HONG v COMMISSIONER OF INLAND REVENUE [2018] NZHC 2539

HONG v COMMISSIONER OF INLAND REVENUE [2018] NZHC 2539 [27 September 2018]IN THE HIGH COURT OF NEW ZEALANDAUCKLAND REGISTRYI TE KŌTI MATUA O AOTEAROATĀMAKI MAKAURAU ROHECIV 2018-404-0774[2018] NZHC 2539UNDER the Income Tax Acts 1994, 2004 and 2007and the Tax Administration Act 1994IN THE MATTER of an appeal from a decision of the TaxationReview AuthorityBETWEEN BOON GUNN HONGAppellantAND COMMISSIONER OF INLANDREVENUERespondentHearing: 25 and 26 September 2018Appearances: B G Hong in personM Deligiannis and L K Worthing for the respondentJudgment: 27 September 2018JUDGMENT OF JAGOSE JThis judgment was delivered by me on 27 September 2018 at 4:00 p.m.pursuant to r 11.5 of the High Court Rules 1985.Registrar/Deputy RegistrarParties/Solicitors:Mr B G HongMs M Deligiannis, Crown Law Office, WellingtonIntroduction[1] In his 2011 income tax return Mr Hong, a solicitor, claimed deductions inrespect of loans he had written off as bad debts of $50,000 and $122,280 respectively.The loans were to two of his legal practice's clients, facing financial difficulties, outof a fund he had created for that purpose.[2] The Commissioner of Inland Revenue disallowed and reversed the deductions,issuing an amended assessment and further imposing shortfall penalties on the basisMr Hong had failed to take reasonable care. On 29 March 2018, the Taxation ReviewAuthority upheld the Commissioner's findings.[3] Mr Hong now appeals the Authority's decision pursuant to s 26A of theTaxation Review Authorities Act 1994. He seeks orders quashing the decision, anddeclarations he is entitled to make the deductions and is not liable for any shortfallpenalties in the circumstances.[4] Mr Hong argues on appeal (as he did before the Authority):(a) his deductions fall within s DB 31 of the Income Tax Act 2007, theexception carved out from the general principle bad debts are notdeductible; and(b) the Commissioner was not justified in imposing shortfall penaltiesunder s 141A of the Tax Administration Act 1994.[5] The appeal operates by way of a full rehearing,1 but I must still undertake myown assessment of the merits of the Authority's decision. I may not interfere with itsdecision unless Mr Hong persuades me a different conclusion should be reached.21 High Court Rules 2016, r 20.18.2 Russell v Commissioner of Inland Revenue (2010) 24 NZTC 24,463 (HC) at [69]; affirmed onappeal in Russell v Commissioner of Inland Revenue [2012] NZCA 128; leave to appeal declinedin Russell v Commissioner of Inland Revenue [2012] NZSC 73.Analysis[6] The Authority's decision is comprehensive, well-reasoned, and to my mind,generally beyond reproach. I do not propose to rehearse its reasons in great depth, butonly so far as is required to make the point I see no reason to depart from its findings.Do the deductions fall within s DB 31 of the Income Tax Act?—the legislative scheme[7] As the Authority recognised, the operative provision in respect of thedeductibility of bad debts is s DB 31 which stipulates, except to the extent expresslyprovided, deductions for bad debt will be denied. Section DB 31(1) overrides thegeneral permission afforded by s DA 1 with the effect, when a deduction is deniedunder the former, it is unnecessary to consider the latter.3[8] Section DB 31 relevantly provides:DB 31 Bad debtsNo deduction (with exception)(1) A person is denied a deduction in an income year for a bad debt,except to the extent to which—(a) the debt is a debt—(i) written off as bad in the income year:(ii) for which the debtor is released from making allremaining payments under the Insolvency Act 2006excluding Part 5, subparts 1 and 2 of that Act, orunder the Companies Act 1993, or under the laws ofa country or territory other than New Zealand, and theperson is required to calculate a base price adjustmentby section EW 29 (When calculation of base priceadjustment required) for the debt for the income year:.(b) in the case of the bad debts described in subsections (2) to (5),the requirements of the relevant subsection are met.3 Income Tax Act 2007, s DB 31(6).