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Special report on the Taxation (Annual Rates for 2020–21, Feasibility Expenditure, and Remedial Matters) Act 2021

April 2021

Feasibility expenditure

(Sections CH 13, DB 66 and DB 67 of the Income Tax Act 2007)

The Taxation (Annual Rates for 2020–21, Feasibility Expenditure, and Remedial Matters) Act 2021 contains changes codifying when businesses can deduct expenditure over five years related to completing, creating or acquiring property (business assets) that is later abandoned. Immediate deductions are also available for such expenditure that in total is $10,000 or less in an income year. Together, the changes are intended to set out the circumstances when expenditure can be deducted for property that but for abandonment would have been depreciable property or revenue account property.

The rules complement the current tax depreciation rules in situations when property is abandoned and not completed.

Deductions for expenditure in relation to abandoned property are clawed back as taxable income if the property is subsequently completed, created or acquired. This effectively puts a taxpayer in the position that they would have been in if they had never abandoned the property.

Taxpayers may be able to obtain certainty on the tax treatment of feasibility expenditure (including for abandoned and completed property) incurred in particular arrangements by applying for a ruling from Inland Revenue’s Tax Counsel Office.

Background

From a policy perspective, the economic value of business expenditure that is expected to decline in value should be either immediately deductible or, when it provides an enduring benefit, deductible over time if that benefit declines over time. When the tax system does not provide for that treatment, an economic distortion is created.

An example of this distortion arises with feasibility expenditure incurred by taxpayers to determine the practicability of a proposal to acquire or create property that will decline in value over time. The Income Tax Act 2007 generally denies immediate deductions for expenditure when it has a connection with property that has the potential to yield future economic benefits beyond the current income year. If the expenditure is required to be capitalised and the property is not completed, the expenditure is not recognised for tax depreciation purposes and is unable to be deducted for tax purposes, resulting in what is referred to as “black hole” expenditure. This creates an incentive for businesses to complete capital projects that would otherwise be abandoned.

The non-deductibility of this expenditure effectively raises the cost of risky investments in new property (where the chance of a viable outcome is uncertain) and therefore can act as a barrier to businesses committing resources to developing new property – which is important to innovation and driving productivity improvements.

The new rules are intended to sit alongside the Income Tax Act’s rules for tax depreciation and Inland Revenue’s interpretation statement IS 17/01[4] for businesses that regularly incur feasibility expenditure.

The amendments respond to private sector concerns following the 2016 decision by the Supreme Court in Trustpower Limited v Commissioner of Inland Revenue,[5] which limited the deductibility of expenditure incurred on property that is subsequently abandoned. The rules reduce tax barriers for businesses seeking to invest in new property, by providing greater deductibility of expenditure where it relates to property that is abandoned.

The amendments do not give tax deductions for expenditure related to property that is not expected to decline in value, such as land, goodwill and shares. While property that is not expected to decline in value sometimes does, it would only be appropriate to provide deductions for this expenditure if the tax system taxed gains in property that appreciated.

The amendments do not alter the rules that exist for:

• tax depreciation (although the rules do allow immediate deductions in some circumstances if the expenditure is less than $10,000 – this is explained in more detail below)
• company administration costs
• costs incurred in the course of abandoning property
• research and development
• resource consents
• unsuccessful software projects
• patents
• plant variety rights.

The amendments also do not affect the application and effect of the general permission test relating to deductions. This is explained in more detail below under ‘Detailed analysis’.

Key features

Section DB 66 allows taxpayers to deduct expenditure incurred in relation to making progress towards completing, creating or acquiring property if:

• the property would be:
  • depreciable property, including depreciable intangible property, or
  • revenue account property
• progress on the property is abandoned with the outcome that the property is not completed, created or acquired, and
• no deduction for the expenditure is allowed under any other provision in the Act.

The deduction does not apply to expenditure on certain items, such as land, shares and goodwill.

