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URL: http://www.bailii.org/uk/cases/UKPC/1998/43.html
Cite as: [1998] UKPC 43, [1999] WLR 873, [1999] 1 WLR 873
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Commissioner of Inland Revenue v. Bruce James Wattie and Others (New Zealand) [1998] UKPC 43 (29th October, 1998)
Privy Council Appeal No. 20
of 1998
The
Commissioner of Inland Revenue Appellant
v.
(1) Bruce James Wattie and
(2) Michael
Gordon Lawrence Respondents
FROM
THE COURT OF APPEAL OF NEW ZEALAND
---------------
JUDGMENT OF THE LORDS OF THE JUDICIAL
COMMITTEE OF THE PRIVY COUNCIL,
Delivered the 29th October 1998
------------------
Present at the hearing:-
Lord Nolan
Lord Mackay of
Clashfern
Lord Jauncey of
Tullichettle
Lord Hoffmann
Sir Christopher
Staughton
·[Delivered by Lord Nolan]
------------------
This appeal raises the question whether the
appellant Commissioner is entitled to claim income tax from the partners in the
firm of Coopers and Lybrand upon a sum of $5 million received by them in 1991
as part of an arrangement whereby the firm entered into a lease of premises to
house its Auckland branch. The
commercial background to the payment of that sum is fully described in the
judgment of Fisher J., and their Lordships think it helpful to quote that
description at some length both because of its interest to those unfamiliar
with the property market in New Zealand at the material time and also because
of its relevance to the issues raised in the appeal. It reads as follows:-
“Commercial lease practices
in general
1. During the 1980s many New
Zealand property developers adopted the practice of recording in lease
agreements apparent rents which exceeded the real cost of the right to
possession. The apparent rent would
inflate the apparent capital value of the building and in turn promote its
financing and ultimate sale. Since tenants were not prepared to pay any more
than actual market rates the parties would also sign a collateral agreement to
compensate the tenant. The collateral
agreement contained enough in the way of ‘inducements’ to return the effective
rental to actual market rates. These
inducements could take a number of forms - lump sum cash payments, rent-free
holidays, the underwriting of part of the leased space, rental subsidies, a
contribution to the lessee's hard and/or soft fit-out, assistance with the
lessee's relocation costs or the underwriting of the lessee's commitment in
respect of existing leased premises. By keeping the existence and content of
the collateral agreement confidential, the developers could delude financiers,
investors and valuers into believing that the consideration provided by
lessees, and hence the value of the building as a whole, was higher than it
really was. No-one seems to have
thought of the possibility that in some circumstances this could have amounted
to fraud.
“Ultimately, the practice was
shown to be ineffective. The Court of
Appeal stressed the need for valuers to be able to refer to genuine market
rents (Modick R.C. Ltd. v. Mahoney [1992] 1 N.Z.L.R. 150) and ruled that attempts to suppress knowledge of collateral agreements
offering side benefits is contrary to the public interest (In re
Dickinson [1992] 2 N.Z.L.R. 43). Ever since it has been
recognised that in order to arrive at the effective or true rent payable by a
lessee a valuer must calculate the net present value of all inducements and
incentives, amortise that sum over the period of the lease term certain, and
deduct it from the contract rent. In
the meantime, however, many leases had come into existence based upon the dual
documentation practice.
“The dual
documentation practice had its genesis in the boom period of the mid-1980's
following de-regulation and associated growth in the New Zealand economy. Mergers in legal and accounting practices
created a demand for larger and more elaborate offices. There was rapid growth in financial institutions
and a high level of buoyancy in financial and business sectors. Office space in the Auckland Central
Business District grew scarce. Low
vacancy levels of around 5 per cent encouraged an unprecedented commercial
building boom.
“The demand
came to an abrupt end with the stock market crash of October 1987 and the
decision to tax superannuation funds two months later. By this stage developers were committed to
partially or completely constructed buildings.
A number of investment and development companies failed. Prices and rentals dropped sharply in an
attempt to capture the dwindling residue of buyers and tenants. From 5 per cent the vacancy rate climbed to
a high of about 30 per cent by 1991. In
consequence financial institutions changed to conservative financing policies
with respect to commercial buildings, demanding higher levels of pre-leasing
commitments for new developments. The
substance and strength of individual lessees became important. Of special importance were major ‘anchor
tenants’ whose long term commitment to a given building could be expected to
encourage others to follow suit.
