4 minute read
Capital vs revenue
Is the expenditure capital or revenue? It’s not always straightforward, says Brett Crombie.
Arecent decision by the Tax Review Authority (TRA) has highlighted the potential cost to businesses when they incorrectly classify capital and revenue expenditure. The case yet again demonstrates that determining the correct classification for tax purposes can be a complicated business.
Why does it matter?
A tax deduction is allowed for expenditure that is incurred for the purpose of deriving income. This is called the ‘general permission’. It is the reason why, from a tax perspective, in any given period it is usually beneficial to maximise the expenditure (deductions) and therefore reduce the tax payable.
While many business owners have a good understanding of the ‘general permission’ and often seek to apply it with great gusto, somewhat less well understood is another rule called the ‘capital limitation’.
The ‘capital limitation’ works to disallow deductions for expenditure of a capital nature. Instead, the accounting method is to create a capital asset and depreciate that asset over time. While this still results in a tax deduction for depreciation, it is spread over several years, which is less appealing for business owners seeking to lower their tax bill.
The recent decision
A TRA case decided last December provides a good example of the type of scenarios the Inland Revenue is likely to challenge. In this case, the taxpayer purchased a property and decided to undertake a programme of work. This was completed over a period of about three years and included an internal refurbishment, the addition of a covered veranda, extension of a deck, additional toilets and the fitout of a container.
The total expenditure amounted to $332,071.90 and the taxpayer classified it as repairs and maintenance, deducting it across the three years as it was spent. The taxpayer’s reasoning was that the work was a series of separate and independent repair and maintenance projects rather than a single capital improvement project.
Inland Revenue disagreed and disallowed the tax deduction. TRA Judge Sinclair concluded that the work undertaken was a single project, which involved a substantial reconstruction and improvement of the original premises. She
How does this apply to plumbing and related businesses?
Take the example of a digger with a blown engine. If you replace the engine with an equivalent engine, it does not change the nature of the digger, so the full cost of the replacement engine will be expensed as ‘repairs and maintenance’ in the year it is installed. However, what if you decide to upgrade the machine with a new hydraulic attachment to improve the capabilities of the machine? Given that the ‘character’ of the digger has changed, the cost of the new attachment is likely to be a capital cost and should therefore be depreciated over several years rather than expensed in the year it is installed.
Every scenario will be a bit different, but plumbers with good advisors on call and a reasonable understanding of the difference between capital and revenue expenditure are better placed to make tax-effective business decisions and avoid wrangles with Inland Revenue.
found that because the project was capital in nature, the expenditure was also capital in nature and therefore not deductible for income tax. Penalties for taking an Unacceptable Tax Position were upheld.
Guidance
Fortunately, over the years there have been a number of court decisions and Inland Revenue interpretation statements that can be used by business owners to avoid getting on the wrong side of an Inland Revenue challenge.
Like many areas of tax law, the correct classification of capital or revenue is found by considering the particular circumstances of the case rather than through any rigid test. However, there are some guiding principles business owners can follow to prevent obvious blunders: 1. Is there a connection between the expenditure and the income being derived?
If not, go no further—the expenditure cannot be deducted. 2. What is the nature and extent of the work done to the asset? If the work done has changed the character of the asset, it is more likely to be capital in nature.
About the author: Brett Crombie is a Chartered Accountant, qualified lawyer and former Inland Revenue tax investigator. He is the owner of Straightedge Accounting, which provides tax, accounting and business advisory services. Contact Brett on 021 301 022 or email brett.crombie@straightedge.nz
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