FULLERS BAY OF ISLANDS LIMITED V THE COMMISSIONER OF INLAND REVENUE CA CA264/04

FULLERS BAY OF ISLANDS LIMITED V THE COMMISSIONER OF INLAND REVENUE CA CA264/04 28 November 2005IN THE COURT OF APPEAL OF NEW ZEALAND CA264/04BETWEEN FULLERS BAY OF ISLANDS LIMITED Appellant AND THE COMMISSIONER OF INLAND REVENUE Respondent Hearing: 3 November 2005 Court: Glazebrook, O'Regan and Robertson JJ Counsel: F B Bolwell for Appellant J H Coleman and K J Maclaren for Crown Judgment: 28 November 2005JUDGMENT OF THE COURT The appeal is dismissed and costs of $6,000 plus usual disbursements are awarded in favour of the respondent. REASONS(Given by Glazebrook J)Table of ContentsPara NoIntroduction [1]Relevant legislation [3]Facts [4]History of the taxation dispute [17]The TRA judgment [21]The High Court judgment [29]The parties' submissions [40]Fullers' submissions [40]The Commissioner's submissions [46]Discussion [57]Result and costs [63]Introduction[1] The issue in this case is whether legal fees paid to Chapman Tripp by Fullers Bay of Islands Limited (Fullers) are on capital or revenue account and thus whether they are deductible for income tax purposes. The fees related to legal advice given and litigation undertaken in the High Court as a result of Fullers' unsuccessful participation in a tender process operated by the Auckland Regional Council (ARC) for a subsidised contract to run the Devonport ferry service for a five-year period. [2] Fullers claimed the legal expenditure incurred by it as a deduction for income tax purposes in the 1999 income year. The Commissioner disallowed the deduction on the basis that the expenditure related to the attempted acquisition of a capital asset. The Taxation Review Authority (TRA) held that the expenditure was on revenue account and thus that Fullers was entitled to a deduction. In the High Court, Baragwanath J concluded that the decision of the TRA was erroneous and that the expenditure was capital in nature. Fullers now appeals against that decision.Relevant legislation[3] The applicable legislation for the purposes of this litigation is the now repealed Income Tax Act 1994. The relevant portions of s BD2 of that Act, which relates to allowable deductions, read as follows:BD 2 Allowable deductionsDefinition (1) An amount is an allowable deduction of a taxpayer (b) to the extent that it is an expenditure or loss (i) incurred by the taxpayer in deriving the taxpayer's gross income, or (ii) necessarily incurred by the taxpayer in the course of carrying on a business for the purpose of deriving the taxpayer's gross income, or . Exclusions (2) An amount of expenditure or loss is not an allowable deduction of a taxpayer to the extent that it is (e) of a capital nature, unless allowed as a deduction under Part D (Deductions Further Defined) or E (Timing of Income and Deductions)Facts[4] Fullers is in the business of providing sea and land transport services. It is also engaged in the tourist industry, providing a range of services both in New Zealand and overseas. Fullers operated in a number of divisions. The main division was the maritime division, which had turnover of $5.4m and accounted for about 60% of the total operating revenue of Fullers in the financial year ending 31 May 1998. [5] In March 1996 the directors of Fullers decided to look at ways of expanding the company's business in the Auckland area. Enquiries were made to the Auckland Regional Council (the ARC) regarding potential business opportunities. Fullers became aware that a significant passenger ferry service run between Devonport and Auckland City was to be offered for public tender which closed on 9 April 1996. At the time, the Devonport ferry service was being run by a competitor, Fullers Group Limited, which is an unrelated entity. [6] After ascertaining that the Devonport ferry service was highly profitable, Fullers submitted a tender seeking the contract. Fullers considered that it could operate the service without proportionate expansion of its infrastructure and using its existing vessels. It was understood from the outset that the tender was for aratepayer subsidised service. Fullers knew that its competitor received a subsidy of $250,000 to run the service and it was also thought (erroneously as it turns out) that the successful tenderer would have a monopoly for the five-year life of the contract. With this in mind, Fullers offered what it considered to be an enhanced service for a subsidy of $10,000. [7] The other option open to Fullers was a commercial registration. A commercial registration is essentially an offer to run the service with no subsidy. The directors of Fullers considered that its planned expansion into Auckland would be unsuccessful if they submitted a commercial registration instead of a tender, as the service could not be run profitably if it faced head-to-head competition with the incumbent operator, Fullers Group. [8] The ARC found the tender submitted by Fullers to be very attractive and decided that Fullers was the preferred bidder. Prior to notification of the result of the bid, however, Fullers Group submitted a commercial registration. Fullers was unaware of this and was not given any opportunity to make a competing unsubsidised bid. The ARC accepted the commercial registration of Fullers Group and the tender round was cancelled. [9] Fullers found this