Taxing but Interesting
Tax is an inevitable part of doing business. Even with the changes to align provisional tax payments more closely with GST, it still remains the case that cash-flow will mean that when time comes to pay the taxman, there may not be sufficient free cash. If a non-company taxpayer borrows, will the interest be deductible?
This article summarises IRD’s views on the topic and questions whether that view is correct.
Tax Treatment of Interest
In pure economic theory, there are strong arguments for recognising all interest as deductible –Valabh Committee, Final Report of the Consultative Committee on the Taxation of Income from Capital  para 7.4.1. However for revenue protection reasons this has never been (and is not likely to be) implemented fully – although the general provision for companies in section DB 7 ITA 2007 is a partial reflection of this approach.
Instead a non-company deduction for interest must satisfy the “general permission” whereby a deduction is allowed under section DA 1 to the extent it is incurred in deriving income or incurred in the course of carrying on a business for the purpose of deriving income. The only apparently relevant “general limitation” is the denial of deduction for expenditure to the extent to which it is of a private or domestic nature (section DA 2(2)).
Relevant extensions or illustrations of the breadth of nexus possible are shown in the cases of Public Trustee v C of T  NZLR 436 (CA) (“Public Trustee”)where trustees of an estate had to borrow funds to pay death duties. Their only alternative had been to sell assets to raise the money for the death duties but instead they borrowed and incurred interest, which they deducted against the income generated from the assets held by the estate.
The Court ruled in favour of the taxpayer, saying provided the expenditure was not involuntary and had been used to preserve business (not private) assets, then interest was permitted. The Australian case Begg v FC of T (1937) 4 ATD 257 had facts similar to Public Trustee and was also decided in the taxpayer’s favour. A liability for interest paid on moneys borrowed by an executor to pay succession and estate duties was deductible because it preserved an income earning asset.
Inland Revenue Views
IRD have issued original (in TIB Vol 3, No 9, June 1992 at p 14) and then amended (in TIB Vol 18, No 6, July 2006 at p 9) Policy Statements, which deal with interest deductibility in general and also the scope and application of the Public Trustee principle. Both papers treat the Public Trustee principle as paramount – i.e. that interest on borrowings to pay tax will only be deductible if the taxpayer would otherwise have had to sell income-producing assets. The 2006 paper discusses the issue at paras 131 and 132, stating:
131. In TIB Vol 3, No 9 the Commissioner’s view of the Public Trustee decision was stated to be as follows:
Interest is deductible if a taxpayer establishes that the capital was borrowed to meet involuntary expenditure to retain assets used in producing assessable income. However, if the capital was borrowed for purposes quite alien from the income producing asset (such as meeting personal obligations), the interest will not be deductible. The onus is on the taxpayer to establish that the interest is deductible, and what portion of it is deductible.
132. The view in the TIB is that the liability must be involuntary, and that the liability met with the borrowed funds must not be “alien” from the income producing assets, or, in other words, must be connected in some way with the income earning assets. In these respects, the view in the TIB and the view in this statement are similar. This statement analyses in more depth when borrowing retains income earning assets, and concludes that for assets to be retained, the taxpayer must at least prove that the borrowing prevented a realization of income earning assets. Also, the Commissioner has clarified that a private use of the funds will not on its own prevent a deduction of the interest, and, that in such a situation, interest may be deductible if there is another use of the borrowed funds that has a sufficient connection with assessable income to establish deductibility.
Alternative to Public Trustee Considered and Rejected
The 2006 paper at paragraph 127 considers but rejects the possibility of the general permission in section DA 1 as being broad enough to apply to interest incurred in respect of expenditure not directly connected with the income earning activity, without the need to resort to or rely upon the Public Trust principle.
The reasons for Inland Revenue’s rejection of this possibility are that payment of tax is a payment made after income has been derived, relying on those of Lord Normand in Smith’s Potato Estates Ltd v. Bolland (Inspector of Taxes); Smith’s Potato Crisps (1929) Ltd v Inland Revenue Commissioners  2 All ER 367 (HL) (“Smith’s Potato Crisps”) at 376. This part of the judgment discussed in an obiter way whether there could be a deduction for a tax payment and held not, because the payment of tax represents an application of derived income, rather than an expense incurred in deriving income.
