MALLOWDALE ENTERPRISES LIMITED V THE COMMISSIONER OF INLAND REVENUE HC AK CIV 2009-404-6703

MALLOWDALE ENTERPRISES LIMITED V THE COMMISSIONER OF INLAND REVENUE HC AK CIV 2009-404-6703 28 January 2011IN THE HIGH COURT OF NEW ZEALAND AUCKLAND REGISTRY CIV 2009-404-6703IN THE MATTER OF the Tax Administratin Act 1994 and the Income Tax Act 1994 BETWEEN MALLOWDALE ENTERPRISES LIMITED Plaintiff AND THE COMMISSIONER OF INLAND REVENUE Defendant Hearing: 18-19 October 2010 (Heard at Wellington) Counsel: G J Harley for Plaintiff E J Norris and R J Wallace for Defendant Judgment: 28 January 2011JUDGMENT OF MILLER JIntroduction[1] A musical adaptation of the 1957 Elvis Presley movie 'Jailhouse Rock' opened in London's West End on 4 April 2004 and closed on 23 April 2005, having failed to meet its backers' expectations of commercial success. [2] The musical was funded by New Zealand investors through partnerships promoted by one of the producers, Volcanic Island Ltd. In return, the profits after payment of running costs were to be first applied to repaying the investors, then divided among the investors and the producers.[3] Substantial revenues were earned, but they did not cover running costs, let alone allow the investors to recoup the costs of getting the musical into production. [4] Most of the investors deducted the losses from their other taxable income, but the Commissioner of Inland Revenue issued assessments disallowing their deductions. He maintains that their investment was of a capital nature. The question in this challenge proceeding is whether that characterisation is correct.The players[5] The Jailhouse Company, a firm domiciled in Sun Valley, Idaho, owns rights to produce and present a stage musical based on the movie 'Jailhouse Rock'. Jailhouse Co has no rights to the song of the same name; they are owned by Elvis Presley Enterprises. [6] Volcanic Island is a New Zealand company owned by Barry Colman, Robin Congreve, Stephen Dee and Jonathon Alver. They are also its directors. Messrs Colman and Congreve are businessmen with interests in the arts. Mr Dee is a producer with long experience in opera and theatre. Mr Alver, a musician by training, is also an experienced producer and theatre manager. Volcanic Island has been responsible for several theatrical productions in New Zealand and elsewhere. Its role in the initial United Kingdom production of 'Jailhouse Rock, The Musical' was that of a producer and supplier of the funding. [7] Theatre Partners Services Ltd is a United Kingdom company with expertise in musical writing, direction and theatrical production. Its principals are Alan Janes and Rob Bettinson. Both are said to be leading writers with successful track records. Theatre Partners was the lead producer and general manager of the initial United Kingdom production, with primary responsibility not only for writing the script but also for song selection, set design and cast selection. [8] Jailhouse Rock (UK) Productions Ltd, now in liquidation, was a United Kingdom company established by Jailhouse Co, Volcanic Island, and Theatre Partners and owned as to a third each. It was established because for some purposesit was convenient to employ a United Kingdom company. In particular, it became less likely that the New Zealand investment vehicle, a partnership, would be deemed resident in the United Kingdom for tax purposes. The company had five directors: Messrs Alver and Dee, representing Volcanic Island; Messrs Bettinson and Janes, representing Theatre Partners; and Rene Sheridan, representing Jailhouse Co. [9] Mallowdale Enterprises Ltd and other New Zealand taxpayers, including Messrs Colman and Congreve, invested in the initial United Kingdom production as partners in two New Zealand partnerships, Jailhouse Rock Nos 1 and 2. The No 1 Partnership was designed to allow the partners to invest directly into a United Kingdom general partnership. As matters turned out, all or almost all of the partners chose to join the No 2 Partnership and counsel agree that I need concern myself with that partnership only. [10] Mallowdale brings this proceeding as a representative plaintiff for 37 investors who claimed a deduction for the production expenses and who have agreed to be bound by the result of this litigation.The agreements[11] Mr Congreve explained that the principals of Volcanic Island were introduced to Mr Sheridan early in 2003. Negotiations began for the rights to a United Kingdom production of a musical based on Jailhouse Rock. Theatre Partners was nominated as writer and co-producer. Unsuccessful attempts were made to have Elvis Presley Enterprises license the song Jailhouse Rock; that firm not only refused to do so but also urged other owners of Presley songs to boycott the musical. The acquisition of songs became a major preoccupation for the producers during following months. [12] In the meantime, by 14 May 2003 agreement had been reached among the three principals on a Memorandum of Terms and a Co-Production Agreement.The Memorandum of Terms[13] Jailhouse Co and Theatre Partners were the only parties to the Memorandum of Terms. It recorded that Jailhouse Co wished to contract with Theatre Partners for, among other things, Theatre Partners to produce (together with Jailhouse Co) and manage the initial United Kingdom production. Mr Janes would act as producer, and a Mr Smith of Theatre Partners would act as the individual general manager. (Another Theatre Partners employee later replaced him.) [14] It was envisaged that the production would be repeated in the United Kingdom and elsewhere. For all future productions worldwide Jailhouse Co and Theatre Partners would be the producers, subject to any arrangements they might make with local producers. Volcanic Island was to have 20 per cent of the profits of all such subsidiary productions. [15] The Memorandum specified that Jailhouse Co would be responsible through an agreement with Volcanic Island for funding the initial United Kingdom production. It would also fund a proposed Australian production through Volcanic Island. In the event that Volcanic Island could or would not provide the funding, Jailhouse Co would endeavour to arrange alternative funding. Theatre Partners was to have no responsibility for funding. [16] Annexed to the Memorandum of Terms was a production budget and cashflow for the initial United Kingdom production. The production budget was £3.28m. The Memorandum provided that Theatre Partners had prepared it for the approval of Jailhouse Co and Volcanic Island, and Theatre Partners undertook