“Facts in this
case
2. By early 1991
several large commercial developments had been completed in Auckland with
little or no pre-commitment by lessees.
Of special importance were large new premium quality office blocks. It was critical to the developers and owners
of these buildings that they attract tenants, particularly major ‘anchor
tenants’. There were few potential
candidates in the latter category.
“One of the
potential candidates was the professional partnership whose members are the
objectors in these proceedings. The
firm had leased offices in towns and cities throughout New Zealand. Since 1973
its Auckland branch had occupied two floors of a building (‘building A’) in the
central business district of Auckland.
As the firm expanded it had progressively taken assignments or
sub-leases of further floors in that building.
By the end of the 1980's it occupied approximately eight floors as well
as another smaller office in another building nearby. The majority of its leases were due to expire in 1993, with one
in 1994 and two in 1997.
“By the end of
the 1980's it became apparent to the Auckland partners that serious consideration
would have to be given to moving to new premises. In the preceding few years the firm's major competitors had all
upgraded their premises. An improvement
was needed to maintain the firm's image.
The majority of its leases expired in February 1993 and some earlier
than that. The firm would shortly have
to commit itself to a renewal for a significant period if it remained in
building A. These thoughts coincided
with a number of unsolicited approaches from property developers seeking to
entice the firm into one of the new office buildings planned or under
construction.
“With these
considerations in mind, in July 1990 the firm's managing partner negotiated
renewals of the leases in building A for a period expiring on 28 February 1993
but on the basis that the firm had the right to withdraw from all its leases in
building A on payment of defined penalties.
At the same time the firm commenced negotiations with property
developers, receiving proposals from five in all. Two of the developers were in the particularly difficult
situation of having large premium accommodation office buildings without a
major tenant to act as a stimulus for other prospective tenants. The firm's managing partner became aware
that there was only one other major potential tenant which might fulfil that
role and even that tenant would require only about half to two thirds of the
space which could be taken by his firm.
In short the economic conditions, the special situation in the central business
district of Auckland, and the desperate situation of these two developers in
particular, combined to make it a uniquely strong tenant's market, particularly
for an anchor tenant.
“Negotiations
between the firm and the developers continued until April 1991. The managing partner knew that he was in a
position to virtually name his own price.
As a minimum, he knew that his partners would not want any increase in
rent over the first six years of the new lease nor to be out of pocket in
respect of relocation costs. In
addition he determined to try for a number of other benefits. These would include naming rights, no
ratchet clause and better car parking arrangements. As to relocation costs, he decided to seek reimbursement for the
$1.6 million loss on the firm's partitions, furniture and fittings in building
A (the actual loss on their disposal ultimately proved to be $1,242,683). He also decided to seek the full rental
which would have been paid had all the building A leases run their full term. Given the forfeiture payments which had already
been negotiated with building A's owner by that stage, the actual cost would be
only $1.398 million if the firm left but he decided to try for the full term
rental of $3.4 million. He also decided to seek payment of all hard and soft
fit-out costs in the new building. The
rent which the firm would have to pay if it stayed on in building A was
approximately $200 per square metre although this was a gross rental including
operating expenses.
“Of the
developers with whom the firm had negotiations, it emerged that the owners of
building B would offer the best terms.
After lengthy negotiations the parties came to an agreement in April
1991 and signed formal documents on 31 May 1991. The documents took the form of an agreement to lease and a
collateral deed. They provided for a 12
year lease term of six floors commencing in February 1992 with occupational
access from June 1991. The firm was to
pay operating expenses and $100 per week per car for 48 car parks.
“On its face
the agreement to lease called for rent of $349.83 per square metre. The quoted rent was fixed for the initial
six years of the lease and was thereafter subject to reviews at three-yearly
intervals with a modified ratchet clause providing for a minimum of $215 per
square metre and $85 per week per car.
The lessor undertook to underwrite the rent for one of the six levels
for a term of six years during which the firm would have no rental obligation
for that level unless it elected to take over that level in preference to
allowing possession to pass to any other tenant found by the lessor. The firm was given naming rights without
payment for the initial six year term.
