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Deductibility of feasibility expenditure for income tax purposes

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Contributed by: Brendan Brown, Fred Ward and Shaun Connolly

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Published on: July 29, 2016

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The Supreme Court’s decision in Trustpower Limited v CIR does away with the practice of applying a commitment test

The Supreme Court has recently released its decision in Trustpower Limited v CIR [2016] NZSC 91, holding that expenditure incurred by Trustpower in obtaining resource consents was on capital account and not deductible. The Court rejected the approach taken by Trustpower that the expenditure was in the nature of ‘feasibility expenditure’ in relation to overall development projects to which it was not committed.

Trustpower’s position was that the relevant expenditure was incurred to assess the viability of four possible projects. Trustpower argued that just as any expenditure incurred to assess whether to embark on acquiring capital assets is deductible, expenditure incurred by Trustpower in relation to acquiring the consents was also deductible.

The Supreme Court rejected those contentions, the essence of its decision being that:1

The expenditure [incurred by Trustpower] on obtaining resource consents in this case was directly related to specific projects that would be on capital account if they came into fruition. The projects could not proceed without resource consents. Obtaining the consents thus represented tangible progress towards their completion. The expenditure is thus on capital account and not deductible.

It did not matter that Trustpower was not committed to proceed with each overall project. The position taken by the Supreme Court, similar to that taken by the Court of Appeal, was that the expenditure was referable to the relevant capital project and therefore capital and non-deductible.

The decision of the Supreme Court has very significant ramifications and cannot be confined to the particular facts concerning Trustpower. The decision is important because it takes a different approach to the deductibility of ‘feasibility expenditure’ than the approach applied by the Commissioner of Inland Revenue (and taxpayers) on the basis of her comprehensive Interpretation Statement: Deductibility of Feasibility Expenditure (IS08/02).

In light of the Supreme Court’s decision, taxpayers will now need to reassess their positions in relation to ‘feasibility expenditure’, which until now would have been considered, and accepted by the Commissioner, as deductible.

The starting point – the Interpretation Statement and until now accepted practice

The Commissioner’s Interpretation Statement sets out an approach, accepted by both the Commissioner and taxpayers, to determine whether expenditure categorised as ‘feasibility expenditure’ in relation to a particular project or transaction was capital in nature. This approach requires an assessment of the point at which the taxpayer is committed to proceeding with the particular capital project or transaction. One relevant paragraph of the Interpretation Statement sets out that accepted approach as follows:2

Feasibility expenditure incurred principally for the purpose of placing a taxpayer in a position to make an informed decision about the acquisition of an asset (or other enduring advantage) will not generally be expenditure incurred in relation to that particular asset or advantage. However, once the decision has been made to proceed with the acquisition or development, any expenditure incurred beyond that point will relate to the acquisition of that asset and will indicate that the expenditure is more likely to be of a capital nature.

This is the so called ‘commitment test’. Expenditure incurred to simply inform a taxpayer whether to commit to a capital project has for the most part been accepted by the Commissioner as deductible.

The consequence of the Supreme Court’s decision is that such an approach cannot now be taken. The Court’s view assigns the commitment test to history, and that view is best encapsulated in the following sentence of the judgment:3

There being no practical utility in the commitment approach, we see the indeterminacy associated with it as introducing complications to this area of the law which serve no useful purpose and are therefore unnecessary.

What is the approach in light of the Supreme Court’s decision?

That then begs the question as to what approach should now be taken in relation to ‘feasibility expenditure’, given the Commissioner’s Interpretation Statement embodies a test which the Supreme Court considers serves ‘no useful purpose’.4

The Supreme Court notes that on a purist view of the capital/revenue distinction, any ‘feasibility expenditure’ addressed to a capital project (such as generation projects in the Trustpower case) is necessarily on capital account (as espoused in an article by Professor John Prebble QC and Hamish McIntosh5). The approach to now be taken is somewhat close to that purist approach, with the Court holding:6

The approach which we adopt is broadly similar to that proposed by Professor Prebble and Mr McIntosh but, for reasons which we explain, allows for some flexibility, for instance, in respect of initial stages of feasibility work.

As is apparent, we consider that some feasibility expenditure referable to proposed capital projects might sometimes be deducted. We do not, however, see such deductibility extending to external costs incurred in respects which do, or were intended to, materially advance the capital project in question.

The Court also held:7

We are not required to determine the status of the expenditure which preceded the decisions to apply for resource consent. It may be that the Commissioner could have denied deductibility in relation to at least some of that expenditure. We are, however, also of the view that expenditure associated with early stage feasibility assessments may be deductible. Such assessments can be seen as a normal incident of business. Treating the associated costs as deductible is consistent with the passages of the judgments of Noel ACJ and Davies J which we have set out. It is also consistent with the use of the expression “to the extent” in the capital limitation, which, as noted, suggests that questions of degree may be involved. Expenditure which is not directed towards a specific project or which is so preliminary as not to be directed towards the advancement of such a project is likely to be seen as being on revenue account.

While these passages provide some elaboration of the new approach to be taken, there does not appear to be any more guidance in the Supreme Court’s judgment regarding what would generally be treated as deductible ‘feasibility expenditure’. However the new approach is applied, less ‘feasibility expenditure’ will now be deductible than would be the case applying the Commissioner’s Interpretation Statement.

What impact will the Supreme Court’s judgment have in practice?

As a result of the Supreme Court’s decision taxpayers must now take a very different approach to the determination of what is deductible ‘feasibility expenditure’.

The line between capital and revenue is now much blurrier than the line under the commitment test embodied in the Interpretation Statement. Furthermore, this line will be crossed at a much earlier time in the course of a business transaction than would have been the case applying the principles of the Commissioner’s Interpretation Statement.

It now seems that very little expenditure will be considered to be deductible ‘feasibility expenditure’ in the sense of informing a taxpayer in relation to a capital project. Such expenditure will not be deductible if it can be considered to advance (or intended to advance) the capital project, which is a very low threshold. Significant amounts of what would have been considered to be deductible ‘feasibility expenditure’ will now be treated as blackhole expenditure. 

The position following the Supreme Court’s decision in our view presents a strong case for legislative reform for two reasons. The first is that the increased incidence of non-deductible blackhole expenditure would cut across the Government’s recent initiatives to provide a principled framework for the deductibility of such expenditure. The second is that the tax treatment of feasibility expenditure is an important issue for a large number of businesses, and it is accordingly desirable that there should be a reasonably certain framework for applying the capital/revenue distinction to such expenditure. Given the Supreme Court’s decision, only Parliament can now provide that certainty.

Dr Geoffrey Harley and Russell McVeagh represented Trustpower Limited in this case.


FOOTNOTES
  1. Judgment at [71].
  2. Interpretation Statement at [18].
  3. Judgment at [69].
  4. Judgment at [69].
  5. John Prebble and Hamish McIntosh “Deducting Expenditure to Assess the Feasibility of Constructing Capital Assets: Opinions from Inland Revenue, the High Court and the Court of Appeal” 6 VUWLR 24/2016.
  6. Judgment at [13(g) and (h)].
  7. Judgment at [72].

This publication is intended only to provide a summary of the subject covered. It does not purport to be comprehensive or to provide legal advice. No person should act in reliance on any statement contained in this publication without first obtaining specific professional advice.

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