Lawrence v Commissioner of Inland Revenue
[2024] NZHC 905
•23 April 2024
IN THE HIGH COURT OF NEW ZEALAND TAURANGA REGISTRY
I TE KŌTI MATUA O AOTEAROA TAURANGA MOANA ROHE
CIV-2022-470-000042
[2024] NZHC 905
UNDER Tax Administration Act 1994 IN THE MATTER OF
A challenge to tax assessments
BETWEEN
ELLA and GAVIN LAWRENCE
Plaintiffs
AND
COMMISSIONER OF INLAND REVENUE
Defendant
Hearing: 19–21 and 23 February 2024 Appearances:
D P Weaver for Plaintiffs
J E Norris and S H Eldridge for Defendant
Judgment:
23 April 2024
JUDGMENT OF ANDREW J
This judgment was delivered by Justice Andrew on 23 April 2024 at 3.00 pm
pursuant to r 11.5 of the High Court Rules 2016 Registrar / Deputy Registrar
Date ………………………….
LAWRENCE v COMMISSIONER OF INLAND REVENUE [2024] NZHC 905 [23 April 2024]
Introduction
[1] The plaintiffs, Mr and Mrs Lawrence, are investors in residential rental property. In 2014, they purchased a rental property in Tauranga. They subsequently discovered it had some leaks. From 2018, significant remedial works were carried out.
[2] In these proceedings, the Lawrences challenge assessments made by the Commissioner of Inland Revenue (the Commissioner) amending their self-assessed income tax returns for the years ending 31 March 2018 to 31 March 2021.
[3] The deductions claimed by the Lawrences in those returns were for their respective shares of partnership expenditure incurred for the remediation works to the Tauranga rental property.
[4] The Commissioner adjusted the remediation expenditure deductions claimed in the Lawrences’ individual tax returns for the tax years ending 31 March 2018 and 31 March 2019. The Commissioner made the adjustments on the basis that the remediation expenditure was capital in nature. Having denied the deductions, the Commissioner then made consequential adjustments to losses carried forward by the Lawrences in their income tax returns for the tax years ending 31 March 2020 and 31 March 2021.
[5] The central issue to be determined by the Court pursuant to powers under s 138P of the Tax Administration Act 1994 (TAA) is whether the disputed assessments are correct. This turns on whether the expenditure incurred in the tax years ending 31 March 2018 and 31 March 2019 is deductible or not.
[6] It is not in dispute that the expenditure satisfies the “general permission” for deduction in s DA 1(1) of the Income Tax Act 2007 (the ITA). That is because the remediation expenditure has a sufficient nexus with assessable income as required under s DA 1(1) of the ITA. Section DA 1(1)(a)(i) and (b)(i) of the ITA requires an amount of expenditure to have been incurred in deriving assessable income, or in the course of carrying on a business for the purpose of deriving assessable income. Here, the expenditure was incurred on the Tauranga rental property used by the Lawrences’
partnership to derive assessable income. This clearly provides a sufficient nexus with assessable income under s DA 1(1).
[7] What is in dispute is the application of the “capital limitation” rule under s DA 2(1) of the ITA to the expenditure. Section DA 2(1) of the ITA provides that a person is denied a deduction for an amount of expenditure to the extent to which it is of a capital nature. This rule is called the “capital limitation” in s DA 2(1).1 The Commissioner amended the Lawrences’ assessments because the expenditure was considered to be capital in nature and, therefore, the capital limitation applied.
[8] In challenging that assessment, the Lawrences say that the expenditure incurred is not subject to the capital limitation and is therefore deductible under the general permission. They say that the remediation works were repairs, not renewal, and were therefore of a revenue nature.
Factual background
Purchase of the property
[9] In 2014, the Lawrences acquired the residential rental property in Tauranga (the property). It was purchased as a long-term residential rental property and at all times has been used for that purpose. The Lawrences remain the owners.
[10]The purchase price was $350,000. The property was listed for sale for
$360,000. At that point, the government valuation was $305,000 (the land value was
$155,000).
[11] Following settlement, the property was immediately used as a residential rental; it still is. At all times the rental income derived has been included in the Lawrences’ tax returns.
1 Section DA 2 of the ITA contains a number of general limitation rules, which are variously named according to their nature.
Original construction
[12] The property comprises a regular oblong-shaped, two-storey, freestanding house with three bedrooms, one bathroom and a single basement garage. It was constructed in 1984.
[13] The house had a pitched “jerkinhead” roof. The roofing material was (painted) six-rib iron. The side walls to the north (north-west) and south (south-east) of the dwelling had a small overhang (particularly the south-east side), and both end walls (i.e. the east or north-east and west or south-west) had no overhang. On the end walls, the roof and gutter edge ended with the outside wall. On the south-east side of the dwelling the roof and gutter edge was next to the outside wall. A fascia bracket (internal) gutter system was used (for which the original plans specified galvanised spouting).
[14] The foundations were concrete with a concrete floor slab on the lower level and a timber framed upper level. The cladding to the upper and lower levels was Fibrolite sheetswith vertical timber boards covering the sheet joints. The cladding was installed with a layer of building paper applied directly onto untreated timber framing. The joinery (window and door) was aluminium with clear single-glazing.
[15] The ground floor consisted of a single car garage and a double bedroom. The first floor consisted of a kitchen, dining and lounge area, two bedrooms, a separate bathroom and toilet, and a laundry.
[16] Before purchasing the property, the Lawrences obtained a pre-purchase inspection report of the property. The report from Advanced Building Consultants (the “Scott Report”) concluded:
At the time of inspection the dwelling appears to be well constructed and was in good condition for its age and will only require a few repairs and maintenance. The house was presented in a clean and tidy condition with average lawns and gardens.
