Advanced Taxation: Comprehensive Guide to Allowable Depreciation in Papua New Guinea Depreciation Laws

Foundations of Depreciation as an Allowable Deduction

Under Section 66 ($S66$) of the Papua New Guinea Income Tax Act 1959 ($ITA 59$), the taxable income of a taxpayer is determined by taking the total assessable income derived during a year and subtracting all allowable deductions. The fundamental formula for this calculation is:

$Assessable Income – Allowable Deduction = Taxation Income$

Depreciation is categorized as an allowable deduction, representing the decrease in the monetary value of an asset over time due to wear and tear, use, or obsolescence.

Statutory Definition and Scope of Section 73 (1)

According to $S73$ of $ITA 59$, depreciation is an allowable deduction during the year of income for any property (excluding buildings located outside of Papua New Guinea) that is classified as plant or articles owned by a taxpayer, provided that:

1. The property is used by the taxpayer during that year for the purpose of producing assessable income.

2. The property is installed ready for use for that purpose and is held in reserve by the taxpayer during that year.

Rationale for Depreciation in Taxation

Assets such as plant, equipment, and machinery involve significant capital expenditures. Because these assets are used over long periods to generate income, it is not appropriate to realize the entire cost as an expense in a single year. Taxation laws allow taxpayers to use depreciation to spread the cost over the asset's effective life, matching depreciation expenses to the revenue generated in specific financial years.

Concepts of Obsolescence and Technological Change

Obsolescence refers to the loss of value due to normal technological changes. The treatment of obsolescence includes:

• Standard Obsolescence: Integrated into the normal depreciation rate.

• Rapid/Abnormal Change: If technology changes at an abnormal pace, a taxpayer may request to change to a shorter estimated useful life. This requires a "clear and convincing basis" for redetermination.

• Increased Allowances: A higher depreciation allowance can be claimed if the Internal Revenue Commission ($IRC$) grants specific approval before the allowance is increased.

Key Regulatory Definitions

• Acquired: Refers to a person becoming the owner of property (plant or articles) or the commencement of construction of the property for that person.

• Initial Year: The specific year of income when the taxpayer first becomes entitled to a depreciation deduction under $S73$ of $ITA 59$.

• New: Refers to items that have not previously been used, acquired, or held for use by any person. This specifically excludes reconditioned or reconstructed items, or articles for which a deduction has already been partially or wholly allowed.

Identification of "Plant or Articles" (S.73(2))

Under $S.73(2)$ of the $ITA$, plant or articles include fixtures, implements, machinery, and apparatus used in any industrial process or for carrying on a business.

• Exclusions: Does not include stock-in-trade.

• Inclusions: Includes all goods and chattels, whether fixed or movable.

• IRC Guidelines: The $IRC$ sets higher depreciation allowances for assets with short expected lives and lower rates for those with long expected lives.

Commonly depreciated assets include:

• Plant and machinery.

• Buildings (including employee accommodation).

• Ships and motor vehicles.

• Furniture, fittings, and office equipment.

• Professional libraries (for doctors, teachers, engineers, etc.).

• Tool kits for tradesmen (carpenters, electricians, etc.); note that the cost of replacement for these tools can often be claimed in full.

Components of Asset Cost and Effective Life

For tax purposes, the "cost" of an asset is not just the purchase price. It includes:

• The purchase cost of the item.

• Installation costs.

• Freight and transport charges (e.g., if imported).

• Customs duties.

All costs incurred up to the point the plant is ready for use are capitalized. The effective life of the asset is determined by the $IRC$. However, taxpayers may apply for approval to adopt a different rate if specific conditions exist.

Methods of Calculating Depreciation (S. 74 & 75)

There are two primary methods permitted under the $ITA 59$:

1. Prime Cost Method (PCM)

Also known as the straight-line method. It applies a fixed rate and assumes the asset loses the same amount of value every year.

2. Diminishing Value Method (DVM)

This is the default method unless a taxpayer formally elects to use the Prime Cost method. Under DVM, the depreciation amount is higher in the earlier years and decreases as the asset's written down value ($WDV$) diminishes.

• Relationship between rates: The $ITA$ stipulates that the Diminishing Value rate is $150\%$ of the Prime Cost rate ($DV_{rate} = 1.5 \times PC_{rate}$).

Procedural Rules for Method Choice

• Election: Once a taxpayer chooses the Prime Cost Method, it must be applied to all units of property currently claimed and all units acquired in future years. Formal $IRC$ approval is required to depart from the default $DV$ method.

• Switching: Taxpayers may switch from $DV$ to $PC$ to maximize annual claims.

