22 November 1994 Internal T.I. 9415927 - EXPENDITURES - CURRENT OR CAPITAL - GAAP

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Whether drop replacement expenditures are capital or current in nature?

Position TAKEN:

They should be capitalized.

Reasons FOR POSITION TAKEN:

For tax purposes, income must be computed in accordance with a method within GAAP that produces the "truer picture". When there is only one acceptable method within GAAP and that method is reflected in the financial statements, the income for tax purposes, absent a specific provision of the Act, should not be different. Accordingly, since the expenditures were capitalized for financial accounting purposes and the taxpayer has not suggested that they were incorrectly capitalized for accounting purposes or that they should be treated as current expenses on the basis of GAAP, the expenditures should be capitalized.

			November 22, 1994

	XXXXXXXXXX District Office	Head Office
	XXXXXXXXXX	Rulings Directorate
C. Chouinard
			957-8953

			7-941592

Drop Replacement Costs

This is in response to your memorandum of June 15, 1994 wherein you requested our opinion on the tax treatment of drop replacement costs. As you requested, we have structured our response in two distinct parts.

Under Part I of your memorandum, you query whether Interpretation Bulletin IT-317R is still valid. You also inquire about the rationale for the distinction between interior and exterior drop costs. Under Part II, you request our opinion regarding the tax treatment of replacement drop costs.

Part I

Our Comments

In response to your first question, according to the Technical Publications Division, IT-317R is still applicable and there are no plans to withdraw or revise this Bulletin.

XXXXXXXXXX

As regards the rationale for the distinction between interior and exterior drop costs, it would appear that the Department's initial position was that both interior and exterior drop costs should be capitalized. The Department, however, altered its position in response to the case of The Elias Rogers Co. Ltd. v. M.N.R., 72 D.T.C. 6199 (F.C.T.D.), such that capitalization would only be required in respect of exterior drop costs.

XXXXXXXXXX

XXXXXXXXXX

Therefore, in response to your second question, it seems clear that the fact that the interior drop costs can be applied against the revenue generated by the cable service was not considered.

Part II

According to your memorandum, drop replacement costs are costs incurred when a cable operator voluntarily or involuntarily replaces the drops at no cost to the customer.

Your concern relates to the tax treatment of these drop replacement costs. XXXXXXXXXX

capitalizes the costs of drop replacements for financial statement purposes but deducts 100% of these costs (interior and exterior) for tax purposes.

Taxpayer's Position

The taxpayer's position is that the costs of the drop replacements constitute a current expenditure since the drop lines are restored to their original condition and the replacement drop lines are not substantially better than or different from the original drop lines. According to the taxpayer, the drop lines were replaced for the following reasons:

• some replacements were involuntary, i.e., they were requested by third parties such as XXXXXXXXXX
• some drop lines were replaced at the request of subscribers, for example, when the drop crosses a swimming pool or some other feature of the landscape;
• some replacements were necessary to maintain quality service to customers after it had been determined that the drop had become defective and was causing impaired or unreliable reception or signal leakage;
• •some cables were replaced due to damage from shovels, ground frost, squirrel bites, ice storms and other causes; and
• some drop lines were replaced to comply with safety regulations.

District Office's Position

You are of the opinion that a portion of these drop replacement costs should be classified as capital assets (Class 8) rather than being treated as a current expense, in accordance with Interpretation Bulletin IT-317. More specifically, you argue that a distinction should be made between voluntary and involuntary replacements.

As to the voluntary replacements, based on the Halifax Cablevision Limited et al. v. M.N.R., 83 D.T.C. 630 (T.C.C.) case, you opine that exterior replacement drop costs should be capitalized. In your opinion, the drop lines were replaced for the sole purpose of allowing the taxpayer to increase its basic monthly fee pursuant to the CRTC Regulations. You further maintain that an expenditure that provides an enduring revenue stream is capital and not current.

With respect to involuntary replacements, in your view, where the drop replacement costs are incurred for reasons beyond the taxpayer's control, both interior and exterior costs constitute a current expense.