an unacceptably unfair process, having regard to an assurance it had allegedly received before embarking on the tender that, once the ARC had settled on a preferred bidder, it would not accept a commercial registration. The directors of Fullers considered that, if the ARC had followed the tender process and the letter of offer had been sent to it, then it would have undoubtedly been awarded the Devonport ferry service contract. Fullers consulted its lawyers and was advised it had a good case against the ARC for compensation arising from unlawful acts or omissions in the course of the tender process. As a result of that advice, Fullers issued proceedings against the ARC and Fullers Group. [10] The relevant proceedings were commenced on 3 October 1996. In its fifth amended statement of claim, which was filed part way through the hearing before Paterson J, Fullers alleged three causes of action against the ARC.[11] First, Fullers claimed that the ARC breached contractual obligations owed to it regarding confidentiality, consideration of a commercial registration and fairness and equal treatment. For this, Fullers claimed declarations that, if the ARC had not breached its contractual obligations, Fullers would have obtained the final contract for the Devonport ferry service. It also claimed damages of $6.2m plus interest. This sum was pleaded as being the discounted value of the future cash flows that would have been generated from the contract. Assuming these cashflow projections to be correct, the operating revenue from Fullers' marine division would have doubled had Fullers been awarded the contract. The TRA held that it would have increased by 50% but an examination of the accounts shows this to be an underestimation. [12] Secondly, Fullers claimed that the ARC had engaged in misleading or deceptive conduct in the course of trade that led to the loss of the Devonport ferry service contract. For this, Fullers claimed damages of $6.2m plus interest. [13] Thirdly, Fullers sought judicial review of the ARC's conduct in allegedly mismanaging the tender process in a number of specified ways. Fullers asked for six declarations, including a declaration that, had the ARC properly managed the tender process, Fullers would have been the holder of the contracted service for the ferry. Significantly, Fullers also sought an order directing that Fullers was the holder of the contracted service for the ferry service for a period of five years from the date of the order, subject to Fullers satisfying the conditions specified by the ARC in its conditional letter of offer. Fullers also sought orders that the ARC set aside the commercial registration of Fullers Group or reconsider its decision granting it. [14] As against Fullers Group, Fullers sought a consequential declaration that its commercial registration for the Devonport ferry service was invalid and an injunction to prevent Fullers Group from continuing to act on the basis of this registration. There was a second cause of action against Fullers Group alleging interference with Fullers' contractual rights and seeking damages of $6.2m plus interest.[15] In a judgment dated 4 June 1999, Paterson J dismissed all claims made by Fullers against the ARC and Fullers Group. [16] Fullers paid Chapman Tripp substantial legal fees for advice and services in relation to the High Court proceedings. The legal fees were shown as an extraordinary item in Fullers' accounts. Fullers claimed a deduction of $612,792.14 for legal expenditure incurred for the 1999 income year.History of the taxation dispute[17] The Commissioner took the view that the deduction for the legal expenditure was not available, on the basis that the Devonport ferry service proposed by Fullers was not in operation, and therefore the expenditure was not incurred in the process of deriving a gross income (s BD2(1)), and that it was capital in nature (s BD2(2)(e)), the contract and the damages being capital expenditure. [18] The statutory disputes resolution process was followed which resulted in the Adjudication Unit determining that there should be no deduction for the legal fees. The Unit concluded that the legal expenditure was for the primary purpose of acquiring the ferry contract. There was sufficient nexus between the expenditure and the income earning process for the legal expenditure to be deductible under s BD2(1). However, the Unit determined that deductibility under s BD2(2)(e) was prohibited on the basis that the expenditure was capital in nature as the contract for the ferry service was an expansion of the structure of the company from which additional revenue could be gained. It was determined that the contract was part of the substrata of the company and therefore capital and non-deductible. [19] It was further determined that, although the expenditure was also incurred for a claim of lost profits, which is revenue in nature, and an apportionment between capital and revenue expenditure is allowed under s BD2(2), Fullers had not suggested a basis on which the apportionment could be made and therefore the total expenditure remained capital in nature and non-deductible.