NEW ZEALAND OSTRICH EXPORT COMPANY LIMITED V THE COMMISSIONER OF INLAND REVENUE HC INV CIV 2005-425-000491

NEW ZEALAND OSTRICH EXPORT COMPANY LIMITED V THE COMMISSIONER OF INLAND REVENUE HC INV CIV 2005-425-000491 21 March 2006IN THE HIGH COURT OF NEW ZEALAND INVERCARGILL REGISTRY CIV 2005-425-000491BETWEEN NEW ZEALAND OSTRICH EXPORT COMPANY LIMITED Appellant AND THE COMMISSIONER OF INLAND REVENUE Respondent Hearing: 13 March 2006 Appearances: T J Shiels for Appellant H Ebersohn for Respondent Judgment: 21 March 2006 at 3.15 PMJUDGMENT OF FOGARTY J Introduction[1] In the income year ended 31 March 2002 the appellant incurred a tax loss of $1,200,526.09. At that time the appellant was a company within a group of companies, in terms of s IG 1 of the Income Tax Act 1994 (ITA). There were three other companies in the group. The appellant elected to offset, pursuant to s IG 2, $44,426.00 to other companies within the same group. The remaining $1,156,100.09 of the loss was, in terms of s HG 16, attributed to the appellant's shareholders. The appellant had been encouraged to do this by an earlier email advice on 20 November 2000 which encouraged the appellant's accountant to the view that this treatment of the loss was possible under the law. The Commissioner now takes a different view, that all the loss must go to the shareholders. Both parties have proceeded on the basis that this is a disputable decision.[2] The Commissioner's view of the law was adopted by the Taxation Review Authority. These proceedings are an appeal against that decision.The Commissioner's position[3] The Commissioner's position is that because the appellant is a loss attributing qualifying company (LAQC) in terms of s HG 14 for the year ended 31 March 2002 the entire tax loss shall be treated for the purpose of the ITA as if it were a loss incurred by the shareholders of the appellant. [4] Section HG 16(1) provides:HG 16 Net losses of loss attributing qualifying company to be attributed to shareholders (Repealed)(1) Subject to section HG 17, where a loss attributing qualifying company has a net loss for any income year, then, for the purposes of this Act— (a) Each shareholder who has an effective interest in the company for that income year shall be deemed to incur an amount of loss equal to the net loss of the company for that income year multiplied by the shareholder's effective interest in the company for that income year; and (b) Subject to subsection (2), the amount of loss deemed to be incurred by each shareholder shall be treated for the purposes of this Act as if it were a loss incurred by that shareholder in deriving gross income of that shareholder for that income year (except to the extent that the net loss of the company includes an attributed foreign loss or a foreign investment fund loss, in either of which cases the shareholder's amount of attributed loss shall be treated for the purposes of this Act as if it were attributed foreign loss or foreign investment fund loss, as the case may be, of the shareholder); and (c) The company shall not be entitled to carry that net loss forward in accordance with any of sections IE 1, IE 3, IE 4, and IF 1 to any income year succeeding that income year, but without prejudice to any right of the company under this Act to carry forward any other net loss. (Emphasis added)[5] The Commissioner argues that in terms of the text of that section the aforesaid tax loss of $1,200,526.09 is a net loss for the income year of 2002. Second, that each shareholder of the appellant is deemed to incur an amount of loss equal to that loss for that year, multiplied by the shareholder's effective interest inthe company under sub-paragraph (a). The effect of that deeming is to remove thenet loss from being further utilised by the company. [6] Finally, the Commissioner argues that the appellant company never had the opportunity to first offset part of its loss to other companies within the same group of companies before attributing the remaining part of the loss to the appellant shareholders pursuant to s HG 16.The appellant's argument[7] In these proceedings Mr Shiels for the appellant argues that net loss can include "a net loss after there has been a reduction in that loss by application of s IG 2". Relevantly s IG 2(2) provides:IG 2 Net loss offset between group companies (2) where in respect of any income year (in this subsection referred to as the "year of offset")— (a) a company (in this subsection referred to as the "loss company") has— (i) a net loss for the year of offset (b) the loss company either— (i) elects by notice in accordance with subsection (3) that the whole or part of the net loss be offset against the net income for the year of offset of another company; or that other company being in this subsection referred to as the "profit company"; and (g) the amount so elected to be offset or the payment (as the case may be) shall— (h) be offset against net income of the profit company in the year of offset; and(i) to the extent so offset, give rise to a reduction in the available net losses of the loss company (in the same order in which the losses arose); and (Emphasis added) [8] Mr Shiels argues that there is nothing in s HG 16, or for that matter in the scheme and purpose of the entire ITA which indicates that Parliament intended to deny the appellant as one of a group of companies the benefit of s IG 2. There is, he contended, no discernible erosion of the tax base by the appellant first offsetting part of its net loss against the net income of another company in the group. [9] Mr Shiels submitted that the ITA, where possible, should be construed to avoid any inconsistency between s IG 2 