Business ceased and no nexus with income-earning activities

Summary

The taxpayer, AAA Developments (Ormiston) Ltd ("AAA"), was a property developer that entered into a sale and purchase agreement to purchase a parcel of land for a retail and residential development and paid a series of deposits. Issues arose between AAA and the vendor, with both trying to walk away from the agreement. In litigation between the parties, the High Court found the sale and purchase agreement was binding and neither party could cancel it. The parties subsequently settled their dispute as to the balance of the deposits.

AAA returned its costs of that litigation and the part of the deposits it could not recover as deductible for income tax purposes, claiming they were incurred in the course of its business and/or were part of the costs of its revenue account land acquisition. The Commissioner of Inland Revenue ("the Commissioner") made new assessments disallowing the deductions on the basis that AAA's business had ceased prior to the sale and purchase agreement litigation and any expenditure after that date had no nexus with the income-earning activities of AAA.

AAA unsuccessfully challenged the Commissioner's assessments in the Taxation Review Authority ("the Authority") and appealed to the High Court.

Impact of decision

The judgment reaffirms the two-stage inquiry for a business in the tax context:

•  the nature of the activities carried on, and
• the intention of the taxpayer in engaging in those activities.

The general deductibility permission in s DA 1 of the Income Tax Act 2007 must still be satisfied for revenue account property. Where it is prejudicial to a party, the Court may decline leave to raise new arguments in an appeal that were not in the statement of position or notice of claim, and are inconsistent with the agreed statement facts.

Facts

This is an appeal by the taxpayer, AAA, of a decision by the Authority that concerned the income tax treatment of certain expenditure incurred by AAA, a property developer formed in 2005.

In February 2006, AAA agreed to acquire a parcel of land ("the Land") for a retail and residential development and paid a series of deposits. The agreement was conditional on the vendor obtaining resource consent for the subdivision of a larger property to obtain title for the Land to be sold to AAA. Issues arose between the parties and at various times each party tried to walk away from the agreement. In subsequent litigation the High Court found that the agreement was binding and neither party could cancel it, with the consequence that AAA was unable to recover a large part of the purchase deposit it had paid.

AAA contended that the litigation costs and the part of the purchase deposit that it was unable to recover were deductible for income tax purposes.

The Commissioner denied those deductions on the basis that AAA's business had ceased on 24 July 2008 and any expenditure after that date had no nexus with the income-earning activities of the business.

The Authority found all expenditure in question after 24 July 2008 was not deductible and AAA appealed to the High Court.

Decision

The High Court dismissed the appeal on all grounds.

Justice Gendall began by referring to s DA 1 of the Income Tax Act 2007 ("the Act") and relevant case law (Commissioner of Inland Revenue v Banks [1978] 2 NZLR 472 (CA); Buckley & Young v Commissioner of Inland Revenue [1978] 2 NZLR 485 (CA)) on deductibility and noted that for AAA to be able to rely on s DA 1 it must establish the three essential elements of deductibility:

1. the expenditure must be incurred by AAA (there was no contest that the expenditure in question was incurred by AAA);
2. there must be a sufficient relationship or nexus between the expenditure and the income-earning process; and
3. none of the general limitations set out in s DA 2 of the Act must apply.

The timing issue and the nexus issue

Justice Gendall first considered what the business of AAA was. He referred to s YA 1 of the Act which defines "business" and Grieve v Commissioner of Inland Revenue [1984] 1 NZLR 101 (CA) in which Justice Richardson articulated a two-stage inquiry, consisting of, first, the nature of the business activity and, second, the intention of the taxpayer. His Honour rejected AAA's submission that it was established "to undertake business-like activities" and concluded that the business of AAA was solely limited to the development of the Land.

Justice Gendall then looked at when that business ceased. His Honour agreed with the Authority's finding that the business of AAA ceased from 24 July 2008 when AAA no longer had any profit-making intention. The property development venture was abandoned on 24 July 2008 and later activities of AAA were directed towards damage control and the recovery of expenditure.

On the nexus issue, Justice Gendall agreed with the Authority's finding that there was no nexus between the disputed expenditure and AAA's business or income-earning process. His Honour found that the deposits paid under the purchase agreement were effectively refunded to AAA who then agreed to pay the equivalent of one half of the deposit and costs to the vendor. This payment was made purely as a litigation settlement after the business had ceased and, therefore, there could not be any enduring benefit to the business associated with this expenditure. The legal, accounting and other related costs incurred by AAA post-July 2008 were simply the costs of AAA's actions in attempting to extricate itself from the onerous contract represented by the purchase agreement.

