Court of Appeal holds that expenditure incurred in deriving dividends is deductible pursuant to s DB 55 of the Income Tax Act 2007

Summary

In its tax returns for the 2011 and 2012 income years, NRS Media Holdings Ltd (“NRS”) claimed deductions for expenditure incurred in deriving exempt foreign dividends. The Commissioner of Inland Revenue (“the Commissioner”) disallowed those deductions on the basis that the expenditure did not have the necessary nexus with the dividends.

NRS commenced challenge proceedings in the High Court; Clark J upholding the Commissioner’s determination (NRS Media Holdings Ltd v Commissioner of Inland Revenue [2017] NZHC 2978, (2017) 28 NZTC 23-048). NRS appealed and the Court of Appeal held that the expenses for which NRS claimed deductions represent recurrent and regular business expenses, which are all manifestly revenue expenses. The Court of Appeal accordingly held that NRS ought to be entitled to a deduction for these expenses.

Impact

This case illustrates that there is little support in the authorities that for expenditure to be deductible under s DB 55 of the Income Tax Act (“the ITA”), a taxpayer has to show a direct link between the expenditure incurred and the derivation of dividends. The authorities also do not suggest that there is any great distinction between the tests for nexus under either subs 1(a) or 1(b) of s DA 1. What is required is the application of the statutory language to the particular circumstances.

Facts

NRS was the sole or majority shareholder of several subsidiaries (the subsidiaries). Two were incorporated in the United Kingdom, one was incorporated in Australia and another was incorporated in Canada. Those subsidiaries derived income by facilitating the purchase of media time by their client advertisers. Central to that business was software developed and licensed to them by a sister company of NRS, Persuaders Concepts (NZ) Ltd (Persuaders). For its part as parent company, NRS set the strategic plan for its group as a whole, and for each of its subsidiaries. In turn, it approved and monitored the business plans and the business activities of its subsidiaries as they operated within those strategic plans. It was in undertaking those activities that NRS incurred the expenses in question.

NRS categorised those expenses as comprising “payroll and consultants”, “marketing and travel”, “rent and occupancy” and “overheads”. These expenses totalled $1,706,568.23 and $1,963,472.31 in the 2011 and 2012 income years respectively.

NRS described the overall objective of its activities as being:

1. to maximise the financial return to the shareholders of NRS through increased dividends from the NRS subsidiaries, for the benefit of NRS; and
2. to enable NRS and its Board to discharge their obligations as parent company, from a legal governance perspective. The NRS subsidiaries were self-sufficient, with their own accounting, sales and management teams, and did not require support or services to be provided by NRS to operate on a day-to-day basis.

Decision

Nexus required under s DB 55 of the ITA

After having considered Commissioner of Inland Revenue v Banks [1978] 2 NZLR 472 (CA), as well as Buckley & Young Ltd v Commissioner of Inland Revenue [1978] 2 NZLR 485 (CA), the Court of Appeal noted Richardson J spoke in the alternative of "the gaining or producing of his assessable income" and "with the carrying on of a business for that purpose" without distinction as regards nexus. In light of this, it concluded that Richardson J appeared to see no reason to distinguish between the approach called for on that issue as regards the two provisions.

The Court of Appeal also held that there was little, if any, support that for the claimed expenditure to be deductible under s DB 55 of the ITA, NRS needed to show that the expenditure was:

1. directly linked to its exempt foreign dividend income in a positive way;
2. factually and casually directed to the production of the dividend income; and
3. incurred in the course of producing the dividend income.

The authorities do not seem to suggest a distinction between the tests for nexus under either of subs 1(a) or 1(b) of s DA 1. Rather, what is required is the application of the statutory language – here "the amount of expenditure incurred by the company in deriving the dividend" – to the particular circumstances.

The Court of Appeal also held that the case of Europa Oil (NZ) Ltd v Commissioner of Inland Revenue [1974] 2 NZLR 737 (CA), did not support the nexus characterisation adopted by the Commissioner and the High Court, and that Thornton Estates Ltd v Commissioner of Inland Revenue (1995) 17 NZTC 12,230 (HC), did not add much to that analysis. The legislative history also did not support the Commissioner's interpretation of s DB 55.

As to whether the nexus between NRS "expenditure and the deriving of dividend income has the necessary characteristics to support deductibility, the Court of Appeal noted that NRS" business was, as its witnesses described, to promote the interests of its shareholder investors by maximising the value of their investment and that there could be little doubt that the activities NRS engaged in for that overall purpose bore the necessary nexus with the deriving of the dividends paid to it by its subsidiaries.

After having considered Mr Gold's evidence, director of NRS, the Court of Appeal held that the necessary nexus did exist between the claimed expenditure and the exempt dividend income derived.

Whether NRS' expenditure was of a capital nature pursuant to s DA 2 of the ITA?

The Court of Appeal noted that the approach for determining whether expenditure is of a capital nature is settled, as demonstrated by the Court's decision in Easy Park Ltd v Commissioner of Inland Revenue [2018] NZCA 296, (2018) 28 NZTC 23-066. Ultimately the focus must be on what the expenditure was calculated to effect from a practical and business point of view.

The Court of Appeal held that NRS' business operations were, fundamentally, the oversight of its subsidiaries. The real value in the media business operated by NRS and NRS' subsidiaries was in the intellectual property of their business systems. From a practical and business point of view, NRS' expenditure was calculated to simply facilitate the operations of the subsidiaries rather than to improve the capital of the subsidiaries. In this respect, the Court of Appeal held that the expenses for which NRS claimed deductions represent recurrent and regular business expenses that NRS was entitled to deduct.