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Auckland Gas Co Ltd v Commissioner of Inland Revenue (2000) 19 NZTC 15,702

Facts of the case

1. Auckland Gas had a network of gas supply through the cast iron pipes. The network was getting pretty old, expensive to repair. It could not maintain the pressure required to distribute the gas efficiently.
2. Cast iron pipes have a long shelf life but the downside is low pressure, leakage and entry of water.
3. Around 1970 the network faced annual wastage of around 20%.
4. In order to solve the problem the company came up with an idea of inserting polyethylene pipe (another layer of pipe) into the existing cast iron pipes.

a. Polyethylene piping had 50 years of life span, and it is tough, flexible and resistant to pressure stress.
b. It was easy to work with, and was less affected by traffic, earthquake, ground vibration than cast iron.
c. Insertion was achieved by breaking open the mains at intervals, and pushing the pipe down the mains.
d. This insertion technique solved the wastage problem, and it was much cheaper than the traditional “find and fix” digging and repair.

The issue

The expenditure on the polyethylene pipe insertion programme was a revenue item or a capital item.
If it was, the expenditure was within s 104 of the Income Tax Act 1976(equivalent to DA1 ) and not excluded as capital expenditure by s 106(1)(a) of the Income Tax Act 1976 (equivalent to DA 2(1)

Commissioner argument:

- Work carried on such a large scale, significant improvement to the network point towards the work carried out was capital in nature.

Taxpayer argument:

- There was no new asset created, overall the whole network is actually one asset. The expense in question is actually repair & maintenance to the network, and if a part of an asset is replaced by a better part this does not mean that a new asset is created.
- Time period the expense in question is spread over 5 years, thus repair in nature.

The judgments of the courts below:

In High Court, Williams J accepted the contention of the taxpayer company. He looked at the overall position and said the method of repair “differed from what might ordinarily be regarded as repair”. In its essence the polyethylene pipe insertion programme was a repair and should be charged to revenue.
The Court of Appeal disagreed. Blanchard J gave the principal judgment.
• If work of a maintenance character had been done on the joints, and if sections of corroded pipe had been replaced, the cost would have been deductible. Then no new asset would have been created. It would simply have been the old pipeline repaired and restored.
• But that is not what occurred. In its nature and scale, the polyethylene insertion programme could not realistically be regarded merely as a repair of the network.
• The old mains and services were effectively abandoned as a conveyor of gas and relegated to the role of housing for the new pipeline.
• The old mains and services no longer performed any function save protecting the polyethylene pipe against vibration and ground movement. That could not fairly be described as a method of fixing the faulty joints and corrosion. Blanchard J said at (1999) 19 NZTC 15,011 at p 15,023; [1999] 2 NZLR 418 at p 433:—
“If a taxpayer faced with costly maintenance bills elects to rebuild the asset in question in a different way which results in a substantial change in its character, the cost cannot be written off for tax purposes as if it were merely an expenditure on maintenance work which was not actually done — even if what was spent may have been less than the cost of the maintenance. Nor is it in point that the asset may give no greater performance and that its potential life-span may be no greater if in truth a different and substantially improved asset has been created by the expenditure.”

Repair and replacement

Judgment of the Privy Council delivered by Lord Nicholls:

In order to decide whether work constitutes repair or replacement:
1. Identify the object to which the test of repair or replacement is being applied. For example- replacement of a worn washer on a household tap is normally regarded as a repair of the tap even though one of its parts has been wholly replaced. The tap has been repaired by the replacement of one of its component parts. Similarly with a car: replacement of a spent battery or a corroded exhaust system will normally be regarded as a repair of the car. The car has been put into working condition again. It often happens that, a replacement part is better than the original and will last longer or function better. That does not, of itself, change the character of the larger object or, hence, the appropriate description of the work.
2. The effect of the work on the character of the object is also an important consideration.
3. In W Thomas & Co Pty Ltd v Commissioner of Taxation of the Commonwealth of Australia (1965) 115 CLR 58 at p 72, Windeyer J observed that repair “involves a restoration of a thing to a condition it formerly had without changing its character”.
4. 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.
5. In FC of T 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.

6. The dominant features which guide to a reasoned conclusion must be capable of being identified.

The appropriate description of the work done by Auckland Gas

• Significant portion of linked pipes were abandoned and replaced with new pipes. The work did go beyond what would normally be regarded as repair.
• New pipes were made of a different material
• The nature and scope of work was large. When the polyethylene insertion programme began in 1987 Auckland Gas's low pressure mains system, comprising cast iron pipes, represented about 70% of the entire mains system. The oral evidence at the trial put the overall length of the mains network at 1,581 km and the length of the low pressure portions at about 1,100 km. The residue of the mains system largely comprised a medium pressure steel arterial system.
• Over the five years in question on this appeal, 1988–92, polyethylene pipes were inserted altogether in 380 km of the cast iron mains. This represented about 23% of the total mains network. In addition, polyethylene pipes were inserted in 150 km or 32%, of the steel services. This meant that, so far as these substantial portions of the distribution system were concerned, gas was no longer distributed through cast iron mains or steel services.
• 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.
• 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.
• A further complicating feature is that, not surprisingly, the insertion programme was spread over many years. 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.
• 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.

Contrary arguments

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.

Reliance was placed on the decision of the (English) Court of Appeal in Morcom v Campbell-Johnson [1956] 1 QB 106. This was a landlord and tenant case. The landlords of a block of flats spent money on replacing an old two-pipes drainage system with a modern one-pipe system. Denning LJ said (at p 115):—
“... the drainage system in these flats is the same now as the system which existed before. All that has happened is that, instead of there being two pipes to carry the water and refuse away, there is one pipe. That is simply the replacement of the older two-pipes system by its modern equivalent of one pipe. It comes, I think, properly within the category of repairs and not that of improvement. So, also, with the cold-water system. In both cases, as the surveyor said, it was a cheaper way of doing it than it would have been simply to restore the old system as it was.”