Citation: 2006TCC5
Date: 20060323
Docket: 2003-1498(IT)G
BETWEEN:
THE O'ROURKE MARKETING CORPORATION LTD.,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Bonner, J.
[1] The Appellant appeals from assessments of income tax for its 1998, 1999 and 2000 taxation years. At issue for the years 1998 and 1999 is the question whether expenditures made by the Appellant for the modification and extension of a building on a property located at 4296 6th Line, Bradford, Ontario (the "Bradford Property") were outlays of capital. The Minister of National Revenue (the "Minister") assessed on the basis that all were capital outlays. The Appellant contended that some were on revenue account.
[2] At issue for the 2000 taxation year is the allocation between revenue and capital accounts of electrical rewiring work and new carpets at another property known as the "Campground Property" which was occupied by the Appellant under a lease. Once again the Minister assessed on the basis that all costs were outlays of capital. The Appellant contended that all were on revenue account.
[3] The Appellant, an Ontariocorporation, carries on the business of selling products and processes to industry for lifting, rigging and securing loads.
[4] I will deal first with the Bradford property. Late in 1997, the Appellant purchased the property from its shareholder, Gary O'Rourke, and his spouse. On the property there was located a mixed-use residential and commercial building. It was the Appellant's intention to make alterations to the building and thereafter to use part of it as its new head office.
[5] Before the Appellant bought the Bradfordproperty it had been occupied by Mr. O'Rourke and his spouse as their residence. The sale to the Appellant was made with the intention that they continue to live in the residential portion of the building under lease from the Appellant.
[6] When the Appellant bought the Bradford property, the commercial portion consisted of office space located underneath a two-car garage attached to the residence. The space was divided into three offices and had an entrance separate from the residence. The offices had at some time in the past been occupied for purposes of the practice of three physicians. However, the offices were not considered entirely suitable for use by the Appellant in their then-existing state. There were some serious problems with the building and improvements which had to be addressed first.
[7] The roof over the garage was flat. It permitted rainwater to collect. The water leaked into the garage and then into the offices below. The leakage caused wood in the roof and walls to rot and it damaged drywall.
[8] The floor of the garage was breaking up due to water and salt falling from the vehicles parked within. The reinforcing steel and steel I-beams and posts were corroded. Ultimately the garage floor would have caved into the offices below.
[9] Immediately behind the office area there was located a large outdoor swimming pool. The swimming pool was cracked. Water leaking from it put pressure on a retaining wall adjacent to the pool causing it to buckle. Previous attempts to fix the crack and stop the leak were unsuccessful.
[10]The well had partly silted up over time. This condition diminished the capacity of the well to such an extent that a supplementary source of water was required to provide an adequate supply for both the residence and the future office staff.
[11]In his testimony, Mr. O'Rourke attributed the problems to the ravages of time, severe weather in the area and to poor construction practices.
[12]Extensive work was carried out to address the problems and to create office space suitable to the Appellant's needs. In the course of carrying out the work, municipal officials discovered that the existing septic system was unsuitable. They imposed a requirement that it be removed and a new system be constructed with a new tile bed in a different location on the property.
[13]The work involved conversion of the existing garage to office space. Garage doors were replaced with windows and the interior was suitably insulated and finished. The former office area below the garage was converted to a storage room. The grade outside the former offices was changed. As a consequence it was necessary to fill in the openings in the walls formerly filled by the windows and doors which served the old offices.
[14]Above the former garage the flat roof was removed. Rotten and mouldy sheathing, trusses and structural elements were removed. A second storey containing a bedroom was added above the former garage and in the area linking the residence to the former garage. The new second storey was topped off by a new sloped roof which allowed the rainwater to run off. A completely new and substantially larger garage was built next to the former garage.
[15]A new staff washroom was provided and the heating, ventilating and air conditioning system was modified and/or extended to serve the newly created office space and, I assume, the newly created bedroom and other space above.
