7 August 1991 Income Tax Severed Letter - Repair of Capital Expenditure

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.

Subject: Repair or Capital Expenditure XXX

We have been asked to reply to your letter of June 18, 1991 to Audit Applications Division concerning the above noted subject.

XXX

As a result of your audit, you concluded that the entire cost of the renovations should be capitalized as leasehold improvements under Class 13. It is the taxpayer's position that the renovations in question were normal repair and maintenance expenses, did not result in the acquisition of assets of enduring value and id not materially improve the property beyond its original condition.

You have asked us whether major repairs such as those under question should be deductible as current repairs or capitalized as leasehold improvements. You point out that the reported court cases which deal with the categorization of expenditures as capital or current relate to assets which were owned by the taxpayer rather than to leasehold interests. Presumably you would like our opinion as to whether the fact that an expenditure is in respect of a leased asset rather than a taxpayer-owned asset would affect the determination of whether an expenditure is current or capital.

Our Comments

There is no simple rules for determining how to characterize an expenditure incurred in respect of depreciable property. With respect to the extensive renovations made by this taxpayer, we feel that a more specific approach is needed rather than applying the 4 principles set out in paragraph 4 of IT-128R to the entire project. In addition, we would like to stress the fact that the 4 principles must be considered in relation to each other rather than as 4 separate tests. However, for ease of explanation we will discuss the 4 principles separately.

Enduring Benefits

The taxpayer stresses the fact that the expenditures represent a short term investment and will provide no enduring benefit. XXX Given that the assets in question are leasehold improvements which may be fully depreciated over a five year period, this line of reasoning does not appear valid. In order to determine whether an expenditure is capital or current, using generally accepted accounting principles, consideration is given to whether the benefit from the expenditure will last longer than one year or an operating cycle. In Vancouver Tugboat Co. Ltd. v. MNR, [[1957] C.T.C. 178] 57 DTC 1126 an engine which was replaced every five, eight or ten years was not considered a recurring expense. We would like to point out, however, that the fact that the expenditure relates to a leased property rather than to a property which is held by the taxpayer has no direct bearing on the classification of the expenditure in and of itself. It is relevant that the rates for capital cost allowance were presumably set in relation to the average expected useful life of an asset in that class and that the higher rate of CCA for a leasehold interest reflects the fact that a leasehold interest will not generally benefit as many future periods as an asset of a different class.

Improvements

The quality of the materials used for renovations was not significantly better than that which was in existence previously. The taxpayer states that the renovations were carried out primarily to maintain competitiveness and should thus be treated as current expenses. We have considered this argument before in response to an article called "Tax Decision Changes Reno Economics" and have rejected it. While there may be some merit in the argument that a needs continual change in order to remain competitive, that XXX competitiveness would likely be achieved through a betterment to the assets in question. Phrased differently, XXX then it may follow that the remodelled furniture is an improvement over the former furniture even if the quality of materials used is not significantly better.

Integral Part

It does not appear as if the taxpayer has addressed this issue. It may be beneficial to consider this question first in order to determine which asset has or has not been improved or has or has not had its life extended. If the furniture is not an integral part of a larger asset being repaired or maintained, then the questions relating to enduring benefit and betterments must be considered in relation to the furniture. The replacement of a worn out asset with a new identical asset will not be a current expense unless the original acquisition of that asset was also a current expense (i.e. the replacement of a worn out automobile with an automobile of a similar quality will be capital even if the expenditure otherwise meets the test of being a current expense).

Relative Value

This principle relates closely to the question of whether the replacement of a part of an asset is considered as a repair of the larger asset or as a separate asset. For example, while a furnace could not operate without a furnace filter, it could be argued successfully that an air furnace filter is a separate marketable asset from the furnace. However, since the relative value of the filter to the furnace is insignificant, it is more reasonable to treat the filter as a part of the furnace. The relative value of the furniture to the building would not be a significant factor in determining whether the expenditures on furniture are treated as current repairs or capital since the building could be operated as a building without the furniture.

We hope the forgoing comments will be of assistance to you.