New Rules for Business Environmental Expenditure

Sections CB 6B, CB 24B, CX 43B, DB 16, DB 37, DP 10, DQ 4, EK 1 - EK 23, Schedule 6B and a number of definitions in section OB 1 of the Income Tax Act 2004, section DJ 10 of the Income Tax Act 1994 and sections 36BC and 91AAN of the Tax Administration Act 1994

The rules covering tax deductions for business environmental expenditure to avoid, remedy or mitigate the discharge of contaminants have been clarified and expanded by:

• specifying categories of qualifying environmental expenditure and default deduction rates;
• giving the Commissioner the power to issue rates for other categories of environmental expenditure;
• removing the current distinction between industrial and non-industrial waste; and
• introducing a mechanism so that site restoration and monitoring costs can be matched against prior business income.

Background

These changes have been made to ensure that all business operating costs, including those for dealing with environmental concerns, are taken into consideration in calculating taxable income, and that the timing of such deductions is appropriate. The changes counter uncertainty regarding the scope of tax deductions available for environmental expenditure.

Previously, business taxpayers could claim a tax deduction for environmental expenditure in three ways: ¹

• a deduction for normal operating (revenue) expenditure;
• a deduction under the tax depreciation rules for certain types of capital expenditure, such as tanks, reservoirs, pipes, pumping machinery and screens; and
• a deduction under section DB 37 (DJ 10) for other capital environmental expenditure.

Under the previous rules, section DJ 10 permitted business taxpayers a deduction for expenditure incurred for the purpose of treating industrial waste when no other allowance was available. It allowed business taxpayers to claim a deduction for the cost of constructing on land in New Zealand any earthworks, ponds, settling tanks, or other similar improvements primarily for the purpose of treating industrial waste to prevent or combat pollution of the environment. When a deduction was available, it was 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 environmental costs, there were certain expenses which were arguably not deductible. Section DJ 10 pre-dated the Resource Management Act 1991, so did not clearly provide a deduction for costs incurred in complying with new health and environmental standards. It was also unclear what was covered by the term "industrial waste". The uncertainty around the meaning of "industrial waste" and ability to claim tax deductions for site restoration resulted in the incorrect calculation and taxation of income from business activities.

There were also problems in matching business income and tax deductions for environmental costs incurred on or after the cessation of business. Even if a tax deduction was permitted it was likely to give rise to a tax loss of limited value. In determining the tax liability of a business, future restoration liabilities were not taken into account.

Key features

A number of changes have been made to the tax rules to counter the problems identified with the tax treatment of business environmental expenditure.

Default expenditure categories and deduction rates

Section DB 37 along with Schedule 6B set out categories of deductible environmental expenditure and the rate at which a deduction is available to business taxpayers. The schedule of deductible environmental expenditure is based around the following four categories of costs:

General description of expenditure	Rate
Testing and feasibility expenditure	100%
Construction/improvement expenditure	Default 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	100%
Monitoring expenditure	100%

Category-specific deduction rates

Where the default deduction rates do not result in the correct calculation and taxation of income from business activities, a business can apply to Inland Revenue for a category-specific rate.

Environmental restoration account (ERA)

A mechanism has been introduced so that site restoration and monitoring costs can be matched against prior business income. Operators of a business can make cash deposits into an ERA equivalent to the tax effect of their accounting restoration provision. This deposit will give rise to a tax deduction so that the business's cash position is unchanged. Interest will be paid on deposits at 3% per annum.

Business taxpayers can obtain a refund from the account if they incur restoration and monitoring expenditure or if the anticipated liability for restoration (as shown by their audited financial statements) decreases. This refund will give rise to taxable income which will be offset by tax deductions for restoration and monitoring expenditure. This is consistent with the objective of matching restoration and monitoring costs against prior business income.

If a business transfers their liability for site restoration or environmental monitoring (for example, on the sale of a site, death, liquidation or bankruptcy) the balance of the restoration account will be transferred to the new taxpayer, if they can be identified, or otherwise to the Ministry for the Environment.

Clarifying the meaning of "industrial waste"

Sections DB 37 (2004 Act) and DJ 10 (1994 Act) have been amended retrospectively to remove the word "industrial". This eliminates the previous distinction between industrial and non-industrial waste.

