When crediting is not payment

Summary

The Court of Appeal 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 the last payment contingent on the financial arrangement. Thus the arrangement had not matured under the financial arrangement rules (“FAR”) and a base price adjustment (“BPA”) was not triggered.

Impact

This decision clarifies that crediting to a shareholder’s current account, when funds are not unreservedly at the disposal of the account holder will not constitute a final payment under the FAR so as to trigger a BPA.
Note: This decision applies the old FAR which have been changed.

Facts

A 1992 Settlement Deed provided that in consideration of Mr Fugle’s payment of $90,000, the Bank of New Zealand (“Bank”) assigned Mr Fugle a debt of $2,659,442.06 (plus accruing interest) owed to the Bank by Mr Fugle’s company, Bathos Properties Ltd (“Bathos”). This transaction is a financial arrangement to which the financial arrangements rule, in subpart EH of the Income Tax Act 1994 applied.

During the 2005 tax year, Bathos credited $2,659,442 to Mr Fugle’s current account.

Mr Fugle drew down $452,754 in the 2005 tax year; $1,064,364 in the 2006 tax year; and $751,475 in the 2007 tax year. The funds drawn down were used in part to support Mr Fugle and his family. Between 2001 and 2010, Mr Fugle returned no income and paid no income tax.

The Commissioner of Inland Revenue (“the Commissioner”) commenced an audit in July 2007 and financial statements for Bathos for the 2005, 2006 and 2007 years were prepared and provided to the Commissioner in 2010. In the financial statements the assignment of debt was credited, as a net sum in Mr Fugle’s current account.

Following the audit, on 10 October 2014, the Commissioner issued a notice of assessment of an additional amount of income of $2,569,442 in the 2005 tax year, derived as the result of a required base price adjustment upon the maturity of the financial arrangement with the crediting to Mr Fugle’s shareholder account.

Mr Fugle challenged the assessment on the grounds that there was no final payment and hence, no base price adjustment was required.

The Taxation Review Authority (“the Authority”) accepted the Commissioner’s argument that the Bathos indebtedness was paid by the crediting of the full amount of the debt to Mr Fugle’s shareholder account. This was on the basis that the funds were placed at Mr Fugle’s disposal and he was able to draw down against payment of that debt as and when he required. They held that it was not necessary for the full amount of the funds to have been immediately available to Mr Fugle. As the crediting of the entire amount of the debt was the last payment contingent upon the financial arrangement, the arrangement matured and a base price adjustment was required.

Mr Fugle appealed the Authority’s decision to the High Court.

The High Court held that the crediting to Mr Fugle’s current account in 2005 was not a payment; there was no sum of money to constitute a payment, but rather an assignment of debt. Consequently, there was no final payment under the FAR and a BPA was not yet triggered.

The High Court further held that the Authority erred in excluding evidence that had not been discovered to the Commissioner, and it accepted that that evidence proved the crediting to Mr Fugle’s account occurred much earlier than the 2005 tax year.

The Commissioner appealed.

Decision

On the first issue, whether crediting in the 2005 tax year constituted payment for the purposes of the FAR, the Court of Appeal held that payment by crediting does not require the actual book entry in the current account to be made at the same time the act of payment is said to occur.

The Court of Appeal held that before there is payment, the company (here Bathos) would have had to have the full amount available to be drawn down by Mr Fugle in the normal course of business and in this matter, there was an implicit agreement between Bathos and Mr Fugle, that the assigned debt would be paid only as permitted by the available resources in the company from time to time. Payment in full was not made until the full amount was unconditionally available to be drawn down, and that did not occur in the 2005 tax year.

Consequently, the crediting of Mr Fugle’s shareholder’s account of an amount greater than the funds then available to Bathos was not the last payment contingent on the financial arrangement. Accordingly, the arrangement had not matured and a BPA was not triggered.

On the second issue, whether the Commissioner could raise an alternative argument that if no BPA was triggered, then Mr Fugle was required to return accrual income pursuant to one of the spreading methods under the FAR, the Court of Appeal held that because the Commissioner’s Statement of Position did not raise an issue to the effect that there was an obligation on Mr Fugle to spread income over the term of the arrangement, s 138G(1) of the Tax Administration Act 1994 precluded the Commissioner from advancing this argument.

The Court of Appeal noted that while the Authority may, on application, allow an applicant to raise new propositions of law and new issues at a challenge to a disputable decision, the Court of Appeal is not granted the same power.

Despite refusing to consider the substance of the Commissioner’s spreading method submission, the Court of Appeal at [41] of its judgment indicated that it did not endorse Cull J’s view in the High Court that the spreading method had no application because the payments were “principal” and not interest citing Sovereign Assurance Company Limited v Commissioner of Inland Revenue [2013] NZCA 652, (2013) 26 NZTC 21-056 (“Sovereign Assurance”).

In Sovereign Assurance the Court of Appeal recognised the central purpose of the accruals regime as being to eliminate the orthodox distinctions between capital and revenue such that the regime takes into account all cash flows.

On the final issue regarding the admissibility of new documents before the Authority, the Court of Appeal, by its conclusion on the primary issue, rendered this matter academic and unnecessary to address.

Mr Fugle sought increased costs on appeal, submitting that the spreading method argument was obviously precluded under s 138G and was clearly wrong and had resulted in increased complexity.

The Court of Appeal held that although it declined to consider the spreading method argument, it did not determine the argument lacks merit. The argument was raised in both the Authority and in the High Court, but was not ruled upon in either instances, thus the Commissioner was entitled to press the point.

No increased costs were awarded.