Report to the Treasurer and Minister of revenue - by a committee of experts on tax complianceBill Birch Treasurer
Report to the Treasurer and Minister of revenue
By a committee of experts on tax compliance
Chapter 3 -
Aspects of the Capital-Revenue Boundary
3.1 The history of tax reform, since the Land and Income Tax Assessment Act 1891, has been punctuated by legislation designed to frustrate attempts by taxpayers to take amounts that are essentially revenue in nature in a capital non-taxable form.
3.2 In this chapter the committee considers certain payments that pose a significant risk to the tax base, because they allow otherwise taxable income to be characterised as non-taxable capital receipts. They are payments for restrictive covenants involving services, inducement payments and certain contributions to capital expenditure. Characterising these payments as capital operates against the government's strategy for a broad-base, low-rate tax system, and creates a risk which is particularly acute in cases of personal exertion, as exemplified by the recent decisions in Henwood v CIR64 and CIR v Fraser65. Such cases seem to afford taxpayers the opportunity to characterise otherwise taxable income from services as tax-free capital receipts. In the government's 1998 December Economic and Fiscal Update, the tax treatment of payments for restrictive covenants and lease inducement payments is included in the list of unquantified fiscal risks. It states that the government is considering policy measures to ensure that these amounts are treated as taxable income.
3.3 It may not be possible to address the opportunities for characterisation of these payments as capital without modifying the boundary between capital and revenue. This could entail a choice between two policy positions, that is, either maintaining the existing tax base, or maintaining the existing capital-revenue boundary.
3.4 Another aspect of the capital-revenue distinction was raised in submissions by the Investment Savings and Insurance Association of New Zealand, that is, on which side of the capital-revenue boundary do investment gains of collective investment vehicles lie. The committee has had insufficient time to consider the issues raised in these submissions fully, but because of their importance, the submissions themselves appear in appendix 8. The committee recommends that Ministers should ask officials to evaluate these submissions, and report on the policy and remedial implications of addressing the concerns raised and the measures that can be implemented to address such matters. The committee considers that the issues identified by the Association are serious. They cause distortions to New Zealand's savings and investment practices, and should be addressed at an early date.
3.5 This section deals primarily with payments for covenants in restraint of trade in cases involving personal exertion. Because they share some of the same characteristics, inducement payments that are related to status are also discussed in this section.
3.6 People sometimes accept payment in consideration for a restriction on their ability to perform services. The courts have often held that such payments are non-taxable as capital in the hands of the recipient.
3.7 In Henwood v CIR66, the taxpayer appeared in two television advertisements for a biscuit manufacturer. He received two payments totalling $42,500 and did not return either of these payments as taxable income. Following an Inland Revenue Department audit, both payments were assessed as income from acting services. The taxpayer objected, stating that only $5,000 was income and the remaining $37,500 was a capital payment in consideration for his agreement to a restraint of trade. The restraint of trade prohibited the taxpayer from promoting any biscuit or confectionery products in competition with the manufacturer during a specified period.
3.8 The Taxation Review Authority found that the taxpayer had received $5,000 for acting services and $37,500 for the restraint of trade. On appeal to the High Court, McGechan J held that both payments were received for acting services and were not referable to the restraint of trade. The Court of Appeal, by a majority, restored the decision at first instance, confirming the taxpayer's treatment of the payment. McKay J, dissenting, preferred the approach of the High Court, and considered that the restrictive covenant in the contract was properly to be seen as an essential component of the taxpayer's income-earning process.
3.9 The issue in Henwood was whether $37,500 of the $42,500 payment (that is, 88 per cent of the total remuneration) was a payment in restraint of trade and as such a non-assessable capital payment, or whether it was a payment for acting services and taxable income. Although the taxpayer was effectively prevented only from making biscuit or sweet advertisements for one other manufacturer of such products in New Zealand, the court found 'a sufficiently substantial intrusion on the future exercise of the appellant's profession to constitute an affair of capital'.
3.10 In CIR v Fraser67, the taxpayer agreed to present a series of commercials for a bank. The taxpayer's services were hired through his own company. A payment of $25,000 was made to induce the taxpayer to enter into the contract, and in addition, payments totalling $140,000 over a three-year period were made restraining him from advertising or endorsing any other product during the term of the contract or its renewal. The taxpayer treated the inducement and restraint of trade payments as capital receipts. The Commissioner assessed these sums as income and the taxpayer objected.
