There has always been a different opinion between taxpayer and the Commission of Inland Revenue in defining repair or capital expense. A taxpayer will always try to encompass its view in such a way that it can label the expenditure as repairs to avail tax advantage in the year of expense. If the expense is labelled as repairs & maintenance you can avail deduction immediately otherwise it is capitalised and depreciated over the useful life of an asset.

Capital can be defined as a tree, and repair is like watering to that tree. In the other words capital expense is something which gives you a brand new asset, and repairs is usual maintenance of that asset. Sounds simple, but it’s not that easy.

The legislation itself does not define repair expense & capital expense, and up until now the case law has provided direction to this issue. In Auckland Gas Co Ltd v Commissioner of Inland Revenue (2000) 19 NZTC 15,702, a company was in the business of gas distribution. It was facing huge gas leakage problems with its existing pipelines so it decided to repair about 380km of its network and upgraded to polyethylene pipe as oppose to existing cast iron pipes. The work resulted in reduced maintenance costs and increased pipe capacity.

The company treated the whole expenditure as an expense but the IRD argued that the work was at such a large scale and exceeded the level of repairs and provided distinct asset so must be accounted as capital expense.
The company argued that the expense in question is specifically related to its revenue stream, there was no new asset created, the replacement of pipe was just a component of the entire gas distribution network. The objective of the project was to restore the system to its original functional state. The method adopted happened to be the most effective and cheapest way to achieve that goal.

Privy Council held the expense in question was an improvement thus capital in nature. Lord Nicolas provided very good explanation and said you must identify the object to which the test of repair is being applied. For example if the object is car, replacement of a battery or an exhaust system will usually be repairs, and if functions better it would still be repair. Now the same concept does not change when it is a large asset. The replaced pipes were component of a same asset, there was no change in function but there was a change in the character of the asset. The new asset is better and improved and it will provide long term enduring benefits as it was done on substantial potions thus it was capital in nature.

Above case provides two-step process to determine whether an expenditure on an asset is of revenue or capital nature for tax purposes.

The first step is Entirety Test: Is the asset complete in itself or it is just a part of an existing asset. Example walls of the building are just the part of the building, so replacing walls will not become asset in itself. To satisfy this test asks these questions:

1. Is the asset complete in itself or aggregation of things forming an asset?
2. Is the asset physically and functionally distinct from its wider setting?
3. Is it capable of separate operation by itself?

Passing the first test is not enough it should also pass the second test. The second step is “Improvement and Extent of Work Test”:- If the character of the asset changes significantly that allows it to function better, and it is done on a large scale it would be capital expense. To satisfy this test asks these questions:

1. Has the work done resulted in the construction, replacement or renewal of the asset or substantially the whole of the asset?
2. Has the work done changed the character of the asset? Taking into account: the nature of the work done and the scale of the work done.
3. Did the work done form part of one overall project?

For example, ABC Limited faces three roof restoration scenarios in its rental house:

1. It needs to repair some part of the roof the cost to do so is $900. No new asset is created and no change in character of the asset, thus it is a repair expense.
2. It replaces the whole roof of the house, which cost $9,000. No new asset is created (only part of the existing building structure is replaced) no change in character, thus it is a repair expense.
3. It replaces the whole roof, which cost $19,000 with better material which allows it function better and it will receive long term enduring benefits. The asset passes the entirety test but fails Improvement and Extent of Work Test, thus capital in nature.

About the author:

Saurav Wadhwa is an Auckland based chartered accountant and a director of IBBZ Accounting Limited. Saurav is a tax specialist with Masters in Tax with Distinction (Auckland) and have 10 years of experience in the industry. He is very passionate about helping small business owners. His easy going personality and a friendly nature makes him easily approachable. For all your tax problems including overdue tax returns, management of tax debt, tax consultancy, and IRD audits & disputes you can contact him atThis email address is being protected from spambots. You need JavaScript enabled to view it. or 027 5555 458.

Disclaimer:

Information above is provided for general use only, if you are intending to rely on any of the information above please consult with us or seek a professional advice. We accept no responsibility of what so ever if above information result in any kind of loss to you, tax laws differs and varies for individual circumstances.

Date: 01 March 2014