[20] In accordance with the Unit's determination, the Commissioner issued a notice of assessment to Fullers dated 7 April 2003 disallowing the deduction.The TRA judgment[21] The dispute then came before the TRA. In a judgment dated 27 February 2004, the TRA concluded that the legal costs were deductible for income tax purposes. [22] The TRA saw the issue as whether Fullers was seeking to enforce a process contract or to obtain specific performance of a contract to supply ferry services. The TRA accepted that, although Fullers wanted the outcome of the Court case to put it in a position where it could obtain a final contract, it was never possible for the Court actually to award Fullers specific performance of the final contract. This was because such a contract never came into existence, due to the ARC's acceptance of a commercial registration. [23] Viewed in that way, the TRA was satisfied that this litigation and the attendant costs were solely directed to obtaining the benefits of the process or preliminary contract. The TRA held that seeking to vindicate a right to a fair contractual process, even if successful, is not to acquire any property of an enduring nature. The TRA also accepted Fullers' submission that the conclusion that the expenditure was on revenue account was reinforced by the fact that, in the year in question, the accountants treated the expenditure as being on revenue account. [24] In case that approach was not correct, the TRA turned to consider the nature of the contract for the ferry service and whether the rights or property sought to be acquired were on capital or revenue account. It referred to Dixon J's dissenting judgment in Hallstroms Pty Ltd v FCT (1946) 72 CLR 634 at 648 where, in deciding whether an outgoing is on account of capital or income, he said the distinction depended upon:what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.[25] On this alternative argument the TRA considered that what was sought to be secured was the final contract for the Devonport ferry service. The TRA pointed out that a number of distinct profit centres were operated within the umbrella of Fullers and that the new activity sought to be undertaken was the same as a number of the other profit centres. In the TRA's view, contracts are part of the stock in trade of a passenger service transport operator. The make-up of the contracts to which Fullers was a party change regularly as some expire and others are sought. [26] The legal costs in asserting title to one of those contracts was, in the TRA's view, no different in kind from any other costs expended in maintaining contracts on foot. This conclusion was reinforced, in the TRA's view, by the accounting treatment. In addition, the TRA determined that the final contract would have become part of the circulating capital of the business operated by Fullers, along with its other passenger service contracts, which was another indicia that the legal expenses were a deductible revenue item. [27] The TRA was therefore satisfied that, even if the legal expenses were incurred in seeking to obtain the final contract, they were expenses incurred in the course of producing potentially assessable income. The expenses would relate to the stock in trade or circulating capital of the company and were, therefore, properly deductible in the year in which they were incurred. [28] Accordingly, the TRA concluded that Fullers was entitled to deduct the legal costs of $612,792.14 from its assessable income in the 1999 income year.The High Court judgment[29] The Commissioner appealed to the High Court, which concluded that the decision of the TRA was erroneous and that the expenditure was capital in nature. [30] Baragwanath J identified and applied the tests for distinguishing between capital and income that had been set out in the Privy Council decision of BP Australia Ltd v Commissioner of Taxation of the Commonwealth of Australia [1966] AC 224 at 264-274.[31] An initial test is whether the expenditure was for the purposes of carrying on an existing trade or rather to enable the taxpayer to enter that trade (the Hallstromstest). In this case, the purpose of Fullers' expenditure was to secure the Devonport ferry service contract as a major revenue producing addition to its business, rather than to retain any existing business. Baragwanath J considered that this was a strong pointer to classification of the expenditure as capital. Although the claim was in part expressed in terms of enforcing a claimed right to due process, the practical and business objective was not just to win a court case but to secure the Devonport contract and a wholly new business. [32] A second test is whether the expenditure is recurrent or made uno flatu, that is, once and for all. Acquisition of a business by the slow process of conventional advertising and building up goodwill entails expenditure on revenue account, whereas acquiring it by purchase is likely to be on capital account. In Baragwanath J's view, Fullers was attempting to secure the income stream uno flatu by securing the contract rather than by building up a competing business in the marketplace. [33] The third test referred to by Baragwanath J was the distinction between the business structure, which is a capital item, and the ordinary process by which it is operated to obtain regular returns, which is a matter of revenue. The ferry contract would have constituted a major addition to the structure of Fullers' business which it would operate to obtain regular returns from passenger fares. The objective was to secure monopoly rights which are capital in nature. [34] Another test for distinguishing between capital and revenue is whether the expenditure is intended to result in an enduring asset. The claim was advanced on the basis of the benefit of the contract subsisting for a further five-year term or, alternatively by way of fallback, for the residue of that term accompanied by compensation. Baragwanath J considered that the fact that the alternative claim is for compensation does not affect its status as filling a capital gap. [35] A fifth test is whether the expenditure is from fixed or circulating capital. The source of the expenditure favoured Fullers. However, in Baragwanath J's view, what matters is the purpose of the expenditure rather than its source.