The hard fit-out was to remain the property of the lessor. The lessor was to provide $1.8 million for
the soft fit-out which would remain the lessor's property subject to a ‘lease
to buy’ provision in the firm's favour.
The operating expense levy for the first year was expected to amount to
$38.54 per square metre.
“The
collateral deed, however, presented a different picture. In combination with the terms of the lease
itself, the effect of the deed was to provide the firm with incentives
totalling $15.08 million valued as at the commencement of the lease. The incentives took the form of a lump sum
inducement of $5 million, hard and soft fit-outs to a maximum of $4.7 million
and a monthly rent subsidy of $94,008.86.
Accepted valuing principles required the incentives to be amortised and
set off against the nominal contract rent of $349.83 per square metre in order
to arrive at the true rent. It is not
disputed that the effect of that process in the present case was to reduce the
true rent to $18.97 per square metre spread across all six floors including the
floor underwritten by the lessors. Even
with the addition of $38.54 per square metre in operating expenses, the
effective cost to the firm came to only $57.51 per square metre of floor space.
“The firm duly
moved to building B, wrote off, or disposed of, its partitions, furniture and
fittings in building A, and paid the forfeiture sum to that building's
owners. They received from the building
B owners the $4.7 million which was spent in fitting out their new
premises. Thereafter the firm received
the monthly rent subsidy from the owners of building B and on their part paid
the contract rent as nominated.
“The firm also
received the $5 million ‘inducement payment’ from the owners of building
B. As between the partners, the
inducement receipt of $5 million was paid into a suspense account. After allowance for losses and costs
associated with the move, the balance was paid out to the partners. The effect of the managing partner's
evidence was that the firm's actual costs in moving came to a total of a little
under $2.9 million ($1.398 million negotiated forfeiting fee paid to building A
owners, $1,242,683 loss on disposal of Building A partitions etc. approx. $100,000 cost of reinstatement to
building A and approx. $100,000 for relocation costs).
“In their
partnership return for income tax purposes the firm claimed as deductions the
foregoing $2.9 million exit costs together with annual rent at the full $350
per square metre. They included the
monthly rent subsidy of $94,008.86 as assessable income but showed the $5
million ‘inducement payment’ as a capital receipt. The Commissioner accepted the other items but assessed the $5
million as income.”
3. The statutory
provisions upon which the Commissioner relies are set out in section 65(2) of
the Income Tax Act 1976. They read as
follows:-
“Without in any way limiting the
meaning of the term, the assessable income of any person shall for the purposes
of this Act be deemed to include, save so far as express provision is made in
this Act to the contrary, -
(a)All profits or gains derived
from any business ...
(l)Income derived from any other
source whatsoever.”
4. Mr. McKay for the Commissioner
submitted before this Board that the $5
million receipt represented a subsidy or offset against the above-market level
of (deductible) rental payable by the partnership pursuant to the Lease, and on
that basis represented assessable income from the carrying-on of the business
for the purposes of section 65(2)(a).
He submitted, in the alternative, that the receipt was assessable, again
on the basis of section 65(2)(a), or alternatively section 65(2)(l), as a gain
arising from a venture entered into in part for the purpose of profit making, a
basis of assessability illustrated by the decision of the High Court of
Australia in Commissioner of Taxation of the Commonwealth of Australia v.
Myer Emporium Ltd (1987) 163 C.L.R. 199.
5. It was common ground that, for
the purpose of determining the true character of the $5 million payment, the
collateral deed and the agreement for the lease (to which the lease itself was
annexed) should be read as one. They were executed on the same day, 31st May
1991, and formed part of the same bargain.
Clause 2 of the collateral deed is headed “Consideration” and, so far as
material, provides as follows:-
“In consideration of C&L
entering into the Agreement to Lease and the Lease it is agreed as follows:
2.1.Cash Inducement Sum
2.1.1.Pacific shall pay to
C&L an amount of $5,000,000 (‘the Cash Inducement Sum’).
2.1.2.The Cash Inducement Sum
shall be paid to C&L:
(a)As to the sum of $1,000,000
within 14 days of the signing of this deed and the agreement to lease by the
party:
(b)As to the balance of the Cash
Inducement Sum on the Lease Commencement Date PROVIDED THAT C&L has
executed and made available the Lease to Pacific ...
