Prepaid expenses and the 12-month rule: when you can claim a bill paid in advance

The basic rule

Normally, a deduction for an expense you pay in advance has to be spread across the period the payment covers. For a business that qualifies as a small business entity, a simpler rule applies: you can claim the full amount in the income year you pay it, provided the thing you are paying for is delivered over a period of 12 months or less and that period ends before the last day of the next income year.

So a 12-month public liability policy that starts on 1 June and runs to 31 May is fully deductible in the year you pay it. A policy that runs from 1 June to 31 May but is paid two years in advance is not, because the period is longer than 12 months.

Who it applies to

The rule is available to a small business entity, which broadly means a business with aggregated turnover below the ATO’s small business threshold, a figure that is set by law and can change. Nearly every sole trader sits well inside it. If you are unsure, the ATO has a small business entity check on its website.

The rule is optional in the sense that it only matters if you actually prepay something. Nothing requires you to bring payments forward.

What counts as a prepaid expense

Common examples for a sole trader include:

• an annual insurance premium for the business
• an annual software licence or subscription
• a yearly association or professional membership
• rent or a licence fee paid for the next 12 months
• an annual registration for a business vehicle, in proportion to business use

In each case you are paying now for something the supplier delivers over the following months. The expense still has to be one you could deduct anyway. A prepaid gym membership or a private health policy is no more deductible paid annually than monthly.

When it does not apply

The rule does not cover payments for a period longer than 12 months, such as a three-year licence. Those are apportioned across the years the payment covers, up to 10 years. Payments of wages to an employee and some other arrangements are treated differently, and an expense that is not an ordinary business cost stays non-deductible whatever the timing.

A payment that is really a deposit on goods you will receive later, or a loan, is not a prepaid expense at all. If you are unsure what a payment is, ask your accountant before you rely on bringing it forward.

How GST fits in

The income tax rule and the GST rule are separate. On a cash basis for GST, you claim the credit in the BAS period in which you pay the bill, if you have a valid tax invoice. On an accruals basis, the credit is claimed when you are invoiced or pay, whichever happens first. Either way you claim the whole credit on a prepayment, even if some of the service falls in the next year, provided it is a creditable purchase for the business. See cash vs accrual GST accounting.

If the expense is partly private, for instance a phone plan used 60% for work, you claim only the business share of both the deduction and the credit. See private use and business percentage.

A simple end-of-year routine

In late May, list every annual renewal due between June and August. Decide which you would pay in June in any case, and whether paying on or before 30 June is cash-flow friendly. Do not borrow money or empty your tax set-aside just to bring a deduction forward, because the deduction is worth only your marginal tax rate on the amount. Keep the invoice and proof of payment dated in the right year. See end of financial year checklist.

Records to keep

Keep the tax invoice, the proof of payment, and anything showing the service period, such as the policy schedule. If you claim only part for private use, keep how you worked out the business percentage. The ATO expects five years of records for claims like this. See record keeping requirements.

How FlowFi helps

FlowFi reads your bank statement, flags large annual payments that look like renewals, and sorts them into the right category with the GST worked out. It does not decide whether the 12-month rule applies to a given payment; that depends on the service period, which only the invoice shows.