Commissioner of Inland Revenue v Peterson [2003] NZCA 27; [2003] 2 NZLR 77; (2003) 21 NZTC 18,060 (19 February 2003)

Last Updated: 18 December 2011

IN THE COURT OF APPEAL OF NEW ZEALAND

CA50/02

	BETWEEN	THE COMMISSIONER OF INLAND REVENUE
		Appellant

	AND	RICHARD DALE PETERSON
		Respondent

Hearing:	2 and 3 December 2002
Coram:	Gault P Keith J Anderson J
Appearances:	J H Coleman and R J Wallace for Appellant C R Carruthers QC and B M Brown for Respondent
Judgment:	19 February 2003

JUDGMENT OF THE COURT DELIVERED BY GAULT P

[1] The respondent taxpayer claimed as a deduction from his taxable income in the 1985 and 1986 income years his shares of losses of a special partnership. By an amended assessment the Commissioner disallowed parts of the deductions essentially on the ground that certain claimed expenditure was not in fact incurred by the partnership. The taxpayer’s objection was upheld by the Taxation Review Authority (TRA) by decision given on 12 March 1999. The Commissioner’s appeal to the High Court was dismissed in a judgment delivered by Hammond J on 19 February 2002. The present appeal is against that judgment.
[2] The partnership was formed as a vehicle for investment in a motion picture film. The special partners, including the taxpayer, agreed to invest, on the basis of the limited liability provided under Part II of the Partnership Act 1908 (s50), the sum of $1.2 million as partnership capital. This sum, together with the further sum of $1.56 million to be raised by a “non-recourse” loan, was to meet the costs in producing and marketing a film entitled “The Lie of the Land”. In the relevant period the production costs of a film could be capitalised and fully depreciated over two years. By the Commissioner’s ruling IR52.3 investors in films were entitled to offset their shares of the costs of producing or marketing films so capitalised and depreciated against income from other sources. The partnership treated in this way the total sum of $2.76 million. The Commissioner maintains that in fact the amount of the non-recourse loan was never applied in the production of the film. The taxpayer’s position is that whether or not the $1.56 million was applied in producing the film it formed part of the total sum paid by the partnership in acquiring the film so that the deductions made are unobjectionable. The Commissioner’s position, on the other hand, is that although the partnership purported to pay $2.76 million for the film, in fact only $1.2 million was paid so that the taxpayer’s claimed share of the loss rightly was reduced proportionately.
[3] At the heart of the matter is an issue of fact. It relates to the $1.56 million the subject of the non-recourse loan. There is no doubt it was advanced by the lender to the partnership. It was lodged to the credit of the partnership in a trust account in England. The Commissioner contends that from there it went in a circle back to the lender, repaying the loan, and was never applied to the production of the film. The taxpayer says that it was disbursed from the trust account in payment for the film and what happened thereafter has no relevance.
[4] Before the TRA the focus was on whether the non-recourse loan was a sham. It was held it was not. Before the High Court the issue was whether the Commissioner’s adjustment disallowing the deduction in issue was justified on the basis that it counteracted a tax advantage obtained by the taxpayer from or under a tax avoidance scheme within s99 Income Tax Act 1976. It was held it was not because the taxpayer had no knowledge of the dealings involving the $1.56 million and therefore was not party to any s99 arrangement. Hammond J agreed with the TRA that the partnership paid $2.76 million for the film in a commercially credible transaction in which the loan moneys were drawn down so that the deductions were allowable.
[5] The contention of the taxpayer, upheld by the TRA and the High Court, is that the deduction is allowable whether or not the loan moneys went in a circle back to the lender.
[6] It is necessary to introduce some facts. A Mr Grahame McLean was a film producer. He organised the financing of production and possible marketing of “The Lie of the Land”. A company of which he was director was South Pacific Broadcasting Corporation Ltd (SPBC). The special partnership was formed with this company as the general partner and the investors, including the taxpayer, as the special partners. The partnership entered into a production deed dated 13 May 1984 with Filmcraft Productions Ltd (Filmcraft) of which Mr McLean was the governing director. By that deed the partnership agreed to manage and operate the project exercising control and management functions through SPBC. The project was defined as extending to production, post-production, marketing and exploitation of the film. Filmcraft undertook on behalf of the partnership to commence and proceed with the production of the film and to manage on behalf of the partnership the affairs of the project. The performance by Filmcraft was guaranteed by Mr McLean. The partnership contracted to contribute to the project $2.76 million which sum corresponded with the “total budgeted expenditure”. This was to be disbursed at the direction of SPBC. The proportionate contributions of the individual investors were conditional upon not less than 50% being received under the deed of loan entered into between the partnership and Steadfold Ltd (Steadfold). Under the production deed the partnership was to receive the net proceeds of exploitation as defined.
[7] The deed of loan dated 5 July 1984 described the lender, Steadfold, as of Andorra, though it subsequently emerged that it was incorporated in England. Steadfold agreed to advance to the partnership $1.56 million to finance production of the film the total cost of the project being stated as “approximately” $2.76 million. The critical provisions in the deed are clause 3(a) to (d) which read:

