When a business acquires a capital asset, determining whether expenses incurred on repairs are deductible for income tax purposes is crucial.
Inland Revenue’s recent exposure draft provides guidance on this issue, clarifying when repair costs can be deducted and when they must be treated as capital expenditure.
Previously Inland Revenue would look at the relevance of whether the price of the asset was discounted as to how any expenses would be treated.
General Rule: Capital vs. Revenue Expenditure
Under the Income Tax Act 2007, expenses related to initial repairs—those necessary to make an asset fit for its intended use—are considered capital in nature and are not deductible under s DA 2(1). However, these costs can typically be added to the asset’s value for depreciation purposes if applicable. In contrast, ongoing repairs and maintenance carried out after an asset is already in use are generally considered revenue expenditure, making them deductible.
What Are Initial Repairs?
Initial repairs are those required to restore an asset to a functional state at the time of acquisition. These costs remain non-deductible, even if similar expenses incurred by a previous owner would have qualified for a deduction. It’s important to distinguish initial repairs from deferred maintenance, which occurs due to wear and tear over time. While deferred repairs may be deductible, initial repairs needed to make an asset operational at purchase are not.
Key Factors in Determining Initial Repairs
When assessing whether a repair expense falls under capital or revenue expenditure, Inland Revenue considers:
🔷The condition of the asset at the time of acquisition.
🔷Whether the repairs were necessary to make the asset usable.
🔷The timing of the repairs relative to the acquisition date.
🔷Whether the purchase price already reflected the asset’s state of disrepair.
Case Law & Legal Principles
Those that like to look up legal cases, Inland Revenue’s analysis is based on established case law, including:
👉BP Australia Ltd v Commissioner of Taxation – Examines whether an expense is capital or revenue in nature based on its purpose and effect.
👉Hallstroms Pty Ltd v Federal Commissioner of Taxation – Introduces the “profit-yielding subject” test, which determines whether an expense enhances the asset (capital) or simply maintains it (revenue).
Examples: Capital vs. Revenue Treatment
Not Deductible (Capital Expenditure)
🔷Repairing a newly acquired trailer that had been sitting unused before purchase.
🔷Fixing an inherited rental property to make it suitable for leasing.
🔷Cleaning and repairing a leased commercial building to meet business needs before use.
Deductible (Revenue Expenditure)
🔷Ongoing repairs to an asset that was already in functional use.
🔷Fixing wear and tear caused by the current owner’s business operations.
Implications for Businesses & Taxpayers
Taxpayers must clearly differentiate between initial repairs (non-deductible) and ongoing maintenance (deductible). If an asset requires repairs to become usable, those costs are capital in nature but may be depreciated over time. This exposure draft serves as a reminder for businesses to carefully evaluate repair costs and their tax treatment to ensure compliance with Inland Revenue’s guidelines.