Shabro Investments Ltd. v. The Queen, 79 DTC 5104, [1979] CTC 125 (FCA)

The Chief Justice:—This is an appeal from a judgment of the Trial Division dismissing an action by way of appeal from the re-assessment of the tax payable by the appellant under Part I of the Income Tax Act for the 1973 taxation year.* [1]

The principal question that has to be decided is whether an amount spent by the appellant in replacing a substantial part of the floor of the lower storey of a two-storey building that was owned by the appellant as a rental property was a revenue expenditure on “repairs” or an expenditure on account of capital. [2]

As I understand them, the relevant facts may be summarized briefly as follows:

(1) when the building, which was built on a site created by fill consisting of garbage and earth, was originally constructed, while the peripheral walls of the building were supported by piles sunk through the garbage fill to solid earth, the bottom floor was concrete slabs reinforced by “wire mesh” laid on the fill and dependent on the fill for support',$ [3]

(2) after some years, the fill compacted causing the floor to subside and break, with the result that the lower storey of part of the building in question became unusable as rental space and “the waterlines, storm drains, plumbing weeping tile and electric wiring” settled and broke under the weight of the floor;

(3) it was recognized that

(a) having regard to the character of the site on which it was located, the damaged floor could not be repaired as, or replaced by, a floor consisting of concrete slabs dependent upon the fill for support, and

(b) for a floor on that part of the site it was necessary to have

(i) support of the same character as had been provided for the peripheral walls—ie, steel piles sunk through the fill to solid earth,

and

(ii) a floor consisting of a concrete slab reinforced by steel so that it could be supported by such piles;* [4]

(4) the space in question, as I understand it, was, accordingly, made usable, in the taxation year 1973, by

(a) breaking up and removing the sunken and fractured floor,

(b) installing steel piles to be used as support for a substitute floor,

(c) creating a new floor by constructing a concrete slab reinforced with steel resting on the steel piles, and

(d) repairing or replacing the waterlines, storm drains, weeping tile and electric wiring that had been damaged or destroyed by the subsidence and fracturing of the old floor; and

(5) the total cost of such operation was $95,198.10, which was treated by the appellant as an operating expense for the 1973 taxation year and was disallowed as such by the Minister of National Revenue who treated it as an outlay on account of capital. [5]

In dismissing the action, the learned trial judge summed up the essential facts as follows:

The facilities in respect of which work was done and expense incurred had not been used up or worn out. The work was not done because of any wear of the facilities. Work was not necessitated by any aging of the materials previously in place. What occured here was not in the nature of an accident as that word is generally used. It is admitted, as set out in paragraph 7 of the statements of claim, that

“The said state of disrepair had resulted from the decomposition of garbage in the land-fill below the building, which caused the lower floor of Electrolite’s space to create a dangerous condition, and the water lines, storm drains, plumbing weeping tile and electric wiring to settle and break under the weight of the floor.”

Furthermore the designing, engineering and construction of the new floor was quite different from that of the previous floor which was destroyed. The new floor was to meet the actual and existing conditions, namely, land partly filled with garbage. The previous one, with slabs on grade and road-mesh in the concrete was indicated for normal soil. Here the soil was not normal. The new floor was supported by steel piles driven through the garbage into solid earth and the concrete flooring was reinforced with steel.

It is futile to suggest that actually the end result is the same in either case because what was accomplished in each case was a floor. By the replacement there was a floor presumably capable of withstanding the inadequacies of and meeting the problems arising from the nature of the land. Previously there was not.

It should be noted that there is no question of any finding that there had been some fault on the part of the designers of the original building. The fact remains that experience showed that the garbage fill site on which the damaged floor was laid was not sufficiently solid to support that floor for the ordinary life of such a building (as a site consisting of ordinary ground would have been) and that for that site, a basic floor so constructed that it could be supported on steel piles was required.

I know of no single test to distinguish between

(a) “repairs”, the cost of which is a revenue expenditure in the year during which they are carried out, and

(b) additions or improvements, the cost of which is an outlay on account of capital.

Generally speaking, replacement of worn or damaged parts, even though substantial, are repairs and are to be contrasted with changes designed to create an enduring addition or improvement to the structure.* [6] In ordinary cases, the difference is evident. Unfortunately, this is not such an ordinary case.

