Payments made in addition to financial redress under Treaty of Waitangi settlements - income tax treatment

Sections BD 3, CA 1(2), CC 3(1), CC 4(1) and EW 3-definitions of "interest" and "money lent"-financial arrangement-income under ordinary concepts-Income Tax Act 2007

Question

We have been asked whether an amount paid by the Crown in addition to Financial and Commercial Redress under a Treaty of Waitangi settlement, that is calculated on the agreed Financial and Commercial Redress (cash and commercial assets) and that is described in the Deed of Settlement as "interest", is income. This amount is referred to in this item as "settlement interest".

Answer

Settlement interest is a capital receipt and not taxable.

Background

Settlements of claims in respect of historical breaches of the Treaty of Waitangi ("the Treaty") are generally conditional upon settlement legislation being passed, as legislation is necessary to ensure the finality of the settlement. This usually means that there will be a delay between agreement being reached as to the amount of the Financial and Commercial Redress (that is, cash and commercial assets) to be provided by the Crown, and payment of Financial and Commercial Redress being made to the claimants. In that event, a further payment, calculated on the amount of the agreed Financial and Commercial Redress for the period from the date on which the Deed of Settlement between the Crown and the claimants is signed to the date of payment of the Financial and Commercial Redress, may be paid by the Crown in addition to the agreed Financial and Commercial Redress. Some Deeds of Settlement have provided for the Crown to pay interest on the amount of the agreed Financial and Commercial Redress from the date of the Agreement in Principle until settlement. (An Agreement in Principle (which sets out the broad outline of the terms of settlement negotiated) is entered into before a Deed of Settlement. Following an Agreement in Principle, the details to be incorporated into the final Deed of Settlement are developed and agreed.) Interest on Financial and Commercial Redress is referred to in this item as "settlement interest".

Financial Redress under a Treaty settlement is a capital receipt: refer Interpretation Statement IS0043: "Income tax treatment of Treaty of Waitangi settlements" Tax Information Bulletin Vol 16, No 10 (November 2004). We have been asked whether settlement interest is income.

Unless otherwise stated, all legislative references are to the Income Tax Act 2007.

Whether settlement interest is income under a financial arrangement

As discussed in IS0043, a Treaty settlement is not a financial arrangement.

Treaty settlements that are conditional upon the passing of settlement legislation do not involve a debt or debt instrument (which are specifically included in the definition of "financial arrangement") as the obligation of the Crown to make payment is conditional: Case Q2 (1993) 15 NZTC 5,005. A Treaty settlement is not a financial arrangement within the definition in section EW 3(2) as the payment made by the Crown is not "in consideration for" a benefit received by the Crown. Treaty settlement payments are made to compensate the claimants for past economic losses suffered as a result of the Crown's breaches of the Treaty rather than in return for anything provided to the Crown under a Treaty settlement. Such payments are not made for undertakings or agreements given by the claimants under a Treaty settlement, which are given as part of the process by which settlement is effected.

Therefore, settlement interest is not income under section CC 3(1).

Whether settlement interest is "interest" under the statutory definition

Settlement interest (as defined above) is not "interest" within the statutory definition, as it is not a payment "in respect of or in relation to money lent" by the claimants to the Crown: definitions of "interest" and "money lent" in section OB 1.

Money is not lent in any way by the claimants to the Crown under a Treaty settlement (paragraph (a) definition of "money lent"). As the claimants do not provide services, property or rights to property without requiring payment from the Crown, a Treaty settlement does not involve the giving of credit by the claimants (paragraph (b) of the definition of "money lent"). A Treaty settlement does not involve an arrangement or obligation under which money is lent or credit is given by the claimants (paragraph (c) of the definition of "money lent"). Paragraph (d) of the definition of "money lent" does not apply to a Treaty settlement as an amount is not paid to the Crown in consideration for the Crown agreeing to pay a greater amount.

Therefore, settlement interest is not income under section CC 4(1).

Whether settlement interest is income under section CA 1(2)

In CIR v Buis Burston (2005) 22 NZTC 19,278 the High Court held that the statutory definition of "interest" applied for the purpose of section CA 1(2). The court considered that as the statutory definition was exhaustive and as the payment in question (interest paid under section 72 of the Accident Rehabilitation and Compensation Insurance Act 1992) was not interest within the statutory definition, the payment was not income under ordinary concepts on the basis that it was interest under the common law.

The effect of the conclusion in Buis that the statutory definition of "interest" is exhaustive is that amounts that would have been income under ordinary concepts (being interest under the common law) may not be income. This result appears to be inconsistent with the relationship between section CA 1(2) and specific provisions defining income. The role of section CA 1(2) is to supplement specific provisions of the Act defining income: see Tillard v C of T [1938] NZLR 795; Louisson v C of T [1942] NZLR 30; Discussion Document on Rewriting the Income Tax Act 1994 (September 1997). This result is also inconsistent with the purpose of the statutory definition of "interest" which was amended in order to widen rather than narrow the meaning of "interest" for income tax purposes: Marac Life Assurance Ltd v CIR (1986) 8 NZTC 5,086.