[16]The work done on the Bradford property was expensive but, in Mr. O'Rourke's opinion, it did not increase the value of the property. I am not convinced of that. Mr. O'Rourke was not an expert in the evaluation of real estate.
[17]The Appellant capitalized part of the costs of the work at Bradford and treated the rest as currently deductible repair and maintenance costs. Virtually all of the work on the Bradford property was done by one contractor. In invoicing the Appellant for the work, the contractor did not separate the costs of the parts of the work which the Appellant claimed were repairs and maintenance from costs for work which the Appellant accepted were on capital account. It was therefore necessary to allocate invoiced costs between the two categories. Evidence on this topic was given by Gary O'Rourke and by Paul Franklin.
[18]Evidence regarding allocation was given by Paul Franklin, an accountant who acted for the Appellant and by Mr. O'Rourke. It was not persuasive. Mr. Franklin used a manual of standard construction costs, applied those costs to the area of newly constructed floor space, added 25% to the figure thus arrived at and concluded that the total so computed was capital. The total of invoiced costs less capital cost so computed was, in his view, the current cost of repairs.
[19]I reject the premise on which Mr. Franklin's allocation was based. The notion that repair cost is total cost minus area costs for new construction based on some manual is not, in my opinion, logical. Moreover, his evidence was essentially in the nature of an opinion. It was not shown that he was qualified to express that opinion.
[20]Mr. O'Rourke's approach to the problem of allocation was more direct. He attempted to determine specific cost figures for portions of the work which the Appellant categorized as current in nature, namely:
a) Work said to be of a "routine maintenance nature" such as
"• the replacement of worn shingles, eaves, soffit and siding
• the replacement of several old doors and windows
• new electrical and plumbing where required
• the painting of walls
• the relocation of a septic tile bed."
b) Repairs to what was said to be "the fabric of a small portion of the building including
"• the repair of a continuous leakage problem in part of the existing roof and basement office space
• the repair of a badly water damaged wall and floor"
c) Other expenditures which were not part of the work on the building itself such as:
"• the breakup and removal of a swimming pool that was one source of the leakage problem
• the removal and relocation of mature trees
• landscaping and restoration"[1]
Mr. O'Rourke's calculations required a great deal of judgment or estimation. I do not question his good faith but I cannot say that I am convinced that he arrived at a demonstrably correct result. This is so because in substance he was trying to arrive at the cost of repairs that might have been made but, in point of fact, were avoided.
[21]A helpful summary of the law dealing with the distinction between repair and maintenance expenses of a revenue nature and outlays of a capital nature is found in Krishna, The Fundamentals of Canadian Income Tax, 8th edition at page 321. The learned author states:
"The dividing line between capital expenditures and current expenses due to routine maintenance and repairs is also unclear. Here too, the underlying principle is easy to state, but difficult to apply. An expenditure in one fiscal period that enhances, substantially improves, enlarges, or prolongs the life of an asset beyond the period is a capital outlay. In contrast, an expenditure that merely maintains an asset or restores it to its original condition is a deductible current expense.
Here, as elsewhere in tax law, it is easy to identify the correct answer in polar cases when one does not really need an answer. It is the grey areas in between that cause the problems and litigation. For example, it is clear that the extension of an existing building by adding new floor space is a capital expenditure; it brings into existence an asset of enduring value. It is equally clear that routine maintenance of an existing building, for example, performance of minor repairs, replacement of light bulbs, cleaning, and maintenance of heating and ventilation systems, are current expenses.
Between these extremes, however, there are cases that cause considerable difficulty. One must distinguish each expenditure in the context of the taxpayer's activities. For example, a taxpayer who expends money to restore a decrepit and rundown building incurs capital expenditures, even though routine deductible maintenance by the previous owner would have prevented the building from deteriorating to a decrepit state. Similarly, a business that regularly expends funds to change the oil in its fleet of automobiles incurs current expenses. Neglecting to change the oil in its automobiles may, at a later date, involve substantial costs by way of engine replacements that would result in capital outlays."