3. (a) For the purpose of securing repayment of the Loan:-

(i) The Borrower hereby assigns to the Lender the right to exploit and market the Film in the home video market in the United States of America (“the Territory”). All moneys received from home video sales or licences or arising out of or in connection with the exploitation of the home video market in the Territory shall after the deduction therefrom of the marketing expenses actually incurred by the Lender be applied in repayment of the Loan.

(ii) In addition the Borrower agrees that all Net External Revenue shall be applied in repayment of the Loan and that the Net External Revenue shall be paid to the Lender until the Lender shall have received payment of the Loan and interest thereon (if demanded) at a rate not exceeding ten per centum per annum (10% p.a.) calculated on a daily basis with yearly rests from the date of advance of the Loan or any instalment thereof.

(b) Notwithstanding any other provision hereof, no External Revenue shall be remitted to the Lender until one (1) year after the date upon which the Loan or last instalment thereof shall have been drawn down by the Borrower.

(c) Except that the Lender shall be entitled to receive repayment of the Loan and interest out of the Net External Revenue as hereinbefore provided, the Lender shall have no recourse against the Borrower in respect of the Loan or interest thereon.

(d) After repayment of the Loan and interest thereon the net proceeds of the exploitation and marketing of the home video market in the Territory shall be paid to the Borrower.

[8] The deed of loan was executed under the seal of Steadfold, the affixing of which was attested to by a Mr Rutherford as Director.
[9] The partnership appointed South Pacific All Media Distributors Ltd (SPAMD) to market and distribute the film. Mr McLean was the governing director of that company also.
[10] By further documents executed on the same day as the deed evidencing the loan from Steadfold to the partnership a company Creative Arts Ltd (CAL) of Jersey in the Channel Islands executed in favour of the partnership a “completion guarantee” guaranteeing completion of the film by Filmcraft and Filmcraft executed performance covenants in favour of CAL.
[11] Before that, on 14 June 1984 an agreement had been entered into by CAL, Filmcraft and SPAMD. Under this agreement CAL agreed to procure acting and other services for Filmcraft and Filmcraft agreed to pay to CAL $1.56 million. This was over and above any expenses CAL might be required to pay to the actors which Filmcraft was to reimburse. The services to be procured were the acting services of a named actor, a completion guarantee (in fact provided by CAL) and certain advisory and negotiation services primarily in connection with overseas exploitation of the film.
[12] The film was duly made but was not commercially released.
[13] The Commissioner, after enquiries, formed the view that although the non-recourse loan was advanced by Steadfold to the partnership by deposit in a trust account in England, the sum of $1.56 million was, the same day, paid in England to CAL at the direction of Filmcraft and then paid by CAL to Steadfold in repayment of the loan. English registry authorities advised that Steadfold had not traded as at October 1984 and was dissolved in March 1987.
[14] The tax investigator, Mr Nash, ascertained that, although CAL had some representation in Jersey, the company was registered in Liberia having been incorporated on 14 November 1983 and was administered by the London accountants Leigh Carr & Partners (M Ralph de Souza) through whose trust account the funds passed. Such information as he was able to obtain indicated that Mr McLean exercised control over this company.
[15] Mr Nash located a file in Mr McLean’s office. It was labelled “LOL/Y financial cocktail”. In that file a memorandum for the information of the Associate Producer of “Lie of the Land’ marked “confidential” and headed “National Affiliates” referred to CAL as a company “we have” in Jersey. In the same file there was a note stating:

Asked J Ruther to lend money + circle same day ... Loan agreement in name of Steadfold.