to spend the cashflow in accordance with a payments schedule. As general manager, Theatre Partners would obtain Jailhouse Co's approval (and that of Volcanic Island, if Jailhouse Co required) for any unbudgeted items. [17] The Memorandum provided for royalties to be paid to Jailhouse Co, Theatre Partners and others. The principals, including Volcanic Island, would also be entitled to charge reasonable fees. It also provided for division of the share of profits (38 per cent) accruing to Jailhouse Co and Theatre Partners after "recoupment" ofcosts; for the initial United Kingdom production and other replica first class productions in the United Kingdom, Europe, Australasia and South-East Asia (excluding Japan) the net profits were to be split equally between Jailhouse Co and Theatre Partners. For other first class productions, Jailhouse Co would receive 75 per cent and Theatre Partners the balance. [18] The Memorandum of Terms contemplated that a long-form agreement would be negotiated, but that was never done.The Co-Production Agreement[19] Jailhouse Co and Volcanic Island were the parties to the Co-Production Agreement, which appears to have been executed on 13 and 14 May. It recited that under the Memorandum of Terms Theatre Partners was to produce and general- manage the initial United Kingdom production, while under the Co-Production Agreement Volcanic Island would co-produce and fully fund that production and subsequent worldwide first-class productions. The three parties were to work together to launch the production in October 2003. [20] Volcanic Island was given the option to co-produce and fully fund the initial United Kingdom production and all future worldwide first-class productions. It could also executive-produce and general-manage productions in certain territories including Australasia, and it acquired a share in subsidiary and ancillary rights such as second-class and amateur productions. It agreed to fund the initial United Kingdom production on a monthly basis in accordance with the production budget and payment schedule. In relation to all first class productions that Volcanic Island had fully funded, it would share control with Jailhouse Co and Theatre Partners, each having one vote. [21] "Fully fund" meant "the provision or procurement, including by way of sponsorship, of funding to facilitate budgeted production costs for any production." Volcanic Island agreed to use its best endeavours to raise the full funding "as cheaply as possible". Should it raise the full funding at a total cost that allowed it toretain more than one-third share of its 60 per cent profit share, it agreed to share the gain with Jailhouse Co. [22] Subject to having met its funding obligations, Volcanic Island was entitled to a share of royalties and 60 per cent of the profits for the initial production and all future first-class productions. The term "profits" rested on a series of definitions: a) Profits meant receipts attributable to the sale of tickets and subsidiary income (including merchandise and cast albums), net of United Kingdom consumption tax (VAT) and after "paying or providing for all actual production costs, all charges and disbursements of whatever kind actually and legitimately incurred as operating or running costs, Recoupment and royalty payments"; b) Recoupment meant "the point in the account of" a production when the aggregate gross weekly box office receipts first exceeded the total of the Production Costs and the aggregate Running Costs "at which point for the avoidance of doubt [Volcanic Island's] investment in the Production in accordance with the Production Budget shall have been repaid"; c) Production Costs meant the actual directly attributable costs of developing, preparing and presenting the relevant production; d) Lastly, Running Costs meant the further and/or continuing bona fide costs of presenting the relevant production, whether of a recurring nature or not and including salaries, royalties, rent, hire charges, replacement costs, advertising, publicity and promotion expenses, together with reasonable reserves for these items. It will be seen that profit-sharing was to commence after payment of production and running costs, including recoupment of Volcanic Island's investment under the production budget.[23] Lastly, the agreement provided that Volcanic Island was to receive a presentation credit jointly with Jailhouse Co and Theatre Partners, and Messrs Alver and Dee would be credited as co-producers.The Information Memorandum[24] Some time passed between the three producers executing their agreements and the New Zealand investors becoming involved. In the meantime, negotiations were held over songs and work began on casting, obtaining a theatre, production design and script development. [25] Subscriptions were solicited under an Information Memorandum made available to selected habitual investors in August 2003. It recorded that the musical would be produced by Theatre Partners, Jailhouse Co and Volcanic Island. The investment was explained as follows:Unlike a film investment, the investors in a theatrical production receive the return of their investment before there is any distribution of profits. The total amount sought from investors is £3.4 million, which is the production budget including a contingency for production overspend and an amount for early running support. Investors will not be liable for anything in excess of their contribution. Should any of the contingencies not be required, the difference will be returned to the investors. Profit from the production is the gross weekly box office receipts less the weekly running costs and a royalty pool paid to rights holders both theatrical and musical. These royalty payments are in line with industry standards. All remaining profits will be applied to repaying the investors, until all investment has been repaid. Then the profits will be divided 40% to the investors and 60% to the producers and co-producers.