goodwill itself should not be deducted. As noted, goodwill can be a valuable component of an enterprise, reflected in such things as company trademarks. It derives from many things, perhaps the most important of which are the quality of the enterprise’s product and advertising. If the costs of carrying on the business, and of advertising, are generally deductible, losses in the value of goodwill itself should not be.109 Obviously, a separate and more accurate solution would be to deny a current deduction for at least certain costs, like advertising and promotion, and to either depreciate them independently if a useful life can be estimated or treat them as part of the cost of creating or maintaining goodwill.110

This argument works with regard to goodwill that is self-created. However, if goodwill is purchased, rather than created, and deductions for a decline in the value of goodwill are disallowed entirely, there may be a tax incentive for self created, rather than purchased, goodwill.111 For example, the German statute permits the amortization of goodwill, but only if it is acquired rather than created; the statute fixes a specific period that is not based on any determinable useful life.112 The United States also allows depreciation of goodwill over a fixed period and limits such amortization in the case of self-created goodwill to licenses, permits, covenants not to compete, franchises, trademarks, and trade names.113 Other jurisdictions also allow depreciation or amortization of goodwill over fixed periods, although the provisions themselves are typically not limited to goodwill, but to categories of nonphysical property.114 The actual periods involved do not appear to be justified by any theory.115 However, the rules presumably assume that an arbitrary period may better match income and expense than assuming an infinite life and allowing recovery only on sale.

As can be seen, there is little consistency among different jurisdictions concerning how the costs of goodwill should be treated. However, particularly if advertising and promotional costs are deductible, there may be an argument for allowing depreciation of acquired goodwill. As noted earlier, the difficulty in determining useful life might require a special exception to the general rule, as well as a specific rate of depreciation. It may also be possible to deny any depreciation deductions until the goodwill is sold or disposed of and a fair market value of the goodwill is obtained. At the time of the realization, the time value of money of the disallowed depreciation can be imputed.

3. Inventory

Any change in the value of property that is stock or inventory is typically accounted for separately from the depreciation provisions.116 Thus, inventory should be expressly excluded from the operation of depreciation.117

4. Property the Costs of Which Have Already Been Accounted For

If the decline in the value of an asset is already accounted for in some way, no deduction for depreciation is needed. Jurisdictions such as France, Germany, and Japan, which generally rely on accounting-type rules, disallow double deductions through their general accounting rules.118 Some jurisdictions, such as Kazakhstan, have a general provision denying multiple deductions for the same item of expense, while others, such as the United States, have a rule specifically denying depreciation for property whose cost has been otherwise deducted. Still others, such as Australia, deny deductions for property that has been depreciated.119 A general rule like that in Kazakhstan could, for the sake of clarity, be supplemented with a more specific statement applying the rule to depreciation.120

III. Depreciation Rates and Methods

A. Economic Depreciation

Ideally, allowed depreciation deductions should reflect the actual decrease in the market value of the property. However, absent a yearly sale or exchange of an identical asset, the actual decrease in fair market value will be difficult to determine.

Example Depreciation Based on Discounted Cash-Flow Analysis

Assume that Taxpayer A purchases the right to use an industrial formula for a period of five years. Assume in this example that there is no inflation and that the formula will produce a cash flow of $1,000 every year until the right to use the formula expires. The market value of the five-year know-how would be equal to the sum of its cash flow. However, $ 1,000 paid two years from now is worth less than $1,000 paid one year from now. To determine the net present value of $1,000 paid each year for five consecutive years, each $1,000 would have to be appropriately discounted.121

Table 1.Depreciation of Asset Yielding Constant Income(In units of local currency)
YearCash ReturnPresent ValueFair Market ValueDepreciationTaxable Income
09524330
11,0009073546784216
21,0008642723823177
31,0008231859864136
41,00078495290793
51,00095248
Cash return: total cash return from investment during the year (as indicated in column 1). Present value: the present value at the beginning of year 1 of $1,000 realized during the year (as indicated in column 1). Fair market value: the value of the investment at the beginning of the year (as indicated in column 1). Depreciation: the accrued capital loss during the previous year (as indicated in column 1) or the change in fair market value during the year. Taxable income: income under a Haig-Simons tax base, or the difference between the cash income of $1,000 and the accrued capital loss listed in the depreciation column.

