NRS MEDIA HOLDINGS LIMITED v COMMISSIONER OF INLAND REVENUE [2017] NZHC 2978 [1 December 2017]

NRS MEDIA HOLDINGS LIMITED v COMMISSIONER OF INLAND REVENUE [2017] NZHC 2978[1 December 2017]IN THE HIGH COURT OF NEW ZEALANDWELLINGTON REGISTRYI TE KŌTI MATUA O AOTEAROATE WHANGANUI-Ā-TARA ROHECIV-2016-485-306[2017] NZHC 2978BETWEEN NRS MEDIA HOLDINGS LIMITEDPlaintiffAND COMMISSIONER OF INLANDREVENUEDefendantHearing: 27-28 Februray 2017Appearances: G J Harley, V L Heine and R L Goss for PlaintiffH W Ebersohn and J Cheng for DefendantJudgment: 1 December 2017JUDGMENT OF CLARK JPursuant to r 11.5 of the High Court Rules I directthe delivery time of this judgment is4.30 pm on 1 December 2017Introduction[1] Under s DB 55 (now repealed) of the Income Tax Act 2007 a company thatderived a foreign dividend was allowed to deduct from its tax liability the expenditureit incurred in deriving that dividend.1[2] NRS Media Holdings Ltd (NRS) claimed deductions under s DB 55 forexpenditure incurred by its Head Office in managing NRS' subsidiaries which paydividends to NRS from time-to-time. The Commissioner disallowed the deductions.NRS challenges the Commissioner's assessments.Background[3] NRS' case is advanced on the following pleaded basis.[4] NRS is a New Zealand resident parent company of subsidiaries incorporatedin foreign jurisdictions: NRS Media (Canada) Ltd, NRS Media (UK) Ltd, NRS Media(Europe) Ltd and NRS Media (Australia) Pty Ltd (Media Australia) (foreignsubsidiaries or subsidiaries). The subsidiaries provide and maintain systems thatfacilitate sales of radio and television advertising space by the subsidiaries' clients.The intellectual property in the systems has, at all material times, been held byPersuaders Concepts (NZ) Ltd (Persuaders).[5] At all material times NRS' Head Office was in Sydney, Australia. The HeadOffice employed a Chief Executive, Chief Financial Officer and four supportpersonnel. NRS seeks deductions totalling $3,670,040.542 for the following HeadOffice costs incurred over two tax years:(a) salaries of the six staff;(b) rent for the office in Sydney;1 Income Tax Act 2007, s DB 55. Section DB 55 was retrospectively repealed on 30 June 2014 bys 49(2) of the Taxation (Annual Rates, Employee Allowances, and Remedial Matters) Act 2014.2 $1,706,568.23 for the 2011 tax year (being the financial year ended 31 December 2010); and$1,963,472.31 for the 2012 tax year (being the financial year ended 31 December 2011).(c) telephone and other communication costs; and(d) travel and overseas accommodation costs for the Chief Executive andChief Financial Officer.[6] The function of the Head Office was to manage NRS' share capital invested inthe subsidiaries. NRS managed the subsidiaries by establishing and managing strategicand business plans; executing projects to increase profitability; reviewing financialperformance; receiving reports from the subsidiaries; regularly visiting eachsubsidiary and reporting to the Board on a monthly basis.[7] NRS shared the premises and some administrative systems with MediaAustralia. Media Australia was the contracting party for staff. Media Australia alsoincurred all Head Office costs which were then charged to NRS and Persuaders fortheir respective shares. NRS' only source of income was dividends distributed by itssubsidiaries. Dividend income was applied to satisfy corporate Head Office costs.[8] In income tax returns for the financial years ending 31 December 2010 and31 December 2011 NRS claimed the following deductions in respect of theexpenditure incurred in administering its foreign subsidiaries (foreign subsidiaryexpenditure or expenditure):Income TaxreturnFinancial year ended Deductions($NZD)31 March 2011 31 December 2010 $1,706,568.2331 March 2012 31 December 2011 $1,963,472.31[9] In a notice of proposed adjustment the Commissioner proposed to disallow thedeductions on the grounds NRS had not incurred the expenditure in deriving dividendincome. The Commissioner's grounds for proposing to disallow the deductionsincluded the following:(a) The steps involved in NRS' income-earning process were theacquisition and continued holding of shares in the subsidiaries.(b) The only possible advantage of the expenditure was to generallyimprove the underlying businesses of the subsidiaries, which could atbest only indirectly affect NRS by contributing to an increase in thedividend income.(c) As a result, the expenditure did not have a nexus to the income-earningprocess of NRS, and had not been incurred in deriving the dividendincome.