However, in Buis the court went on to consider whether the payment in question was income under ordinary concepts on any other basis, and found in that case that it was not income.

In Reid v CIR (1985) 7 NZTC 5,176 Richardson J set out three propositions on the meaning of income under ordinary concepts.

The first proposition was that income is something that comes in. This means that to be income, there must be either a payment in money, or a non-cash benefit, that is convertible into money; a saving in expenditure is not income: Tennant v Smith [1892] AC 150. Settlement interest is a payment of cash. Hence, it is "something that comes in".

The second proposition is that income imports the notion of periodicity, recurrence and regularity. Settlement interest is not paid periodically, recurrently or regularly. However, the periodicity, recurrence or regularity (or the absence of periodicity, recurrence or regularity) of payments is not determinative of itself as to whether the payment is income. It is necessary to consider the relationship between the payer and recipient and the purpose of the payment in order to decide whether the payment is income under ordinary concepts. The judgment of Richardson J in Reid makes this clear:

The major determinant in many cases is the periodic nature of a payment (FC of T v Dixon (1952) 86 CLR 540; and Asher v London Film Productions [1944] 1 All ER 77). If it has that quality of regularity or recurrence then the payments become part of the receipts upon which the recipient may depend for his living expenses, just as in the case of a salary or wage earner, annuitant or welfare beneficiary. But that in itself is not enough and consideration must be given to the relationship between payer and payee and to the purpose of the payment, in order to determine the quality of the payment in the hands of the payee. (p. 5,183)

To similar effect, in FC of T v Dixon (1952) 86 CLR 540 Fullager J commented:

It seems to me that the appellant's receipts... must be regarded as having the character of income. They were regular periodical payments - a matter which has been regarded in the cases as having some importance in determining whether particular receipts possess the character of income or capital in the hands of the recipient... This consideration, while not unimportant, is not decisive. What is, to my mind, decisive is that the expressed object and the actual effect of the payments made was to make an addition to the earnings, the undoubted income of the respondent... (p 567) [emphasis added]

In FCT v Cooling90 ATC 4472 Hill J said:

While the recurrent nature of transactions will suggest that the profit derived from them will be income, Myer at p. 210 makes it clear that the fact that a transaction is a one-off transaction will not preclude the profit generated being characterised as income. Similarly, while periodicity is a factor which leads to the conclusion that the periodical receipts are income: F.C. of T. v. Dixon (1952) 86 C.L.R. 540, the fact that a payment was received as a lump sum or as a once and for all payment will not necessarily result in the payment being received on capital account. Periodicity or the lack of it is but a factor to be taken into account. (p 4480)

The third proposition is that whether a particular receipt is income depends on its quality in the hands of the recipient. This proposition means that it is necessary to determine the character of a receipt from the point of view of the recipient (and not the payer). In McLaurin v FCT (1961) 104 CLR 381 the High Court of Australia commented:

...in point of law it would plainly be unsound to allow a determination of the character of a receipt in the hands of the recipient to be affected by a consideration of the uncommunicated reasoning which led the payer to agree to pay it. (p. 391)

In determining the character of a payment, it is necessary to consider the relationship between the parties and the purpose of the payment: see Reid; The Federal Coke Company Ltd v FCT 77 ATC 4255; Riches v Westminster Bank Ltd [1947] AC 390. The label given to the payment does not determine the true character of the payment: see Buckley & Young Ltd v CIR (1978) 3 NZTC 61,271.

Whether compensation is income or capital depends on whether it is paid to compensate for a loss of a capital or revenue nature: see Case V8 (2001) 20 NZTC 10,092. Compensation for the damage, destruction or loss of a capital asset is capital: CIR v McKenzies NZ Ltd (1988) 10 NZTC 5,233. However, compensation for the loss of the right to use a capital asset is income, being compensation for loss of profits: London and Thames Haven Oil Ltd v Attwooll [1967] 2 QB 772.

The manner in which compensation is calculated does not determine its character. An amount paid to compensate for a loss of a capital nature that is calculated by reference to interest remains an amount of capital: Glenboig Union Fireclay Co Ltd v IR Commrs (1922) 12 TC 427; Simpson v Executors of Bonner Maurice as Executor of Edward Kay (1949) 14 TC 580.