[26] Profit from the production was defined as the gross weekly box office receipts less weekly running costs and a royalty pool paid to rights holders. The net profit was to be applied first to repaying investors. Thereafter profits would be divided 40 per cent to the investors and 60 per cent to the producers. The Information Memorandum defined running costs to include compensation paid to the cast and personnel, management fees, office expenses, advertising and other running expenses incurred in presenting the musical. Production costs were also defined, asthe total expenses incurred by the producer in connection with the production prior to the first paid public performance. [27] The sum of £3.4m comprised budgeted expenditure necessary to bring the production to the stage, including a contingency of £650,000 to cover early running support. The budget categorised the expenditure under: fees (including royalties and creative) £272,000, salaries £396,000, technical (including scenery, costume, props, sound and music) £589,000, theatre (deposits, advances and rental) £344,000, administration (travel, casting, rehearsals and development) £623,000 and marketing £525,000. This was essentially the same budget that had been attached to the Co- Production Agreement. [28] New Zealand tax resident investors were advised that they must return both income and losses as they were made.The Jailhouse Rock (No 2) Partnership Agreement[29] The partnership agreement was entered between Messrs Congreve and Colman on 29 August 2003. It recited that the two men carried on business in partnership as investors in the United Kingdom stage production of the musical. They wished to become partners in a New Zealand partnership which others might join. Its business would be that of investing directly or through an ordinary partnership in the production or co-production of the musical. The partnership was confined to the initial United Kingdom production. Clause 14 provided:The partnership shall invest directly or through an ordinary partnership in the production or co-production of the Musical and the amount invested shall be the amount of the capital of the partnership.[30] Messrs Congreve and Colman contributed the initial capital of £2,000. The agreement provided that others would join the partnership by deed of accession, contributing capital in multiples of £1,000. The money would be held in a trust account and released for investment on the directors of Volcanic Island deciding that sufficient funds had been raised for the United Kingdom production to be staged.[31] Clause 15 provided that Volcanic Island would invest in the production as trustee for the partnership:The investment of the partnership in the production or co-production of the Musical shall be taken in the name of Volcanic Island Limited in trust for and on behalf of the partnership and the partners authorise Volcanic Island Limited on behalf of the partnership to negotiate and enter into an investment agreement on terms similar to the specimen investment agreement in the form set out in Schedule 4 or on such other terms including (but not limited to) the provision of an indemnity as Volcanic Island Limited may in its discretion determine are satisfactory to the partnership.[32] Attached was a specimen form of investment agreement which envisaged that Volcanic Island as fund manager would pay the money to Jailhouse Rock (UK) Productions Ltd as producer. Subscriptions would be paid to the initial capital of the production, which capital was £3.4m comprising production costs with a contingency. Investors would be under no obligation to advance any more money (meaning that losses exceeding the investors' initial investment would be borne by the producers, should they choose to carry on). Proceeds would be applied to running costs, production costs and contingencies, repayment of investors' capital and net profits. The investment agreement was never executed. [33] The partnership agreement further provided that the partnership would be dissolved if the directors of Volcanic Island decided that insufficient funds had been raised, or if the investment agreement referred to in clause 15 had not been executed, and in any event when the initial United Kingdom production ended its run. [34] All payments received from the production were to be distributed to partners in proportion to their share of the partnership capital and applied firstly in repayment of capital and secondly on account of profits from the business of the partnership. Volcanic Island was to keep the books of account. [35] On 28 October 2003 Mallowdale signed a deed of accession which recorded that it had joined the No 2 partnership and had contributed an amount of capital, £50,000. Others joined the partnership between May 2003 and May 2004.No written agreement among the three producers, nor between New Zealand partnerships and Volcanic Island.[36] No document records an agreement among Jailhouse Co, Theatre Partners and Volcanic Island, or an agreement between the New Zealand partners and Volcanic Island. [37] Mr Congreve's evidence was that the three producers never regarded themselves as a partnership. Rather, they operated as an unincorporated joint venture governed by the Co-Production Agreement and the Memorandum of Terms. [38] So far as the relationship between the partners and Volcanic Island was concerned, Mr Congreve explained that Volcanic Island could have chosen to raise money in a number of ways – for example, by inviting investors to acquire an interest in Volcanic Island itself – but he and Mr Colman chose instead to establish the New Zealand partnerships. He maintained that Volcanic Island took on its co- production function for itself and the investors in the partnerships, acting as the agent of investors for that purpose. The relationship between the partnerships and Volcanic Island was not documented because there was no need to do so. Messrs Congreve and Colman established the partnerships and were substantial investors in the No 2 partnership, providing about 30 per cent of its equity. Other partners knew that, and would not have invested but for the involvement of the two men. The personal involvement of the four directors of Volcanic Island was referable as much as to the partnership interests as to Volcanic's own interest. The partners understood that Messrs Congreve and Colman would all be representing their interests as investors and acting for them as co-producer. [39] Mr Harley submitted that the relationships among the parties can be depicted diagrammatically as follows:11 The profit shares do not sum to 100 per cent because 2 per cent went to a law firm for its work.