[36] The final test referred to by Baragwanath J was how the payment would be treated on ordinary principles of commercial accounting. He noted, however, that the parties did not treat this test as of particular assistance and pointed out that the accountants' treatment of the expenditure as being on revenue account was merely an expression of their opinion which differed from the position they had taken in the two preceding years. [37] Overall, Baragwanath J was not persuaded by the TRA's analysis. As to the TRA's view that the occasion of the expenditure was to enforce a claim to fair contractual process, he noted that that was part only of the total object of the litigation which was to secure the ferry contract. Further, he considered that, as what matters is purpose, the fact that the expenditure produced no asset or advantage of an enduring nature was irrelevant. [38] Baragwanath J also disagreed with the TRA's view that the expenditure was not related to the structure of the business. Although operating a business so as to build it up does not require conventional revenue expenditure to be reclassified as capital, a dominant purpose of acquiring assets to ensure a future revenue flow is likely to lead to classification of the expenditure as on capital account. The Judge also considered that how Fullers would have treated the profit centre of a new stand-alone Devonport ferry operation does not determine the essential question of the object of the expenditure made to acquire it. [39] Considering the purpose of the expenditure overall, Baragwanath J was satisfied that it was to secure a capital asset, however it may be characterised for other purposes. He therefore allowed the appeal and restored the Commissioner's determination that the $612,792.14 expenditure was not deductible.The parties' submissionsFullers' submissions[40] Ms Bolwell, for Fullers, submitted that Baragwanath J applied the incorrect conceptual framework in reaching his decision, which led to a decision wrong inlaw. In her submission, Baragwanath J incorrectly determined the purpose of the expenditure. She submitted that he proceeded on the incorrect basis that the purpose of the litigation was the same as the purpose of entering the tender round, namely to secure the ferry contract. Although Fullers entered into the tender round with the practical and business objective of securing the ferry contract, the purpose of the litigation was, in her submission, threefold. Fullers wished first to establish that a preliminary contract existed between it and the ARC as to a fair process, second to prove that this contract was breached and finally to obtain a remedy for that breach. [41] Ms Bolwell submitted that Baragwanath J was incorrect to omit the first part of the equation, which contains the critical purpose of the litigation. His focus remained firmly on the acquisition of the Devonport ferry service, which was only one of the remedies sought and was only introduced 15 days into the trial. In any event, the fact that Fullers sought such a remedy does not change the purpose of the litigation, which was to establish a breach of a preliminary contract and obtain compensation. It was submitted that it is clear from the judgment of Paterson J that much of the focus of Fullers and its legal advisors was directed towards the first two purposes and one can infer that a considerable proportion of the legal expenditure was also devoted to this issue. Therefore, in her submission, the dispute was about contractual rights to fair process and not about a capital item. This indicates that the expenditure was on revenue account. [42] Ms Bolwell submitted further that, if Baragwanath J had considered the difficulties in the remedies sought and the nature of the damages claim, this would have highlighted the fallacy of focusing on one aspect of the litigation only. She submitted that the successful outcome of the litigation could have a variety of results, unlike the successful outcome of the tender process, which would have resulted in the ARC awarding Fullers the ferry contract. Although the practical and business objective of entering the litigation was to win the case, winning the case certainly did not mean obtaining the ferry contract. Various remedies were sought in the five statements of claim and there were a variety of approaches that the Court could have adopted. Indeed, it was recognised by 1999 that damages were the most likely remedy if the claim was successful, as only two years of the contract remained. She emphasised that Fullers was not going