Sufficient connection - section DA 1 of the Income Tax Act 2004

Summary

The Commissioner of Inland Revenue ("the Commissioner") disallowed interest deductions claimed by the appellant, Ean Innes Brown, in the 2005 to 2007 income tax years. The Taxation Review Authority ("TRA") and now the High Court have upheld the Commissioner's assessments disallowing the interest deductions due to there being an insufficient connection between the deductions and the appellant'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 sufficient connection between the expense and the income-earning process for the nexus to be met.

Facts

The appellant, Ean Innes Brown, who practised as a chartered accountant, claimed interest deductions in the 2005, 2006 and 2007 income tax years. The Commissioner disallowed the deductions on the basis that the appellant did not incur the interest expenditure and that there was no sufficient nexus between the payments made by the appellant and the appellant's income-earning process. The Commissioner also imposed shortfall penalties in those income years for failure to take reasonable care. Those assessments were challenged before the TRA and the assessments were upheld.

Background

The appellant practised as a chartered accountant through a company ("Accounting"). The appellant, his wife, and his business partner were the three directors. A trust ("Trust") was settled by the appellant in 2000. His wife and business partner were the trustees. In 2000, the Trust borrowed $420,000 from the bank and on-lent this to Accounting, which used the funds to purchase an accountancy practice.

In 2004, Trust borrowed a further $250,000 from the bank and on-lent it to Accounting to acquire another accountancy practice. Accounting gave a guarantee of the Trust's indebtedness to the bank. The appellant and others also gave guarantees of the indebtedness to the bank. Over the relevant tax years, the appellant paid the bank the interest charged to the Trust on the loans, in total nearly $100,000.

Decision

Contractual obligation to reimburse

The appellant relied upon a minute of the trustees dated 14 April 2004 which recorded that "at the request of [the Bank] … it is agreed [the appellant] will pay the interest and principal payment on the two loans …". The Court found the appellant's evidence did not establish a legally enforceable obligation on the appellant to pay the interest.

The Court confirmed the finding and reasoning of the TRA that there was no definitive commitment on the appellant to make the interest payment.

Statutory or common law right of indemnity to reimburse

The appellant asserted an alternative argument that the Trust was liable to reimburse the appellant, either under sections 84 and 85 of the Judicature Act 1908 or under the common law right of indemnification, which arises when a guarantor makes a payment on behalf of the principal debtor.

The Court upheld the finding of the TRA that the appellant has no right to indemnity from the Trust for the interest paid. The Court noted that a prerequisite to the application of sections 84 and 85 of the Judicature Act is that the person seeking to invoke the rights conferred is a "surety for the debt or duty of another", or "liable with another for any debt or duty".

The Court held that the appellant was not a guarantor of the Trust's indebtedness to the bank. Accordingly, the Court found that the appellant's claim to a right of indemnity from the Trust must fail.

Nexus

Counsel for the appellant proposed that in circumstances where a particular item of expenditure does not have any other nexus with the derivation of any other assessable income, the existence of a right to be reimbursed that item of expenditure by another is sufficient to make both the payment and the subsequent reimbursement part of the income-earning process. No authority was cited in support of this proposition.

As the Court found that there was no contractual, statutory or common law right of indemnity upon the Trust to repay the appellant, it was unnecessary for the Court to consider whether an expectation of reimbursement would meet the test in section DA 1 of the Income Tax Act 2004. The Court found that the interest in this case was not deductible.

Shortfall penalties

The Court upheld the TRA's finding that a shortfall penalty was payable because the taxpayer did not take reasonable care in taking the tax position he did when claiming a deduction for the amounts paid to the bank. This was largely due to the fact that the appellant is a partner in a firm of chartered accountants with expertise in the field. The TRA upheld the Commissioner's contention that the disputant had not acted as a reasonable person would have in the same circumstances (at [40]-[41] of X Ltd (Chartered Accountant) v Commissioner of Inland Revenue [2013] NZTRA 03).

The amount of penalty under section 141A of the Tax Administration Act 1994 ("TAA") for not taking reasonable care is 20 per cent of the resulting tax shortfall. The TRA held that this was reduced by 50 per cent under section 141FB(2) of the TAA.