[40] I have reproduced the diagram only because it demonstrates by reference to the intended money flows that the series of contracts established a profit and risk- sharing relationship among the three producers and the New Zealand investors. That I consider significant for reasons developed below. I do not find it necessary to decide whether the relationship among the producers should be described as a joint venture. [41] Ms Norris referred to acrimonious correspondence about the eventual liquidation of Jailhouse Rock (UK) Productions Limited. She seemed to be suggesting that there was something questionable about the parties' failure to document their arrangements in a manner that would have committed them to a particular tax treatment from the outset. It does seem that as the production went on Volcanic Island was concerned to ensure that investors could deduct the production expenses. But there is no evidence that, for example, the failure to execute the proposed investment agreement between Jailhouse Rock (UK) Productions Ltd and Volcanic Island (para [33] above) at the outset was attributable to such concern. And Ms Norris disclaimed any argument that there was an element of sham about the arrangements.Funds as equity Jailhouse Rock NZ Partnerships Volcanic Island Ltd (co-producer)Retains 20% for agency Theatre Partners Services Ltd(co-producer)Jailhouse Company(US Licence holder)Jailhouse Rock, The MusicalUnincorporated joint venture 40% profit share funds provided 60% profits 19% profits and royalty 19% profits and royaltyVolcanic Island's role as co-producer[42] A good deal of the evidence was directed to whether Volcanic Island was truly a producer, or merely a provider of funds which was given "vanity" or "courtesy" billing as a co-producer. [43] The evidence resolved this issue decisively in favour of the plaintiff. Mr Congreve's evidence confirmed that Volcanic Island did play a substantial role in the production and was treated by the other parties as a co-producer, although its role was junior to that of Theatre Partners, the lead producer and general manager. All four of Volcanic Island's directors were actively involved. The principals attended auditions for the lead roles and were involved in selecting the cast. Mr Alver was engaged full-time in this work, based in London. Volcanic Island did not simply take the partners' money and pay it to Theatre Partners when called upon; rather, it exercised control over when investors' money was drawn down and how the money was spent. It provided accounting software to monitor expenses and maintained discipline over day to day expenditure, resulting in the pre-opening expenditure coming in below budget. Mr Congreve spent substantial periods in London supervising this activity. Mr Colman was heavily involved in decisions about the theatre to be used. [44] The Commissioner called Stewart MacPherson, a well-known theatrical producer of long experience. He compared the production and funding arrangements with industry standard practices and expressed the opinion that Volcanic Island was essentially a provider of capital and not an active co-producer. He doubted the competence of Volcanic Island and its principals in theatre production, and he suggested that it was absurd to stage the musical without rights to the title song. I do not find it necessary to explore why the production failed, and I gained limited assistance from his comparison of the arrangements in this case with industry standard practice. I am satisfied that Volcanic Island was more than a courtesy or vanity producer. It was a co-producer, and its contribution was substantial. Whether it acted in that capacity as agent for the investors is a question of fact and law to which I must return.Expenses and revenue of the production[45] In practice there was no clear demarcation between production and running costs. The production costs included technical expenses such as the set which presumably might endure for the life of the production, but many of the costs were of a current and recurring nature, such as rent, salaries, royalties, marketing and administration. Further, the production both generated revenue and incurred running costs before the West End opening night on 4 April 2004. There were trial runs in Plymouth and Manchester on 20 February and 9 March which generated ticket sales of some £423,000. The West End production also generated ticket sales of £168,000 in the week beginning 29 March 2004. [46] The gross costs (before income) prior to opening night were less than the commitment that the partnerships had made to the production. After opening night cashflow remained negative, in that costs of running the production exceeded ticket sales and it was necessary to cover running costs by calling on the contingency sum in the production budget. The balance of the No 2 partnership contributions was spent in the income year ending 31 March 2005. [47] The production never generated a profit or returned funds to investors.The deductions disallowed[48] The No 2 partnership deducted losses, after conversion to New Zealand currency, of $5,461,855 in the March 2004 year, based on a trading loss for the partnership of $6,932,238. (The difference is accounted for by certain timing and other tax adjustments.) The total expenditure for the period was $8,731,363 and income of $1,742,596 was generated. For the year ending 31 March 2005 losses of $3,750,313 were deducted. Total expenditure for the period was $15,346,785, and income of $13,013,514 was generated. [49] The Commissioner disallowed all of these deductions, drawing no distinction between production and running costs. His position was that the partnership might have incurred minor deductible expenses that could have been set off against profitsafter recoupment, had any profits been realised, but none of the production or running costs were deductible, for they were capital in nature. The partnership was not in the business of producing a musical; its business rather was that of investment. [50] The statement of claim pleads that for the No 2 partnership, the losses disallowed were $5,461,855 in 2004 and $3,539,058 in 2005. Mallowdale's shares were $80,965 and $55,593. The relief sought is the cancellation of the amended assessments in which these sums were disallowed.The legislation[51] The income tax legislation was rewritten during the period relevant to this litigation, the Income Tax Act 1994 being replaced by the Income Tax Act 2004, but it is common ground that the legislation across all relevant income years has the same effect in law. Counsel accordingly focused on the language of the 1994 Act, which prescribed in s BD 2 when a taxpayer might deduct expenditure from gross income for income tax purposes:BD 2 Allowable deductions(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.