It's Not What You Think It Is!

MALCOLM GUNN FTII, TEP discusses a Tax Bulletin item relating to work carried out on let residential property.

HAVE YOU EVER tried one of those quizzes in which an everyday object is depicted at some unrecognisable angle and blown up out of all proportion? After much head-scratching you learn that what looks like an elephant's foot is actually a saucepan lid; and what must surely be an alien spacecraft turns out to be a potato peeler.

If such trivia send you into raptures, then look no further than this magazine for more of the same. I have recently discovered one in the issue of 4 July 2002. Before readers are spotted on the train home staring at all the pictures in that issue upside down and sideways on, let me hasten to explain further.

What I have in mind is an item which appeared in the Revenue's Tax Bulletin for June 2002 entitled 'Schedule A; computation of profits repairs to let property'. This item was reproduced in the aforesaid issue of this magazine. The Tax Bulletin article included a statement which announced a change of practice by the Revenue in relation to the cost of replacing single-glazed windows with double-glazed windows. Previously this had been treated as improvement expenditure, which is therefore disallowable as capital, and the item reported that the Revenue now accepts that this work is to be treated as allowable expenditure on repairs. So far, so good; this was very welcome relaxation of Revenue practice in relation to a matter which had previously been a frequent cause of dispute and difficulty.

The oddity which was undoubtedly not what you thought it was at the time was buried elsewhere in that article.

The entire asset

A perennial problem with any work to property is identifying the 'entirety' of the asset concerned. The key point is that if the 'entirety' of the asset is reconstructed or rebuilt, that is capital expenditure which is not deductible from rents, or from trading profits as the case may be, whereas if there is a replacement of a subsidiary part of the whole, that is deductible repair cost. The Tax Bulletin offered the following helpful guidance on this matter as it relates to let property:

'In the case of residential accommodation we accept that the entirety will normally be the house or the block of flats that is let. So if your roof is damaged and you replace the damaged area, your expenditure is allowable.'

Unfortunately, as I shall explain in a moment, what must now be said about this pronouncement is: 'It's not what you think!'. It seemed fair enough to me at the time, although perhaps slightly out of character for the Revenue which has consistently down the years argued for a very narrow, some might say extreme, interpretation of what constitutes the entirety in property cases. As I see it, general thread which has run through the Revenue's argument in each case is that any free-standing unit, however large or small, must itself be regarded as an entirety. I think it is probably fair to say that the Revenue's success rate with this interpretation has been about 50 per cent. Although it is a sweeping over oversimplification, the success rate has generally related to more substantial structures within larger commercial sites, and the successes for the taxpayer have tended to relate to less significant structures. One also gains the impression that the Revenue considers the cases it has won to have overruled all those it lost, although each of the judges forgot to mention this important point.

The latest case

The most recent case in which this tricky issue has been examined was a Privy Council decision in Auckland Gas Co Ltd v Commissioner of Inland Revenue [2000] STC 527. This is what was said in that case:

'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.'

The judgment went on to explain this point by saying that 'repair may not be the appropriate description of the work The effect of the work on the character of the object is also an important consideration'.

The Auckland Gas case itself related to a network of pipelines in New Zealand and the House of Lords accepted that the entire network of pipes should be treated as one asset of its own, albeit with a proviso that if a significant proportion of the pipe network were abandoned and replaced, such work may readily go beyond what would normally be regarded as repair, especially if the new pipes were made of better materials.

Some elucidation

I wrote to the Revenue's Press Office in December last year concerning the Tax Bulletin item and was very pleased to receive a response from the Revenue's Business Tax Policy Division in less than a week. My reading of the statement in the Tax Bulletin concerning the entirety of a let property was that the full structure on a domestic site is accepted by the Revenue as being the entirety. I believe that was the reading of the item by others as well, both within and outside the Revenue. Alas, it's not what you think! I asked the Revenue's Press Office about the treatment of a garage, for example, built at the same time as the original structure and the response came as a surprise:

1. 'Thank you for your letter of 13 December.

2. 'Repairs involve the replacement of a part. The question of what is the entirety that is being repaired has been addressed in our instructions at IM 338. This contains a comprehensive review of the leading tax cases. As you will see, what is the entirety is a question of fact and degree to be addressed in the light of the specific circumstances of each individual case.

3. 'You are particularly interested in the example of a semi-detached house with a garage built at the same time as the original structure.

4. 'If the semi-detached house has a wholly separate garage, I think it is clear from the authorities that there are two entireties: the house and the garage. At the other extreme, if the garage is an integral part of the house, I think it is equally clear that there will be only one entirety: the single structure. If the garage were built against one side of the house, the answer would depend on the particular facts of the case.'