[10] Following the exchange of statements of position the matter was referred to theDisputes Review Unit (DRU) of the Inland Revenue Department. In its AdjudicationReport the DRU concluded the claimed deductions were not allowed under s DB 55.NRS had failed to show the expenditure it claimed was:3• directly linked to its exempt foreign dividend income in a positive way;• factually and causally directed to the production of the dividend income;• incurred in the actual course of producing the dividend income.Even though the expenditure may have had a nexus with [NRS'] subsidiaries'income-earning process or the carrying on of the subsidiaries' businesses, thisis one step removed from the process whereby [NRS] derived its exemptforeign dividend income.[11] As a consequence of this determination the Commissioner issued notices ofassessment for the financial years ending 31 December 2010 and 31 December 2011in which no deduction was made for the expenditure.[12] NRS seeks a declaration that the assessments are incorrect and, pursuant tos 138P of the Tax Administration Act 1994:(a) a determination that the assessments be cancelled; or(b) a determination that the assessments be reduced or modified orotherwise varied.3 Adjudication Report, Office of the Chief Tax Counsel, NRS Media Holdings Ltd (11 March 2016)at [1.5]–[1.6].Issues[13] Two issues arise for my determination:(a) What is the scope of s DB 55(1)(a)?(b) Does NRS expenditure fall within the scope of s DB 55(1)?[14] The broad powers available to this Court, as a hearing authority, to confirm orcancel or vary an assessment4 "contemplate a right of hearing de novo on the meritswith the hearing authority determining the correct tax liability and making assessmentaccordingly".5[15] Before turning to the issues it is necessary to set out the statutory framework.Statutory framework[16] A person's annual gross income for a tax year is the total of their income thatis assessable for tax liability ("assessable income"). Assessable income does notinclude exempt income.6 Dividends received from foreign subsidiaries are exemptincome.7[17] A tax deduction is subtracted from the annual gross assessable income to givethe taxable income payable by the taxpayer.8 Under s DA 1(1) of the Income Tax Act,the "General Permission", a deduction is allowed to a person for an amount ofexpenditure or loss depending upon the manner by which the expenditure or loss isincurred:94 Tax Administration Act 1994, s 138P.5 Tannadyce Investments Ltd v Commissioner of Inland Revenue [2011] NZSC 158, [2012] 2 NZLR153 at [25].6 Income Tax Act, s BD 1(5). Income is exempted from tax liability under subparts CW or CZ:s BD 1(2).7 Income Tax Act, s CW9(1).8 An amount is a deduction if it is allowed under Part D of the Act.9 Section DA 1.DA 1 General permissionNexus with income(1) A person is allowed a deduction for an amount of expenditure or loss,including an amount of depreciation loss, to the extent to which theexpenditure or loss is—(a) incurred by them in deriving—(i) their assessable income; or(ii) their excluded income; or(iii) a combination of their assessable income andexcluded income; or(b) incurred by them in the course of carrying on a business forthe purpose of deriving—(i) their assessable income; or(ii) their excluded income; or(iii) a combination of their assessable income andexcluded income.General permission(2) Subsection (1) is called the general permission[18] Exempt income is expressly excluded from the General Permission.Section DA 2(3) provides:Exempt income limitationA person is denied a deduction for an amount of expenditure or loss to theextent to which it is incurred in deriving exempt income. This rule is calledthe exempt income limitation.[19] Section DB 55 overrides the exempt income limitation. It allows a companythat derives a dividend from a foreign company to deduct expenditure incurred by thecompany in deriving that dividend:DB 55 Expenditure incurred in deriving exempt dividend(1) A company that derives a dividend that is exempt income of thecompany under s CW 9 (Dividend derived by company fromoverseas) is allowed a deduction of–(a) the amount of the expenditure incurred by the company inderiving the dividend ...(3) This section supplements the general permission and overrides theexempt income limitation. Other general limitations still apply.