Article
CIR v Trustpower Ltd: Unfeasibility expenditure
Tax Alert - July 2015
By Campbell Rose and Matthew Scoltock
Introduction
Hopes for a turning of the tide may have been high in the wake of Justice Andrews’ refreshingly practical and commercially-minded High Court (“HC”) judgment for the taxpayer in Trustpower Ltd v CIR - not to mention the other recent taxpayer win in Vector Ltd v CIR.
Unfortunately, the Court of Appeal (“CA”) has dashed those hopes in ruling against the taxpayer by allowing the Commissioner’s appeal in Trustpower. In delivering judgment for the Court, Justice White has held that $17.7m outlaid by Trustpower in applying for various resource consents relating to four potential electricity generation projects in the South Island was non-deductible capital expenditure.
The commercial setting
Trustpower is a generator and retailer of electricity. It generates (via hydro or wind) roughly half of the electricity it sells. The balance is purchased on the retail market from other electricity generators.
Trustpower has in place a “development pipeline” of approximately 200 hydro and wind generation projects at varying stages of assessment for feasibility. The development pipeline enables Trustpower to decide whether, at any given time, it is best placed to ‘build’ electricity generation capacity or ‘buy’ electricity for sale in the retail market. With no guarantee that any given generation project will proceed to a finished product, Trustpower’s development pipeline provides a means to explore the viability of electricity generation or – as one Trustpower witness put it in the HC – to “invest in a chance”.
The legal issues
From 2006 to 2008, Trustpower claimed as deductible $17.7m of expenditure relating to its application for various consents in respect of four potential generation projects in the development pipeline. This was on the basis that:
- The expenditure did not procure ‘stand-alone’ assets and was therefore deductible feasibility expenditure. This was indistinguishable from recurring operational expenditure for the purpose of sourcing electricity for resale (i.e. a ‘cost of goods sold’ characterisation).
- Even if the consents could be regarded as stand-alone assets, they were held on revenue account and the expenditure incurred in acquiring them was therefore deductible.
Conversely, the Commissioner submitted that:
- The consents (with the exception of the land-use consents that had unlimited lives) were “depreciable intangible property” in terms of the Income Tax Act 2007 (the “Act”) so that the expenditure incurred in acquiring them was on capital account (but depreciation deductions could be claimed once the consents were “available for use” by Trustpower).
- In any event, the costs were non-deductible capital expenditure.
The CA’s judgment – capital vs revenue account
The CA dismissed the Commissioner’s first submission as an incorrect interpretation of the Act. Justice White considered the scheme of the Act clearly contemplated that – although the relevant consents were specifically included in the schedule 14 list of “depreciable intangible property” – this did not prevent their cost instead (in appropriate circumstances) being deductible up-front on revenue account.
The CA therefore saw the first question for its consideration not as whether the general permission for deductibility had been satisfied, but, rather, ‘whether the expenditure was on account of capital or revenue’. If Trustpower’s expenditure was on revenue account, it would be deductible under the general permission and the depreciation regime therefore could not apply.
In considering that first question, the CA traversed well-established case law principles focusing on whether expenditure has created, acquired or enlarged the business structure within which income is earned; or whether it is a cost of earning income or of income-earning operations.[1] The question depended on what the expenditure was intended to achieve from a practical or business point of view, rather than a legalistic examination of the rights involved.[2]
Within that framework, the CA held that:
“… the expenditure was incurred for the purpose of enabling Trustpower to extend or expand its electricity generation business … The “development pipeline” was a means of determining the viability, feasibility, and costs of building new generation capacity. In the words of Dixon J in Hallstroms, new generation capacity related to the acquisition of the means of production by extending the business organisation. From a practical and business point of view, the expenditure was calculated to effect the extension or expansion of Trustpower’s business structure … The fact that Trustpower may not have made its build or buy decision to commit to proceed with the projects before the expenditure was incurred is irrelevant. Like all the expenditure in the development pipeline, it was incurred for the purpose of possible future capital projects … Determined objectively, there was a sufficient connection between the expenditure and capital.”
The CA found that the role of the consents in moving generation projects along the development pipeline – which was central to the HC’s view that the expenditure was revenue in nature – confirmed that the expenditure was truly intended to extend or expand Trustpower’s business. This meant that the expenditure was therefore capital/non-deductible.
Deloitte comment
Interestingly, the CA appears to have ignored the general permission (nexus with carrying on a business) as a starting point, and has moved directly to the ‘capital vs. revenue’ inquiry. A finding that the expenditure was capital in nature has then formed the basis of the CA’s view that the expenditure also did not satisfy the general permission.
In doing so, it seems the CA has reversed the usual steps of assessing the deductibility of expenditure under the core provisions. Expenditure is deductible if it has the necessary nexus with income unless one of the statutory limitations – including the capital limitation – applies. In other words, if the general permission is not satisfied, the expenditure is not deductible and the capital limitation is never considered.