[16] There was a further note in Mr McLean’s writing setting out the text of two telex messages as follows:

TELEX TO LONDON 88488 LEICAR

ATTN: RALPH DE SOUZA

RE CREATIVE ARTS LTD

PLEASE PROCEED WITH

ESTABLISHMENT OF TRUST.

THANK YOU

GRAHAME MCLEAN

And

TELEX TO LONDON 88488 LEICAR

ATTN: RALPH DE SOUZA

RE: SOUTH PACIFIC BROADCASTING CORPORATION LIMITED AND COMPANY,

(SPECIAL PARTNERSHIP)

FORMED ON 30TH DAY OF APRIL 1984 UNDER LYNETTE SHAW,

WELLING ACT 1955

1. YOU WILL RECEIVE A CHEQUE FROM STEADFOLD LIMITED FOR UK£702,000.
   
2. PLEASE DEPOSIT SAME IN LEIGH CARR TRUST ACCOUNT THEN ESTABLISH ESCROW FOR SPECIAL PARTNERSHIP
   

P.T.O.

3. SEND TELEX TO EUAN WRIGHT ARTHUR YOUNG & CO TX

NO

ADVISING THAT YOU HAVE

RECEIVED FUNDS BEING

LOAN FROM STEADFOLD

AND REQUEST INSTRUCTIONS

4. YOU WILL RECEIVE INSTRUCTIONS BY TELEX TO PAY CREATIVE ARTS LTD
   
5. CREATIVE ARTS WILL REPAY THE LOAN
   

I SHALL BE AVAILABLE AT WELLINGTON

NZ 64 (04) 670 484

FROM NZ 20:00 HOURS TODAY

REGARDS GRAHAME MCLEAN

[Doc 43]

[17] It is common ground that at the prevailing exchange rate £702,000 was the equivalent of $1.56 million.
[18] Such (draft) accounts of Filmcraft as could be located did not show receipt of the full amount of $2.76 million. But the available evidence pointed to the telex instructions having been acted upon.
[19] Because the film was never released the negotiation and advisory services CAL contracted to provide were not required. The actor was employed. Documents indicated that negotiations to procure her services were conducted by Filmcraft and Mr McLean. Payments were made by Filmcraft. The Associate Producer’s services were contracted for in the name of CAL but seemingly that matter was arranged by Mr McLean. The investigator did not uncover evidence of any services in fact provided by CAL.
[20] Not surprisingly, the Commissioner formed the view that this was an elaborate arrangement to give to the investors in the partnership the impression that loan funds were obtained and applied in the production of the film. That increased the amount they were able to deduct against other income as their shares of the partnership losses (at $1,300 for every $1,000 invested, at the 66% rate then applicable) whereas the loan moneys were never so applied and were returned the same day to the “lender”.
[21] Although he was a director and the Secretary of the general partner responsible for the management of the partnership and supervision of the film project, Mr McLean gave no evidence before the TRA. The case for the taxpayer concentrated on the non-recourse loan and proof that the $1.56 million was in fact advanced to the partnership and disbursed at the direction of Filmcraft thereby reflecting operation of the deed of loan and the production deed according to their terms. That is perhaps understandable since the primary focus appears to have been on whether the loan transaction was a sham.
[22] In his decision the TRA would not countenance the suggestion of sham. He stated.

The Commissioner contends that because of the instruction in doc 43 the result which obtained in the Ensign Tankers case [Ensign Tankers Leasing Ltd v Stokes [1992] 2 All ER 275] should apply here and I should treat the loan transaction as self-cancelling and disallow that part of the purported expenditure. In the context of the sham argument there is no evidence this is so. To the contrary as discussed above the loan was paid to Creative Arts to provide specified services. It may be an open question whether or not Creative Arts performed its bargain by supplying all of the services for which it was contractually responsible, but the fact remains that the Partnership remains liable on the loan according to its terms. If the film were revived and revenue generated there is nothing on the evidence to prevent Steadfold from claiming back the money owed to it. The fact that no such revenue is available is Steadfold’s contractual risk. It is not in any way suggestive of a sham transaction.