and s HG 16. He contended that even if there is a prima facie inconsistency, it is possible to construe the provisions so as to give effect to both and that that is what a proper approach to interpretation requires. [10] Mr Shiels presented a very careful argument examining in some detail the legislative history up to the enactment of qualifying company provisions of the statute. He brought to the attention of the Court, in some detail, the content of two reports of a consultative committee on the taxation of income from capital (which came to be known as the Valabh Committee, after its chairman, Mr Arthur Valabh), being its November 1990 report entitled "The Taxation of Distribution from Companies" and its final report in July 1991. [11] Mr Shiels also relied on an interpretation of the precursor to s HG 16 in the 1976 Act, s 393P(1) of that Act which provides:393P Losses Of Loss Attributing Qualifying Company To Be Attributed To Shareholders (Repealed)(1) Subject to section 393Q of this Act, where a loss attributing qualifying company incurs a loss in any income year, then, for the purposes of this Act— (a) Each shareholder who has an effective interest in the company for that income year shall be deemed to incur an amount of loss equal to that loss incurred by the company in that income year multiplied by the shareholder's effective interest in the company for that income year; and(b) Subject to subsection (2) of this section, the amount of loss deemed to be incurred by each shareholder shall be treated for the purposes of this Act as if it were expenditure or loss incurred by that shareholder in gaining or producing that shareholder's assessable income for that income year (except to the extent that the loss of the company is an attributed foreign loss or a foreign investment fund loss within the meaning of section 245A of this Act, in either of which cases the shareholder's amount of attributed loss shall be treated for the purposes of this Act as if it were attributed foreign loss or foreign investment fund loss, as the case may be, of the shareholder); and (c) The company shall not be entitled to carry that loss forward in accordance with section 188 or section 245M or section [245RJ] of this Act to any income year succeeding that income year, but without prejudice to any right of the company under this Act to carry forward any loss other than that loss. (Emphasis added)[12] He noted immediately that s 393P does not contain within it the term net lossbut simply refers to "incurs a loss". [13] Mr Shiels argued that the 1994 Act should be interpreted as re-enacting the law rather than changing it and relied on ss AA1 and AA3(1). Section AAA1 provides:AA 1 Purposes of ActThe main purposes of this Act are (a) to impose tax on income; (b) to impose obligations in respect of tax; (c) to set out rules to be used to calculate the tax and to satisfy the obligations imposed.Section AA3 provides:AA 3 InterpretationPrinciple of interpretation (1) The meaning of a provision of this Act is found by reading the words in context and, particularly, in light of the purpose provisions, the core provisions and the way in which the Act is organised. Aids to interpretation (2) Diagrams, flowcharts, reader's notes, and defined terms that follow sections in this Act are included only as interpretational aids, and(a) if there is a conflict between an interpretational aid and a provision of this Act, the provision prevails, and (b) if a defined term is used in a section and is not included in the list of defined terms for that section, the term is nevertheless used in the section as it is defined.Analysis[14] Mr Ebersohn for the Crown argued that the enactment of the Taxation Core Provisions Act 1996 reflected in part a mischief identified as an inconsistent basis of tax accounting caused by the indiscriminate use of both net and gross concepts in the 1976 Act. See the discussion document "Core Provisions: Rewriting the Tax Act", May 1995, paragraphs 1.5 and 1.9 released by the Ministers of Finance and Revenue. Mr Ebersohn argued that in the ITA the core provisions included for the first time definitions of net loss and available net loss giving greater precision to the references to loss in the legislation. He argued that if a consequence of the introduction of these definitions is to resolve what might be an ambiguity in sections such as 393P so be it, that the principal instrument for determining the tax position of the appellant in this case is the ITA 1994 as it was at the material time. [15] The definitions of net loss and available net loss will be referred to shortly. But it is important to recognise at the outset that the introduction of these provisions may be different from the re-organisation of existing provisions and changes of style and language contained in the Income Tax Act 1976. Section AA 1 referred to above does not stand in the way of a shift of meaning or clarification of meaning as a result of the enactment of the ITA 1994. [16] Before attempting any interpretation of s HG 16 it is necessary to have a broad appreciation of the scheme and purpose of the tax legislation relating to LAQCs. It is vital to read any tax provision in its context alive to its place in the scheme of the Act and where possible in the light of its purpose. As with any statute, the text of a tax statute has to be construed against the maxim of s 5 of the Interpretation Act 1999:5 Ascertaining meaning of legislation(1) The meaning of an enactment must be ascertained from its text and in the light of its purpose. (2) The matters that may be considered in ascertaining the meaning of an enactment include the indications provided