NRS MEDIA HOLDINGS LTD v COMMISSIONER OF INLAND REVENUE [2018] NZCA 472 [1 November

2018]

IN THE COURT OF APPEAL OF NEW ZEALAND

I TE KŌTI PĪRA O AOTEAROA

CA728/2017

[2018] NZCA 472

BETWEEN

NRS MEDIA HOLDINGS LIMITED

Appellant

AND

COMMISSIONER OF INLAND

REVENUE

Respondent

Hearing:

12 June 2018 (further submissions received 6 July 2018)

Court:

Brown, Clifford and Williams JJ

Counsel:

G J Harley and R L Goss for Appellant

H W Ebersohn and J B Y Y Cheng for Respondent

Judgment:

1 November 2018 at 3.30 pm

JUDGMENT OF THE COURT

A The appeal is allowed.

B The appellant is entitled to deductions totalling $1,706,568.23 and

$1,963,472.31 in the 2011 and 2012 years respectively.

C The respondent must pay the appellant costs for a standard appeal on a

band A basis and usual disbursements.

D Any order for costs in the High Court is quashed. Costs in the High Court

are to be determined by that Court in accordance with this judgment.

____________________________________________________________________

REASONS OF THE COURT

(Given by Clifford J)

Introduction

[1] In its tax returns for the 2011 and 2012 years, NRS Media Holdings Ltd (NRS)

claimed deductions for expenditure it said it had incurred in deriving exempt foreign

dividends. The Commissioner of Inland Revenue (the Commissioner) disallowed

those deductions. She said the expenditure in question did not have the necessary

nexus with those dividends. NRS took challenge proceedings in the High Court, where

Clark J upheld the Commissioner’s determination.1 NRS now appeals.

Statutory context: issues

[2] NRS claimed its deductions in reliance on s DB 55 of the Income Tax Act 2007

(the 2007 ITA) which, at the time, provided:

DB 55 Expenditure incurred in deriving exempt dividend

Deduction

(1) A company that derives a dividend that is exempt income of the

company under section CW 9 (Dividend derived from foreign

company) is allowed a deduction of the amount of the expenditure

incurred by the company in deriving the dividend.

…

Link with subpart DA

(3) This section overrides the exempt income limitation. The general

permission must still be satisfied and the other general limitations still

apply.

[3] The Commissioner based her decision, that NRS’ expenditure did not have a

sufficient relationship to the dividends paid to it by its subsidiaries, on the words used

in s DB 55(1) compared to the words used in s DA 1 (the general permission for the

deduction of expenditure). That section reads:

DA 1 General permission

Nexus 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 the

expenditure or loss is—

(a) incurred by them in deriving—

1 NRS Media Holdings Ltd v Commissioner of Inland Revenue [2017] NZHC 2978.

(i) their assessable income; or

(ii) their excluded income; or

(iii) a combination of their assessable income and excluded

income; or

(b) incurred by them in the course of carrying on a business for the

purpose of deriving—

(i) their assessable income; or

(ii) their excluded income; or

(iii) a combination of their assessable income and excluded

income.

General permission

(2) Subsection (1) is called the general permission.

[4] The Commissioner reasoned that the words “in deriving” found in s DA 1(1)(a)

describes a closer nexus between the relevant expenditure and the income derived than

do the words “in the course of carrying on a business for the purpose of deriving”

found in s DA 1(1)(b). The same “closer” nexus was therefore required under

s DB 55(1) given the use in that section of the same phrase “in deriving”.

[5] NRS says there is no real distinction between the nexus with income described

in the two subsections. Certainly, any difference is not sufficient to interpret s DB 55

in the way the Commissioner did. The Commissioner and NRS both say the

interpretation they argue for is supported by legislative history.

[6] The Commissioner also based her conclusion on the proposition that the

expenses for which NRS sought deductions were of a capital nature: therefore, any

deductions were necessarily prohibited by the capital limitation found in s DA 2(1) of

the 2007 ITA (which is not overridden by s DB 55). The High Court did not need to

consider that argument, because it upheld the Commissioner’s interpretation of

s DB 55. On appeal, the Commissioner supports the High Court’s decision on the

alternate basis of the applicability of the capital limitation.

[7] We first consider whether the High Court was correct in upholding

the Commissioner’s categorisation of the nexus required between expenditure and

income for deductibility under s DB 55. We then consider the Commissioner’s

alternative argument about the applicability of the capital limitation.

The facts

[8] NRS was the sole or majority shareholder of a number of subsidiaries

(the subsidiaries). Two were incorporated in the United Kingdom, one was

incorporated in Australia, and another was incorporated in Canada. Those subsidiaries

derived income by facilitating the purchase of media time by their client advertisers.

Central to that business was software developed and licensed to them by a sister

company of NRS, Persuaders Concepts (NZ) Ltd (Persuaders). For its part as parent

company, NRS set the strategic plan for its group as a whole, and for each of its

subsidiaries.2 In turn, it approved and monitored the business plans and the business

activities of its subsidiaries as they operated within those strategic plans. It was in

undertaking those activities that NRS incurred the expenses in question.

[9] NRS categorised those expenses as comprising “payroll and consultants”,

“marketing and travel”, “rent and occupancy”, and “overheads”. They totalled

$1,706,568.23 in the 2011 year, and $1,963,472.31 in the 2012 year. In those years,

NRS derived exempt foreign dividend income of $1,989,357.00 and $1,892,295.00

respectively.