[9] The only relevant subsection on the present facts is subsection (3), whichprovides:Deduction: financial arrangement debt: dealers and holders(3) A person is allowed a deduction, quantified in subsection (3B), for anamount of a bad debt owing under a financial arrangement to whichthe financial arrangement rules apply, if—(a) the person carries on a business for the purpose of derivingassessable income; and(b) the business includes dealing in or holding financialarrangements that are the same as, or similar to, the financialarrangement; and(c) a requirement of subsection (1)(a) is met for the bad debt; and[10] Thus, to deduct the bad debts presently at issue, Mr Hong needed to establish:(a) under subsection (1)(a), either:(i) the relevant debts were written off as bad between 1 April 2010and 31 March 2011, being the income year in which thedeductions were claimed; or(ii) the debtors were released from making all remaining paymentsby law, the relevant law here being the Insolvency Act 2006;and(b) under subsection (3)(a), he carried on business for the purpose ofderiving accessible income; and(c) under subsection (3)(b), that business included dealing in or holdingfinancial arrangements that were the same as, or similar to, the financialarrangement for which the deductions are claimed.—application[11] The Authority explained in detail why Mr Hong failed to establish any of thoserequirements. I see no reason to depart from its findings.[12] First, Mr Hong has not shown, according to his own accounting procedures,4the loans had been written off in the 2011 income year.5 Instead:(a) except for Mr Hong's assertion his office administrator, Ms Chan, hadentered the write-offs in the spreadsheet during the 2011 income year,there was no evidence of that entry or its timing;(b) Ms Chan – who was said to make all computer entries for inclusion inthe spreadsheet – was not called by Mr Hong. Mr Hong had to call herto obtain direct evidence of his assertion, and her evidence couldexplain or elucidate the entry and timing of the write-offs in thespreadsheet, but her absence was unexplained (beyond Mr Hong'spreference she remain at work than become involved in the litigation).An inference is therefore available what she may have said in evidencewould not have assisted Mr Hong;6(c) the database of financial transactions apparently compiled during the2011 income year, from which the spreadsheet was in part derived,omitted any reference to the write-offs;(d) Mr Hong's 2011 return was completed in conjunction with those for2006-2010 and 2012, after the Commissioner initiated an audit of MrHong's compliance, given the absence of his returns for those years;(e) on 24 September 2012, Mr Hong advised the Commissioner "[his] staffhad entered all the transaction details for [him] to complete the returnsover this weekend", and sought an extension of time to 1 October 2012to complete the returns; and(f) Mr Hong himself said he had included the bad debts in the 2011 return,ultimately filed in October 2012, "as more or less it was then that Iturned my mind to this".4 Case W3 (2003) 21 NZTC 11,014 at 11,030.5 Budget Rent a Car Ltd v C of IR (1995) 17 NZTC 12,263 at 12,271; Case N69 (1991) 13 NZTC3,541 at 3547-3548.6 Perry Corp v Ithaca (Custodians) Ltd [2004] 1 NZLR 731 (CA) at [153].[13] Mr Hong complained the Commissioner unlawfully raised, and in any eventthe Authority wrongly accepted, the investigator's evidence the spreadsheet wascreated at 10:30am on 20 September 2012, based on the investigator's observation ofthe spreadsheet's metadata recording its "Content created" at that time and date. Theobservation was not included in the Commissioner's statement of position. Mr Hongnotes the same time and date is specified for each of the 2006-2012 spreadsheetsincorporated with his belated returns, and says it would be impossible for him to havecreated all seven documents contemporaneously. Certainly that coincidence suggeststhe 20 September 2012 spreadsheets are copies of earlier created documents.[14] Be that as it may, nothing in particular turns on the date the spreadsheet wascreated. Even if it existed during the 2011 income year, there is no evidence the write-off of the bad debts was recorded in it at that time. The Authority's finding of thespreadsheet's "true creation date" is distinct to its conclusion Mr Hong failed toestablish the bad debts were written off during the 2011 income year. In any event, MrHong misapprehended the scope of the amended s 138G(1) of the Tax AdministrationAct, which omitted the subsection's former exclusion of "facts and evidence" notdisclosed in statements of position. The Commissioner was entitled to tender theevidence.