The Supreme Court has dismissed Trustpower’s appeal against the Court of Appeal’s decision to disallow deductions for “feasibility” costs incurred in obtaining resource consents for proposed electricity generation projects.
The Court found that the costs were capital in nature, on the basis that the consents were “tangible progress towards eventual completion” of capital projects.
At issue was the tax treatment of $17.7m incurred by Trustpower to obtain resource consents for four proposed electricity generation projects. At the time the costs were incurred, Trustpower had not committed to building any of the projects and there was never any assurance that they would proceed.
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.
- The first step consists of all assessments made prior to the obtaining of resource consents.
- The second step, after the resource consents are obtained, involves, among other things, engineering and geo-technical assessments, the working up of detailed costings, devising how the scheme might be connected to the national grid or local networks and a judgement as to the net present value of the project if completed.
- The third and final stage involves the preparation of a business case for the board and a decision by the board whether or not to proceed.
The resource consents in question were obtained following the first step. Of the four projects, only one proceeded to part completion, with the balance of that project and the other three being left in limbo.
Trustpower succeeded in the High Court, but lost on appeal to the Court of Appeal.
The Court of Appeal found that the expenditure was not deductible on the basis that it did not have a sufficient nexus with Trustpower’s ordinary business activities or its income and, as a result, the general permission in section DA 1 of the Income Tax Act 2004 (the Act) was not satisfied.
Alternatively, the expenditure was capital in nature, so that section DA 2 of the Act would deny deduction.
Supreme Court judgment
The Supreme Court:
- disagreed with the Court of Appeal’s conclusion that section DA 1 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 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 for other taxpayers
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 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.