In this example, the decline in the value of the formula accelerates very slightly over the years. The example assumes that no changes in supply or demand or of obsolescence in the formula will affect its rate of return. Also, at the end of the term during which the taxpayer may exploit the formula, the formula has no residual value.

Now assume that, instead of a formula of limited term, the investment in the example is an item of physical property. The example would then assume that the property produces the same amount of income every year for five years and then abruptly stops producing any. In the real world, it is unlikely that many physical assets would perform in such a manner over the period of their useful life. A number of studies of individual physical properties have been undertaken over the years to estimate how quickly they lose value over their useful lives. On average, it seems that most physical property tends to lose a greater amount of value earlier than the property in the example.122 Also, at the end of a physical property’s useful life, the property often has a residual or scrap value.

B. Straight-Line and Accelerated Depreciation

Financial accounting techniques typically use a different method of estimating depreciation deductions.123 Straight-line depreciation, which is perhaps the most basic type, assumes that the property will lose an equal amount each year during its useful life. In the above example, this would be one-fifth of the cost of $4,330 in each of the five years, or $886 a year. This yearly amount in deductions would be more than that allowed in the example for the first three years and less for the last two. Because of the time value of money, the straight-line deductions are more generous.

Other methods of financial accounting, usually reserved for physical property, allow for greater depreciation deductions in the early years than is found in the straight-line method. Empirical evidence suggests that most physical property declines more rapidly than assumed either in the example or in the slightly faster straight-line depreciation. For this reason, faster depreciation may be provided for such property. There may be another, even faster rate to account for physical property that is subject to unusually rapid technological obsolescence, such as computers, or to other property like cars and trucks, which can continue to operate even when partially broken down.

Even faster depreciation may be allowed to offset the erosion of nominal property value attributable to inflation. This chapter does not specifically address the effects of inflation, which is treated more generally in chapter 13 (see vol. 1). However, it is worth noting here that if there were no other method in place for adjusting for the effects of inflation, increasing the rapidity of depreciation deductions could reflect the faster decrease in nominal value of property attributable to an overall increase in prices.

Another reason for allowing for faster depreciation is that tax rules often seek to provide taxpayers with a schedule of deductions that is more beneficial to them than actual economic depreciation. As a result, effective tax rates are reduced below the apparent or statutory tax rate. This is often justified by the argument that increasing depreciation deductions for an asset in the early years will create an incentive to invest in that asset. This is often known as “accelerated” depreciation, although that term can sometimes be used to refer to any method of depreciation faster than straight-line. Using accelerated depreciation to reduce the rate of taxation on income from a particular asset below that of income from other assets creates an incentive for the taxpayer to invest in that asset, which would distort choices otherwise dictated by the market. Economists would also argue that the incentive effects are heavily biased toward less risky assets.124

C. Declining-Balance Depreciation

One technique of increasing the proportion of total allowable deductions taken in the early years is called the “declining-balance” method, which is often expressed as a factor of how much more depreciation is to be taken relative to straight-line. If a factor of 2 in a declining-balance method were used in the example (sec. III(A)), in the first year twice the amount of straight-line depreciation would be allowed. Because straight-line allowed one-fifth, or 20 percent, double-declining depreciation would allow 40 percent, or $1,772. However, if depreciation is to reflect a reduction in market value of an asset, 40 percent of cost cannot be allowed each year for five years; the total would add up to more than the cost of the asset, and an asset cannot be worth less than zero. The declining-balance method requires that, for each consecutive year after the first, the percentage allowed as depreciation be taken not of original cost, but of the amount of cost remaining after the previous year’s deduction. In this example, the “balance” left for depreciation would be $4,330 minus $1,772, or $2,558. Forty percent of that amount would be $1,023.

Under a pure declining-balance system, not all the depreciation is taken over the predicted useful life of the asset. Instead, the amount of depreciation is extended indefinitely, with ever smaller amounts allowed in each successive year. Indefinite depreciation for each asset would not, however, be practicable. This issue can be resolved in several ways. First, a declining-balance system can be used until the last year of the useful life, at which point the remaining amount can be deducted in the final year. A variation on this rule is to either require or allow the taxpayer to switch over to a straight-line system sometime before the end of the useful life.125 Second, the depreciation account for the asset could simply be kept open past the end of the asset’s useful life. Such depreciation accounts are referred to as “open-ended” because they include assets placed in service in more than one year.