2.3.Rental Payment
2.3.1.Pacific shall pay to
C&L the sum of $94,008.86 (“the Monthly Subsidy”) on each monthly rental
payment date under the Lease, to occur during the period (“the Rent Subsidy
Period”) by 72 consecutive monthly payments commencing on the Lease
Commencement Date and ending on the date being one calendar month prior to the
sixth anniversary of the Lease Commencement Date AND notwithstanding the
commencement of the Lease and the obligations of C&L as lessee under the
Lease to pay Premises rent monthly in advance from the Lease Commencement Date,
Pacific will accept from C&L in full satisfaction of the monthly base rent
instalment due by C&L under the Lease an amount equal to the result of the
calculation:
X-Y
6. Where X = the monthly base rent
instalment payable under the Lease; and
8. The Lease Commencement Date was
1st February 1992. The $1 million and
$4 million making up the Cash Inducement Sum of $5 million were duly paid in
accordance with Clause 2.1. The term of
the lease was twelve years with rights of renewal. As will be seen from Clause 2.3.1. the Monthly Subsidy was
payable during the first six years of the Lease. Provision was made for a rent review at the end of the six year
period, with further reviews after nine years and on the occasion of any
renewal of the Lease.
9. Although the argument before
their Lordships covered a wide range of decided cases there was much common
ground between the parties, and the issue raised by the first of the
Commissioner's submissions became clear and relatively narrow. Thus, it was common ground before their
Lordships that the $5 million was not a receipt arising from C & L’s
ordinary business operations which consist, of course, in the practice of the
accountancy profession. Nor, as Fisher J. had found, could it be regarded as
arising from an ordinary incident of that business, and thus liable to tax
under section 65(2)(a) by reference to the principle applied by the Australian
High Court in
10. Nor has the
Commissioner sought at any stage to challenge the deductibility of the
above-market level of rental payable under the lease as a proper debit item in
the computation of the firm's profits for the purposes of section
62(2)(a). The Commissioner's primary
case before their Lordships' Board was simply that the sum of $5 million was
indistinguishable in principle from the monthly rental subsidy payments made
under clause 2.3.1. which were agreed by Coopers and Lybrand to form part of
the revenue receipts of their business.
The respondents, on the other hand, contended that the $5 million was of
the same nature as a normal premium on a Lease, though paid in this instance,
because of the unusual state of the property market, by the landlord to the
tenant rather than vice-versa, and was thus a capital receipt in their hands.
The Commissioner's case found favour with Fisher J. and with Thomas J. who
wrote a dissenting judgment in the Court of Appeal, but the majority of the
Court of Appeal upheld the contention of the respondents.
11. It is well
settled that in considering whether a particular item of receipt or expenditure
is of a capital or revenue nature the approach to be adopted should be that
described by Dixon J. in
“… depends on what the expenditure is calculated to
effect from a practical and business point of view, rather than upon the
juristic classification of the legal rights, if any, secured, employed or
exhausted in the process.”
B.P. Australia Ltd v. Commissioner of Taxation
of the Commonwealth of Australia [1966] A.C. 224 and has been
followed in many other cases of high authority. The passage from the Board's judgment in the B.P. Australia Ltd case at page
264 in which the approach of Dixon J. is adopted was described by Richardson J.
in Commissioner
of Inland Revenue v. Thomas Borthwick and Sons (Australasia) Limited
(1992) 14 N.Z.T.C. page 9 line 101, 103, as exemplifying the “governing
approach” in New Zealand. Dixon J. was speaking in terms of expenditure but it
is familiar law that within the context of the same business, similar
principles will apply to payments and to receipts. This appears from the
general discussion of the earlier cases by Lord Macmillan in Van Den Berghs Limited v. Clark
[1935]
A.C. 431 at pages 438 to 441, and from the Borthwick case itself, which
was concerned with the character of a receipt.
