Deductibility of Aircraft Overhaul Expenditure

8/9/2019 Deductibility of Aircraft Overhaul Expenditure

1/4

7 October 2011

Craig PhillipsSenior Policy AdvisorPolicy Advice DivisionInland Revenue DepartmentPO Box 2198Wellington 6140

Dear Craig

Deductibility of Aircraft Overhaul Expenditure

Further to our recent discussions regarding the above we set out our comments in response to your letterof 29 November 2010.

While we have focused our considerations on persons who are not required to comply with InternationalFinancial Reporting Standards (IFRS), we are supportive of IFRS compliant entities using accounting rulesto govern the treatment of aircraft overhaul expenditure. We have also had regard to IFRS in thinkingabout an appropriate method of accounting for this expenditure for non-IFRS people.

At a broad policy level the Institute welcomes the review of the deductibility of aircraft overhaulexpenditure The Institute supports the following proposals (in order of preference):

Codify the existing practice;Modify the general principles to be applied to this type of expenditure;Make available a scheme similar to the income equalisation scheme for taxpayers in the agricultural,fisheries and forestry sectors.

The discussion paper also raises the issue of dilapidation expenditure, and we discuss this separatelybelow.

Codify existing practice

The Institute believes there is a strong case to codify the Commissioners existing practice to allow a full

deduction for the provision of aircraft overhaul expenditure. While this approach may not satisfy the strictlegal requirements of the general permission, in our view it is the correct policy outcome to allow thededuction for a provision. This outcome should apply regardless of whether the aircraft is leased orowned.

The case for departing from the general law is founded in better matching outcomes for the expenditureand the revenue generating activity of the aircraft, the consequent impact on the cash flow of thebusinesses concerned, and in public policy outcomes related to safety.

In terms of matching, this is not well served by the standard incurred test in s DA 1 of the Income Tax Act.As you are aware, in order to carry on an aircraft business for hire or reward, regular aircraft enginemaintenance and overhauls are required. For leased aircraft, this will be a provision of the lease. This

expenditure is fundamental to the persons business operation and is generally measured based onengine hours and standard time intervals. In terms of entities required to comply with IFRS, the cost of a


2/4

27 October 2011Deductibility of Aircraft Overhaul Expenditure

full engine overhaul is spread over the life of the engine when the aircraft is owned. If leased, a provisionfor future expenditure is established, which depends on the nature of the lease. Either way, for IFRSpeople, the accounting treatment aligns the expenditure with the use of the aircraft in the income earning

process.

In NZICAs view, non-IFRS businesses would be better served if they too could match the engine overhaulexpenditure with the use of the aircraft in the income earning process. For many operators, the engineoverhaul represents a material cost to the business. The general deductibility rules in the Income Tax Actdo not achieve this. While it could be argued that depreciation deductions ameliorate this in part, it is notclear to what extent, if at all, that this covers engine overhaul costs. With the depreciation rates for aircraftat 9.5% DV for fixed wing and helicopters (with an exception for top-dressing aircraft at 18% DV) the ratesseem too low to incorporate engine overhaul costs. In the case of leased aircraft, these costs would fall ontop of the standard lease payments, and the benefit of the depreciation deductions will not arise directly tothe lessee.

Many smaller aviation operators are reliant on seasonal income flows. For these operators in particular, inthe absence of better matching, the standard deduction rules risk having a detrimental effect on alreadystrained cash flows as tax will be overpaid in some periods.

As above, in our view, an argument can also be made for departing from standard tax rules when there isa competing and valid policy reason to do so. In an aviation context, retaining the current provisioningpractice would be consistent with encouraging good safety management practices, and the protection ofthe public. To put the issue another way, maintaining a provisioning approach would not impose cash flowdisadvantages on an industry when safety is a paramount consideration.

NZICA appreciates that tax policy considerations, as a rule, do not have regard to other unrelated public

policy considerations. However, tax policy does not exist in a vacuum and, in the case of the aviationindustry, when the costs of the engine overhaul are frequently driven by safety considerations, it would becontrary to good policy making to deliberately adopt policy objectives that oppose one another.

Importantly, in this context, codification of existing practice would harmonise the regulatory frameworkunder which the aircraft industry operates and ensure engine overhaul costs are correctly factored intocost structures for tax and accounting.

No transitional issues will be necessary if the existing practice is codified unless the method of calculatingthe reserve was to change. However the governing provisions should clearly state that section EA 3(Prepayments) of the Income Tax Act does not apply.

Modifying general principles

As we understand this proposal, an amortisation regime for the aircraft engine overhaul expenditure wouldbe used. By its very nature amortisation recognises that capital items wear out when they are used toderive assessable income. The amortisation deduction promotes the matching principle.