[52] The section also provided that expenditure of a capital nature was non- deductible: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).The issue[53] Counsel agreed that the general issue is whether the No 2 partnership's expenditure was deductible to the partners as expenditure incurred in deriving their gross income. Since it is not in doubt that the investors' money was spent to that end, the issue can be defined more specifically as whether the expenditure was capital in nature, and so non-deductible.The capital/income distinction[54] In tax law capital is a construct that privileges from tax certain gains that might otherwise be accounted income. Conversely, expenditure of a capital nature is not deductible from the taxpayer's gross income. Fundamental though the distinction between capital and income is, the legislation does not exhaustively define either term; rather, the work of definition has been left to the Courts, which have gone about it on a case by case basis without, as Dixon J put it in 1946, "any very conspicuous attempt at analysis". 2 In the result, it has been said of income tax that it "lacks any single underlying principle which is relevant to its function of sharing command over resources between individual and Government". 3 The decision whether a given receipt or outgoing is capital or income for tax purposes has been described as an "almost insoluble conundrum", in which legal, accounting and economic concepts jostle for ascendancy. 4[55] From a legal perspective, income has traditionally been seen as a regular flow, measured annually.5 That concept is ancient, having been traced to the first true income tax which was established in 1799. The same concept was adopted in2 Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634 at 646.3 Ross W Parsons "Income Taxation: An Institution in Decay" (1991) 13 Syd LR 435 at 437.4 Regent Oil Co Ltd v Strick (Inspector of Taxes) [1966] AC 295 (HL) at 343 per Lord Upjohn.trust law, in which it traditionally defined the rights of the remainderman. 6 Broadly, for purposes of trust law revenue flowing from trust property was income, while increases in the value of the property were not. [56] From an accounting perspective, capital expenditure is expenditure that benefits later periods so is carried forward to be charged against the periods (years, by convention) in which it is used up. By contrast, revenue expenditure is current; it is spent on inputs which are consumed in the same year. Non-current assets are those, like most property, plant and equipment, that are not expected to be sold during the current year. An allowance is normally made for depreciation of such assets over their useful lives. The expected life of an asset or liability may also affect its characterisation for tax purposes. Because income tax is charged upon annual income, an item is more likely to be deemed capital if it cannot be attributed to a particular year. 7[57] From an economic perspective, income is simply gain; the result obtained by adding consumption during a given period to wealth at the end of the period then subtracting wealth at the beginning, whether or not the gains were realized in that period.8 This comprehensive approach to income would not privilege capital gains from taxation. [58] The principles which the Court will consider when characterising a given receipt or expenditure emerge from the speech of Lord Pearce in BP Australia v Commissioner of Inland Revenue: 9(a) The need or occasion which called for the expenditure; (b) The use to which the funds were put;5 John Prebble "Income Taxation, a Structure Built on Sand" (2002) 24 Sydney Law Review 301 (Inaugural Parsons Memorial Lecture, University of Sydney, 2001).6 Ross W Parsons "Income Taxation - An Institution in Decay?" (1986) 12 Monash University Law Review 77.7 Commissioner of Inland Revenue v Wattie [1999] 1 NZLR 529 (PC) at 539.8 H C Simons, Personal Income Taxation: the Definition of Income as a Problem of Fiscal Policy(Chicago, Chicago University Press, 1938) at 23.9 BP Australia Ltd v Federal Commissioner of Taxation (1965) 112 CLR 386 (PC) at 397-398, 403; See also Commissioner of Inland Revenue v McKenzies (NZ) Ltd [1988] 2 NZLR 736 (CA).(c) Whether the payments were made from fixed or circulating capital; (d) Whether the payments were of a once and for all nature, producing assets or advantages which were an enduring benefit; (e) How the payments would be treated on ordinary principles of commercial accounting; (f) Whether the payments were expended on the business structure of the taxpayer or whether they were part of the process by which income was earned. [59] Any given receipt or expenditure is also to be characterised as income or capital in the hands of the recipient or payer. 10 That is so because, as the principles just listed illustrate, the decision is likely to turn not on the nature of the item but on the use to which it has been put. [60] The decision on any given set of facts is said to rest ultimately on a "commonsense appreciation of all the guiding features", 11 analogies drawn from the authorities, and a practical assessment of what the expenditure is calculated to achieve rather than "the juristic classification of the legal rights, if any, secured, employed, or exhausted in the process." 12 That said, it is not permissible to disregard the parties' agreements and assess tax on the footing that they are economically equivalent to some other arrangement. On the contrary, legal form may be decisive. Any agreements are to be construed in the ordinary manner, as the Court would do if the parties to such arrangements were in dispute. 13[61] This miscellany of guiding principles is not in dispute here. Counsel joined issue on their application to the facts.10 Reid v Commissioner of Inland Revenue [1986] 1 NZLR 129 (CA), at 138 per Richardson J. See also 145 per Thorp J.11 BP at 397, approved in McKenzies (NZ) Ltd at 740.12 Hallstroms at 648 per Dixon J.13 Commissioner of Inland Revenue v Renouf Corporation Ltd (1998) 18 NZTC 13,914 (CA) at 13,919.Characterisation in this case[62] Mr Harley argued that the investors obtained no identifiable capital asset, merely the contingent right to benefit from future ticket sales, which were inherently on revenue account. Their money was spent on the costs of producing and marketing a service, not in creating some enduring asset, and the costs were deductible even if the revenue that they would produce was to come in some future period. The money was properly characterised as circulating capital, as opposed to fixed capital; it was spent on producing ticket sales, and when tickets were sold it was laid out again to fund further sales. In