The principle underlying land compensation cases such as Marshall v Commissioner of Taxes [1953] NZLR 335, Public Trustee v CIR [1960] NZLR 365 Federal Wharf Co Ltd v Deputy Federal Commissioner of Taxation 1 ATD 70 and Haig v FCT 94 ATC 5002 is that where a taxpayer has received "interest" by virtue of a statutory power in respect of a sum of money that they would have invested for income purposes, the "interest" is income under ordinary concepts because it compensates for the loss of use of a capital sum during a period in which it would otherwise have earned income. It represents the annual value or flow from that capital. In the Federal Wharf Company case Rich J said:

In my opinion, the character of the interest payable under s. 26 is that of recompense for loss of the use of capital during a period of time in which it would earn income. It represents the annual value of capital. It is paid because the owner has been deprived of a capital asset which he had and has not received the fund which is to be substituted for the capital asset. The interest is the flow of that fund. In my opinion it is income. (p. -73)

In such circumstances, interest for the period before an award of compensation is made would be income under ordinary concepts.

In each case the purpose for which a payment described as "interest" was paid determines whether it is income. In the context of compensation for personal injury interest for the period from the date when the injury is suffered to the date of judgment (referred to in the judgment as "pre-judgment interest") is not regarded as compensation for loss of earnings as it is not paid in circumstances where the compensation would have been invested to derive income: Whitaker v FCT 98 ATC 4285. "Pre-judgment interest" in relation to compensation for personal injury does not relate to a foregone investment opportunity. It is an essential and integral element of compensation for the personal injury suffered by the taxpayer (being a payment "awarded for the period until the judgment takes effect which allows the plaintiff to be placed in or restored to the situation, as far as money can do, in which he or she would have been but for the defendant's negligence": Haines v Bendall (1991) 172 CLR 60). "Pre-judgment interest" is, therefore, a receipt of capital. However, interest for the period from judgment until payment (referred to in the judgment as "post-judgment interest") is income: Whitaker v FCT. "Post-judgment interest" is not paid to compensate the taxpayer for personal injury. The amount of compensation for personal injury was established by the judgment of the lower court in favour of the taxpayer. The court considered that "post-judgment interest" was paid because there was a delay between judgment being given, and payment being made.

The following principles can be drawn from the cases:

• To be income, there must be a payment in money or a non-cash benefit that is convertible into money: Tennant v Smith [1892] AC 150.
• Periodicity, recurrence and regularity may be a characteristic of income but periodicity, recurrence and regularity (or the absence of periodicity, recurrence or regularity) of payments is not determinative as to whether a payment is income: see Reid v CIR (1985) 7 NZTC 5,176; FC of T v Dixon(1952) 86 CLR 540; FCT v Cooling 90 ATC 4472.
• The character of a receipt is to be determined from the point of view of the recipient (and not the payer): McLaurin v FCT (1961) 104 CLR 381.
• In determining the character of a payment, it is necessary to consider the relationship between the payer and recipient and the purpose of the payment: see Reid v CIR (1985) 7 NZTC 5,176; The Federal Coke Company Ltd v FCT 77 ATC 4255. The label given to the payment does not determine the true character of the payment: Buckley & Young Ltd v CIR (1978) 3 NZTC 61,271.
• Whether compensation is income or capital depends on whether it is paid to compensate for a loss of a capital or revenue nature: Case V8 (2001) 2 NZTC 10,092. Compensation for the damage, destruction or loss of a capital asset is capital: CIR v McKenzies NZ Ltd (1988) 10 NZTC 5,233. However, compensation for loss of profits is income: London and Thames Haven Oil Ltd v Attwooll [1967] 2 QB 772.
• The manner in which compensation is calculated does not determine its character: Glenboig Union Fireclay Co Ltd v IR Commrs (1922) 12 TC 427; Simpson v Executors of Bonner Maurice as Executor of Edward Kay (1949) 14 TC 580.
• A payment made to compensate for the loss of the use of compensation, during a period in which the compensation would have been invested for income earning purposes, is income under ordinary concepts: Federal Wharf Co Ltd v Deputy Federal Commissioner of Taxation 1 ATD 70.
• In the context of compensation for personal injury, interest for the period from the date of injury until the date of judgment ("pre-judgment interest") is not regarded as compensation for lost earnings, as it is not paid in circumstances where the compensation would have been invested for income earning purposes. Pre-judgment interest does not relate to a forgone investment opportunity: Whitaker v FCT 98 ATC 4285.
• If there is no right to compensation, there is also no right to compensation for the loss of the use of compensation. In Whitaker (interest for the period from the date of judgment to payment) "post-judgment interest" was treated as income because there was a judgment debt owing. In Marshall it was accepted that if the Compensation Court had the power to award interest, the amount awarded was interest income for tax purposes. The majority considered that the Compensation Court had such a power. Therefore, for interest paid in the context of compensation to be income, it must be established that the interest accrued in respect of a period during which the taxpayer had an entitlement to compensation.

