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HMRC internal manual

Business Income Manual

Capital/revenue divide: tangible assets: character of the asset

As with other questions over the capital/revenue divide it may ultimately be necessary to apply the test set out by Dixon J in the case of Hallstrom’s Pty Ltd v Federal Commissioner of Taxation 72CLR634, at page 648, see BIM35045:

‘What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view.’

In effect, does the expenditure simply leave you with the same asset that you had before, but in a better state of repair, or not? In the context of repairs, a similar approach has been referred to in some cases as looking to see if the ‘character of the asset’ has changed?

In the Privy Council case of Auckland Gas Co Ltd v CIR [2000] 73TC266 Lord Nicholls of Birkenhead said at page 271:

‘The effect of the work on the character of the object is also an important consideration.

This is explicit, or implicit, in several decided cases. In W. Thomas & Co. Pty. Ltd. v. Commissioner of Taxation of the Commonwealth of Australia (1965) 115 CLR 58, 72, Windeyer J. observed that repair ‘‘involves a restoration of a thing to a condition it formerly had without changing its character’’ (emphasis added). In Highland Railway Co. v. Balderston (Surveyor of Taxes) (1889) 2 TC 485 parts of the main railway track were relaid, not after their existing fashion, but with steel rails and heavier chairs. The Court of Session held this substitution was a material alteration and great improvement, and contrasted this with taking away any worn rails and renewing them along the line: that ‘‘would not alter the character of the line’’ (see the Lord President, Lord Inglis, at page 488). The Judicial Committee applied this dictum in Rhodesia Railways Ltd. v. Collector of Income Tax, Bechuanaland Protectorate [1933] AC 368, where the cost of relaying a railway line so as to restore it to its former condition was held to be a legitimate charge against income. Consistently with this, in Mitchell v. B.W. Noble, Ltd. [1927] 1 KB 719, at page 729; (1927) 11 TC 372 Rowlatt J. observed that replacement of a railing which perpetually falls down or needs painting with a brick wall would be capital expenditure. In Federal Commissioner of Taxation v. Western Suburbs Cinemas Ltd. (1952) 86 CLR 102 a dangerous ceiling in a cinema was replaced with a new and better ceiling. Kitto J. regarded the work as different in degree and kind from the type of repairs properly allowed for in the working expenses of a theatre business.’

Effectively what the courts are asking is simply whether the asset is the same asset before and after the work? If it has been changed to do something else, or has been changed to do more, then the character of the asset has changed and it has not merely been restored to its previous efficiency. It has become something else. This is capital expenditure.

This principle can be seen to apply where an asset is acquired. For example in the case of The Law Shipping Co Ltd v CIR [1923] 12TC621, the expenditure turned a ship that had been acquired in an unusable condition into a ship that could be used to generate income. The character of the asset had been changed by the expenditure from something that was little more than a hulk to a merchant ship capable of carrying cargo.

The character of the asset is particularly important where a large programme of work is carried out. In the case of Auckland Gas Co Ltd v CIR [2000] 73TC266 Lord Nicholls of Birkenhead commented on the question of major work and said:

‘Demolition and rebuilding of a dangerous flank wall of a house would normally be regarded as repairing the house. The answer might not be so obvious if an entire derelict wing of a large house were demolished and rebuilt, especially if the new construction were substantially different from the original. Questions of degree may arise in such cases.’

He went on to say:

‘As shown by the above example of the demolition and reconstruction of the derelict wing of a house, sometimes repair may not be the appropriate description of work even though it falls far short of being a replacement of substantially the whole of the relevant subject-matter.

The effect of the work on the character of the object is also an important consideration.’

The question to ask is whether, looked at in the round, the work resulted in a restoration of what was there before, or did it create something new?

How this question can be applied in practice can be seen from the case of Conn v Robins Bros Ltd [1966] 43TC266 (see BIM35472). In this case, the Company’s description of the premises as being ‘gutted and modernised’ is entirely reasonable as the premises had a new roof, new interior, new shop front and even parts of the timber framing of the building were replaced.

The key to the decision that the expenditure was on repairs was that the character of the asset remained unchanged. Whilst there may have been changes to the building, looked at from the point of view of how the building was used, the work was simply a restoration to enable it to be used to do the job it had long been used for.