General permission not satisfied when shareholder incurs legal fees in derivative action

Summary

The issue in this case was whether a shareholder/director was entitled to a deduction for legal fees he incurred in bringing a derivative action against other directors. The Taxation Review Authority (“Authority”) concluded that the true nature of what was gained and what was sought to be gained by the expenditure of legal fees was the same thing – recovery of losses suffered by the company. Any recovery by the shareholder would be an indirect consequence of a successful claim by the company. The Authority held that the general permission was not satisfied as there was insufficient linkage between the payment of the legal fees and the shareholder’s income earning process for the expenditure to be deductible.

Impact

The judgment provides a useful statement on the application of s DA 1 of the Income Tax Act 2007 (“ITA”) with respect to legal fees incurred by individual shareholders pursuing derivative actions in the name of a company. It confirms the position that such expenditure does not satisfy the general permission under s DA 1.

Facts

The disputant was a director and shareholder (as to 3/900 shares) of ABCL. The disputant’s family trust was also a shareholder (as to 297/900 shares) in the company. The remaining shares were held by the other two directors of ABCL, Ms M and Mr X, who held 300/900 shares each. 

A dispute arose between the disputant on the one hand, and Ms M and Mr X on the other. When the dispute could not be resolved, the disputant sought leave to bring a derivative action in the name of ABCL against Ms M and Mr X, under s 165 of the Companies Act 1993 (“CA 1993”). Leave was granted on condition that the disputant would be personally responsible for all costs and disbursements. The disputant did not seek an order under s 166 of the CA 1993 for the costs to be borne by ABCL.

ABCL did not succeed on its principal claims, but enjoyed limited success in relation to two causes of action. In its statement of claim, the remedy sought was an award in favour of ABCL for damages and/or an account of profits and/or damages for loss of anticipated profits. However, the order sought in ABCL’s closing submissions at the hearing was for equitable compensation to be paid directly to the disputant in the amount of one third of such loss as ABCL may be found to have suffered.

The Court ordered that Ms M pay equitable compensation in the amount of $3,333.33 (being one third of the company's loss) to the disputant; and that both Ms M and Mr X pay equitable compensation in the amount of $8,200 to the disputant. As ABCL did not succeed on its principal claims, the Court held that it was appropriate for costs to lie where they fell.

In the current proceeding, the disputant claimed a deduction of $78,348.91 for the legal fees incurred by him in bringing the derivative action. Even though the disputant recognised that the compensation awarded to him was for losses suffered by ABCL, the disputant claimed that because the company was not in liquidation, ABCL's funds in his hands could only be a dividend to him, which was his assessable income. This was so even though the compensation was not paid in proportion to the shareholdings in ABCL.

In the disputant’s submission, he had incurred the legal expenses with a view to receive the equitable compensation, which he claimed was his assessable income. He therefore claimed that there was a sufficient nexus between his assessable income and the legal expenditure so as to make the legal expenses deductible under s DA 1 of the ITA.

Alternatively, the disputant contended that the compensation received by him was his income under ordinary concepts (being funds which replaced a dividend that would clearly have been his income). The disputant submitted that consequently the legal fees incurred in deriving the compensation were deductible.

Decision

The Authority found that no deduction was allowed for the legal fees incurred by the disputant in respect of the derivative action because there was an insufficient nexus between the expenditure on the legal fees and the disputant’s assessable income.

Referring to Buckley Young Limited v Commissioner of Inland Revenue [1987] 2 NZLR 485 (CA) at 487, the Authority noted that a deduction is available under s DA 1 only where the expenditure has the necessary relationship both with the taxpayer concerned and with the gaining or producing of the taxpayer’s assessable income or with the carrying on of a business for that purpose.

The Authority commented that the legal fees for which the deduction was claimed were clearly incurred for the purpose of prosecuting the derivative action. As such, the Judge recognised that the expenditure could be said (at least in part) to be "incidental and relevant" to the gaining or producing of assessable income by ABCL (The Authority cited from Magna Alloys Research Pty Ltd v Federal Commissioner of Taxation (1980) 33 ALR 213 at 225; which was followed in Creer v Federal Commissioner of Taxation 28 ATR 442 (FCA)).

The Judge did not accept the disputant’s submission that the quality of the advantage gained (as opposed to what was sought to be gained) should be the focus of the inquiry so that the equitable compensation took on the quality of income in the disputant’s hands. The Authority accepted the Commissioner’s submission that the true nature of what was gained and what was sought to be gained was the same; namely the recovery of losses suffered by ABCL as a consequence of the alleged breaches by two of its directors/shareholders. In the Authority’s view, the fact that an order was made to pay equitable compensation of one third of such losses to the disputant did not alter the purpose of the expenditure and did not create the necessary linkage between the expenditure and the gaining or producing of assessable income by the disputant.

In the disputant’s submission, it was incorrect and too narrow to conclude that the disputant only sought to gain an advantage for ABCL. Rather, the disputant claimed that he incurred the legal fees to benefit himself. The Authority did not accept the disputant’s submission and found that, while the disputant would have pursued the derivative action with the hope/expectation of some recovery to the remaining shareholders, any such advantage to the disputant would be an indirect consequence of a successful claim by ABCL.

Referring to Case T9 (1997)18 NZTC 8,049, the Authority observed that where a business person conducts business through a company in which that person is a shareholder, expenditure by that business person on behalf of the company is very likely to relate to the company’s income earning process not to the income earning process of the business person.

The Authority was satisfied there was an insufficient nexus between the expenditure on legal fees incurred by the disputant in respect of the derivative action and the gaining or producing of the disputant's assessable income. It therefore found that the general permission under s DA 1 was not satisfied.

As the Authority had concluded that the general permission under s DA 1 had not been satisfied, her Honour concluded that it was not necessary to consider whether the expenditure was income or capital under s DA 2.