Crediting may not constitute payment

Summary

The High Court held that crediting an amount to a shareholder's current account in respect of an existing liability in circumstances where there were insufficient funds for the shareholder to draw down the full amount, did not constitute payment.  Because there was no final payment under the financial arrangement in this case, a base price adjustment ("BPA") was not required.

Impact

Where the crediting of a shareholder account reflects a pre-existing liability and all the funds are not actually available to be placed unreservedly at the disposal of the account holder, the crediting of a current account may not constitute a final payment under a financial arrangement, so as to trigger a BPA.

The decision is also an example of the difficulty in preventing new documents being introduced before a hearing authority  under s 138G of the Tax Administration Act 1994 ("TAA").

Facts

The appellant is the sole shareholder and director of Bathos Properties Ltd ("Bathos"). In 1986, Bathos became indebted to the Bank of New Zealand ("BNZ").  The appellant personally guaranteed the lending and Bathos gave BNZ a debenture over its assets as security. Bathos then ran into financial difficulty and BNZ appointed receivers.

The resulting litigation between BNZ and the appellant was settled by an agreement whereby the appellant agreed to pay BNZ $90,000 in return for Bathos' debt to BNZ, which amounted to $2,659,442.06, being assigned to him. The agreement was formalised in a Deed of Admission of Liability and Settlement ("Deed").

Between 1996 and 2004, Bathos did not trade. In 2004, after Bathos commenced trading, it credited $2,659,442 (being the amount of the debt assigned under the Deed) to the appellant's current account.

Financial statements for Bathos for the 2005 to 2007 income years showed net drawings over this three year period of $2,238,592. The assigned debt was not recorded in the financial statements as a term liability.

The appellant returned no taxable income for the 2001 to 2010 income years. The appellant had no bank account. He did not draw a salary from Bathos and drew money from his current account to fund family living expenses.

The Taxation Review Authority ("TRA") found that the payment by the appellant of $90,000 to BNZ to acquire Bathos' debt was a financial arrangement for the purposes of the accrual rules in Part EH of the Income Tax Act 1994 ("ITA"). The TRA further found that the financial arrangement had matured in 2005, which meant a BPA was required in that year. The appellant appealed to the High Court.

Decision

The appeal was allowed.

Was the credit to the current account a "payment"?

Cull J distinguished the authorities relied on by the Commissioner of Inland Revenue ("the Commissioner") where funds which had been credited into current accounts were held to be "payments" for the purpose of paying dividends and director's fees. She noted that in those cases, the dividends or salary credits constituted an allocation of income or retained earnings which were not previously payable. She also noted that crediting to a current account will only amount to payment where it is done with the shareholder's consent.  

In this case, Cull J found that the crediting to the appellant's current account was recognition of an existing liability, there had been insufficient funds available to pay the appellant had he demanded immediate payment of the full amount, and there had not been a decision by Bathos to make a payment to the appellant in the 2005 tax year. Accordingly, the Court held that the crediting to the current account in the present case did not constitute a "payment".

Had the financial arrangement matured?

Cull J did not accept the Commissioner's submission that even if there were insufficient available funds the appellant could have drawn down funds from related entities and written off the remaining $690,000 as a bad debt. The Court again distinguished the cases relied upon by the Commissioner, noting that in those cases money was placed unreservedly at the disposal of the directors or shareholders, whereas in the present case there was not a sum of money to constitute payment, but rather an assignment of debt. The Court found that because there had been no final payment under the financial arrangement, a BPA had not yet been triggered. Accordingly, the Court found that it would be premature to tax the full credit sum in the 2005 tax year as no taxable event had occurred in that year.

Should the application by the appellant to admit documents have been allowed?

On the day of the TRA hearing, the appellant sought leave to produce further accounting documents dated between 1992- 2003. The TRA relied on s 138G(2) of the TAA to refuse to admit the documents. The TRA held that there was a new issue being raised, that the documents could have been located before the hearing and that there was no manifest injustice to the appellant. Leave was refused under r 8.31 of the District Court Rules to admit the documents because of the risk of prejudice to the Commissioner.

The High Court found that the TRA erred in refusing to admit the documents. Cull J held that the documents did not raise a new issue, but corroborated the evidence of the appellant that there was no payment in 2005. Her Honour considered that, as the documents were supportive of the appellant's position, it was in the interest of fairness that they should be admitted. Any prejudice to the Commissioner could have been overcome by adjourning the hearing. As the TRA is a Commission of Inquiry, the Judge found that it should have received the documents as evidence that would have assisted it to deal effectively with the subject of the enquiry under s 4B(1) of the Commissions of Inquiry Act 1908.

Did the crediting to the appellant's account take place in 2005 or prior, and if prior to 2005, what significance, if any, should be attached to the date of crediting?

The Court noted that the amount of the assigned debt had been owing to the appellant for a decade. Referring back to her earlier finding that the crediting did not constitute "payment", Cull J went on to say that the only significance which could be attached to the date of the retrospective crediting to the appellant's account was that Bathos recommenced trading in 2005. So Bathos was then in a position to enable the appellant to draw down part of the debt owing to him.

Other matters

Receipt of benefits under the accrual rules

The Court did not accept the Commissioner's submission that the movements of benefits have to be taken to tax under the accrual rules. The Court noted that there is no reference to benefits within the accrual rules under the ITA.

Obligation on disputant to show that the assessment is wrong and by how much

The Court was satisfied that the appellant had discharged the onus of proving why the Commissioner's assessment was wrong.

Alternative spreading method

The Court was not satisfied that the Commissioner’s proposed alternative spreading method in s EH1(2)-(7) was applicable. It noted that it was now open to the Commissioner to reassess the appellant’s income tax liability, in light of the High Court’s decision.