[20] Section DB 55 was retrospectively repealed on 30 June 2014 by s 49(2) of theTaxation (Annual Rates, Employee Allowances, and Remedial Matters) Act 2014. Therepeal became effective on 30 June 2009. The 2014 Act contained a savingsprovision.10 It is not disputed that NRS falls within the savings provision.What is the scope of s DB 55(1)?The parties' positions[21] Mr Harley, counsel for NRS submits that s DB 55 does not bear the narrow"direct" or "tracing" gloss asserted in the Adjudication Report11 and which theCommissioner seeks to apply. The legislature had ample opportunity to limit theprovision in some way but did not do so. Nor have the New Zealand courts acceptedthis narrow approach. That is exemplified in the leading Court of Appeal decision inCommissioner of Inland Revenue v Brierley.12[22] Mr Harley submitted there is no formula applicable to all cases. Leadingauthorities require a factual relationship to be established between the advantagesought to be obtained from the expenditure (in this case the Head Office costs) and theincome earning process. Contrary to the Commissioner's approach (which is notreflected in the case law) there is no requirement for the expenditure to be directlylinked in some positive way, nor factually and causally directed (at deriving foreigndividends). Rather, the taxpayer must establish the costs in question were "incurredin the course of" deriving the income. Mr Harley submitted:10 Section DB 55 was repealed (with effect on 30 June 2009 and applying to a person and incomeyears beginning on or after 1 July 2009, except if the person meets the following requirements:applying to a person and the 2015–16 and later income years if the person takes a tax position, foran income year beginning on or after 1 July 2009, inconsistent with section 49(2) of the Taxation(Annual Rates, Employee Allowances, and Remedial Matters) Act 2014, and in a tax return filedbefore 22 November 2013), on 30 June 2014, by section 49(2) of the Taxation (Annual Rates,Employee Allowances, and Remedial Matters) Act 2014 (2014 No 39).11 Referred to at [10] above.12 Commissioner of Inland Revenue v Brierley [1990] 3 NZLR 303 (CA).As explained, particularly by reference to the Public Trustee and Brierley13cases, the expenditure being disputed could never have a direct linkage or becausally directed (because of the nature of the borrowing, and the capital assetthat the borrowing supported).[23] The Commissioner contends for a "narrower" scope. Mr Ebersohn, counselfor the Commissioner, submitted s DB 55 is concerned with expenditure incurred inthe operation of a taxpayer to earn its income, not expenditure incurred in the operationof its subsidiary. The latter expenditure is focussed on improving the subsidiary andonly indirectly linked to deriving dividends.[24] Mr Ebersohn distinguishes Brierley and suggests the position NRS takesmisunderstands the distinction between deductions of interest allowed under aprovision specific to interest deductibility and allowable deductions under the GeneralPermission. Mr Ebersohn submitted:Unlike with the general deduction provision (now the General Permission),the [interest deductibility section with which Brierley was concerned]expressly allowed a deduction of interest provided the capital was employedin the production of assessable income.[25] In that context, it was irrelevant that the expenditure was of capital nature.Assessment[26] The terms of s DA 1(1)(a) are similar to s DB 55(1)(a). Section DB 55 doesnot, however, have a limb equivalent to s DA 1(1)(b) such that a deduction is allowedfor expenditure incurred "in the course of carrying on a business for the purpose ofderiving [the specified income]".[27] There is no case law on s DB 55. There is, however, substantial case law onthe interpretation of the two limbs of the General Permission.[28] Buckley & Young Ltd v Commissioner of Inland Revenue is one of the leadingauthorities on the General Permission.14 Delivering the judgment of the Court ofAppeal Richardson J addressed the test for deductibility under s 111 of Land and13 Referring to Commissioner of Inland Revenue v Brierley, above n 12 and Public Trustee vCommissioner of Taxes [1938] NZLR 436 (CA).14 Buckley & Young Ltd v Commissioner of Inland Revenue [1978] 2 NZLR 485 (CA).Income Tax Act 1954 (an earlier equivalent to the General Permission). He reasoneda deduction is available where only the expenditure has the "necessary relationship"with the taxpayer and the gaining or producing of his or her assessable income or withthe carrying on of a business for that purpose:15The heart of the inquiry is the identification of the relationship between theadvantage gained or sought to be gained by the expenditure and the incomeearning process. That in turn requires determining the true character of thepayment. It then becomes a matter of degree and so a question of fact todetermine whether there is a sufficient relationship between the expenditureand what it provided or sought to provide on the one hand, and the incomeearning process on the other, to fall within the words of the section.