[17] The Scott Report was a non-invasive visual inspection report. Under the heading “Exterior Report Details” it stated that the dwelling did not have any of the design features that could be described as a leaky home. However, the report noted
that the cladding was Fibrolite cement sheets; the windows had no scribers fitted or flashings down their side; there was small or minimal overhang; the guttering was internal and concealed; and the gully trap was too low to the surrounding ground level.
Leaking at the property
[18] On 17 December 2014, the property manager notified the Lawrences that there was a leak in the kitchen. A roofing contractor was engaged to investigate the issue. Quotes were then obtained by the property manager to address the leak and were provided to the Lawrences for their consideration.
[19] A quote from Absolute Gutter Solutions Ltd (AGS) identified the old “Taylor” internal guttering on the house as being rusted out on the north-west side. It also noted that on the north-east end wall (where the leak occurred) the roof was too low in the gutter, which caused blockage problems. AGS also noted that the gutters on the other two sides of the house (i.e. the south-east and south-west) were rusting, but not rusted through.
[20] The Lawrences selected the quote from AGS, which would replace the rusted through gutter on the north-west side. In March 2015, AGS was told to go ahead with the quote, which also included replacing the north-east side guttering if required.
[21] The work carried out by AGS included the replacement of 13.5 metres of the internal gutter on the north-west side of the house and the installation of four overflows to the gutter system. It also included cleaning out the gutters on the north-east and south-west sides (gable ends), which upon inspection were found to be very small custom gutters meaning it was only possible to clean them. AGS noted that the condition of the small gutters was fine, but that the design was bad.
[22] In March 2017, the property manager contacted the Lawrences about water coming into the kitchen again. Spotless Spouting was then engaged to: clean out the spouting above the kitchen and remove gutter foam, clean the spouting all around, and complete a flow test.
Tax year ending 31 March 2018
[23] In early July 2017, the property manager advised the Lawrences that there were still issues with water coming into the kitchen from the soffit when it rained in a certain direction and that the tenants had recently reported dampness in the master bedroom. She had organised to meet with the builder at the property.
[24] Having met with the builder, Mr Tim Watson, on 7 July 2017, the property manager advised the Lawrences that the water problem was mainly caused by the roof line at the gable ends of the house – where there was no overhang and water had cracked the cladding. She noted signs of damage inside at both ends and asked whether the Lawrences wished her to proceed to get a building report from Mr Watson.
[25] The Lawrences then commissioned a property inspection report from Sherlock Home Inspections. The inspection was carried out on 14 July 2017. The report (the “Sherlock Report”) identified all leaks as coming from the roof flashing above the kitchen and around the window in the back (master) bedroom. The report advised that this needed to be addressed as soon as possible in accordance with the report.
[26]The Sherlock Report found:
(a)wetness in bedrooms, and that all wet drywall needed to be removed and replaced;
(b)evidence of past leaking in the kitchen;
(c)wetness in the kitchen, meaning that the drywall that would need to be removed so that any wet or rotten timber from the leak could be replaced;
(d)the roof flashing appeared inadequate and a licenced roofer should review the flashings for replacement or repair as necessary;
(e)there was water present on timber framework in the attic, and any wet or rotten timber would need to be replaced;
(f)a roofer should fix the flashings and check other flashings were installed correctly;
(g)there was inadequate insulation;
(h)all windows needed to be sealed down the sides – there was a hole in the cladding at the bottom of a window and cracked sheets of cladding needed to be replaced;
(i)the lack of eaves put the home in a high-risk rating; and
(j)there was no cavity batten system.
[27] Watson Residential Ltd (Mr Watson) was then asked to get some quotes for the roof flashings and what wall framing would need replacing once wall cladding, or internal lining was removed.
[28] In August 2017, Mr Watson and a roofer physically inspected the roof. The roofer recommended changing the two ends of the house to gable ends with overhangs. Mr Watson advised that the whole design of what had been done was totally inadequate and the gutter system outlets did not work until completely full and leaking internally. Mr Watson had discussed the situation with his architect (Mr Dan Cullen of Cullen Keiser Architecture), who had suggested an effective design solution was changing to gable ends and replacing the internal guttering system to fascia and external guttering.
[29] In September 2017, the Lawrences were given two options for building consent plans and documentation by Watson Residential Ltd. Option 1 was for a roof extension to the gable ends and a partial re-clad (i.e. the gable ends only). Option 2 was for a roof extension to the gable ends and a full re-clad. Based on the Sherlock Report, Cullen Keiser Architecture suggested preparing drawings for a full re-clad as there may be water damage in other walls, and if that was the case the plans would need to be re-drawn and the permit process gone through again. The Lawrences elected to go with option 2.
[30] In September 2017, the Lawrences engaged Watson Residential Ltd to obtain building consent plans and documentation for a re-clad of the entire dwelling and a roof eave extension with a gable design.
Building consent
[31] In early October 2017, the Lawrences received the first draft of drawings prepared by Cullen Keiser Architecture for their consideration. Those drawings provided for a full re-clad of the property with Axon panel on a 20 mm cavity (on existing building wrap on existing timber framing). They included a re-design of the north-east and south-west roofs ends to gable ends with overhangs and a partial re-roof. The existing six-rib iron roofing is shown as remaining complete, and new six-rib roofing on the extension is to match the existing roof. The fascia internal gutter system remains in-situ on the north-west and south-east sides. The notes in the drawing stated that: any defective timber found would be replaced with comparable treated material, that there is no report to identify that this is a leaky home, and that the owner is unaware of any leak issues.
[32] On 17 October 2017, Cullen Keiser Architecture submitted a building consent application to the Tauranga City Council. The submitted drawings provided for all roof cladding, fascia and gutters to be removed completely.
