NRS Media Holdings Limited v Commissioner of Inland Revenue
[2017] NZHC 2978
•1 December 2017
IN THE HIGH COURT OF NEW ZEALAND WELLINGTON REGISTRY
I TE KŌTI MATUA O AOTEAROA TE WHANGANUI-Ā-TARA ROHE
CIV-2016-485-306 [2017] NZHC 2978
BETWEEN NRS MEDIA HOLDINGS LIMITED
Plaintiff
AND
COMMISSIONER OF INLAND REVENUE
Defendant
Hearing: 27-28 Februray 2017 Appearances:
G J Harley, V L Heine and R L Goss for Plaintiff
H W Ebersohn and J Cheng for DefendantJudgment:
1 December 2017
JUDGMENT OF CLARK J
Pursuant to r 11.5 of the High Court Rules I direct the delivery time of this judgment is
4.30 pm on 1 December 2017
NRS MEDIA HOLDINGS LIMITED v COMMISSIONER OF INLAND REVENUE [2017] NZHC 2978
[1 December 2017]
Introduction
[1] Under s DB 55 (now repealed) of the Income Tax Act 2007 a company that derived a foreign dividend was allowed to deduct from its tax liability the expenditure it incurred in deriving that dividend.1
[2] NRS Media Holdings Ltd (NRS) claimed deductions under s DB 55 for expenditure incurred by its Head Office in managing NRS’ subsidiaries which pay dividends to NRS from time-to-time. The Commissioner disallowed the deductions. NRS challenges the Commissioner’s assessments.
Background
[3] NRS’ case is advanced on the following pleaded basis.
[4] NRS is a New Zealand resident parent company of subsidiaries incorporated in foreign jurisdictions: NRS Media (Canada) Ltd, NRS Media (UK) Ltd, NRS Media (Europe) Ltd and NRS Media (Australia) Pty Ltd (Media Australia) (foreign subsidiaries or subsidiaries). The subsidiaries provide and maintain systems that facilitate sales of radio and television advertising space by the subsidiaries’ clients. The intellectual property in the systems has, at all material times, been held by
Persuaders Concepts (NZ) Ltd (Persuaders).
[5] At all material times NRS’ Head Office was in Sydney, Australia. The Head Office employed a Chief Executive, Chief Financial Officer and four support personnel. NRS seeks deductions totalling $3,670,040.542 for the following Head Office costs incurred over two tax years:
(a) salaries of the six staff;
(b) rent for the office in Sydney;
1 Income Tax Act 2007, s DB 55. Section DB 55 was retrospectively repealed on 30 June 2014 by s 49(2) of the Taxation (Annual Rates, Employee Allowances, and Remedial Matters) Act 2014.
2 $1,706,568.23 for the 2011 tax year (being the financial year ended 31 December 2010); and
$1,963,472.31 for the 2012 tax year (being the financial year ended 31 December 2011).
(c) telephone and other communication costs; and
(d) travel and overseas accommodation costs for the Chief Executive and
Chief Financial Officer.
[6] The function of the Head Office was to manage NRS’ share capital invested in the subsidiaries. NRS managed the subsidiaries by establishing and managing strategic and business plans; executing projects to increase profitability; reviewing financial performance; receiving reports from the subsidiaries; regularly visiting each subsidiary and reporting to the Board on a monthly basis.
[7] NRS shared the premises and some administrative systems with Media Australia. Media Australia was the contracting party for staff. Media Australia also incurred all Head Office costs which were then charged to NRS and Persuaders for their respective shares. NRS’ only source of income was dividends distributed by its subsidiaries. Dividend income was applied to satisfy corporate Head Office costs.
[8] In income tax returns for the financial years ending 31 December 2010 and
31 December 2011 NRS claimed the following deductions in respect of the expenditure incurred in administering its foreign subsidiaries (foreign subsidiary
expenditure or expenditure):
Income Tax
return
Financial year ended Deductions
($NZD)
31 March 2011 31 December 2010 $1,706,568.23 31 March 2012 31 December 2011 $1,963,472.31
[9] In a notice of proposed adjustment the Commissioner proposed to disallow the deductions on the grounds NRS had not incurred the expenditure in deriving dividend income. The Commissioner’s grounds for proposing to disallow the deductions included the following:
(a) The steps involved in NRS’ income-earning process were the acquisition and continued holding of shares in the subsidiaries.