[29] In recommending the amendment that introduced the two limbs of s 111 theTaxation Review Committee observed the second limb is not as restrictive as thefirst:16The suggested new wording of the section introduces two standards by whichthe deductibility of an expenditure or loss would be tested. The first is ageneral standard which could apply to any item or expense or loss "incurredin gaining or producing the assessable income" and to all taxpayers whetherin business or employment. The second is applicable only to expense or loss"necessarily incurred in carrying on a business for the purpose of gaining orproducing such (assessable) income." The latter test is not [as] restrictive asthe first one as the expenditure or loss would not have to be directly related tothe income derived from the business. It would be sufficient if it were anecessary expense or loss in the carrying on of the business.[30] And in Europa Oil (NZ) Ltd v Commissioner of Inland Revenue McCarthy Psaid of the second limb of s 111:17In the new s 111 a second limb has been introduced covering an expenditure"necessarily" incurred in carrying on a business for the purpose of gaining orproducing the assessable income. Consequently it covers expenditure whichmay not be demonstrable as having gained or produced assessable income.[31] In assessing the difference between the first and second limbs of s 104 of the15 At 487.16 The amendment was introduced as s 111 of the land and Income Tax Act 1954. It is the equivalentof the General Permission, s DA 1, in the 2007 Act. Taxation Review Committee, Taxation inNew Zealand (October 1967) at [478].17 Europa Oil (NZ) Ltd v Commissioner of Inland Revenue [1974] 2 NZLR 737 (CA) at 738-739.Income Tax Act 1976 (another equivalent provision of s DA 1), Hansen J acceptedthere are two bases for deduction:18(a) The first limb allows a deduction for any expenditure or loss which isfactually and causally relevant to the production of a taxpayer'sassessable income.(b) The second limb, while narrower, acknowledges that in the conduct ofa business, expenditure "may be made which cannot be directly linkedwith the creation of assessable income in some positive way".[32] It is plain that the authorities recognise a distinction between the first andsecond limbs of the General Permission. Given the materially similar terms ofs DB 55(1) to the first limb of the General Permission there is no basis for placing adifferent construction on each. Contrary to NRS' submission, the similarity betweenthe provisions does not mean the same interpretative approach applies to the GeneralPermission as a whole. That is because s DB 55 does not contain any equivalent ofthe wider second limb of the General Permission.[33] Section DA 1(1)(b), the second limb of the General Permission, allowsdeductions for expenditure incurred in the course of carrying on a business for thepurpose of deriving an income. The deductions allowed under s DB 55 are availableonly in respect of those expenses incurred in deriving dividends. It follows that evenif expenditure is incurred for the purpose of deriving a dividend (second limb), theexpenditure will not be deductible unless the taxpayer establishes the expenditure wasincurred in the actual course of deriving the dividend (first limb). In this case NRSmust establish its expenditure is factually and causally directed at deriving a foreigndividend.19[34] I do not draw from Brierley assistance in determining the nexus required bys DB 55.20 In Brierley, the taxpayer borrowed substantial sums to subscribe for18 Thornton Estates Ltd v Commissioner of Inland Revenue (1995) 17 NZTC 12,230 (HC) at 12,235.19 Europa Oil (NZ) Ltd v Commissioner of Inland Revenue, above n 17, at 738–739; Thornton EstatesLtd v Commissioner of Inland Revenue, above n 18, at 12,235.20 Commissioner of Inland Revenue v Brierley, above n 12.additional shares in Brierley Investments Ltd offered in cash issues to shareholders.The taxpayer claimed deductions for the interest paid each year on the sums borrowed.The Court of Appeal considered the deductibility of interest under s 106(1)(h) of the1976 Income Tax Act which provides:Notwithstanding anything in section 104 of this Act, in calculating theassessable income derived by any person from any source, no deduction shall,except as expressly provided in this Act, be made in respect of any of thefollowing sums or matters:(h) Interest, except so far as the Commissioner is satisfied that —(i) It is payable on capital employed in the production of theassessable income; or[35] Section 106 specifically allows expenditure to be made on capital that producesassessable income. The nexus in s 106 contemplates expenditure being a step removedfrom the actual production of assessable income. By contrast, s DB 55 requiresexpenditure to be directed at deriving the exempt income.