[33]The building consent was issued by the Tauranga City Cou
[34]]ncil on 11 December 2017. The consented work included:
(a)complete replacement of fascia and internal gutter system with a new Coloursteel external gutter;
(b)complete replacement of the existing painted six-rib roof with new Coloursteel MAXX profiled metal roofing to match new Coloursteel gutter and fascia;
(c)addition of a new roof area of 4.2 metres squared at each of the dwelling;
(d)all existing board and batten cladding to be removed completely;
(e)removal of all aluminium joinery to be stored for reinstatement, subject to assessment by a licenced building practitioner confirming weathertightness;
(f)addition of Axon panel cladding on a 20 mm cavity on building wrap on existing timber framing;
(g)reinstatement of existing aluminium joinery to suit Axon panel cladding on a 20 mm cavity with new flashings as per the manufacturer’s specifications;
(h)all external fittings to be stainless steel as per the design; and
(i)proposed details for the work.
Remediation work on the property
[35] On 21 December 2017, the Tauranga City Council building inspector carried out his first on-site inspection (i.e. a pre-construction inspection). The inspection report (number one) noted that the deck was in a very poor state with decaying balustrade timber and a stringer only nailed to the wall. The inspector considered that the deck was getting to a dangerous stage and should be replaced under the consent.
[36] In early February 2018, Tasman Aluminium Ltd (Tasman) recommended replacing the existing aluminium joinery because it required remedial work and they would otherwise not be able to offer a weathertightness warranty. A quote to replace the aluminium joinery with new clear single-glazed joinery was provided. The quote also provided an option for double-glazing. Tasman recommended replacement with double-glazing.
[37] In February 2018, Cullen Keiser Architecture applied for an amendment to the building consent for a new deck.
[38] By the beginning of March 2018, the new fascia, external guttering, roof and soffits were completed. The first cladding was then removed. Rotten timber framing was noted by the building inspector at the front door and above the garage. The inspection report (number three) recommended that the way forward was to remove all cladding and building paper for inspection and mark-up any timber frame needing replacement.
[39] Once the cladding had been removed, a further inspection was carried out. The inspection report (number four) recorded, amongst other matters:
(a)The wall framing studs and plate construction were non-compliant and needed to be rectified.
(b)The two end walls (i.e. the north-east and south-west sides) required total replacement and the south-east wall required replacement as marked up.
(c)Areas of the basement and garage door needed retaining to keep soil off the building and also some consideration should be given to retaining under the house to keep soil away from the wall framing.
(d)Any timber framing not replaced could be treated with a frame saver product.
Tax year ending 31 March 2019
[40] An amendment to the building consent for a new deck was approved on 6 April 2018.
[41] In August 2018, the building inspector advised the builder that an engineer’s opinion on the ability to load the area proposed for the retaining wall should be sought. An engineer was consulted and confirmed that the driveway would surcharge any future retaining wall. As the proposed retaining wall was not part of the building consent, an engineer’s design and supporting drawings were required.
[42] Work on the new main deck was completed by 20 September 2018 and work had commenced digging footing holes for the retaining wall. However, work had to stop due to an issue with the required 1800 mm deck because at 1300 mm the water table had been struck. An engineering solution was required. Accordingly, the proposed design for the retaining wall was revised.
[43] In October 2018, an on-site minor variation was approved for an engineered retaining wall at the front entry, and also a site drawing for the new entrance deck.
[44] On 10 November 2018, the Lawrences gave Mr Watson permission to proceed with the required drainage work.
[45] On 13 December 2018, Telfer Young (Tauranga) Ltd, issued a market valuation of the property for the ANZ Bank of New Zealand for mortgage lending purposes on behalf of the Lawrences. Telfer Young valued the property (on 11 December 2018) at
$700,000 including GST. The land value was assessed at $365,000, the dwelling and other improvements at $320,000, and chattels at $15,000.
[46] In January 2019, a further inspection of the property was undertaken and the building inspector required a fence above the new retaining wall to be installed.
Tax year ending 31 March 2020
[47] In May 2019, the drainage work that had been undertaken was failed by the building inspector because it was not consistent with the approved minor variation or the site notice instructions.
Tax year ending 31 March 2021
[48] In June 2020, the engineer met with Mr Watson on-site to assess what needed to be done with drainage. This included soakage tests to confirm the soakage rate for the existing soak holes. The engineer’s recommended solution was to install a below-ground retention tank in the lawn area for stormwater to drain into.
Tax year ending 31 March 2022
[49] An amendment to the building consent for the stormwater design was approved by the Tauranga City Council on 8 June 2021.
[50]As of 1 July 2021, the rating valuation for the property was: capital value at
$630,000 (land value of $350,000 and improvements of $280,000).2
[51] By 10 November 2021, the soakage trench had been installed and connected to the existing stormwater outfall in accordance with the plans. The building inspector granted approval to backfill the drains.
[52] The plumbing and drainage work was passed by the building inspector on 24 November 2021.
Tax year ending 31 March 2023
[53]A final inspection report (number 18) was issued on 22 September 2022.
[54] On 3 October 2022, the code of compliance certificate for the work was issued by the Tauranga City Council.
Tax positions taken
[55] The Lawrences included the remediation costs (what they say is repair and maintenance work) as deductible expenditure in their 2018 and 2019 income tax returns, being $61,140 and $303,654 respectively.
[56] During 2021, the Commissioner commenced a review of the Lawrences’ tax returns for the income years ending 31 March 2018, 2019, 2020 and 2021.
[57] The Commissioner contended that the costs incurred during the 2018 and 2019 income years were non-deductible capital expenditure. The Lawrences disagreed.
2 In both his opening and closing submissions, the Commissioner contends that the rating value as at 1 July 2021 was: capital value at $950,000. No evidence reference is given for that figure which appears to be the 2023 capital value.