[22]Support for this summary may be found in Shabro Investments Limited v. The Queen, 79 DTC 5104 where Jackett, C.J. stated at p. 5106:
" 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. In ordinary cases, the difference is evident...."
[23]In a footnote to this statement Jackett, C.J. added:
"While I am not aware of any authority on the point, I am inclined to the view that, as between the two possibilities, an expenditure must be classified as either revenue or capital. Specifically, where it is decided to make a capital improvement that eliminates the necessity for repairs that might otherwise have been necessary, the cost of the capital improvement cannot be treated as a revenue expenditure to the extent of the cost of the repairs so avoided. I can remember no case where such a division in the classification of a disbursement was tried or permitted." (emphasis added)
[24]What is said in the footnote has particular application to the work now in question. The problems which beset the Bradfordproperty were not addressed by work which in any true sense of the word could be described as repairs. The swimming pool was not repaired. It was eliminated. The septic system was not repaired. It was eliminated and replaced by a new one.
[25]The leaking roof and damage resulting from it were not repaired in any real sense of the word. The existing roof over the commercial area disappeared in the course of the reconstruction of all or almost all of the commercial wing of the building and was replaced by an entirely new roof. That reconstruction involved the extension of the building both horizontally by the addition of a new garage and vertically by the addition of the second storey above the old garage and the area connecting it to the house.
[26]The reconstruction also involved the conversion of the existing garage with water-damaged walls and salt-damaged floors into office space. The offices below the existing garage were converted into storage space. The new drilled well and septic system were major elements of the overall project which were necessary to make the reconstructed building habitable and therefore complete for purposes of the intended use.
[27]The necessity for the allocation of invoiced costs underlines the fact that the work done was part of, and inseparable from, a major reconstruction and extension of the commercial wing of the building. The extent of that work is evident from photographs, Exhibits A-2, A-3, A-5 and A-6 and a plan, Exhibit A-1, tab 3. The work did eliminate the need to address the deficiencies which existed before the project was undertaken but that is not a basis on which the work can be regarded realistically as a cluster of disparate repairs. The cost of the entire project including peripherals such as landscaping, well and septic system is, in my view, an outlay of capital.
[28]I turn next to the appeal for 2000. It arises from work done in offices which the Appellant occupied under lease. The leased premises were located in a building on land known as the "campground property".
[29]The work done consisted of upgrading existing electric wiring in order to make it adequate for loads imposed by the Appellant's office equipment. The work included repairs to drywall which was damaged in the course of doing the rewiring. Finally, it included replacement of worn and tattered carpets. The total cost of the work was about $27,000. On assessment the Minister of National Revenue treated the cost as an outlay of capital.
[30]I fail to see any basis for treating the cost of this work as capital. I need only refer to the passage from Krishna reproduced at paragraph 21. The simple replacement of a carpet made shabby by use is, in my view, a classic example of simple maintenance. It is the sort of recurrent expense which arises from time to time as an owner, including the owner of a leasehold, maintains an existing asset.
[31]It is only slightly less obvious that the upgrading of an existing electric wiring system (and attendant repair of plaster) gives rise to current not capital expense. As I understand it, there was nothing wrong with the wiring system which existed before the work was done. It was the increased demand which was imposed by the Appellant's use of the electrical system which made the work necessary. The work cannot, in my opinion, be said to have brought into existence an asset or advantage for the enduring benefit of the Appellant's business[2] particularly where, as here, the premises were leased to meet a need for accommodation which was temporary in nature only.
[32]The appeals from the assessments for 1998 and 1999 will be dismissed. The appeal from the assessment for 2000 will be allowed and the assessment will be referred back to the Minister for reassessment to permit the deduction of the costs as a current expense. The Respondent is entitled to 75% of the costs of the proceeding.
Signed at Toronto, Ontario, this 23rd day of March 2006.
"Michael J. Bonner"
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