[10] NRS described the overall objective of its activities as being:

(a) to maximise the financial return to the shareholders of NRS through

increased dividends from the NRS subsidiaries, for the benefit of NRS;

and

(b) to enable NRS and its Board to discharge their obligations as

parent company, from a legal governance perspective.

2 As we return to, NRS maintains that it did not manage the subsidiaries.

[11] The NRS subsidiaries were self-sufficient, with their own accounting, sales and

management teams, and did not require support or services to be provided by NRS to

operate on a day-to-day basis.

The correct interpretation of s DB 55

Judgment under appeal

[12] The High Court first concluded, as had the Commissioner’s adjudication

report, that for the claimed expenditure to be deductible under s DB 55, NRS needed

to show that expenditure was:3

(a) directly linked to its exempt foreign dividend income in a positive way;

(b) factually and causally directed to the production of the dividend

income; and

(c) incurred in the course of producing the dividend income.

[13] That conclusion was influenced by the following observations of

the Taxation Review Committee in recommending the amendment that introduced the

two limbs of s 111 of the Land and Income Tax Act 1954 (now s DA 1 of the 2007

ITA) in October 1967:4

The suggested new wording of the section introduces two standards by which

the deductibility of an expenditure or loss would be tested. The first is a

general standard which could apply to any item of expense or loss “incurred

in gaining or producing the assessable income” and to all taxpayers whether

in business or employment. The second is applicable only to expense or loss

“necessarily incurred in carrying on a business for the purpose of gaining or

producing such (assessable) income”. The latter test is not [as] restrictive as

the first one as the expenditure or loss would not have to be directly related to

the income derived from the business. It would be sufficient if it were a

necessary expense or loss in the carrying on of the business.

[14] The explanation “the latter test is not [as] restrictive as the first one as the

expenditure or loss would not have to be directly related to the income derived from

3 NRS Media Holdings Ltd v Commissioner of Inland Revenue, above n 1, at [10] and [33]. 4 Taxation in New Zealand — Report of the Taxation Review Committee (Taxation Review

Committee, October 1967) at [478].

the business” was — as we understood the argument — the basis for the requirement

of direct linkage.

[15] Referring to Europa Oil (NZ) Ltd v Commissioner of Inland Revenue5 and

Thornton Estates Ltd v Commissioner of Inland Revenue6 the Judge reasoned:7

[32] It is plain that the authorities recognise a distinction between the first

and second limbs of the General Permission. Given the materially similar

terms of s DB 55(1) to the first limb of the General Permission there is no basis

for placing a different construction on each. Contrary to NRS’ submission, the

similarity between the provisions does not mean the same interpretative

approach applies to the General Permission as a whole. That is because

s DB 55 does not contain any equivalent of the second limb of the

General Permission.

[33] Section DA 1(1)(b), the second limb of the General Permission, allows

deductions for expenditure incurred in the course of carrying on a business for

the purpose of deriving an income. The deductions allowed under s DB 55 are

available only in respect of those expenses incurred in deriving dividends. It

follows that even if expenditure is incurred “in the course of carrying on a

business” for the purpose of deriving a dividend (second limb), the

expenditure will not be deductible unless the taxpayer establishes the

expenditure was incurred in the actual course of deriving the dividend (first

limb).

[16] That meant, the Judge said, that NRS must establish its expenditure was

factually and causally directed at deriving a foreign dividend.8

[17] The expenditure giving rise to the deductions claimed by NRS had not met that

test. It was:9

… insufficiently related to the derivation of foreign dividends. The derivation

of foreign dividends was one step removed from the purpose of the

expenditure, which was to increase the value of the subsidiaries. …

[18] The Judge summarised the evidence of Mr Gold, a director and

majority shareholder of NRS, as being that NRS’ expenditure provided services to the

subsidiaries to “maximise the value” and “profitability” of each subsidiary.10 The

factual and causal effect of that expenditure “was to improve the value and profitability

5 Europa Oil (NZ) Ltd v Commissioner of Inland Revenue [1974] 2 NZLR 737 (CA). 6 Thornton Estates Ltd v Commissioner of Inland Revenue (1995) 17 NZTC 12,230 (HC). 7 NRS Media Holdings Ltd v Commissioner of Inland Revenue, above n 1. 8 At [33]. 9 At [46]. 10 At [47].

of the subsidiaries.”11 That was the first consequence of NRS’ expenditure. A further

possible consequence was receipt of dividends. As she put it:

[50] I accept the purpose of NRS was “stewardship” of its investors

directed at an increasing dividend stream derived from the share capital

invested in the subsidiaries. But the purpose of the expenditure is irrelevant

to the question whether expenditure is incurred in deriving the dividend.[12]

Deriving dividends was an ancillary consequence of the increasing

profitability and value of the subsidiaries. Expenditure on maximising value

and profitability of the [company’s] returning dividends is not deductible

under s DB 55. Such expenditure may fall within the broader category of

expenditure incurred “in the course of carrying on a business for the purpose

of deriving income” (the second limb of the General Provision) but it does not

fall within the more restricted scope of s DB 55.

[19] For NRS, Mr Harley submitted that distinction was neither called for by the

words of the legislation nor supported by case law. Mr Harley based that submission

on a number of cases, including Commissioner of Inland Revenue v Banks13 and

Buckley & Young Ltd v Commissioner of Inland Revenue.14

The cases

[20] Both the requisite nexus for deductibility and the relationship between the first

and second limbs have been discussed in a number of cases. Given the parties’ reliance

upon these cases, it is necessary to discuss these in some detail.