In my view, on the uncontested facts, the learned Trial Judge reached the correct conclusion at least with reference to the installation of the steel piles for support of the floor.

When that part of the building in question was erected, there was a hidden defect in the structure thereof! [7] which adversely affected its intrinsic value but, being unrecognized, would not have affected its market value. When that defect became apparent, it seriously diminished, if it did not destroy, the market value of the part of the building involved. The installation of supporting piles for the basic floor was necessary to eliminate the defect, which had always existed but had just become apparent. Elimination of the defect was necessary to give the building the character of a long term usable asset that it had previously seemed to have but did not actually have. In my view, installation of the piles was a permanent addition to the structure of the building of a foundation that had not previously existed and was not a repair to the building as it had existed prior to their installation. An addition to the essential structure of a building for the period of life contemplated for it does not, in my view, become a “repair” merely because the necessity for it was overlooked when the building was built and it is added when the lack of it becomes apparent. In so far, therefore, as the expense of $95,198.10 can reasonably be regarded as attributable thereto, I am of opinion that it was properly disallowed as not being a current expense but as being an outlay on account of capital.

In so far as the outlay of $95,198.10 is reasonably attributable to the removal of the damaged floor and its replacement by a floor supported by the steel piles, I have more difficulty.

As indicated by the part of his Reasons that I have quoted, the learned Trial Judge seems to have taken the view that such expenditure cannot be regarded as a “repair” expenditure because

(a) the work was not done because of “any wear of the facilities” or “any aging of the materials previously in place”, and

(b) the designing, engineering and construction of the new floor was quite different from that of the previous floor but was to meet conditions for which the previous floor did not qualify.

In my view, these are not reasons that necessarily disqualify money spent on remedying damage to the structure of a building from being treated as current expense on repairs. Damage caused by accident or vandalism, just as much as that caused by deterioration from wear and tear or aging, can call for “repairs” in the profit and loss sense; and, similarly, “repairs” do not become disqualified as “repairs” in that sense merely because they are carried out in the light of technology unknown when the original structure was built or because they take into account conditions (such as dampness) not taken into account when the original structure was built.” [8]

I am of the view that, if the replacement of the floor could otherwise be regarded as being the remedying of damage to the fabric of the building, it would have been properly deducted as a current expense on repairs notwithstanding

(a) that the damage arose from a hidden defect in the original structure and not from wear and tear, aging of materials or some accidental or malicious happening in the course of use, or

(b) that the damage was remedied in accordance with technology or knowledge as of the time thereof that incidentally effected an improvement in the structure over what it was when originally built.

The real problem, in my view, with regard to that part of the $95,198.10 that can reasonably be attributed to the replacement of the floor, is whether the replacement of the floor was merely the remedying of damage to the fabric of the building as it had theretofore existed or whether it was an integral component of a work designed to improve the building by replacing a substantial part thereof by something essentially different in kind.

My conclusion is that, prior to the change, the part of the building in question had a floor (consisting of concrete slabs resting on garbage fill) which made the lower floor of that part of the building unusable and that to remedy that situation and to improve the building by making the space in question usable it was necessary to replace that floor by a floor consisting of a concrete slab reinforced by steel resting on steel piles. With some hesitation, my view is that the improvement operation was the whole replacement work and not merely the sinking of the steel piles.

Again, I return to the fact that, while the difference between repairs and capital additions or improvements is obvious in certain cases, it becomes a matter of difficulty in others. Examples of cases that, I suggest, are evident, are

(a) if a building were built with a thatched roof, while filling in holes in the roof would be repairs, replacing the thatched roof, by reason of its unsuitability to modern living, with a modern roof, metal or wooden, would be a capital improvement in the structure of the building;

(b) if a building were built leaving one side without a wall but partially protected from the elements by a metal awning that was an essential part of the structure, remedying damage to the awning would be a “repair” but replacing it by a wall along the open side would be a capital improvement;

(c) if a building were built with the floor of the lowest storey consisting of dry fill spread on the ground, remedying losses of fill and smoothing it out would be a “repair” but replacing the dry fill with a concrete floor would be a capital improvement.

