A recurrent issue faced by many taxpayers is whether expenditure that they incur on “repairs and maintenance” is deductible, or whether the expenditure must be capitalised. The answer to this is often not clear cut.
The IRD has recently released an Interpretation Statement IS 12/03 entitled Income Tax – deductibility of repairs and maintenance expenditure – general principles, which seeks to clarify the position for taxpayers. This confirms expenditure on repairs and maintenance will only be deductible if a sufficient nexus can be established between the expenditure incurred and the taxpayers income earning process and the expenditure is not of a capital nature. A number of useful and relevant examples are included within the Interpretation Statement.
While determining whether repair and maintenance expenditure is of a capital or revenue nature is a fact specific matter, the courts have established a general two stage approach to assist with the process. Stage one identifies the relevant asset that is being repaired or worked on while stage two focuses on the nature and extent of the work that is undertaken on the asset.
Stage 1: Identifying the relevant asset:
This is always a question of fact, degree and impression. Rather than focusing on a profit-earning structure or entity the courts have tended towards the “entirety test”. The key considerations for this test are:
Is the asset complete in itself and not part of an asset or aggregation of things forming an asset?
Is the asset physically and functionally distinct from its wider setting?
is the asset capable of separate operation as an entirety by itself?
Stage 2: Nature and extent of the work done:
Work undertaken on an asset that results in the reconstruction, replacement or renewal of the asset or substantially of the whole asset, will be work of a capital nature.
Expenditure that is incurred to repair or maintain the asset, over and above making good wear and tear that has the effect of changing the nature of the asset would also be capital expenditure.
On the other hand, expenditure that is incurred to repair or maintain an asset without replacing, reconstructing, or renewing the asset, or without changing its character will be held on revenue account.
A deduction may be allowed for repair expenditure that is incurred to bring a newly acquired asset up to the condition necessary for it to be used in the taxpayer’s business. This is based on the presumption that the purchase price was not reduced to reflect the work that was needed to be undertaken. If the purchase price of the asset was reduced, the expenditure is likely to be held on capital account.
Highlighted below are a few examples in relation to the deductibility of repairs and maintenance expenditure.
Temporary break in rental activity:
Repair and maintenance work that is undertaken on a temporarily vacated rental property to make it more attractive to potential tenants will have a sufficient nexus with the taxpayers income derivation if the taxpayer intends to have the property tenanted again once the work is complete.
Ceased rental activity:
If a taxpayer decides to move into their rental property themselves and no longer derives assessable income from the property, expenditure incurred on repair and maintenance would not have a sufficient nexus and would therefore be non-deductible.
Introduction of a new asset:
The cost of insulating a rental property that was previously un-insulated would be held on capital account as a new asset is being introduced that improves and changes the nature of the asset.
Replacing or repairing an existing asset:
The cost of insulating a rental property that was previously insulated is likely to be held on revenue account on the basis that the work only restores the property to its former condition and the repair does not change the character of the asset.
Note that the outcome may differ depending on the materials that are used to repair an existing asset. Where a material that is required for repair work is no longer available or is no longer able to be used due to regulations, the use of a comparable or equivalent alternative may still be held on revenue account even though a newer, more modern material is used. If a taxpayer simply decides to upgrade to more durable material in place of the existing material which is readily available the expenditure may be held on capital account as it changes the nature of the asset.
Leaky home repairs:
Repairs undertaken on a “leaky home” would be deductible if the work done does not amount to a reconstruction, replacement, or renewal of substantially the whole of the house. For example, if recladding work is undertaken in the course of repairing a “leaky home”, the cost of re-cladding is likely to be a deductible repair if it simply replaces the existing cladding with a similar product that does not improve the asset or add value. However if the cladding is replace with a more superior product that improves the assets value, the cost incurred may be capital in nature.
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Posted on Fri, 1 February 2013
by Shawn O'Grady