3.11 The High Court found that the inducement offered and the payments in restraint had caused the taxpayer to leave his position as a current affairs journalist and to take up the bank's advertising campaign. It was imperative for the bank that the taxpayer should be restrained from offering his advertising services to others and from presenting other television programmes during the advertising campaign. The payments were intended as compensation for the restraint on the taxpayer's activities. The taxpayer had given up a substantial part of his potential income-earning activities in return for the payments, which were classified on capital account and not assessable. This decision was upheld by the Court of Appeal.
3.12 A status-related inducement payment is the consideration paid when a person gives up his or her previous status or position and enters a new contract of or for services. A line of United Kingdom case law holds that such payments are not assessable. For example, a payment made to a barrister to become an employee of a company was held not to be an assessable emolument from employment. Instead, the payment was considered compensation for the barrister giving up his status and position as a practitioner at the Bar.
3.13 In Fraser, a payment was made to compensate the taxpayer for the loss of his career opportunities as a result of his entering into the agreement with the bank and for the risk he took in doing so. Such payments are perhaps the only employment-related inducement payments that are not covered by the definition of 'monetary remuneration' in section OB 1 of the Income Tax Act 199468.
3.14 Considerable potential exists for the decisions in Henwood and Fraser to be exploited to the detriment of the revenue. Some tax advisers have suggested that the decisions provide a precedent for taxpayers to characterise payments for services as non-taxable capital receipts. The payer may also be able to deduct these payments, if they are a regular incident of business, as could be the case with an advertising firm.
3.15 In these cases, taxpayers receive a sum of money in return for entering into a contract that incorporates different elements, such as providing acting services and agreeing to a restraint of trade. Once the total fee for a contract containing both capital and revenue items has been struck, the apportionment of receipts between the different elements can be highly sensitive to tax considerations. Taxpayers will want to maximise tax-free capital receipts, and minimise taxable revenue receipts. At present, the Inland Revenue Department and the courts are poorly placed to respond, except in the most extreme cases.
3.16 This incentive highlights an issue of enforcement for the Inland Revenue Department. Payments in restraint are prevalent in the entertainment, modelling, sports and advertising industries. If this practice were to spread to other industries, the resources required to determine whether a payment is correctly characterised as a payment in restraint or is merely part of the recipient's ordinary remuneration would have to be increased.
3.17 The decisions in Henwood and Fraser are likely to promote the use of payments in restraints of trade. This use would pose a significant risk to the tax base representing income from personal exertion, which comprises 75 per cent of the total income tax base.
3.18 In the absence of legislative change, the courts would be left to develop principles through case law. Considering the risk to the income tax base, the committee prefers a legislative solution. This solution would necessarily involve bringing to tax some forms of capital receipts. It is not clear that a legislative response could be limited to restrictive covenants for personal services, because it would be possible to characterise the payment as another form of capital receipt, for example, a payment for the sale of shares in a company which held the restrictive covenant over the taxpayer. Any legislation targeting services-related payments in restraint would need to be buttressed by anti-avoidance rules to prevent it being circumvented by such arrangements.
3.19 A legislative solution would reduce compliance and administrative costs, because taxpayers would have greater certainty in the taxation of income from services. Taxpayers would no longer expend resources on characterising income from services as tax-free capital receipts, and Inland Revenue Department investigators would not incur the costs of identifying such arrangements.
3.20 In the United Kingdom, the legislation treats payments made under restrictive covenants relating to employment69 contracts entered into after 8Â June 1988 as taxable emoluments from employment. This precedent could be considered for New Zealand, although in the United Kingdom the legislation is supported by the comprehensive taxation of capital gains.
3.21 In conclusion, the decisions in Henwood and Fraser illustrate the point that service contracts, both employment contracts and contracts for services, are particularly sensitive to tax considerations. There is an incentive for taxpayers to structure their remuneration so as to maximise tax-free capital receipts and minimise taxable revenue receipts. It is the element of substitutability in service contracts that gives rise to concerns about the protection of the tax base, because existing case law gives taxpayers considerable latitude to characterise otherwise taxable income from services as tax-free capital receipts. Because a payment in restraint of trade and a payment for services are closely substitutable, the capital-revenue boundary that distinguishes these payments, with very different tax consequences, is vulnerable to manipulation. From the perspective of tax policy, it is undesirable to have a boundary between close substitutes.
3.22 The committee considers that in cases involving personal exertion, all payments in restraint of trade and status-related inducement payments should be taxable and recommends that the government should consider legislation to ensure their assessability. These amendments would need to include anti-avoidance rules to prevent their circumvention.
3.23 Lease inducement payments are an example of payments received in business for which claims of a capital character are made. In Wattie v CIR70, the court considered whether lease inducement payments are taxable in New Zealand. The issue was whether a cash payment of $5 million, made as an inducement to an accounting firm to enter into a 12-year lease of new office premises in Auckland, was a capital receipt.