If the existing practice is not codified, the Institute supports allowing an amortisation deduction for theprovision of aircraft overhaul expenditure for the reasons discussed above; that is better matching and notinconsistent with aviation safety. Some of the advantages of this option include simplicity and familiarity. Italso removes any arguments on the capital/revenue boundary that may arise.

In the Institutes view it would be appropriate for the amortisation deduction to apply only to major engine

overhaul expenditure. Regular maintenance of the aircraft frame should be deductible in accordance withthe general permission. In addition the amount of the deduction should be determined by reference to


3/4


something that fairly represents the availability of the aircraft to be used to derive assessable income; forexample, number of running hours of the aircraft engine or the term of the aircraft lease. This wouldreduce administrative costs and encourage voluntary compliance.

If the amortisation approach were adopted it may then be necessary to separate the value of the aircraftengine from the aircraft itself. It may also be necessary to determine a residual value of the engine (thevalue at the end of its useful life) such that only the overhaul cost is amortised.

If general principles are modified to allow an amortisation approach, transitional issues regarding thetreatment of current provisions (for which deductions have already been claimed) will need to beconsidered. A simple solution would be to adjust the value of the engines by the amount of the reservealready deducted, or alternatively to require an adjustment in the year the overhaul expenditure is actuallyincurred, that is, add back the value of the reserve against the deductible overhaul costs. As the amountsinvolved are likely to be material it may be appropriate to allow the income arising on this transition to bespread over, say, three years.

An issue with an amortisation approach arises for aircraft subject to an operating lease. In this case, theleasee may not have the records to separate out the value of the engines. The Institute is not aware of thepercentage of non-IFRS people who lease aircraft. However, for aircraft subject to an operating lease, aprovisioning approach as discussed above would be more manageable. It would also align broadly withIFRS treatment.

Equalisation method

Smaller aircraft operators may be reliant on seasonal income flows. Establishing an income equalisationscheme would assist to smooth the impact of seasonal fluctuations. The Institute therefore considers it

would be beneficial if an income equalisation regime was made available. This regime could operateconcurrently with the other options discussed, that is, there is no reason why this should be seen as amutually exclusive option. To increase flexibility, the equalisation regime could be optional, as it is now forthe agriculture sector.

Should an income equalisation scheme replace existing practice (as opposed to working concurrently withexisting practice) transitional rules could be considered if there was thought to be a risk that a doublededuction will arise. However, in NZICAsview this is unlikely to be a large risk. Aircraft engine overhaulreserves established to date would no longer be able to be added to.

Risks of providing a statutory basis

Your letter outlines some of the risks of providing a statutory basis, namely:

Existing principles for the timing of deductions;Existing principles for distinguishing capital and revenue expenditure;The tax treatment of depreciable assets;

Accounting practice, for example, requirements of the IFRS framework.

We appreciate that allowing a specific timing regime for aircraft engine overhauls (be it provision,amortisation or income equalization) may set the statutory rules for aviation engine overhauls on adifferent footing to other taxpayers. However, given the regulatory environment and safety considerationsthat apply to the aviation industry, as discussed above, a strong case can be made for distinguishingaircraft engine overhaul expenditure.


4/4


In relation to the capital / revenue boundary, there would not appear to be any clear rule in this area. Ourresearch shows such expenditure could be treated as either fully deductible, or as a capital asset anddepreciated at the rate attributable to the main asset. Thus, it is not clear to what extent any codification of

the deductibility of aircraft engine overhaul reserves would conflict with the existing rules for timing or therules for distinguishing between capital and revenue.

We accept that if a separate timing regime were adopted for aircraft engine overhauls that consideration ofthe depreciation rates may be corollary. However, given that these are not unduly high, the anomaly withleased aircraft, and that there is a claw back of depreciation on sale of the aircraft, this is not adeterminative or urgent consideration.

In relation to the IFRS framework, we have had regard to that in our consideration of this matter andbelieve our response for non-IFRS aircraft operators to be consistent with IFRS.

Residual issues

In relation to dilapidation expenditure there is an existing TRA case on an aircraft that treats any discountgiven of the sale of an aircraft that is subject to an inspection as non-deductible. General case law ondilapidation also treats dilapidation expense as a capital item. This should not change.

Thought should also be given to the treatment of aircraft engines that are acquired as backup to engineson the wing.

Industry view

As with the Institutes general approach to industry specific matters, if our view is in conflict with that of the

aviation industry, NZICA is happy to defer to the views of the industry.

Thank you for the opportunity to comment. Should you have any questions regarding the above please donot hesitate to contact me.

Yours sincerely

Craig MacalisterTax Director

P: +64-4-474 7860E:[email protected]

I:\Member Services and Support\Tax\Tax\T1\Tax Policy\Aircraft overhaul expenditure\Aircraft overhaul ltr to PAD.doc
mailto:[email protected]:[email protected]:[email protected]

Documents

Deductibility of Aircraft Overhaul Expenditure