Deductions meeting the conditions above can be spread in equal proportions over a five-year period starting in the income year the property was abandoned (section DB 66(2)). However, there is no entitlement to any remaining portions of the deduction if the abandoned property is completed, created or acquired within the five-year spreading period.

Section DB 67 allows an immediate deduction in the income year for expenditure incurred in relation to making progress towards completing, creating or acquiring property if the total expenditure incurred in an income year that could be subject to this provision is $10,000 or less and:

• the expenditure is related to depreciable property or revenue account property, and
• no deduction for the expenditure is allowed under any other provision in the Act.

As is the case with section DB 66, new section DB 67 does not allow a deduction for certain items, such as land, shares or goodwill.

Given that section DB 67 allows immediate deductions if the expenditure is less than $10,000 (even if the property has not been abandoned), this rule will in some circumstances override the general depreciation rules. This is explained in more detail below under ‘Detailed analysis’.

The expenditure under both sections must be incurred in relation to making progress towards completing, creating or acquiring the property.

The amount of the available deduction is equal to the expenditure the taxpayer incurs related to making progress towards completing, creating, or acquiring property.

For abandoned property that is later completed, created or acquired, new section CH 13 claws back the deductions allowed under section DB 66 by treating the amount deducted as income. The property may then be subject to the tax depreciation rules in subpart EE, or the revenue account property rules in section DB 23.

New sections DB 66 and DB 67 override the limitation for expenditure of a capital nature.

Application date

The amendments apply to qualifying expenditure incurred in the 2020–21 and later income years.

Detailed analysis

Spread deduction rule for feasibility expenditure

New section DB 66 is directed at expenditure incurred by taxpayers in relation to making progress towards completing, creating or acquiring property that is subsequently abandoned. The term “property” is defined by reference to property that if completed would be depreciable property, including certain types of intangible property, and/or revenue account property.

Progress will, generally, be considered to be abandoned when a decision has been made that no further progress will be undertaken to complete, create or acquire the property. For larger projects, such a decision will likely be documented by the taxpayer. However, for small businesses a decision to not proceed with the property may be reflected in that no further money has been applied to completing, creating or acquiring the property.

The available deduction is equal to the expenditure the taxpayer has incurred in relation to the abandoned property, which is not otherwise deductible under any other provisions of the Act. The intention is to permit a broad range of expenditures to be deducted, including direct costs that would ordinarily be considered to be the “cost” of depreciable or revenue account property, and expenses that have an indirect relationship with the property, such as administration or general overhead costs.

A deduction is not available for expenditure on acquiring property such as land, shares and goodwill in the course of developing another asset that is abandoned. This is because expenditure on such items is not typically associated with feasibility type activity but could potentially otherwise fall within the broad wording of the feasibility rules.

Deductions for the expenditure are spread in equal proportions (one-fifth) over a five-year period, starting in the year of abandonment. However, as discussed below, there is no entitlement to any remaining portions of the deduction if the abandoned property is subsequently completed, created or acquired before the five-year spreading period has expired.

Application of general permission

The new rules override the capital limitation, but not the general permission requirements. The general permission requires that the expenditure must have a connection to an existing business or income-earning process of the taxpayer in order to be deductible under the rules. In situations where the expenditure is incurred before any decision is made to enter into the business or income-earning activity, the expenditure will have been incurred too soon and will not be deductible. Similarly, where a business already exists, feasibility expenditure incurred in relation to a new business will still need to have sufficient nexus to the existing business. However, feasibility expenditure that is recurrent and incurred as part of the ordinary income-earning process of a business is likely to be deductible under the new provisions (if not already deductible under existing law in line with the principles in Inland Revenue interpretation statement IS 17/01: Income tax – Deductibility of feasibility expenditure).

The correct time for considering whether the expenditure satisfies the general permission is when the expenditure is incurred, not when the relevant property is abandoned.

Apportionment

Expenditure will be deductible under the rules only to the extent that it is connected with making progress towards depreciable or revenue account property. Where an amount of expenditure relates to a mixture of, for example, depreciable and non-depreciable property, then only a portion of the expenditure will qualify for a deduction under the rules.

