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29 Mar 2018
Appeal Status

Lawyer who lent money to clients denied deduction for bad debts

The disputant is a solicitor in sole practice who claimed two deductions for bad debts in respect of loans he had extended to clients of his legal practice.

XXX v Commissioner of Inland Revenue [2018] NZTRA 03


The disputant is a solicitor in sole practice who claimed two deductions for bad debts in respect of loans he had extended to clients of his legal practice. The Taxation Review Authority (“the Authority”) found that the deductions were not allowed because the disputant had not shown that he had written the debts off as bad in the income year in which he had claimed them, nor were the debtors released from their obligations to pay by operation of law in that income year. Furthermore, the Authority found that the disputant had not satisfied the requirement of carrying on a business which included dealing in or holding financial arrangements. A shortfall penalty was imposed for not taking reasonable care under s 141A of the Tax Administration Act 1994 (“the TAA”).


The decision provides the first authority in respect of the application of subsection DB 31(1)(a)(ii) of the Income Tax Act 2007 (“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 position taken by the Authority in respect of the existence of the public ruling and the imposition of shortfall penalties provides a nuance of the legal position as taken in Easy Park Limited v Commissioner of Inland Revenue [2017] NZHC 1893 ("Easy Park"). In Easy Park Ellis J reasoned that the existence of a public ruling suggested the subject matter was difficult and controversial and went on to find that the tax position taken by the plaintiff was not unacceptable for the purpose of imposing shortfall penalties under s 141B of the TAA. The Authority in the present case also considered that the public ruling signified a complexity of the law, but found that a reasonable person in the disputant’s circumstances ought to have sought legal or tax advice before taking the tax positions when confronted with complex and technical legislation. Shortfall penalties were therefore found to have been properly imposed for failing to take reasonable care under s 141A of the TAA.

The Authority otherwise applies settled legal principles (including the business test laid down in Grieve v Commissioner of Inland Revenue (1984) 6 NZTC 61,682) in considering the application of s DB 31 of the ITA and whether the disputant could avail himself of any of the listed exceptions to the general rule that deductions for bad debts are not allowed.


The disputant, a barrister and solicitor in sole practice, operated the ‘Benevolence on the Conscience Loan Fund’ (“the Fund”) from which he extended loans to clients of his legal practice. The disputant described the Fund as adjunct to and part and parcel of his legal practice. His money lending services were extended only to longstanding clients who met his criteria of being people of good standing who could benefit from his assistance and where the need for assistance was related to a matter arising in the course of the disputant acting for the client.

In return, the clients had to agree to treat the disputant equitably. On this basis, the disputant hoped that the clients would pay him a bonus as well as interest on the lending. The disputant explained the benevolence part of the lending was that if clients could not pay it would be against his conscience to bankrupt them.

In his 2011 income tax return the disputant claimed deductions in respect of two loans of $50,000 and $300,000 which he had written off as bad debts.

The first loan was recorded in a basic loan agreement dated 12 July 2006, the terms of which provided that the borrower authorised the disputant to pay the net loan advance of $44,000 to the bank account held in the name of a company (“XY Limited”) and $4,000 to “Mr C”. The loan provided that it was to be a ‘short term of loan: repayable on demand with interest at 10% on repayment’. The loan was unsecured.

The second loan was made by the disputant to “Mr T” and was recorded in a loan agreement in similar form dated 20 December 2006. This loan was also unsecured and described as being short term: “Repayable on demand with fair interest to you [the disputant] on repayment”.

The disputant also claimed to have made at least three further loans of $200,000, $1,300,000 and $595,000 from the Fund since its inception in 2005. A previous loan of $20,000 was made in 1998. A loan agreement detailed that this loan was secured against a motor vehicle, interest of 22.4% per annum, default rate of 25% per annum. The borrower defaulted and the disputant had issued proceedings. The disputant explained he had not written off this debt as bad in his accounts as the borrower had been an associate and not a client of the firm.