[21] In Banks this Court considered the deductibility of home office expenses.

At the time, s 111 of the Land and Income Tax Act provided the general authority for

deductions in calculating assessable income. It read:

Expenditure or loss incurred in production of assessable income

In calculating the assessable income of any taxpayer, any expenditure or loss

to the extent to which it—

(a) Is incurred in gaining or producing the assessable income for any

income year; or

11 At [48]. 12 In this appeal, the Commissioner accepted the Judge erred in saying the purpose of the expenditure

was irrelevant. As we discuss from [24] onwards, purpose can be relevant, and even determinative,

in deciding whether the required nexus for deductibility exists between expenditure and derived

income. 13 Commissioner of Inland Revenue v Banks [1978] 2 NZLR 472 (CA). 14 Buckley & Young Ltd v Commissioner of Inland Revenue [1978] 2 NZLR 485 (CA).

(b) Is necessarily incurred in carrying on a business for the purpose of

gaining or producing the assessable income for any income year—

may, except as otherwise provided in this Act, be deducted from the total

income derived by the taxpayer in the income year in which the expenditure

or loss is incurred.

[22] As can be seen, whereas s DA 1(1)(a) now uses the words “incurred by them

in deriving their assessable income” s 111(a) used the words “as incurred in gaining or

producing the assessable income”. It was not suggested to us that there was any

material difference between those wordings.

[23] Richardson J reasoned that there were two features of s 111, and its place in the

scheme of the deduction provisions, of particular importance. It is the first of those

that is relevant here. That is, “the expenditure must meet the statutory standards in

relation to the assessable income of the taxpayer claiming the deduction”.15

The deduction was “available only where expenditure [had] the necessary relationship,

both with the taxpayer concerned and the gaining or producing of his assessable

income”.16 A relationship with the taxpayer was not, in itself, sufficient, as the

prohibition of a deduction for capital expenditure (s 112(1)(a)) and private and

domestic expenditure (s 112(1)(i)) made clear. There must be the statutory nexus

between the particular expenditure and the assessable income of the taxpayer claiming

the deduction.17 It is with the proper categorisation of that “statutory nexus” that we

are concerned.

[24] Speaking generally Richardson J said:18

The language of s 111 is deceptively simple. The width and generality of the

statutory language has posed problems for Courts and tribunals faced with

applying the provisions in a practical way. There has been an understandable

unwillingness in the cases to attempt to establish hard and fast rules to cover

all situations in an area of the law which, so far as possible, should reflect

commercial realities. There are constant reminders in the judgments that each

case of this kind depends on its own facts and the dividing line between

deductibility and non-deductibility is blurred. It will often be helpful, in

determining and applying the statutory criteria, to consider the analysis and

exposition of the statutory provisions in the decisions of the Courts and review

15 Commissioner of Inland Revenue v Banks, above n 13, at 476. 16 At 476. The second feature, not relevant here, was the contemplation in the statutory language of

apportionment. 17 At 476. 18 At 477.

tribunals and the considerations regarded as particularly significant in

individual cases. However, this is not an area of the law where it is possible

to devise a judicial formula which, as a substitute for the statutory language,

could be applied in all cases and, in the end, a decision in a particular case

must be reached on the application of the statutory language to its particular

circumstances. The focus of the inquiry necessarily shifts, depending on the

circumstances of the particular case.

[25] Richardson J went on to state that it did not advance the argument in the case

before the Court to emphasise the character of the expenditure for which deduction is

sought.19 It all depended, the Judge reasoned, on the relationship between the

particular premises or asset in respect of which the payment was made and the income

earning process.20 So, further analysis of the relationship between expenditure and

income earning activities was required.21

[26] In an important passage of the judgment, Richardson J referred to relevant

Australian authorities in the following terms:22

In the Australian cases under the counterpart of s 111(1) there has been

considerable stress on the character of an outgoing in the sense of its being

incidental and relevant to the gaining or producing of the assessable income.

Statements to that effect emphasise the relationship that must exist between

the advantage gained or sought to be gained by the expenditure and the income

earning process. They do not, and cannot, specify in concrete terms the kind

and degree of connection between the expenditure and the gaining or

producing of assessable income required in individual cases for the

expenditure to qualify for deduction. As was observed in Lunney v Federal

Commissioner of Taxation:

“Examination of these cases, however, readily shows that the

expression ‘incidental and relevant’ was not used in an attempt to

formulate an exclusive and exhaustive test for ascertaining the extent

of the operation of the section; the words were merely used in stating

an attribute without which an item of expenditure cannot be regarded

as deductible under the section.”

Putting it positively, Dixon J said in Amalgamated Zinc (de Bavay’s) Ltd v

Federal Commissioner of Taxation and we respectfully agree:

“The expression ‘in gaining or producing’ has the force of ‘in the

course of gaining or producing’ and looks rather to the scope of the

operations or activities and the relevance thereto of the expenditure

than to purpose in itself.”

19 At 477. 20 At 477. 21 At 477. 22 At 478 (citations omitted).

As is clear, Richardson J was endorsing the Australian approach.

