More tax issues around earthquake strengthening and leaky buildings

COMMENT

New Zealand sits on top of a fault line and is frequently buffeted by intense rainstorms.

Both these natural elements have contributed to building integrity issues which are now bubbling to the surface as hot tax topics.

The issues are whether earthquake strengthening (beyond the minimum requirement) is considered an improvement and therefore capital in nature and attracting tax.

The tax deductibility of work carried out to remedy “leaky buildings” is also a live issue.

Tax traps
One of the key tax questions over costs of building work is the distinction between what is capital expenditure and what is revenue. In most cases the difference is clear, but the boundary between the two is full of traps that can be difficult to avoid.

For this reason, the courts have been asked many times to determine whether certain types of expenditure are capital or revenue, most commonly in relation to physical structures including buildings. Given the wide variety of facts that have been considered, some of those decisions are not consistent and the distinction remains somewhat murky.

Up until 2012, the effect of classifying expenditure on a building as capital was that tax depreciation could be claimed, compared to revenue expenditure, where a deduction for the full amount could be claimed when incurred.

However, with the removal of the ability to claim tax depreciation deductions for buildings from the 2012 income year onward, any building expenditure that is treated as capital now means no deduction would be available in most circumstances.

This makes identifying the capital/revenue border even more vital for taxpayers and Inland Revenue.

We have had a number of clients approach us for advice about the tax treatment of earthquake strengthening costs and we expect this will become a hot topic in the near future.

The tax deductibility of work carried out to remedy “leaky buildings” is a live issue. In both cases, there is no simple answer and the position depends on the facts of each case.

Earthquake strengthening

Following on from the Christchurch earthquakes local authorities, building owners and their tenants nationwide have become much more conscious of the earthquake rating of commercial property. My firm is seeing commercial issues arising for clients where properties they hold require work to improve the earthquake rating.

In cases where expenditure needs to be incurred in strengthening the property the costs involved can be significant and the issue of whether they are capital or revenue will be a key concern.

A number of property commentators are already advising that building owners “future proof” their buildings by increasing the strengthening beyond what is required, thereby increasing the costs of strengthening and the tax deduction at stake.

A recent Inland Revenue Interpretation Statement on repairs and maintenance outlines its view that the capital or revenue nature of expenditure does not change even if damage was caused by an event such as an earthquake. The focus is on the work undertaken, and if the work is seen to improve the asset it will be deemed to be of a capital nature.

The interpretation statement outlines (by reference to case law) that work undertaken to strengthen a building, whether or not earthquake damaged, is considered to be an improvement to the building and capital in nature. Inland Revenue consider this is likely to be the case even in circumstances when the work was required by law, such as to comply with council consents.

The potential scale of this issue has already been identified by policymakers and there has been a call by some to change the law to enable a tax deduction to be claimed for earthquake strengthening costs. The government has said it will not make any decision on any tax concessions until after the royal commission of inquiry into the Canterbury earthquakes issues its final report later this year, so watch this space.

In the meantime, as a general comment, it may be helpful if work undertaken to strengthen a building is clearly separated from expenditure incurred to restore the building to its original condition, or from other work that would ordinarily be classified as repairs and maintenance.

Discuss any work that might be undertaken with your tax adviser before expenditure is incurred so appropriate advice can be provided.

Leaky building

Inland Revenue considered the tax deductibility of repair costs on a building with “leaky building syndrome” in Inland Revenue’s Questions we have been asked issued on 1September 19, 2006. In its view, factors that indicate capital expenditure are:

• The damage repaired is fundamental to the structure of the building.
• That the expenditure does more that renew or replace defective parts and renews or replaces substantially the whole asset.
• The work changes the character of the property. The example given is re-cladding the property in a different material as a permanent solution to prevent water access … is likely to be of a capital nature.
• The work results in a significant increase in the value of the asset, although this is not determinative in itself.

Part of the concern of the IRD is if a taxpayer buys property at a reduced cost with the knowledge there is a leaky building issue and that major expenditure would be required to remedy the issue. In those cases the IRD would be more likely to assert that the costs of bringing the building up to an acceptable state are capital because the work significantly increases the value of the asset.

There may be a reasonably arguable position for the tax deductibility of expenditure incurred to repair a leaky building provided the taxpayer was unaware of the leaky nature of the building and did not pay a lower price because of it.

A reasonably arguable position (subject to the individual facts of the case) may be supported if the following are met:

• The property was acquired with the expectation that this would be a water-tight property entirely suitable to derive assessable income for many years and the price paid reflected this.
• The repair work will not improve the property beyond what it originally appeared to be, and the character of the property will not be changed.
• It was always the taxpayer’s intention to derive assessable income from the property after repairs were completed.

Given the complex issues arising from expenditure of this nature, we recommend specific tax advice is sought before any tax filing position is taken.

Mike Rudd is tax director at Staples Rodway, Auckland