[36] I have been referred to a wealth of background documentation, includinglegislative materials and case law. Mr Harley presented s DB 55 as operating in anarcane world.In that world of complexity and technicality, we have a provision that inessence turns the income tax world on its head, providing explicitly for adeduction against exempt income. There is no other provision in the Act thatcreates what is an unnatural response in an income tax system that brings tocharge assessable income. In that highly technical controlled foreigncompany regime, the interpretative approach must work from the actual wordsused, on the basis that Parliament was reflecting what is a technical rule in acomplex area of income tax policy. The language chosen deliberately andspecifically reflects that technicality.[37] Ultimately, however, I think the test under s DB 55(1) requires expenditure tobe factually and causally directed to the derivation of foreign dividend income.Expenditure having as a purpose, the deriving of a foreign dividend that is not causallyrelated, is too broad to bring it within the restrictive scope of s DB 55.[38] NRS argued before the DRU that a "narrow" interpretation of s DB 55(1)(a)leads to an absurd result because "nobody would ever get a deduction under theprovision if it were interpreted in this way". Mr Harley made a similar submission inthis Court. In rejecting the proposition the DRU:21 considered that a non-exhaustive list of the types of expenditure that maybe incurred in deriving dividend income is as follows:• interest on borrowings to buy shares that pay dividends;• accounting for the share portfolio;• postage incurred in order to manage the share portfolio;• investment publications that provide information that helps manage theshare portfolio;• travel expenses to consult with a stockbroker;• travel expenses to attend a company's annual general meeting;• subscriptions to sharemarket information services where these are takenout for the purpose of deriving dividends;• telephone, internet and data access costs incurred for share-tradingactivities and/or in accessing live sharemarket information;• depreciation of share-trading software;• management and consulting fees for advice relating to the managementof the share portfolio.[39] The Adjudication Report produced by the DRU contains an exhaustive analysisof the statutory context in which s DB 55(1) is placed and of the case law which hassettled the test for deductibility under the analogous first limb of the GeneralPermission.[40] I have concluded, as did the DRU, that the nexus required under s DB 55(1)will be present when the taxpayer establishes its expenditure to be factually andcausally incurred in the derivation of foreign dividend income.[41] NRS' expenditure improved the value and profitability of its subsidiaries andwas incurred in carrying on a business for the purpose of deriving foreign dividend21 Adjudication Report, Office of the Chief Tax Counsel, NRS Media Holdings Ltd, 11 March 2016,at [3.32].income. NRS' expenditure is a step removed from being factually and causallyincurred in the derivation of foreign dividend income.Does NRS' expenditure come within the scope of s DB 55?[42] The issue under this head is whether NRS' expenditure was factually andcausally directed at deriving foreign dividend income. For the reasons contained inthe foregoing analysis the purpose for which the expenditure was incurred isirrelevant.The parties' positions[43] NRS says its primary asset is its ownership of the subsidiaries. NRS' HeadOffice directed costs to the receipt of an increasing dividend stream derived from theshare capital invested in the subsidiaries. Mr Harley submitted once it is establishedas a matter of fact, on the evidence, that the relationship between the expenditure ofthe Head Office is entirely focused on its derivation of its exempt dividend stream,then (from NRS' shareholder perspective) the disputed expenditure cannot properlyrelate to anything else.[44] NRS accepts as "self-evident" the activities of the Head Office contributed toincreased performance and therefore profitability of the subsidiaries; and this had animpact on the value of the subsidiaries. It is considered, however, those benefits are aby-product of Head Office activity. Mr Harley pointed to evidence to this effect.[45] The Commissioner's case is that NRS' expenditure was calculated to developand grow the subsidiaries and thereby the plaintiff's share value in the subsidiaries,the shareholding being a capital asset. While NRS submitted such expenditure wasultimately aimed at obtaining dividends, the Commissioner argues those dividends areone step removed, or an indirect consequence of the improvement of the operations ofthe subsidiaries; the expenditure was first and foremost aimed at improving thefunctioning of the subsidiaries.Assessment[46] I have concluded that s DB 55 requires expenditure to be factually and causallyincurred in the derivation of foreign dividend income.