The parties then entered the dispute resolution procedures under Part 8A of the TAA. Under the statutory procedures the parties then exchanged a Notice of Proposed Adjustment and a Notice of Response. The parties subsequently agreed to opt out of the remaining steps in the dispute resolution procedures to enable this matter to be determined by the court.
The statutory scheme
Deductibility
[58] The general permission section DA 1(1) of the ITA prescribes when a taxpayer may deduct expenditure from gross income for income tax purposes:
DA 1 General permission
Nexus with income
(1)A person is allowed a deduction for an amount of expenditure or loss, including an amount of depreciation loss, to the extent to which the expenditure or loss is—
(a)incurred by them in deriving –
their assessable income; or
(ii)their excluded income; or
(iii)a combination of their assessable income and excluded income; or
(b) incurred by them in the course of carrying on a business for the purpose of deriving—
(i)their assessable income; or
(ii)their excluded income; or
(iii)a combination of their assessable income and excluded income.
General permission
(2)Subsection (1) is called the general permission.
[59] Section DA 2 contains general limitations to the deduction of expenditure. Section DA 2(1) provides:
DA 2 General limitations
Capital limitation
(1) A person is denied a deduction for an amount of expenditure or loss to the extent to which it is of a capital nature. This rule is called the capital limitation.
[60] In accordance with s DA 2(7) of the ITA, the capital limitation overrides the general permission.
Relevant legal principles
Capital versus revenue
[61] The general principles that apply in determining whether expenditure is capital or revenue are well-established.3 Those general principles are applied regardless of the nature of the object or the subject of the work.
[62] Where cases are close to the borderline between capital and revenue, the application of further guiding factors is required. Many courts take into account the factors identified in BP Australia Ltd v Commissioner of Taxation of the Commonwealth of Australia,4 subsequently adopted by the Court of Appeal in Commissioner of Inland Revenue v Mckenzies (NZ) Ltd:5
(a)the need or occasion which called for the expenditure;
(b)whether the payments were made from fixed or circulating capital;
(c)whether the payments were of a once and for all nature producing assets or advantages which were an enduring benefit;
(d)how the payment would be treated on ordinary principles of commercial accounting; and
3 Commissioner of Inland Revenue v Trustpower Ltd [2015] NZCA 253, [2015] 3 NZLR 658 at [51]; see also Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634; and Commissioner of Taxes v Nchanga Consolidated Copper Mines Ltd [1964] AC 948 (PC).
4 BP Australia Ltd v Commissioner of Taxation of the Commonwealth of Australia [1966] AC 224 (PC).
5 Commissioner of Inland Revenue v McKenzies (NZ) Ltd [1988] 2 NZLR 736 (CA) at 740.
(e)whether the payments were expended on the business structure of the taxpayer or whether they were part of the process by which income was earned.
[63] In determining the nature of the expenditure, the answer depends on a close examination of the particular facts to ascertain the nature and purpose (i.e. effect) of the relevant expenditure. The solution is not to be found by any rigid test or description but upon a consideration of all the circumstances and what the expenditure was calculated to effect from a practical or business point of view.6 Each case will turn on its own facts, and care must be taken in applying authority to different circumstances.
[64] The case law draws the distinction between repairs and capital improvements.7 In the latter case, the character of a capital asset is altered. It falls within the capital limitation and is therefore non-deductible.8
[65]In Transco v Dyall,9 the Special Commissioners held:
[79] From this authority [Lurcott v Wakely & Wheeler] we derive the principle that the replacement of part of an asset is repair, that that is not altered by the fact that the replacement of part is by a new component of different materials, and that a test to decide whether there is a repair or an improvement is whether the character of the asset is changed by the work. Repair occurs when part of a complex whole is renewed or replaced and renewal occurs when substantially the whole is reconstructed or when the character of the subject-matter changes.
[66] A repair involves the restoration of a thing to a condition it formerly had without changing its character. The High Court of Australia, in W Thomas & Co Pty Ltd v The Commissioner of Taxation of the Commonwealth of Australia, described a repair as follows:10
6 BP Australia Ltd v Commissioner of Taxation of the Commonwealth of Australia, above n 4, at 264–265.
7 Lurcott v Wakeley & Wheeler [1911] 1 KB 905 (CA) at 914, 919 and 924.
8 W Thomas & Co Pty Ltd v The Commissioner of Taxation of the Commonwealth of Australia
(1965) 115 CLR 58; see also Lurcott v Wakely & Wheeler, above n 7.
9 Transco plc v Dyall (Inspector of Taxes) [2002] STC (SCD) 199.
10 W Thomas & Co Pty Ltd v The Commissioner of Taxation of the Commonwealth of Australia, above n 8, at 72.
Repair involves a restoration of a thing to a condition it formerly had without changing its character. But in the case of a thing considered from the point of view of its use as distinct from its appearance, it is restoration of efficiency in function rather than exact repetition of form or material that is significant. Whether or not work done upon a thing is aptly described as a repair of that thing is thus a question of fact and degree.
[67] Replacement of, or improvements to, capital assets will often be expenditure of a capital nature. However, expenditure is usually on revenue account when it is for the maintenance of an income-producing capital asset. W Thomas & Co Pty Ltd v The Commissioner of Taxation of the Commonwealth of Australia described maintenance as follows:11
Maintenance involves a periodic repair of defects that are the result of normal wear and tear in operation. It is an expense of a revenue nature when it is to repair defects arising from the operations of the person who incurs it.