to obtain the contact of service it sought, asthe commercial registration of Fullers Group had been accepted and it was running the ferry service. [43] Ms Bolwell's next submission was that the ferry service contract, if obtained, was not structural. The contract sought by Fullers in the tender round was intended to sit alongside the commercial registrations it already held for bus transport, passenger ferry transport and vehicular ferry transport. It was temporary in duration and, at the time of trial, was to be put back to tender in two years time, again for a period of limited duration. In Ms Bolwell's submission the contract was not, as Baragwanath J held, a set up cost of the business. The business already existed and no expansion of Fullers' infrastructure was needed. [44] Ms Bolwell's final submission was that Baragwanath J wrongly applied the well-known tests to determining whether the damages would have been on capital or revenue account. She submitted that the Commissioner's position that a damages claim based on a lost opportunity to earn profits, if awarded, would be on capital account is illogical and not in accordance with the usual approach of the Commissioner when assessing such damages. Ms Bolwell submitted that any compensation awarded to Fullers, whether in the form of a contract or damages, would have had the effect of "filling a hole" in its profits and would, therefore, have been on revenue account. The evidence was that Fullers has gone from strength to strength in its business operations since losing the litigation. There was no loss of the business, major disruption or a curtailment of the use of any of its capital assets. Ms Bolwell submitted that, as Fullers has moved on very successfully from its inability to secure the Devonport ferry contract, any damages received from the litigation would have filled a hole in its profits, rather than compensated for the loss of the business. [45] After the hearing we received some additional material from Ms Bolwell. In the circumstances of this case, we did not find the material of assistance and so make no further mention of it.The Commissioner's submissions[46] In response to Ms Bolwell's submission that the concentration should be on what was intended to be achieved by the litigation, Mr Coleman's submission was that the approach taken by Fullers is wrong, as it focuses on the relief that could be expected in the litigation. In his submission, this is to focus on the juristic rights expended or secured in the process rather than on the business objective of Fullers. This approach clashes with the governing approach as set out in Hallstroms andBP Australia. In his submission, the business objective of the litigation must have been to secure the contract or damages to compensate for its loss. [47] As to the ferry contract itself, Mr Coleman, for the Commissioner, submitted that whether an item of expenditure or receipt is on capital or revenue account is ultimately determined by the Hallstroms test, that is, what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process. [48] Mr Coleman submitted that legal fees can be either capital or revenue in nature, depending on the purpose for which they were incurred. In his submission, the expenditure in this case was incurred to secure the contract for the Devonport ferry service, a monopolistic contract which would have been a major addition to Fullers' business. In his submission, such expenditure must be on capital account. He submitted that it is irrelevant that this objective was not achieved – see Milburn NZ Ltd v CIR (2001) 20 NZTC 17,017 at 17,023-24 and John Fairfax & Sons Ltd v FLT (1959) 101 CLR 30 at 49. [49] Mr Coleman submitted that, in this case, the Court is not required to descend into the weighing and balancing of the various factors that have proven to be helpful in borderline cases. In his submission, however, applying the factors listed inBP Australia does produce the same result, namely that the expenditure is on capital account.[50] The first factor is an examination of the need or occasion for the expenditure. Mr Coleman submitted this was a desire by Fullers to expand its business into the Auckland market. After the failed tender, the object was to obtain the contract (or damages) by means of litigation. The occasion was, therefore, one of attempted business expansion. In Mr Coleman's submission, the cost of creating, acquiring or enlarging the permanent structure by which the income is produced is capital in nature. Mr Coleman submitted that the submissions for Fullers focused, with the benefit of hindsight, on a juristic analysis of what could or could not have been achieved in litigation, rather than on what the expenditure was calculated to achieve from a business perspective. In his submission, the correct focus is the ultimate business objective and not the immediate means employed to achieve the business ends. [51] The second factor is whether the payments were made from fixed or circulating capital. In Mr Coleman's submission, this test is not particularly helpful either way on the facts of this case. He pointed out that this test has been criticised in New Zealand – see Milburn at [48]. [52] Thirdly, Mr Coleman submitted that the costs of litigating to obtain the ferry contract were a "once and for all" payment which would produce