Interest deductibility and nexus
2013 case note - confirms interest can only be deducted where it is incurred by the person and that must be a direct link between expense and income-earning process.
Income Tax Act 2004, Tax Administration Act 1994
The disputant did not incur the interest payments and no direct nexus existed between the payments made by the disputant and the disputant's income-earning process.
Impact of decision
This decision confirms that interest can only be deducted where it is incurred by the person and that there must be a direct link between the expense and the income-earning process for nexus to be met.
The disputant practices as a chartered accountant through his company Accounting Limited. In 2005, 2006 and 2007, the disputant claimed deductions for interest on amounts paid to the bank on behalf of the WY Trust ("the Trust"). The disputant, his wife and business partner are directors of Accounting Limited and trustees of the Trust.
The disputant and his wife are also shareholders of another related loss attributing qualifying company Farm Limited. The sole director of Farm Limited is the disputant's wife. In the 2005 to 2007 income years, a portion of Farm Limited's losses were attributed to its shareholders and were subsequently offset against the disputant's personal income.
On 6 June 2000, Accounting Limited agreed to guarantee the Trust's indebtedness to the bank. On the same date the disputant and others guaranteed Accounting Limited's indebtedness to the bank.
On 30 June 2000, the Trust borrowed $420,000 from the bank and advanced this sum to Accounting Limited by way of loan. On 1 February 2002, the Trust assigned the loan balance to Farm Limited.
The Trust advanced a further $250,000 it had borrowed from the bank to Accounting Limited on 14 April 2004. This was recorded in Farm Limited's accounts as a loan from the Trust to Farm Limited.
In the 2005 to 2007 income years, the bank charged the Trust interest on the borrowed funds. Farm Limited received interest from Accounting Limited on the outstanding loan balance but Farm Limited did not pay interest on the amount owed to the Trust. In the 2005 to 2007 income years, the disputant personally paid the interest charged by the bank to the Trust.
The disputant claimed deductions for the interest payments. The Commissioner disallowed the deductions and imposed shortfall penalties.
Was interest incurred?
The Commissioner asserted that it was the Trust that incurred the interest as opposed to the disputant.
The disputant submitted that he had entered into an oral agreement with the bank and the Trust to pay the interest directly. While there was no written documentation evidencing this agreement, the disputant stated that the agreement was recorded in a Trust Minute. The disputant also stated that he understood that his liability under his guarantee for Accounting Limited's obligations included its obligations under the guarantee of the Trust's indebtedness. The disputant considered the Trust to be under a "moral obligation" to repay the interest.
The Taxation Review Authority ("the Authority") found that there was no evidence of a written agreement and the Trust Minute recorded no enforceable agreement. Further, there was no obligation on the disputant under his guarantee of Accounting Limited's indebtedness to pay the interest payments on the Trust's behalf. At most the disputant had an indirect contingent liability which would only be triggered upon default by the Trust.
The Authority concluded that there was no "definitive commitment" on the disputant to make interest payments.
Was there sufficient nexus between the payments and the disputant's income-earning activities?
The disputant submitted that as guarantor in respect to the interest owing by the Trust, and as a result of the disputant repaying the interest, the Trust in turn became obliged under the contractual doctrine of indemnity and/or the restitutionary doctrines of contribution and reimbursement, to repay the disputant an equivalent amount.
The Authority found that there was no right to indemnity as there was no default and the disputant was not liable as guarantor to make payment. Likewise, there was no right to claim contribution because the disputant and the Trust were not co-sureties and the disputant had no obligation to contribute to the payment of the interest. Further, there was no right to claim reimbursement as the disputant had not been compelled by law to make interest payments.
In the alternative, the disputant argued there was nexus because the borrowed funds assisted in maintaining the Trust capital (and therefore its ability to support the advances to Farm Limited). This in turn enabled Farm Limited to derive assessable income, with the resulting tax consequences assessable to the disputant. The Authority referred to Case S5 (1995) 17 NZTC 7,056 (TRA), which confirms that there must be a direct link between the payments and the income-earning process and indirect "side benefits" are insufficient. Although the Authority accepted the payment of interest may have indirectly increased the disputant's income, that benefit was not sufficiently direct.
The Authority considered that in these circumstances reasonable care would include exercising reasonable diligence to determine the correctness of a return and keeping adequate books and records amongst other considerations.
The Authority found that the disputant, in his capacity as an accountant, was in a position to research the law on interest deductibility and to take legal advice if necessary. In addition, as the disputant was a businessman with extensive farming interests, he could be expected to have a high level of knowledge and experience regarding business transactions and tax legislation. Accordingly, the Authority considered the disputant had shown a lack of reasonable care and was therefore liable under section 141A of the Tax Administration Act 1994.
Further, the Authority considered that the disputant was not entitled to a 75% reduction for a temporary shortfall under section 141A of the Tax Administration Act 1994.