OS 007 Income tax treatment of certain expenditures on conversion of land from one farming or agricultural purpose to another (Jul 2004) (Technical tax area)

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OS 007 Income tax treatment of certain expenditures on conversion of land from one farming or agricultural purpose to another (Jul 2004)

This Operational Statement also appears in Tax Information Bulletin Volume 16 Number 6 (July 2004).

Introduction

This Operational Statement sets out the Commissioner of Inland Revenue's ("Commissioner") practice and provides guidelines as to the income tax treatment of certain expenditures on the conversion of land used for one farming or agricultural purpose to another (hereafter referred to as "agricultural expenditure" or "agricultural expenditures").

Application

This Operational Statement sets out the Commissioner's existing position of the application of the law in this area.

Background

Inland Revenue has developed guidelines on the correct income tax treatment of certain expenditures incurred in carrying on a farming or agricultural business, particularly in relation to the costs of converting farming properties from one use to another (for example, from sheep farming to dairy farming).
This statement has been produced in order to provide greater certainty as to Inland Revenue's practice in relation to the income tax treatment of these expenditures.
The practices and guidelines provided in this statement may be applied to a wide variety of expenditures other than those relating to farm use conversions, but they do not cover all situations involving expenditures in carrying on a farming or agricultural business.

Legislation

Income Tax Act 1994

BD 2 ALLOWABLE DEDUCTIONS
BD 2(1) [Definition] An amount is an allowable deduction of a taxpayer

if it is an allowance for depreciation that the taxpayer is entitled to under Part E (Timing of Income and Deductions), or
to the extent that it is an expenditure or loss
1. incurred by the taxpayer in deriving the taxpayer's gross income, or
2. necessarily incurred by the taxpayer in the course of carrying on a business for the purpose of deriving the taxpayer's gross income, or
3. allowed as a deduction to the taxpayer under Part C (Income Further Defined), D (Deductions Further Defined), E (Timing of Income and Deductions), F (Apportionment and Recharacterised Transactions), G (Avoidance and Non-Market Transactions), H (Treatment of Net Income of Certain Entities), I (Treatment of Net Losses), L (Credits) or M (Tax Payments).

BD 2(2) [Exclusions] An amount of expenditure or loss is not an allowable deduction of a taxpayer to the extent that it is

of a private or domestic nature, or
incurred in deriving exempt income under Part C (Income Further Defined), D (Deductions Further Defined) or F (Apportionment and Recharacterised Transactions), or
incurred in deriving income from employment, or
incurred in deriving scheduler gross income subject to final withholding, or
of a capital nature, unless allowed as a deduction under Part D (Deductions Further Defined) or E (Timing of Income and Deductions), or
disallowed as a deduction under Part D (Deductions Further Defined), E (Timing of Income and Deductions), F (Apportionment of Recharacterised Transactions), G (Avoidance and Non-Market Transactions), H (Treatment of Net Income of Certain Entities), I (Treatment of Net Losses), L (Credits) or M (Tax Payments).

DO 3 CERTAIN EXPENDITURE ON LAND USED FOR FARMING OR AGRICULTURAL PURPOSES

DO 3 Any taxpayer who in any income year is engaged in any farming or agricultural business on any land in New Zealand shall be allowed a deduction of the amount of any expenditure incurred by the taxpayer in that year, being expenditure that is not deductible otherwise than under this section or under section DO 4, in –

The destruction of weeds or plants detrimental to the land:
The destruction of animal pests detrimental to the land:
The clearing, destruction, and removal of scrub, stumps, and undergrowth:
The repair of flood or erosion damage:
The planting and maintaining of trees for the purpose of preventing or combating erosion:
The planting and maintaining of trees for the purpose of providing shelter:
The construction on the land of fence for agricultural purposes, including the purchase of wire or wire netting for the purpose of making new or existing fences rabbit-proof.

DO 4 EXPENDITURE ON LAND IMPROVEMENTS USED FOR FARMING OR AGRICULTURE

DO 4(1) [Land owned by taxpayer] Any taxpayer who carries on any farming or agricultural business on any land owned by that taxpayer in New Zealand shall in any income year other than the income year in which that taxpayer sells or otherwise disposes of that land, be allowed a deduction in respect of any expenditure of any of the kinds specified in Part A of Schedule 7 incurred by the taxpayer or by any other taxpayer in preparing or otherwise developing that land, and being expenditure which is of benefit to the business in that income year.

DO 4(2) [Land not owned by taxpayer] Any taxpayer who carries on any farming or agricultural business on any land in New Zealand which is not owned by that taxpayer shall in any income year other than the income year in which that taxpayer ceases to carry on that farming or agricultural business on that land, be allowed a deduction in respect of any expenditure of any of the kinds specified in Part A of Schedule 7 incurred by that taxpayer in preparing or otherwise developing that land and being expenditure which is of benefit to the business in that income year.