[68] However, repairs to a capital asset on acquisition for use in the business will be a cost of acquisition (and hence capital expenditure) and not a cost of maintenance.12
The two-step enquiry
[69] In accordance with the leading Privy Council decision, Auckland Gas Co Ltd v Commissioner of Inland Revenue (Auckland Gas), there is a two-step enquiry to determine the nature of the expenditure:13
(a)The first step involves identifying the asset/object on which work has been done.14
(b)The second step requires identifying the nature and extent of the work on the physical object to ascertain the effect of the work on the asset/object.15
11 W Thomas & Co Pty Ltd v The Commissioner of Taxation of the Commonwealth of Australia, above n 8, at 72.
12 W Thomas & Co Pty Ltd v The Commissioner of Taxation of the Commonwealth of Australia, above n 8, at 72–73.
13 Auckland Gas Co Ltd v Commissioner of Inland Revenue [2000] 3 NZLR 6 (PC) [Auckland Gas].
14 Auckland Gas Co Ltd v Commissioner of Inland Revenue, above n 13, at [14].
15 Auckland Gas Co Ltd v Commissioner of Inland Revenue, above n 13, at [17] and [27].
[70] In addressing the issue of the nature and extent of the work, the following tests are applied:
(a)whether the work resulted in the reconstruction, replacement, or renewal of substantially the whole of the asset;
(b)whether the work changed the character of the asset; and
(c)whether the work formed one project of work.
[71] In Auckland Gas, the Privy Council also recognised that some assets do not lend themselves readily to the exercise of characterisation:16
The nature of some objects and their component elements is such that replacement of one or more components will not necessarily be regarded simply as a repair of the larger object. This is particularly so if the replaced element differs from the damaged original in such a way as to change the character of the whole. A house is a simple example of this. Demolition and rebuilding of a dangerous flank wall of a house would normally be regarded as repairing the house. The answer might not be so obvious if an entire derelict wing of a large house were demolished and rebuilt, especially if the new construction were substantially different from the original. Questions of degree may arise in such cases.
[72] The Privy Council considered that the replacement of corroded joints in cast iron piping would have been a repair. However, in that case, new polythene piping was inserted into the original cast iron piping. While this repaired the leaks it was also an upgrade that allowed for greater vibration and ground movement and carried gas at a higher pressure. The Privy Council held that far from restoring the gas distribution system to its original state, the work changed the character of the existing gas distribution system and upgraded a significant portion of it.17
[73] The Privy Council further held that the desire to solve a maintenance problem was not inconsistent with carrying out work of a capital nature. The nature and extent of the work carried out to the physical asset are what determines the character of the work.18
16 Auckland Gas Co Ltd v Commissioner of Inland Revenue, above n 13, at [15].
17 Auckland Gas Co Ltd v Commissioner of Inland Revenue, above n 13, at [24].
18 Auckland Gas Co Ltd v Commissioner of Inland Revenue, above n 13, at [27].
[74] The Privy Council acknowledged that the advancement of technology often means that a replacement part will last longer and/or function better than the original.
That does not, however, necessarily change the character of the work.19
[75] In that case, however, the character of the gas distribution system had been changed by the work.
[76] A similar conclusion was reached by the Court of Appeal in Poverty Bay Electric Power Board v Commissioner of Inland Revenue, where it was held that replacement of overhead electrical wires with underground cables constituted a different and operationally superior asset.20 It was not possible to regard the work as anything but a capital improvement.21
[77] Work that forms part of an overall project to reconstruct, replace or renew an asset, or substantially the whole of an asset, and/or changes its character, takes its nature from that project as a whole.22
[78] If the work results in the reconstruction, replacement, or renewal of the asset, or substantially the whole of the asset, it will be in the nature of capital. If the work falls short of being reconstruction, replacement or renewal of the asset, or substantially the whole of the asset, then its nature will depend on the work done. Work that goes beyond repairs and changes the character of the asset will be capital.
[79]In Auckland Gas, Lord Nicholls observed:23
…sometimes repair may not be the appropriate description of work even though it falls far short of being a replacement of substantially the whole of the relevant subject-matter. The effect of the work on the character of the object is also an important consideration.
[80] Lord Nicholls also observed that the nature and scale of work on an asset is relevant to the consideration of whether the character of the asset has been changed.24
19 Auckland Gas Co Ltd v Commissioner of Inland Revenue, above n 13, at [14].
20 Poverty Bay Electric Power Board v Commissioner of Inland Revenue [1999] 2 NZLR 438 (CA).
21 Poverty Bay Electric Power Board v Commissioner of Inland Revenue, above n 20, at 446.
22 Colonial Motor Co Ltd v Commissioner of Inland Revenue CA51/94, 6 October 1994.
23 Auckland Gas Co Ltd v Commissioner of Inland Revenue, above n 13, at [17].
24 Auckland Gas Co Ltd v Commissioner of Inland Revenue, above n 13, at [11] and [20].
The Privy Council recognised the distinction between an alteration that results in great improvements as opposed to merely renewing worn bits of an asset but not altering its character.
[81] The character of the work is usually changed where the work improves or enhances the asset or makes it more advantageous. This may include changes to value, earning capacity, useful life, function and operating capacity. It also includes consideration of the extent and importance of the work.25
Analysis and decision
[82] As noted, the overarching issue is whether the disputed expenditure is capital in nature and therefore the capital limitation in s DA 2(1) of the ITA applies to deny its deduction.
[83] The Lawrences, as taxpayers challenging an assessment in civil proceedings, must demonstrate on the balance of probabilities that the Commissioner’s assessment is wrong and, if so, by how much.26
[84] The Lawrences say that the expenditure in dispute is repairs and maintenance and therefore revenue in nature. The Commissioner says that the expenditure on the house was capital as the remediation work resulted in the reconstruction or renewal of substantially the whole of the asset.