(b)The only possible advantage of the expenditure was to generally improve the underlying businesses of the subsidiaries, which could at
best only indirectly affect NRS by contributing to an increase in the dividend income.
(c) As a result, the expenditure did not have a nexus to the income-earning process of NRS, and had not been incurred in deriving the dividend income.
[10] Following the exchange of statements of position the matter was referred to the Disputes Review Unit (DRU) of the Inland Revenue Department. In its Adjudication Report the DRU concluded the claimed deductions were not allowed under s DB 55. NRS had failed to show the expenditure it claimed was:3
• directly linked to its exempt foreign dividend income in a positive way;
• factually and causally directed to the production of the dividend income;
• incurred in the actual course of producing the dividend income.
Even though the expenditure may have had a nexus with [NRS’] subsidiaries’ income-earning process or the carrying on of the subsidiaries’ businesses, this is one step removed from the process whereby [NRS] derived its exempt foreign dividend income.
[11] As a consequence of this determination the Commissioner issued notices of assessment for the financial years ending 31 December 2010 and 31 December 2011 in which no deduction was made for the expenditure.
[12] NRS seeks a declaration that the assessments are incorrect and, pursuant to s 138P of the Tax Administration Act 1994:
(a) a determination that the assessments be cancelled; or
(b)a determination that the assessments be reduced or modified or otherwise varied.
3 Adjudication Report, Office of the Chief Tax Counsel, NRS Media Holdings Ltd (11 March 2016)
at [1.5]–[1.6].
Issues
[13] Two issues arise for my determination:
(a) What is the scope of s DB 55(1)(a)?
(b) Does NRS expenditure fall within the scope of s DB 55(1)?
[14] The broad powers available to this Court, as a hearing authority, to confirm or cancel or vary an assessment4 “contemplate a right of hearing de novo on the merits with the hearing authority determining the correct tax liability and making assessment accordingly”.5
[15] Before turning to the issues it is necessary to set out the statutory framework.
Statutory framework
[16] A person’s annual gross income for a tax year is the total of their income that is assessable for tax liability (“assessable income”). Assessable income does not include exempt income.6 Dividends received from foreign subsidiaries are exempt income.7
[17] A tax deduction is subtracted from the annual gross assessable income to give the taxable income payable by the taxpayer.8 Under s DA 1(1) of the Income Tax Act, the “General Permission”, a deduction is allowed to a person for an amount of expenditure or loss depending upon the manner by which the expenditure or loss is
incurred:9
4 Tax Administration Act 1994, s 138P.
5 Tannadyce Investments Ltd v Commissioner of Inland Revenue [2011] NZSC 158, [2012] 2 NZLR
153 at [25].
6 Income Tax Act, s BD 1(5). Income is exempted from tax liability under subparts CW or CZ:
s BD 1(2).
7 Income Tax Act, s CW9(1).
8 An amount is a deduction if it is allowed under Part D of the Act.
9 Section DA 1.
DA 1 General permission
Nexus with income
(1) A person is allowed a deduction for an amount of expenditure or loss, including an amount of depreciation loss, to the extent to which the expenditure or loss is—
(a) incurred by them in deriving—
(i) their assessable income; or
(ii) their excluded income; or
(iii) a combination of their assessable income and excluded income; or
(b) incurred by them in the course of carrying on a business for the purpose of deriving—
(i) their assessable income; or
(ii) their excluded income; or
(iii) a combination of their assessable income and excluded income.
General permission
(2) Subsection (1) is called the general permission
…
[18] Exempt income is expressly excluded from the General Permission. Section DA 2(3) provides:
Exempt income limitation
A person is denied a deduction for an amount of expenditure or loss to the extent to which it is incurred in deriving exempt income. This rule is called the exempt income limitation.
[19] Section DB 55 overrides the exempt income limitation. It allows a company that derives a dividend from a foreign company to deduct expenditure incurred by the company in deriving that dividend:
DB 55 Expenditure incurred in deriving exempt dividend
(1) A company that derives a dividend that is exempt income of the company under s CW 9 (Dividend derived by company from overseas) is allowed a deduction of–
(a) the amount of the expenditure incurred by the company in deriving the dividend ...