Our Comments

In determining profit from a business for purposes of subsection 9(1) of the Income Tax Act (the "Act"), a taxpayer must have regard to the generally accepted accounting principles (GAAP). In the situation at hand, the taxpayer has, in determining its profit for financial statement purposes, capitalized the costs of replacing the drop lines. However, for income tax purposes, it fully deducted such costs in the year in which the expense was incurred. Presumably, the financial statements of the taxpayer were prepared in accordance with GAAP. This raises the question of whether there is a requirement to use the same GAAP method in computing income for tax purposes as that which has been used for general financial statement purposes. This question was 0addressed in the case of West Kootenay Power and Light Co. Ltd. v. The Queen, 91 DTC 5214 (F.C.A.), where the Court concluded that, where there are two methods acceptable within GAAP, the accounting method which presents the "truer picture" of the taxpayer's revenue is the appropriate one for income tax purposes. Thus, for tax purposes, income must be computed in accordance with a method within GAAP that produces the "truer picture". When there is only one acceptable method within GAAP and that method is reflected in the financial statements, the income for tax purposes, absent a specific provision of the Act, should not be different. Hence, the question to be answered is whether the drop replacement costs are on account of capital and whether reporting these costs as such would produce the "truer picture".

The question whether an expenditure, in this case, replacement drop costs, is capital in nature, because depreciable property was acquired or improved, or whether it is currently deductible, because it is in respect of the maintenance or repair of a property, is largely a question of fact and often a question of degree. The determination cannot be made by the application of any rigid test or definition. Rather, it is derived from an appreciation of the whole set of circumstances, some of which may point to the conclusion that the expenditure is capital in nature and others which indicate it is an expense. While no single definition or test exists, a number of criterion have been established by the Courts. These criteria, which are set out in paragraph 4 of Interpretation Bulletin IT-128R, are as follows:

(1)Enduring Benefit: when an expenditure is made "with a view to bringing into existence an asset or advantage for the enduring benefit of a trade", that expenditure normally is looked upon as being of a capital nature. Where, however, it is likely that there will be recurring expenditures for replacement or renewal of a specific item because its useful life will not exceed a relatively short time, this fact is one indication that the expenditures are of a current nature.

(2)Maintenance or Betterment: where an expenditure made in respect of a property serves only to restore it to its original condition, that fact is one indication that the expenditure is of a current nature. Where, however, the result of the expenditure is to materially improve the property beyond its original condition, such as when a new floor or a new roof clearly is of better quality and greater durability than the replaced one, then the expenditure is regarded as capital in nature. Whether or not the market value of the property is increased as a result of the expenditure is not a major factor in reaching a decision.

(3)Integral Part or Separate Asset: another point that may have to be considered is whether the expenditure is to repair a part of a property or whether it is to acquire a property that is itself a separate asset. In the former case, the expenditure is likely to be a current expense and in the latter case, it is likely to be a capital outlay. For example, the cost of replacing the rudder or propeller of a ship is regarded as a current expense because it is an integral part of the ship and there is no betterment; but the cost of replacing a lathe in a factory is regarded as a capital expenditure because the lathe is not an integral part of the factory but is a separate marketable asset. Between such clear-cut cases, there are others where a replaced item may be an essential part of a whole property yet not an integral part of it.

(4)Relative value: the amount of the expenditure in relation to the value of the whole property or in relation to previous average maintenance and repair costs often may have to be weighed. This is particularly so when the replacement itself could be regarded as a separate marketable asset. On the other hand, the relationship of the amount of the expenditure to the value of the whole property is not, in itself, necessarily decisive in other circumstances, particularly where a major repair job is done which is an accumulation of lesser jobs that would have been classified as current expense if each had been done at the time the need for it first arose; the fact that they were not done earlier does not change the nature of the work when it is done, regardless of its total cost.

It is difficult to determine from the limited information provided whether the expenditures to replace the drop lines are current or capital in nature, since it appears from the above guidelines that they fall somewhere in between:

(1)Enduring Benefit: it appears from the information provided by the taxpayer that drop lines have to be replaced on a fairly frequent basis, either at the request of a third party or because the lines have been damaged or are defective. Nevertheless, it is difficult to determine conclusively whether the replaced drop lines constitute a passing as opposed to an enduring benefit without further information, such as, the useful lifetime of the expenditures and the nature of the advantage to be gained.