Under the open-ended accounting system, a declining balance can be expressed simply as a yearly percentage deduction of the remaining cost. An estimate of the useful life of an asset can be used to determine which percentage should be allowed; in the above example, one can determine that a 200 percent declining-balance system is equal to a 40 percent annual deduction for those assets with five-year useful lives. But once the 40 percent annual deduction is selected for a particular asset, the useful life is no longer relevant to determining the allowable deductions.126

While in the real world some physical property such as computers or cars might actually lose value as rapidly as is estimated in a 200 percent declining-balance system, in the majority of cases it is likely that such a system would vastly overstate economic depreciation.127 However, a declining-balance system need not “accelerate” depreciation over actual economic depreciation; the net present value to the taxpayer of a declining-balance system depends on the percentage of annual balance allowed. For many physical assets, a declining-balance rule probably reflects economic depreciation more accurately than does straight-line.128 A system seeking to increase the value of depreciation over straight-line can do so also by reducing the estimated useful life of the asset by a certain percentage. Either a straight-line or a declining-balance system can then be used.

Using a rule of thumb percentage (such as 125 percent) of straight-line over useful lives as a rough estimate of economic depreciation still depends on determining the useful lives of assets, an activity that is hardly an exact science. And, obviously, trying to fix depreciation not on some rule of thumb, but on even more accurate empirical data, is more difficult. There are an enormous number of different assets, and, as noted earlier, technology and markets constantly change. Giving the authority to the taxpayer on her or his own to determine depreciation allowances is clearly an invitation to overestimation; giving the government such authority could easily overburden the tax administration.

Whenever there is great mismeasurement of the depreciation of an asset for tax purposes and the amounts invested in such assets are significant, the effect on tax revenues (and investment incentives) can be substantial. For example, in Indonesia, such sectors as cement, steel, and mineral processing are very important to the economy, employ long-lived assets, and, under their system of depreciation, had been entitled to what empirically appears to have been massively accelerated allowances. As a result, the effective tax rate on income from such assets has been very low. In such circumstances at least, special classes with special depreciation schedules should be fixed.

Certain assets clearly depreciate very rapidly. For example, cars, trucks, and especially computers (as well as other office equipment) may depreciate very rapidly even though their useful lives are rather long. While cars or computers may be used for years, their fair market values may drop precipitously in a short time. For these assets, a rapid declining-balance system would be appropriate. To require slower depreciation would increase the effective tax rate on returns from such equipment, and would create a disincentive to invest in them.

Countries often also provide special depreciation incentives for certain types of preferred property. These choices are not based on any attempt to match economic with tax depreciation. Instead, they are designed to create incentives for the taxpayer to invest in such property by reducing the effective tax rate on the income it produces. Special tax incentives designed to distort market investment choices are not generally the subject of this chapter. However, when such incentives are adopted, policymakers should make public both the intended effects of such incentives and the justification for adopting them.

As noted earlier, jurisdictions have vastly different basic statutory structures for determining amounts of depreciation deductions. Apart from special incentive provisions, they can be divided into (1) those that base deductions primarily on useful life, (2) those that use somewhat broader rules of thumb, but that are also based primarily on useful life, and (3) those that use rules that appear to be largely arbitrary. Those systems that use (1) may also provide guidance, either mandatory or suggestive, as to what the useful lives of a range of properties are. Those that use (1) and (2) often provide acceleration for properties that appear to decline in value more quickly than straight-line suggests. There is also a difference with regard to which jurisdictions include in their estimation the likely scrap value of the property, if any, once it has reached the end of its useful life.

