A special report by the Policy Advice Division of Inland Revenue
16 August 2004
Business environmental expenditure - more on the proposed changes
The government announced in a statement on 4 August 2004 that it would introduce legislation to clarify and amend the tax treatment of environmental expenditure. The changes would ensure that all business costs, including those for dealing with environmental problems, are taken into consideration in calculating taxable income, and that the timing of such deductions is appropriate. Since the announcement, there have been several requests for details on how the new legislation would work. This special report details the proposed changes.
At present, there is a great deal of uncertainty in law regarding the existing scope of tax deductions available for environmental expenditure (such as expenditure to prevent, remedy or mitigate the discharge of contaminants). It appears that some environmental costs are not deductible. This results in the incorrect calculation and taxation of income from business activities, and thus can penalise socially and economically desirable types of expenditure.
Tax policy officials have reviewed the tax treatment of environmental costs and undertaken targeted consultation with interested parties in order to develop proposals for clarifying and improving the rules. The parties consulted have been supportive of changes to clarify the scope of deductions for environmental expenditure and to provide a matching mechanism for restoration costs.
The government subsequently announced that the rules for environmental expenditure will be clarified and expanded by:
- specifying categories of qualifying environmental expenditure (including restoration) and default amortisation rates;
- giving the Commissioner of the Inland Revenue the power to issue special amortisation rates for certain categories of environmental expenditure;
- removing the current distinction between industrial and non-industrial waste; and
- introducing a matching mechanism so that site restoration and monitoring costs can be matched against prior business income.
The changes will be included in the taxation bill scheduled for introduction in November 2004.
Background to the current treatment
Business taxpayers are currently able to claim a tax deduction for environmental expenditure in three ways:[1]
- a deduction for normal operating (revenue) expenditure;
- a deduction under the depreciation rules [2] for certain types of capital expenditure, such as tanks, reservoirs, pipes, pumping machinery and screens; and
- a deduction under section DJ 10 of the Income Tax Act 1994 for other capital environmental expenditure.
Section DJ 10 was introduced to permit business taxpayers a deduction for expenditure incurred for the purpose of treating industrial waste when no other allowance might otherwise be possible. It allows business taxpayers to claim a deduction for the cost of constructing, on land, any earthworks, ponds, settling tanks or similar, primarily for the purpose of treating industrial waste to prevent or combat pollution of the environment. When a deduction is available, it must be spread evenly over five years, beginning with the year in which the expenditure was incurred.
Despite the existence of a specific section to provide for deductions of this nature, there are certain environmental costs which are not currently deductible - such as costs incurred in dealing with non-industrial waste and restoration costs.
The wording of the current section appears to have resulted from the fact that, at the time of its introduction, landfills were operated by local councils, who were outside the tax net. Therefore no consideration was given to whether deductions should be allowed for the disposal of non-industrial waste. Similarly, the section also pre-dates the Resource Management Act 1991. Therefore section DJ 10 does not provide a deduction for costs incurred in complying with new health and environmental standards, such as site restoration. The inability to claim tax deductions for dealing with non-industrial waste and site restoration costs results in the incorrect calculation and taxation of income from business activities.
Because the current tax treatment of environmental expenditure results in the incorrect taxation of business income, there have been a number of calls for a change to the current rules. As a result, tax policy officials have reviewed the current tax treatment of environmental expenditure, an exercise which has included some targeted consultation. The review has resulted in a number of proposals for legislative change.