…
(3) This section supplements the general permission and overrides the exempt income limitation. Other general limitations still apply.
[20] Section DB 55 was retrospectively repealed on 30 June 2014 by s 49(2) of the Taxation (Annual Rates, Employee Allowances, and Remedial Matters) Act 2014. The repeal became effective on 30 June 2009. The 2014 Act contained a savings provision.10 It is not disputed that NRS falls within the savings provision.
What is the scope of s DB 55(1)?
The parties’ positions
[21] Mr Harley, counsel for NRS submits that s DB 55 does not bear the narrow “direct” or “tracing” gloss asserted in the Adjudication Report11 and which the Commissioner seeks to apply. The legislature had ample opportunity to limit the provision in some way but did not do so. Nor have the New Zealand courts accepted this narrow approach. That is exemplified in the leading Court of Appeal decision in Commissioner of Inland Revenue v Brierley.12
[22] Mr Harley submitted there is no formula applicable to all cases. Leading authorities require a factual relationship to be established between the advantage sought to be obtained from the expenditure (in this case the Head Office costs) and the income earning process. Contrary to the Commissioner’s approach (which is not reflected in the case law) there is no requirement for the expenditure to be directly linked in some positive way, nor factually and causally directed (at deriving foreign dividends). Rather, the taxpayer must establish the costs in question were “incurred
in the course of” deriving the income. Mr Harley submitted:
10 Section DB 55 was repealed (with effect on 30 June 2009 and applying to a person and income years beginning on or after 1 July 2009, except if the person meets the following requirements: applying to a person and the 2015–16 and later income years if the person takes a tax position, for an income year beginning on or after 1 July 2009, inconsistent with section 49(2) of the Taxation (Annual Rates, Employee Allowances, and Remedial Matters) Act 2014, and in a tax return filed before 22 November 2013), on 30 June 2014, by section 49(2) of the Taxation (Annual Rates, Employee Allowances, and Remedial Matters) Act 2014 (2014 No 39).
11 Referred to at [10] above.
12 Commissioner of Inland Revenue v Brierley [1990] 3 NZLR 303 (CA).
As explained, particularly by reference to the Public Trustee and Brierley13 cases, the expenditure being disputed could never have a direct linkage or be causally directed (because of the nature of the borrowing, and the capital asset that the borrowing supported).
[23] The Commissioner contends for a “narrower” scope. Mr Ebersohn, counsel for the Commissioner, submitted s DB 55 is concerned with expenditure incurred in the operation of a taxpayer to earn its income, not expenditure incurred in the operation of its subsidiary. The latter expenditure is focussed on improving the subsidiary and only indirectly linked to deriving dividends.
[24] Mr Ebersohn distinguishes Brierley and suggests the position NRS takes misunderstands the distinction between deductions of interest allowed under a provision specific to interest deductibility and allowable deductions under the General Permission. Mr Ebersohn submitted:
Unlike with the general deduction provision (now the General Permission), the [interest deductibility section with which Brierley was concerned] expressly allowed a deduction of interest provided the capital was employed in the production of assessable income.
[25] In that context, it was irrelevant that the expenditure was of capital nature.
Assessment
[26] The terms of s DA 1(1)(a) are similar to s DB 55(1)(a). Section DB 55 does not, however, have a limb equivalent to s DA 1(1)(b) such that a deduction is allowed for expenditure incurred “in the course of carrying on a business for the purpose of deriving [the specified income]”.
[27] There is no case law on s DB 55. There is, however, substantial case law on the interpretation of the two limbs of the General Permission.
[28] Buckley & Young Ltd v Commissioner of Inland Revenue is one of the leading authorities on the General Permission.14 Delivering the judgment of the Court of
Appeal Richardson J addressed the test for deductibility under s 111 of Land and
13 Referring to Commissioner of Inland Revenue v Brierley, above n 12 and Public Trustee v
Commissioner of Taxes [1938] NZLR 436 (CA).