in the enactment. (3) Examples of those indications are preambles, the analysis, a table of contents, headings to Parts and sections, marginal notes, diagrams, graphics, examples and explanatory material, and the organisation and format of the enactment.Section 5 is not an exhaustive statement of matters that may be considered. Especially in the case of technical statutes the Courts will examine law reform reports antedating the legislation. [17] If in any one financial year the money spent to earn income exceeds the income earned that is a loss, which in economic terms is a bygone event. However, for policy reasons the tax legislation has allowed that loss to be carried forward by the taxpayer and set off against assessable income in future years arising because the gross income exceeds the allowable deductions. This has been New Zealand income tax legislation policy since at least 1922, see Land and Income Tax Amendment Act 1922, s 6. [18] Second, the legislature has long recognised as meritorious treating companies as a group where they have a significant degree of commonality of shareholding, so that the loss of one company can be offset against the profit of another. This enables the overall enterprise to pay tax only on the profit overall. This has been policy since at least 1968, see Land and Income Tax Amendment (No. 2) Act 1968, s 27. [19] Coming forward to the 1980s, a taxpayer grievance was that income of business enterprises was taxed twice; first by way of taxation of company profits and then by way of taxation of dividends in the hands of shareholders. Some reforms were introduced in 1998. The Valabh Committee in 1990 proposed a modification of the then inputation regime in respect of companies which were in substance equivalent partnerships. In its first report the Committee noted that:Shareholders in closely-held companies have a practical choice of operating either as a sole proprietorship, a partnership, or a trust. Differences in thetax treatment of these forms of enterprise compared with the treatment of companies are therefore likely to bias investment and structural choices. Significant differences in tax treatment between these forms of enterprise also tend to be perceived as discriminatory. (15-16)The Committee used the term "qualifying companies" to refer to this type of closely held company which would be able to adopt the modified imputation scheme. [20] In that first report the Committee indicated it was not in favour of losses passing through to shareholders because of complications caused by different share classes. It proposed tax reform focussed upon facilitating the passing of gains from such closely held companies to the shareholders. [21] In the submissions received to this first report a number of submitters considered that the cost involved in entering into such a qualifying company regime did not justify the benefits as one of the principal costs of entry was seen as the inability of shareholders to access qualifying company losses. In its final report the Valabh Committee reconsidered the pass-through of losses. The report relevantly provided in paragraph 2.2.4:2.2.4 Pass-through of Losses A further matter which we have reconsidered is the pass-through of company losses. We agree that the pass-through of losses is closer to an integration objective. However, our concerns over achieving a practicable mechanism lead us to reject such a proposal in our discussion document. To some degree, this view also is affected by an assessment of the extent to which shareholders would be in receipt of other income when their associated closely-held company has a tax loss. Submissions argued strongly in support of a loss pass-through mechanism. These submissions have convinced us that we could support a recommendation of passing through losses for the following type of closely- held company: (a) it would have only one class of share. The same rule would extend to all qualifying companies in the group. In other words, if a qualifying company within the group breached this rule, no group company would be eligible for this concession. In this context, one class of share means shares that are identical in all respects and in particular, where all shares have the same voting rights, rights to dividends, rights to return of capital, and the same rights under the company's constitution. The one class of share rule would also encompass section 192 and 195 debentures.These requirements are necessary to avoid complex rules to allocate losses to shares of differing classes and to reduce opportunities for losses to be 'streamed' to shareholders best able to use the. We also have doubts as to whether such attribution rules in relation to companies with different rights attaching to shares could be formulated or properly administered; (b) its loss would be statutorily attributed to shareholders according to the proportion of shares held in the course of an income year. They would therefore be attributed on a per share, per day held basis; (c) its loss would be completely extinguished in each year by the statutory attribution process. Losses attributed to shareholders would have the same status as any other loss incurred by a shareholder. They would therefore be able to be carried forward or offset against other income; (d) the pass-through of losses would be elective for any qualifying company which met the requisite criteria. Election into the regime would be the same as for qualifying companies (requiring the unanimous vote of all shareholders and directors). Elections would be effective prospectively and apply from the start of the next income year. However, a company that ceases to qualify