[85] The parties called expert evidence on this critical issue. Mr Rex Moyle, with 54 years’ experience in the construction industry, concluded that the remediation works did not change the character of the building. Mr Frank Wiemann, building surveyor, architect and director, gave evidence for the Commissioner. He addressed two issues: whether the remediation work substantially reconstructed, replaced or renewed the house and whether such works changed the character of the dwelling. He concluded that the remediation work was not in the nature of what would be
25 Commissioner of Inland Revenue v Auckland Gas Co Ltd CA240/97, 15 December 1998; Auckland Gas, above n 13; and Poverty Bay Electric Power Board v Commissioner of Inland Revenue, above n 20.
26 Buckley & Young Ltd v Commissioner of Inland Revenue [1978] 2 NZLR 485 (CA).
characterised as maintenance in the building industry. In Mr Wiemann’s view, that was because the remediation went well beyond the sort of repairs and maintenance required to keep the parts of the building performing as expected. He noted the building work was carried out in almost all significant areas of the house and to the immediate surroundings of the property, affecting the roof, roof shape, gutters, cladding, windows, timber framing, as well as the decks, surrounding retaining and drainage. He concluded that this changed the building in all aspects of its appearance and improved its performance, durability and usability. In his supplementary brief of evidence in reply, Mr Moyle challenged Mr Wiemann’s view that the scope of works was not repairs and maintenance.
[86] Both witnesses are obviously very experienced in the industry. However, I prefer and adopt the evidence of Mr Wiemann. He was an impressive witness with greater command of the subject matter and addressed the issues in a thoroughly professional manner. It is not relevant that Mr Wiemann has not physically visited the property, in contrast to Mr Moyle, who did. Mr Wiemann had access to extensive photographs and documentation and had an impressive and full grasp of the relevant facts and details. Mr Wiemann’s evidence was substantially helpful and in a very systematic and clear fashion analyses the nature and scale of the remediation works. Overall, Mr Wiemann’s evidence was of a superior quality and more convincing.
[87] Ultimately, it is of course for the Court to determine the critical issue of whether an item of expenditure is revenue or capital in nature. My ultimate finding is that this is actually a very clear-cut case. The nature and scale of the remediation works here resulted in the reconstruction or renewal of substantially the whole of the house and the works changed the character of that asset. The Lawrences have failed to establish that the Commissioner’s assessments are wrong and that the capital limitation does not apply.
[88] The disputed expenditure was incurred on the property to address aspects of the original design and reconstruction that placed it at risk of water ingress. That expenditure was once and for all; not recurring/ongoing. Such expenditure formed part of the fixed capital rather than circulating capital. It was invested in the capital asset used to derive income.
[89] The expenditure created advantages which were for the enduring benefit of the Lawrences’ rental accommodation business. The expenditure related to the profit- earning structure (the property) through which the Lawrences carried out their profit- earning process.
[90] The extent of the work carried out was substantial and included replacement of all exterior elements of the building envelope, alteration of the design of external elements, substantial replacement of internal elements and the addition of a retaining wall and stormwater disposal.
[91] In my view, the work undertaken changed the character of the property. The original design was altered, including the roofline and guttering which had made it vulnerable to water ingress, and were replaced with a superior design, materials/products and systems (with associated advantages), as well as new or enhanced elements such as a retaining wall and stormwater disposal. As a result, the property was much improved from its original construction.
[92] The work formed one overall project. It commenced with the engagement of a project manager on 20 September 2017 and ended with the issuance of the Code of Compliance Certificate on 3 October 2022. The project included the re-design and alteration of the roofline and guttering system, recladding, timber remediation (and consequential work on internal areas of the property), retaining wall, decking and stormwater disposal. These matters all formed part of the building consent plans.
[93] The parties are, of course, agreed that the relevant asset is the dwelling. I agree with the submission for the Commissioner that the new retaining wall and the new stormwater disposal system should properly be regarded as part of the dwelling. The new retaining wall was constructed as part of the project of work. It is necessary to protect and support the building and the driveway. The new stormwater disposal system forms part of the dwelling because it protects the building by disposing of excess water in a safe and contained way.
[94] The cumulative effect of the following factors support my finding that the remediation work on the property resulted in a change to its character.
The roof re-design
[95] The roof replacement and change of roof shape addressed design issues with the original construction and improved technical performance. This work was not simply addressing a requirement to repair any weathertightness issues. The roof shape at both gable ends of the building was changed, incorporating a useful roof overhang. This was an improvement to weathertight performance because the viable transition between roof and wall is now protected by the roof clearly covering the top of the gable wall. The lack of eaves on the original construction was a high-risk feature and a design problem.
[96] The change to a gable roof also created a reduction in upkeep and therefore improves the building (there are fewer corners and edges). As Mr Wiemann noted, the perception of the building is now a clean architectural appearance and modern exterior.
[97] Mr Moyle accepted that a portion of the work on the gable ends could be seen as an improvement on the original design rather than simply remedial work and/or repairs and maintenance of the original structure.
The roofing replacement
[98] The steel roofing material was replaced in its entirety with a superior product which is pre-coated and does not need painting. The main difference is that the original six-rib material was a galvanised sheet that had been painted and was maintained by regular painting. In contrast, the Endura replacement product is a steel sheet with a zinc and aluminium coating. This has a superior protection against corrosion.
[99] Mr Moyle agreed that the Endura ColorSteel is a better product than the six-rib iron galvanised steel that was on the roof previously.
The gutter replacement
[100] The internal guttering was replaced with a ColorSteel external gutter system. The replaced guttering system consisted of a gutter hidden behind a fascia and the gutter itself had the distinct disadvantage that it was lower on the inside face towards
the building than it was on the outside face. Therefore, any water that reached the gutter and brought it overflowing would always discharge towards the building side of that gutter.
[101]Mr Moyle accepted that the old Taylor guttering system did have issues.