Deductibility of Use of Money Interest
UOMI paid to a taxpayer is deemed to be gross income of that person and subject to resident or non-resident withholding tax. Interest is assessable to the taxpayer in the income year in which it is refunded or applied against some other tax liability. Correspondingly, UOMI paid by a taxpayer should be deductible where the taxpayer is in business, and this has been confirmed as the Inland Revenue view (although it has been advised that this is under review) – see eg TIB Volume Five, No. 11 April 1994.
An Alternative View?
It is strongly arguable, in the writer’s view, that interest on funds borrowed to pay provisional tax will be deductible even when the Public Trustee criteria cannot be satisfied.
A factor which is apparent is that this is an area where the Courts give due regard to structural choices which taxpayers make as to whether borrowing will be applied to business as opposed to private purposes – regardless of whether those choices result in an unfortunate outcome for the taxpayer (e.g. Borlase v CIR (2001) 20 NZTC 17,261 (HC) compared with Case M29 (1990) 12 NZTC 2,174);
Given it is a legitimate and accepted structural choice to fund business-related expenditure from borrowings regardless of whether or not private assets could be realised, the ratio of Public Trustee has to be understood as being that interest is deductible if the borrowing prevents the sale of business assets (and therefore has a necessary connection with the business) rather than only if the borrowing prevents the sale of business assets (i.e. the necessary connection can exist because of other reasons). The IRD papers seem to fall into the trap of treating “if” as meaning “only if”.
It is clear that expenditure will be deductible where it has to do with running a business even when the income-earning process has been conceptually and temporally completed – in circumstances that therefore have no nexus with deriving assessable income. See for example Case L89 (1989) 11 NZTC 1,508 where it was accepted that interest on a business’s loan would continue to be deductible after the business had finished trading and its affairs were being tidied up.
It is also clear that, conceptually, deductions for interest on tax payments are available in at least some circumstances which have no necessary connection with satisfying the Public Trustee criteria:
· There is an explicit carve out for deductibility of tax payments in section DB 1 (implicitly therefore, absent that, even tax payments might be deductible),
· Inland Revenue allows deductibility of UOMI (which has no more nexus with income-earning process or carrying on business than borrowing to pay the tax in the first place), providing the other deductibility tests are made – this would be nonsensical if UOMI could never be deductible because of, for example, the Smiths Potato Crisps principle;
· Interest on foreign tax is excluded under section DB 1 if that interest is of the same nature as penalties – implicitly therefore it is deductible if not of same nature as penalties, provided of course other deductibility tests are made out.
Provisional tax also has features which distinguish it from those aspects which led the House of Lords in Smiths Potato Crisps to hold that tax payments were unconnected with the carrying on of a business for deriving income:
· Provisional tax is predominately calculated on the past year’s profits (section RC 5) and payable during the income year to which it relates (section RC 9);
· Interest is payable for default on payment of the calculated amount by the due date (section 120KB Tax Administration Act 1994);
· Payment of provisional tax will often take place temporally prior to the receipt (or at least, and more importantly, the entitlement to receipt) of the income in respect of which it is paid, and is calculated independently of that income;
· The payment of provisional tax therefore impacts on the profit-making process in respect of which it is paid, and is not logically or temporally subsequent;
· Hence the reasoning which commended itself to the majority in the Smith’s Potato Crisps case is simply inapplicable – Provisional tax is set and paid based on the income, profits and gains of the previous year and not as with income tax on the income earned in the year of assessment itself. Moreover it is paid during the income tax year, not afterwards. Therefore the payment of provisional tax directly (and the imposition of UOMI if it is not paid) affects the profits or losses of the income year in respect of which it is paid.
It follows that any expenditure incurred in meeting the provisional tax burden would therefore be laid out wholly and exclusively for the purposes of business, and would be deductible under the general permission.
While this reasoning might also allow a deduction for provisional tax, this is specifically excluded by section DB 1(1)(c).
There seems to be a lot to be said in favour of interest on funds borrowed to pay a business’s provisional tax being deductible, and the current IRD views may be unduly restrictive.
 Arthur Murray (NSW) Pty Ltd v C of T 114 CLR 314