3.24 In the High Court71, the Commissioner argued that the receipt was assessable as income from a business on several grounds. First, the receipt was a subsidy against the non-market level of rental which the firm was committed to pay under the lease. Secondly, the receipt was assessable as a gain arising as an incident of the carrying on of the firm's business, on the authority of a line of Australian Federal Court decisions beginning with the decision in FCT v Cooling72.Thirdly, the receipt was assessable as a profit-making scheme under the principle laid down by the High Court of Australia in FCT v Myer Emporium73.
3.25 In the High Court, Fisher J held in favour of the Commissioner on the first ground. The rental provided for in the lease was purely nominal, and the 'true' rent payable under the composite arrangement represented by the lease and deed collateral documents could be arrived at only by taking into account the $5 million benefit provided by the lessor to the partnership. Fisher J found as a fact that a market rental for the leased premises was arrived at only if all benefits received by the firm, including the $5 million payment, were set off against the nominal rental. Applying the test in Hallstroms 74and BP Australia75, Fisher J concluded that the $5 million was effectively a rent subsidy and, therefore, a revenue receipt. Fisher J did not accept the second of the Commissioner's arguments, declining to follow the Federal Court of Australia in Cooling, and did not find it necessary to examine the Commissioner's third submission on Myer Emporium.
3.26 By a majority, the Court of Appeal reversed the decision in the High Court76. The Court of Appeal held that the receipt was derived on capital account because it had been received by the partnership in association with its entry into a long-term lease. The lease was on capital account and the receipt took a similar character. The court agreed with Fisher J that the gain did not arise as an incident of the carrying on of the firm's business, and the Cooling line of cases, therefore, had no application. The correctness of the decision in Cooling was doubted. Finally, the court held that the decision of the High Court of Australia in Myer Emporium was no more than a restatement of the principle applying to the assessability of a gain arising from an adventure in the nature of trade. On the facts in Wattie, the Court of Appeal held that it was impossible to say that any 'gain' had been derived by the firm. The payment amounted to a negative premium and was a capital item in the same way as a payment by a lessee to obtain surrender of its lease.
3.27 Thomas J, dissenting, held that the sum was paid to the accounting firm to procure the firm's agreement to pay rent at a figure substantially in excess of the market rent. As no capital asset was disposed of by the firm in consideration for the receipt, he considered that any analogy between the receipt and a negative premium was ill-founded.
3.28 On appeal to the Privy Council, the Commissioner sought to reverse the Court of Appeal judgment on two grounds; first, that the receipt represented a subsidy or offset against the above-market level of rental payable by the partnership under the lease and on that basis was assessable income derived from the carrying on of a business. Alternatively, the Commissioner argued that the receipt was assessable as a gain arising from a venture entered into in part for the purpose of profit-making.
3.29 The taxpayer's argument in Wattie can be expressed in one proposition, namely, that when a lease is a capital asset, lump sum payments made or received in relation to the acquisition, disposition or modification of that lease, are capital and are neither assessable nor deductible. As the payment received by the taxpayer related to the acquisition of a capital asset of the business, the payment was, therefore, a capital receipt.
3.30 The Privy Council upheld the decision of the Court of Appeal77. Although the payment was commercially, financially and mathematically linked to the rental payments, it was a premium, and premium payments have always been recognised as capital rather than revenue. The court followed the reasoning in British Insulated and Helsby Cables Ltd78, that when an advantage for the enduring benefit of the trade is brought into existence, the expenditure is properly attributable to capital.
3.31 As with services-related payments in restraint, the tax-free status of lease inducement payments poses a risk to the tax base. Accepting that lease inducement payments would be deductible to a commercial lessor, as in Wattie, there is an incentive for parties to leasing contracts to arbitrage the tax cash value of non-assessable but deductible lease inducement payments. This arbitrage opportunity means that the apportionment of receipts between different but readily substitutable elements, for example, between inducement payment and rent, can be highly sensitive to tax considerations.
3.32 The committee, therefore, recommends that the government should consider legislative reform to make lease inducement payments taxable. Canada has enacted legislation to make lease inducement payments assessable in section 12(1)(x) of its Income Tax Act. This legislation may provide a worthwhile model for New Zealand.
3.33 Taxpayers incurring capital expenditure in their business sometimes receive a contribution to that expenditure from another person. Under existing case law, that contribution is not assessable to the recipient. Moreover, the recipient is entitled to full depreciation deductions for that expenditure. For example, say a utility company receives a payment from a major power consumer in return for which it removes an above-ground transmission line supplying that consumer and replaces it with an underground transmission line. Under a separate power supply contract, the consumer is supplied power at a lower price than it would have been charged if it had not made the contribution to the utility company's capital expenditure on the replacement transmission line. For the purposes of the example, the utility company is in the business of supplying power and not in the business of dealing in transmission lines.
