P L Brown Farms Limited v Commissioner of Inland Revenue
[2014] NZHC 1601
•9 July 2014
IN THE HIGH COURT OF NEW ZEALAND WELLINGTON REGISTRY
CIV-2013-485-3850 [2014] NZHC 1601
BETWEEN P L BROWN FARMS LIMITED
Plaintiff
AND
COMMISSIONER OF INLAND REVENUE
Defendant
Hearing: 3 June 2014 Counsel:
M T Lennard for Appellant
S M Kinsler and I Mara for RespondentJudgment:
9 July 2014
RESERVED JUDGMENT OF MACKENZIE J
I direct that the delivery time of this judgment is
4.30 pm on the 9th day of July 2014.
Solicitors: Perkinson Law, Whangarei, for Appellant
Crown Law, for Respondent
P L BROWN FARMS LTD v COMMISSIONER OF INLAND REVENUE [2014] NZHC 1601 [9 July 2014]
[1] This is an appeal against a decision of the Taxation Review Authority (TRA), delivered on 9 July 2013 by Judge A A Sinclair, upholding assessments by the Commissioner and dismissing the appellant’s challenge to those assessments.1
[2] The factual background is set out fully in the judgment under appeal. I need summarise it only briefly. There are three relevant companies all ultimately owned by Mr and Mrs Brown. Adopting the convenient nomenclature used by the Judge, I refer to the appellant as “Farms” and to the other two companies as “Sharemilking” and “Beef” respectively. Farms operates a dairy farm on land leased from Sharemilking and a beef farm on land leased from Beef. Farms borrowed from a bank on commercial terms and on-lent the borrowed funds to Sharemilking and Beef, apparently on terms that interest was payable on demand, but in fact no interest was demanded from or paid by them. The money was used by those companies to purchase land now leased to Farms. The land purchase by Sharemilking included the purchase of shares in Fonterra Ltd. The milk produced by Farms’ dairy business was sold to Fonterra. Those sales were invoiced through Sharemilking, because it held the necessary Fonterra shares. The income from those sales was treated by both Farms and Sharemilking as Farms’ income.
[3] Farms claimed deductions in the 2006 and 2007 income years for interest paid to the bank on the money borrowed and on-lent to Sharemilking and Beef. The Commissioner disallowed the deductions on the basis that the expenditure did not satisfy the general permission in s DA 1 of the Income Tax Act 2004 (the Act), under which a deduction is allowed for expenditure incurred in deriving assessable income.
[4] Under s DB 6 of the Act, a person is allowed a deduction for interest incurred. The general permission must still be satisfied and the other general
limitations still apply. The general permission is in s DA 1 which provides:
1 X Ltd (A Farming Company) v Commissioner of Inland Revenue [2013] NZTRA 2.
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
(ii) 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.
[5] The essential issue on this appeal is whether the TRA was correct to hold that this general permission is not satisfied because there is not, as the heading to the section puts it, a nexus between the interest paid by Farms and the assessable income derived by Farms from its farming businesses.
[6] The respective cases before the TRA, which are in essence the same as those advanced on this appeal, were succinctly summarised by the Judge in her decision in these terms:
[22] The disputant argues that there is a nexus between the interest
payments and the disputant’s income earning process because:
(a) the borrowed funds on which interest was paid were used to acquire land on which the disputant carried on its farming business; and/or
(b) in return for making the advances interest free the disputant received
(by way of barter) the land at a lower lease cost.
[23] The Commissioner contends that there is not a sufficient nexus between the interest expenditure and the disputant’s income earning process because:
(a) the advances were not used directly in the disputant’s income
earning process;
(b) there was no income in respect of which the interest expenditure in question could be matched; and/or
(c) the disputant has not established that there was a barter transaction in these circumstances.
[7] The appellant’s first proposition is that there is a nexus, because the borrowed money on which the interest was paid was used to acquire land on which Farms carried on its farming business. That proposition would be incontrovertible, if the land had been purchased by Farms. But it was not. It was purchased by Sharemilking and Beef, and leased to Farms. The three companies are separate legal entities. The arrangements between and among them must be analysed, to determine whether those arrangements establish a nexus between the borrowing of the money from the bank, in respect of which the deduction is claimed, and the acquisition of the land which was used by Farms to carry on the farming businesses from which it derived income.