In each of such cases there has been, in the “replacing” operation, a substitution for some part of the building something that is essentially different in kind from what was there before and constitutes an improvement to the building rather than a mere repair thereto.

There is no doubt that, in this case, from the point of view of the persons making physical use of the building, once the floor was replaced, it was essentially the same as the old floor as it was before it subsided. So regarded, the replacement of the floor could be regarded as a repair of damage to the building.* [9] However, from the point of view of the owner or tenant of the building as such, a building the floor of which was “floating” on garbage fill has been changed into a substantially improved building, namely, a building the floor of which is supported by steel piles. Moreover, the removal of the old floor and construction of a floor consisting of a single concrete slab reinforced by steel so as to be suitable for being supported by piles was an essential part of that change. As already indicated, with some hesitation I have come to the conclusion that the problem must be so regarded and that the removal of the old floor, the sinking of the piles and the placing thereon of a concrete slab reinforced by steel was a single operation whereby an improvement was made to the building that was essentially different in kind from a repair to the building as it originally was.

In so far as the balance of the amount in question is concerned (viz, that part of the $95,198.10 that can reasonably be regarded as the cost of replacing or repairing of the waterlines, etc.), the learned Trial Judge was of the view that the cost attributable to them must be disallowed because what was done was not due to wear, aging or deterioration resulting from use or passage of time. I am of the view that that was not a reason for disallowing them. Whether or not this part of the amount in dispute or some part of it qualifies for deduction on current account, in my view, depends on whether, apart from what made the expenditures necessary, they are to be regarded as the cost of repairs or as an outlay on account of capital.* [10] In my view, it has been shown that this portion of the amount was disallowed on a wrong basis and that the matter should be referred back for reconsideration thereof on a proper basis.

I would allow the appeal, set aside the judgment of the Trial Division and the assessment in question and refer that assessment back for reassessment on the basis that any part of the $95,198.10 that is not reasonably attributable to the replacement of the old floor by a floor supported by steel piles and that would otherwise be deductible as a current expense should be allowed notwithstanding that its expenditure became necessary as a result of the subsidence or fracturing of the original floor.

Urie, J:—I have had the advantage of reading the reasons for Judgment of the Chief Justice. I agree with his proposed disposition of the appeal and substantially with his reasons therefor. However, having regard to the fact that this superficially simple matter turned out, for me, to be a difficult one, I wish to set out, as briefly as possible, the reasoning whereby I arrived at the same conclusion as the Chief Justice.

He has set out in sufficient detail all of the relevant facts so that I need not repeat them. I have only two additional comments with respect to his review of them. They are (a) that not only the peripheral walls of the building were supported by piles but also, according to the evidence, so were the columns which presumably supported the upper floor and roof; and (b) as I read the evidence, the ground level floor for each section was a solid concrete slab reinforced by wire mesh, and not composed of a number of such Slabs comprising the floor of each section as Appellant’s memorandum seems to imply. These additional facts are referred to only for sake of Clarification and do not have any bearing, in my view, on the result of the appeal.

Perhaps the starting point in the determination of whether an expenditure is a capital one or an income one is the expression used by the Lord President in the case of Valambrosa Rubber Company, Limited v Farmer, 5 TC 536 where he said:—

Now I don’t say that this consideration is absolutely final or determinative, but in a rough way I think it is not a bad criterion of what is capital expenditure—as against what is income expenditure—to say that capital expenditure is a thing that is going to be spent once and for all, and income expenditure is a thing that is going to recur every year

As observed by Rowlatt, J in Dunsworth v Vickers, Limited, [1915] 3 KB 267 no stress is placed on the words “every year”. Rather “the real test is between an expenditure which is made to meet a continuous demand for expenditure, as opposed to an expenditure which is made once for all, to put it shortly.” Thus it is a question of fact in each case and often a question of degree. It is the latter question which causes difficulty in characterization, ie, frequently from one point of view the expenditure is simply one made to repair an existing asset not to renew, replace or improve it. All repairs involve to some degree, renewal and replacement of parts of the subject matter of the repair and, therefore, of necessity an improvement to the repaired structure, machine or whatever the subject matter is. That alone, it appears from the jurisprudence, is not sufficient to convert an expenditure for repairs to an income producing property from an income expenditure to a capital expenditure. The crucial question it appears was the outlay such as to bring into existence a capital asset different from that which it replaced?