for the pass-through of losses after entry to that regime would be disqualified from the entire qualifying company regime as at the end of the income year prior to that during which disqualification occurs. A disqualified company may re-enter the qualifying company regime if it again meets all the criteria however; (e) any company losses carried forward on entry to this loss pass- through regime would continue to be carried forward and offset against future profit but would not be eligible for attribution; and (f) rules would be needed to deal with contractual and other arrangements over shares where there are differences between legal and beneficial ownership. These are outline in the attached draft legislation. The Committee acknowledges that the loss-attribution rules outlined above are complex. They are an indication of the complexity of rules that are needed to support a full integration regime.[22] Section HG 16 can be seen readily to flow from this recommendation of the Valabh Committee. Section HG 16 falls within sub-part G of part H of the 1994 Act, addressing qualifying companies. Section HG 1 provides:HG 1 Qualifying company regimeSubject to the express provisions of this Subpart, any company that—(a) Is owned by 5 or fewer natural persons as counted in accordance with section OB 3; or (b) Is a flat-owning company within the meaning of subsection (1)(b)(ii) of that section,— and that otherwise meets the requirements of that section may, by making the appropriate elections,— (c) Make distributions to its shareholders of its gains in such a fashion that the distributed gains are treated for taxation purposes; and (d) Where the company has only one class of shares, allocate its net losses to its shareholders in such a fashion that the net losses are treated for taxation purposes,— in like manner to that which would have occurred had the company been a partnership.This section reflects the final report of the Valabh Committee. [23] Nothing in s HG 1 addresses a policy purpose for amending the statutory policy as to the allocation of losses and profits within groups of companies. However, qualifying companies were intended to still be able to take advantage of the group company provisions, provided the other company is also a qualifying company. For s HG 10 provides:HG 10 Taxation of qualifying companyNotwithstanding any other provision of this Act,— (a) Section CB 10 shall not apply to treat as exempt income any dividend derived by a company which has been at any time before the date of derivation a qualifying company, except to the extent that the dividend is a dividend to which section CB 10(1) applies; and (b) Section IG 2(2) shall not apply to permit any qualifying company to offset against its net income any amount on account of— (i) The loss of any other company; or (ii) A payment made to any other company,— unless the other company is also a qualifying company.[24] Section HG 14 then provides for LAQCs. It is not necessary to set out that provision. It provides effectively that each share in the company must have common rights of voting concerning distributions and the constitution of the company, capitaland appointment and election of directors, and common rights as to profits and distribution of assets. It further provides that there has to be an election by each person who is a shareholder or a director that the company be a loss attributing qualifying company. [25] Against that background of scheme and context, one turns then to an analysis of the text of s HG 16 and in particular to the meaning of the words a net loss. [26] Part B of the Income Tax Act contains the core provisions. Section BC 1 provides a useful diagram:[27] Sections OB 1 and BC 6(3) define net loss:OB 1 DefinitionsIn this Act, unless the context otherwise requires,— net loss means a net loss for an income year determined under section BC 6 and reduced by the amount extinguished by the Commissioner under section 177C(5) of the Tax Administration Act 1994, and includes a loss incurred by a taxpayer prior to the 1997–98 income year that the taxpayer would have been entitled to claim in the year or to carry forward to a subsequent income year under section IE 1 or IF 1, if the Taxation (Core Provisions) Act 1996 had not been passed:Section BC 6 provides:BC 6 Net income and net loss Deductions more than income (3) If for an income year a taxpayer's annual allowable deductions are more than the taxpayer's annual gross income, the difference is the taxpayer's net loss for the year, and the taxpayer is deemed to have net income for the year of zero.[28] The term net loss has the same meaning in this case as the term "tax loss" was used in the introduction to this case referring to the loss incurred for the year ended March 2002. [29] As the diagram shows the ITA distinguishes between net loss and available net losses. Section BC 7 provides:BC 7 Taxable incomeA taxpayer's taxable income for an income year is determined by offsetting any available net losses of the taxpayer in accordance with Part I (Treatment of Net Losses) against the taxpayer's net income.