SCHEDULE 7

Sections DL 2, DO 4, and DO 5

Expenditure on Land and Aquaculture Improvements

General description of expenditure		Percentage of diminished value of expenditure allowed as a deduction
PART A
FARMING AND AGRICULTURE
1.	The eradication or extermination of animal or vegetable pests on the land.	5
2.	The felling, clearing, destruction, and removal of timber, stumps, scrub, or undergrowth on the land	5
3.	The destruction of weeds or plants detrimental to the land.	5
4.	The preparation of the land for farming or agriculture, including cultivation and grassing, but excluding expenditure incurred in respect of any of the items specified in clause 2.	5
5.	The draining of swamp or low-lying lands	5
6.	The construction of access roads or tracks to or on the land.	5
7.	The construction of dams, stopbanks, irrigation or stream diversion channels, or other improvements for the purpose of conserving or conveying water for use on the land or for preventing or combating soil erosion.	5
8.	The construction of earthworks, ponds, settling tanks, or other similar improvements primarily for the purpose of the treatment of waste products in order to prevent or combat pollution of the environment.	5
9.	The repair of flood or erosion damage.	5
10.	The sinking of bores or wells for the purpose of supplying water for use on the land.	5
11.	The construction of aeroplane landing strips to facilitate aerial topdressing of the land.	5
12.	The planting of vines or trees on the land other than trees planted primarily and principally for the purposes of timber production.	10
13.	The construction on the land of fences, including the purchase of wire or wire netting for the purpose of making new or existing fences rabbit proof.	10
14.	The erection on the land of electric-power lines or telephone lines.	10
15.	The construction on the land of feeding platforms, feeding yards, plunge sheep dips, or self-feeding ensilage pits.	10
16.	The construction on the land of supporting frames for growing crops.	10
17.	The construction on the land of structures for shelter purposes	10

Standard Practice

When considering the effect of sections BD 2, DO 3 and DO 4 of the Income Tax Act 1994 on expenditure incurred in carrying on a farming or agricultural business, the Commissioner will apply the principles outlined in this statement.
The expenditure in a farming or agricultural business can range from normal farming outgoings (for example, rates, fertilising , petrol, feed, water and electricity) through to expenditure incurred as a result of constructing access roads, building dams, sowing land for the first time, and developing and preparing land, which involves activities such as leveling, contouring, grassing, land clearing and cultivation.

Relevant Legislation

Agricultural expenditure that is revenue in nature is deductible under the normal deductibility provisions (sections BD 2(1)(b)(i) and (ii)). Expenditure of this type will usually be expenditure that is incurred as part of the everyday agricultural business operation. Examples of such agricultural expenditures are feed for stock, water, electricity, maintenance of plant and machinery, fertilising and rates.
Expenditure which is capital in nature cannot be deducted under section BD 2(1) because of the general prohibition on capital expenditure set out in section BD 2(2). It may, however, give rise to depreciation deductions.
Agricultural expenditure that is capital in nature may be deductible if specified in sections DO 3 or DO 4. Examples of such expenditures are land preparation, development of land, fencing, constructing access roads and removal of timber. Some agricultural expenditures may instead be the subject of depreciation deductions under Part EG, by virtue of section BD 2(1)(a).
Where there is an overlap between sections DO3 and DO 4 in that some expenditures specified by section DO 4 are also specified under section DO 3, taxpayers have the choice of deducting the expenditure pursuant to either provision.
Agricultural expenditure that is capital in nature and not deductible under either sections DO 3 or DO 4 will not be deductible unless it qualifies for treatment under the depreciation provisions.

General Test: Capital v Revenue

The income tax treatment of the various types of agricultural expenditures is primarily dependent upon whether the agricultural expenditure in question is of a capital or revenue nature.
In order to determine the nature of a particular expenditure the following considerations will be taken into account by the Commissioner:
1. The character of the advantage sought (Whether an enduring benefit is obtained, whether an asset is gained):
  - Where no enduring benefit is obtained, no asset is produced or where the product from the expenditure will be consumed over the income year, the expenditure may be of a revenue nature;
  - Where an enduring benefit does arise or an asset is obtained, the expenditure points to being of a capital nature.
2. The manner in which the product of the expenditure is to be used (Whether it is to be used in a recurring manner):
  - The expenditure is likely to be revenue where the product from the expenditure is consumed in the business and will require regular outlay to obtain more;
  - The expenditure is likely to be capital where the product from the expenditure is used over a number of years and does not reoccur within an income year.
3. The means adopted to fund the expenditure (Whether the expenditure is funded from fixed or circulating capital, whether payment is periodic, one-off or spread over time):
  - Requirement of regular payments over the course of an income year or funding from circulating capital as it is turned over in the course of making a profit will likely point to a revenue nature;
  - A one-off payment or payment spread over a number of years funded from the business' fixed capital will likely indicate a capital nature.
4. Whether the expenditure is in relation to the profit-yielding structure or the process used to obtain regular returns:
  - The expenditure will likely be of a revenue nature where it is in relation to the agricultural business process to obtain regular returns;
  - The expenditure will likely be of a capital nature where it is in relation to the profit-yielding structure of the business.
All the considerations will be taken into account and balanced against each other in order to determine whether a particular agricultural expenditure is of a capital or revenue nature.