• Pro-rata Adjustments ($S.75(A1)$ & $S.82$): Deductions must be reduced proportionally if the plant is not used exclusively for producing assessable income.

Mathematical Examples of Depreciation Calculations

Prime Cost Method Example

Data: Equipment cost is $K200,000$, expected life is $10$ years, residual value is $K5,000$.

• Year 2015: $\{K200,000 - K5,000\} / 10 = K19,500$. Remaining $WDV = K180,500$.

• Year 2016: $\text{Same calculation} = K19,500$. Remaining $WDV = K161,000$.

• Year 2017: $\text{Same calculation} = K19,500$. Remaining $WDV = K141,500$.

Diminishing Value Method Example

Data: Equipment cost is $K200,000$, expected life is $10$ years, $DV$ rate is $15\%$.

• Year 2015: $K200,000 \times 15\% = K30,000$. Remaining $WDV = K170,000$.

• Year 2016: $K170,000 \times 15\% = K25,500$. Remaining $WDV = K144,500$.

• Year 2017: $K144,500 \times 15\% = K21,675$. Remaining $WDV = K122,825$.

Disposal, Loss, or Destruction of Assets (S. 78)

When a depreciated asset is disposed of, lost, or destroyed, a balancing adjustment must be calculated to reconcile the written down value with the consideration received.

The Calculation: $Sale Price (SP) – Written Down Value (WDV) = Gain/Loss$

• Balancing Deduction (Loss): If the consideration received is less than the $WDV$, the difference is an allowable deduction.

• Balancing Charge (Gain): If the asset is sold for more than its $WDV$, the excess (up to the original cost) is treated as assessable income.

• Capital Gain: If the sale price exceeds the original cost price (SP > CP), the portion above the original cost is a capital gain and is not included as assessable income in the balancing charge.

Numerical Case Studies for Disposal

Example 1: Loss situation

• Cost Price: $K10,000$

• Accumulated Depreciation: $K3,000$

• $WDV$: $K7,000$

• Sale Price: $K5,000$

• Loss & Balancing Allowance: $K2,000$ (Allowable Deduction).

Example 2: Gain situation

• Cost Price: $K12,000$

• Accumulated Depreciation: $K3,000$

• $WDV$: $K9,000$

• Sale Price: $K11,000$

• Profit & Balancing Charge: $K2,000$ (Assessable Income).

Example 3: Capital Gain situation

• Cost Price: $K12,000$

• $WDV$: $K9,000$

• Sale Price: $K13,000$

• Total Profit: $K4,000$

• Capital Gain Portion ($SP - CP$): $K13,000 - K12,000 = K1,000$ (Excluded).

• Assessable Balancing Charge: $K3,000$.

Options for Treatment of Balancing Charges (S. 78(3))

Taxpayers have the option to set off a balancing charge against the value of other assets rather than including it directly in assessable income. The order of priority is:

1. Cost of replacement asset (acquired up to $2$ years later).

2. Cost of other assets purchased in the year.

3. Depreciated value (at the start of the year) of other existing assets (if no new assets were purchased).

Example: Trade-in

• New vehicle cost: $K50,000$

• Balancing charge from old vehicle trade-in: $K3,000$

• Value for Depreciation (New Asset): $K50,000 - K3,000 = K47,000$.

Pooling of Assets

Effective from the year $2001$ onwards, taxpayers may group certain assets together for simplified depreciation treatment.

Value Thresholds for Pooling

• < K1,000: Immediately expensed as an outright deduction.

• $K1,000 \leq \text{Value} \leq K100,000$: May be pooled with other assets of the same depreciation rate.

• > K100,000 (and all buildings): Must be depreciated individually; pooling is prohibited.

Rules for Pooled Assets

• The Diminishing Value Method must be used for pools.

• Depreciation is calculated on the total pool value at the end of each year.

• Pool value changes with additions (costs added) or disposals (sale price subtracted).

• Simplicity Provision: For pools, balancing charges and deductions from disposals are ignored. The sale price is simply deducted from the pool value, and the specific $WDV$ of the disposed asset is not considered.

Pooling Calculation Example

• Beginning of Year ($BOY$) $WDV$: $K1.4 \times 10^6$

• Additions during year: $K450,000$

• Sub-total: $K1,850,000$

• Disposals (Sale Price): $K250,000$

• Current Pool Value: $K1,600,000$

• Depreciation ($30\% \text{ DVM}$): $K480,000$

• End of Year ($EOY$) Value: $K1,120,000$.

External Resources

Taxpayers and students are advised to refer to the official Internal Revenue Commission (IRC) web page for the most up-to-date schedule of rates for both Prime Cost ($PCM$) and Diminishing Value ($DVM$) depreciation.