(2)Maintenance or Betterment: according to the taxpayer, the expenditures to replace the drop lines only served to restore the lines to their original condition. Although the replacement drop lines offer marginally better insulation than the old lines, we agree with the taxpayer's argument that repairs do not become disqualified as deductions "merely because they are carried out in light of technology unknown when the original structure was built".

(3)Integral Part or Separate Asset: where the purpose of the expenditure is to repair a part of a property, as opposed to acquiring a separate asset, the expenditure is likely to be a current expense. As you indicated in your memorandum, the Court, in the Halifax Cablevision Limited case, made clear that, drop lines are "a group of assets forming an essential part of the physical plant used continuously in the generation of revenues...". This would indicate that the expenditures to replace the drop lines are current expenses.

(4)Relative Value: although you indicated that the cost of replacing the drop lines can amount to over $XXXXXXXXXX dollars annually, as you have not indicated the value of XXXXXXXXXX we cannot weigh the amount of the expenditures in relation to the value of the entire operation or to the previous average costs of replacing the drop lines.

As regards the Gold Bar Developments Ltd. v. The Queen, 87 DTC 5152 (F.C.T.D.) case, both yourself and the taxpayer rely upon that case in support of your argument that the purpose of the outlay is a determining factor in deciding whether an expenditure is on account of capital or fully deductible. The facts in the Gold Bar case are in many respects very similar to the facts in the Shabro Investments Ltd. v. The Queen, 79 DTC 5104 (F.C.A.) case. However, very different decisions were rendered in these two cases, which are, as a result, somewhat at odds. In the words of D.E. Spiro, who commented on the Gold Bar case in the Canadian Tax Journal, Vol. 35, No. 2:

"At first glance, this qualification on the improvement test appears to be of help to the taxpayer. On further analysis, however, it becomes clear that it is too vague to represent any meaningful change. Contrasting Gold Bar with Shabro Investments illustrates this imprecision. In Shabro, the taxpayer, found that the concrete floor of his commercial building was collapsing. The floor had been constructed atop an inherently unstable landfill site and ought to have been better reinforced. This construction deficiency constituted a "hidden defect... which had always existed but had just become apparent." A new, stronger floor had to be built to replace it. The Federal Court of Appeal held that the expenditure was on account of capital because the new floor was an improvement on the old one in the light of the new floor's enhanced structural strength. On the other hand, it is arguable that there was no improvement because, for all practical purposes, the new floor served exactly the same purpose as the old floor. In functional terms, nothing new had been created. The same situation obtained in Gold Bar: the wall had been improved but it was nonetheless only a wall.

It is disappointing that the Federal Court - Trial Division did not discuss Shabro, but merely cited it as support for the improvement test. The two cases cannot stand together. It appears that they are distinguishable only to the extent that the court in Shabro made a finding of fact that the floor was "greatly improved," while the court in Gold Bar found that the wall had not been "greatly improved." (at pages 422-23)

The above quote probably explains why the Department has appealed the Gold Bar case. For that reason, in our opinion, very little reliance should be placed upon this case.

Moreover, although Interpretation Bulletin IT-317R specifically deals with the characterization of expenses in respect of exterior and interior drop costs, it does not address the question of whether the costs of replacing such property are in the nature of repairs or constitute capital expenditures. Rather, the guidelines for determining whether such costs are currently deductible or capital in nature are set out in IT-128R mentioned above.

The taxpayer's representations in support of current deductibility of the drop replacement costs for income tax purposes are silent on the capitalization treatment of these costs for accounting purposes. It would appear that, in preparing its financial statements, the taxpayer considered the drop replacement costs to be on account of capital. As the taxpayer has not suggested that these costs were incorrectly capitalized for accounting purposes or that they should be treated as current expenses on the basis of GAAP, we question whether capitalization is not the one and only treatment within GAAP. Since we cannot determine conclusively from the information provided whether capitalization is the only treatment and given that the taxpayer has capitalized the drop replacement costs for financial accounting purposes, we agree with your position that the expenditures incurred by XXXXXXXXXX in respect of drop replacements should be capitalized. However, should the taxpayer's representative provide information to the contrary, we would be pleased to consider it and their arguments as to the "truer picture" for income tax purposes.

R. Albert
for Director
Business and General Division
Rulings Directorate
Policy and Legislation Branch