The French and German rules, although somewhat different, provide some of the purest examples of system (1). They are primarily based on the useful life of the property, with special provisions for unexpected or exceptional falls in value, though never for increases in value. In France, the useful life of the property is determined by financial accounting principles, although a 20 percent variance is permitted.129 Straight-line depreciation is then generally required for the property, including all nonphysical property, unless declining balance is specifically allowed.130 Declining-balance depreciation is allowed, although not required, for certain physical property, including most machinery used in manufacturing and transport, office machines, and buildings used for light industry with a useful life of less than 15 years.131 The degree of declining balance depends on useful lives: 1.5 for useful lives of 2–4 years, 2.0 for 5–6 years, and 2.5 for 6 years or more.132 However, because the French system is based on an actual attempt to duplicate real decreases in value of the asset, extra depreciation can be taken on any property to reflect special wear, changes in technology, or even the market for the good.133 However, the depreciation deductions that are taken for tax purposes also have to be taken for financial reporting purposes.134 Depletion allowances are uncharacteristically based largely on special provisions that have no apparent relationship to actual depletion. In addition, there are many special rules for accelerated depreciation for specially favored property.

The German rule also bases depreciation primarily on the useful life of the property.135 However, most useful lives are not determined strictly by financial accounting principles, in that the Ministry of Finance has listed recommended rates by category (machinery, office equipment, office furniture) and then more specifically by individual type.136 In addition, the statute provides specific rates for certain buildings.137 However, as in France, a declining-balance system is permitted in some instances for physical property; but in Germany, all movable fixed property is eligible, and up to a factor of 3 over straight-line may be used, but with a limit of 30 percent total deduction a year.138 Unlike in France, there is also a provision that, for all movable fixed property, allows the taxpayer to fix depreciation as a percentage of output, although the taxpayer must provide “proof.”139 There is also, as in France, a general provision allowing for “extraordinary technical or financial depreciation.”140 There are many special rules for accelerated depreciation for specially favored property.

The Japanese rules have a similar mix of straight-line and declining-balance methods, also based on useful lives for which the Ministry of Finance provides guidance;141 special deductions can also be taken for most physical property for extra wear or obsolescence.142 The depletion rules are nearly identical to those in Germany.143 Accelerated depreciation is also provided for favored property. In both Germany and France, scrap value is not normally taken into account in determining depreciation; however, any value realized from the sale of a depreciated asset would be included in income.144

The British rules, not surprisingly, are a fairly good example of system (3) above, where the rules appear to be largely arbitrary. As noted earlier, British depreciation rules are based on neither useful lives nor any other apparent estimation of actual declines in value. With only two rates available for all depreciable physical and nonphysical assets (including depletion), it can be guaranteed that allowances do not approximate reality.145

At least with regard to the limited categories of property that the statute includes as depreciable, Australia is a fairly good example of system (2) above, or those that use somewhat broader rules of thumb, but that are also based primarily on useful lives. Most physical property is put into one of seven categories, based on useful life.146 A declining-balance system is then used, unless the taxpayer opts for a straight-line system at rates published in the statute.147 Taxpayers generally determine the useful lives of property, although the Commissioner of Inland Revenue publishes recommended lives, which the taxpayer can use.148 For most nonphysical property, a straight-line system based on useful life is used.149

Lesotho seems to lie somewhere between the British and Australian systems. Its law relies on a broad and rather crude rule of thumb for three different categories of physical property, including depletion, selected by type and not by useful life; these categories allow a 5 percent, 20 percent, or 25 percent annual deduction.150 However, there is also a catchall category for physical property not otherwise listed (except buildings other than industrial, which may not be depreciated), at the annual rate of 10 percent.151 However, intangible assets are depreciated over their useful lives in accordance with the straight line system.152

The Kazakh statute is similar to both the British and Lesotho rules.153 As with Lesotho, there is a residual class covering all property (other than land) not listed in the other classes.154 Like the U.K. system, a single, arbitrary depreciation rate is fixed for all nonphysical property.155 These systems do not consider scrap value.

