Deductibility under s DB 55(1)
2017 case note – High Court found taxpayer required to show expenditure has been incurred in deriving foreign dividend income – tax deductions.
NRS Media Holdings Ltd ("NRS") sought to claim deductions under s DB 55 of the Income Tax Act 2007 ("ITA"), for expenditure incurred by its head office in managing NRS' subsidiaries that periodically pay NRS dividends. The Commissioner of Inland Revenue ("the Commissioner") disallowed the deductions and NRS challenged the Commissioner's assessment.
The High Court found DB55 requires expenditure to be factually and causally incurred in the derivation of foreign dividend income. The expenditure claimed was insufficiently related to the derivation of foreign dividends which was one step removed from the purpose of the expenditure; which was to increase subsidiary value.
The test for deductibility under s DB 55(1) requires the taxpayer to show the expenditure has been incurred in deriving the dividend. A nexus showing only a connection between the expenditure and the carrying on of the business from which the dividend is derived is insufficient to satisfy the requirements.
It is noted that s DB 55 was retrospectively repealed by the Taxation (Annual Rates, Employee Allowances and Remedial Matters) Act 2014 effective 30 June 2009 for income years beginning on or after 1 July 2009, therefore this decision has limited impact going forward.
NRS is a New Zealand resident parent company of subsidiaries incorporated in various foreign jurisdictions. The subsidiaries provide and maintain systems that facilitate the sales of radio and television advertising space by their clients. The NRS Head Office has at all material times been located in Sydney, Australia, and consisted of a Chief Executive, Chief Financial Officer and four support personnel.
NRS sought deductions for the costs incurred over the course of two tax years by its Head Office, on the basis of foreign subsidiary expenditure. The deductions sought totalled $3,670,040.54 and were made up of the following elements:
- The salaries of the six staff;
- The rent of the office in Sydney;
- Telephone and other communication costs; and
- Travel and overseas accommodation costs for the Chief Executive and Chief Financial Officer.
The Commissioner proposed to disallow the deductions on the grounds that NRS had not incurred the expenditure in deriving dividend income.
The matter was later referred to the Disputes Review Unit and the Adjudication Report concluded that the claimed deductions were not allowed under s DB 55. Assessments were issued on this basis which NRS challenged.
The Court briefly discussed the relevant statutory framework including the calculation of assessable income, the 'general permission' for allowable deductions under s DA(1), and the 'exempt income limitation' which excludes deductions for amounts incurred in deriving exempt income. Dividends received from foreign subsidiaries are exempt income under s CW9(1) of the ITA.
Under s DB 55, the exempt income limitation may be overridden. It allows a company that derives a dividend from a foreign company to deduct expenditure incurred by the company in deriving that divided.
S DB 55(1)
NRS argued s DB 55 did not bear the narrow interpretation advanced by the Commissioner, and contrary to the Commissioner's approach, there is no requirement for the expenditure to be directly linked in some positive way, nor factually and causally directed. Rather, the taxpayer must establish the costs in question were "incurred in the course of" deriving the income.
The Commissioner argued a 'narrower' scope for s DB 55 that concerns itself with expenditure incurred in the operation of a taxpayer in earning its income, not expenditure incurred in operation of a subsidiary. The expenditure focussed on improving subsidiary and was only indirectly linked to deriving dividends.
There is no case law on DB55 but a substantial amount on the 'general permission' in s DA 1. The Authorities recognised the distinction between the first and second limb of s DA 1. Given the materially similar terms of DB55(1) to the first limb of s DA 1, the High Court considered there is no basis for placing a different construction on each.
Section DB 55 does not contain an equivalent of the second limb of the General Permission, which allows deductions for expenditure incurred in the course of carrying on a business for the purpose of deriving income. The deductions allowed under s DB 55 are available only in respect of those expenses incurred in deriving dividends. NRS had to establish that its expenditure factually and causally was directed at deriving a foreign dividend.
Justice Clark found the expenditure claimed was insufficiently related to the derivation of foreign dividends and was one step removed from the purpose of the expenditure which was to increase the subsidiary value.
The evidence provided by NRS showed the expenditure provided services to the subsidiaries to maximise the value of each subsidiary and therefore its profitability. The first consequence of the expenditure was to improve the subsidiaries and a further consequence was the receipt of foreign dividends. Deriving dividends was an ancillary consequence of the increasing profitability and value of the subsidiaries.
Expenditure in order to maximise value and profitability of companies returning dividends is not deductible under DB55. Such expenditure might fall within the second limb of the general permission but not within the more restricted scope of s DB 55.
Accordingly, NRS' foreign subsidiary expenditure is not deductible and the Commissioner's assessments were confirmed.
Income Tax Act 2007 section DB 55