Equitable tax treatment of earthquake strengthening costs needed

OPINION

The aftermath of Christchurch’s two devastating earthquakes, including the Royal Commission recommendations on mandated seismic strengthening standards for all commercial buildings, has left many businesses and building owners facing significant economic loss. 

To stay in business they must fund the cost of strengthening their buildings but, to add insult to injury, they must do so while paying tax (as if there was no such cost) because of grossly unfair tax laws. 

Here’s the problem. ‘Joe Bloggs’ owns a commercial building in Wellington which is council-assessed as below the mandated standard and therefore in need of strengthening. Joe has engineers assess what is needed to get the building up to standard but the costs of improvement are prohibitively high. 

The tenants of that building opt to move out because it is deemed unsafe for their staff. The building quickly becomes ‘tainted’ and no-one wants to occupy it. With the loss of income, Joe’s bank sees he is not meeting his mortgage repayments. His insurers see that he is not undertaking the seismic strengthening work required and the ongoing insurance cover becomes uncertain. 

What are Joe’s options? To try to sell the unsafe building at a loss to someone with deeper pockets who can undertake the necessary work or, if that fails, to walk away from the building and leave it abandoned. 

Sell or walk away?
The government sees the solution as modifying the royal commission’s recommendations on national strengthening standards according to seismic risk; New Zealand will be categorised into low, medium and high seismic risk zones with timeframes for assessment of five, 10 and 15 years and strengthening of 15, 25 and 35 years. A select committee is currently reviewing these recommendations. 

Though a more targeted approach is a step in the right direction, the government has to date not engaged with the Seismic Tax Coalition, of which Kiwi Property, Local Government NZ and The Wellington Company are members, to address the most fundamental issue facing commercial property owners: the treatment of tax deductibility and losses.

Let’s go back to Joe Bloggs in Wellington: if, heaven forbid, the city were struck with a massive earthquake, Joe’s building would collapse. If tenanted, people could be killed. 

Under our current tax rules Joe can claim tax deductions for his losses. If he had been able to raise the money to strengthen the building (and reduce the risk to life), he could not have claimed any deductions on the cost of that major seismic strengthening work. 

Put simply: do nothing, earthquake strikes, tax deductibility on losses; do something, strengthen building, no deductibility. Or put another way: kill people, claim losses; save lives, no deductibility claim. The status quo is untenable.

Recognise it for tax purposes
In tax policy terms, the underlying rationale is that the loss in value of a building as a result of reassessment of seismic risk is an economic loss to the owners. This loss is a reduction in income and, under any income tax, should in principle be recognised for tax purposes. 

Seismic strengthening work is the mechanism by which building owners restore value to buildings. It is an objective proxy for the underlying and prior economic loss faced by building owners. On that basis, in principle, seismic strengthening costs should be deductible expenditure for tax purposes.

The government’s strategy on seismic costs seems to be that the public sector will meet this considerable challenge with respect to the buildings it owns, and possibly, some heritage buildings of particular social value. The government, in return, expects the private sector to meet the costs of seismic strengthening for the buildings in private ownership.

As a general principle, this appears reasonable. However, by not updating tax laws to allow recognition of seismic strengthening costs, the government is undermining its own strategy by placing a further barrier on the ability of the private sector to meet its share of the costs. 

On the one hand the government says these are the costs of being in business and should be met by business. On the other hand the government is saying it is comfortable that our income tax rules ignore the very existence of these costs.

After all, even if the government were to accept that seismic strengthening costs did exist for income tax purposes and it allowed them to be deductible with other business costs, the private sector would still be expected to meet 72% of the costs (at a 28% company tax rate). Under an income tax the government shares in the costs and profits of business. The 28% of costs met by providing a tax deduction is simply what should happen under a fair income tax.

Undermining the private sector
Why is the government not addressing this iniquitous situation? Fiscal cost, pure and simple. But strengthening work will be carried out over periods of 20 to 50 years, based on the government’s proposed low, medium or high risk zones, and the fiscal cost (revenue loss) would be minimal compared to the social and economic cost of not providing this deductibility for commercial property owners as they fund the cost of strengthening their buildings.

By allowing short-term fiscal concerns to take precedence, the government is undermining the private sector’s ability to meet the cost of strengthening, and this creates a risk of adverse social and economic outcomes, which would in turn create a greater burden for the government. That would be a false economy.

The current loss to the country from the situations such as Joe’s is grave; property owners unable to strengthen their buildings will have no choice but to relinquish them, creating the prospect of cities and provincial towns peppered with unsafe, derelict and abandoned buildings. This scenario, as a consequence, will undermine local authorities’ rating bases, and the burden of dealing with earthquake-prone or structurally obsolete buildings will increasingly fall on central and local government as the private sector is discouraged from meeting these costs.

The government has made a positive start by introducing a more targeted approach for earthquake-prone buildings, as recently announced by Building and Housing minister Nick Smith. However, this must be followed by a review of the tax laws covering earthquake strengthening. 

It would be extremely short-sighted and unfair not to do so and there is no case for ignoring a significant business loss because of fiscal concerns. The current situation is untenable and requires urgent review. 

Chris Gudgeon is the chief executive of Kiwi Property, the largest listed property company on the New Zealand Stock Exchange. Kiwi Property owns and manages a $2.28 billion portfolio of real estate. 

Use MyNBR Tags to track people and companies — and receive key-word email alerts. Find out how here.