The legislation does not specify a particular approach or methodology for how expenditure needs to be apportioned in these circumstances. This provides some flexibility to taxpayers in how they approach the apportionment exercise. Any fair and reasonable method of apportionment may be used.

Whether an apportionment is fair and reasonable will depend on the relevant facts and circumstances related to the expenditure. It is not necessary that the apportionment method applied be the most accurate, but it must reflect what an objective person would consider to be fair and reasonable in the circumstances. The method should reflect the contribution of the expenditure towards the relevant item of property. A method that could be considered fair and reasonable in some instances may be one based on estimates by qualified professionals of the values of respective in-scope and out-of-scope property at the time the property was abandoned. There may equally be other methods that can be applied that will provide a fair and reasonable apportionment.

Records that taxpayers would be expected to hold in support of their chosen apportionment method would include (but are not necessarily limited to) the following:

• Any records detailing what their plan was, in terms of what property they were looking to complete, create or acquire.
• Details of categories of expenditures that can be directly attributed to depreciable property, revenue account property, or property that is excluded from the scope of section DB 66.
• Categories of expenditures that relate to both depreciable property/revenue account property and property that is excluded from the scope of section DB 66.

The Inland Revenue interpretation statement IS 17/01: Income tax – Deductibility of feasibility expenditure notes that expenditure that is not directed towards a specific project or which is so preliminary as to not be tangibly progressing or materially advancing such a project will be on revenue account and therefore immediately deductible if the business regularly carries out feasibility studies. This being the case, it is expected that, by the time that tangible progress has been made on a specific capital project, the taxpayer will likely have a better understanding of the share of remaining costs between depreciable property and revenue account property, and property that is specifically excluded.

Partial abandonment

It is possible that a capital project may produce a number of distinct items of property that together achieve the overall objective of the project. In the process of developing the overall project, it is possible that some smaller items of property may be considered and abandoned even though the project as a whole is completed. Guidance on how to identify the relevant property can be found in Interpretation Statement IS 12/03: Deductibility of Repairs and Maintenance – General Principles.

If the costs that were incurred in exploring the viability of the abandoned property cannot be capitalised to the cost of depreciable or revenue account property resulting from the project and are otherwise not deductible, a deduction for the expenditure relating to the abandoned option may be available under section DB 66. As discussed above under ‘Apportionment’, any deduction would be limited to the extent the expenditure relates to depreciable property or revenue account property, had it been completed.

Immediate deduction for feasibility expenditure

Section DB 67 works in a similar way to section DB 66, with modifications to reflect that section DB 67 is a compliance cost saving measure. That is, feasibility expenditure can be immediately deducted by the taxpayer if the total expenditure incurred is $10,000 or less in an income year. There is no requirement that the property be abandoned.

However, like the requirements of section DB 66, the expenditure must satisfy the general permission provisions and not be deductible elsewhere under the Act. Section DB 67 is not a replacement for tax depreciation for low-value assets. This means that a person who acquires an item of depreciable property must apply the depreciation rules from the year the property is actually acquired. A deduction for the cost of the property is not available under section DB 67 in this situation.

If the person had incurred expenditure in merely looking into purchasing the property, or started to make or construct the property but did not complete it within the income year so that it could then be depreciated, then a deduction for the expenditure would be available under section DB 67. In this situation, if the property is completed (resulting in an item of depreciable property), then any expenditure relating to the property that has previously been deducted under section DB 67 is excluded from the cost of the completed property for tax depreciation purposes.

Only one deduction is allowed for the relevant expenditure

Once a deduction is claimed under section DB 66 or section DB 67, no further income tax deduction is available for this expenditure. This is a function of the income tax rules, which do not allow more than one deduction for the same item of expenditure.

However, if expenditure has been effectively denied by the application of the clawback in section CH 13 (discussed below), it is intended that the expenditure may be subsequently deductible if it otherwise satisfies the requirements to be part of the cost of depreciable or revenue account property.