[8] The rent paid under the leases is a deductible expenditure for Farms, incurred by it in carrying on its farming businesses. Before the interest cost incurred in making the advances could also be held to be incurred in carrying on the farming businesses, a nexus between the making of the advances by Farms and the granting of the leases by Sharemilking and Beef would be necessary. Whether that nexus exists must be determined by the formal agreements entered into, and performed. There is no evidence of any agreement between Farms and either of Sharemilking or Beef which makes the granting of those leases conditional on receipt by Sharemilking or Beef from Farms of the funds borrowed by Farms. Conversely, there is no evidence of any agreement that the advances by Farms to Sharemilking and Beef were conditional on the granting of the leases to Farms.
[9] There is no accordingly no evidence of any contract or other arrangement between Farms on one hand, and Sharemilking and Beef respectively on the other, to create a nexus between the borrowing and the acquisition of the land by Farms. The
proposition advanced by Mr Brown in evidence was that it is self-evident that this nexus must have been agreed because:
(a) there was a commonality of ownership between all entities;
(b)the acquisition amounts for the various properties matched the advances made;
(c) the properties were leased to Farms on acquisition;
(d) no interest was ever agreed or charged between Sharemilking and
Beef and Farms;
(e) the lease costs were not at market but were at an amount significantly below market; and
(f) the refinancing of one of the properties resulted in its being leased to
Farms where it had not previously been.
[10] The Judge rejected that argument. She was right to do so. Mr & Mrs Brown chose to structure their affairs using the three companies. They created three separate legal entities. The fact that they had the ability to control all three entities does not mean that the relations between those entities are to be determined by reference to what could have been agreed, rather than by the legal arrangements which they put in place. As a general rule, the true nature of a transaction, for the purpose of assessing income tax as well as for other purposes, can only be ascertained by careful consideration of the legal arrangements actually entered into and carried out. It is not determined by an assessment of the broad structure of the transaction measured by the results intended and achieved or of the overall economic consequences to the parties. Nor is it determined by the legal consequences which would follow from an alternative course which they could have adopted had they
chosen to do so.2
2 See I L M Richardson “Appellate Court Responsibilities and Tax Avoidance” (1985) 2(1) Australian Tax Forum 3-20.
[11] There are exceptions to that general rule. In some situations, it is permissible to look behind the form of the legal arrangements, when those do not truly reflect the substance. That is not what the appellant urges here. What is submitted is that, in the absence of formal legal arrangements, the Commissioner and the Courts should infer the existence of arrangements that the entities have not made. Except in particular situations (such as tax avoidance) which are not in issue here, income tax is imposed by the application of the Act to the legal arrangements which have been entered into, not by considering what other arrangements the parties might have, but did not, enter into. There is, on the evidence, no nexus between the advances by Farms to Sharemilking and Beef on one hand, and the leases by these two companies to Farms on the other. The most that can be said on the evidence is that the ultimate controllers of all three companies had the ability to achieve, and did achieve, the outcome that the borrowed money was used to buy land which was then leased to Farms. That is not a nexus in terms of s DA 1.
[12] The TRA considered case S5 to be directly on point.3 There, the taxpayer sought to deduct interest expenditure on borrowed funds that were advanced interest free and on demand to a company of which he was the majority shareholder. There was no written record of any agreed terms. The interest was held not deductible. The appellant seeks to distinguish that case on the basis that there, the loan did not result in the acquisition or creation of an asset which could be used in a business or to derive income, but simply repaid accrued indebtedness. In rejecting that distinction, the TRA observed that the appellant is not in the business of money lending and cannot rely on s DA(1)(b) as expenditure incurred in the course of carrying on a business for the purpose of deriving assessable income. Mr Lennard for the appellant submits that the TRA erred in restricting the applicability of s DA(1)(b) in this case to the business of money lending.