Applying the tests to expenditure on land conversion

The following test may also be used to determine the nature of a particular agricultural expenditure in addition to the capital/revenue considerations set out above:
1. Determine the subject matter of the work or the asset in relation to the expenditure in question; and
2. Consider the nature and extent of the expenditure (Is it substantial or extensive? Does the expenditure relate to the improvement of land as the site for carrying on the agricultural business?); and
3. Fact and degree (Is there a new asset? Is there substantial improvement? Does the expenditure produce something different, superior or enduring?).
Agricultural expenditure will be considered to be of a revenue nature where the subject matter of the work or the asset in question has not had substantial or extensive work done to it and does not result in the subject matter or asset being materially or substantially different. This would include expenditures such as periodic fertilizing, petrol, water, electricity and recurrent grassing.
Agricultural expenditure will be considered to be of a capital nature where the subject matter of the work or the asset in question has had substantial or extensive work done to it resulting in the subject matter or asset being materially or substantially different. Such agricultural expenditures would be expenditures such as conversion expenditure (which can include removal of fences and plants, cultivation and grassing in some cases), contouring, leveling and constructing dams.
There will be certain types of agricultural expenditures (for example, weeding, pest destruction or minor/part conversion of land) that will be harder to characterize definitively as being either capital or revenue. The character of the expenditure will depend on the facts of the particular case at hand and the overall result of the application of the capital/revenue considerations to it.
Where the agricultural expenditure in question is determined to be of a revenue or capital nature, it is of that nature in its entirety.

Discussion

All legislative references are to the Income Tax Act 1994 unless otherwise stated.

The income tax treatment of various agricultural expenditures

Deductibility of agricultural expenditure under the normal deductibility provisions – sections BD 2(1)(b)(i) and (ii)

Sections BD 2(1)(b)(i) and (ii)

In calculating income tax liability for any income year, a taxpayer is permitted to subtract from their gross income, any allowable deductions. An allowable deduction is defined in section BD 2 of which the main tests are set out in sections BD 2(1)(b)(i) and (ii) (normal deductibility provisions). A deduction is permitted to the extent that the expenditure or loss is incurred by the taxpayer in deriving gross income or is necessarily incurred in the carrying on of a business to produce gross income. Section BD 2(1)(b)(iii) refers to deductions allowed under separate parts of the legislation, which would include sections DO 3 and DO 4, discussed below.
Section BD 2(2) forbids a deduction to the extent that it is of a capital nature (unless it is expressly allowed under Parts D or E). Therefore, when considering whether expenditure is deductible under the normal deductibility provisions the capital/revenue distinction needs first to be considered even though in a number of instances a similar full deduction is available under section DO 3.
Outlined below are two approaches, one based on wide general principles and then one using an analogy, itself based on the same principles, relating to expenditure on repairs and maintenance.

Capital/Revenue distinction

General introduction (BP Australia)

To assist in the determination of the capital/revenue distinction, the courts have laid down a number of tests to be applied to the facts of each case. The leading case is the Privy Council's decision in BP Australia v F C of T ^[1] which held that each case will turn on its own facts, the tests that the courts have laid down assisting to characterize the transaction but no particular one will turn the decision one way or the other. Some may dominate the consideration but all have to be balanced against the others.

Sun Newspaper Ltd v FCT – Three matters to consider

In the case of Sun Newspapers Ltd and another v Federal Commissioner of Taxation ^[2] Dixon J in discussing the capital/revenue distinction states:

"There are, I think three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment".

As held in British Insulated and Helsby Cables Ltd v Atherton, ^[3] if the character of the advantage sought produces an enduring benefit for the business, it will in all probability point to the expenditure being of a capital nature.
The second test that Dixon J refers to ie, the manner in which it is to be used, reiterates the premise that the practical and business effects of the expenditure are paramount over any legal rights that might be obtained.
The third test ie, the means adopted to obtain it, works on the premise that if the benefit secured is of a revenue nature then there will generally be periodic payments over the period of the benefit. If there is one lump sum payment or payment is for a long period, then the nature of the benefit suggests capital. However, as was pointed out in BP Australia , this will not always hold true. Again, the facts of each case must be considered on its own.
A further test is whether the expenditure is funded from fixed or circulating capital. Fixed capital relates to fixed assets (for example, plant) which are employed in the business to create the opportunity for making profits or gains. Circulating capital relates to current assets (for example, stock) and is turned over in the course of making a profit and eventually comes back in your trading operations. Expenditure in relation to fixed capital is usually considered to be capital while expenditure on circulating capital is usually revenue.
A further consideration put forward in Sun Newspapers is the distinction between the business entity or structure or the profit yielding organization as opposed to the process by which it operates to obtain regular returns by means of regular outgoings or outlays. Expenditure incurred on the profit-yielding structure will usually be regarded as being of a capital nature. This principle will particularly apply to expenditure incurred in establishing, replacing, or enlarging the business structure. This can apply to significant restructuring of a farming or agricultural operation.