Application dates

The majority of amendments apply for income years beginning on and environmental expenditure incurred after 10 June 2005 . However, the removal of the distinction between industrial and non-industrial waste is retrospective to the 1995-96 income year. This protects businesses 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. Businesses who have not taken a wide interpretation of the legislation will not be able to take advantage of the retrospective change.

Detailed analysis

Default expenditure categories and amortisation rates

Section DB 37 along with Schedule 6B set out categories of deductible environmental expenditure and the rate at which a deduction is available to business taxpayers.

Taxpayers are now able to claim a tax deduction for environmental expenditure under section DB 37 if:

• they carry on business in New Zealand;
• they incur, as part of that business, or in ending the operations of the business, expenditure listed in Schedule 6B;
• the expenditure is not listed in Part C of Schedule 6B (land reclamation expenditure, non-environmental dredging expenditure or expenditure related to the acquisition of land);
• the expenditure is not incurred in relation to revenue account property (other than land that is subject to a section CB 6B election); and
• no other provision allows a tax deduction for the expenditure.

Farming businesses are included in these provisions so that when the specific agricultural provisions do not provide for an environmental tax deduction, farmers can now rely on section DB 37.

The default categories of expenditure in Schedule 6B are:

Expenditure in avoiding, remedying, or mitigating detrimental effects of discharge of contaminant

Part A - Expenditure relating to activity or improvement to land

General description of expenditure		Rate
1	Expenditure on investigating and testing locations and methods before a decision is made to use a location or method for an activity or improvement that is intended to avoid, remedy, or mitigate future detrimental effects on the environment from the discharge of a contaminant.	100%
2	Expenditure, in the construction of an improvement on land in New Zealand, incurred in order to avoid or mitigate future detrimental effects on the environment from the discharge of a contaminant.	Lesser of 1/35 or 1/consent period
3	Expenditure on screen planting on land in New Zealand incurred in association with the construction of an improvement to the land that is intended to avoid, or mitigate future detrimental effects on the environment from the discharge of a contaminant.	Lesser of 1/35 or 1/consent period
4	Expenditure on riparian planting on land in New Zealand incurred in order to avoid or mitigate future detrimental effects on the environment from the discharge of a contaminant.	Lesser of 1/35 or 1/consent period
5	Expenditure on an activity that is intended to avoid or mitigate the future discharge of a contaminant.	Lesser of 1/35 or 1/consent period

 

Part B - Expenditure relating to monitoring, remedies, and mitigation

1	Expenditure related to monitoring the discharge of a contaminant.	100%
2	Expenditure related to monitoring detrimental effects on the environment from the discharge of a contaminant.	100%
3	Expenditure incurred after the discharge of a contaminant, on avoiding, remedying, or mitigating detrimental effects on the environment from the discharged contaminant.	100%
4	Expenditure, incurred after the discharge of a contaminant, on removing an improvement to land in New Zealand for the purpose of avoiding, remedying, or mitigating detrimental effects on the environment from the discharged contaminant.	100%
5	Expenditure, incurred after the discharge of a contaminant, on the installation of impermeable surfaces on land in New Zealand with the purpose of avoiding, remedying, or mitigating detrimental effects on the environment from the discharged contaminant.	100%
6	Expenditure, incurred after the discharge of a contaminant, on replanting land in New Zealand in association with expenditure to avoid, remedy, or mitigate detrimental effects on the environment from the discharged contaminant.	100%
7	Expenditure, incurred in the cessation of a business, on disposing of a stored substance that is a potential contaminant in a way that avoids detrimental effects on the environment.	100%

 

Part C - Excluded expenditure

1	Expenditure related to land reclamation.
2	Expenditure relating to dredging, other than dredging for the principal purpose of remedying or mitigating detrimental effects on the environment from a discharged contaminant.
3	Expenditure related to the acquisition of land.

To avoid the uncertainty surrounding the definition of industrial waste, section OB 1 now contains a definition of "contaminant". The definition is linked to section 2(1) of the Resource Management Act 1991 and an item can still be a contaminant even if it is never discharged into the environment.