[27] In our view, two further passages from the judgment in Banks capture well the

approach mandated:23

It then becomes a matter of degree, and so a question of fact, to determine

whether there is a sufficient relationship between the expenditure and what it

provided, or sought to provide, on the one hand, and the income earning

process, on the other, to fall within the words of the section.

…

As we see it, the essential question for consideration in this respect is whether

part of the premises — whether set up as a workshop or surgery or study

(cf Caffrey v Federal Commissioner of Taxation), or whether simply used for

income related activities — has a sufficient connection with the taxpayer’s

income earning process to justify the conclusion that expenditure referable to

that part of the premises is incurred in the course of gaining or producing the

assessable income.

[28] Richardson J took a similar approach in Banks when considering the taxpayer’s

claim for interest deductibility under s 112(1)(g), which permitted a deduction for

interest “payable on capital employed in the production of the assessable income”.

He said:24

Having regard, too, to the statutory language “in the production of the

assessable income” in s 112(1)(g) and “in the gaining or producing of the

assessable income” in s 111(a), an inquiry under the former provision will

ordinarily involve essentially the same considerations in determining whether

or not there is a sufficient connection between the expenditure of interest and

the income earning activities involving the use of the property, for the interest

to qualify for deduction.

Sections 111 and 112 were considered again in 1978, by Richardson J in Buckley &

Young Ltd v Commissioner of Inland Revenue.25 The case involved payments made

by a company to a senior employee after an acrimonious retirement. As relevant, the

company made annual payments of $6,000 on account of the employee’s covenant in

restraint of trade, contributed to his superannuation scheme, provided him with a car

and met his legal expenses. The issue for this Court was whether those payments were,

for the company involved, of a capital or revenue nature. Nexus was not the issue.

23 At 478 and 482 (citations omitted and emphasis added). 24 At 483 (emphasis added). 25 Buckley & Young Ltd v Commissioner of Inland Revenue, above n 14.

But, in describing the legislative scheme Richardson J again identified the features of

nexus and apportionment found in s 111 as being of particular importance. Relevantly,

he described the nexus in the following terms:26

The first is that a deduction is available only where the expenditure has the

necessary relationship both with the taxpayer concerned and with the gaining

or producing of an assessable income or with the carrying on of a business for

that purpose. The heart of the inquiry is the identification of the relationship

between the advantage gained or sought to be gained by the expenditure and

the income earning process. That in turn requires determining the true

character of the payment. It then becomes a matter of degree and so a question

of fact to determine whether there is a sufficient relationship between the

expenditure and what it provided or sought to provide on the one hand, and

the income earning process on the other, to fall within the words of the section

(Commissioner of Inland Revenue v Banks).

[29] It is of some significance, in our view, that Richardson J speaks in

the alternative of “the gaining or producing of his assessable income” and “with the

carrying of a business for that purpose” without distinction as regards nexus. It would

appear the Judge saw no reason to distinguish between the approach called for on that

issue as regards the two provisions.

[30] As can been seen, thus far there is little if any support for the approach

the Commissioner took to deductibility, as summarised at [12] above. There is simply

no reflection, in the authorities, of the concepts of “directly linked in a positive way”

and “factually and causally directed”. Nor is it suggested that there is any great

distinction between the tests for nexus under either of subs (1)(a) or (b) of s DA 1.

Rather, what is required is the application of the statutory language — here “the

amount of the expenditure incurred by the company in deriving the dividend” — to

the particular circumstances.

[31] In his oral submissions, Mr Harley drew our attention to like approaches to the

required nexus for deductibility found in a number of earlier decisions. Reference to

one of those will suffice to support the general conclusion we have just reached.

[32] In Ronpibon Tin No Liability v Federal Commissioner of Taxation

the High Court of Australia commented on the phrase “incurred in gaining or

26 At 487 (emphasis added and citations omitted).

producing the assessable income” as it then appeared in both limbs of s 51(1) of the

Income Tax Assessment Act 1936 (Cth) in the following way:27

For expenditure to form an allowable deduction as an outgoing incurred in

gaining or producing the assessable income it must be incidental and relevant

to that end. The words “incurred in gaining or producing the assessable

income” mean in the course of gaining or producing such income. Their

operation has been explained in cases decided under the provisions of the

previous enactments: see particularly Amalgamated Zinc (de Bavay’s) Ltd v

Federal Commissioner of Taxation and W Nevill & Co Ltd v Federal

Commissioner of Taxation.

Notwithstanding the differences in other respects in the present provision, the

expression “incurred in gaining or producing the assessable income” has been

left unchanged and bears the same meaning. In brief substance, to come within

the initial part of the sub-section it is both sufficient and necessary that the

occasion of the loss or outgoing should be found in whatever is productive of

the assessable income or, if none be produced, would be expected to produce

assessable income.

[33] In our view, the phrase “whatever is productive of the assessable income” is a

helpful way both of characterising the factual inquiry that the application of the

statutory language requires and of describing the nexus that is the focus of that inquiry.

[34] In our view, Europa Oil (NZ) Ltd and Thornton Estates Ltd do not provide

support for the Commissioner’s stance.