Adoption of principles in New Zealand

The New Zealand courts have followed the principles laid down in BP Australia with Commissioner of Inland Revenue v McKenzies Ltd ^[4] being a recent example. The Privy Council has reaffirmed the approach taken in BP Australia in Commissioner of Inland Revenue v Wattie.^[5]

Application of capital/revenue tests

The following factors will be taken into account when deciding whether expenditure incurred is of a capital or revenue nature:
1. The character of the advantage sought (Whether an enduring benefit is obtained, whether an asset is gained)
  - Where no enduring benefit is obtained, no asset is produced or where the product from the expenditure will be consumed over the income year, the expenditure points to being of a revenue nature;
  - Where an enduring benefit does arise or an asset is obtained, the expenditure points to being of a capital nature.
2. The manner in which the expenditure is to be used (Whether it is to be used in a recurring manner):
  - The expenditure is likely to be revenue where the product from the expenditure is consumed in the business and will require regular outlay to obtain more;
  - The expenditure is likely to be capital where the product from the expenditure is used over a number of years and does not reoccur within an income year.
3. The means adopted to obtain the expenditure (Whether the expenditure is funded from fixed or circulating capital, whether payment is periodic, one-off or spread over time):
  - Requirement of regular payments over the course of an income year or funding from circulating capital as it is turned over in the course of making a profit will likely point to a revenue nature;
  - A one-off payment or payment spread over a number of years funded from the business' fixed capital will likely indicate a capital nature.
4. Whether the expenditure is in relation to the profit-yielding structure or the process to obtain regular returns:
  - The expenditure will likely be of a revenue nature where it is in relation to the agricultural business process to obtain regular returns;
  - The expenditure will likely be of a capital nature where it is in relation to the profit-yielding structure of the business.
5. As part of normal farming operations, expenditures incurred such as the purchasing of feed, grassing pastures, buying fertilizer, purchasing stock food and purchasing petrol, will be of a revenue nature and therefore deductible under the normal deductibility provisions.
6. Other expenditures may be incurred in either setting up the business or developing it. Expenditure of this type is in relation to the infrastructure of the business and not to the process of obtaining regular returns. This type of expenditure will be considered to be of a capital nature and not deductible under section BD 2. Examples of these types of expenditures are purchasing of land, building farm structures, acquiring plant and machinery and initial preparation of land for a new activity.

Characterization of conversion expenditure

The types of activities involved in converting a farm to another type of farming operation may be contouring the land, fencing, cultivation and grassing, building of new structures, irrigation schemes and roading. The indicators that point towards this type of agricultural expenditure being of a capital nature are:
1. The character of the advantage sought: Substantial portions of the farming structure will be changed to enable the operation of the new type of farming. The business will be materially different to the previous one and an enduring benefit is obtained.
2. The manner in which it is to be used: The new structure will form the basis for the new farming operation. The change will presumably last over a number of years and a substantial amount of the expenditure will be one-off and will not reoccur in a periodical manner.
3. The means adopted to obtain it: Large amounts of expenditure for example, contouring the land and the building of new structures, will most likely be secured by making a one-off payment, most likely from a loan through a bank or finance company. The expenditure will be funded from fixed capital because it produces a business structure from which profits are made.
4. Profit-yielding structure/process: The expenditure is related to the profit-yielding structure, putting the business in a position to make profits rather than the process to obtain regular returns.
Where part of the farmland is developed, the same considerations will apply and it will depend on the facts whether the expenditures are in relation to the profit-yielding structure and are therefore capital or whether they are related to the process to obtain regular returns.
In relation to the question of land preparation expenditure and whether it is of a capital or revenue nature, Lord Johnston in Vallambrosa Rubber Co Ltd v Farmer (Surveyor of Taxes) ^[6], referring to the preparation of land for cultivating rubber trees states:

"For this purpose land had to be acquired, cleared and drained, roads made, and building erected, before the cultivation began. What was expended for these purposes was I think capital expenditure, and not, in the sense of the Income Tax Act, money laid out and expended for the purposes of the trade".

This supports the contention that any development costs, whether incurred when first starting a farm or changing its use, will be of a capital nature and not deductible under the normal deductibility provisions.
It is necessary to identify the asset in question (for example, the area of land to be used for the new type of farming) and to use the same tests as previously discussed, to determine the nature of the expenditure. Where the land use is changed materially from its former use, this suggests that the expenditure will be capital. If the change is only required to maintain current or past usage for example, regular fertilizing or grassing, it would tend to suggest revenue.

Repairs and maintenance

Introduction

As an alternate approach, the Commissioner has looked at the analogous situation of expenditure on repairs and maintenance (R&M) on assets, as opposed to acquiring a new one.
The R&M principles have been used by the Commissioner as a guide to the determination of the deductibility of agricultural expenditure because the process of determining whether work carried out on an asset is R&M or not, requires consideration of the capital/revenue distinction and a commonsense approach which looks at the subject on which work is carried out (and then a fact and degree determination of whether the work is substantial). The same is applicable to the determination of agricultural expenditure.
A series of relevant principles can be taken from the following cases.

