Trust in business of holding financial arrangements and allowed bad debt deduction

Summary

The TRA held that there was "just, and only just" a sufficient level of activity to support the disputant trustees intention of profit from their holding of financial arrangements to constitute a business. Consequently, the trustees were entitled to a bad debt deduction under s DJ 1 and s EH 54 (3) of the Income Tax Act 1994.

Impact of decision

The Commissioner considers that the judgment is confined to its particular facts.

Facts

On 1 January 2000 the disputant Trust was settled.

On 26 April and 5 May 2000, $180,000 and $100,000 respectively were advanced to the disputant Trust, interest free and repayable upon demand.

Mr B, a trustee and the accountant for the disputant Trust, requested Mr O, a mortgage broker, to refer to him interesting opportunities for consideration by the disputant Trust and other entities Mr B was involved with.

The disputant Trust entered into five arrangements:

1. On 16 November 2000 the disputant Trust advanced $100,000 to D W Ltd on the security of a debenture and the personal covenant of the company's director. The principal of $100,000 and interest of $25,000 were to be repaid on 17 May 2001.
2. On 22 February 2001 the disputant Trust loaned $100,000 to Mr L and on 5 April 2001 received back from him $103,041.09 inclusive of interest and principal.
3. On 5 April 2001 the disputant Trust entered into an agreement for sale and purchase of real estate with N Ltd for the disputant Trust to purchase a city unit at $120,000. The agreement provided that N Ltd would repurchase the unit from the disputant Trust for $130,000 no later than 6 June 2001.
4. On 5 July 2001 the arrangement with N Ltd was restructured as a loan with interest payable at an effective rate of 53.36% per annum capitalised monthly until full repayment.
5. On (or about) 4 October 2001 the arrangement with N Ltd was once more restructured, this time as a term loan for $155,000 with interest at 20% per annum (with a penalty rate of 30% per annum). $20,000 was to be repaid on the signing of the loan contract and the balance by 30 November 2001. Second mortgages were to be given over certain properties.

The opportunities concerning D W Ltd, Mr L and N Ltd were referred to Mr B by Mr O.

On 10 April 2002 the disputant received $72,000 from N Ltd in partial repayment of the loan to it.

Trust minutes dated October 2002 noted the loan to D W Ltd and the balance of the loan to N Ltd as unrecoverable and recorded "write off both loans as bad immediately and remind accountant to include in financial accounts this period".

On 16 October 2003 the disputant Trust filed income tax returns (and financial statements) for the income years ended 31 March 2001, 2002 and 2003. The 2003 return and financial statements recorded a bad debt write-off of $100,000. The journal for the disputant Trust's income tax year ended 31 March 2003 recorded bad debt write-offs for the loan to D W Ltd and the balance of the loan to N Ltd. The date the journal entries were made was not known.

The draft accounts and journal for the income tax year ended 31 March 2004 recorded the balance of the loan to N Ltd as a trust asset.

In May 2007 the disputant Trust filed a "revised return" for the income year ended 31 March 2003 recording bad debts written off in the amount of $148,000.

By an assessment dated 12 June 2008, the Commissioner denied the disputant Trust's claim for a bad debt deduction in the 2003 income tax year for the $100,000 loan made to D W Ltd on two grounds:

1. The disputant Trust had failed to satisfy the burden on it that the bad debt was actually written off in the 2003 income year.
2. The activity carried on by the disputant Trust was an investment activity and not that of carrying on a business.

Decision

The disputant Trust and the Commissioner agreed that the:

• loan made by the disputant Trust to D W Ltd was a bad debt
• disputant's loan to D W Ltd was a financial arrangement for the purposes of the Division 2 accruals rules
• loan made by the disputant Trust to Mr L was a financial arrangement for the purposes of the Division 2 accruals rules
• two restructured arrangements with N Ltd were financial arrangements for the purposes of the Division2 accruals rules.

The disputant Trust's activity involved the holding of financial arrangements (the loan to Mr L and the restructured arrangements with N Ltd) with attributes similar to the D W Ltd loan. Those attributes being the:

1. provision by the disputant Trust of money to the borrower at the start of the arrangement
2. borrower being required to repay the money to the disputant Trust at a future date plus interest.

The disputant Trust and the Commissioner disagreed in respect of three issues:

1. The correct characterisation of the 5 April 2001 agreement for sale and purchase between N Ltd and the disputant Trust. On that issue:
   1. The disputant Trust contended that the arrangement was a loan secured by a caveat, and as such, had attributes similar to the D W Ltd loan, the loan to Mr L and the restructured arrangements with N Ltd.
   2. The Commissioner contended that the arrangement was correctly classified as an agreement for sale and purchase of real estate with a buy-back clause and its attributes were not the same or similar to the loan to D W Ltd, the loan to Mr L and the two restructured arrangements with N Ltd.
   3. The Authority held that the documented purchase and buy-back of the apartment was as a security for a loan to N Ltd. The Authority observed that such a method of providing security is quite common and well understood in commerce as a form of security for a loan.
2. Whether the disputant Trust's activity in holding the D W Ltd loan, the loan to Mr L and the two restructured arrangements with N Ltd was of sufficient scale and involved sufficient time, effort and money in its ordinary operations (ie not its debt recovery efforts) to be the activity of carrying on a business. On that issue:
   1. The parties agreed that in order to satisfy the burden on it of proving that the disputant Trust carried on, at all material times, the business of holding financial arrangements the disputant must satisfy the business test formulated by Richardson J in Grieve v CIR [1984] 1 NZLR 101 (CA).
   2. The Authority held, having regard to the factors considered in Grieve, that there was "just, and only just" a sufficient level of activity to support the disputant Trust's intention to profit so as to constitute the business of lending money at all material times.
3. Whether the disputant Trust wrote off the D W Ltd debt in the 2003 income year. On that issue the Authority accepted Mr B's evidence that the relevant journal entries, to write off the debts in issue, were made at proper times in the 2003 accounting year.