the hands of the producers the expenses incurred under the production budget were plainly of a revenue nature. The expenses have the same character in the hands of the investors who funded them, for Volcanic Island acted as their agent when producing the musical. [63] Ms Norris responded that the investors did obtain an identifiable asset, the right to repayment of the capital that they invested and thereafter to a share of profits. That right was the entire profit-making structure of the partnership, the only other asset of which was a bank account. The investors' expenditure was incurred acquiring it, not producing the musical. The partners were mere passive investors, and Volcanic Island did not act as their agent when performing its co-production function. A commonsense appreciation must lead to the conclusion that the investment was on capital account; that being so, the expenses must be of the same character. [64] When analysing the evidence I have considered each of the criteria identified by Lord Pearce in BP Australia, but the headings used focus rather on the relevant features of this case.The nature of the asset acquired[65] It is common ground that the initial United Kingdom production itself was not an asset of the partnership, which acquired no rights to it. Counsel agreed that investors did obtain an asset, in the form of a chose in action: the right to receive payment, first by recoupment of the investment from profits, then by a 40 per centshare of profits. In other words, investors' payments gained them a source of income, albeit for a limited period, the duration of the initial United Kingdom production. [66] An intangible asset can be a capital item for tax purposes. 14 Accordingly, Mr Harley acknowledged that he could not go so far as to argue that a chose in action is by definition not a capital item. However, he did emphasise that a chose in action is not within the class of non-current assets that by their nature are ordinarily considered capital, such as plant and machinery or a lease forming part of the business structure. 15 As Lord Pearce held in BP Australia, non-current assets of that kind are by convention and practice placed in the statement of financial position and depreciated for tax purposes. But: 16No such clear practice or convention exists with respect to choses in action and their Lordships cannot accept the contention that a chose in action must be a capital benefit if its value outlives the year of accounting.[67] Counsel confirmed that no allowance is available for depreciation of a right such as the taxpayers acquired in this case, whether or not its benefit is realised over a number of years. [68] Further, the right to a given share of income, although valuable, differs from many tangible assets – a factory or other plant, for example – which are used in some process to generate income. No work was done on or by the chose in action to create income. For that reason, the familiar metaphor of capital forming the tree, and income the fruit, is not readily applicable. 17 At the risk of labouring the metaphor, a tree is more than a structure on which the fruit hangs; it also hosts processes which supply the fruit with nutrients. [69] Against that, the asset was to endure for the life of the initial United Kingdom production, an important consideration. 18 The agreements did not specify what that period might be; it depended undoubtedly on commercial success. But investors14 Regent Oil at 329; Commissioner Inland Revenue v Carron Co (1968) 45 TC 18, (HL).15 McKenzies (NZ) Ltd at 746.16 BP at 268.17 Commissioner of Taxes v Nchanga Consolidated Copper Mines Ltd [1964] AC 948 (PC) at 960.18 Nchanga at 959.were led to expect that the production might endure for some time; the Information Memorandum expressed the hope that it would emulate another musical, Buddy, with which Messrs Bettinson and Janes had been involved. That ran for 13 years in the West End. By way of confirmation, the estimated payback period for the initial expenditure was 60 weeks but might be as long as 182 weeks, showing that the producers expected the show to run for substantially longer than the year in which the investment was made.Nexus between expenditure and income[70] Although the investors acquired a valuable right of some intended duration, its value was attributable to a future income stream that was not yet realisable. Two conditions must first be satisfied: first, that sufficient money be raised to cover the production budget; and second, that investors' funds be deployed to meet all of the expenses necessary to bring the production to the stage. It follows, importantly, from the second of these conditions that the money was not simply spent on acquiring a right to income. Indeed, the right might have been worthless had the money not been spent on the production expenses. Further, there was no guarantee that the production would be brought to the stage for the budgeted expenditure, since the budget was only an estimate. [71] I am satisfied that Volcanic Island acted as agent of the investors in satisfying both conditions. As a contractual matter, Volcanic Island was responsible for meeting the requirement in the Information Memorandum and No 2 partnership agreement that investors' money, which was initially held in trust, be drawn down only when the budget had been fully funded. The partnership agreement provided that the money would be invested in the production of the musical, and that the investment was to be taken in Volcanic Island's name as trustee for the investors. It was identified as one of the producers, who were to spend the money, and the Information Memorandum specified that it was to be responsible for meeting any cost over-runs. Should the production not open, the Information Memorandum and partnership agreement together envisaged that Volcanic Island would return to the investors whatever was unspent or capable of salvage. It is implicit in these arrangements that Volcanic Island was to ensure the investors' money was spent onthe production budget – and wisely spent, since the budget was an estimate but the right to a share of profits could be realised only if the musical went into production for the budgeted expenditure. And as a factual matter, I have already found that Volcanic Island did perform these functions. [72] Of course Volcanic Island had a substantial private interest in the initial United Kingdom production, in the form of its percentage of royalties, and in any future productions worldwide. That interest sprang from