Commissioner of Inland Revenue v National Distributors Limited
Application of section CB3 of Income Tax Act 2007 (current section)
Facts of the case:
• The taxpayer company was a member of Self Help Group of Companies owned by the Sutherland family. The principal business of the group was investing in properties to earn rental income.
• Cash surplus from trading operations were invested in the purchase of 11 listed companies on NZX.
• Total investment in shares of $107k derived $12k dividend and net gains on sale of $42k
• shares in question which were sold in the 1980 and 1981 years were held for varying periods between 8 months and 3 years
• The investment in shares was very small portion (7%) of group investments & it involved very little time of the managing director. All sale & purchase decisions were primarily taken by the managing director, Mr John Sutherland, who held that position for over 35 years until shortly before his death in 1986.
• His son, Mr GJ Sutherland, in his capacity as executive director he sought approval from the Inland Revenue Department for a tax free distribution to shareholders from profits of $40,744 arising on the sale of listed shares in the year ended 30 June 1981.
• The Department declined approval considering that the gains in question were assessable income of the taxpayer, and not exempt income in the hands of individual shareholders
Section 65 of Income Tax Act 1976 outlines items included in assessable income of taxpayer:
65 2 (a) All profits or gains derived from any business
65 2 ( e) All profits or gains derived from the sale or other disposition of any personal property or any interest therein (not being property or any interest therein which consists of land within the meaning of section 6 of this Act), if the business of the taxpayer comprises dealing in such property, or if the property was acquired for the purpose of selling or otherwise disposing of it, and all profits or gains derived from the carrying on or carrying out of any undertaking or scheme entered into or devised for the purpose of making a profit:
Key point here:
- Profit or gains made from selling shares if the shares were acquired for the purpose of selling/making profit.
When the purpose of buying shares is to generate enough returns over inflation rate, would this situation come under the scope of the second limb of sec 65(2)(e) of the Income Tax Act 1976.
Argument by the Commissioner:
The gains were business profits within sec 65(2)(a); that they were profits from a business of dealing in property. And that they were profits derived from a profit making undertaking or scheme within sec 65(2)(e) under which assessable income is deemed to include:
“all profits or gains derived from the sale or other disposition of any personal property ... if the property was acquired for the purpose of selling or otherwise disposing of it ....”
The purpose was to make profit, that purpose is sufficient to apply the section.
Argument by the Taxpayer:
• There was no regular or systematic review of shareholdings.
• No business requirement to generate more profit.
• Argued investment in shares were long term investment plan to keep up with inflation.
• Any private investor in shares is likely to follow the movements of stock position and will sell at a favourable time. This is a normal process of the management of assets
• Suggested capital gain was possibility but not the main purpose, the motive was to keep pace with inflation i.e. management of portfolio in such a way so that investment are protected against inflationary increases.
• When the dominant purpose was not to sell/make profit sec 65(2)e cannot be applied.
Majority court decision:
- Section 65(2) is expressed as a deeming provision, second limb of the section focuses on profits derived from the sales of shares if they were acquired for the purpose of sale.
- Test of purpose is subjective requiring consideration of the state of mind of the purchaser, if there are more than one purpose the whether the dominant purpose was one of sale. There is a distinction between motive and purpose.
- Hunter and Holden case judgement was material to this issue, taxpayers wanted to remit funds to New Zealand. Taxpayers purchased government stock in sterling and immediately sold in New Zealand for dollars, rather than remitting the funds to New Zealand through banking channel.
o The motive which inspired the transactions was no doubt that they provided an advantageous method of remitting funds from England to New Zealand, but that in acquiring the stock the taxpayer had done so for the purpose of selling it again. The dominant purpose of the purchase of the stock was sale.
o Second action would not have occurred without happening first,
- To describe a purchase as a hedge against inflation may not provide tax immunity, shares were purchased for the purpose of sale. Overall motive was to maximise the returns but that would not have occurred without action the sale.
- The taxpayer has the onus of proof that the property in question was not acquired for the purpose of sale or other disposal.
- The nature of the asset is always an important consideration. Some assets may be intended for private use and enjoyment other provides economic reward. Shares in listed companies can scarcely be regarded as intended for private use or enjoyment.
- The length of time the shares are held before being sold is regarded as of particular importance. If they are held for a period of years during which time the market has moved upwards and downwards, that is a factor tending to displace the proposition that the shares were acquired for the purpose of sale.
- Assets may have acquired by a taxpayer who has no clear purpose in mind. There may be no more than an intention to buy with the expectation of benefiting the taxpayer's financial position in some unformulated way, and without any clear consideration of the advantages of either retention or resale sooner or later. If that state of affairs is established the statutory onus on the taxpayer to prove that the shares were not purchased for the dominant purpose of sale will have been satisfied. To put it another way, to discharge the onus it is not necessary to establish some other specific purpose.
- Shares held for an average of 19 months seems doubtful to treat as long term investments.
Minority court decision
In the ordinary world property is not acquired for sale at any price. The only situations are auction with no reserve, reduce to clear or liquidation.
- In Williams Property Developments Ltd v C of IR (CA) (1980) 4 NZTC 61,537 at p 61:
o “If a person buys a piece of land because he believes that it will go up in price and that he will then be able to resell it at a profit then it seems open to regard resale at a profit as his dominant purpose even though his ability to fulfil that purpose depends on the contingency of a rise in value.”
- The acquisition was a “hedge against inflation”, it is not for the purposes of profit or gain.
- The taxpayer's purpose can be the avoidance of loss in the real value of the money. This is quite a different purpose from the purpose of seeking to achieve a profit or gain.
- If the legislature intends the second limb to be a simple capital gains tax, then the outcome would have been different but in the absence of that this transaction/outcome cannot be held part of assessable income.
- Capital windfall: cash issue entitlement cannot be disregarded. As the taxpayer received the offer of share which was not available to the general investor.
- Fletcher shares were sold not because they had been acquired for the purposes of resale, but because of a reconstitution of Fletchers, with the shares being sold because of the late Mr John Sutherland's uncertainty about the future management of Fletchers.
- In the case of the Brierley shares, it has to be noted that a significant aspect of the difference between cost and resale prices appears to relate directly to the substantial increase in the holding, flowing from the cash issue entitlement from which 3,167 shares were acquired for $1,459.50, ie 46 cents per share, as against the original holding which had cost something in the order of $2.28 per share. It is difficult, therefore, to treat the apparent capital appreciation of $11,629.45 at its face value.
- The dominant purpose of acquisition of the shares in question lay in a mixture of income production and avoiding loss in the purchasing power of the taxpayer's money or, alternatively, that there was no clear dominant purpose, and there was not a dominant purpose of resale.
It was an appeal by the commissioner against High Court judgement where profit making from selling shares was treated as not a part of taxpayer’s assessable income.
Overall there were two things which stand out if those things were present in the case the outcome would have been different:
1. Label of the transaction; the taxpayer labelled the transaction as “protection against inflation”. If the label would have been different such as purchase of shares for building capital for future generations of the family.
2. Tenure of investment; decision of sale should not have been made in very short time. If the shares were held for a longer period.
CB 3Profit-making undertaking or scheme ITA 2007, is the current section which corresponds to this case:
An amount that a person derives from carrying on or carrying out an undertaking or scheme entered into or devised for the purpose of making a profit is income of the person.