The breadth of business issue

This was a new argument raised by AAA on appeal and concerned the question of whether the nature of AAA's business was wider than the property development for which it was formed.

Justice Gendall held, having pointed out the argument was not in AAA's statement of position or notice of claim and that no application had been made to amend the pleadings, that the Commissioner would be prejudiced if AAA were now permitted to bring this new argument on appeal. Despite this, for completeness, the Court considered the argument briefly. AAA contended that as a constitution was not required by the Companies Act 1993, it was not constrained in any way as to the nature of the business activities it carried on and its business would include any undertaking for profit. The Court found that although this argument had a superficial attraction, in the circumstances it was inconsistent with the facts in the notice of claim and the agreed statement of facts and was "purely a concocted and unsupported last minute afterthought" with no merit. Leave was not granted to bring this new argument as it would be prejudicial to the Commissioner and inconsistent with the facts before the Authority and the High Court and agreed for the purpose of these proceedings.

The interest in land issue

AAA argued that even if its business did cease on 24 July 2008 and even if there was no nexus with an income-earning process, the expenses are still deductible because they are part of the costs of revenue account property, being the equitable interest in the Land that AAA acquired in 2006 when it entered into the purchase agreement.

Justice Gendall referred to s YA 1 of the Act, which provides that a property developer's land is revenue account property, and s DB 23, which allows deductions for expenditure incurred as the cost of revenue account property. His Honour noted that s DB 23(3) of the Act requires that the general permission contained in s DA 1 of the Act must still be satisfied and the Authority was correct to find there was no sufficient nexus in this case.

"Land taxing" provisions

Justice Gendall then moved on to consider AAA's alternative submissions on "land taxing" provisions – ss CB 6, CB 7, CB 9 and CB 10 of the Act.

AAA argued that because the income from disposing of the Land (the equitable interest) would be taxable under s CB 6 of the Act, then all expenses incurred in relation to the equitable interest of the Land should be deductible. The same analysis would apply if the amount derived from the disposal of the Land were taxable under ss CB 7, 9 or 10.

Putting to one side whether these sections could be raised because of the application of s 138G of the Tax Administration Act 1994 and the relevance of them given this is not an assessability case but a deductibility case, the Court considered that, regardless of which "land taxing" provision AAA attempted to rely on, the question will always be whether the general permission in s DA 1 has been satisfied. Section CB 6 does not apply here as no income was derived from disposing of the Land, there was no evidence that AAA intended to dispose of the equitable estate and even if s CB 6 applied, then pursuant to s DB 23(3) the general permission in s DA 1 of the Act would still need to be satisfied for the expenses to be deductible.

The Court also referred to AAA's argument that as a result of the settlement entered into with the vendor, AAA gave up its equitable interest in the Land and derived "income" for doing so. His Honour held that the "land" disposed of only ever consisted of an equitable interest, which AAA never had the requisite intention on acquisition to dispose of. As the vendor had succeeded before Clifford J that AAA was in breach of the purchase agreement, AAA no longer had any right to sue for specific performance to obtain legal title and AAA's interest related simply to a claim to the balance of the deposit.

AAA argued the settlement agreement between AAA and the vendor was, itself, a sale and purchase agreement. However, the plain wording of the settlement agreement was that it was in full and final settlement, first of the civil proceedings and, second, of all matters arising out of the purchase agreement. AAA's earlier equitable interest in the Land was contingent on full payment of the purchase price (which AAA clearly was not intending to pay nor able to pay). Therefore, it was not possible to construe the settlement agreement as including any disposition of an equitable interest in land.

The Court also noted that if AAA claimed that one of the land taxing provisions applied, then it should have returned the income in its 2011 return following the settlement. It did not and clearly the arguments AAA was endeavouring to advance were inconsistent.

The penalty issue 

Justice Gendall held that the Authority did not err in taking the position it did to hold the 20% shortfall penalty under s 141B of the Tax Administration Act 1994 for taking an "unacceptable tax position" applied. Viewed objectively, the tax position taken by AAA did not meet the standard of being about as likely as not to be correct.

The Court dismissed the appeal.