Deduction denied following cessation of property development business
2014 case note – deduction of expenses denied following cessation of property development business – resource consent.
Tax Administration Act 1994, Income Tax Act 2007, Resource Management Act 1990
The taxpayer entered into a sale and purchase agreement to purchase land for the purpose of undertaking a large retail and residential development. The taxpayer obtained resource consent to build the development but the sale and purchase agreement was cancelled following civil litigation between the taxpayer and the vendor of the land. The taxpayer sought to deduct all expenses incurred in relation to the land and subsequent court proceedings with the vendor. The Commissioner of Inland Revenue ("the Commissioner") denied deductions incurred after the taxpayer had sought to cancel the agreement for sale and purchase on the basis it was no longer in business, as it did not have the intention to make a profit once it sought to extricate itself from the agreement.
Impact of decision
The Taxation Review Authority ("TRA") has confirmed that deductions will not be available after the cessation of a business.
The disputant entered into a sale and purchase agreement ("the Agreement") in February 2006 for a block of land ("the Land") from AB Limited ("the Vendor").
The Agreement was conditional on the Vendor obtaining resource consent for the subdivision of a larger property to be able to provide title to the Land. The disputant and the Vendor subsequently agreed to extend the date for the satisfaction of this condition.
On 10 March 2008, the Vendor's lawyers wrote to the disputant's lawyers recording that the condition relating to the subdivision had not been satisfied and therefore the Agreement was at an end. On 17 March 2008, the disputant's lawyers replied stating that it did not accept the Vendor's purported cancellation of the Agreement.
On 23 April 2008, the disputant was granted resource consent for land use to build a mixed retail/apartment development on the Land.
On 1 May 2008, the disputant issued proceedings against the Vendor seeking an order for specific performance of the Agreement.
On 2 July 2008, resource consent for the subdivision of its property was granted to the Vendor. On 24 July 2008, the disputant's lawyers replied to the vendor stating that "our client now accepts the unlawful termination as repudiation and the contract is therefore at an end subject to the right to seek damages for losses incurred".
The disputant initiated court proceedings in the High Court for specific performance of the Agreement, but later amended its claim (after the contract was declared unconditional) to seek damages from the Vendor. Those proceedings were settled in December 2010.
On 9 December 2011, the disputant entered into an agreement to sell the documentation and resource consent rights related to the project ("the Project Rights Agreement"). However, the Project Rights Agreement did not proceed and the resource consent for land use eventually expired on or about 5 March 2013.
The Commissioner disallowed all income tax deductions claimed by the disputant after 24 July 2008 on the basis that the disputant was not in business after the date it sought to cancel the Agreement.
The disputant claimed that its business did not cease until on or about 5 March 2013 when the resource consent rights for the project expired or when the parties entered into a settlement agreement in December 2010. Alternatively, it argued the expenditure was deductible as a revenue expense.
The Commissioner's assessments for the 2009, 2010 and 2011 years were confirmed and the imposition of a shortfall penalty for the 2011 year was upheld.
Cessation of business
The TRA found the disputant's focus clearly changed after 24 July 2008 and its time, effort and resources moved from advancing settlement of the purchase of the Land to getting out of the Agreement and recovering the deposit and costs incurred. The TRA did not accept that there was any temporary cessation of business by the disputant after 24 July or that the disputant had any expectation of resuming its business of property development following the High Court proceedings between the disputant and the Vendor.
The TRA dismissed the disputant's alternative argument that it ceased being in business after the cancellation of the Project Rights Agreement in December 2011 or on the expiry of the resource consent. It recognised that the disputant's business was that of property development and not one of selling resource consents.
Land held on revenue account
The disputant also argued that the Land was acquired for the purpose of resale and was therefore held on revenue account. It contended that any gains derived by the disputant would have been taxable under ss CB1, CB3, CB6 or CB7 of the Income Tax Act 2007 ("ITA"). Taxable profit could have been derived from the sale of its equitable interest in the Land, the sale of the Land, damages awarded in the High Court proceeding or from the sale of the resource consent and plans.
The disputant went on to argue that, accordingly, any expenses incurred are on revenue account and deductible under s DA1(1)(a) of the ITA. This would include at :
- a payment made by the disputant to escape an onerous agreement; or
- a loss of the disposal of equitable rights in and to the land; or
- a payment of damages.
The TRA did not consider there to be sufficient nexus between the expenses claimed and any income-earning process undertaken by the disputant. It found that the disputant's payment was to escape the onerous contract after the business had ceased. Furthermore, the only income the disputant earned after 24 July 2008 was interest on the deposit paid. The TRA agreed with the Commissioner that there was no nexus between the disputant's deriving or earning its interest income and the expenditure incurred to extract itself from the Agreement.
The TRA found no income was derived from disposing of the land and therefore s CB6 of the ITA did not apply.
Finally, the TRA did not accept the disputant's argument that payment of damages is an "occupational hazard for property developers" and is therefore an "expected expense".
Expenses incurred before business ceased
The disputant argued that as it paid the deposit of $1,942,655 on 1 June 2007, the loss related to the forfeiture of part of the deposit was an expense to which the disputant had been legally committed from that date (being at a time when the disputant was in business) as were some of the legal fees.
The TRA dismissed this argument, finding there was not sufficient nexus under s DA1(1)(a) of the ITA for two reasons. First, the legal fees were incurred by the disputant trying to get out of the property development project. Second, the settlement sum paid to the Vendor was a negotiated amount paid from the deposit monies held by the disputant's lawyer as stakeholder rather than payment of the deposit.
Section CG4 of the Income Tax Act 2007
At the end of the hearing on 6 August 2014, Mr Carruthers, for the disputant, made oral submissions on the possible application of s CG4 of the ITA. The TRA found that this was a new proposition of law and no explanation has been provided as to why this was not included in its statement of position, meaning it did not need to consider it.
However, the TRA considered the argument and found the disputant was not able to claim a deduction for its legal fees in reliance on s CG4 as the disputant was not in the business of civil litigation, and as such, there was no nexus.
The TRA determined that this case involved the application of established principles and did not raise any novel points of law. In its view, the disputant's claim for deductions for the expenditure incurred in the 2011 income tax year did not have any prospect of being close to a 50% chance of success. Accordingly, the disputant failed to meet the standard of being "about as likely as not to be correct" and is liable for an unacceptable tax position shortfall penalty.