Court of Appeal dismisses Honk Land Trustee Limited's appeal in relation to a $1.1m management fee tax deduction

Summary

The Court of Appeal upheld decisions of the High Court and the Taxation Review Authority ("the TRA") confirming the Commissioner of Inland Revenue's ("the Commissioner") disallowance of a $1,116,000 management fee for income tax purposes.The Court of Appeal dismissed Honk Land Trustees Limited’s ("HLT") appeal on the following alternative grounds: (1) there was no satisfactory evidence to show that management services were in fact provided; (2) there was no sufficient nexus shown; and (3) in the event the management fees were deductible, they were nevertheless part of a void tax avoidance arrangement. Additionally, the Court of Appeal agreed that the Commissioner was entitled to impose abusive tax position shortfall penalties.

Impact

The Court of Appeal provided statements on the deductibility of management fees between related entities, including useful guidance as to what it would expect to see in order to show that management fees were in fact provided.

Introduction

This case is a further appeal by HLT of the TRA’s decision confirming an assessment made by the Commissioner disallowing a $1,116,000 income tax deduction HLT claimed in the 2005 income year. The deduction related to a management fee that, in its capacity as the corporate trustee of Honk Land Trust ("the Trust"), HLT had paid to a related entity, Honk Land Limited ("HLL").

The High Court (per Ellis J) found that the TRA was correct to find that no management services were provided by HLL to the Trust. HLT appealed Ellis J's decision to the Court of Appeal.

The essence of the decision of the TRA, endorsed by the High Court, was:

1. The management fees were not deductible because there was insufficient proof they related to any relevant services actually provided by HLL.
2. Alternatively, the charging of the fees was a contrivance designed to enable the Trust to avoid paying tax.
3. The imposition by the Commissioner of a 50 per cent shortfall penalty was appropriate on the ground that HLT had taken an abusive tax position.

Facts

Mr David Andrew Tauber ("Mr Tauber") is the settlor and a discretionary beneficiary of the Trust, which was created in 2002. Initially, HLL was the Trust’s corporate trustee but was replaced in July 2004 by HLT.

In 2005 Mr Tauber was the controlling mind of a number of companies and other entities beneficially owned by the Trust. HLT directly owned Honk Group Limited which, in turn, directly and indirectly owned various other companies undertaking different business activities. HLL was one of those subsidiary companies.

The Trust’s financial statements in the 2005 income year included a management fee expense of $1,116,000 to HLL. The income tax effect of this management fee was that the Trust had no tax to pay. In turn, HLL offset the $1,116,000 payment it received against existing losses with the result that HLL paid no tax on the management fee income.

Decision

Were management services provided by HLL to HLT?

Counsel for HLT submitted that the High Court was wrong to find that HLT had not satisfied the onus of establishing that management services were in fact supplied by HLL to HLT.

Before providing its own analysis, the Court of Appeal set out the reasoning of the High Court and TRA’s findings on this point. The Court of Appeal observed that the TRA had noted the absence of any documentary evidence other than the recording of the expense in the end-of-year financial statements for both entities, and the absence of any detailed evidence of particular services for which the management fees were charged or for what entity particular work was done. The Court of Appeal also observed that the High Court, having reviewed the transcript of the evidence given before the TRA, had concluded that Mr Tauber's evidence was “implausible, contradictory, vague and equivocal”; that there was a lack of clarity in Mr Tauber's evidence about the extent to which the fee charged included an amount for services allegedly provided in the 2004 year; and that there was a surprising and contradictory shift in Mr Tauber's evidence as to which entity had provided the services to the Trust.

While acknowledging that it was not in dispute that the Trust required some management in respect of its own assets and business, the Court of Appeal held that HLT had simply failed to meet the threshold of identifying what management services were provided to the Trust and did not prove they were performed by HLL.

The Court of Appeal referred to the following key points:

1. in the 2004 income year, HLT paid a total of $378,393 in management fees directly to Basin Ridge Management Limited (Basin Ridge, Mr Tauber's management company) and to another entity associated with Mr Tauber's business associate. HLL did not receive any income from management fees but was charged $424,282 by Basin Ridge;
2. in the 2005 income year (although according to Mr Tauber HLL undertook the management work for all entities in the Honk Group) HLL was charged management fees totalling $497,970 by Basin Ridge and three other providers. That was necessary because HLL had no employees of its own;
3. the 2005 income year was the first and only time HLL charged the Trust management fees, and this expense happened to be claimed in the first year the Trust made a profit;
4. the management fee matched the surplus profit in the Trust and had the effect of eliminating the tax otherwise payable by HLT;
5. the management fee also enabled HLL to offset the amount received against its losses; and
6. without the management fee payment, HLT would have been liable to pay tax of $368,280 and HLL would have had a loss of $966,788 for the year.