The U.S. statute is similar to the Australian, with most physical property put into one of nine categories based on the property’s useful life; three categories are based on rules of thumb without any direct reference to useful lives: residential rental property, nonresidential real property, and railroad grading or tunnel bores.156 Of course, such reference to useful lives is indirect in that property with similar useful lives was chosen for each class, and the allowable depreciation was based on estimates of those useful lives. Depreciation is allowed using a 200 percent declining balance, switching to straight-line when more beneficial to the taxpayer, except for 15- or 20-year property, for which only 150 percent declining balance is allowed, and for immovable property or railroad property, for which straight-line is required.157 Nonphysical property is depreciated at a straight-line,158 and depletion is based either on a “reasonable allowance” or on a fixed annual percentage based on a large number of different categories of mineral.159

There is an obvious advantage to trying to match tax depreciation to real decreases in value. The accounting-type rules do at least set this as a principal goal. However, there are a number of objections to these systems: they are too complicated, and they give the taxpayer too much of an opportunity either to understate lives or to take unjustified additional depreciation. Therefore, justification can be found for the somewhat simpler rules followed in the United States and in Australia and for the much simplified rules followed in Lesotho and Kazakhstan. However, if administrative considerations permit a somewhat more sophisticated system, compromises can be made to keep the best of the accounting-based systems, without allowing too much latitude to the taxpayer. A compromise might include the following: along the lines of the French, German, and Japanese systems, a general rule could set annual depreciation rates as equal to straight-line over the useful life unless an exception is provided.

The first exception would allow a 150 percent declining balance for all physical property, to take account of the apparently greater speed with which such property actually declines in value. The taxation authority could then publish properties by type, as amended from time to time, along with their useful lives and the yearly depreciation rates. The second exception could allow, where specifically provided in regulations, 200 percent declining balance for physical property that tends to experience more rapid declines in value, as provided by regulation. The taxation authority could then publish properties by type, as amended from time to time, along with their useful lives and the yearly depreciation rates. In addition, any policy to accelerate depreciation for purposes other than ease of administration should be clearly stated and reflected not simply in changes in allowable yearly deductions.

The question of whether scrap value should be taken into account is really one of ease of administration. Certainly, as a matter of theory, scrap values should be included where appropriate, because the existence of a scrap value would mean that the asset does not decline to worthlessness over its useful life. A rule could require that if scrap values are assumed in financial accounts, they should be included in tax depreciation accounts as well. Another possibility would be for the tax administration to provide estimates of scrap values for those items of physical property for which it publishes useful lives, at least those for which scrap value is high. Another would be to use the Japanese rule of thumb method.

D. Depletion

Minerals that are extracted from the land will result in a reduction in the land’s value; if the value of the minerals can be separated from the value of the rest of the land, a reduction in value of this separate amount can then be estimated. For a number of reasons, allowances for decreases in the value of mineral or similar property are often conceived of as separate from the accounting for depreciation of other property. One of the most important is that natural resources are often exploited at varying rates over the years. The rate of exploitation directly affects the decline in the value of the natural resource. This is in contrast to the assumption that underlies depreciation allowances for most other property, both physical and nonphysical: the rate of decrease is relatively constant throughout the property’s useful life.

To account for the possibility that exploitation may vary over time, depreciation can be fixed on the basis of a reasonable estimate as to how much of each unit extracted reflects a decrease in the amount of total remaining mineral. This is known as “unit-of-production depletion.”160 Of course, this could be expressed as a given useful life, but only assuming a fixed rate of extraction. The second problem is that it is often difficult to determine the exact quantity of a natural resource. Without knowing how much exists, it is difficult to calculate unit-of-production depletion.

Another way to determine depletion allowances is to assume that a certain percentage of the gross income from the exploitation of the resource represents the cost of the depletion of the resource. Unlike with unit-of-production depletion, the amount of cost recovery allowed is reflected in a fixed rule of thumb percentage of gross income, and total deductions may not be limited to the cost of the original investment. This is known as percentage depletion.

The German statute allows depletion allowances to be based either on a useful life analysis or on accurate unit-of-production depletion analysis, the latter of which must be based “according to the portion of the substance consumed.”161 The French and Japanese each have special provisions for depletion. The French statute provides two different fixed annual percentage depletion amounts for hydrocarbons and other minerals; there is no limitation on deductions relative to the total cost of the natural resource.162 The Japanese allow unit-of-production depletion or the related system based on the estimated life of the mineral or on any other reasonable estimate.163 The Indonesian rule is similar to the German rule.164

