It's Official - Extracts from The Revenue's fifty-ninth Tax Bulletin.

Schedule A and repairs

The cost of the house or block of flats that is being let is capital expenditure and so is the cost of any additions or improvements. So if you add to the premises something that was not there before, for example if you build an extension or a new porch, this is capital expenditure. It does not matter how small the addition is. If you add an extractor fan or fit an additional cabinet in the bathroom or kitchen, this is also capital expenditure.

To decide whether expenditure incurred on 'repairs' to property is allowable, the first step is to identify the 'entirety' that is being repaired. In the case of residential accommodation, the Revenue accepts that the 'entirety' will normally be the house or the block of flats that is let. So if a roof is damaged and you replace the damaged area, your expenditure is allowable.

Even if the repairs are substantial, that does not of itself make them capital for tax purposes, provided the character of the asset remains unchanged. For example, if a fitted kitchen is refurbished, the type of work carried out might include the stripping out and replacement of base units, wall units, sink, etc., re-tiling, work top replacement, repairs to floor coverings and associated re-plastering and rewiring. Provided the kitchen is replaced with a similar standard kitchen, then this is a repair and the expenditure is allowable. If at the same time additional cabinets are fitted increasing the storage space, or extra equipment is installed, then this element is a capital addition and not allowable (applying whatever apportionment basis is reasonable on the facts). But if the whole kitchen is substantially upgraded, for example if standard units are replaced by expensive customised items using high quality materials, the whole expenditure will be capital. There is no longer any relief for 'notional repairs', that is the notional cost of the repairs that would otherwise have had to be carried out.

The Revenue accepts that the replacement of a part of the 'entirety' with the nearest modern equivalent is allowable as a repair for tax purposes. An example is double-glazing. In the past, the Revenue took the view that replacing single-glazed windows with double-glazed windows was an improvement and therefore capital expenditure. The Revenue now accepts that replacing single-glazed windows by double-glazed equivalents counts as allowable expenditure on repairs.

Depreciation in trading stock

The Revenue has been asked to explain how a recent judgment of Lord Millett in the Hong Kong Court of Final Appeal case of Commissioners of Inland Revenue v Secan (FACV No 9 of 2000) affects the treatment for tax purposes of depreciation included in trading stock.

Statement of Standard Accounting Practice 9 sets out the principles governing the valuation of stock. Stock is valued at the lower of cost or net realisable value. Cost should include 'those overheads (including depreciation) which relate to production' (paragraph 20). Where depreciation is taken into account in arriving at the stock valuation, the taxpayer may argue that the commercial profit has not been reduced by the depreciation charged to stock. So the relevant depreciation should not be added back in the tax computations until it does reduce those profits, normally when the stock is sold.

The Secan case concerned the capitalisation of interest into trading stock/work in progress. Secan was a property development company. It had been treating interest as a development cost and adding it to the cost of its property stock, so that it was carried forward each year. When it started making sales, it decided that it wanted to rewrite the accounts retrospectively so that interest was set against profits of the year in which it was incurred. The case was about whether it could do that or not.

The relevant Hong Kong tax law is very close to United Kingdom tax law, and the relevant accountancy principles are much the same. The Revenue believes that Lord Millett's judgment [see the Tax Bulletin article for an extract from it] would have been in identical terms had the point arisen first in the House of Lords. So it is extremely persuasive.

In the Revenue's view, his analysis provides a complete answer to the assertion that, if depreciation of fixed assets is included in the valuation of stock, only the net amount of depreciation has been charged against profits, and so only that amount should be added back.

Where depreciation is included in trading stock, taxpayers are deducting the full amount of depreciation in their profit and loss account and are bringing in a credit representing the value of the stock on the other side of the profit and loss account. The fact that the 'cost' or fall in value of the fixed assets has been included as part of the value to the taxpayer of the stock carried forward does not mean that the full amount of depreciation has not been charged to the profit and loss account. Further, even if the accounts show only the 'net' figure charged to profit and loss account, this is irrelevant. It is not a matter of accounting principle. Rather it is, in Lord Millett's words, 'merely a matter of presentation'.

Where an adjustment to the depreciation add-back in respect of depreciation in trading stock has been an accepted part of tax computations, taxpayers will now have to move to the correct basis for computing taxable profits. The treatment for tax purposes of this 'change of basis' is covered by proposed legislation in this year's Finance Bill (clause 63 and Schedule 22).

The foregoing are extracts from longer articles published in the Tax Bulletin which is crown copyright. The full text in the Bulletin should be reviewed where readers have cases potentially affected by them. The Bulletin also includes an item dealing with tax equalisation for foreign nationals and it is planned to publish an article discussing this shortly.

Issue: 3864 / Categories: