16 August 1993 Income Tax Severed Letter 9309747 - Asbestos Removal Costs

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.

                                         August 16, 1993

Toronto District Office                  Business and General 
Business Enquiries Group                   Division
                                         A. M. Brake
Attn:  P. Keirstead                      (613) 957-2133
                                         930974

XXXXXXXXXX Deductibility of Asbestos Removal Costs

This is in reply to your memorandum of March 25, 1993 concerning the treatment to be given costs related to the removal of asbestos contaminated material from buildings.

Facts
                      XXXXXXXXXX

                      XXXXXXXXXX

TAXPAYER'S POSITION

The asbestos removal business is extremely risky and costly. Asbestos workers must wear specially designed clothes and respiration, and be decontaminated when they leave work. Additional liability insurance for the period of removal must be obtained if available. The danger, insurance costs of both the owner and the asbestos removal business contributes to the high cost of removing asbestos. Also contributing to the high cost is the increased demand for removal and a shortage of qualified removers.

Costs associated with the removal of asbestos can generally be classified as follows:

1. consultant reports assessing the problem

     2. costs of removing building parts to get at the 
        asbestos

3. costs of removing the asbestos

4. cost of moving tenants while the work is performed

5. costs of re-insulation

6. cost of repairs required due to the removal process.

They believe that the cost of asbestos removal which they have deducted currently for tax purposes is proper and may in fact be overly conservative as they deducted only the costs as outlined in points 1 to 3 above. Accordingly, the remainder of their representations discusses the rationale for deducting currently the costs as outlined in points 1 to 3 above.

Certain principles have been derived from case law over the years in determining whether a cost is a capital expenditure on depreciable property verses a current expenditure on repairs and maintenance.

(i) Maintenance or Betterment

Where an expenditure is made in respect of a property serves only to restore it to its original condition is an indication that the expenditure is current in nature. Where, however, the result of the expenditure is to materially improve the property beyond its original condition, then the expenditure is generally 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. In any event, in determining whether an expenditure materially adds to the value of the property, the proper starting point is the value of the property prior to the condition necessitating the expenditure, not the situation existing immediately prior to the repair. Any other view appears illogical as all property performed repairs add value.

The removal of asbestos and re-insulation with monokote does not extend the life or alter the use of the property. Although a building that does not contain asbestos has more value than a building with asbestos the structure of the non-asbestos is not improved. For these reasons the cost of asbestos removal are more of a current nature.

(ii) Integral Part or Separate Asset

Another factor to be considered is whether the expenditure is to repair part of a property or whether it is to acquire a property that is itself a separate and distinct asset. In the former case the expenditure is likely to be a current cost and in the latter case it is likely to be a capital outlay. Costs associated with the removal of asbestos do not create or enhance a separate and distinct asset and hence should be currently deductible.

(iii) Enduring Benefit

When an expenditure on a depreciable property is made with a view to bringing into existence an asset or advantage for the enduring benefit of a trade then that expenditure is normally viewed 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 is short, this is an indication of an expenditure of a capital nature. It is not expected that the cost of removing asbestos will be of a recurring nature, however, it is not known if the product monokote that is used today to replace the asbestos will be a health risk 10 years from now. As the removal of the asbestos and re-insulation with monokote does not prolong the life or alter the use of the building, no enduring benefit results.

(iv) Relative Value

The amount of the expenditure in relation to the value of the property should be considered. The cost of asbestos removal are relatively minor compared to the total cost of the building for the two properties where asbestos has been removed.

(v) Anticipation of Sale

Repairs made in anticipation of a sale of the property or as a condition of the sale are generally regarded as capital in nature. The buildings where they have removed asbestos are both owned by them today.

Asbestos removal costs are a reasonable and necessary cost in running an efficient and viable business and the asbestos is removed for a number of sound business reasons.

A. Properties that have asbestos are more difficult to lease than non-asbestos buildings. More and more tenants are inquiring whether a building has asbestos in it before signing a lease. Accordingly, rental rates are lower in buildings that contain asbestos.

B. Buildings that contain asbestos are more difficult to arrange financing for as the risk of tenants leaving is increased and hence the cash flow to service the debt is viewed as less stable. In addition, the potential environmental liabilities will be extended to the lender if the lender ever takes control of the building.

C. Under the Canadian Environmental Protection Act there potentially could be a liability extended to corporate directors and offices. Ontario's Ministry of the Environment in several cases of contamination of land by corporations, has named directors and officers personally in the clean-up order. The directors and officers selected are generally those who are perceived by the Ministry to have an active role in the management and operation of the company. The removal of asbestos eliminates such liabilities.

For these reasons, they believe that the treatment of currently deducting the asbestos removal costs as indicated is proper.

YOUR VIEW

1. You believe that the above-mentioned asbestos removal costs are not deductible in computing XXXXXXXXXX income for tax purposes, as they are capital outlays. Accordingly, they should be capitalized for tax purposes as was done for the financial statements purposes. This practice is in accordance with generally accepted accounting principles ("GAAP"), as prescribed by the Canadian Institute of Chartered Accountants ("CICA") Handbook.

The Handbook indicates that where an expenditure can benefit a future period, capitalization should take place (see section 3065 entitled "Capital Assets").

2. Contrary to XXXXXXXXXX position, you are of the view that:

     a)   The removal of asbestos does extend the useful 
          life of the building.  However, if the 
          replacement had not taken place, the building 
          would be unsuitable for tenants and potential 
          purchasers. As stated in XXXXXXXXXX 
          representations, the buildings will now attract 
          additional tenants at a higher rent which, in
          fact, benefits future periods.  The replacement 
          of insulation is a replacement of an asset, not 
          a repair.  This replacement has created an 
          enduring improvement to the structure and the 
          amount should therefore be treated as a capital 
          expenditure;

     b)   The removal of asbestos does, in fact, enhance 
          the value of a separate and distinct asset—
          namely the building.  As stated by XXXXXXXXXX, 
          buildings containing no asbestos are re-financed 
          at preferred terms and rented at higher rates. 
          Consequently, those buildings have higher resale 
          values;

     c)   The enduring benefit that the client refers to 
          is the increased rental revenues that will result 
          from an asbestos-free building. Without the 
          clean-up, as mentioned below, the client would 
          have greater difficulty in attracting tenants, 
          would receive lower rental rates, and would incur 
          higher financing charges given the increased 
          exposure to liability.

     d)   It is also unreasonable to suggest that insulation 
          will continually have to be replaced in short 
          periods of time.  As stated by the client, 
          asbestos was used as an insulating material in 
          buildings as early as 1920.  They also state that 
          an expenditure which materially improves the 
          property beyond its original condition is often 
          considered capital.  The new insulation does 
          improve the original condition of the building
          given that asbestos has always had the same 
          health hazards, albeit only identified fairly 
          recently;

     e)   As of the date of this request, monokote is not 
          a health risk and will not need to be replaced 
          in the short term.  Insulation removal costs 
          will not be incurred from one year to the next. 
          Therefore, those costs are not part of "running 
          expenses" of XXXXXXXXXX business.  
          In fact, such costs do enhance the marketability 
          of the buildings, the borrowing and refinancing
          power.  As mentioned by the client, this type of 
          expenditure is generally considered to be on 
          account of capital;

     f)   The asbestos removal costs should be evaluated 
          in determining whether they are on account of 
          capital or income.  Such an evaluation should 
          not include comparing the relative dollar amounts 
          of the asbestos removal costs with that of the 
          total costs of the buildings involved.  It also 
          has no bearing whether the buildings, after the 
          removal of asbestos, are retained for rental
          purposes or sold thereafter.

     g)   The possibility of a legal action for the 
          non-removal of asbestos from the buildings in 
          question against the directors and officers
          of XXXXXXXXXX does not necessarily 
          make the removal costs fully deductible for 
          tax purposes.

3. According to a published article in The Financial Post, dated November 25, 1992 (a copy of which you enclosed), the Internal Revenue Service (the IRS) has issued a ruling stating that the asbestos removal costs are not deductible under the Internal Revenue Code. You believe that the ruling does lend support to your position.

4. XXXXXXXXXX

5. Finally, you agree with XXXXXXXXXX that the Department should be consistent in uniformly applying its assessing policies and procedures. Accordingly, you referred this matter for our evaluation and comments.

                      XXXXXXXXXX

Our Comments

Subsection 9(1) of the Act states that "subject to this part, a taxpayer's income for a taxation year from a business or property is his profit therefrom for the year." Profit from a business is computed in accordance with GAAP. For financial statement purposes XXXXXXXXXX have treated the costs in question as capital expenditures in the 1987, 1988, 1989 and 1990 years.

Yet in the latter three years they have treated these amounts as deductible expenses for tax purposes and now request that we reassess to allow for tax purposes amounts previously capitalized in 1987 for both financial statement and tax purposes.

The argumentative position that income reported in accordance with GAAP for financial statement purposes must also be the income for tax purposes is clarified in the case of West Kootenay Power and Light Co. Ltd. v MNR,

91 DTC 5214, at the Federal Court Trial Division and the Federal Court of Appeal, 92 DTC 6023. The taxpayer until 1979 had not taken into income, either for accounting or for tax purposes, amounts which had been earned but were not billed at its year end. It began to do so, however, when reporting its income for its 1979 taxation year, adjusting its 1978 return to reflect the new treatment for 1979. This change was accepted by the Minister. In reporting its income for tax purposes for its 1983 and 1984 taxation years, however, the taxpayer reverted to his pre-1979 practice, of eliminating from its income for tax purposes for both of those years all earned amounts which had not been billed. Expert evidence given at the Trial Court showed that either method of reporting revenues was acceptable within GAAP. The witness, Mr. Culver, went on to say that, in his opinion, the accruing of unbilled income more closely matches the revenues of the organization with its relevant costs and therefore produces a more accurate determination of net income for a particular period. Trial Judge, MacKay, J., concluded that the Act does not require or permit a taxpayer to account for revenues, and thus profits, on one basis for financial statement purposes and on another basis for tax purposes not withstanding that both methods are within GAAP. At the Appeal Court, Justice MacGuigan determined that the Trial Judge had erred in finding that as an absolute requirement under the Act that there must always be conformity between the accounting treatment used in any taxpayer's financial statements and its tax returns. When there are two methods acceptable within GAAP, MacGuigan decided the approved principle to be followed is that, for tax purposes, the accounting method which presents the "truer picture" of the taxpayer's revenue is the appropriate one. In summary, income for tax purposes, must be computed in accordance with a method within GAAP that produces the "truer picture". Hence, 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.

We assume that the auditor's report contains a statement indicating that the income was computed in accordance with GAAP for the four years now under consideration. We, also, accept that for accounting purposes the amounts in question were properly capitalized and that the income reported for financial statement purposes would be the profit for purposes of section 9 of the Act.

In computing income for tax purposes the profit, for purposes of section 9 of the Act, computed in accordance with GAAP, could be decreased by amounts that may be claimed in respect of certain deductions clearly provided by specific provisions of the Act. Paragraph 20(1)(a) of the Act is one such provision which provides for a deduction in respect of the capital cost of property as is allowed by Regulation. Alternatively, paragraph 18(1)(b) specifically denies any deduction in respect of "an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this part."

Depreciation is properly deductible in computing income in accordance with GAAP for financial statement purposes, however, paragraph (b) prevails to specifically deny such a deduction, notwithstanding GAAP. Similarly, paragraph (b) will prevail to specifically deny a deduction in respect of costs relating to the replacement of asbestos, if such costs are held to be on account of capital. Hence, the question to be answered is whether the amounts are on account of capital.

The representations in support of deducting these amounts for tax purposes are silent on the capitalization treatment for accounting purposes. It would appear that in preparing the financial statements they must have considered the amounts to be on account of capital or else they would not have been capitalized for accounting purposes. There is no suggestion that these amounts were incorrectly capitalized for accounting purposes and the taxpayer is not suggesting that these amounts should be treated as current expenses on the basis of GAAP. Hence, it is reasonable to assume that they were capitalized because they were on account of capital. Also, they are silent as to why the accounting treatment should be different than the tax treatment.

The CICA Handbook, paragraph 3060.29 "Betterment", states, in part:

"The cost incurred to enhance the service potential of a capital asset is betterment. Service potential may be enhanced when there is an increase in previously assessed physical output or service capacity, associated operating costs are lowered, the life or useful life is extended, or quality of output is improved. The cost incurred in the maintenance of the service potential of a capital asset is a repair, not a betterment. If a cost has the attributes of both a repair and a betterment, the portion considered to be a betterment is included in the cost of the capital asset."

Based on the above, we support your position and agree with the reasons you have put forward that these amounts constitute capital expenditures. Also, paragraphs A. and B. of the taxpayer's representations in support of the removal of asbestos for sound business reasons, we feel, support the position that there was betterment and, therefore, the amounts are capital in nature. The fact that GAAP dictates capitalization for the accounting treatment, also, supports the position that they are capital expenditures.

You made reference to the fact that the IRS in the United States are treating such expenditures as being on account of capital, according to a published article in The Financial Post, dated November 25, 1992 which reads, in part, "... new IRS ruling prohibiting the deduction of costs associated with asbestos removal ...". The fact that a foreign taxing authority considers such costs to be on account of capital because they produced "benefits beyond the year in which the expenditure was incurred", lends support to the position that the amounts in question are of a capital nature.

In summary, given that these amounts are on account of capital and we feel that they are, clearly, paragraph 18(1)(b) specifically denies such capital outlays as a deduction in computing income for tax purposes. Also, to our knowledge, since capitalization is the one and only treatment within GAAP, the "truer picture" for income tax and financial statement purposes can only be one and the same—capitalization. However, should the taxpayer's representative provide information to the contrary regarding the treatment within GAAP, we would be pleased to consider it and their arguments as to the "truer picture" for income tax purposes.

Our research indicates that this is the first time that we have expressed a written opinion on the deductibility of costs relating to the removal of asbestos from buildings.

R. Albert for Director Business and General Division Rulings Directorate Legislative and Intergovernmental Affairs Branch