[47] The expenditure on salaries, rent for the office in Sydney, telephone and othercommunication costs, and travel and overseas accommodation for the Chief Executiveand Chief Financial Officer are insufficiently related to the derivation of foreigndividends. The derivation of foreign dividends was one step removed from thepurpose of the expenditure, which was to increase the value of the subsidiaries. Myreasons follow.[48] In his evidence Mr Gold, director and majority shareholder of NRS,summarised NRS' focus in all its endeavours as being to:(a) establish business in the relevant foreign countries;(b) introduce its expertise and knowhow into each subsidiary so that eachwould build a viable and effective business with clients, and so becomemore competitive in those markets and more profitable;(c) ensure that each subsidiary had the resources and well trained andmotivated people needed to be effective in their markets;(d) enhance the different product lines and methods and to make themavailable to each group company including a major new businessdevelopment strategy in 2008/2009;(e) provide financial controls, management reporting and appropriategovernance for each group company so that the group operatedeffectively and profitably as a whole and review performance ofsubsidiaries in detail and recommend changes to their respectivebusiness strategies; and(f) maximise the value of each group company's business, and henceprofitability.[49] While the plaintiff says its expenditure was ultimately aimed at obtainingdividends in my view the expenditure is a step removed from expenditure whichfactually and causally derives a dividend. As Mr Gold stated the expenditure providedservices to the subsidiaries to "maximise the value" of each subsidiary and "henceprofitability". The factual and causal effect of this expenditure was to improve thevalue and profitability of the subsidiaries.[50] Mr Harley characterised as "self-evident" that the activities of the Head Officecontributed to increased performance and therefore profitability of the subsidiaries andthis had an impact on the value of the subsidiaries. But I do not accept Mr Gold'sdescription of these benefits as a "by-product" of Head Office activity. The firstconsequence of NRS' expenditure was to improve the subsidiaries. The furtherpossible consequence was receipt of foreign dividends.[51] I accept the purpose of NRS was "stewardship" of its investors directed at anincreasing dividend stream derived from the share capital invested in the subsidiaries.But the purpose of the expenditure is irrelevant to the question whether expenditure isincurred in deriving the dividend. Deriving dividends was an ancillary consequenceof the increasing profitability and value of the subsidiaries. Expenditure onmaximising value and profitability of the companies returning dividends is notdeductible under s DB 55. Such expenditure may fall within the broader category ofexpenditure incurred "in the course of carrying on a business for the purpose ofderiving income" (the second limb of the General Provision) but it does not fall withinthe more restricted scope of s DB 55.[52] That NRS may have determined the magnitude and timing of distributionsfrom the subsidiaries to NRS and that those dividends were required to meet HeadOffice costs as well as provide a return to the shareholders of NRS does not lead meto conclude the expenditure was other than factually and causally directed atincreasing the profitability of the subsidiaries.[53] The conclusion I have reached makes it unnecessary to engage in the purportedcapital nature of the expenditure, an analysis which Mr Ebersohn undertook on behalfof the Commissioner.Conclusion[54] The test for deductibility under s DB 55(1) requires the taxpayer to show theexpenditure has been incurred in deriving the dividend. A nexus showing only aconnection between the expenditure and the carrying on of the business from whichthe dividend is derived is insufficient.[55] NRS' expenditure had the purpose of improving the value of its subsidiaries,and in consequence, its own shareholding and potential for dividend income. Thisexpenditure is a step removed from the relationship required by s DB 55. AccordinglyNRS' foreign subsidiary expenditure is not deductible.Result[56] The application for a declaration is dismissed.[57] The Commissioner's assessment is confirmed.[58] The Commissioner is entitled to costs. Mr Harley submitted the evidence NRSwas required to call transpired to be unnecessary in light of the acceptance byMr Ebersohn in his memorandum filed 16 February 2017 that the true dispute is theinterpretation and application of s DB 55. If the parties are unable to agree costs, briefand focussed memorandum may be submitted._____________________________Karen Clark JSolicitors:Chapman Tripp, Wellington for PlaintiffCrown Law Office, Wellington for Defendant