an asset of an enduring nature. Contracts constitute assets of an enduring nature when they relate to the structure of a business. In Mr Coleman's submission, a five-year contract is sufficiently long to constitute a contract of a capital nature. [53] In terms of the fourth factor as to how the payment would be treated on ordinary principles of commercial accounting, Mr Coleman submitted that the fact that the legal expenses were treated as an extraordinary item in Fullers' accounts suggests that it was not a business as usual item of recurrent expenditure. Although the expenditure did not meet the accounting definition of an asset, as there was not in the 1999 income tax year the necessary probability that there would be future service potential from the expenditure, tax law and accounting are different in this respect. In terms of tax law, the important factor is what the expenditure was designed to achieve from a business perspective, rather than the outcome of the expenditure.[54] Another factor Mr Coleman identified was whether the payments were expended on Fullers' business structure, rather than as part of the process by which income was earned. In his submission, expenditure seeking to secure a substantial route contract is related to the structure within which Fullers' business of providing transport services operates. [55] Finally, Mr Coleman challenged Fullers' proposition that, had it received damages in its case against the ARC and Fullers Group, the receipt would have been income in nature. In his submission, damages for the permanent loss of a capital asset, such as damages for the loss of the ferry contract, are on capital account. He submitted that, in the case of the total loss of a capital asset, the fact that the lost profitability from the use of that asset is taken into account in assessing the quantum of the compensation does not mean that the compensation is on revenue account. [56] Accordingly, Mr Coleman submitted that the appeal should be dismissed as the Baragwanath J was correct to find that the expenditure for legal fees was on capital account.Discussion[57] Ms Bolwell's submissions before us were essentially threefold: (a) The object of the litigation was to enforce the process contract and not to secure the ferry contract. Although a claim for the contract was made, realistically the most that could have been achieved by the litigation was an award of damages; (b) The ferry contract was, in any event, merely one of a number of contracts and thus any expenditure to secure it would be on revenue account; (c) Any damages received as a result of the litigation would have been for loss of profits and therefore on revenue account. The expenditure to secure that result was therefore deductible.[58] We do not accept any of these submissions, essentially for the reasons set out in Baragwanath J's judgment and by Mr Coleman in his submissions. We add a few comments. [59] Taking Ms Bolwell's first submission, we do not consider the matter can be looked at so narrowly. The object of the litigation, insofar as the statement of claim was concerned, was to enforce the process contract but as a step to secure the ferry contract or damages equivalent to the value of the ferry contract. This must have been the objective also from a practical business point of view or there was no point in issuing the litigation. [60] Even if the object of the litigation had been merely to enforce the process contract, this was designed to ensure a chance (presumably assessed as high by Fullers) of securing the contract or compensatory damages. Given the way the claim was framed, the assumption was that, were the process contract properly enforced, the ferry contract would have followed, given the preferred bidder status and Fullers' willingness to abide by the conditions. There was thus no substantive difference between the process contract and the ferry contract itself. [61] As to Ms Bolwell's second point, we consider it incontrovertible that the ferry contract would have been on capital account in the particular (and rather unusual) circumstances of this case. It was a long term monopolistic contract and it represented a major expansion of Fullers' business into the Auckland area. It was projected to double the operating revenue of the marine division, a division which contributed some 60% of Fullers' revenue. It follows that any expenditure to secure the contract was on capital account, whether or not it resulted in the contract being obtained. The fact that the litigation did not turn out as was hoped does not change the nature of the expenditure. [62] Ms Bolwell's third point on damages can be shortly dealt with. What was claimed were damages for the loss of a capital asset, the ferry contract. The value of capital assets are often calculated on the basis of discounted cashflows. This does not turn a claim into a loss of profits claim. It remains a claim for loss of a capital asset. The fact that any income from the contract, if it had been awarded, wouldhave been on revenue account is irrelevant. Income from any capital asset is on revenue account.Result and costs[63] For the above reasons, the appeal is dismissed. Costs of $6,000 plus usual disbursements are awarded to the respondent.Solicitors: Nola Dangen & Associates, Auckland for Appellant Crown Law Office, Wellington