Deductibility of management fees/tax avoidance
2015 case note – Decision of TRA in deductibility of management fees and tax avoidance - Section BD 2, s BG1, s 141D.
The Taxation Review Authority ("TRA") found for the Commissioner of Inland Revenue ("the Commissioner") on the basis there was no evidence that management services were provided and that the Q Land Trust ("the Trust") incurred the management fees. The TRA was also satisfied the arrangement was one of tax avoidance.
This decision confirms that a deduction is available only where the expenditure has the necessary relationship both with the taxpayer concerned and with the gaining or producing of his assessable income, or with the carrying on of a business for that purpose.
The disputant is the corporate trustee of the Trust. The disputant challenged the Commissioner's assessment that disallowed $1,116,000 claimed as a deduction for a management fee expense paid by the disputant to Q Land Limited ("Land Limited") in the 2005 income tax year.
Mr X was the settlor and a discretionary beneficiary of the Trust. Mr X was also shareholder and director of the disputant.
The Trust purportedly undertook management services for related companies and trusts. The Trust did not have any employees and at all material times it used management services provided by Land Limited to manage its property and other business interests. There was no written management agreement between the Trust and Land Limited.
Mr X gave evidence that Land Limited incurred significant costs in undertaking management services for the Trust in the income tax year ended 31 March 2005. Mr X also gave evidence that Land Limited engaged Mr X and Mr Y through their respective management companies to provide management services. However, no formal agreements were executed in relation to the provision of these services.
The financial statements of the Trust for the 2005 year record management fees totalling $1,152,824 as an expense to the Trust. $1,116,000 of this sum is recorded as being management fees paid to Land Limited.
Without the management fee expense the Trust would have recorded income of $1,685,529 in the 2005 year. After the distribution of dividend income, the Trust would have had trustee income of $1,116,000 with tax to pay of $368,280. The management fee expense had the effect that the Trust then had no tax to pay.
The Commissioner disallowed the management fee expense on two grounds:
- that it was not incurred in the derivation of gross income, or necessarily incurred in the course of carrying on a business for the purpose of deriving the disputant's gross income and was not therefore deductible under s BD 2 of the Income Tax Act 1994 ("ITA"); or
- alternatively, if the management fee meets the requirement of s BD 2, it was part of a tax avoidance arrangement under s BG 1 of the ITA, which is void against the Commissioner for tax purposes.
The Commissioner also sought to impose a shortfall penalty for taking an abusive tax position or in the alternative, for taking an unacceptable tax position (in both cases reduced by 50%).
Deductibility under s BD 2 of the ITA
Section BD 2(1)(b) of the ITA allows a taxpayer a deduction for an amount of expenditure or loss to the extent it is either:
- incurred by the taxpayer in deriving the taxpayer's gross income; or
- necessarily incurred by the taxpayer in the course of carrying on a business for the purpose of deriving the taxpayer's gross income.
The TRA referred to the relevant case law on deductibility which made it clear a deduction is available only where the expenditure has the necessary relationship both with the taxpayer concerned and with the gaining or producing of his assessable income, or with the carrying on of a business for that purpose.
The TRA agreed with the Commissioner's submission that an entry in the Trust's financial statements recording a management fee expense does not establish that management services were provided. It found there was no evidence of any company resolution or any agreement between the Trust and Land Limited for the charging of management services, and there was no invoice for the management fee or supporting accounts for any of the work allegedly done.
The TRA concluded that the management fee was not deductible under s BD 2 of the ITA. It was not satisfied on the evidence that management services were provided and that the management fee was incurred by the Trust. Accordingly, it was not satisfied that there was the requisite nexus between the management fee of $1,116,000 (or any part thereof) and the gaining or producing of the Trust's assessable income or the carrying on of its business.
The TRA went on to consider whether the transaction is part of a tax avoidance arrangement under s BG 1 of the ITA, in the event it was wrong in finding the management fee was not deductible under s BD 2.
The TRA stated that the general avoidance provision does not confine the court as to the matters that may be taken into account when considering whether a tax avoidance arrangement exists.
The TRA found the whole transaction to be contrived and artificial and that it made no commercial sense. It was satisfied that one of the purposes of the arrangement was the avoidance of tax. Accordingly, the TRA was of the view that the tax avoidance purpose or effect of the arrangement was not merely incidental and as such, the arrangement is void against the Commissioner in accordance with s BG 1.
The TRA was also satisfied that the disallowance of the deduction claimed by the Trust was the only step required to be taken by the Commissioner to counteract the tax advantage.
The TRA considered that it could not be said (on any basis) that when viewed objectively the tax position adopted by the disputant was "about as likely as not to be correct".
The TRA was satisfied that when viewed objectively under either the deductibility provisions or an anti-avoidance arrangement, the transaction had a dominant purpose of avoiding tax. Accordingly, the TRA imposed a shortfall penalty under s 141 D of the TAA for taking an abusive tax position reduced by 50% for previous good behaviour under s 141FB.
Income Tax Act 1994, Tax Administration Act 1994