[35] As reported, Europa Oil (NZ) Ltd contains this Court’s discussion of the then

recently enacted s 111 of the Land and Income Tax Act. It would appear that the factual

issue related to the availability of deductions for the cost of stock-in-trade. The report

provides little detail beyond that. The new s 111 governed three of the tax years

involved. Each of the Judges wrestled with the difference between the old and the

new. McCarthy P wrote:28

The reasons for the changes are by no means certain. McMullin J [the High

Court Judge] has pointed to some, and it has also been suggested that one

special purpose of limb (b) may have been to include expenditure such was

the subject of the Privy Council’s judgment in Ward & Co Ltd v Commissioner

of Taxes, which, though it may have been incurred for the purpose of protecting

or advancing the taxpayer’s business, cannot be shown to have been expended

in producing assessable income. I think this may well be so, but I do not feel

27 Ronpibon Tin No Liability v Federal Commissioner of Taxation (1949) 78 CLR 47 at 56–57

(citations omitted). 28 Europa Oil (NZ) Ltd v Commissioner of Inland Revenue, above n 5, at 739 (citations omitted).

sufficiently convinced of any explanation other than the new section was

intended to relieve taxpayers somewhat from the rigorous test which the courts

had found it necessary to impose because of the earlier wording.

[36] Richardson J acknowledged that the language of the new s 111(b) would likely

“widen the field of deductibility”, at least for taxpayers who were “carrying on a

business”.29 Other than comparing the wording of the two sections he proffered little

further explanation.

[37] Beattie J also saw the amendment as having an expansionary purpose.

He wrote:30

I consider that the new section enlarges the scope of deductible expenditure.

As I shall later discuss, under s 111(a) there is no qualifying adverb and under

s 111(b) the qualification has changed.

[38] But, again, beyond that Beattie J also offered no further explanation.

[39] As can be seen, the comments in Europa Oil (NZ) Ltd reflect the general

proposition that the second limb of s 111 may not be as restrictive as the first. Beyond

that, they do not materially assist. In our view, the case does not support the nexus

characterisation adopted by the Commissioner and the High Court.

[40] Nor does Thornton Estates Ltd add much, if anything, to that analysis.

The case concerned the accrual rules, and the timing of the availability of deductions

for the cost of land and its subsequent development. That the relevant expenses were

deductible was not challenged by the Commissioner: the question was timing. In the

course of extended submissions, and having correctly summarised the general

principles found in Banks and Buckley & Young Ltd, the taxpayer’s lawyer paraphrased

the nexus requirement under s 104(a) of the Income Tax Act 1976 (the 1976 ITA) by

the phrase “factually and causally relevant to the production of the taxpayers’

assessable income”. The Judge noted:31

The Commissioner did not make any submissions in relation to s 104, and it

seems to me those made by Mr Martin are correct. …

29 At 740. 30 At 741. 31 Thornton Estates Ltd v Commissioner of Inland Revenue, above n 6, at 12,235.

[41] To the extent the Commissioner’s phrase “factually and causally directed”

appears to come from Thornton Estates Ltd, we did not find the case to be of any great

authority, nor the phrase itself to be relevant or helpful.

Legislative history

[42] We now turn to the legislative history of s DB 55 because, as noted, both

the Commissioner and NRS say the interpretation they argue for is supported by the

legislative history. Notwithstanding the helpful submissions we received, both in

writing and orally, by the end of the hearing the position on that matter was not as clear

as we might have wished. We therefore requested a joint memorandum from counsel

setting out, hopefully on an agreed basis, s DB 55’s legislative history and its role over

time.

[43] The memorandum we subsequently received was, as requested, agreed albeit

with one exception. That exception was of some significance: the parties were unable

to agree on the reason for the enactment of s DB 55. That has not helped our task.

Moreover, the material is dense and now historical.

[44] We also note that in her submissions the Commissioner relied in particular on

correspondence from an individual taxpayer to the Select Committee as evidencing the

type of expenditure Parliament had in mind when enacting s DB 55. We think that

expands the net of legitimate interpretational material at least a step too far. Whatever

may or may not have been the motivation of an individual taxpayer, or group of

taxpayers, in seeking a particular amendment to the legislation does not, in our view,

constitute relevant interpretational material, beyond the extent to which that material

becomes part of the official Parliamentary record.

[45] Subject to those reservations, we now set out our understanding of the

legislative history of s DB 55. At the end of the day, and taken overall, our sense is

that the deductions NRS claimed may not have been at the forefront of Parliament’s,

or the Commissioner’s, minds when the section was introduced. That, of itself, is not

determinative of the issues here.

[46] Section DB 55 was originally introduced in 2004 as s DJ 11B of

the Income Tax Act 1994. It was retrospectively repealed on 30 June 2014 by s 49(2)

of the Taxation (Annual Rates, Employee Allowances, and Remedial Matters) Act

2014 (the 2014 Act). The repeal was effective as of 30 June 2009. However, the 2014

Act contained a savings provision: provided certain criteria were met, the repeal did

not apply to tax returns filed before 22 November 2013, the date the Bill was

introduced to Parliament. It is not disputed that NRS’ challenged returns fall within

that savings provision.

[47] Section DB 55 did an apparently curious thing. It allowed a deduction for

expenses incurred in deriving exempt income. That is, s CW 9(1) of the 2007 ITA

provides:

A dividend from a foreign company is exempt income if derived by a company

that is resident in New Zealand.

[48] Such an allowance is contrary to the scheme of the 2007 ITA. Section DA 2(3)

provides:

(3) A person is denied a deduction for an amount of expenditure or loss to

the extent to which it is incurred in deriving exempt income. This rule

is called the exempt income limitation.

