Deductions
1873. Accounting and tax treatment of repairs
October 2010 - Issue 134

The implementation of the revised IAS 16 Property Plant and Equipment in 2005 signaled a widening of the gap between the accounting and tax treatment of asset repairs. Previously, for a repair to be capitalised for accounting purposes, it had to be shown that future economic benefits, in excess of those originally expected, resulted from the repair. However, under the current IAS 16, a repair is to be capitalised when the cost of the repair can be reliably measured and it is probable that future economic benefits associated with the item will flow to the entity - in other words, if it meets the normal IAS 16 recognition criteria to recognise an asset. Judgment is required in applying these recognition criteria to the entity’s specific circumstances as IAS 16 requires day-to-day servicing costs to be expenses as incurred. Thus the cost of painting a building once every six years should be capitalised, but not the cost of washing the windows once a month.

From a tax perspective a repair is a restoration by renewal or replacement of a subsidiary part of the whole (as held in CIR v African Products Manufacturing Company Ltd [1944] (13 SATC 164). Repairs are not tax deductible in terms of section 11(a) of the Income Tax Act No.58 of 1962 (the Act) as they constitute capital expenditure. However, in terms of section 11(d) repairs may, inter alia, be claimed as tax deductible expenses if they are actually incurred in the year of assessment on the repair of property:

·      occupied for the purposes of trade, or

·      in respect of which income is receivable, or

·      in respect of machinery, implements, utensils and other articles used by the taxpayer for the purposes of his trade.

A repair must be distinguished from an improvement which occurs when remedial work also results in increased income-earning capacity or aesthetic improvement. Improvements must be capitalised for tax purposes and written off in terms of the relevant capital allowance provisions contained in the Act (e.g. section 12C and section 13 – interestingly, section 11(e) does not deal with the write-off of improvements to ‘wear and tear’ assets and their treatment is uncertain).

To illustrate the difference between the accounting and tax treatment, assume a taxpayer owns and rents out an office block. During the year of assessment, the control panel of one of the lifts breaks down resulting in people continuously ending up on the wrong floors. The parts required to repair the control panel are no longer available. Accordingly the taxpayer installs a new control panel at a cost of R100 000. The old control panel had a carrying amount of R40 000 for accounting purposes on the date of its replacement.

For accounting purposes, the old control panel is derecognised as an asset in accordance with IAS 16 resulting in a loss on disposal of R40 000. The new control panel has a cost that can be reliably measured and it is probable that future economic benefits associated with the control panel will flow to the entity, hence it is recognised as an asset at R100 000. Subsequently it is depreciated over its estimated useful life. Assume the depreciation on the new asset for the year is R10 000.

From a tax perspective the replacement of the control panel constitutes a repair (a replacement of a subsidiary part of the lift, which is not an improvement as it does not result in an increase in income earning capacity) and therefore qualifies for an immediate deduction. Wear and tear continues to be based on the cost of the lift (which includes the original control panel).

The tax computation for the year will therefore contain the following adjustments:

The tax treatment is more beneficial because the full cost of the replacement asset can be written off in terms of section 11(d) in year one.

Taxpayers need to be aware that if they incorrectly capitalise the cost of repairs for tax purposes, they could lose a substantial portion of the deduction. For example, say a taxpayer incorrectly capitalises repairs of R100 000 in 2005 and claims an annual wear and tear allowance of R20 000 over the next five years (see table below).

On 1 July 2010 SARS conducts an audit in respect of the taxpayer’s 2006 – 2009 tax years (the 2005 tax return has already prescribed). It finds that the R100 000 does not constitute an improvement and disallows the section 11(e) allowance in respect of the 2006, 2007, 2008 and 2009 tax years. The taxpayer wishes to claim the section 11(d) allowance of R100 000 in 2005, but SARS refuses to amend the 2005 tax return as it prescribed on 31 December 2009. The result of this unfortunate situation is that the taxpayer loses R80 000 of its possible R100 000 tax deduction.

This example illustrates the importance of examining the accounting asset register when preparing the tax return in order to establish whether any amounts capitalised for accounting purposes should be claimed as immediate tax deductions in terms of section 11(d).

Ernst & Young

IT Act:S 11(a), s 11(d), s 11(e)

IT Act:S 12C

IT Act:S 13

Other: IAS 16