[30] Section OB 1:OB 1 DefinitionsIn this Act, unless the context otherwise requires,— Available net loss means an amount a taxpayer is entitled to offset against net income under Part I:Part I of the ITA is that part of the statute dealing with the tax treatment of groups of companies. [31] The extent to which a taxpayer is entitled to offset amounts against net income in the tax treatment of groups companies is dealt with in sub-part G. I have already had occasion to set out parts of s IG 2(2) above. The reader may now notice that the reference is to available net losses of the loss company, see paragraph [7]. [32] A net loss is an excess of allowable deductions over gross income in any one year. But recall that losses can be carried forward. So s IG 2 (2)(i) is reflecting that a particular loss company may have an accumulation of losses which have arisen over a period of income years. It does not follow that all of those losses are available for offsetting for there are other provisions in s IG 2 (not set out) which impose other conditions, for example, continuity of ownership. The important concept in s IG 2 is that before a net loss can be offset it must first be incurred, and then be available to be offset. [33] Mr Shiels contends that as a matter of policy the Court should strive to interpret s HG 16 to accommodate the policy in s HG 10, to allowing offset between qualifying companies. The other companies in this group are qualifying companies. He says the way to do this is to interpret net loss for the purposes of HG 16 as including the reduction of the total net loss, if any, where the company has made a prior election, as in this case, under s IG 2 to allocate some of that loss to another qualifying company in the group.[34] Section OB 1 begins by saying:In this Act, unless the context otherwise requires,—It is plain from considering the whole of s OB 1 that Parliament has gone to a considerable endeavour to define a number of terms. Where these are also effectively part of the core provisions and address the subject of loss, one can presume they are carefully thought out. Hence, some emphasis should be given to the term "requires". Some positive justification should be looked for. So it is necessary for the Court to find that the context and juxtaposition of ss HG 10 and HG 16 requires an extension of the term "a net loss" to include a reduction of the net loss after an offset. [35] I find it difficult to apply that test of "required". Net loss has been defined in a very simple way to be the difference between available deductible expenses and gross income. To expand the meaning of net loss in subs (1) of s HG 16 to allow for reduction of that loss by an offset election under s IG (2)(i) does more than just qualify the definition. It effectively changes the meaning completely, by incorporating the consequence of an election. It is now addressing part of a net loss. This has ongoing consequential adjustments required when applying sub-paragraphs (a) and (b) of s HG 16(1). [36] Sub-paragraph (c) provides a further complication to Mr Shiels' argument. For sub-paragraph (c) of subs (1) is a conscious reflection on the application of the group loss taxation. Because it is necessary for shareholders and directors to each elect that a qualifying company be an LAQC it is possible for a company to be just a qualifying company in some financial years and then thereafter to become an LAQC. Accordingly, Parliament has addressed the fate of available net losses prior to the company becoming an LAQC. In subs (c) it has preserved the right for those losses to be carried forward. If those losses are to be carried forward by reason that they were incurred when the company was not an LAQC that gives strength to the argument that the company should be able to make use of those losses for itself (should it come into profit in a future year) or by offsetting them to another qualifying company within the group. The point does not directly arise for decision here but I record that the Commissioner interprets s HG 16(1)(c) available losses asavailable to be utilised as contemplated by s HG 10 and s IG 2(2) as offsets to other qualifying companies within the group. Had Parliament intended availability of any net loss of an LAQC to be offset with qualifying companies it is unlikely that s HG 16(1) would have been drafted in this manner preserving the right to allocate losses accrued prior to the LAQC status in sub- paragraph (c). [37] Mr Shiels notes that the Valabh reports do not directly discuss the possibility of a prior partial offset. Nor does the final Valabh report suggest any policy reason why there cannot be a prior offset of part of the loss before the pass-through mechanism takes effect. There are passages in paragraph 2.2.4 of the final report which indicate that the Committee was clearly envisaging that the whole of the net loss would pass through on election of a QC to be an LAQC, for example at paragraph (c) where the Committee noted "its loss would be completely extinguished in each year by the statutory attribution process". [38] I conclude that there is nothing in the text and structure and scheme of the legislation or otherwise a discernible purpose of the ITA 1994 which "requires" departing from the definition of net loss in s OB 1 where the term appears in s HG 16(1). A departure would have a relatively minor disadvantageous fiscal effect, altering to the groups' advantage the timing of tax payments. It is not for this Court to decide whether that is a good thing. That is a policy decision. [39] Sections HG 10 and IG 2 and HG 16 can co-exist. The correct interpretation of s HG 16 is that it has the effect of passing through the losses of the LAQC to the shareholders, where they accrue after the election to become an LAQC. If there is no election, then s HG 10 and IG 2 can be used.[40] Accordingly, the decision of the TRA is correct. The appellant, having become an LAQC, did not have the power to allocate part of its net loss to other companies in the group. The whole of the 2002 loss passes through to its shareholders. The appeal is dismissed. Costs are reserved. Fogarty JSolicitors: Macalisters, Winton, for Appellant Crown Law Office, Wellington, for Respondent