The CA’s decision also implicitly rejects the Commissioner’s published guidance on the deductibility of feasibility expenditure (IS 08/02: Deductibility of feasibility expenditure). Despite the Commissioner and Trustpower having agreed that feasibility expenditure was deductible (up to the point when a decision was made to proceed with a project), the CA concluded that expenditure with the necessary connection to “a capital purpose” will never be deductible (but is possibly amortised through the depreciation regime).
In IS 08/02 – which has been in circulation for seven years – the Commissioner’s view is that feasibility expenditure will be deductible under the general permission where it has a sufficient nexus with the taxpayer’s business (i.e. where it is part of the taxpayer’s “ordinary business operations”). The usual tests will then indicate whether feasibility expenditure is capital or revenue in nature. Significantly in Trustpower’s context, the statement notes that where feasibility expenditure is part of a taxpayer’s “normal business operations (i.e., part of the constant demands on the enterprise)”, the expenditure will more likely be deductible. While the statement suggests that certain types of feasibility expenditure might be capital in nature, it does not state that expenditure which might ultimately procure a capital asset will never be deductible.
At first blush the outcome here may appeal to ‘purists’. However, it arguably establishes a concerning principle: if expenditure is subjectively intended to increase sales (say, a new marketing strategy), but objectively from a practical and business point of view it must ultimately have been intended to increase production/capacity to generate those increased sales (which would involve a structural/capital asset being created or acquired), then on the CA’s approach it is non-deductible capital expenditure given that “connection”. This is despite the marketing spend being part of “normal business operations” (which Trustpower’s development pipeline was, on the evidence before the HC). Or was the CA simply influenced, significantly, by the fact that Trustpower actually acquired and held consents themselves? On the CA’s reasoning, however, that did not matter: as the baseline shift in enquiry is to whether the taxpayer’s expenditure ultimately has “a capital purpose”.
Putting the CA’s reasoning to one side, the result for the tax system runs counter to recent legislative amendments allowing deductions for specific ‘black hole’ expenditure, where the underlying policy objectives have focused on helping businesses grow and make meaningful contributions to New Zealand’s economy. Against that backdrop, unless it is overturned on an appeal to the Supreme Court, the CA’s view adds fuel to the fire in terms of the need for a legislative solution to allow general deductibility of business-related black hole expenditure (such as in Australia, where it is deductible over five years on a straight-line basis if not otherwise deductible and certain other conditions are met).
Nexus with income
The CA also found that Trustpower’s expenditure did not even satisfy the general permission:
“… the disputed expenditure was not incurred “in carrying on” Trustpower’s business or in earning the income of the existing business or in performing the income-earning operations of the existing business. Trustpower’s profit-making enterprise is the generation and retailing of electricity, not the development of its pipeline of possible new projects or the investigations of, and applications for, resource consents for those projects. Possible future projects in its development pipeline are for the purpose of extending, expanding or altering its business structure in the future, not part of the carrying on of Trustpower’s ordinary business activities or the taking of steps within that framework, being the generation and retailing of electricity. In terms of s DA 1 the requisite nexus between the incurring of the expenditure and the deriving of the income is not established.”
Deloitte comment
In our view, this is arguably an even more curious aspect of the CA’s judgment. “Carrying on” a business is a well-established concept, which has been interpreted widely as including “abnormal” expenditure in the course of business that is not incurred in deriving assessable income (and is therefore not deductible under the first limb of the general permission), as well as expenditure incurred in the course of carrying on “ordinary business operations”.[3]
By contrast, in the CA’s view, expenditure aimed at growing an existing business – the goal, surely, of every business – is not incurred in carrying on that business. Taken to its logical conclusion, this means that only expenditure directly incurred in relation to the income-earning aspect of a business will ever be deductible (i.e. cost of goods sold).
Given the scheme of the Act as described above, this would mean that the capital limitation effectively serves no purpose – as any structural or ‘expansion’ related expenditure falls at the first “general permission” hurdle – well before the second “capital” hurdle is in sight.
If the decision is appealed, it is hoped that the Supreme Court will clarify the application of these fundamental building blocks in our tax system.
Used or available for use?
Briefly, for completeness, it is worth noting the CA’s conclusion that the consents were available for Trustpower’s use (for depreciation purposes) once they were granted – despite Trustpower not having decided to use them and not being able to obtain land access at that point. “Available” here simply meant “capable of being used” (even if not actually used).
Applying the CA’s approach, the consents should have been depreciated by Trustpower as soon as they were acquired.
Given the recent clarification by the HC in Westpac[4] (another taxpayer win) regarding the breadth of the Commissioner’s discretion in considering requests to amend previous assessments, one assumes that Trustpower’s section 113 application will be looked upon favourably if it does not pursue a Supreme Court appeal.
[1] Commissioner of Taxes v Nchanga Consolidated Copper Mines [1964] AC 948 at 960 (PC).
[2] Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634 (HCA).
July 2015 Tax Alert contents
CIR v Trustpower Ltd: Unfeasibility expenditure
Bright-line test for sale of residential property - issues paper released
Currency conversions for branches – draft released
Tax avoidance: Inland Revenue sheds further light on their approach in practice
Take care when transferring funds from a UK pension plan
New tax bill – the start of the business transformation process
Increase in pooling value threshold for depreciation purposes