Clawback of deductions

The feasibility expenditure rules include an integrity measure (referred to as the “clawback”) that applies where previously abandoned property is subsequently created, acquired or completed.

The clawback is directed at situations where taxpayers may be incentivised to prematurely abandon work on property. For example, property may be partially abandoned to take advantage of the five-year deduction if this would accelerate the deductions that would have been allowed had the property been completed and depreciated. A further example is where the deductions under the feasibility rules would be greater than would otherwise be available under the tax depreciation rules if the property was completed.

The clawback applies in the income year that the abandoned property is completed, created or acquired. This also applies in the situation where the taxpayer subsequently acquires property that is similar to the abandoned property.

The effect of this measure is to put taxpayers into a similar tax position to where they would have been had they never abandoned the property.

The clawback in new section CH 13 deems an amount of income equivalent to the deductions previously taken under section DB 66 in relation to the property. The requirement to include as income amounts that were previously deducted does not apply to expenditure that has been immediately deducted under the $10,000 de minimis rule.

To minimise compliance costs and provide greater certainty to taxpayers, a seven-year time limit applies to the clawback. The seven-year time limit aligns with the general business record retention requirements in the Tax Administration Act 1994, starting in the year immediately following the income year for which the fifth and final deduction was taken under the rules. This means that the deductions are not clawed back if abandoned property is subsequently created or completed more than seven years after the income year to which the last deduction relates, or if the property or similar property is acquired more than seven years after that income year.

Abandoned property subsequently created, acquired or completed

In order to apply the clawback, taxpayers need to identify and monitor whether any property subsequently arises from the expenditure that has been deducted under section DB 66.

In many situations a taxpayer will simultaneously abandon work on multiple items that, if completed, acquired or created, would have been depreciable or revenue account property. This may be due to the abandonment of all or part of a project being undertaken by the taxpayer.

In determining whether the clawback applies, the rules require an analysis of each separate piece of property that is subsequently created, completed or acquired. In other words, the relevant assessment is not in relation to the wider project, but to individual items of depreciable or revenue account property for which a deduction was allowed under section DB 66.

This will require an understanding of what property the expenditure relates to, which is an exercise that is likely to have been undertaken as part of the process of claiming a deduction under section DB 66 (for instance, in claiming a deduction there needs to be an apportionment between depreciable/revenue account property and other property).

It is possible that expenditure could relate to multiple potential items of depreciable or revenue account property, of which only some is subsequently created, acquired or completed. In this case, it will be necessary to make an apportionment of this expenditure on a fair and reasonable basis for the purpose of applying the clawback.

Similar property

A feature of the clawback is that it also applies to property acquired that is “similar” to the property that was abandoned. The need for the rules to apply where similar property is acquired is to protect against the clawback being ineffectual if the acquired property has even a slight modification or difference to the abandoned property.

It is important to note that the “similar property” requirement only attaches to property that is acquired by a taxpayer, rather than property that is created or completed by the taxpayer. This is because taxpayers will have greater opportunity to acquire property that is similar to (but not the same as) the original property that was abandoned. However, this is not expected to hold true for property that is created or completed by a taxpayer. In this case, the created or completed property is likely to be a continuation of the property that was abandoned.

The term “similar property” is not defined in the legislation. Acquired property is likely to be similar to abandoned property where it has a resemblance in appearance, character, function, purpose or quantity to the property that was abandoned. In determining the appearance, character, function, purpose or quantity of the property, regard may be had to any project and design plans relating to the abandoned property, which may include details of the assets required to be acquired for the project and their respective specifications.

No further deductions once clawback is triggered

In some situations, abandoned property may be reinstated and completed before the five-year spreading period has ended, resulting in the clawback being triggered before all the deductions available under section DB 66 have been claimed. In this situation, all the previously claimed deductions are clawed back as taxable income. There is no entitlement to the remaining deductions under s DB 66 once the relevant property is completed, created or acquired. As noted above, clawed back expenditure may be deductible under the depreciation or revenue account property rules, subject to meeting the relevant deductibility criteria.