Unfortunately the reference to the Inspector's Manual at paragraph 338 produces no text on my electronic version of the manuals, and possibly the reference is to paragraph 995 of the same manual. There it is stated 'If only part of the entirety is involved, the work is normally a repair and the cost is allowable as a revenue expenditure unless there is a significant element of improvement'. That statement seems to me to stack up quite well with what was said in the Auckland Gas case, although the Privy Council seemed to allow themselves some leeway to step back from the facts of a particular case and simply ask: 'Can you really say that what is happening here is repair work?'. All the same, my expectation would be that if the derelict wing which the Privy Council mentioned were part of a listed building and it had to be replaced exactly as it was, then their Lordships would agree that this is best described as repair work.

A disappointing response

The last paragraph of the Revenue's letter to me came as both a disappointment and a surprise. The Tax Bulletin appeared to encourage the view that the Revenue was no longer going to dissect residential properties into their constituent parts, but apparently that is a misconception. The Revenue remains set in its view that any physically separate structure is an entirety of its own and even a single structure may be divided into its constituent parts. The last sentence of the Revenue's letter was disappointing for a different reason: it leaves the self-assessing taxpayer floundering in the dark and wondering what particular facts might influence the Revenue's view about the treatment of lean-to garage structures built with the original house along one side.

A contrary view

Before the Auckland Gas case, the most recent wide-ranging review by the courts of the whole topic of what constitutes the 'entirety' in relation to a property was in Brown v Burnley Football and Athletic Co Ltd [1980] STC 424. That decision contained a summary of many of relevant cases and drew some threads together from them. In the interests of not making this brief article a miserable experience for both the reader and myself, I will not trawl through them here name by name, but a selection of quotations to be found in that judgment will, I hope, help readers to formulate their views:

Generally

'No one factor can be isolated and elevated into a governing criterion.'

'The premises may sometimes be the whole of the trader's business premises and may sometimes be a specific building forming part of the premises.'

Chimneys

1932 case: 'This was a factory chimney it was unsafe and would not do anymore anyhow they simply built a new chimney and started to use that one instead of the old one. I think the chimney is the entirety here and they simply renewed it.'

1951 case: 'It is no part of our duty to review the decision [just quoted above] the chimney with which we are concerned is physically, commercially and functionally an inseparable part of an entirety which is the factory.'

The size of the structure

1951 case: 'If, for example, a retort house in a gasworks was destroyed and had to be rebuilt, one would hardly call that a repair to the gasworks. The size of the retort house would compel one to regard that as the premises.'

1952 case: 'Having regard to the size and importance of the new barrier in relation to the factory as a whole, I think it is proper to regard the barrier itself as the premises.'

What is the complete entity?

1957 case: 'The profit-earning entity is the whole of the premises taken together, and the replacement of a unit, even if such a unit be a separate building, must be viewed in relation to the profit-earning entity.'

1977 case: 'I am forced into saying in this case that the [cattle] ring itself must be considered the premises, for if I take the mart as a whole, the ring is the nerve centre where the whole of the business of buying and selling takes place ...'

Sports stadia

The 1980 case: 'It may be that, for instance, a sports stadium designed and built as a single building would constitute separate premises and that replacement or renewal of a part would be a repair of the premises as a whole, though it is not easy to see why, in such a case, a car park, baths and changing rooms forming an integral part of the structure should not be as much part of the stadium as the spectators' seats and the ground itself.'

'In the present case the premises occupied by the club comprised a number of distinct structures. It was not designed, far less built, in accordance with a single plan.Each separate part of the whole had its own distinct function.'

It's not what you think

What then do we glean from all these brief extracts from the various judgments? They seem to me to show that major work to any particular premises runs a risk of introducing new features and thereby taking the work out of the scope of being repair. If the main building, or 'nerve centre', is rebuilt that cannot normally be treated as repair. If it is sensible to treat several buildings on one site as one entirety, then individual units may be replaced as repair work, but if each of the separate buildings is substantial in its own right, or alternatively forms a key function of its own, it may not be appropriate to regard them as part of a larger entirety comprising the whole site.

Buildings designed together as one plan are more likely to form an entirety together, particularly where they are 'physically, commercially and functionally inseparable', but buildings constructed on a piecemeal basis over the years on the site are less likely to be part of a single entirety.

Applying these principles, it does not seem to me that the average lean-to garage, built with virtually every semi-detached house in Britain, would fall to be treated as a separate entirety, if it were rebuilt in situ. The Revenue's letter indicates that it may accept this, but only in certain circumstances; unfortunately we do not know what those circumstances are.

The idea that a separate garage is in every case a separate entirety does not ring true to me according to the authorities. Most garages these days are used for storing domestic junk and it seems hard to me to regard them as performing a key function of their own or as being sufficiently sizeable in relation to the whole property to form its own entirety.

That is how it all shapes up from my perspective, although I can almost here a voice from Somerset House saying 'its not what you think either'!

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