[49] Section DB 55 had its origins in New Zealand’s international tax regime. That

tax regime, designed to protect New Zealand’s tax base and remove distorting

incentives for off-shore investment, was introduced by the Income Tax Amendment

Act 1988 (No 5). Three regimes for taxing foreign-sourced income were established:

(a) the CFC regime;

(b) the foreign investment fund (FIF) regime; and

(c) the foreign dividend withholding payment (FDWP) regime.

[50] The CFC regime was necessary to ensure that foreign-sourced income was

taxed effectively. Before the CFC regime, New Zealand residents could avoid tax by

accumulating income in companies resident offshore, but effectively controlled from

New Zealand. The CFC regime now applies to all taxpayers who have an “income

interest” of greater than 10 per cent in a foreign company that is effectively controlled

by a New Zealand shareholder or group.32 The threshold for effective control is

generally 50 per cent. Thus, each of NRS’ subsidiaries was a CFC.

[51] When introduced, the CFC regime provided for full attribution of a CFC’s

income to the New Zealand controlling shareholder — unless the CFC was resident in

a grey list country (Australia, Canada, France, Germany, Japan, the United Kingdom

and the United States). Given the incorporation of NRS’ subsidiaries in

the United Kingdom, Canada and Australia, NRS was not required to attribute their

income.

[52] FDWP applied to dividends received by a New Zealand company from foreign

companies, subject to a credit in the case of dividends from grey list companies. That

credit worked on the basis that, for dividends from grey list countries, the foreign

company would be presumed to have paid foreign tax equal to the New Zealand

income tax payable. So, in effect, there would be no withholding payment to pay.

Thus, just as NRS was not required to attribute its subsidiaries’ income, neither was it

required to pay FDWP on dividends actually received from those subsidiaries.

[53] That was not the case for all corporate taxpayers, including investment vehicles

like unit trusts, for whom dividends from foreign companies were exempt income but

nonetheless subject to FDWP. Notwithstanding the effective tax of the FDWP,

s DA 2(3) precluded deductions for expenses incurred in deriving that exempt income.

That mismatch was, counsel advised, addressed by taxpayers structuring such

dividends as bonus issues. As we understand it, in that way liability to pay FDWP did

not arise. In 2003, however, changes were proposed which would treat such bonus

issues as dividends and therefore as exempt income. So, the mismatch — the objective

significance of which was not explained to us — would exist again. In response,

s DJ 11B was introduced “to allow a deduction for expenditure incurred by a company

deriving dividends that are exempt under section CB 10(1) …”.33

32 Income Tax Act, s CQ2 and subpt EX. 33 Taxation (Annual Rates, Venture Capital and Miscellaneous Provisions) Bill 2004 (110-2)

(select committee report) at 19.

[54] New Zealand’s international tax regime was changed again in 2009.

The introduction of the active/passive distinction and its application in the attribution

of CFC income resulted in the abolition of FDWP. Our understanding is that NRS’

grey list subsidiaries were not affected by that repeal, as FDWP had not applied to

them. How the CFC provisions applied going forward to NRS and its subsidiaries,

however, was not explained. What was agreed was that “no deductions [were] allowed

to the shareholder … in relation to [the] active income” of a CFC.

[55] What is reasonably clear is that with those changes in 2009 the rationale for

s DB 55 no longer existed. That is, the abolition of FDWP, and the nexus for

deductibility provided by the attribution of CFC income, eliminated the mismatch that

the section had been intended to address. That fact was, however, overlooked, as was

subsequently explained in the Officials’ Report to the Finance and Expenditure Select

Committee considering the Taxation (Annual Rates, Employee Allowances, and

Remedial Matters) Bill 2014, which proposed the repeal of s DB 55:34

When a New Zealand company receives a dividend from a foreign company,

the dividend is exempt from income tax. Section DB 55 allows deductions

despite the fact that the dividends are exempt from income tax.

The rationale for this, is that before 2009, the dividends were subject to a

special levy, known as “foreign dividend payment” or [FDWP] which was

equivalent to income tax.

In 2009 there was a major reform of New Zealand’s international tax rules.

This reform was designed to reduce tax barriers on New Zealand businesses

that expand offshore. It did this by exempting most types of income that

businesses earned through foreign subsidiaries. As part of this reform all tax

on foreign dividends paid to New Zealand companies, including [FDWP] was

removed.

In the course of implementing the 2009 reforms, the need to repeal section

DB 55 was overlooked. We are now seeking to repeal it as part of the current

bill.

Maintaining section DB 55 in the absence of [FDWP] would be contrary to

general tax principles of not allowing deductions which relate to exempt

income (now that the dividends are truly exempt). It would effectively be a

tax concession or subsidy.

…

34 Inland Revenue Taxation (Annual Rates, Employee Allowances, and Remedial Matters) Bill

Officials’ Report to the Finance and Expenditure Committee on Submissions on the Bill

(March 2014) at 256.

[56] Thus, and as that Report makes clear, in claiming deductions for expenses

incurred in deriving exempt dividend income, NRS was the unintended beneficiary of

a legislative oversight. In our view, however, that does not advance

the Commissioner’s argument.

[57] We therefore conclude that here the legislative history does not support

the Commissioner’s interpretation of s DB 55. Rather, taking account of the plain

words of the section, the statutory context and the recorded legislative intent, we think

the ambit of the deductibility provided by s DB 55 is to be decided in accordance with

the general principles that we have already explained.

