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Supreme Court narrows access to tax deduction on feasibility costs

The Supreme Court has dismissed Trustpower’s appeal against the Court of Appeal’s decision to disallow deductions for “feasibility” costs of over $17 million incurred in obtaining resource consent for four proposed electricity generation projects.

The Court found that the expenditure was capital in nature as the consents were “tangible progress towards eventual completion” of capital works. 

The context

There was never any assurance that any of the projects would proceed and – indeed – only one was started and it was only partially completed. They were part of a continually evolving “development pipeline” containing over 200 potential projects. 

Projects in the pipeline go through three steps of feasibility analysis: assessment prior to resource consent application, then – post-consent - engineering and geo-technical assessments, detailed costings, net present value calculations etc, and finally; preparation of a business case for the board.

The resource consents in question were obtained following the first step.

Supreme Court judgment

The Supreme Court:
  • disagreed with the Court of Appeal’s conclusion that section DA 1 of the Income Tax Act 2004 (the Act) was not satisfied, finding that the expenditure was incurred by Trustpower in the course of carrying on its existing business as an electricity generator and retailer and had a sufficient nexus to income, but
  • agreed with the Court of Appeal that the expenditure was capital in nature, with section DA 2 of the Act denying a deduction. 
In reaching this view, the Court rejected Trustpower’s argument that expenditure in relation to capital projects is on revenue account until the taxpayer commits to the completion of the project (described as the “commitment approach”). 

The Court accepted that the concept of commitment could be material in determining whether new business activities satisfy the general permission in section DA 1, but did not see it as providing a logical or principled test for determining whether the capital limitation in section DA 2 applied. The Court considered the concept of commitment to be indeterminate and found its implicit subjectivity to be problematic.

Instead of the commitment approach, the Court preferred the general proposition that everything that relates to a possible capital asset is non-deductible, whether or not a capital asset results.  Notwithstanding that general proposition, the Court accepted that preliminary expenditure on feasibility studies could sometimes be deductible.

In Trustpower’s case, the Supreme Court found that the expenditure was:
“directly related to specific projects that would be on capital account if they came to 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 noted that in other cases expenditure “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.”

Implications

There should be some relief for taxpayers that the Supreme Court concluded so easily that the expenditure had a nexus with Trustpower’s existing business (albeit that will be of little comfort to Trustpower). The Court of Appeal’s approach to section DA 1 was surprising (not least because the Commissioner of Inland Revenue did not argue for it) and had the potential to have wide ramifications. 

The Supreme Court’s conclusion on the capital/revenue distinction represents a narrowing of the circumstances in which “feasibility” type expenditure will be immediately deductible as revenue expenditure. This has the potential to extend cases of “blackhole” expenditure where neither an immediate deduction nor depreciation deduction is available. 

It is interesting that the Supreme Court questioned the description of the costs as “feasibility expenditure”, noting that the term “does not fully capture the significance of resource consents and thus the costs incurred in obtaining them. Securing the consents amounted to tangible progress towards eventual completion of the projects (which could not be built without them)”.  

This was perhaps seen as relevant in light of the Court’s departure from Inland Revenue’s Interpretation Statement IS 08/02, which espouses the commitment approach and has formed the basis of accepted practice for deductibility of feasibility expenditure since it was issued in June 2008. 

While the Supreme Court considered commitment could be relevant in the context of a new business and application of the general permission in section DA 1, it is clear from the judgment that the Court sees commitment as irrelevant to the capital/revenue test. Although this may not be unreasonable given the practical difficulties the Court identifies as arising from the commitment approach, it is a significant departure from current practice. 

Clearly taxpayers should not rely on Interpretation Statement IS 08/02 going forward but this decision creates uncertainty for those who have relied on IS 08/02 previously. One hopes that Inland Revenue will not challenge historical positions taken in reliance on the Interpretation Statement. 

Some timely guidance from Inland Revenue on this would be welcome.


Bevan Miles is a special counsel at Chapman Tripp and Vivian Cheng is a senior associate. Both specialise in tax law.