Infrastructure tax: a new focus on internal employee capital costs
Tax Alert - September 2020
By Troy Andrews & Liz Nelson
What your employees are working on may become important under a new “Capex Questionnaire” that Inland Revenue has started issuing to taxpayers. The questionnaire targets taxpayers that have significant levels of capital expenditure (capex) or where employees are involved in capex delivery.
The focus of the questionnaire is on how employee expenditure associated with capital expenditure is treated for tax purposes (i.e. whether or not it is capitalised to the cost of the project or asset). This is often missed by taxpayers who mistakenly think that salary and wages are always deductible when incurred, rather than considering whether they should be capitalised for tax purposes.
The purpose of the eight page questionnaire is claimed to be to help Inland Revenue understand:
- what adjustments (if any) your business makes (for tax purposes and accounting) to capture the time and costs of employees engaged in capital expenditure projects;
- how that adjustment is reflected in the financial statements and tax calculation; and
- how the adjustment is calculated.
By definition, capital expenditure projects can be very broad in nature. In the questionnaire, Inland Revenue defines them as follows:
“Capital expenditure (Capex) projects in this context are widely defined and refers to all steps taken to bring assets owned by you into their present location and position. This for example, would include all expenditure incurred by the company from an initial feasibility / concept design stage through to completion / installation of the finished asset; whether that be a simple replacement. Typically, employees can be involved in capital works through: procurement (e.g. of material for capital projects); scoping projects and project selection; design, project management, consenting and legal, purchase negotiations, travel e.g. to site visits; to review plant, technology; licensing, installation, manufacture, software development and so on in order to bring an asset into being or into its present location and condition.”
Clearly the definition is very broad and may include projects such as the purchase and installation of a new asset, implementing a new software system, or the more extreme cases of constructing a new plant or building.
Requirement to capitalise internal labour costs
The requirement to capitalise internal labour costs to the cost of a capital asset or project was confirmed in the 1993 High Court case Christchurch Press Company Limited v Commissioner of Inland Revenue (1993) 15 NZTC 10,206. In Christchurch Press, the taxpayer was a newspaper publisher who was purchasing a new asset to increase and enhance the printing capacity of the press. Some of the electricians and engineers employed by the taxpayer were used to install and wire up the new equipment. In addition, the taxpayer carried out a renovation that involved a replacement of the electrical wiring, using its own staff to carry out the work. In this case the taxpayer was denied deductions for wages paid to these staff while undertaking these capital projects.
The High Court found that the principal purpose of the wages paid to these employees over the period of the installation was for the installation of a capital asset. The same treatment would also apply if a third party contractor had been used to complete the installation and renovation works. Where there is room for apportioning wages between capital projects and deductible wages, this needs to be done on a reasonable basis.
What does this mean for me?
If your business does carry out capex projects (as most do, however small), we recommend you review how you identify costs that are capitalised to a particular project.
In particular, can you identify the specific employees or contractors that are involved in the capex project? This includes employees up the chain to the decision makers all the way down to those physically working on or building the capital asset.
Do you have systems in place by which you can capture the time spent on each particular project? Is this based on timesheets or an approximate percentage of each employee’s time? Is it for the length of the project?
Are there other costs that should be capitalised, for example overheads? You should consider your basis for allocating other costs of the business, both directly and indirectly related to the capital project.
What about feasibility expenditure?
The questionnaire also puts a spotlight on distinguishing between feasibility expenditure and capital expenditure. The current view (as a result of the Trustpower decision) is that feasibility expenditure is only deductible where it is incurred in the ordinary course of business and one of the following situations applies:
- The expenditure is not directed towards a specific capital project; or
- A specific capital project has been identified, however the expenditure is so preliminary as not to be directed towards materially advancing that specific project.
The Inland Revenue questionnaire seeks a description of the approach a business takes to distinguishing between feasibility expenditure and capital expenditure. As this distinction is fact specific it is important that you can demonstrate there are clear policies and guidelines in place to help make this determination.
Can I depreciate these costs?
Once you have identified the relevant costs that should be capitalised to a particular project (including internal labour costs), the next step is to allocate them to a specific asset. If there is no specific asset, then it is likely that the costs will not be able to be depreciated. If there is a specific asset, for example a new piece of machinery, or even a building, then the costs may be depreciated in line with the relevant tax depreciation rate for that asset.
There are situations where no depreciable asset is created, in which case the costs will not be deductible. We refer to this as “black hole” expenditure, but legislative change is currently before Parliament to help address this.
The general rule is the tax treatment of the internal labour costs should follow the tax treatment of the capital project.
Up until now, we have not seen Inland Revenue explicitly focus on the distinction between feasibility expenditure and capital expenditure. However, this new questionnaire indicates that this may now be an area of focus. The Inland Revenue’s Interpretation Statement on the deductibility of feasibility expenditure has been in place for some time now and Inland Revenue is expected to resurrect audit activity after a brief COVID-19 hiatus; it seems logical that the capital/revenue boundary is something that Inland Revenue may look to test.
We have not previously seen this type of specific focus on the deductibility of internal labour costs, however this questionnaire indicates that Inland Revenue will be focusing on this going forward for certain taxpayers.
If you have any questions about your capital expenditure and the treatment of internal labour costs, please contact your usual Deloitte tax advisor.
September 2020 Tax Alert contents
- Infrastructure tax: a new focus on internal employee capital costs
- COVID-19 represents unique opportunity for businesses to reconsider their options when it comes to motor vehicles