14 Buckley & Young Ltd v Commissioner of Inland Revenue [1978] 2 NZLR 485 (CA).
Income Tax Act 1954 (an earlier equivalent to the General Permission). He reasoned a deduction is available where only the expenditure has the “necessary relationship” with the taxpayer and the gaining or producing of his or her assessable income or with the carrying on of a business for that purpose:15
The heart of the inquiry is the identification of the relationship between the advantage gained or sought to be gained by the expenditure and the income earning process. That in turn requires determining the true character of the payment. It then becomes a matter of degree and so a question of fact to determine whether there is a sufficient relationship between the expenditure and what it provided or sought to provide on the one hand, and the income earning process on the other, to fall within the words of the section.
[29] In recommending the amendment that introduced the two limbs of s 111 the Taxation Review Committee observed the second limb is not as restrictive as the first:16
The suggested new wording of the section introduces two standards by which the deductibility of an expenditure or loss would be tested. The first is a general standard which could apply to any item or expense or loss “incurred in gaining or producing the assessable income” and to all taxpayers whether in business or employment. The second is applicable only to expense or loss “necessarily incurred in carrying on a business for the purpose of gaining or producing such (assessable) income.” The latter test is not [as] restrictive as the first one as the expenditure or loss would not have to be directly related to the income derived from the business. It would be sufficient if it were a necessary expense or loss in the carrying on of the business.
[30] And in Europa Oil (NZ) Ltd v Commissioner of Inland Revenue McCarthy P
said of the second limb of s 111:17
In the new s 111 a second limb has been introduced covering an expenditure “necessarily” incurred in carrying on a business for the purpose of gaining or producing the assessable income. Consequently it covers expenditure which may not be demonstrable as having gained or produced assessable income.
[31] In assessing the difference between the first and second limbs of s 104 of the
15 At 487.
16 The amendment was introduced as s 111 of the land and Income Tax Act 1954. It is the equivalent of the General Permission, s DA 1, in the 2007 Act. Taxation Review Committee, Taxation in New Zealand (October 1967) at [478].
17 Europa Oil (NZ) Ltd v Commissioner of Inland Revenue [1974] 2 NZLR 737 (CA) at 738-739.
Income Tax Act 1976 (another equivalent provision of s DA 1), Hansen J accepted there are two bases for deduction:18
(a) The first limb allows a deduction for any expenditure or loss which is factually and causally relevant to the production of a taxpayer’s assessable income.
(b)The second limb, while narrower, acknowledges that in the conduct of a business, expenditure “may be made which cannot be directly linked with the creation of assessable income in some positive way”.
[32] It is plain that the authorities recognise a distinction between the first and second limbs of the General Permission. Given the materially similar terms of s DB 55(1) to the first limb of the General Permission there is no basis for placing a different construction on each. Contrary to NRS’ submission, the similarity between the provisions does not mean the same interpretative approach applies to the General Permission as a whole. That is because s DB 55 does not contain any equivalent of the wider second limb of the General Permission.
[33] Section DA 1(1)(b), the second limb of the General Permission, allows deductions for expenditure incurred in the course of carrying on a business for the purpose of deriving an income. The deductions allowed under s DB 55 are available only in respect of those expenses incurred in deriving dividends. It follows that even if expenditure is incurred for the purpose of deriving a dividend (second limb), the expenditure will not be deductible unless the taxpayer establishes the expenditure was incurred in the actual course of deriving the dividend (first limb). In this case NRS must establish its expenditure is factually and causally directed at deriving a foreign dividend.19
[34] I do not draw from Brierley assistance in determining the nexus required by s DB 55.20 In Brierley, the taxpayer borrowed substantial sums to subscribe for
18 Thornton Estates Ltd v Commissioner of Inland Revenue (1995) 17 NZTC 12,230 (HC) at 12,235.
19 Europa Oil (NZ) Ltd v Commissioner of Inland Revenue, above n 17, at 738–739; Thornton Estates
Ltd v Commissioner of Inland Revenue, above n 18, at 12,235.
20 Commissioner of Inland Revenue v Brierley, above n 12.
additional shares in Brierley Investments Ltd offered in cash issues to shareholders. The taxpayer claimed deductions for the interest paid each year on the sums borrowed. The Court of Appeal considered the deductibility of interest under s 106(1)(h) of the
1976 Income Tax Act which provides:
Notwithstanding anything in section 104 of this Act, in calculating the assessable income derived by any person from any source, no deduction shall, except as expressly provided in this Act, be made in respect of any of the following sums or matters:
…
(h) Interest, except so far as the Commissioner is satisfied that —
(i) It is payable on capital employed in the production of the assessable income; or
[35] Section 106 specifically allows expenditure to be made on capital that produces assessable income. The nexus in s 106 contemplates expenditure being a step removed from the actual production of assessable income. By contrast, s DB 55 requires expenditure to be directed at deriving the exempt income.
