High Court confirms deductions for bad debts not available as operating a “Benevolence on the Conscience Loan Fund” not a money lending business

Summary

Unsuccessful taxpayer appeal of a decision in the Taxation Review Authority (“the TRA”). The High Court confirmed the Commissioner of Inland Revenue’s (“the Commissioner”) assessments disallowing two deductions for bad debts under s DB 31 of the Income Tax Act 2007 (“the ITA”) and imposing shortfall penalties under s 141A for not taking reasonable care. The appellant was found not to carry on a business of holding financial arrangements, nor had he discharged the onus of proving that he wrote the debts off as bad in the 2011 income year.

Impact

This is the first High Court authority on the application of s DB 31 of the ITA (or its predecessors) in 23 years, the latest being Budget Rent a Car Ltd v Commissioner of Inland Revenue (1995) 17 NZTC 12,263. It is also the first time the High Court considers subsection DB 31(1)(a)(ii) of the ITA which was inserted in the legislation on 27 February 2014 with retrospective effect to debts that go bad on or after 1 April 2008.

The High Court approached s DB 31 consistent with previous TRA decisions and applied settled legal principles (including the business test as laid down in Grieve v Commissioner of Inland Revenue [1984] 1 NZLR 101). For the most part, the case turned on its facts.

Facts

In a decision dated 29 March 2018, the TRA upheld the Commissioner’s assessments disallowing two deductions claimed in the appellant’s 2011 income tax return for bad debts in the amount of $50,000 and $122,280 respectively and imposing shortfall penalties under s 141A of the Tax Administration Act 1994 (“the TAA”) on the basis the appellant had not taken reasonable care (“the TRA’s Decision”). The loans were advanced in 2006 to two clients of the appellant’s legal practice out of a fund which the appellant had created for this purpose in 2005 and which he called his “Benevolence on the Conscience Loan Fund”. The clients were facing financial difficulties.

On appeal, the High Court upheld the TRA’s Decision.

Decision

The High Court found the appellant had not shown, according to his own accounting procedures, that the loans had been written off in the 2011 income year. Jagose J noted that except for the appellant’s own assertion there was no evidence that his office administrator, Ms Chan, had entered the write-offs in the spreadsheet during the 2011 income year. Ms Chan’s absence as a witness was unexplained. An inference was therefore available that what she may have said in evidence would not have assisted the appellant.

The High Court further found that the debtors (both being natural persons) had not been released at law from making further payments as they had not been discharged from bankruptcy under s 304 of the Insolvency Act 2006 at the time the deductions were claimed. Section DB 31(1)(a)(ii) of the ITA was therefore not applicable.

His Honour applied the business test in Grieve and held that the appellant was not carrying on, even in part, a lending business for the purpose of deriving assessible income. The appellant’s only hope of financial return was if grateful clients elected to reimburse him. The lending was a side project which was not carried on in an organised and coherent manner, or with sufficient continuity and extent to constitute a business.

There was also an insufficient connection between the appellant’s legal services business and the financial arrangements for which deductions were sought. Jagose J noted the two do not easily or naturally co-exist as lending money to clients raises significant issues under the Lawyers and Conveyancers Act (Lawyers: Conduct and Client Care) Rules 2008.

The High Court upheld TRA’s findings that the appellant failed to take reasonable care on the basis that a reasonable person in the appellant’s circumstances would have: (a) taken sufficient steps to understand relevant taxpayer obligations; (b) kept adequate books and records in regards to the Claimed Loans and the reasons for assessing the debts had gone bad; and (c) filed returns and paid tax on time.