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Business Income Manual

Capital/revenue divide: tangible assets: case law: a tale of two pipelines

This page looks at the Privy Council decision in the New Zealand case of Auckland Gas Co Ltd v CIR [2000] 73TC266 where the Council found that the cost of inserting polyethylene pipes into an existing iron pipe was capital expenditure. It then considers the different facts that led the Special Commissioners to distinguish the case in Transco Plc v R A Dyall (HMIT) [2002] SpC310 where it was decided that the cost of inserting polyethylene pipes into an existing iron pipe was a repair and allowable expenditure.

Although Auckland Gas Co was a Privy Council decision and such decisions are only of persuasive authority in the UK (see BIM35610), there is no reason to believe that the decision on a UK case would differ.

In that case, the company supplied its customers through a network of mainly low-pressure underground cast iron or steel pipes. The pipes were made of many comparatively short sections (12 or 18 feet) and consequently there were many thousands of joints. The joints fractured because of ground subsidence, traffic vibration or corrosion resulting in a serious problem of leakage. The introduction of natural gas exacerbated the problems because it dried out the joint sealing material. To deal with the problem, Auckland Gas adopted the technique of inserting polyethylene pipes into the existing cast iron and steel pipes. As a result of this technique the old leak-prone joints lay outside the polyethylene pipe containing gas which could be transmitted at much higher pressure than through the old cast iron pipes.

The company claimed the cost of inserting polyethylene pipe into the old metal pipes as revenue expenditure, in effect a repair.

Lord Nicholls of Birkenhead analysed the work that had been done. The old metal pipes functioned as gas carriers. After the insertion of polyethylene piping the old metal pipes no longer functioned as gas carriers; they functioned as supports for the new gas carriers; saying at page 273:

‘Had these new pipes been laid wholly outside the old mains and services, they could not sensibly have been regarded as a repair of the old mains and services or as carrying out repairs to the existing pipeline system. Had this been done, the new pipes, differing significantly from the old, would have comprised a complete replacement of whole portions (“network sectors”) of the existing system.

The course actually followed, of inserting the new pipes inside the old, was not materially different. In future the gas was carried by the new polyethylene pipes, not the old mains and services. The unusual and complicating feature is that the old mains and services, which remained on site, still discharged a useful function: providing support for the new pipes. But, for present purposes, that feature is neither here nor there. The function for which the old mains and services were laid and used was as gas carriers. That was their function as part of Auckland Gas’s distribution system. After the insertion of the new pipes, they no longer discharged that function. They became redundant as gas carriers. Leaks and holes and corrosion in the old mains and services no longer mattered. Far from restoring the gas distribution system to its original state, the work changed the character of the existing gas distribution system: a significant portion of it had been upgraded. Substantial portions of the cast iron mains and steel services were superseded by polyethylene pipes having the differences and advantages mentioned above.’

Lord Nicholls dealt with the argument that because the company was concerned to solve a maintenance problem, the expenditure amounted to a repair; saying at page 274A:

‘A maintenance problem such as existed here may be capable of being solved in more than one way. It may be solved by work which would be regarded as a repair of the existing structure. Or it may be solved by scrapping all or much of the existing structure and providing a new one. In overall functional terms the result may be much the same in the two cases, but that is not by itself a reliable guide. If the latter alternative is chosen, the expenditure may well be of a capital nature.’

Lord Nicholls dealt with the argument that the programme was spread over many years and with no definite end in sight; saying at page 273:

‘A further complicating feature is that, not surprisingly, the insertion programme was spread over many years. By June 1992 the work had not been completed, nor was there any certainty it ever would be. The board of Auckland Gas would be bound to keep such a major item of expenditure under review. In their Lordships’ view, this feature does not assist the taxpayer. The speed or slowness with which the work was carried out cannot affect its nature or, hence, its proper characterisation. In any event, as shown by the figures already mentioned, by June 1992 the work completed covered a substantial part of the entire mains network. This work was spread more or less evenly over each of the five relevant years.’

Lord Nicholls also dealt with the argument that the revenue nature of the expenditure was indicated by Auckland Gas’s objective, to restore the system to its original functional and reliable state; saying at page 274:

‘Counsel further submitted that the revenue nature of Auckland Gas’s expenditure is shown or confirmed by the company’s objective. The objective was not born out of a desire to improve the distribution system or to add new or improved features. The objective was to restore the system to its original functional and reliable state. The method adopted, of inserting polyethylene piping, happened to be the most effective and cheapest way to achieve that goal. The Court of Appeal, it was said, ignored the practical and business goal Auckland Gas set out to reach. Their Lordships cannot agree. As already noted, the desire to solve a maintenance problem is not inconsistent with carrying out work of a capital nature. The nature and extent of the work carried out to the physical asset are what is determinative of the character of the work. The fact that the method chosen is the cheapest and most effective is neutral. It does not deprive expenditure of its capital character. Replacing an object may be cheaper and better than patching and mending.’

At first sight the case of Transco Plc v R A Dyall (HMIT) [2002] SpC310 was similar to Auckland Gas. Again the case involved the insertion of polyethylene pipes into the existing cast iron and steel pipes, however the Special Commissioners identified a number of key differences as follows.

  • There was no plan for replacing the whole network and less than 1% a year of the whole pipeline was being replaced with polyethylene.
  • Pipes were only replaced when necessary for safety reasons.
  • 38% of the pipes in the local distribution system remained of cast iron.
  • In most runs of pipe the gas flowed through a mix of metallic and polyethylene pipes, not just polyethylene.

As a result it could not be said that that the previous system had been substituted by a system constructed of a new and different material.

In addition, unlike in the Auckland case, the work was not linked to the switch to natural gas, which in the UK had been completed 20 years before the years under appeal. The network in the UK had coped with the change.

The conclusion of the Special Commissioners at paragraph 92 was that:

‘We conclude that the distinction between repair and replacement is a matter of fact and degree and regard must be had to all the circumstances. In this appeal we are satisfied that what was done was repair by renewal of subsidiary parts of the entirety of the pipeline system. It was not renewal or improvement of substantially the whole of the subject matter. There was no “wholesale” renewal or renewal sector by sector but only renewal of individual pieces and so the character of the whole did not change.’

As they said at paragraph 79:

‘It remained a pipeline through which gas was transported; neither the pressure nor the capacity was materially increased.’

The expenditure was allowable because all that was being done were repairs to the existing asset. There was no new asset when the work was done, nor was there any real difference to the asset, it still transported gas in the same way that it had before it had been repaired.