Over the last couple of months, a few business owners have reached out to find out when an expenditure would be considered an operating expense versus a capital cost. In this blog, we’ll give you those details but before we get to that, let's define these terms first.
1) Operating expense - These expenses are considered everyday costs for running a business for things that are used continuously or will be used within one year.
For example, fees paid for a business license, advertising, utilities, etc. are everyday costs required to operate your business.
2) Capital cost - These expenses are considered as costs to extend the useful life or otherwise better your existing property/asset. Capital costs provide a long-lasting benefit typically over many years.
For example, the purchase of a building and equipment are capital as these items are used for a long period of time in the business.
Canada Revenue Agency Criteria
In determining what is an operating expense and what is a capital cost, Canada Revenue Agency (CRA) of course has some handy assistance for business owners. Below are the criteria provided by CRA to assess how costs should be treated:
CRA Criteria (Note 1)
Is there a lasting benefit?
The costs incurred provide a lasting benefit to the property.
The cost does not provide a lasting benefit (expense for a short period).
Does the cost improve the property?
The cost incurred improves the property beyond its original condition.
The cost incurred restores the property to its original condition.
Is the cost part of an asset or a separate asset?
The cost incurred replaces an asset.
The cost incurred repairs one part of the asset.
What is the value of the cost? (This test is used only if the above three tests can not determine whether the expense is capital or operation.)
The total cost incurred is compared to the total value of an asset. If the cost is considerable value, then it would be considered capital in nature.
This test is not a determining factor on its own. Sometimes the total cost is higher than normal due to not conducting maintenance regularly.
Were the repairs done to put the asset into a suitable condition for use?
Were the repairs incurred to sell the asset?
Repair costs made in anticipation of a sale or condition of a sale.
If repairs were going to be made regardless of a sale, and sale negotiations occurred during the repair work.
None of the criteria is more important than the other, and each criteria should be reviewed separately. Facts and circumstances for each expense need to be considered before making a determination.
Note 1: https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/rental-income/operating-expenses-capital-expenses.html
Why is it important to understand the nature of the expense and to understand how to classify each expense? While many expenses can easily be classified as operating or capital cost, a few expenses need to be analyzed to the above criteria to ensure they are classified appropriately and are in line with the tax rules. As a business owner, you may prefer to take the total cost of the expense as a tax deduction as it would provide an immediate benefit and reduce the tax expense for the business in the year the cost was incurred.
However, something to keep in mind is that CRA conducts audits of expenses. If CRA concludes the expense should be considered capital, then it would result in a reassessment and higher tax expense for the business.
To help make further sense of these criteria, here are two examples:
Example 1: Deck Replacement
An individual purchased a rental property with a deck that needed significant repairs. The owner replaced the whole deck at a cost of $8,200 rather than fixing certain portions of the deck. How does the owner account for the cost for tax purposes?
Option 1 – Would the owner include the full cost as an operating expense for repairs and maintenance and deduct it in the year the money was spent?
Option 2 – Would the owner include the full cost as a capital cost and deduct the cost over several years?
This is a real example where the property owner and CRA had different opinions on which option is in line with tax rules, and the issue ended up in tax court. The property owner decided to go with option 1 and to include the total cost as repairs & maintenance on their tax return. The expense was audited by CRA which resulted in a reassessment for the property owner. CRA concluded the new deck has been improved over its original condition due to new technologies and better materials.
The property owner challenged CRA’s reassessment which resulted in a favourable outcome for the owner and the costs were left as an operating expense. Factors for classifying the new deck as an operating expense were:
The expense was simply to replace a deck that was 20 years old and fixing only portions of the deck would not improve the deck to its original condition.
The deck was restored to its original condition with minor changes. The deck overall was not significantly better than the original design.
As long as repairs were done to preserve the asset and NOT create a new asset, then the repairs are considered operating expenses. The ruling was also based on reviewing the cost of the repair in comparison to the value of the home which was an insignificant value of the home.
Special Note: Had the new deck been significantly different in form and function than the original deck, the deck replacement cost would likely have been viewed as a capital cost.
Example 2: Roof Replacement
ABC Inc. replaced a roof on its parking garage which took over 2 years to do with a price tag of over $4 million. ABC Inc. treated the roof replacement cost as an operating expense on their tax return and deducted the costs fully as incurred.
Unfortunately for ABC Inc., CRA questioned this treatment and argued that the roof will benefit the property over many years. In addition, they said that the materials and technology are better today, and the roof will last longer than the original roof. Therefore, the replacement should be considered a capital cost and the CRA disallowed the $4 million in repairs and maintenance operating expenses.
The business challenged CRA ruling and the case went to court which resulted in the court siding with ABC Inc. The business was allowed to deduct the whole cost as a repairs and maintenance operating expense. Factors for classifying the roof replacement as an operating expense were as follows:
The purpose of the repairs was to make the garage function in the same way that it did previously.
There was no increase in the garage's functionality or profitability nor did the roof increase the value of the building.
Special note: Again, had the roof offered some sort of betterment or additional functionality, the roof might have been considered a capital cost.
It is our recommendation for you to know the criteria rules for classifying expenses and how these rules are applied to your business. Make sure to follow these steps to determine if the cost is an operation expense or capital cost.
Step 1: Refer to the CRA criteria above to make the determination.
Step 2: Consider the above examples in your determination.
Step 3: If you are not sure, talk to your accountant.