The Authority first noted that the general rule is that deductions are not available for bad debts, subject to certain exceptions set out in s DB 31 of the ITA. Her Honour then went on to consider whether those exceptions applied.

Loans not physically written off as bad in the income year

Her Honour noted that the issue for determination is whether the debt has in fact been written off as bad in whatever books of account or accounting procedures are kept by the taxpayer. The disputant’s evidence was that he operated a single-entry accounting system based on excel spreadsheets. He claimed that his legal executive had noted the write-offs in the profit and loss spreadsheet at the time the disputant became aware of Mr T’s bankruptcy and when Mr C’s company had been struck off the Companies Register.

The investigator gave evidence that in his experience profit and loss accounts were usually prepared after the end of the financial year as it was then that all the final figures were available. The investigator also gave evidence that he had checked the metadata of the profit and loss excel spreadsheet and noted that the document was created on 20 September 2011 (i.e. in the 2012 income year).

Her Honour noted that the legal executive had not been called to give evidence and found the disputant’s evidence as to the steps taken by her to be unreliable. Accordingly her Honour found the debts had not been physically written off during the 2011 income year so as to satisfy the requirements in s DB 31(1)(a)(i) of the ITA.

Loans not released by operation of law

The Authority first found that the $50,000 loan had been extended to Mr C as an individual as opposed to XY Limited, as evidenced from the loan agreement which used personal pronoun throughout. As such it was the Insolvency Act 2006 (“the IA”) as opposed to the Companies Act 1993 which contained the operative provisions which could release a loan by law. Section 304(1) of the IA provides that a person is released from their debts upon discharge from bankruptcy. As Mr C had never been adjudicated bankrupt and Mr T was only discharged from bankruptcy in 2013, the requirements in s DB 31(1)(a)(ii) of the ITA in respect of the debts being released by operation of law had not been met.

Disputant did not carry on a business which included holding financial arrangements

The Authority held that the disputant had not carried on a business which included holding financial arrangements. While her Honour accepted that the disputant had a profit making intention when extending the loans the disputant had committed very little time or effort on the operation of the Fund and the lending activities of the Fund were not carried out on anything like a commercial basis. The disputant had not required periodic payments of either interest or principal and the disputant had not taken any steps to recover any of the outstanding balances and did not take security for the loans. The disputant’s evidence was that he had forgotten about the loan to Mr C until he was approached by Mr C for a second loan in 2009. Furthermore, the disputant had not advertised his moneylending services and had in fact required the confidentiality from his clients in respect of his lending to them.

Her Honour characterised the lending activity as that of a private individual using his capital funds to make loans to assist clients in financial difficulty who also meet his lending criteria. Accordingly, the requirements under s DB 31(3) had also not been met.

Deduction not allowed under general permission

The disputant argued that if a deduction was not available under s DB 31 of the ITA then a deduction should be allowed under the general permission. The Authority noted that s DB 31(6) set out the relationship between s DB 31 and subpart DA and found that as s DB 31(3) overrides the general permission it was not necessary to consider whether a deduction is available under the general permission once a determination is reached under s DB 31(3).

Shortfall penalties properly imposed

The Authority found that shortfall penalties for failing to take reasonable care pursuant to s 141A of the TAA had been properly imposed. The disputant had failed to act with the degree of care expected of a taxpayer in his position in not satisfying the obligations placed on taxpayers under s 15B of the TAA. The Authority further found that the disputant, when faced with complex and technical legislation, should have sought advice from a tax advisor before claiming sizable deductions which would necessarily result in a tax shortfall if the disputant was wrong in his application of the law.

Tax Administration Act 1994 ss 3, 15B, 138G, 141A, 141FB, 141I and 149; Income Tax Act 2007 ss BD 4, DB 31, DA 1 and EW 29; Insolvency Act 2006 s 304.