The U.K. statute is quite different. It provides a single, and apparently arbitrary, depletion rate for all minerals.165 Unlike the British provisions, the Australian provisions are based on a useful life analysis.166 The Lesotho rule is like the British.167 The U.S. rule gives the taxpayer a choice: it allows depletion based on a reasonable allowance or allows percentage depletion as provided in the statute. The percentage allowed is based on a large number of different categories of mineral.168 As with France, total allowable depletion is not limited to cost of the mineral. The Kazakh statute is similar to both the British and Lesotho rules.169

Because of the relatively greater potential variability of natural resource exploitation, unit-of-production depletion should probably be required. The German phrasing seems adequate. However, because of the difficulty of administering such a rule and the often imperfect science of determining the size of at least some mineral wealth, providing rules of thumb for classes of minerals should also be contemplated. These rules of thumb should be based on empirical evidence of the local jurisdiction.

Probably one of the easiest ways of creating such rules of thumb is through a percentage depletion allowance, as is done in the United States. However, it makes sense to limit the total costs allowed through percentage depletion to the total costs of acquiring the depletable natural resource.

E. Transfer of Property

Depreciation (and depletion) allowances are designed to provide estimates of decreases in the value of property. However, except when they are based on the limited terms of nonphysical property, such decreases are unlikely ever exactly to equal the actual decline in the value of property. Therefore, if such property is transferred (or if it stops being used for the production of currently taxable income) before it becomes worthless, it is likely to have a value either greater or smaller than that predicted by depreciation. Also, in those instances where declining-balance depreciation is used, the property may well become worthless before or after the expiration of its useful life; if declining-balance depreciation is used, the property is nearly certain to become worthless before the balance reaches a trivial amount.

A transfer before the completion of depreciation allowances is therefore likely to result in an actual value at variance with its written-down value. If the actual value is lower, an additional deduction is required; if higher, the difference should be taken into income.

The accounting-type jurisdictions as a general rule take into account gains and losses on the transfer of business assets; this includes those with written-down or depreciated values.170 The United States has a number of provisions whose net effect is similar.171 For those assets that are not pooled,172 the United Kingdom has a number of provisions that generally allow an immediate deduction for a loss and require immediate taxation of gain, although some special rules exist.173 Australia, which allows pooling for most property, also has specific provisions that tax gains and losses, while permitting the rollover of gains in certain circumstances.174 Both Kazakhstan and Lesotho include all gains on property as income.175 Both laws also have specific rules regarding gains and losses on all depreciable physical assets.176

In order to ensure that no property, either physical or nonphysical, falls through the cracks, there should be a general provision that includes in income all gains and losses on the disposal of business property, including property subject to any depreciation or depletion allowances.

F. Partial Years

Not all depreciable property is acquired and used on the first day of the tax year; nor may it necessarily be eligible for depreciation allowances for an entire tax year. Therefore, many countries provide a mechanism for ensuring that a full year’s depreciation is not deductible when an asset is in use for only part of a year. Again, different systems use different techniques. The accounting-type jurisdictions generally use the accounting rules in their jurisdictions. In France, this means that depreciation is prorated monthly, as of the first day of the month in which it was “acquired” or “built.”177 The Japanese rule is nearly identical.178

The general German rule is similar; however, this rule is trumped for movable physical property by an exception that lets the taxpayer round to the nearest half year.179 The British rule allows a full deduction starting in the tax year in which the taxpayer’s “obligation to pay … becomes unconditional,”180 while the Australian and Lesotho rules require an apportionment based on the number of days from the moment the property is “used” or “installed.”181 The United States, on the other hand, generally assumes that physical property was “placed in service” during midyear, allowing for only one-half of the typically allowable deduction.182

Which rule is selected will depend on a balance between the relative importance of administrative simplicity and accuracy. There is probably a benefit to requiring consistent treatment among all types of depreciable or depletable property.