The new cavity and cladding system
[102] The cavity construction is a marked technical and performance improvement compared to the original direct fixed cladding. The new cavity, described by Mr Wiemann as part of a system, creates a safety distance between the back of the new cladding and the timber framing. This allows drainage and the drying of any moisture that might enter behind the cladding. With the original cladding, any water that entered behind the cladding immediately reached the timber framing past the non-watertight building paper. The new cladding system is vastly superior to the original direct fixed cladding.
[103] Mr Moyle accepted that a cavity batten system is superior to a direct fixed system.
[104] Mr Weaver, on behalf of the Lawrences, challenged the proposition “that a cavity system and cladding system and double-glazing have improved the building to the extent that it has altered its overall character”. However, that is not an entirely accurate description of the Commissioner’s position. None of these factors are to be considered in isolation. It is the overall degree and scale of the change and improvement that is key. The vastly superior new cladding system is one of many factors to take into account.
[105] I note also that where the work forms one project, the expenditure incurred cannot be apportioned. Here, the project of work included all work undertaken at the property between the engagement of the project manager and the subsequent issuance of the certificate of code of compliance.
The new exterior joinery
[106] The evidence clearly establishes that double-glazing is superior. It improves window performance over single-glazing in terms of improved insulation, the prevention of condensation on the glass surface (common on windows that are single-glazed) and, in context with the renewed wall installation, the overall thermal performance of the building after refurbishment.
The new decks
[107] The change to the deck, especially the adjustment of the balustrades to comply in heights and distances, was a clear improvement in terms of safety. This may have been a compulsory requirement of the building code. However, that is not relevant; this was still an improvement of some significance.
[108] Mr Moyle agreed that aspects of the deck design and materials had been improved since 1984, in terms of structural support and safety.
The new stormwater disposal
[109] The stormwater disposal system did not replace an existing stormwater disposal system. It was a substantial enhancement of the status quo in terms of directing excess water away from the building in a safe and contained way.
The overall effect of the work
[110] The building work resulted in improvements to multiple and significant components of the property. This included the immediate surroundings of the property, the roofing, roof shape, gutters, cladding, windows, decks and surrounding retaining and drainage. I agree with the evidence of Mr Wiemann that this changed the building in all aspects of its appearance and improved its performance, durability and usability.
[111] The expenditure on the property in the 2017 and 2018 tax years was significant, totalling $364,794. The work clearly improved the value of the property.
[112] As at 1 July 2015, the rateable value (RV) of the property was $305,000. Three years later, the RV had increased to $365,000, corresponding with the completion of work on the dwelling house and the deck. A market valuation for mortgage lending purposes, dated 11 December 2018, valued the property at $700,000. That valuation noted that the property market and the dwelling had improved significantly since the plaintiffs purchased it. As at 1 July 2021, the RV was $630,000.
[113] The following factors support my conclusion that the remediation works reconstructed and renewed substantially the whole asset:
(a)The extent of the work carried out to the property was substantial.
(b)All external elements of the building were removed and replaced, and the roofline was extended at the ends.
(c)External work also included painting, replacement of two decks, construction of structural retaining, drainage and installation of an engineer-designed stormwater disposal system (to retain water and distribute it to the soak holes installed on the property as part of the work).
(d)There was significant work carried out on internal elements of the building as well. This included extensive replacement of timber framing and external walls (and application of frame saver to timber) and some timber replacement of internal walls. Mr Moyle estimated that 25 per cent of the timber framing was replaced. Mr Wiemann was not prepared to give a figure as such, but stated that Mr Moyle’s estimate of 25 per cent was “probably pretty low” and Mr Wiemann believed it was probably a higher amount than that.
(e)Work on the interior of the building also included:
(i)replacement of flooring;
(ii)tiling;
(iii)installing insulation;
(iv)stopping;
(v)electrical work;
(vi)internal plastering; and
(vii)painting.
[114] The more significant or integral the part of the asset being worked on or replaced, relative to the whole asset, the more likely the expenditure will be capital.27 In this case, the scale of the remediation works was significant. The work done affected nearly every part of the property. This included the roof, gutters, cladding, windows, timber framing, decks, retaining and surrounding drainage. As noted, the work also addressed design issues and replaced damaged materials.
[115] Counsel for the Lawrences, Mr Weaver, accepted that extensive works were carried out on the property. However, he contended that while there was replacement of the roof, cladding, windows and parts of the timber framing, overall the work fell short of replacement or reconstruction of the whole, or substantially the whole, asset. He argued that this was merely replacement and renewal of defective parts. However, I reject those submissions. The scale of the works here, as a matter of fact and degree, was significant for the reasons outlined above. The test is one of renewal or replacement of “substantially the whole” and in my view the test is clearly made out here.
[116] Mr Weaver also submitted that the work carried out did not create any new asset but, rather, simply restored it to a state which would enable it to continue to generate assessable income (rent). He contended that the works were not additions or alterations to the property giving it a greater income-earning capacity than it had had prior, being previously in a sound state. Mr Weaver further argued that the work
27 Federal Commissioner of Taxation v Western Suburbs Cinemas Ltd (1952) 86 CLR 102 at 106; and Case L68 (1989) 11 NZTC 1,398 (TRA).
undertaken “merely prevented the asset from being sterilised so that it could continue to earn income”.
[117] I reject those submissions. The test is not one of creating a “new asset”. Furthermore, the work undertaken was far more than the prevention of the asset “being sterilised”. In reality, the remediation works have resulted in a substantial extension of the building’s useful life and its purpose as a habitable rental property. The significant expenditure, reflecting the scale and nature of the remediation works, created advantages for the Lawrences which were and are for the enduring benefit of their rental accommodation business.
[118] I accept that the Lawrences may not originally have intended the significant scale of the works that were actually carried out. Regrettably, and as many owners of leaky homes have experienced, ongoing investigation throughout a project will often give rise to more extensive and expensive remediation works being required (that is the nature of latent defects). However, that is not determinative. In any event, I note that the original plans put forward, and the consented plans, provided for a full re-clad of the dwelling. Yes, the Lawrences hoped to achieve a more limited re-clad but they always knew that option two, namely a full re-clad, was always a possibility.