Auckland Trotting Club v CIR

Auckland Trotting Club (Incorporated) v Commissioner of Inland Revenue ^[7] held that the first step to determining whether the expenditure in question is deductible R&M is to identify the asset in question. The next step is to determine the nature and extent of the activity.
Applying those principles, where the agricultural expenditure is fertilizing for instance, the asset in respect of which the expenditure is incurred is the land. Fertilizing the land is only one minor part of the overall workings of the land. Fertilizing the land does not materially change the land; it is merely replacing the previous fertilizer that was last applied to the land.
This is compared to conversion expenditure where although the asset is still the land, the asset is changed in its usage, (for example from sheep farming to dairy farming). If the expenditure is necessary to effect this change in use, it would not constitute revenue expenditure.

Mt Isa Mines v FCT (Improvement on land)

In Mount Isa Mines Limited v F C of T ^[8] and F C of T v Broken Hill Pty Co Ltd ^[9] it was held that where the expenditure incurred is in respect of land or the site on which the business is being carried out and is more than minor in nature, the expenditure is of a capital nature.
Where the agricultural expenditure is part of the normal farming operations for example, feed, grassing or petrol for farm vehicles, it would not be characterized as being capital in nature as it is not in respect of the farmland on which the farming business is being carried out nor is it more than minor in nature.
Expenditures such as contouring, the construction of access roads or conversion of use of the land, on the other hand would be capital in nature as they are for the improvement of the farmland on which the farming business is being carried out and are improvements that have an enduring character, and which require substantial work to be carried out. All parts of those expenditures including incidental grassing and fertilizing (which in other years may be revenue in nature) would be capital in nature.

Poverty Bay Electric v CIR and Auckland Gas (subject matter, nature and extent of work)

In the decisions of both Poverty Bay Electric Power Board v CIR ^[10] and CIR v Auckland Gas Company Limited ^[11] it was decided that where the original asset is replaced with another asset that although performing the same function, is newer, substantially superior, performs better, is of a different make up and requires substantial or extensive work, the expenditure in such a case would be unlikely to be classed as R&M.
Expenditures that are incurred for the conversion of farmland from one use to another as well as other agricultural expenditures that are not part of the farm's normal operations (for example, the building of dams or the erecting of power lines), would be non-deductible.
The expenditures would result in the land being materially and operationally different after taking into account all the improvements taken together as part of the project. The nature of the work involved with regards to those expenditures would require extensive work. Therefore, expenditure such as conversion of the farmland would be characterized as being capital in nature.
The same principle applies whether it is the whole or part of the farmland that is being converted.

Expenditure to be treated as a whole (capital or revenue)

The Commissioner has considered whether items in a normal year would be deductible such as grassing costs, should be treated as part of the capital conversion costs.
With regards to conversion expenditure, it may be argued that parts of the expenditure qualify as revenue expenditure as they would have been incurred as part of the normal farming operation. Conversion involves grassing, fertilizing, fencing, irrigation and other various activities.
As activities such as grassing are usually part of the normal farming operation it may be argued that the grassing expenditure is deductible albeit it was part of the larger conversion activity . Where the conversion expenditure is characterized as capital, the whole of the expenditure is capital and cannot be separated into parts which can be deductible and parts that cannot.
The Court of Appeal in Poverty Bay held that:

"…it is not possible to claim as expenditure on a repair a payment which has not actually been expended for that purpose. There cannot be a dissection of what is spent upon capital work because part of it might otherwise have been laid out on repairs, but was not".

The court adopted the reasonings in Margrett (HM Inspector of Taxes) v Lowestoff Water and Gas Co ^[12] and FC of T v Western Suburb Cinemas Ltd ^[13], particularly the words of Kitto J in the latter case:

"If a total expenditure is of a capital nature, so is every part of it; you cannot take a portion of the work done, such as the erection of a scaffolding and, closing your eyes to the purpose for which it was in fact erected, attribute to the cost of that portion an income nature for no better reason that that the same scaffolding would have been erected in order to serve a purpose which, if it had existed, would have made the total expenditure an income charge".

Where a project is held to be capital, it is of that character in total notwithstanding that certain parts of the project might have been undertaken as part of the normal business operations, or might be revenue if repeated in the future.
In Auckland Trotting , Richmond J stated that no part of the money spent on constructing the new trotting track was, in fact, spent on repairs and it was not possible to treat part of it as notionally spent on repairs when that is not what happened. In the case of conversion expenditure, it is not possible to treat part of the expenditure as notionally spent as revenue expenditure when that is not what happens.

