R&M or Capital?

In the past year, Inland Revenue has increased its audit activity after a period of subdued activity that stretched from before the Covid-19 pandemic. As their activity has increased, it has been interesting to see what areas they are focusing on. Observation suggests that one of those areas is the classic capital / revenue boundary. This is an area that is notoriously difficult because of the grey areas that can arise – where two different people could easily reach contrary conclusions. One such example was recently heard by the Taxation and Charities Review Authority which had to consider whether building work qualified as either tax-deductible repairs and maintenance or non-deductible capital expenditure.

For context, repairs and maintenance refer to costs that keep a property in good condition or restore it to its original state, such as repainting walls or replacing a broken window. These costs are usually deductible in the year they are incurred, reducing taxable income. Whereas, capital expenditure improves or upgrades a property, such as adding rooms or installing new heat pumps, for which costs are not immediately deductible but may be depreciated over time.

The case involved a company that owned part of a large commercial building originally leased to a large commercial retail business. The company’s part of the building was worth about $95m. After the main tenant moved out, foot traffic decreased and another seven tenants vacated. The company spent over $13 million on upgrades to accommodate a new tenant that wanted the space to be converted from retail into offices. The upgrades included structural strengthening, improved glazing, a new glass façade, a new atrium, strengthening car park panels and bathroom upgrades. The company and IRD agreed on whether particular items were capital or revenue, but they could not agree on the classification of the glass façade and earthquake work. Hence, the decision focusses on those two items only.

The company asserted the façade was simply replacing existing glass, and that the earthquake strengthening was necessary safety maintenance, not an upgrade. It pointed out that the ground floor already had glass panels and that the seismic work didn’t extend the buildings life, it just ensured it was up to safety standards. But the Authority saw things differently. It ruled that these works weren’t just repairs. They were integral parts of a much larger project. The glass façade wasn’t a like-for-like replacement; it was a modern design that changed the building’s appearance and use, including replacing some solid walls with glass and enclosing previously open spaces. The seismic work also wasn’t just a fix up, it was a significant upgrade to the structure that made the building safer and more marketable.

The judge said that even though these works were only about 1% each of the building’s value, their impact on the overall character of the building meant they had to be treated as capital expenditure. Because they were part of a larger project that changed how the building looked and functioned, they didn’t qualify as routine repairs, and it was deemed a ‘commercial necessity to undertake the work to secure a new anchor tenant’.

In areas of uncertainty, there is the need to do your homework before a position is taken. Consider it akin to ‘insurance’ if Inland Revenue decides to investigate.