13. What, then, was the $5 million
payment in the present case calculated to effect from a practical and business
point of view? The answer must be
determined from the particular facts of the present case. In submitting that the $5 million was a
rental subsidy, Mr. McKay relied upon its analysis by Thomas J. in the
Court of Appeal where the learned judge said:-
“The lessor paid Coopers and
Lybrand $5 million, along with other inducements, to enter into the lease and
pay rent at a figure substantially in excess of the market rent or the rent
which Coopers and Lybrand would otherwise have been prepared to pay. If that rent had represented or even
approximated the market rent the lessor would not have paid Coopers and Lybrand
the inducement payment. That is the commercial reality.”
14. Like Fisher J., Thomas J. was
influenced by Canadian decisions in which payments made to lessees as
inducements to enter into leases had been held to be of a revenue nature and
taxable accordingly. Thus in
“(Bowman J.) also found that the payment was an
‘integral element’ of the day-to-day costs of Ikea's business operations, and
therefore concluded that the receipt was on income account because, in essence,
it constituted reimbursement for expenses which were also on income account:
either the payment of rent, or the assumption of other obligations incident to
carrying on business in the premises, or both.
15. I can find no fault with this reasoning or this
conclusion.”
16. Mr. McKay submitted that the
same reasoning was applicable to the facts of the present case. He pointed out that in Ikea, as in
the present case, there was no restriction upon the manner in which the
inducement payments could be employed by the recipients. They differed from the fit-out payments
received by Coopers and Lybrand, which had to be spent on the premises, and which
were accepted accordingly as constituting capital receipts.
17. Mr. McKay denied (as had Fisher
J. and Thomas J.) that the approach of the Canadian Courts involved taxation on
the basis of economic equivalence. He
accepted that, as their Lordships' Board had declared in
“It is not legitimate ... to disregard … the nature of
the contracts made and to tax Europa on the substantial or economic or business
character of what was done.”
18. Mr. McKay submitted, however,
that the requisite study of what the payment was calculated to effect from a
practical and business point of view inevitably involved a review of the
factual context in which the payment was made.
That review could not properly be precluded by what he described as the
“economic equivalence prohibition”, even if the review had regard to the
economic or financial impact of the inducement payment upon levels of rental
nominally paid.
19. This appears to their Lordships
to be the crux of the matter. It brings
to mind the arguments put forward by the taxpayer in
“The appellants bring forward two arguments at this
stage. First, they say (truly enough)
that the sums or premia were calculated by reference to the gallonage of petrol
expected to the sold at the sites, the suggestion being that this made them
resemble, or be, rebates on the price.
An effective answer to this was given in the Court of Appeal where Lord
Denning M.R. [1964] 1 W.L.R. 1166, 1175) said that it confuses the measure of
the payment with the payment itself. A
more elaborate form of the argument was that the sums were circulating capital
because Regent expected to get its money back out of current profits as sales,
gallon by gallon, day by day, were made.
Of course they did; many traders who lay out capital expect to get both
a return on the capital and the amortisation of the capital expenditure out of
the profits of the periodical sales and, whether consciously or not, they
calculate the amount they are willing to lay out accordingly; but the fact that
they have this expectation and so calculate their expenditure does not enable
them to claim that the expenditure is of a revenue character”.
“On behalf of the appellant it was said that their
Lordships must look through the transparent form of the lease-sublease to some
underlying commercial reality and that, having performed this penetration, we
should see that this was merely part of Regent’s normal marketing operations,
or, alternatively, that the payments were nothing but disguised rebates. I cannot accede to this. Without embarking here upon the question how
far it is permissible in taxation matters to go behind the legal forms which
the parties have chosen, where these forms are not a mere sham, I am satisfied
that in this case form and substance fully coincide.”
“Here the nature of the payments
- lump sums - the nature of the advantages obtained - security in respect of
the placing of orders for a period - the substantial periods involved, the
shortest being a period of five years, more than adequately establish the
expenditure as made for the acquisition of capital assets.”
22. Mutatis mutandis the same
reasoning appears to their Lordships to apply to the facts of the present
case. The respondents, through their counsel
Mr. Green and Mr. Harley, do not dispute that the $5 million payment is
commercially, financially and mathematically linked to the rental payments due
from Coopers & Lybrand. The same,
they submit, will normally be true of the ordinary premium payable by a lessee
to a lessor upon the grant of a lease.
But in the absence of special legislation to the contrary a premium has
always been recognised, in the law of New Zealand as in the law of the United
Kingdom, as capital rather than revenue.