[15] Next, the Authority did not err in finding Mr Hong's debtors – both naturalpersons – had not been released at law from making any further payments, relevantlyby dint of being discharged from bankruptcy under s 304 of the Insolvency Act.Specifically, one debtor was only released from bankruptcy in 2013, after the 2011income year; and the other had not been adjudicated bankrupt at all.[16] Plainly, whether there had been any 'release' was alternative to the Authority'sfinding on the timing of the bad debts' write-off. Mr Hong is wrong in arguing theAuthority incorrectly combined the two heads of s DB 31(1)(a).[17] I do not accept the $50,000 loan to Bill Chan, Sai Kwong is to be construed asbeing made to his company, Far South Investment Society Co Limited. The loandocumentation, prepared on Mr Hong's behalf, is determinedly expressed in personalterms on account of Mr Chan's "overspent funds renovating my restaurant". Thatdocumentation also directs payment 90 per cent to Mr Chan's company "to clear rentand other creditors owed"; and 10 per cent to himself, but "I undertake to pay back theloan as quickly as I can". And, even if it was to the company, there was no evidencethe company had been released from its obligations to pay.[18] Further, Mr Hong was not carrying on, even in part, a lending business for thepurpose of deriving accessible income:7(a) the fund from which the loans had been advanced was set up with thedual objective of, first, assisting Mr Hong's clients in financialdifficulty according to his assessment of their qualification for suchassistance; and second, increasing the amount available for a finaldistribution upon Mr Hong's death to his charity of choice, WorldWildlife Fund. None of that objectively suggests business activities;8(b) the lending activity was not carried on in an organised and coherentmanner, or with sufficient continuity and extent.9 Mr Hong's primarybusiness was providing legal services, and the lending was a sideproject to which he gave minimal time and energy. Until Mr Chansought a further loan, Mr Hong had 'forgotten' he had lent money toMr Chan at all. The evidence was clear Mr Hong did not undertake duediligence on his lending, or monitor the balances of his loan account.Neither did he take any formal security or derive any significant incomefrom the lending; and(c) Mr Hong went to lengths to impress he lent out of benevolence and inreliance on conscience; his fund was called the "Benevolence on theConscience Loan Fund". His only hope of financial return was ifgrateful clients elected to reimburse him (whether at all, or withinterest, or even including a 'bonus'). His lending was "at least as7 Grieve v Commissioner of Inland Revenue [1984] 1 NZLR 101 at 110.8 Compare Case 5/2011 (2011) 25 NZTC 1-005 at [57]-[58].9 Grieve v Commissioner of Inland Revenue, above n 7, at 106.consistent" with charitable giving or, at most, a passive investment,either way not satisfying subsection (3)(a).10[19] So far as the subject loans are concerned, the last may well have been MrHong's approach to their recovery, but the Chan loan is expressed as being"[r]epayable on demand with interest at 10% on repayment", and the Tololi loan alsois "[r]epayable on demand with fair interest on repayment". Even if Mr Hong's'benevolent' lending could be viewed as part of his legal services business, these loansdo not appear the same as or similar to their 'conscience' character. Mr Hong hasrecourse to demand, as an alternative to awaiting his clients' action. It also is notablethe $300,000 Tololi loan (of which only $122,000 is claimed to be written off, with noexplanation as to whether the balance has been or remains to be reimbursed, with orwithout interest or 'bonus') includes Mr Hong's recourse to such surplus funds as MrTololi or his group of companies may leave with him. That is a separate distinguishingfeature from any 'conscience' loan.