Meg Saksida considers a tax question that can cause some uncertainty and confusion.
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In calculating the taxable profits of a let property business, one of the most important concepts to understand is the difference between capital and revenue expenditure.
Revenue expenses can generally be offset against income tax in the tax year they are incurred. Taxpayers find this much more desirable than capital expenditure, as it is (mostly) subject to tax deduction through capital allowances over a number of years.
Enduring benefit?
The differentiation in capital and revenue expenses generally was summed up in a historic case from 1925, Atherton v British Insulated and Helsby Cables Ltd (1925) 10 TC 155, in which Viscount Cave of the House of Lords concluded:
“… when an expenditure is made, not only once and for all, but with a view to bringing into existence, an asset or an advantage for the enduring benefit of the trade … there is good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such expenditure as properly attributable not to revenue but to capital.”
Let’s look at how repairs are considered on purchase, and then throughout the ownership of the let property.
Repairs: On purchase
When considering repairs made on a property which has recently been purchased, the major cases which provide us with guidance are Law Shipping Co Ltd v IRC (1923) 12 TC 621 and Odeon Associated Theatres Ltd v Jones (1971) 48 TC 257.
In the Law Shipping case, the taxpayer, a shipping company, purchased a second hand ship. After a Lloyds survey of the ship’s seaworthiness, it was concluded that the ship required extensive repairs before it could be sailed. The ship had already been used (sailed) by the shipping company and the survey had not been carried out until six months had passed after the acquisition. The repairs were made and the company claimed the repairs as a revenue expense. However, it was held that although a small part of the expense could be allocated against the six-month period in which the ship had been used, the majority of the repair costs were related to the cost of the acquisition of the ship and were, therefore, capital in nature. The logic behind this was that should the ship have been of a seaworthy quality at the date of purchase, the price would have been higher to reflect this, and hence the expenditure was capital.
In the Odeon case, although similar circumstances existed, the repairs were all held to be revenue expenses. Odeon had purchased several cinemas. It was in the post-war period and the cinemas were tired and needed redecoration and repairs. The cinemas were used as picture theatres from the date of purchase. The purchase price represented predominantly the structure of the building and the land, not the internal décor. The purchase price in this case, unlike Law Shipping, would therefore not have been significantly different had the theatres been already repainted and carpeted. Eventually, over the years, the cinemas were repaired and these expenses were all able to be deducted against the profits as revenue expenses.
In both cases, the taxpayer purchasers knew repairs were necessary to the asset and would need to be carried out eventually; but only in the Law Shipping case did these required repairs impinge on the price of the asset.
Applying this principle to a let property, the landlord must establish if the requirement for the repair had reduced the price paid for the property. For example, if in a survey the landlord found the house needed a new roof, and through negotiations with the vendor a reduction in the purchase price was negotiated, the eventual cost of the roof’s repair would be capital. If, on the other hand, the roof’s repair was not significant enough to warrant a deduction of the price at purchase, and the price remained the same, the repair could be deducted against revenue. Repairs that are required cyclically, such as those because of a boiler service, are also able to be classified as revenue, even if the repair is due at the time the sale completes and the new landlord must pay for this.
Repairs: During ownership
Returning to the Atherton case quote, when considering repairs on an ongoing basis in the property, the landlord will need to establish if a repair has “…[brought] in[to] existence an asset…” or merely restored the original asset to its former capacity.
For example, in a let property, if the kitchen is tired and needs repairs to the cupboard fittings and some redecoration, and these repairs are made to restore the kitchen to functionality, this would fit the definition of a repair and the cost could be deducted for income tax purposes in the year of expenditure. This is because the repair has restored the existing kitchen to its original state and functionality.
To establish whether it is a new asset or a repair to an existing asset, we must understand what “the entirety of the asset” is. Every repair is in some way a replacement, so one could argue that every repair is capital on a stand-alone basis. However, if it is a part of an existing capital asset, it can be a repair. But what is the entirety of that existing capital asset? For example, if in the kitchen above a cupboard door was replaced, this door would be a new asset; but is it a capital new asset? No. This is because the cupboard door is not the ‘entirety’ of the asset. It is part of the kitchen for which the ‘entirety’ is the house.
In the case of O'Grady v Bullcroft Main Collieries Ltd (1932) 17 TC 93, the taxpayer replaced a faulty chimney. Because the chimney was a stand-alone chimney, the replacement of the chimney was the replacement of the ‘entirety’ of the asset and, therefore, a capital expense. This can be compared with the case of Jones & Co (Devonvale) Ltd v IRC (1951) 32 TC 513, where there was also a chimney to be replaced. Although initially the Commissioners deemed the chimney to be capital, the Lord President of the Court Of Session held that the replacement was revenue as the factory was the ‘entirety’.
Functionality and modern equivalents
Once the ‘entirety’ has been established, and that it is a repair, the other issue to consider is the functionality of the new asset. Does the repair simply place the original asset in the same functional position it was in before, or is it a more advanced, efficient, bigger or feature-heavy asset? Where there are significant improvements in the asset, the repair or replacement of the asset is more likely to be a capital expense than a revenue expense.
In HMRC’s Business Income manual at BIM46920, their position is clear; When it comes to different or improved materials, ‘The work is a repair and not an improvement if after the work is carried out, the asset can just do the same job as before’ and ‘The work is an improvement and therefore disallowable as capital expenditure if, as a result of the work, more can be done with the asset, or the asset can be used to do something that it could not do before’.
However, this is not always the case if technological changes mean that one cannot replace like-for-like. If the new asset is simply the modern equivalent of the old asset, this will remain a repair even if it is an improvement. HMRC gives the example of double glazing. As double-glazed windows are now the industry norm, replacing single glazing with double glazing, notwithstanding the fact that double-glazed windows are clearly an improvement, will not be capital expenditure, ‘as it was simply replacing like with currently available like’.
Practical tip
Trying to get the capital versus revenue split correct is one of the most contentious issues in the tax world. In Strick v Regent Oil Co Ltd (1965) 43 TC 1, Lord Upjohn stated: “No part of our law of taxation presents such almost insoluble conundrums as the decision whether a receipt or outgoing is capital or income for tax purposes”. It therefore merits careful attention and good advice in order to ensure the split is correct.