I have concluded that in this case it did. A new floor, of a different character and quality than the old floor came into existence. It performs the same function as the old floor and it adds nothing to the earning capability of the old one, but it substituted one kind of floor for another. The old floor was designed for use on a normal soil base. Experience demonstrated that the base at the site in question was not normal soil but was, in fact, subnormal in that it was composed to a large extent of decomposing garbage as well as soil. Therefore, the floor slab designed for use on normal soil, reinforced though it was, was unsuitable for the kind of underlying base that existed at the site of the building. That kind of base called not only for a differently designed reinforced floor slab, but also for that slab to be supported by piles driven through the underlying fill until they reached a solid base. The whole, in my view, is a material alteration—an improvement of a magnitude that removes it from being classified as the income expenditure it might have been if the floor had deteriorated for some reason and had had to be replaced by a floor of similar design to the old one, to one capital in nature.

The fact that the floor was only a single component of the lower level of one section of the entire building and, in terms of function, was not superior after the reconstruction to what it was prior thereto does not affect this result. The fact is that, while the function vis-a-vis the building as a whole has not changed, the asset itself has markedly changed. The method whereby it performs its function as a floor has changed because to enable it to perform its function as a floor and as an integral part of the building, it had to have an entirely new character not envisaged at the time the original floor slab was designed and laid. Thus, while undoubtedly the function to be performed by the subject matter of a renewal, repair or replacement is an element to be considered in characterizing the nature of the work, it is only one element and must be examined, as I see it, against the whole background of the work. Not the least important in this background is the determination of whether or not a simple replacement of the old subject matter would permit the function to be performed satisfactorily. Obviously in this case it would not.

Counsel for the appellant in his able argument devoted a considerable portion thereof, supported by some American and Australian decisions, to showing that it is not the cause of the damage giving rise to the need for repairs that is important, but rather the purpose and effect of the repairs themselves that must be examined. The purpose in this case, he said, was merely to restore the lower level of a section of the building to its former operating condition without increasing the value of the building as a whole or increasing its income-producing capacity. The short answer to that submission is that while it was necessary to restore the floor to earn income, an entirely new capital asset was created, having a like function to the old one, but otherwise substantially different. The floor itself was designed to function in a different way than its predecessor. The purpose was not simply to repair a floor; it was to bring into being a new capital asset to enable the building to function as an income-producing property.

The Chief Justice referred in his reasons to his having some hesitancy in deciding whether or not there might be some distinction made between the expenditures incurred for the slab itself and those incurred for the piles alone. The following excerpt from the opinion of Lord Carmont in William P Lawrie v Commissioner of Inland Revenue, [1952] SLT 413 at 416 perhaps puts the answer to the question of the necessity for that distinction being made as succinctly as possible:—

Any sum claimed by the taxpayer as having been actually spent on repair can be analysed by the Inspector, or by the Commissioners, with a view to determining whether or not it is a repair or renewal, but once it is determined that the matter is a renewal the whole of the sum must be treated as capital outlay and it is not allowable to split up the cost of the renewal so determined, with a view to showing that a certain part of it should be debited to income because that amount would have been expended if the necessary work had been done as a repair, because that course would be going back on the decision that has already been arrived at, viz, that the work done should be charged as a renewal. In the present case, the appellants, having made up their mind to deal with their premises on the basis of renewal, are not entitled to treat any part of that outlay as income expenditure. They are not entitled to say that if they had treated the premises by repairing them they would in that event have spent £x and to suggest that they are entitled to separate that sum estimated for repairs from the cost actually spent as renewal and to debit it against income.

Insofar as the removal of the material derived from the breaking up of the old floor is concerned, I agree with what was said by the Chief Justice. I find it difficult to differentiate between site clean-up at the commencement of the construction ofla building, which it seems to me is clearly part of the ultimate capital cost and clean-up of the site in this case before commencement of construction of the new floor, which as above found, is a new capital asset.

With respect to the question of consequential or incidental costs arising from the construction, I also agree with the Chief Justice and, as I indicated earlier, with his proposed disposition of the appeal.