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Deductibility of Retention Payments

The Inland Revenue Department (IRD) has released a Technical Decision Summary regarding whether retention payments are deductible under S DA 1 of the ITA 2007 and in which income year.

Decision

The Tax Counsel Office (TCO)decided that retention payments are deductible under S DA and s BD 4 allocates the deduction to the income year in which the payments were made. 

The council also decided that the capital limitation in s DA 2(1) does not apply to deny a deduction (except for capital portion).

Key issues and Reasons for Decisions

The reasons behind these decisions are the following:

The General Deductibility Rules

Subpart DA provides the general rules for deductibility. Section DA 1(1)(b) provides for the deductibility of expenditure incurred in the course of carrying on a business for the purpose of deriving assessable income. The first limb requires a nexus with the deriving of assessable income, and the second a nexus with the carrying on of a business. There must be a sufficient relationship between the expenditure and deriving of income.

Timing

Section BD 4 provides the general rule that a deduction will be allowed in the income year that the expenditure is incurred unless there is a specific provision stating otherwise. TCO considered that the starting point must be that the Retention Payments were incurred when they were paid on the basis that is when the obligation to pay them arose. Therefore, in accordance with s BD 4 the deduction for the Retention Payments (other than the Capital Portion) is allocated to the income year (or part income year) in which the payments were made.

Capital Limitation

TCO considered that this issue was very finely balanced because the Retention Payments, while incurred as an incentive to retain key staff, were also incurred during the Sale Transaction (i.e., disposing of a capital asset). The Applicants stated that the purpose of the Retention Payments was the continuity of key staff in Company A while its options were being considered, prior to the Sale Transaction. The expenditure on the Retention Payments was calculated, from a practical and business point, to affect the retention of staff in the business while the possible sale of the business was considered.

On balance, TCO concluded that the Retention Payments were revenue (and not capital) in nature. Therefore, the capital limitation does not apply.

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