the Co-Production Agreement and Memorandum of Terms, which lay 'upstream' from the No 2 partnership. I accept Ms Norris's submission that Volcanic Island did not enter those agreements as agent for the subsequently-introduced investors. Volcanic Island also had its own financial exposure to the initial United Kingdom production; if the production could not be staged on budget and the producers elected to continue, it would have little option but to meet the budget shortfall itself. But to say all of that is not to deny that Volcanic Island acted as agent for the investors in ensuring that their right to an income stream would be realised by bringing the initial United Kingdom production to the stage. That created a close nexus between the partners' investment and the production expenses and Volcanic Island's role as co- producer. [73] Ms Norris accepted that an expense may be deductible to a principal although an agent incurred it on the principal's behalf. It is a question of judgement and degree whether the activity is that of the principal or the agent. 19 For the reasons just given, I am satisfied that the expenditure provided for in the production budget was that of the investors, managed by Volcanic Island on their behalf. Some support for this conclusion may be found in Commissioner of Taxation v Faywin Investments Pty Ltd, in which the issue was whether money paid to a producer via an agent was money "expended directly" to produce the resulting film. 20Expenses mostly current in nature19 A M Bisley & Co Ltd v Commissioner of Inland Revenue (1985) 7 NZTC 5,082 (HC).20 Commissioner of Taxation v Faywin Investments Pty Ltd (1990) 22 FCR 461.[74] I have already noted that most of the production costs comprised current and recurring expenses of a sort that were incurred in both pre-production and production phases. Few were incurred once and for all. The most durable of the resulting items was presumably the set (and perhaps the script, to the extent that the budgeted creative expenditure paid for it; the evidence on this point is unclear). In an Adjudication Report which preceded this litigation the Commissioner sought to distinguish pre-production from running expenses, characterising the former as capital in nature, but before me Ms Norris understandably took the high ground, choosing not to distinguish among the expenses either on a pre and post-opening night basis or by type.Fixed or circulating capital?[75] The distinction between fixed and circulating capital is imprecise but enduring. It is said to be attributable to Adam Smith: 21Since Adam Smith drew the distinction in the Second Book of his Wealth of Nations, which appears in the chapter on the Division of Stock, a distinction which has since become classical, economists have never been able to define much more precisely what the line of demarcation is. Adam Smith described fixed capital as what the owner turns to profit by keeping it in his own possession, circulating capital as what he makes profit of by parting with it and letting it change masters. The latter capital circulates in this sense.[76] In BP Australia, a case about lump sum trade tie payments, Lord Pearce elaborated upon the distinction:Fixed capital is prima facie that on which you look to get a return by your trading operations. Circulating capital is that which comes back in your trading operations. The sums in question were sums which had to come back penny by penny with every order during the period in order to reimburse and justify the particular outlay. If one imagines a BP agent justifying the price of petrol to a retailer or discussing whether price reduction was possible, it is hard to imagine him omitting the lump sum so paid (divided by the estimated gallonage) as an item in the cost per gallon. It is doubtful if he would even relegate it to overheads since it was in the forefront of the wholesalers selling costs. Nor can one imagine the retailer demurring at such a calculation. Prima facie therefore the lump sums were circulating capital which is turned over and in the process of being turned over yields a profit or loss; they were part of the constant demand which must be answered out of the returns of the trade. This, however is merely one indication and by no means concludes the matter.21 John Smith & Son v Moore [1921] 2 AC 13 (HC) at 19-20.Mr Harley contended that that passage could be applied directly to this case. He emphasized that Lord Pearce was there explaining why, in the absence of any underlying capital asset effecting the trade ties, they were on revenue account although they might endure for five years or longer. [77] The position is not quite that simple. As between Volcanic Island and the investors, on the one hand, and Jailhouse Co and Theatre Partners, on the other, the investors' money was to be recouped before profit-sharing began. Thereafter no question would arise of the original investment serving as circulating capital. [78] Until that point, however, I accept that investors' money was fairly characterised as circulating capital. Revenue from ticket sales was to be applied to meeting aggregate running costs, which were defined as the continuing costs of presenting the initial United Kingdom production, and to repaying production costs, which were defined as the actual directly attributable costs of developing, preparing and producing the production. Only then would the production be profitable. Put another way, production costs were to be recovered in the short run, while the production was to continue indefinitely. And running and production costs were substantially current in nature and of the same type, such as salaries and rent and administration. Finally, investors' money continued to serve as working capital in the sense that revenues were applied to recoupment only as and when a surplus arose after provision for running costs. Consistent with that, the production budget included the contingency sum to cover any initial shortfall in revenues over running costs, and the Information Memorandum contemplated that recoupment might take as long as 182 weeks.Right to repayment before profit-sharing with other investors[79] Contrary to Ms Norris's submission, the priority accorded to repayment of the investors does not characterise their investment as capital. I have already observed that the series of contracts established a profit and risk-sharing agreement among all of the participants. Recoupment operated as between investors and the other participants, to ensure that the initial investment was