3.34 The contribution from the power consumer has the character of capital in the hands of the utility company, and is not taxable under section CD 5 of the Income Tax Act 1994. This treatment is based on the principle established in Boyce v Whitwick Colliery Company Ltd79, that a receipt contractually required to be applied by the recipient to a capital purpose has a capital nature. In addition, as the utility company is not in the business of constructing or otherwise dealing in transmission lines, the contribution by the consumer is not taxable under section CD 3.
3.35 In CIR v City Motor Services Ltd; CIR v Napier Motors Ltd, the Court of Appeal found the relevant contribution receipt to be capital. In City Motors, the oil company contributed to the cost of constructing the taxpayer's new premises. The money was paid directly to the contractors doing the work. In Napier Motors80, the oil company paid the taxpayer half the cost of moving petrol pumps inside the taxpayer's premises as required by the city council. In both cases, having regard to the origin and purpose of the contributions voluntarily made by the oil companies towards the cost of improving the capital assets of the taxpayers, the court found that the payments made were not profits or gains derived from the current operation of the taxpayers' businesses and were, therefore, not assessable. Turner J noted that before an amount could be taxable as income from a business there must be something more than merely a receipt arising as a result of the fact that the company was carrying on business. He held that the statutory language 'from the business' must mean 'from the current operations of the business'.
3.36 Case law, then, supports the view that receipts that are contractually required to be expended on capital assets, or which reimburse capital expenditure, are of a capital nature. The factors taken into account are that a benefit accrues to the payer, and that the expenditure incurred is at the request of the payer, even when a benefit also accrues to the recipient. Provided the benefit is not derived from the current operations of business, the receipt will not be on revenue account. With composite agreements, containing both revenue and capital elements, provided an amount can be attributed to the capital component, that amount will be of a capital nature.
3.37 In the example used above, assuming first, that the utility company acquires the transmission lines for the dominant purpose of using them for transmissions as part of its principal business activity, and secondly, that the dominant purpose of devising or entering into the contract is not profit-making, the payment by the power consumer to the utility company will not be taxable under any of the three limbs of section CDÂ 4. The cost price for depreciation purposes for the expenditure incurred by the utility company in relocating its transmission lines is not reduced by the amount of the contribution by the power consumer.
3.38 As with services-related and lease inducement payments, the capital contribution and power supply payments received by the utility company are close substitutes. The fact that placement of these payments falls on either side of the capital-revenue boundary means that taxpayers may approach the issue of apportionment between these items bearing in mind the tax consequences.
3.39 This is an example of what seems to be a general principle that payments for conducting a business in a certain manner are likely to be tax-free. The committee suggests that any legislative reform would need to consider issues in this context.
3.40 The committee notes that contributions of this type would be taxable under section 12(1)(x) of the Canadian Income Tax Act, which brings to tax all amounts received by a taxpayer in the course of earning income from a business or property as a contribution towards the cost of property or towards an outlay or expense.
3.41 In conclusion, the committee believes that it is not possible to address tax base maintenance concerns without modifying the existing capital-revenue boundary. It could, therefore, be necessary for the government to choose between two positions, that is, either maintaining the existing tax base, or maintaining the existing capital-revenue boundary. The existing tax base is a matter of policy. The boundary between capital and revenue is more a matter of an historical accretion of judicial decisions.
3.42 The committee notes that the Income Tax Act 1994 already taxes a number of payments that are on the capital side of the judicially delineated boundary, such as redundancy payments and consideration received for the sale of patent rights. Reform along the lines proposed would complement the government's commitment to a broad-base, low-rate tax system. The committee, therefore, recommends that payments for restrictive covenants involving services, inducement payments, certain capital contribution payments, and other similar payments should be taxable.
65(1996) 17 NZTC 12,607
66 (1995) 17 NZTC 12,271
67 (1996) 17 NZTC 12,607
68Vaughan-Neil v Inland Revenue Commissioners (1979) STC 644
69Section 313, Income and Corporation Taxes Act 1988 (UK)
70 (1997) 18 NZTC 13,297
71(1996) 17 NZTC 12,712
72(1990) 22 FCR 42
73 (1987) 163 CLR 199
74Hallstroms Pty Ltd v FCT (1946) 72 CLR 634
75BP Australia Ltd v FCT  AC 224
76(1997) 18 NZTC 13,297
77 (1998) 18 NZTC 13,991
78 AC 205 at 213
79 (1934) 18 TC 655
80  NZLR 1010