G. Pooling

A number of countries, rather than requiring the separate tracking of assets for depreciation purposes, either permit or require certain properties to be “pooled.”183 Pooling can be accomplished using either closed-ended accounts (meaning that only property added in the same tax year is included) or openended accounts (meaning that property added in a different tax year is also included). Typically, in a pool, different properties with the same tax depreciation attributes are treated as if they were all one property. In the case of open-ended accounts, whenever a property is created or acquired, the appropriate costs are added to the sum in the appropriate pool, that is, the pool that includes all costs of assets with the same depreciation attributes as defined by the statute.184

If a property is sold or exchanged, the value received is subtracted from the pool.185 If the value of the pool drops below zero, that amount is taken directly into income.186 At the end of each tax year, a percentage of the entire pool is subtracted as a deduction for depreciation.187De minimis rules may provide for a complete deduction if the value of the pool drops below a certain amount.188 A complete deduction for the closing balance is also allowed if all the assets in the pool have been retired or disposed of. As noted earlier, pooling can work only in the case of declining-balance depreciation. This is because no record is kept of the remaining useful life of any individual asset.

The principal difference in economic effect between pooling systems and separate accounting is that, under pooling, if allowable depreciation differs from actual (i.e., economic) depreciation and the asset is transferred before it is scrapped or becomes worthless, the gain or loss cannot be immediately reflected as taxable income (except when the value of the pool drops below zero). For example, under a separate accounting system, if an asset with a cost of $100 and a written-down value (i.e., after depreciation) of 0 were sold for $100, that $100 would be taken into income immediately.189 Under pooling, however, the written-down value of the asset would not be recorded, so it would be impossible to determine the amount of gain. Instead, the $100 would be subtracted from the pool. This would mean that the taxpayer would not have to take into income $100 immediately, but only over the future in the form of lost allowances.

However, the present value of those future deductions will be less than $100 in immediate income. The extent of the benefit (or detriment) of pooling to a taxpayer over separate accounting will depend on the difference between tax and economic depreciation for each asset and on how often the particular taxpayer disposes of those assets.190 If all such assets sold were purchased by others who were taxed at the same rate, then the net effect of a sale of an asset on state revenues would be nil; the asset would continue to be in use somewhere, and while value would be subtracted from one depreciation pool, it would be added to another pool. However, this may not always be the case. Some purchasers of assets may pay tax at different rates. Others may pay no tax, either because they have offsetting losses, or because they are otherwise tax exempt as governmental or nonprofit entities, or because they are not residents. Some, for example, have reported that oil companies in particular like pooling systems, where different subsidiaries can trade large assets like drilling platforms or other equipment depending on the availability to the subsidiary of other losses and where such assets can be traded out of the pooling jurisdiction entirely.

The economic effects of rolling over the capital gain associated with errors in tax depreciation increase both as the error increases and as the cost of the property increases. Perhaps in part for this reason, jurisdictions that provide for pooling generally require that structures and often other large capital items such as ships, public utilities, or locomotives be depreciated separately.191 Depending on the wording of the statute, this can be accomplished by requiring either that such property be kept out of the pooling system or that each item of property be kept in its own pool, that is, a separate account.192

The oft-stated benefit of pooling is that it encompasses simpler record keeping than single-asset depreciation. However, under typical financial accounting standards, larger taxpayers often must keep separate accounts for assets of any substantial cost. Obviously, for these taxpayers, it may not be particularly onerous to require separate asset accounting for such assets. For taxpayers who are not required to keep separate accounts, the simplicity argument is more compelling. However, for any taxpayer, keeping separate account of assets that are longer lived and of a substantial cost does not seem particularly onerous. How these items of property are identified will depend on earlier choices regarding the structure of the depreciation system. However, as a general matter they could be identified through one or more attributes of cost, type, and length of useful life (or rate of declining-balance depreciation).

For example, all property with total costs in excess of a certain amount, and with a useful life of greater than 10 years or a declining balance of greater than 15 percent, could be required to be depreciated separately. Therefore, while a statutory provision could allow a pooling method for assets with similar depreciation profiles (meaning that they have the same rate of declining-balance depreciation), the tax administration should be permitted to deny its use in certain cases. This would allow both for ease of administration (broad classification of some assets, pooling) and for selective, careful tracking of economic depreciation for important assets.

An additional consideration in deciding whether to use a pooling system is the interaction between the depreciation method used for tax purposes and that used for financial accounting purposes. It is convenient, although not necessary, for tax and financial accounting to be the same in this respect. Although financial accounting is generally done on a single-asset method, pooled methods are often permitted under national accounting standards.193

    Other Resources Citing This Publication