[13] It is not a necessary condition of deductibility that Farms should be carrying on a money lending business. A deduction would be permitted if the interest expenditure was properly incurred in the course of carrying on the farming business. But, for the reasons I have given, it was not so incurred. The distinction which the
appellant seeks to draw, namely that the loan in this case resulted in the acquisition
3 S5 (1995) 17 NZTC 7,036 (TRA).
of a business asset, is invalid for those same reasons. The money borrowed by Farms was not spent in acquiring land used in the farming business. It was on-lent to the other two companies. The only relevant assets in the books of Farms were the loans to Sharemilking and Beef. Those assets were not income-producing. The expenditure by Farms in securing the land on which it operated its farming businesses was the rental expenditure, not the interest expenditure.
[14] The next submission is that there is a nexus between the interest free loans and the leases, because the rent charged by Sharemilking and Beef to Farms was less than a market rental. The appellant submits that the arrangements are to be categorised as a barter transaction under which Farms received (by way of barter) the land at a lower lease cost. That argument must fail, for essentially the same reason the previous argument must fail: there is no evidence of any barter agreement to that effect. There is no agreement between Farms and the other two companies linking the rental payable to the interest which would be payable if interest was demanded on the advances.
[15] Furthermore, the claimed barter transaction has not resulted in an equal exchange of value. The evidence is that, for the income years concerned, the values did not equate. The interest payable by Farms to the bank on the loans exceeded the difference between actual rental and the market rental for the land it leased. The evidence of the Commissioner’s investigating officer is that in both income years the interest foregone by Farms was greater than the rental foregone by Sharemilking and Beef.
[16] Mr Lennard makes two submissions about that inequality of value. The first is that there is no requirement that deductible expenditure must be matched by assessable income, so that the fact that an item of expenditure may not result in an equal or greater amount of income in that income year, or over a number of years, does not affect its deductibility at all, let alone on a year by year basis. That submission is correct, in broad terms. But that is not the issue here. The issue is whether a barter transaction is established. The significant inequality in value between the items said to have been bartered, in the two income years in issue, is a substantial obstacle to a finding that a barter transaction should be inferred. Second,
Mr Lennard submits that the situation in which the reduced rental is less than the interest expense could be expected to change over time because interest costs will diminish as the loan is repaid and the rental value of the leased land will increase. The only evidence relied upon to support that submission is that of the investigating officer, when that proposition was put to him in cross-examination. He accepted as a general proposition that generally, over time, borrowed money is repaid so interest reduces, while the value of the land, and therefore rent, increases. He did not accept that this might well happen in this case, and said that claim had not been made in this case. There is no evidential basis for a factual finding that the values will equate over time.
[17] The relevant question on this aspect of the argument is whether an offset has been agreed between the rental cost and the interest cost, by way of barter. The essence of a barter transaction, between arms length parties, is an exchange of non monetary items which the parties regard as having a sufficiently equivalent value to make the transaction acceptable to both parties. In this case, the monetary values of the respective exchanges can be quantified. On one side, the benefit to Sharemilking and Beef of the interest free loans is at least equal to Farms’ cost of borrowing from the bank. On the other, there was evidence of the difference between the market rental and the actual rental. If the parties proceeded on the basis that these would balance out over the long term, there should be evidence to that effect. There is none.
[18] Mr Lennard further submits that there is a nexus between the interest payments and the derivation of income because the funds borrowed by Farms were used in part by Sharemilking to purchase the Fonterra shares under which the milk produced by Farms was sold. That submission must fail, for the same reason the primary submission must fail: the money borrowed was not used by Farms to acquire the shares: the shares were acquired by Sharemilking. Just as there is no nexus between the interest expense incurred by Farms and the acquisition of the land by Sharemilking, there is no nexus between the interest expense and the acquisition of the Fonterra shares. Further, there is no evidence that Farms derived any income as a direct result of the acquisition of the Fonterra shares. The moneys paid by Fonterra were substantially (if not totally) payment for milk supplied. There is no
evidence of the extent (if any) to which Farms or Sharemilking derived dividend income from the Fonterra shares.
[19] The decision of the TRA to uphold the Commissioner’s assessments was
correct. The appeal is dismissed.
[20] The Commissioner is entitled to costs, which I fix on a 2B basis.
“A D MacKenzie J”
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