The reason has probably never been better expressed than by Viscount
Cave L.C. in the familiar passage from his speech in British Insulated and
Helsby Cables Limited v. Atherton [1926] AC 205 at page 213 when he
said:-
“But when an expenditure is
made, not only once and for all, but with a view to bringing into existence an
asset or an advantage for the enduring benefit of a trade, I think that there
is very good reason (in the absence of special circumstances leading to an
opposite conclusion) for treating such an expenditure as properly attributable
not to revenue but to capital.”
23. This passage, of course, finds
its echo in the conclusion reached by Lord Wilberforce in Strick which
is quoted above.
24. Viscount Cave’s reference to “an
asset or an advantage” (emphasis added) is to be noted. A payment may be capital although not made
for the acquisition or disposal of a particular asset. The crucial question is whether in all the
circumstances the payment or receipt can properly be attributed to a particular
year. The question is crucial because
income tax is charged annually upon the income or profits of each year. If the payment or receipt cannot properly be
brought into the income tax reckoning for a particular year then (apart from
special statutory provision) it cannot be brought into that reckoning at all.
In Commissioner of Inland
Revenue v. McKenzies (NZ) Ltd [1988] 2 N.Z.L.R. 736 the Court of Appeal,
applying this principle, held that a lump sum payment made by a lessee to a
lessor in order to secure the termination of an onerous lease with a
substantial period still to run was of a capital nature. In the present case the $5 million was paid
by the lessor to the lessee for undertaking an onerous lease for a substantial
period. The majority of the Court of
Appeal decided that the same principle applied. They described the payment as “a negative premium” and as “the
mirror image” of the payment in McKenzies. Their Lordships are in full agreement with this view of the
matter. In this case, as in Strick,
there is no conflict between the legal nature of the payment and the practical
and business effects it was intended to secure.
25. Their Lordships would
accordingly reject the first of the contentions put forward by the
Commissioner. Their Lordships would
wish to make no comment upon the decision of the Supreme Court of Canada in the
Ikea case save to observe that the Canadian Courts appear to have
adopted a different approach from that of the Courts of New Zealand and the
United Kingdom, and of their Lordships’ Board.
26. In the light of the foregoing
their Lordships can deal more briefly with the Commissioner’s alternative
contention, that is to say that the $5 million is assessable as a gain arising
from a venture entered into in significant part for the purpose of making a
profit, so as to fall within the charge either under section 65(2)(a) or
section 65(2)(l). This contention is based upon the decision of the High Court
of Australia in Myer Emporium Limited (1987) 163 C.L.R. 199. Mr. McKay was content to accept, in general
terms, the Court of Appeal’s interpretation of Myer Emporium as
contemplating a profit arising from what is commonly referred to as an
adventure in the nature of trade, of the kind illustrated by the decision in Californian
Copper Syndicate v. Harris (1904) 5 T.C. 159. He also accepted that the dominant purpose of Coopers &
Lybrand in entering into the transaction with the lessors was to acquire new
office accommodation. But, he
submitted, Coopers & Lybrand also had the purpose of securing a profit of
$5 million. Without that profit they
would not have entered into the obligations imposed by the lease.
27. Like the majority of the Court
of Appeal their Lordships are unable to understand how the $5 million can be
regarded as a profit. It could only be
so regarded if it constituted a benefit or bonus accruing to Coopers &
Lybrand quite independently of the other terms of the bargain between the
parties. To regard it in this way would
be plainly erroneous in principle, as well as being contradictory of the first
contention put forward by the Commissioner.
In support of that contention Mr. McKay had argued, correctly, that the
$5 million was inextricably linked to the payment by Coopers & Lybrand of
the above-market rental. It might be
described as the price received by them in return for their undertaking to pay
that rental. Given that, according to
the evidence, the undertaking was equal in value to the price then there could
be no profit element in the latter.
28. Their Lordships are accordingly of the opinion
that the second contention of the Commissioner must also be rejected. They will humbly advise Her Majesty that the
appeal should be dismissed. The
appellant must pay the respondents’ costs before their Lordships’ Board.
© CROWN
COPYRIGHT as at the date of judgment.
© 1998 Crown Copyright