[23] He held that the partnership purchased the film and the rights to market and distribute it for $2.76 million and assumed a liability to Steadfold of $1.56 million. That, he determined, was no more than a straightforward commercial transaction. Those conclusions contrast sharply with those arrived at in respect of a similar financing arrangement for a different film in which the same taxpayer invested: Case U32 (2000) NZTC 9302. That matter is the subject of a separate judgment to be delivered contemporaneously with the present judgment.
[24] The TRA went on to determine that, because the tax losses flowed from a genuine commercial transaction the “arrangement” did not have the purpose or effect of tax avoidance within s99.
[25] The Commissioner did not persist with the sham argument. On appeal to the High Court by way of case stated, although the question posed was stated generally as whether the TRA erred in reducing the claimed losses, the Commissioner relied on the power in s99 to counteract a taxation advantage obtained from or under a tax avoidance arrangement. By the time the case was heard in the High Court the judgment of this Court had been delivered in CIR v BNZ Investments Ltd [2002] 1 NZLR 450. In that case (which is on further appeal) it was held that for there to be an arrangement caught by s99 there must be a consensus, a meeting of minds, which must encompass explicitly or implicitly the dimension which actually amounts to tax avoidance (para [52]). Hammond J accepted the evidence (as had the TRA) that neither the taxpayer nor the accountant for the partnership had the necessary knowledge to satisfy the meeting of minds requirement. He therefore agreed that there was no tax avoidance arrangement to which s99 applied. He also rejected an argument for the Commissioner that Mr McLean’s knowledge should be attributed to the taxpayer.
[26] Just as the TRA had done, the Judge found that the partnership had entered into a credible commercial arrangement to purchase the film for a fixed price and the partners’ share of the depreciation could be based on that cost.
[27] The Commissioner’s appeal to this Court was again based on s99. His argument was a simple one. It was submitted that, accepting the findings that the taxpayer had no knowledge of the arrangement involving the circular movement of the “loan” moneys, still the Commissioner could counteract the tax advantage obtained by the taxpayer as a “person affected” by a tax avoidance arrangement.
[28] Section 99(2) and (3) read:

(2) Every arrangement made or entered into, whether before or after the commencement of this Act, shall be absolutely void as against the Commissioner for income tax purposes if and to the extent that, directly or indirectly, -

(a) Its purpose or effect is tax avoidance; or

(b) Where it has 2 or more purposes or effects, one of its purposes or effects (not being a merely incidental purpose or effect) is tax avoidance, whether or not any other or others of its purposes or effects relate to or are referable to, ordinary business or family dealings,-

whether or not any person affected by that arrangement is a party thereto.

(3) Where an arrangement is void in accordance with subsection (2) of this section, the assessable income ... of any person affected by that arrangement shall be adjusted in such manner as the Commissioner consider appropriate so as to counteract any tax advantage obtained by that person from or under that arrangement, and, without limited the generality of the foregoing provisions of this subsection, the Commissioner may have regard to such income as, in his opinion, either –

(a) That person would have, or might be expected to have, or would in all likelihood have, derived if that arrangement had not been made or entered into; or

(b) That person would have derived if he had been entitled to the benefit of all income, or of such part thereof as the Commissioner considers proper, derived by any other person or persons as a result of that arrangement.