[36] I have been referred to a wealth of background documentation, including legislative materials and case law. Mr Harley presented s DB 55 as operating in an arcane world.
In that world of complexity and technicality, we have a provision that in essence turns the income tax world on its head, providing explicitly for a deduction against exempt income. There is no other provision in the Act that creates what is an unnatural response in an income tax system that brings to charge assessable income. In that highly technical controlled foreign company regime, the interpretative approach must work from the actual words used, on the basis that Parliament was reflecting what is a technical rule in a complex area of income tax policy. The language chosen deliberately and specifically reflects that technicality.
[37] Ultimately, however, I think the test under s DB 55(1) requires expenditure to be factually and causally directed to the derivation of foreign dividend income. Expenditure having as a purpose, the deriving of a foreign dividend that is not causally related, is too broad to bring it within the restrictive scope of s DB 55.
[38] NRS argued before the DRU that a “narrow” interpretation of s DB 55(1)(a)
leads to an absurd result because “nobody would ever get a deduction under the
provision if it were interpreted in this way”. Mr Harley made a similar submission in this Court. In rejecting the proposition the DRU:21
… considered that a non-exhaustive list of the types of expenditure that may be incurred in deriving dividend income is as follows:
• interest on borrowings to buy shares that pay dividends;
• accounting for the share portfolio;
• postage incurred in order to manage the share portfolio;
• investment publications that provide information that helps manage the share portfolio;
• travel expenses to consult with a stockbroker;
• travel expenses to attend a company’s annual general meeting;
• subscriptions to sharemarket information services where these are taken out for the purpose of deriving dividends;
• telephone, internet and data access costs incurred for share-trading activities and/or in accessing live sharemarket information;
• depreciation of share-trading software;
• management and consulting fees for advice relating to the management of the share portfolio.
[39] The Adjudication Report produced by the DRU contains an exhaustive analysis of the statutory context in which s DB 55(1) is placed and of the case law which has settled the test for deductibility under the analogous first limb of the General Permission.
[40] I have concluded, as did the DRU, that the nexus required under s DB 55(1) will be present when the taxpayer establishes its expenditure to be factually and causally incurred in the derivation of foreign dividend income.
[41] NRS’ expenditure improved the value and profitability of its subsidiaries and was incurred in carrying on a business for the purpose of deriving foreign dividend
21 Adjudication Report, Office of the Chief Tax Counsel, NRS Media Holdings Ltd, 11 March 2016, at [3.32].
income. NRS’ expenditure is a step removed from being factually and causally incurred in the derivation of foreign dividend income.
Does NRS’ expenditure come within the scope of s DB 55?
[42] The issue under this head is whether NRS’ expenditure was factually and causally directed at deriving foreign dividend income. For the reasons contained in the foregoing analysis the purpose for which the expenditure was incurred is irrelevant.
The parties’ positions
[43] NRS says its primary asset is its ownership of the subsidiaries. NRS’ Head Office directed costs to the receipt of an increasing dividend stream derived from the share capital invested in the subsidiaries. Mr Harley submitted once it is established as a matter of fact, on the evidence, that the relationship between the expenditure of the Head Office is entirely focused on its derivation of its exempt dividend stream, then (from NRS’ shareholder perspective) the disputed expenditure cannot properly relate to anything else.
[44] NRS accepts as “self-evident” the activities of the Head Office contributed to increased performance and therefore profitability of the subsidiaries; and this had an impact on the value of the subsidiaries. It is considered, however, those benefits are a
by-product of Head Office activity. Mr Harley pointed to evidence to this effect.
[45] The Commissioner’s case is that NRS’ expenditure was calculated to develop and grow the subsidiaries and thereby the plaintiff’s share value in the subsidiaries, the shareholding being a capital asset. While NRS submitted such expenditure was ultimately aimed at obtaining dividends, the Commissioner argues those dividends are one step removed, or an indirect consequence of the improvement of the operations of the subsidiaries; the expenditure was first and foremost aimed at improving the functioning of the subsidiaries.