Summary of R&M rules

The factors to take into account when determining whether an expenditure is R&M (hence revenue) can be summarized as follows:
1. Determine the subject matter of the work or the asset alleged to have been repaired;
2. Consider the nature and extent of the work (Is it substantial? Is it extensive? Does it relate to the improvement of land as the site for carrying on business?);
3. It is a question of fact and degree (Is there a new asset? Is there substantial improvement? Is it different, superior or enduring?).
Agricultural expenditure that is part of the normal farming operations such as periodic fertilizing, feed for stock, grassing and petrol would generally be classed as revenue expenditure as they do not require extensive or substantial work and do not result in the land being materially or substantially different, unless they are part of a larger capital project.
Agricultural expenditures such as conversion expenditure, sowing land for the first time, contouring, leveling or the construction of access roads would not be deductible under the normal deductibility provisions as they generally require substantial work and result in the land being substantially improved, materially different and arguably operationally superior. Moreover, improvement of the land as the site for carrying on of the farming business is classed as capital.
Certain agricultural expenditures are harder to class definitively as being either capital or revenue. Such expenditures could be weeding, pest destruction or minor/part conversion of land. The result will depend on the facts of the particular case at hand. Generally however, where there is part conversion of farmland, the expenditure would constitute capital expenditure given the nature and extent of the work required in such an undertaking.

(ii) Deductibility of agricultural expenditure under section DO3

Even if it is determined that the expenditure is of a capital nature and not deductible under the normal deductibility provision, it may nevertheless be deductible under sections DO 3 or DO 4.

Section DO 3

Section DO 3 permits a full deduction in relation to certain expenditures on land that is used for farming or agricultural business purposes. The expenditures that are deductible under section DO 3 would otherwise not be deductible were it not for it or section DO 4. In each case the expenditure must be incurred in carrying on a farming or agricultural business, however.

Types of agricultural expenditure deductible under section DO 3

Section DO 3 specifies the types of agricultural expenditure which are to be fully deductible to a person carrying on a farming or agricultural business. The specified expenditures are:
- The destruction of weeds or plants detrimental to the land.
- The destruction of animal pests detrimental to the land.
- The clearing, destruction, and removal of scrub, stumps, and undergrowth.
- The repair of flood or erosion damage.
- The planting and maintaining of trees for the purpose of preventing or combating erosion.
- The planting and maintaining of trees for the purpose of providing shelter.
- The construction on the land of fences for agricultural purposes, including the purchase of wire or wire netting for the purpose of making new or existing fences rabbit-proof.
In the conversion of farmland context, the removal of weed, scrub, and stumps and the construction of fences would be expenditures that are fully deductible under section DO 3. However, other similar costs (for example, the removal of existing fences) are not covered and must be considered under section DO 4.

(iii) Deductibility of agricultural expenditure under section DO 4

Section DO 4

It should be noted that where expenditure incurred in the planting of trees is not deductible under section DO 3 (by reason of not being for the purpose of providing shelter or combating erosion), it may nevertheless be deductible pursuant to section DO 7 subject to certain conditions.
Section DO 4 provides for the treatment of expenditure incurred by taxpayers on improvements made to land that is used for the benefit of their farming or agricultural businesses. The criteria apply whether the taxpayer owns the land (section DO 4(1)) or leases the land (section DO 4(2)). It permits a deduction for the types of expenditure specified in Part A of Schedule 7 that have been incurred in "preparing or developing" the land.
Unlike section DO 3, which permits a full deduction, section DO 4 provides for an amortisation-like deduction by allowing a certain percentage of diminished value of expenditure in each year.

Types of agricultural expenditures deductible under section DO 4

The types of expenditure on land improvements used for agricultural purposes that are permitted the amortisation-like deduction are specified in Part A of Schedule 7. An example is the preparation of the land for farming or agriculture including cultivating and grassing and the draining of swamp or low-lying lands. Hence such expenditure, even if treated as capital, remains deductible under section DO 4.
Expenses in relation to the improvement of land used for farming or agricultural purposes that are capital in nature are permitted an amortisation-like deduction if they are specified in Part A of Schedule 7.

The relationship between sections DO 3 and DO 4

Introduction

A comparison of the types of expenditures that are specified by sections DO 3 and DO 4 reveal that there are overlaps in that a number of the expenditures specified by section DO 4 are also specified in section DO 3. Examples of the overlap are the repair of flood or erosion damage and the destruction of animal pests detrimental to the land. The Commissioner has considered the issue of which provision takes priority where there is an overlap.

Purposes of sections DO 3 and DO 4

The common theme arising out of both the provisions' purposes is to permit certain agricultural expenditures that are capital in nature to be deductible where they otherwise would not be under the normal deductibility provisions.
Section DO 3 permits a full deduction for certain agricultural expenditures whereas section DO 4 provides an amortisation–like deduction for agricultural expenditures that are in relation to land development and preparation.

Difference in wording of provisions

Section DO 4 applies to preparation or developmental expenditure. It does not specifically exclude agricultural expenditures from being deductible under section DO 3. Section DO 3 provides for a specified expenditure to be deductible that "is not deductible otherwise than under this section or under section DO 4". On the wordings of the provision, it can be said that some overlap was contemplated and that where there is an overlap, it allows the taxpayer to make a choice as to which provision to apply to deduct the expenditure in question.

