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It’s feasible that feasibility expenditure may still be deductible… sometimes

Tax Alert - October 2016

By Robyn Walker  

Back in July we reported on the outcome of the Supreme Court decision in Trustpower v Commissioner of Inland Revenue [2016] NZSC 91.  A first read of the case left many feeling dread about how they were to prepare their tax returns, with the case throwing doubt on what feasibility expenditure might still be deductible. 

Following the release of the Supreme Court judgment we were on record saying “All eyes now turn to the Inland Revenue to find out what its next step will be.” Late last month we saw Inland Revenue’s next step, with the Office of the Chief Tax Counsel releasing a draft revised interpretation statement on the deductibility of feasibility expenditure (available here) which seeks to provide practical guidance on how the judgment should be applied. 

Inland Revenue’s former guidance hinged on whether a taxpayer had “committed” to a particular asset or course of action.  This approach was strongly dismissed by the Supreme Court, and accordingly Inland Revenue has revised its approach to be:

“Therefore, in the Commissioner’s view, expenditure is likely to be deductible in accordance with the Supreme Court decision if it is a normal incident of the taxpayer’s business (see [72] of Trustpower (SC)) and it satisfies one of the following:

  • the expenditure is not directed towards a specific capital project; or
  • the expenditure is so preliminary as not to be directed towards materially advancing a specific capital project – or, put another way, the expenditure is not directed towards making tangible progress on a specific capital project.”

The draft revised interpretation statement goes on to provide lengthy commentary as to what these two tests mean, but they are most meaningfully explained in plain terms through the use of examples provided by Inland Revenue.  We replicate two of the examples below:

Example 1: Acme Electricity Generation Limited

Acme Electricity Generation Ltd generates electricity for sale to consumers.  Currently, its electricity is predominantly generated by coal-fired power plants.  However, it also has some small hydro stations and one wind farm.  Acme routinely investigates new generation opportunities and intends to focus its future generation projects on sustainable sources.

Acme sends an employee to Norway on a general fact finding trip to learn about the generation methods that they use and the pros and cons of each of them.  Expenditure on the fact finding trip is deductible as it is not linked to a specific capital project or asset.

One of the generation types that Acme learned about in Norway is “blue energy”, which uses seawater and fresh water to generate electricity.  Acme identifies five potential places in New Zealand that it believes would be suitable for this type of generation plant.  Acme then sends two employees to Norway to talk to the generation company involved.  They get general information about “blue energy” including the water conditions that are required for successful generation, the land area required for a plant, the potential generation capacity and ballpark costs for running a plant.  This expenditure is also deductible.  The expenditure relates to a specific project (a “blue energy” generation plant).  However, the expenditure is preliminary and it does not result in any tangible progress of the project or any capital asset or other enduring benefit.

Based on the information that Acme gathered in Norway, it chooses one of the five potential sites that it believes has the best conditions for a viable “blue energy” plant.  Acme sends the two employees back to Norway with site plans to get expert advice on the best design for the plant.  While there they commission a Norwegian engineer to draw blueprints for the plant.  This expenditure is not deductible as having the expert advice and plans for construction materially advances the capital project.

Example 2: National restaurant chain

A national restaurant chain is continually looking for new sites on which to build restaurants.  It is considering opening a new restaurant in Wellington.  To help identify a suitable potential site, the company hires a contractor to survey traffic flows in different areas around Wellington.  This expenditure is deductible.  The expenditure relates to a specific project (building a new restaurant).  However, the expenditure is preliminary and it does not result in any tangible progress of the project or any capital asset or other enduring benefit.

Overall, the draft revised interpretation statement is a good step towards restoring order and giving taxpayers a better idea of how they should determine tax return positions in respect of feasibility expenditure. However, this is only one step of the journey as while there is now guidance, the reality is that a test based on material advancement / tangible progress results in costs being treated as capital earlier than under a commitment test.

What the Trustpower case has done is shone a spotlight on the existing tax policy settings which can prevent a significant amount of expenditure from ever being deductible for tax purposes. We have seen a number of ad hoc measures to correct problems with software and other intangible assets, but issues still exist. This includes when a taxpayer incurs expenditure to materially advance a tangible asset that ultimately never gets completed (in order to qualify for depreciation deductions), and also when there is unsuccessful expenditure directed at non-depreciable assets (for example undertaking a due diligence on a business ultimately not purchased). There will be a range of options for solving this problem, but perhaps the simplest one may be to look to align the tax treatment with the accounting treatment of such expenditure as we have already done with research and development expenditure.  

The Office of the Chief Tax Counsel have played their part, the next move belongs to the Tax Policy team.

Submissions on the draft interpretation statement close on 9 November. 

 

Tax Alert October 2016 Contents:

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