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

Summary

This was a second appeal from a decision of the Taxation Review Authority (“the TRA”) which had been upheld by the High Court on a first appeal. The Commissioner of Inland Revenue (“the Commissioner”) had issued assessments disallowing two deductions 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”) for not taking reasonable care.

In 2005 the appellant, a barrister and solicitor in sole practice, had created a fund which he called his “Benevolence on the Conscience Loan Fund”, from which he extended loans to clients facing financial difficulties. The two loans for which the appellant had claimed bad debt deductions had been advanced from this fund in 2006. The appellant wrote the debts off, claimed deductions for them in his 2011 income tax return and carried part of the losses through into the 2012 income year. He asserted that he was in the business of dealing in or holding financial arrangements and that he had physically written off the debts as bad in the 2011 income year. The Commissioner contested these assertions.

Impact

This is the first Court of Appeal authority on the application of s DB 31 of the Income Tax Act 2007 (“the ITA”) (or its predecessors). It confirms the approach taken by lower courts in earlier cases, including that the Grieve v Commissioner of Inland Revenue [1984] 1 NZLR 101 (“Grieve”) business test is appropriate for determining whether a taxpayer carries on a business of dealing in or holding financial arrangements and that a physical write off is required to be made in whatever books of account used by the taxpayer during the income year in which the deductions are claimed. It is also the first time the Court of Appeal considers the application of s 141A of the TAA.

The Court of Appeal also confirmed that tax litigation is a specialist area of law, meaning it is reasonable to engage out of town counsel and recover disbursements for travel and accommodation for counsel attending hearing.

Decision

The Court of Appeal found that the appellant had not shown that the loans had been written off in the books of account used by the appellant during the 2011 income year. Their Honours noted that, except for the appellant’s own assertion as a witness, there was no evidence that his office administrator, Ms Chan, had entered the write-offs in the spreadsheet during the 2011 income year. The Court of Appeal upheld the lower courts’ findings that the appellant had failed to discharge the onus of proof in respect of the physical write off requirement. The Court of Appeal also noted that the meta data which the Commissioner’s Investigator had presented as evidence in the TRA was not excluded under s 138G of the TAA as that section only excludes new issues or propositions of law (but not evidence) from being raised unless included in the parties’ Statements of Position.

The Court of Appeal further upheld the lower courts’ findings that the debtors (both being natural persons) had not been released by operation of law from making all remaining payments under s DB 31(1)(a)(ii) of the ITA. This was because neither debtor had been discharged from bankruptcy at the time when the deductions were claimed.

The lower courts were found to have correctly applied the business test in Grieve and had been correct to hold that the appellant was not carrying on, even in part, a lending business for the purpose of deriving assessable income. Their Honours noted the overwhelming evidence which, viewed objectively, fell well short of establishing the appellant was engaged in the business of moneylending. Despite the appellant’s repeated assertions that he subjectively intended to make a profit from his lending activities, the Court of Appeal agreed with the Commissioner’s characterisation of the lending as being better described as passive investment or charitable advancement of funds. The appellant’s profitmaking intention, while subjectively present, in reality amounted to little more than a “hope” that the client would eventually be able to pay interest or even a bonus to the appellant.

The Court of Appeal also agreed with the lower courts’ findings that there was an insufficient connection between the appellant’s legal services business and the financial arrangements for which deductions were sought. Noting the potential for a conflict of interest in advancing loans to clients and the prohibition under the Lawyers and Conveyancers Act (Lawyers: Conduct and Client Care) Rules 2008 on engaging in conflicting business activities, their Honours’ commented that the appellant could not have it both ways.

The lower courts’ findings that the appellant failed to take reasonable care and was liable to pay shortfall penalties under s 141A of the TAA were also upheld. While agreeing with Jagose J’s finding that it will not always be necessary to take advice from a tax adviser to take reasonable care, the Court of Appeal noted that, in the present case, the appellant had neither conducted his own research nor sought advice from a professional (because he had found it expensive).

The Court of Appeal finally confirmed that costs had been appropriately awarded to the Commissioner in the High Court. Their Honours also awarded costs for a standard appeal on band A for the Court of Appeal proceeding.