Nexus

[58] The question then becomes whether the nexus between NRS’ expenditure and

the deriving of the exempt dividend income has the necessary characteristics to support

deductibility.

[59] As a holding company, NRS’ business was, as its witnesses described, to

promote the interests of its shareholder investors by maximising the value of their

investment. That is basic company law. At the same time, there can be little doubt

that the activities NRS engaged in for that overall purpose bore the necessary nexus

with the deriving of the dividends paid to it by its subsidiaries.

[60] Mr Gold’s evidence summarises the position well:

103 [NRS] was the group company shareholder, and its functions were as

described above, reflecting the four major cost types. Those costs and

functions were directed at building and managing the respective

businesses of the foreign companies, to make them profitable. [NRS]

was not itself running those foreign companies — each had their own

highly skilled and competent management teams, to run their

businesses (CEO, CFO, marketing and sales functions and

administration). [NRS’] costs were incurred in respect of the function

of providing group stewardship including financial control, leadership

and development. It would never have derived the dividends without

these functions, and the costs incurred in providing them.

104 [NRS] was not a passive investor of its share capital. Quite the

reverse. The Corporate Office team were totally active in every sense,

in driving the highest possible dividend returns, from the ongoing

stewardship of all the company’s capital and intellectual property.

105 In fact, the payment of Corporate Office costs was reliant on dividend

streams from the subsidiaries. From the practical perspective, it had

to incur the Corporate Office costs that are in issue here, in order to

derive those dividends.

[61] In our view, those comments illustrate why the necessary nexus did exist

between the expenditure and the exempt dividend income derived to make that

expenditure deductible.

Were NRS’ expenses of a capital nature?

[62] We therefore turn to the matter not addressed in the High Court: that is, the

significance here of the capital limitation.

[63] Section DA 2 of the 2007 ITA contains what are described as the

general limitations. These are overriding principles of non-deductibility. The first of

those reads as follows:

Capital limitation

(1) A person is denied a deduction for an amount of expenditure or loss

to the extent to which it is of a capital nature. This rule is called the

capital limitation.

[64] As subs (3) of s DB 55 makes clear, in allowing deductions incurred in deriving

exempt dividend income, the legislature did not override the capital limitation or the

other general limitations. The subsection provides:

Link with subpart DA.

(3) This section overrides the exempt income limitation. The general

permission must still be satisfied and the other general limitations still

apply.

[65] So, notwithstanding our conclusion that the necessary nexus between the

expenses incurred and the exempt dividend income derived exists, if those expenses

are properly categorised as being of a capital nature, then they will not be deductible.

Submissions

[66] The Commissioner’s argument here is that the subsidiaries were capital assets

of NRS and therefore expenditure in respect of improving the value of such assets is

capital in nature. It did not matter, the Commissioner argued, that the expenditure was

recurrent nor of a category that could, in other circumstances, be considered to be in

respect of revenue. Whether the expenditure is capital or revenue is determined by the

nature of the asset acquired or improved by the expenditure. The Court of Appeal has

called this the “identifiable asset test”.35 The asset improved by the expenditure here

was, the Commissioner argued, NRS’ subsidiaries. Those assets “were part of the

business structure of [NRS] that is held on capital account”.

[67] That was, NRS responded, a rerun of arguments designed to limit interest

deductibility unsuccessfully advanced in a series of decisions culminating in this

Court’s decision in Commissioner of Inland Revenue v Brierley.36 Those cases concern

the extent of the deductibility of interest provided for by s 106(1)(h) of the 1976 ITA.

The question was whether deductibility could be declined to the extent that the capital

in respect of which the interest was being paid itself increased in value in a

non-assessable way. Mr Harley pointed to the following extract from the decision of

Richardson J in Brierley in support of his argument:37

The legislature must be taken to have well understood that capital employed

in income earning activities may in the course of those activities change in

value and that the owner may derive capital returns in variety of forms. On a

narrower view it might be said that such an asset is always employed in the

production of both assessable income and prospective capital benefits.

However it would be contrary to both past practice and to the principle that

income is a flow reflecting the fruit of the tree to treat the existence of actual

or prospective capital appreciation or actual or prospective capital returns as

providing a basis for the apportionment of interest expenses. It would also be

inconsistent with the scheme of the legislation, and in particular the specific

and limited provisions for clawback of interest, to refuse deduction for an

assumed capital element of interest under s 106(1)(h).

[68] By analogy, Mr Harley argued that the fact that NRS’ activities might have

increased the value of its subsidiaries did not disentitle NRS to the deduction allowed

by s DB 55.

[69] We can see that argument: but the distinction here is the Commissioner’s

reliance on the general capital limitation. Given that Parliament explicitly retained the

35 The Commissioner cited Commissioner of Inland Revenue v McKenzies (NZ) Ltd [1988]

2 NZLR 736 (CA) in support. 36 Commissioner of Inland Revenue v Brierley [1990] 3 NZLR 303 (CA); Pacific Rendezvous Ltd v

Commissioner of Inland Revenue [1986] 2 NZLR 567 (CA); and Eggers v Commissioner of Inland

Revenue [1988] 2 NZLR 365 (CA). 37 At 310–311.

general limitation on the deductibility of expenditure of a capital nature when

providing for deductibility with respect to exempt dividend income, it clearly provided

a different scheme from the one Mr Harley based his argument on.

