Deductibility of share losses

Summary

The partnership invested in shares overseas and eventually lost all that was invested. The partnership claimed the loss and the partners to the partnership each claimed the deduction. The Commissioner denied the claim. The Taxation Review Authority ("TRA") found the expenditure was on revenue account and deductible.

Impact of decision

The TRA has taken a broad view on what constitutes a business. The TRA has also taken the view that the disputant using funds from the Family Trust without authority did not mean there was no loan. This case also follows the reasoning in Inglis and Stockwell whereby, if shares are purchased with the intention of selling to make a profit, any loss will be deductible.

Facts

The taxpayer is a husband and wife partnership. The husband received a "cold call" from overseas brokers offering the opportunity to invest in shares. The brokers were extremely convincing, persuasive and persistent. The modus operandi of the brokers was to purchase undervalued shares in companies in the United States and then persuade overseas persons to buy those shares at a highly inflated price. The brokers promised the buyers that they would be able to sell the shares at a profit after the shares became publicly listed on the American Stock Exchange.

Over a period of about three years from 1999 to 2002, the disputant purchased shares in five USA companies at a total cost of about $1.1 million.

While the shares were purchased in the name of the partnership, the funds used to pay for the shares came from the Family Trust.

Eventually, after ongoing difficulty in obtaining share certificates and responses to his request for information, the partners realised that the money spent had been lost.

The partnership claimed the loss in its 2003 income year and each partner claimed $627,564 as their half share of the partnership loss. The Commissioner denied the deductions and imposed a shortfall penalty on both the husband and the wife for having taken an unacceptable tax position.

Decision

It was put to the TRA by the Commissioner that the disputant could not demonstrate that it acquired any such shares or incurred any such loss. The Commissioner claimed that the shares did not exist and it was the Family Trust that paid for the shares, not the disputant. Also, that there was no agreement between the disputant and the Trust for the lending of the money.

However, the TRA found that the disputant did incur a loss and that real shares were purchased by the disputant, which became worthless by late 2003.

Judge Barber concluded that the partnership borrowed the money from the Trust:

... Much was made in submissions as to whether the Trust could have been the shares purchaser in reality, or as a result of a resulting Trust or an agency or something like that; but with a complete absence of records as to any funding contract from the Trust to the partnership, I consider that the partnership simply borrowed money from the Trust, possibly, on an unauthorised basis without clear terms and without any arrangements for payment of interest by the disputant partnership to the Trust [10].
It seems to me that the disputant partnership acquired funds (mainly by borrowing from the Family Trust) and, at all material times, owned the funds which it applied to the share purchases listed above ... [42].

Judge Barber found that real shares were acquired by the disputant:

I understand that, until the hearing before me, the defendant Commissioner had not been prepared to accept that [...] Groups sold real shares to the disputant, and considered that the so-called brokers had simply misappropriated the disputant's funds. However, the hearing before me showed that the disputant did receive real shares and these were known as Regulation S shares ... [60].

The relevant sections in regards to whether losses are deductible are sections BD 2 and CD 4 of the Income Tax Act 1994. The leading authorities on the deductibility of losses incurred in respect of shares to which section CD 4 applies are CIR v Inglis [1993] 2 NZLR 29 (CA) and CIR v Stockwell [1993] 2 NZLR 40 (CA).

Judge Barber considered whether the disputant was operating a business of trading in shares. His Honour considered that it seemed that there was sufficient activity on the part of the disputant regarding those speculative investments for the activity to amount to a business, when coupled with the intention of seeking fairly quick profit, and that those investments were real. While the husband admitted to the Inland Revenue investigator that he was not carrying on a business of share dealing, Judge Barber said that that was an issue for the Court to decide.

However, Judge Barber said that the point was peripheral in this case because he considered that the partnership had the dominant intention of purchasing the shares for a fairly speedy resale at a profit. Judge Barber concluded:

The evidence is clear that the speculative share purchase transactions were entered into by the disputant with a view to profit for the partners ... [11].
The evidence is that the partners purchased the shares with the intention of soon selling them at a profit, as promised by the high powered broker vendors [13].
I find from the evidence adduced to me that the husband purchased the shares listed above for the disputant with the intention of the disputant very soon selling the shares at a profit after they became publicly listed on the American Stock Exchange [47].

Therefore, the TRA found expenditure was on revenue account and deductible.