The Court of Appeal opined that the lack of documentary evidence and the fact that the management fee amount was decided at or after the end of the financial year (and retrospectively allocated monthly by journal entry) was not necessarily fatal for HLT. The problem for HLT was that Mr Tauber had failed to provide any detailed or convincing explanation as to what management services were provided or how the sum charged was calculated.

The Court of Appeal agreed that the proper inference to draw is that the management fees for 2005 were fixed by reference to HLT’s taxable income and for the purpose of eliminating its liability for tax in that year. There was no satisfactory evidence to support the claim that management services were provided by HLL to HLT or in what amount.

Was the High Court correct to find there was no sufficient nexus shown between the management fees and the earning of HLT’s assessable income and/or in the course of carrying on its business?

The authorities relating to deductibility of expenses are well known and were not in dispute. HLT submitted that it was difficult to differentiate between management services provided or required for individual entities in the Honk Group. Counsel argued that in such circumstances, with tightly held companies and other entities, it was permissible to take a global approach to the allocation of management fees. This argument was rejected by the Court of Appeal for two main reasons. First, s BD 2 of the Income Tax Act 1994 (“ITA”) is focussed on expenditure by the tax-paying entity concerned and which has the required nexus with the derivation of that taxpayer’s income. Second, the section permits deductions for expenditure only to the extent that it is incurred for any of the purposes identified in that section. The Court of Appeal noted that “to the extent that” contemplates apportionment between expenditure that is properly attributable to the identified statutory purpose and that which is not.

Although the Court of Appeal acknowledged that complete precision may not always be possible with regard to the division of management services between the members of a group, the Court found that the evidence in this case fell well short of even a modest degree of precision.

Was the High Court correct to hold that if the management fee was deductible, it was part of a tax avoidance arrangement under s BG 1 of the ITA?

The Court of Appeal also considered the Commissioner’s alternative submission that if the management fees were deductible under s BD 2 of the ITA, then the transaction was part of a tax avoidance arrangement pursuant to s BG 1. The Court of Appeal said they would have had no difficulty agreeing with the High Court that there was a tax avoidance arrangement. The Court of Appeal was satisfied that the circumstances in which the management fees were fixed and charged were contrived and artificial and were clearly made for the purpose of eliminating the income tax otherwise payable. The Court of Appeal agreed with the Commissioner that another purpose and effect of the arrangement was not only to eliminate any tax obligation in HLT but was also to transfer taxable profits out of the Trust to HLL which effectively amounted to a loss offset between a company and a trust, which is not permitted.

Additionally the Court of Appeal was satisfied that it would have been unnecessary for the Commissioner to exercise the reconstruction powers available under the ITA. The Court of Appeal agreed with the Commissioner that it was irrelevant that, instead of using the management fee to transfer the Trust profits to HLL, HLT could have distributed the profit to HLL as beneficiary income. Citing the Court’s decision in Alesco New Zealand Ltd v Commissioner of Inland Revenue [2013] NZCA 40, [2013] 2 NZLR 175 at [39] and [40], the Court of Appeal held that the question was whether the particular arrangement had the effect of avoiding or reducing any liability to income tax; the issue was not whether the taxpayer would have been equally able to avoid or reduce its liability by implementing a different and permissible arrangement.

Was the High Court correct to hold that HLT was liable for an abusive tax position penalty under s 141D of the Tax Administration Act 1994 (“TAA”)?

The Court of Appeal agreed that the Commissioner was entitled to impose a shortfall penalty under s 141D of the TAA. The basis for the Court’s finding included the following factors: there was clearly a tax shortfall for the 2005 income year, an unacceptable tax position was taken by HLT entering into arrangements with the dominant purpose of reducing or removing its tax liability, and HLT could not have reasonably concluded that it was appropriate to deduct management fees for services not actually provided.