Conclusion

Where there is an overlap, taxpayers have the choice of deducting the particular agricultural expenditure either under section DO 3 or DO 4.

"Preparing or otherwise developing land"

That term is broad and may encompass many facets. The Concise Oxford Dictionary (10th edition) ^[14] defines "prepare" as "make ready for use or consideration".^[15]
The term "develop" is defined as "grow or cause to grow and become larger or more advanced; convert (land) to a new purpose".^[16]
Using the definitions, the term "preparing or otherwise developing land" means getting the land ready to be able to farm it including changing the land from one state to a new and improved state (for example, conversion of land from sheep to dairy farming). The amount of preparation versus development will vary from case to case.
In the case of virgin land, not previously used for farming, substantial preparation would be required before it could be farmed. Some development would also be required for example, construction of buildings. In the case of converting an existing farm from one use to another (for example, sheep to dairy farming), the amount of development would most likely be greater than actual preparation.
In reality, the two terms are used interchangeably and the income tax treatment of the expenses incurred in either undertaking land preparation or land development is the same.

Income tax treatment of "preparing and otherwise developing land"

Normal deductibility provisions

Expenditure incurred in preparing and otherwise developing land from one use to another is of a capital nature and not deductible under the normal deductibility provisions.
This holds true notwithstanding that some of the expenditure incurred is in relation to items that in the normal course of business operations, would be considered to be revenue and therefore deductible. Once the nature of the project is classified as capital, all the expenditure within are considered to be capital.

Sections DO 3 and DO 4

Although expenditure incurred in preparing and otherwise developing land is capital in nature, the expenditure may still be deductible under sections DO 3 or DO 4.
Section DO 4 allows a deduction with regards to the types of expenditures specified in Part A of Schedule 7 that were incurred by the taxpayer in preparing or otherwise developing land. Clause 4 of the schedule specifically allows a deduction for "the preparation of the land for farming or agriculture, including cultivation and grassing, but excluding expenditure incurred in respect of any of the items specified in clause 2". Clause 2 refers to the felling, clearing, destruction and removal of timber, stumps, scrub or undergrowth on the land.
If as part of preparing the land the taxpayer incurs expenditure in relation to the removal of timber, for instance, then the deduction under section DO 4 in relation to the removal will be pursuant to clause 2 of the schedule and not clause 4.
A number of other items are specified in the schedule and depending on the facts of each case, some or all of the expenditure incurred may be deductible under section DO 4. If construction of fences is involved in preparing and otherwise developing of land the deduction for the fence construction under section DO 4 will be made pursuant to clause 13 of Schedule 7.
Items of expenditure incurred in preparing and otherwise developing land for agricultural purposes may be fully deductible under section DO 3. The range of items included in section DO 3 is not as comprehensive as those specified in Schedule 7 and some items are deductible under both sections DO 3 and DO 4.
Taxpayers have the choice of deducting the particular agricultural expenditure under either sections DO 3 or DO 4 where there is an overlap

Miscellaneous

Farmers that are in the business of forestry should not look to sections DO 3 or DO 4. Instead, section DL 2 or the general deductibility provision of BD 2 should be considered for the deduction of forestry expenditure.
Sometimes taxpayers incur agricultural expenditure on farm land that they own but let to farmers that carry on a farming or agricultural business on the land. The owners of the land may be allowed deductions in respect of expenditure specified in sections DO 3 or DZ 3 by virtue of section DO 6 provided that the deductions would have been allowed to the owners had they personally carried on a farming or agricultural business on the land during the term of the lease. The types of deductions permitted do not extend to those allowed under section DO 4.

Case examples

Case example one

Scenario

Joe Smith is a sheep farmer in North-Canterbury. The time has come for Joe to re-sow and re-fertilize his paddocks, activities that he undertakes regularly. Joe uses the same type of grass seed and fertilizer every time.

Tax consequence

Inland Revenue considers the expenditure (sowing and fertilizing) to be revenue in nature as they are incurred regularly as part of the farm's normal operations and hence fully deductible.

Case example two

Scenario

Blossom Kahu is a sheep farmer in Hawkes Bay . She normally undertakes regular re-sowing and re-fertilizing but due to drought conditions in recent times she has not been able to afford regular application of fertilizer or re-sowing of grass. As a result, the farm has deteriorated and production has gone down.

Blossom comes into significant money after her aunt Myrtle left her $500,000. As a result, she is now able to afford fertilizer application and re-sowing that she had let slip in the previous years due to the drought. Fertilizer application increases ten-fold to bring the farm back to its normal productivity level. Contractors are also brought in to plough and sow new grass.

Blossom also decides that given droughts appear to have become more frequent over recent times she will need to install some sort of irrigation. She installs a new irrigation system which provides irrigation to one-third of the property thus being able to maintain a viable economic unit and production.