Businesses planning to take advantage of these changes to secure tax deductions for the investigation, remediation and aftercare of contaminated land should refer to the best practices for management of contaminated land set out in the Ministry for the Environment's Contaminated Land Guidelines series and, in particular, the minimum reporting standards in Guideline Number 1 of that series.

 

Amount and timing of deduction

Section DB 37 sets out the amount of the tax deduction and when this can be claimed. The amount of the deduction for an income year is calculated by multiplying the value of the expenditure by the applicable rate.

The default rates are 100% for testing and feasibility, restoration and monitoring expenditure (listed in Schedule 6B, Part A, item 1 and Part B) and based on the lesser of 35 years or the length of the applicable resource consent for construction and improvement expenditure.

The formula for calculating the rate for construction and improvement expenditure is set out in section DB 37(7). Businesses can opt for either a straight-line or diminishing value deduction by adjusting the rate accordingly. The rate is 100% divided by the assumed life of the environmental expenditure and rounded to the nearest rate listed in Schedule 11. For expenditure that does not require a resource consent the assumed life is
35 years. For expenditure that requires a resource consent, the assumed life is the lesser of 35 years and the number of years remaining in the resource consent period at the time the expenditure is incurred.

Businesses can also obtain a rate for specific categories of environmental expenditure by applying for a determination from the Commissioner (section DB 37(4)(c)).

Section DB 37 also provides for the destruction of an environmental improvement or closure of a business. In these situations, a business can claim the remaining unamortised balance of the expenditure.

The definition of diminished value has been amended to take into account the new environmental expenditure rules. For environmental improvements, diminished value is calculated by taking the amount of environmental expenditure as described in section DB 37, adding any claw-back income under section CB 24B(8) and deducting any environmental tax deductions previously claimed.

Claw-back

While the default deduction rate for environmental construction and improvement expenditure is based on the life of the applicable resource consent, there is a claw-back mechanism in section CB 24B. This is intended to prevent businesses from manipulating the period of their resource consent for the purpose of obtaining a faster tax deduction.

Where a business has claimed a tax deduction based on the period of a resource consent and then substantially altered the period of that consent (consent period is extended or renewed by more than 50%) the taxpayer will be required to calculate tax deductions based on the default rate of 35 years. Any difference between the deductions claimed to date will be clawed back as taxable income in the year that the consent is altered.

Other changes

A tax deduction for restoration expenditure will not always equate to the loss in land value from contamination but in the majority of circumstances it provides a practical solution. However, landfill operators are likely to suffer a complete loss in land value no matter how much is spent on site restoration. The new environmental tax rules therefore allow taxpayers who acquire and use land for the purpose of constructing and operating a landfill to file a revenue account property election under section CB 6B. This ensures a tax deduction is available for the cost of land used for a landfill.

The section CB 6B election must be made before
24 June 2006 or 12 months after the date of acquisition (whichever is the latest). To ensure a consistent treatment, all of a business's landfill sites and those of any associated parties also need to be subject to the same election. Any consideration received on the disposal of the landfill property will also be taxable income of the business under section CB 6B.

Sections DB 16 (amounts paid for non-compliance and change in use) and DP 10 (cost of timber) have been amended to ensure that section DB 37 remains the section of last resort for deducting environmental expenditure.

Category-specific deduction rates

Where the default deduction rates will not result in the correct calculation and taxation of income, a business is able to apply to Inland Revenue under section 91AAN of the Tax Administration Act 1994 for a category-specific deduction rate.

The Commissioner may determine that a person, group or class of persons is to use a particular diminishing value or straight-line rate listed in Schedule 11 for certain types of environmental expenditure.

In making the determination, the Commissioner may consider a number of factors including:

• the length of time that the expenditure is expected to be effective for its intended purpose;
• the length of time that the expenditure is expected to earn income;
• the accounting treatment (including depreciation method);
• the period of any associated resource consent; and
• a valuer's estimate.

The Commissioner may decline to issue a determination if the information supplied in support of the determination request is insufficient or if the proposed rate does not differ sufficiently from the existing rate.

Within 30 days of issuing a determination the Commissioner must give notice of the determination to the applicants and publish a notice in the New Zealand Gazette stating where copies of the determination can be obtained. A business affected by a determination may dispute or challenge the determination under Parts 4A
and 8A.