[70] It is therefore necessary to address this aspect of the Commissioner’s argument

in terms of first principles and by considering NRS’ expenditure from a practical and

business point of view.

The law

[71] The approach in New Zealand is now settled, as this Court’s decision in

Easy Park Ltd v Commissioner of Inland Revenue shows.38 The governing approach

is summarised by the observations of Lord Pearce in BP Australia Ltd v Commissioner

of Taxation of the Commonwealth of Australia, adopted by this Court in Commissioner

of Inland Revenue v Thomas Borthwick & Sons (Australasia) Ltd:39

The solution to the problem is not to be found by any rigid test or description.

It has to be derived from many aspects of the whole set of circumstances some

of which may point in one direction, some in the other. One consideration

may point so clearly that it dominates other and vaguer indications in the

contrary direction. It is a commonsense appreciation of all the guiding features

which must provide the ultimate answer. Although the categories of capital

and income expenditure are distinct and easily ascertainable in obvious cases

that lie far from the boundary, the line of distinction is often hard to draw in

borderline cases; and conflicting considerations may produce a situation where

the answer turns on questions of emphasis and degree. That answer:

“depends on what the expenditure is calculated to effect

from a practical and business point of view rather than upon

the juristic classification of the legal rights, if any, secured,

employed or exhausted in the process”:

per Dixon J in Hallstroms Pty Ltd v Federal Commissioner of Taxation. As

each new case comes to be argued felicitous phrases from earlier judgments

are used in argument by one side and the other. But those phrases are not the

deciding factor, nor are they of unlimited application. They merely crystallise

particular factors which may incline the scale in a particular case after a

balance of all the considerations has been taken.

38 Easy Park Ltd v Commissioner of Inland Revenue [2018] NZCA 296, (2018) 28 NZTC 23-066. 39 BP Australia Ltd v Commissioner of Taxation of the Commonwealth of Australia [1966] AC 224

(PC) at 264–265 (footnotes omitted); and Commissioner of Inland Revenue v Thomas Borthwick

& Sons (Australasia) Ltd (1992) 14 NZTC 9,101 (CA) at 9,103.

[72] The courts have also identified a number of relevant, but not determinative,

indicators. These include the “enduring benefit test”,40 the “fixed or circulating capital

test”,41 and whether the expenditure was recurrent. Ultimately, however, the focus

must be on what the expenditure was calculated to effect from a practical and business

point of view.

[73] With that in mind, it is necessary to briefly summarise the nature of NRS’

business. As noted above, NRS is the parent company of subsidiaries incorporated in

foreign jurisdictions. The subsidiaries provide and maintain systems that facilitate

sales of radio and television advertising space by the subsidiaries’ clients. The

intellectual property in the systems has, at all material times, been held by Persuaders.

The High Court summarised:42

The function of the Head Office was to manage NRS’ share capital invested in

the subsidiaries. NRS managed the subsidiaries by establishing and managing

strategic and business plans; executing projects to increase profitability;

reviewing financial performance; receiving reports from the subsidiaries;

regularly visiting each subsidiary; and reporting to the Board on a monthly

basis.

[74] NRS took issue with that synopsis on appeal — it claimed “each subsidiary had

its own independent Board of Directors, Chief Executive, Chief Financial Officer and

operating staff”. This is reflected in Mr Gold’s evidence, as set out above at [60].

[75] The Commissioner relies on selected pieces of evidence to support her

argument, including:

(a) the agreement between NRS and Persuaders, which noted that the

funding of the head office was to ensure the “ongoing development and

successful management of the [group]”;

(b) Mr Gold’s brief of evidence, which noted that oversight of the

subsidiaries included expansion into new markets, new product

40 Commissioner of Inland Revenue v Trustpower Ltd [2015] NZCA 253, [2015] 3 NZLR 658 at [62]. 41 Commissioner of Inland Revenue v Inglis [1993] 2 NZLR 29 (CA). 42 NRS Media Holdings Ltd v Commissioner of Inland Revenue, above n 1, at [6].

development, and existing product improvement and business

development”; and

(c) the expenditure included the establishment of business plans, making

of surplus profits that were not only paid out as dividends but reinvested

within the group, and the development and improvement of products.

[76] In our view, however, that does not properly reflect the nature of NRS’

business. NRS’ business operations were, fundamentally, the oversight of its

subsidiaries. As Mr Gold explained at one point in his brief of evidence, the real value

in the media business operated by NRS and NRS’ subsidiaries was in the intellectual

property of their business systems. From a practical and business point of view, NRS’

expenditure was calculated to simply facilitate the operations of the subsidiaries rather

than to improve the capital of the subsidiaries. In this respect, the expenses for which

NRS claimed deductions represent recurrent and regular business expenses — payroll

and consultants, marketing and travel, rent and occupancy, and overheads. These are

all manifestly revenue expenses. In our view, NRS ought to be entitled to a deduction

for these expenses.

Result

[77] The appeal is allowed.

[78] The appellant is entitled to deductions totalling $1,706,568.23 and

$1,963,472.31 in the 2011 and 2012 years respectively.

[79] The respondent must pay the appellant costs for a standard appeal on a band A

basis and usual disbursements.

[80] Any order for costs in the High Court is quashed. Costs in the High Court are

to be determined by that Court in accordance with this judgment.

Solicitors: Chapman Tripp, Wellington for Appellant Crown Law Office, Wellington for Respondent