[29] The argument is that because of the inclusion at the end of subs(2) of the words “whether or not any person affected by that arrangement is a party thereto” and subs(3) empowers the Commissioner to adjust the assessable income of “any person affected”, the adjustment to the assessable income of the taxpayer in this case was not erroneous.
[30] This is a different argument from that at the centre of the BNZ Investments Ltd case. There the Commissioner’s case was that BNZ Investments Ltd was a party with knowledge of the whole arrangement under consideration.
[31] We consider that the concentration by the TRA and the High Court on the lack of knowledge of the taxpayer and the accountant for the partnership meant that the crucial issue in the case was obscured. In our view that crucial issue is whether or not the loan from Steadfold to the partnership was repaid as the Commissioner decided. We think the evidence overwhelmingly indicates that the loan was advanced on the basis that the funds would be returned the same day and that occurred. Certainly the taxpayer has not shown that the evidence on which the Commissioner has quite reasonably relied is wrong and that the loan remains owing.
[32] The decision of the TRA seems to rest on reasoning that because the loan was advanced it remains owing. The judgment of the High Court reasons that because the knowledge of the general partner could not be attributed to the taxpayer, the belief by the taxpayer that the loan still was repayable (in the event that the film generated returns) was sufficient.
[33] But, with respect, neither of these approaches is sustainable. If the non-recourse loan had been repaid, then even if moneys were received from exploitation of the film from the United States home video market or from other sources outside New Zealand, there could be no warrant for them (in terms of the deed of loan) to be “applied in repayment of the loan”. Plainly the correct focus must be on whether the loan was repaid, not on what the taxpayer knew. It would be strange indeed if partners could treat as a debt of the partnership a loan that the partnership has repaid simply because they did not know it had been repaid.
[34] On the evidence we are satisfied that after the investigation it was open to the Commissioner to take the view that the amount of the non-recourse loan had been returned to Steadfold in repayment of the loan. That satisfied the partnership’s loan obligation which therefore did not form part of the cost to the firm of the film. The depreciation calculation therefore could not include the $1.56 million as part of the cost. That should dispose of the matter.
[35] By the time the matter reached this Court, it was enmeshed in a complex s99 analysis. The Commissioner appears to have given up on the more straightforward approach. For this reason it seems necessary now to consider the matter in terms of s99. It would be surprising if a different conclusion emerged however.
[36] Section 99 applies to arrangements having as their purpose or effect tax avoidance. “Arrangement” is defined in the section as meaning any contract, agreement, plan or understanding (whether enforceable or unenforceable) including all steps and transactions by which it is carried into effect. The curial challenge with this section and its predecessors has been to distinguish between arrangements by which taxpayers conduct their affairs legitimately taking advantage of the structure and operation of the tax system and arrangements that constitute tax avoidance as defined and are of a character incompatible with legitimate and credible tax planning: see BNZ Investments paras [38] to [42].
[37] The concept of “arrangement” which, as already mentioned, requires consensus or a meeting of minds, is but one element. There must be a purpose or effect of tax avoidance. In the present case those elements are clearly present if there is established an arrangement under which the film cost on which depreciation was calculated has been inflated by the value of a loan that was not applied to the purchase. Mr McLean represented the mind of the partnership. He was a director of the general partner acting in the management of the project. He arranged the loan from Steadfold and its repayment the same day. He provided the information from which the partnership accounts were prepared. He well knew (as a signatory) that the prospectus, by which subscription for units in the partnership were invited, held out the tax advantages to investors on the basis of a total cost of acquisition of the film of $2.76 million including $1.56 million from a “limited recourse” loan.
[38] This brings us to the point of the only issue said to be alive on the appeal. That is whether, if there was a tax avoidance arrangement, the Commissioner was entitled to adjust the taxable income of the taxpayer who was not a party to the arrangement and had no knowledge of it.
[39] Mr Carruthers QC, for the taxpayer, submitted that such an adjustment cannot be made against a taxpayer who is not a “participant” in the arrangement and his client could not be because of the concurrent findings below of his lack of knowledge. He relied first upon the principal joint judgment in the BNZ Investments Ltd case (para [51]) where it was said with reference to the requirement as an essential element of an “arrangement” of a meeting of minds:

The justification for construing the concept of arrangement in that way is that it would be inequitable for a taxpayer who enters into an apparently unobjectionable transaction to be deprived of its rights thereunder merely because, unknown to the taxpayer, the other party intended to meet its obligations under that transaction, or in fact did so, in a legally objectionable way.

[40] That is directed to the issue of what constituted an arrangement within s99, not to the implications for a “person affected” who is not party to the arrangement once an arrangement exists.
[41] Counsel relied also on the following passages in the concurring judgment of Blanchard J:

It is a fundamental prerequisite to the use of s99 against a taxpayer that there be a contract, agreement, plan or understanding (the words the legislature chose to use in s99(1) in defining “arrangement”) in which the taxpayer is a participant. This state of affairs cannot exist for the taxpayer unless there has been formally or informally – even if unenforceably – a consensus between the taxpayer and another or others as to what, in general terms, will occur pursuant to the arrangement. The taxpayer does not have to know all the detail or be able to discern exactly how the arrangement will avoid tax by producing the illegitimate tax advantage, by which I mean an advantage which the legislature cannot have contemplated as flowing from the legislation. But the taxpayer must at least have a broad appreciation of the character of what is occurring.