Environmental Restoration Account

The new environmental tax rules introduce a matching mechanism so that site restoration and monitoring costs can be matched against prior business income.

Section EK 1 establishes a Crown Bank Account called the Environmental Restoration Funds Account (referred to as an ERA in subpart EK) into which businesses can
make payments towards their restoration and environmental monitoring liabilities.

Section EK 4 requires the Commissioner to keep an ERA in the name of every business who makes a qualifying payment. Every payment made under section EK 2 must be entered in that person's ERA.

Amounts entered into a business's ERA may not be removed except by way of refund under sections EK 9 or EK 12 or by way of transfer. However, the Commissioner is allowed to close an ERA if the balance of the account is zero.

Payments to an ERA

Under section EK 2, to be eligible to make payments to an ERA, a taxpayer must carry on business in New Zealand and expect to incur future expenditure that:

• is listed in Part B of Schedule 6B (monitoring and restoration expenditure);
• is not listed in Part C of Schedule 6B (land reclamation, non-environmental dredging and land acquisition costs); and
• is not on revenue account property (other than where section CB 6B applies).

The business must also make a provision for such expenditure in its audited financial statements.

Section EK 3 deals with the size of payments to an ERA.

The minimum payment level is $1,000. A business's maximum payment is defined in section EK 22 as the lesser of:

• the amount by which the maximum account balance exceeds the ERA balance at the end of the income year; and
• the amount permitted as a deposit under the initial five-year spreading mechanism.

A business's maximum account balance (defined in section EK 23) is:

• zero, if the person does not satisfy section EK 2; or
• an amount calculated by multiplying the level of their accounting restoration provision by the applicable tax rate.

The spreading mechanism is a transitional measure intended to reduce the cost of allowing payments for historic restoration liabilities. After the initial five-year period taxpayers will be able to make payments up to the (tax effected) level of their accounting restoration provision.

Under the spreading mechanism, the maximum payment for the 2005-06 to the 2010-11 income years is calculated as follows:

Level increase plus (year times 0.2 times initial level) minus contents

• "Level increase" is the greater of zero or the amount by which the maximum account balance exceeds that for the 2005-06 income year.
• "Year" is 1 for the 2005-06 income year and increases by 1 for each successive income year. This allows a "catch-up" if no deposit is made for the 2005-06 income year.
• "Initial level" is the maximum account balance for the 2005-06 income year.
• "Contents" is the amount of the ERA at the end of the income year

A business is allowed a tax deduction under section DQ 4 for a payment to an ERA. The amount of the deduction is calculated by dividing the amount of the payment by the applicable tax rate (section EK 7). The applicable tax rate is the highest rate of income tax that is stated in Schedule 1 which could apply to the business. The deduction is allowed for the income year for which the payment is made. Section EK 3 deals with the amount and time for making payments to an ERA. Any payment made up to six months after the end of an income year will be treated as a payment for that income year. Discretion has also been given for the Commissioner to accept payments made after this period.

To ensure that the Commissioner has sufficient information to deal with an ERA payment, section EK 5 requires a business making a payment to provide (within two working days) some basic information. This includes:

• the name of the person;
• the income year for which the payment is made;
• a calculation of the business's maximum payment; and
• any additional information required by the Commissioner.

When this information is not supplied, section EK 9 requires the Commissioner to refund the payment to the payee as soon as it is practical. The payment will not qualify for a deduction under DQ 4 or for interest under section EK 6. Similarly, the refund will not be taxable under section CX 43B (section EK 10). Any payment which is in excess of a business's maximum payment receives the same treatment.

Section EK 21 gives the Commissioner the power to require ERA information in an electronic format and section 36BC of the Tax Administration Act 1994 allows the Commissioner to prescribe the electronic format in which details may be provided. This provides flexibility should the system be administered via the internet in the future.

ERA transfers

A business may also apply for a transfer from an ERA. An amount may be transferred from an ERA:

• to the ERA of another business in accordance with sections EK 15 or EK 16(3)(b);
• to the department responsible for the
  administration of the Environment Act 1986
  under section EK 16(3)(a); or
• to an ERA of an amalgamated company under section EK 19.

The transfer application must be in writing, state the grounds on which the application is made and the
amount of the transfer required (section EK 14). A business who makes a transfer from their ERA under sections EK 15, EK 16 or EK 19 derives income equivalent to the grossed-up amount of the transfer (section CB 24B).