repaid before profit- sharing began. Had the investment been capital in nature, one would expect it to beexpensed over the expected life of the production. Instead its treatment was similar to that of running costs; it was to be repaid as soon as revenues permitted. [80] Although Ms Norris did not make this argument, capital can also be described as the owner's interest, that which is left on a notional winding up after all other claims have been provided for. The investors' interest was residual in the sense that they would recoup their money only if revenues covered production and running costs. As matters turned out, other participants appear to have been paid fees and royalties but the investors recovered nothing. However, I do not think this perspective assists the Commissioner. The investors did not own the musical or even the initial United Kingdom production.Limited liability of partners[81] The No 2 Partnership Agreement specified that having subscribed their capital, the partners attracted no further liability for the production. Ms Norris pointed to that as evidence of the investment being capital in nature. I do not think there is anything in this. The cap served to limit investors' liability among themselves and as between themselves and the other participants. Its existence does little to inform characterisation of the expenditure made using the money that they did invest. She also observed that the agreement itself described the money invested as the partnership capital. I accept that it made sense as among investors to describe their subscriptions as capital, since the money had to be put to work to gain an income. The question, however, is whether the use to which their money was put was capital in nature.No closely analogous cases[82] Lacking any clear guiding principle, the Court usually seeks analogies in the cases, but counsels' research located none that were close. I find Commissioner of Inland Revenue v Nchanga Consolidated Copper Mines Ltd of some assistance.22Two mining companies paid a third and related company to cease production of copper for a year, allowing them to increase their own production modestly while22 Commissioner of Taxes v Nchanga Consolidated Copper Mines Ltd [1964] AC 948 (PC) at 960.sustaining the market price. The payment was held to be on revenue account for the payer although it was made in exchange for a right: the right to have the third company out of production for a year. The Privy Council considered that there was no enduring benefit to the payer, noting that the right was of only 12 months duration. However, their Lordships also looked past the right that the payment secured to the purpose of the payment, finding the payment analogous to an operating cost because it was incidental to the payer's production and sale of copper. 23[83] Ms Norris did argue that there is no meaningful distinction between the interest that Mallowdale acquired and a company share held on capital account, the ownership of which entitles a shareholder to a share of profits but not a right to deduct expenditure incurred by the company in generating such profits. I reject this submission. There is in this case a close nexus between the investment and the expenses which is wholly lacking for an investor who simply acquires a share (even assuming the share to have been acquired not from another shareholder but from the company itself in a capital raising exercise). Nor is a share associated with a right to repayment of the investor's capital before profits are distributed. In this case the investors did acquire such a right; its terms suggest that investors' money was used as circulating capital.Accounting treatment[84] No evidence was led about how the expenses would be treated on ordinary principles of commercial accounting. With respect to the related question of disclosure of taxpayers' financial affairs to the Commissioner, counsel did agree eventually that any revenue received would have to be accounted for in the investors' returns. They differed on how that would be done, Ms Norris maintaining that the revenue would be treated as a capital receipt until recoupment was completed (a net income approach) and Mr Harley insisting that it would be treated as income (a gross income approach). I am in no position to resolve this difference.Treatment of theatre investment in United Kingdom tax law23 At 962.[85] Ms Norris referred me to correspondence from the producers' United Kingdom advisor explaining how stage productions are normally treated for tax purposes in that jurisdiction. It suggested that the producers themselves would not account for the production expenses, since the investors incurred those. The producers would account only for income they received by way of fees or royalties. From the investors' perspective, theatre investment would normally be on capital account. This submission assumed that United Kingdom tax law is relevantly identical to New Zealand law, but there was no evidence of that. And although Mr Harley did not object to the correspondence being used in evidence, I am not prepared to accept it as an authoritative statement of the tax treatment of theatre investment in United Kingdom law. If the United Kingdom position was relevant for present purposes, a debateable point, it ought to have been the subject of expert evidence.Conclusion[86] As seems typical in such cases, the indicia do not all point in the one direction, and not all are equally important in the particular circumstances. The leading considerations, in my opinion, are the taxpayers' admitted bona fide purpose, that of earning income, the close nexus between such income and their expenditure, the current nature of the expenditure, and the employment of investors' money as circulating capital. Together these considerations lead me to conclude that the expenditure was not capital in nature. The Commissioner erred by disallowing the losses associated with it.Decision[87] There will be judgment for Mallowdale. The amended assessments in which the expenditure was disallowed in Mallowdale's case are cancelled. I do not understand there to be any need for further relief, but I reserve leave to apply should the parties require me to exercise any other powers under s 138P of the Tax Administration Act 1994.[88] Mallowdale is entitled to costs, which I am provisionally inclined to fix on a 3B basis. Counsel may file memoranda if they cannot reach agreement on costs. Miller JSolicitors:Atkins Holm Joseph Majurey for Plaintiff Crown Law, Wellington for Defendant