...

As the principal judgment records at para [42], there are three successive inquiries. The first is as to the extent of the arrangement; the second is as to whether it has the purpose or effect of tax avoidance and the third, which arises only where the second is answered affirmatively, is as to the adjustment to be made to counteract the tax advantage. The adjustment can be made against both a party to the arrangement and a person affected, who is not necessarily a party. But it can be made only where a tax advantage has been obtained “under that arrangement”. The Commissioner therefore cannot make an adjustment as against someone who is not a party merely because that person has received a payment subsequent to the operation of an arrangement but outside the arrangement.

[42] The first of those paragraphs is similarly directed to the issue of what constitutes an arrangement within the section. The second, as we read it, is unfavourable to counsel’s argument and provides a basis for distinguishing the result in the BNZ Investments Ltd case from the present case. First, it clearly recognises that an adjustment can be made to the assessable income of a person affected though not a party to the arrangement. Secondly, it reflects the Judge’s view that BNZ Investments Ltd obtained any tax advantage not from or under the “downstream” tax avoidance arrangement, but by another, “upstream” arrangement. In our case, however, the tax advantage obtained by the taxpayer was derived directly from the very arrangement in which the loan funds were included in the cost to the partnership of the film.
[43] Mr Carruthers also sought support from the legislative history but we were not persuaded that in that there is justification for disregarding the words of the section and concluding that only parties to or “participants” in an arrangement are persons affected by it.
[44] There will be circumstances in which questions will be raised as to the degree of proximity necessary to qualify as a person affected for the purpose of s99(3). This will be another aspect of line-drawing, as it was termed in the BNZ Investments case, so as to distinguish between a tax advantage that may be legitimately retained and one that is vulnerable to adjustment. But we do not see the situation of the appellant in this case (despite the fact that it concerns a special partnership) as even approaching the line.
[45] Mr Carruthers argued also that, although it was not a matter of relevance to his client, it could well have been the case that the series of dealings involving the passing of the $1.56 million through Filmcraft, CAL and Steadfold represented unconnected and quite legitimate business dealings which his client taxpayer was in no position to verify. But it is the position with regard to the loan that is crucial. If it was repaid the same day, the provision, without record, of procurement services by CAL to Filmcraft to exactly the value of the loan stretches coincidence too far. The evidence points to repayment having been effected and we are not convinced that, having invested in a partnership the management of which was in the hands of Mr McLean, the taxpayer can distance himself from that management to the extent of not ascertaining whether the partnership loan from Steadfast in fact was repaid and simply insist he is entitled to assume that the partnership accounts from which his deductions were derived are accurate.
[46] However, the real point of counsel’s argument was that insofar as it was said that Filmcraft enhanced the cost of production of the film by introducing an intermediary, CAL, to which payments were made, it is not for the Commissioner to go behind the transactions of the parties and second guess the value of the services provided and paid for. He relied on the decision of the High Court of Australia in Cecil Bros Pty Ltd v The Commissioner of Taxation of the Commonwealth of Australia [1964] HCA 82; (1964) 111 CLR 430, the authority of which for New Zealand was said to be confirmed by the Privy Council in Europa Oil (NZ) Ltd v CIR [1976] 1 NZLR 546, 556. But we find nothing in the judgments in those cases precluding the Commissioner from declining to recognise costs not truly incurred.
[47] Viewing the matter overall, we are satisfied that it was open to the Commissioner on the evidence before him to conclude that there was an arrangement to finance the making of the film, orchestrated by Mr McLean, by which the cost to the partnership included on-going liability for the loan moneys which were immediately repaid so that the deduction for depreciation by which the investors derived tax benefits was overstated. The assessable income of the taxpayer, as a person affected, was rightly adjusted to counteract the tax advantage obtained under the arrangement.
[48] Accordingly, the appeal is allowed. The answer to the question posed in the case stated to the High Court is answered “Yes” the Authority erred in finding the Commissioner acted incorrectly.
[49] The Commissioner is entitled to costs in this Court and in the High Court. Costs in the High Court are to be fixed in that Court in light of this judgment. In this Court we fix costs at $5,000 together with disbursements as approved, if necessary, by the Registrar.

Solicitors
Crown Law Office, Wellington, for Appellant
Harkness & Peterson, Wellington, for Respondent