The transfer is treated by the recipient as a payment (meaning a tax deduction is available under section DQ 4) as long as the associated environmental obligations have also been transferred, and the business would be entitled to make an equivalent ERA payment. If any part of the transfer does not satisfy these requirements the Commissioner may return the non-qualifying amount back to the transferor. This will be effective as at the date of the original transfer.

As well as a voluntary transfer by a business, the ERA rules also provide for a transfer on the death, bankruptcy or liquidation of a taxpayer. Under section EK 16, if the administrator of a person's estate, the Official Assignee or a person's liquidator notifies the Commissioner that the obligation associated with an ERA deposit has been transferred to another person, the Commissioner must transfer the ERA balance to that person. Where the obligation has "in effect" been transferred to the New Zealand Government (for example, where it is an orphan site) then the Commissioner is required to transfer the associated ERA balance to the Ministry for the Environment (or the department that is at the time responsible for the administration of the Environment
Act 1986).

The amount of the transfer will be the amount in the business's ERA on the day they die, become bankrupt or are put into liquidation. The transfer will result in income for the transferor derived on the day before the taxpayer's death, bankruptcy or liquidation. For administrative purposes, section EK 17 places a $1,000 minimum threshold on the value of transfers. This applies apart from where the ERA balance is less than $1,000 at the date of refund or transfer.

Finally, sections EK 19 and EK 20 sets out what happens upon an amalgamation or tax consolidation. If an amalgamating company ceases to exist on an amalgamation then there is a transfer to the ERA of the amalgamated company. The amalgamated company is treated as having made all the payments, transfers and refunds made by the amalgamating company. Under section EK 20, on consolidation, the nominated company makes payments and receives refunds on behalf of the consolidated group.

Refunds from an ERA

Under section EK 11, a business is able to apply for an ERA refund when they have incurred Schedule 6B Part B (monitoring and restoration) expenditure that is not listed in Part C of the schedule. The expenditure must be incurred after the date that the business first establishes their ERA (by payment or transfer) and must be equal to or greater than the amount calculated by dividing the refund requested by the applicable tax rate (section EK 12). The application for the refund must be in writing, state the amount of the refund required, grounds on which the refund is made and provide evidence to support those grounds. The amount of the refund is limited to the lesser of the refund requested, the balance of the ERA, and the amount of qualifying expenditure.

The Commissioner must also make a refund where a business's ERA balance exceeds their maximum account balance.

A refund is income under section CB 24B. The amount of income is calculated by dividing the value of the refund by the applicable tax rate. ERA refunds are sourced from payments on a first-in-first-out basis (section EK 18).

Interest on ERA balances

To encourage businesses to participate in the ERA scheme, the rules provide for a small amount of interest (3% p.a.) to be paid on deposits. This is equivalent to the interest rate paid on the income equalisation scheme.

Interest is calculated from the day after a payment is made until the date it is included in a refund under section EK 12 or transfer under sections EK 15, EK 16 or EK 19.

Interest is paid annually rather than being credited to the ERA. Interest is paid out on the earlier of 31 March each year or the date that the payment is included in a refund or transfer under sections EK 15, EK 16 or EK 19.

Clarifying the meaning of "industrial waste"

The previous environmental tax rules (section DB 37 of the Income Tax Act 2004 and section DJ 10 of the Income Tax Act 1994) applied solely to dealing with "industrial" waste. There was no definition of this term which led to ongoing uncertainty as to when tax deductions were available for environmental expenditure.

The word "industrial" has been removed from sections DB 37 and DJ 10 to protect taxpayers who have taken a wide interpretation of the term "industrial waste". This clarifies that a tax deduction is available for dealing with all forms of waste.

This change to section DB 37 applies for income years (and expenditure incurred) beginning before 10 June 2005 . The change to DJ 10 is retrospective (back to the 1995-96 income year) and applies where a taxpayer has filed a tax return, notice of proposed adjustment or response notice, or has requested a reassessment, before 16 November 2004, and the correctness of the tax position, notice or request depends on the interpretation of the meaning of "industrial waste".

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¹ Excluding industry-specific provisions.