Assessment
[46] I have concluded that s DB 55 requires expenditure to be factually and causally incurred in the derivation of foreign dividend income.
[47] The expenditure on salaries, rent for the office in Sydney, telephone and other communication costs, and travel and overseas accommodation for the Chief Executive and Chief Financial Officer are insufficiently related to the derivation of foreign dividends. The derivation of foreign dividends was one step removed from the purpose of the expenditure, which was to increase the value of the subsidiaries. My reasons follow.
[48] In his evidence Mr Gold, director and majority shareholder of NRS, summarised NRS’ focus in all its endeavours as being to:
(a) establish business in the relevant foreign countries;
(b)introduce its expertise and knowhow into each subsidiary so that each would build a viable and effective business with clients, and so become more competitive in those markets and more profitable;
(c) ensure that each subsidiary had the resources and well trained and motivated people needed to be effective in their markets;
(d)enhance the different product lines and methods and to make them available to each group company including a major new business development strategy in 2008/2009;
(e) provide financial controls, management reporting and appropriate governance for each group company so that the group operated effectively and profitably as a whole and review performance of subsidiaries in detail and recommend changes to their respective business strategies; and
(f) maximise the value of each group company’s business, and hence
profitability.
[49] While the plaintiff says its expenditure was ultimately aimed at obtaining dividends in my view the expenditure is a step removed from expenditure which factually and causally derives a dividend. As Mr Gold stated the expenditure provided services to the subsidiaries to “maximise the value” of each subsidiary and “hence profitability”. The factual and causal effect of this expenditure was to improve the value and profitability of the subsidiaries.
[50] Mr Harley characterised as “self-evident” that the activities of the Head Office contributed to increased performance and therefore profitability of the subsidiaries and this had an impact on the value of the subsidiaries. But I do not accept Mr Gold’s description of these benefits as a “by-product” of Head Office activity. The first consequence of NRS’ expenditure was to improve the subsidiaries. The further possible consequence was receipt of foreign dividends.
[51] I accept the purpose of NRS was “stewardship” of its investors directed at an increasing dividend stream derived from the share capital invested in the subsidiaries. But the purpose of the expenditure is irrelevant to the question whether expenditure is incurred in deriving the dividend. Deriving dividends was an ancillary consequence of the increasing profitability and value of the subsidiaries. Expenditure on maximising value and profitability of the companies returning dividends is not deductible under s DB 55. Such expenditure may fall within the broader category of expenditure incurred “in the course of carrying on a business for the purpose of deriving income” (the second limb of the General Provision) but it does not fall within the more restricted scope of s DB 55.
[52] That NRS may have determined the magnitude and timing of distributions from the subsidiaries to NRS and that those dividends were required to meet Head Office costs as well as provide a return to the shareholders of NRS does not lead me to conclude the expenditure was other than factually and causally directed at increasing the profitability of the subsidiaries.
[53] The conclusion I have reached makes it unnecessary to engage in the purported capital nature of the expenditure, an analysis which Mr Ebersohn undertook on behalf of the Commissioner.
Conclusion
[54] The test for deductibility under s DB 55(1) requires the taxpayer to show the expenditure has been incurred in deriving the dividend. A nexus showing only a connection between the expenditure and the carrying on of the business from which the dividend is derived is insufficient.
[55] NRS’ expenditure had the purpose of improving the value of its subsidiaries, and in consequence, its own shareholding and potential for dividend income. This expenditure is a step removed from the relationship required by s DB 55. Accordingly NRS’ foreign subsidiary expenditure is not deductible.
Result
[56] The application for a declaration is dismissed.
[57] The Commissioner’s assessment is confirmed.
[58] The Commissioner is entitled to costs. Mr Harley submitted the evidence NRS
was required to call transpired to be unnecessary in light of the acceptance by
Mr Ebersohn in his memorandum filed 16 February 2017 that the true dispute is the interpretation and application of s DB 55. If the parties are unable to agree costs, brief
and focussed memorandum may be submitted.
Karen Clark J
Solicitors:
Chapman Tripp, Wellington for Plaintiff
Crown Law Office, Wellington for Defendant
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