[20] Last, there is no sufficient connection between Mr Hong's legal servicesbusiness, and the financial arrangements he seeks to deduct as bad debts. That the twoloans at issue happen to be to his clients is not enough. The two services do notnaturally or easily co-exist. Mr Hong lending money to his clients raises significantissues under the Lawyers and Conveyancers Act (Lawyers: Conduct and Client Care)Rules 2008 – specifically, in addressing conflicting interests – about which there is noindication Mr Hong is aware or has addressed. It is also significant Mr Hong did notuse his legal business bank account for the lending activities, and seeks to account forthe write-offs as "Extraordinary losses".Was the Commissioner justified in imposing shortfall penalties?[21] Section 141A of the Tax Administration Act governs the imposition of shortfallpenalties for not taking reasonable care. Subsection (1) provides:A taxpayer is liable to pay a shortfall penalty if the taxpayer does not takereasonable care in taking a taxpayer's tax position (referred to as not taking10 Commissioner of Inland Revenue v Stockwell [1993] 2 NZLR 40; compare Dale v NicholsConstructions Pty Ltd [2003] QDC 453 at [47]-[48].reasonable care) and the taking of that tax position by that taxpayer results ina tax shortfall.'Reasonable care' is not defined in the Act. However, the section provides the safeharbour a person will have taken reasonable care if that person:(a) under subsection (3), takes an acceptable tax position; or(b) under subsection (2B), relies on an action or advice of a tax advisorengaged by the taxpayer.[22] I take no issue with the Authority's finding Mr Hong failed to take reasonablecare – which is to say, a reasonable person in his circumstances would have foreseenthe tax shortfall as a reasonable possibility.11 In particular, Mr Hong failed to do whata reasonable person in his circumstances would have done:(a) taken sufficient steps to understand relevant taxpayer obligations,commensurate with the complexity and exceptionality of the taxposition to be taken;(b) kept adequate books and records to substantiate the making, repayment,and enforcement of the loans, and the reasons for assessing the debtshad gone bad and for deciding to write them off; and(c) filed returns and paid tax on time (Mr Hong did not file income returnsfor the entire income period 2006 to late 2012, and made no provisionaltax payments after May 2008).However, I think the Authority goes too far in saying a reasonable person "would havesought advice from a tax advisor" (and, inferentially, relied on it). That leaves nomargin between the 'reasonable' person and the safe harbour. I prefer theCommissioner's alternative as I have expressed it at (a) above.1211 Case 3/2013 (2013) 26 NZTC 2-002 at [38] citing Case W4 (2003) 21 NZTC 11,034 at [60] andCase Y21 (2008) 23 NZTC 13,227 at [74].12 See also Case W3 (2003) 21 NZTC 11,014 at [113], and Case 9/2016 (2016) 27 NZTC 3-031 at[45]-[46].[23] The legislation provides another safe harbour: a taxpayer who takes anacceptable tax position will have taken reasonable care.13 But the position taken by MrHong was also objectively unacceptable: that is, it could not on rational grounds beargued to be right.14 There is no rational ground to assert a deduction in an incomeyear for a bad debt, without evidence either the debt was written off as bad in theincome year or the debtor was released from making remaining payments.[24] Mr Hong fell well short of the standard of care expected of taxpayers generally,as set out in s 15B of the Tax Administration Act, and in those circumstances, I see noerror in the Authority upholding the (reduced) penalty imposed by the Commission.Result[25] The appeal is dismissed.Costs[26] As the successful party, my preliminary view is the Commissioner is entitledto costs on a 2B basis. If that is not accepted by any party, and costs cannot otherwisebe agreed between them, costs are reserved for determination on short memoranda ofno more than five pages – annexing a single-page table setting out any contendedallowable steps, time allocation, and daily recovery rate – to be filed and served by:(a) the Commissioner within ten working days of the date of this judgment;(b) Mr Hong within five working days of service of the Commissioner'smemorandum; and(c) the Commissioner strictly in reply within five working days of serviceof Mr Hong's memorandum.Jagose J13 Tax Administration Act 1994, s 141A(3).14 Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2008] NZSC 115, [2009] 2NZLR 289 at [184].