As a result of the significant fertilizing and grassing, the farm's production has increased.

Tax consequences

Fertilizing and grassing – Inland Revenue considers the fertilizing and grassing expenditures to be revenue in nature as although of a significant level, they are incurred to bring the farm back to its normal former productivity state. The expenditure is also incurred as part of the farm's normal operation albeit deferred. Hence the fertilizing and grassing expenditure are fully deductible under the normal deductibility provisions.

Irrigation – This expenditure would be considered to be capital in nature as it is not a recurring expense and brings into existence an enduring asset (irrigation unit). It is not deductible under the normal deductibility provisions. However, it is deductible under section DO 4.

Case example three

Scenario

Jane, a farmer owns 300 hectares of land, which she uses for sheep farming. Due to better financial prospects from dairying, Jane has recently decided to convert 150 hectares of her land to dairy farming.

To do so will require removal of the existing fence on the 150 hectares and the erection of suitable fencing for dairy farming (to allow irrigation systems), demolition of old buildings (necessary for running the dairy cattle on), building a cow shed, border dyking, contouring, grassing and fertilizing.

At the same time, Jane has decided to regrass the remaining 150 hectares of sheep farm as the regular grassing activity that Jane undertakes is due.

Tax consequences

Inland Revenue considers the two activities to be distinct and separate from each other. Inland Revenue considers the whole of the expenditure associated with the 150 hectares (being a separate identifiable asset) to be capital in nature as a new enduring asset has been created as a result of the expenditure , in effect a new business structure. Although the expenditure is not deductible under the normal deductibility provision, the majority of it is deductible under section DO 3 and/or DO 4.

Therefore the fencing would be fully deductible under section DO 3; the border dyking, contouring, grassing (for the 150 hectares) and fertilizing would be deductible in the amortisation-like manner pursuant to section DO 4; and the cow shed not deductible under either provision, but depreciable. There is no deduction allowed either for a loss incurred on the demolition of the old buildings or for the expenses involved in the demolition.

Inland Revenue considers the grassing expenditure on the 150 hectares of sheep farm to be revenue in nature as it is an expenditure that is incurred regularly as part of the farm's normal operations and hence fully deductible.

Case example four

Scenario

Jake, a sheep farmer, decides to change his farming operations to dairy farming. To do so will require substantial and extensive development such as building a cow shed, border dyking, contouring, erecting suitable fences, clearing timber, regrassing, irrigation and fertilizing.

Tax consequence

Inland Revenue considers the whole of the expenditure to be capital in nature and not deductible under section BD 2(1)(b)(ii). The expenditure resulted in major work undertaken to materially and substantially change the existing farm (ie. from sheep to dairy) and brought into existence a different enduring asset (ie. the farm asset). Although the expenditure is not deductible under the normal deductibility provision, it is deductible under section DO 3 and/or DO 4.

Therefore, the fencing would be fully deductible under section DO 3; the border dyking, grassing, fertilizing, contouring, irrigation and timber clearing would be deducted in an amortisation-like manner under section DO 4; and the cow sheds not deductible under either provisions,- but depreciable.

Case example five

Scenario

The Merino Trust is in the business of renting land and buildings. The trust leases one of its farm properties to a farming partnership, made up of Jack and Jill. The partnership uses the land for dairy farming. The trust incurs developmental expenditure for the land in getting it ready so that it can be leased out as a dairy farm.

Tax consequence

Inland Revenue considers that the Merino Trust is not able to claim a deduction under section DO 4 for the developmental expenditure given that it does not carry on a farming or agricultural business even though it does own the land. The farming partnership in the scenario would not be able to claim a deduction for the developmental expenditure either as although it carries on a farming business, it did not incur the expenditure for the benefit of its dairy farming business. Therefore, in this scenario, neither the Merino Trust nor the farming partnership would be able to claim the depreciation-like deduction for the developmental expenditure incurred. However, the lessor may be able to qualify for a deduction of the expenditures covered in section DO 3 by virtue of section DO 6 provided that the deductions would have been allowed had the lessor personally carried on a farming business on the land during the term of the lease.

This Operational Statement was signed by me on 5 July 2004

Graham Tubb
National Manager (acting)
Technical Standards

[1] [1965] All ER 209
[2] (1938) 61 CLR 337
[3] [1926] AC 205, 213 (HL)
[4] (1988) 10 NZTC 5,233
[5] 18 NZTC 13,991
[6] (1910) SC 519; 5 TC 529
[7] [1968] NZLR 967
[8] 92 ATC 4755
[9] (1968) 15 ATD 43
[10] (1999) 19 NZTC 15,001
[11] (1999) 19 NZTC 15,011
[12] (1935) 19 TC 481 at pp 488-489
[13] (1952) 86 CLR 102 at pp 107-109
[14] Concise Oxford Dictionary (Tenth edition, revised) (Oxford University Press; 2001, New York)
[15] Ibid.
[16] Ibid.

Other pages in: Operational statements

Date published: 25 May 2006

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Technical tax area: Operational statements