[119]Mr Weaver also submitted as follows:
If the Commissioner’s position was correct, repair work done to a building after lengthy periods of time would almost certainly not be deductible. That is because the repair work would involve the use of more modern building materials, construction techniques or systems. That proposition has not been accepted by the courts as the basis upon which work should be categorised as either capital or revenue.
[120] I agree that simply because modern building materials and construction techniques or systems are used does not mean that the works are not repairs or maintenance. Repairs or maintenance will inevitably involve the use of contemporary code compliant materials and systems. However, it is not correct to say that if the Commissioner’s position was correct, repair work done to a building after lengthy periods of time would almost certainly not be deductible. It is again, and always, a question of fact and degree and it is the cumulative overall effect and scale of the works, not individual items in isolation, that is key. As Judge Barbar held in Case J92,
deductibility must be determined by what in fact took place.28 Here, there was one overall project – the reconstruction of substantially the whole house. There was not a sequence of repair work items.
[121] Both counsel referred to a range of authorities to support their respective positions. Mr Weaver, contending for a practical and common-sense approach, relies on the High Court decision in Sherlaw v CIR29 and the TRA decision in Case T43.30 He contended that both decisions refused to “adopt the narrow view” for which the Commissioner contends.
[122] In Case T43, the plaintiff claimed a deduction for repairs to a building that involved replacement and covering of deteriorated timber flooring, removal and re-routing of a drainage system under the building, replacement of a Fibrolite roof with a new corrugated iron roof, and replacement of external cladding and rotted framing. The focus in the case was on whether the repairs were capital or revenue. Judge Willy, rejecting the Commissioner’s submissions, held that all of the work involved repairs to defective parts of the premises and, therefore, the expenditure was deductible. His Honour referred to the distinction between repair and renewal and noted that the test to apply is one of fact and degree and an application of “common- sense” to the facts.
[123] In Sherlaw v CIR, the plaintiff included a deduction for expenditure on repairs to a commercial boat storage building. The expenditure was required to repair pile foundations which had deteriorated. Rather than repair the existing piles, holes were cut in the floor and roof of the building to enable the damaged piles to be entirely replaced through the use of a crane. Ultimately, this led to the floor and roof needing to be replaced in a slighter higher position than before. The cost of the work was substantially more than the price paid for the original building. The Commissioner’s case was that the work was close to a complete reconstruction of the building. He also argued that the plaintiff chose to improve, rather than repair, the asset and that the scale
28 Case J92 (1987) 9 NZTC 1,518 (TRA) at 1,522.
29 Sherlaw v CIR (1994) 16 NZTC 11,290 (HC).
30 Case T43 (1998) 18 NZTC 8,287 (TRA).
of the work done was so disproportionate to the value of the asset that this, in of itself, was enough to indicate the work was capital in nature.
[124] Doogue J held that the repairs were deductible. His Honour distinguished the Auckland Trotting Club31 decision on the basis that in that case the trotting track had to be reconstructed because the original reconstruction was entirely unsatisfactory and dangerous. By contrast, in Sherlaw, the building’s piles gradually deteriorated and needed to be replaced. The replacement of the piles then resulted in other work becoming essential.
[125] Each case must, of course, be considered on its own facts. As Judge Willy noted, it is a question of fact and degree. In my view, neither of these two cases assists the Lawrences. The amount of expenditure at issue in Case T43 was relatively modest (even allowing for the early 1990s date when the expenditure was incurred) and the overall scale of the works was different from this case.
[126] In Sherlaw, it was accepted by the taxpayer that some of the work constituted capital improvements. Doogue J held that the taxpayer’s replacement of the roof and flooring followed maintenance of the piles and “nothing more”. He concluded:
The very course adopted by the taxpayer of doing, wherever possible, work by himself and with friends, with secondhand and recycled materials, indicates clearly that this was not an endeavour to improve the structure of the building but simply to ensure that necessary maintenance was carried out to it.
[127] The present case is very different from Sherlaw. There were inherent design problems in the Tauranga property that were addressed in the remediation. It is also clear from the consent plan that the Lawrences were prepared to complete a full re-cladding of the property, although they hoped they wouldn’t need to. Furthermore, unlike the taxpayers in Sherlaw, the Lawrences hired professionals and purchased high quality materials (such as Endura Coloursteel) rather than attempting to do the repairs themselves and/or with second-hand materials. Accordingly, the facts are clearly distinguishable.
31 Auckland Trotting Club (Inc) v Commissioner of Inland Revenue [1968] NZLR 967 (CA).
[128] In conclusion, I find that the Commissioner’s assessments, the subject of the challenge, are correct. The capital limitation applies to the expenditure in dispute.
Result
[129] The plaintiffs’ claim for a declaration at [111] of the statement of claim is dismissed. I enter judgment for the defendant, the Commissioner of Inland Revenue.
[130] I note that the Commissioner has sought orders under s 138P of the TAA adjusting the Lawrences’ 2020 and 2021 tax returns on the basis of my findings in this judgment (as they relate to the years ending 2018 and 2019). In order to address that question, I seek further submissions from the parties. Upon receipt of those submissions, I will determine that issue on the papers. I make the following directions:
(a)The Commissioner is to file and serve written submissions on this issue
within 21 days.
(b)The plaintiffs are to file and serve written submissions 21 days after that.
[131] As to costs, I am of the preliminary view that having succeeded, the Commissioner is entitled to costs on a 2B basis (plus disbursements). If costs cannot be agreed, then memoranda (no more than five pages) are to be filed and served within 21 days.
Andrew J
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