Nature of settlement interest

If settlement interest is part of the Treaty redress, settlement interest would be a capital receipt for the reasons outlined in IS0048. Settlement interest is not part of the financial redress (as defined) under Deeds of Settlement. However, the description used in the deed does not conclusively determine the nature of settlement interest. In determining the character of a payment, the starting point is the document embodying the transaction. The nomenclature used by the parties does not necessarily determine the nature of a payment and it is appropriate to take into account the surrounding circumstances in order to determine the character of the payment: Buckley & Young Ltd v CIR (1978) 3 NZTC 61,271, 61,273-61,274. Therefore, it is appropriate to consider the context in which Treaty settlements are made in order to determine whether settlement interest constitutes part of the Treaty redress.

Under the Treaty the Crown guaranteed to Maori "the full exclusive and undisturbed possession of their Lands and Estates Forests Fisheries and other properties which they may collectively or individually possess so long as it is their wish and desire to retain the same in their possession". The Crown has accepted that this obligation was breached in some instances and that land was acquired from Maori in ways that breached the principles of the Treaty. Most historical Treaty claims relate to land loss in circumstances involving a breach of the Crown's obligations under the Treaty. See Healing the Past, Building a Future: A Guide to Treaty of Waitangi Claims and Negotiations with the Crown 2nd ed (2002), Wellington: Office of Treaty Settlements ("the OTS publication").

The redress under a Treaty settlement includes the acknowledgement and apology made by the Crown for the wrongs done to the claimant and cultural redress (which is intended to meet the cultural interests of the claimants) as well as redress for economic losses.

The overall value of the redress and the form in which redress for economic losses is provided (cash or property) is a matter entirely for negotiation between the claimants and the Crown. The main factors taken into account in determining the overall redress quantum are the amount of land lost by the claimants, the seriousness of the Crown's breaches and the benchmarks set by previous settlements: the OTS publication p. 89.

The OTS publication notes that full compensation for all economic losses resulting from historical Treaty breaches is not possible given the difficulty of calculating the losses resulting from the Crown's Treaty breaches (due to the time that has elapsed, the complexity of identifying the effects of various causes on the present economic status of the claimant group and overlaps between many claimant groups) and the high burden that full compensation or the "damages" approach to redress would place on present and future generations of taxpayers (p. 89). The aim of financial and commercial redress is to "contribute to re-establishing an economic base as a platform for future development" (p. 87). The OTS publication says (p. 95):

If settlement legislation is required to make a settlement complete, there may be a significant delay between signing the Deed of Settlement and the payment of cash or transfer of other assets. Depending on the expected length of the delay, the Crown and claimant groups may need to negotiate whether the Deed should provide for interest on the redress quantum from the date of the Deed to when it is actually paid. This will maintain the value of the settlement to the claimant group. Interest is paid in a lump sum with the settlement quantum, but does not form part of the redress quantum. This is because it is a transaction cost rather than redress. If the Crown agrees to pay interest, the rate of interest will depend on market conditions and, as with any interest receipt, tax may be payable. [emphasis added]

Once the overall value of the redress is agreed, negotiations are carried out in respect of the form in which redress is to be provided (cash or assets). Treaty settlements are intended to be full and final settlements of historical claims and the settlement of historical grievances is intended to put the relationship between the Crown and claimants on a new footing based on the principles of the Treaty: OTS publication p. 84. The Crown recognises that unless settlements are fair and remove the sense of grievance, they will not be durable: OTS publication p. 28.

The terms of the settlement between the claimants and the Crown are recorded in a formal Deed of Settlement that sets out the rights and obligations of the Crown and the claimants. Generally a Deed of Settlement and the settlement itself are conditional on the enactment of settlement legislation and the establishment of a governance entity to receive Financial and Commercial Redress. However, some provisions in a Deed of Settlement (such as the obligation to take steps to enable the conditions in the Deed of Settlement to be satisfied) are binding on execution of the Deed.

No rights arise under a Treaty settlement until settlement legislation is enacted. The enactment of settlement legislation is part of the process by which claimants become entitled to receive redress.

The Commissioner accepts that the true nature of settlement interest is that it is an economic or present value adjustment to maintain the value of the agreed redress. Settlement interest is an integral element in the calculation of compensation for a loss of a capital nature. The payment of settlement interest maintains the economic value of the agreed principal amount. Settlement interest is part of the price for securing settlement. Without such an adjustment to the principal amount to compensate for the delay in payment following settlement being reached between the parties, the claimants' grievances may not be completely addressed.

Therefore, the Commissioner considers that given these factors and the unique nature of the treaty settlement process, settlement interest is a capital receipt, being a further instalment of compensation for a capital loss.