The proposed changes
Clarifying the scope of deductions
To clarify the scope of deductions available for environmental expenditure, section DJ 10 of the Income Tax Act 1994 will be revised so that it sets out categories of deductible expenditure and the rate at which a deduction is available. Although policy officials are continuing to consult with interested parties on the proposed rates and categories, they are expected to be, broadly, as follows
| General description of expenditure | Amortisation rate |
|---|---|
| Testing and feasibility expenditure - Expenditure incurred in testing and determining the feasibility of different options for preventing, remedying or mitigating the discharge of contaminants until the time the taxpayer commits to one particular option. | 100% |
| Construction/improvement expenditure - Expenditure incurred in the construction on land in New Zealand of earthworks, ponds, settling tanks, or other similar improvements for preventing, remedying or mitigating the discharge of contaminants. This category of expenditure will also need to deal with environmental solutions such as riparian planting. | A default amortisation rate based on the lesser of 35 years (1/35) or the length of the applicable resource consent granted (1/life of resource consent). |
| Restoration expenditure - Expenditure incurred in remedying the effects of contaminants. | 100% |
| Monitoring expenditure - Expenditure incurred in monitoring the effects of contaminants or other environmental solutions. | 100% |
Inland Revenue power to issue rates
While, in general, the length of a consent is considered to be a good approximation of the economic life of environmental expenditure, there may be situations where this is not the case. It has therefore been agreed that the Commissioner of Inland Revenue will be given the power to set amortisation rates for individual categories of environmental expenditure. In determining the appropriate amortisation rate, the Commissioner will have regard to the fact that for environmental expenditure, estimated useful life for tax purposes may be less than physical life. Estimated useful life may also be less than the life of the applicable resource consent.
Removing the distinction between industrial and non-industrial waste
In setting categories of expenditure and amortisation rates, the aim is to ensure tax deductions are available for all environmental expenditure, no matter what the source of the contaminant. The intention is not to create incentives for taxpayers to select one environmental solution over another.
Therefore, the current section DJ 10 will be amended to remove the word "industrial". This change is likely to be retrospective, to protect taxpayers who have taken a wide interpretation of the term "industrial waste".
Post-cessation restoration and monitoring costs
Even when site restoration and monitoring expenditure is deductible this is of little use when incurred after a company has ceased business. When a taxpayer ceases business, it may incur tax-deductible expenditure but have no income to offset that expenditure. In such a situation, no benefit is obtained for the resulting tax loss, even though the taxpayer may have paid significant amounts of tax in the past. Under existing law, taxpayers cannot match these deductions against income derived while carrying on the business.
Matching income and deductions could be achieved by allowing a tax deduction for accounting restoration provisions. However, allowing a deduction for an estimate of restoration and monitoring costs would open up the tax rules to manipulation and would contradict the established taxation treatment of provisions.
Other jurisdictions deal with this issue by allowing businesses to calculate a terminal loss on cessation of trade. The terminal loss may then be offset against earlier profits of that entity. The introduction of a loss carry-back is not supported because it is inconsistent with the general structure of New Zealand's tax system. It would also have significant operational issues for both taxpayers and Inland Revenue. For example, it would be necessary to amend and reassess earlier tax returns.
Instead, taxpayers will be allowed to establish a restoration fund with Inland Revenue. The establishment of a restoration fund would be voluntary. Over the life of a business (if the discharge of contaminants is resulting from operations) a cash deposit equivalent to the tax effect of the accounting restoration provision could be made into the fund. This deposit would give rise to a tax deduction so that the taxpayer's cash position is unchanged. Interest would also be paid on deposits at the same rate as that applying to income equalisation scheme deposits (3% per annum).
On cessation of business, the taxpayer would be entitled to a refund from the restoration fund. This refund would give rise to taxable income which would be offset by tax deductions for restoration and monitoring expenditure. The restoration fund would achieve matching of expenses and income but would provide controls around the level of deduction available.
To spread the cost of implementing the proposal, taxpayers will be required to spread initial deductions from establishing a restoration fund over at least five years. This recognises that the majority of these costs relate to deferred restoration deductions.
Application dates
It is proposed that the amendments to section DJ 10 (including the establishment of a restoration fund) apply for income years beginning and environmental expenditure incurred after the date the amending legislation is enacted.
The removal of the distinction between industrial and non-industrial waste is likely to be retrospective, however, to protect taxpayers who have taken a wide interpretation of the term "industrial waste" (either in filing their tax returns or in raising a dispute with Inland Revenue). Taxpayers who have not taken a wide interpretation of the legislation should not be able to take advantage of the retrospective change.
[1] The review of environmental costs focused on the treatment of these costs generally and did not consider industry-specific provisions (such as for mineral and petroleum mining).
[2] A recent officials' issues paper, "Repairs and maintenance to the tax depreciation rules", looks at a number of depreciation issues, including the treatment of environmental expenditure, and suggests possible changes to the rules. Submissions on the paper close on 31 August.