The Judicial Committee of the Privy Council Decisions

The Commissioner of Inland Revenue Appellant

v.

New Zealand Forest Research Institute Limited Respondent

FROM

COMMITTEE OF THE PRIVY COUNCIL,

Delivered the 12th June 2000

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Lord Nicholls of Birkenhead

[Delivered by Lord Hoffmann]

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1. The issue in this appeal can be shortly stated. The taxpayer company agreed to acquire the assets and undertaking of a business. As a part of the consideration for the acquisition of the business, it agreed to take over certain liabilities, including certain of the vendor’s contractual obligations to its employees. These included their vested or contingent entitlements to paid leave, attributable to their service with the vendor. The question is whether the subsequent payment of these sums was deductible for the purposes of calculating the company’s profits assessable to income tax. Salmon J. held that, as liability to make the payments had been assumed as part of the consideration paid for the assets of the business, they were a capital expense. The Court of Appeal held that as they had been paid pursuant to the employees’ contracts of employment, they were a revenue expense.

2. The question is slightly complicated by the existence of a statutory background. The vendor was the Crown and the business was that of forestry research, which had previously been undertaken by a government department. The sale was pursuant to the Crown Research Institutes Act 1992. The Act provided for the disposal of the assets and liabilities of research undertakings to companies designated Crown Research Institutes that had been specially incorporated for the purpose. The taxpayer company ("the Institute") was so incorporated and acquired the relevant assets and liabilities with effect from 1st July 1992 (the "Transfer Date") pursuant to a Transfer Agreement dated 30th June 1992 between the Crown and the Institute and subject to the provisions of the Act. Section 39 of the Act provided that the Crown and the Institute could agree upon the "transfer" of employees engaged in the activities which formed part of the business acquired by the Institute. Section 40 provided that a transferred employee should be employed by the Institute on terms and conditions "based on" the terms and conditions of his former employment by the Crown until varied. And section 41(1) provided:-

"Every employee of a Government department who is transferred to a Crown Research Institute pursuant to section 39 of this Act shall, on the date of the transfer, become an employee of the Crown Research Institute, but, for the purposes of every enactment, law, determination, contract, and agreement relating to the employment of each such employee, the contract of employment of that employee shall be deemed to have been unbroken and that employee’s period of service with that department, and every other period of service of that employee that is recognised by that department as continuous service, shall be deemed to have been a period of service with the Crown Research Institute."

 

3. The consideration given by the Institute for the acquisition of the assets was a sum of money calculated in accordance with a formula contained in the agreement, together with the assumption of "the Liabilities", which were defined to include:-

"… the liabilities (actual or contingent) of the Crown that relate or attach to, or arise or may arise because or out of … (v) … the transfer or employment of any employee of any Government Department or Ministry to or by the Company or the terms on which any such employee was previously employed by a Government Department or Ministry (but without limiting the Crown’s obligations to the Company in respect of Accrued Staff Liabilities) …"

 

4. "Accrued Staff Liabilities" was defined as:-

"… amounts or benefits that a person employed on the Transfer Date by the Company, and who was employed by the Crown on 30 June 1992, is eligible to be paid or take on the Transfer Date in respect of employment by the Crown prior to the Transfer Date (and for this purpose such a person shall be deemed to be eligible to be paid amounts on account of annual, long service, resignation and retirement leave even if all conditions for eligibility have not yet been satisfied) …"

 

5. The formula adopted for the ascertainment of the cash consideration involved a calculation of the value of the assets transferred and a deduction of, among other things, an estimated sum in respect of the Accrued Staff Liabilities. As Richardson P. pointed out in the Court of Appeal, the sum deducted was not necessarily the same as the amount expended. But their Lordships do not think that this matters. The deduction merely shows that the parties treated the assumption of the liabilities as part of the consideration for the assets.

 

6. Leaving aside for the moment the provisions of section 41, the position was that the Institute, pursuant to the Transfer Agreement and as part of the consideration for the purchase of the assets, accepted a liability under its employment agreements with former Crown employees not merely to remunerate them for services to the Institute but also to discharge obligations, either vested or contingent upon some future event, which were attributable to their previous service with the Crown. It seems to their Lordships plain that, viewed in this light, the payments were capital expenditure, being part of what was paid for the acquisition of the assets. There can be no doubt that the discharge of the vendor’s liability to a third party, whether vested or contingent, can be part of the purchase price. It does not matter that the payment is not made at once but pursuant to an arrangement whereby the purchaser agrees to be substituted as debtor to the third party.

 

7. Nor can it matter that the payments would be income in the hands of the third party recipient. In Royal Insurance Co. v. Watson [1897] AC 1 the purchaser of a business agreed as a term of the acquisition to employ a manager previously employed by the vendor at a salary, with power to commute the salary by payment of a lump sum. The purchaser company took on the manager and shortly afterwards exercised the power of commutation and paid him £55,846. The House of Lords held that the payment was part of the capital consideration paid for the business. It will be noticed that the payment was made in that case pursuant to a new contract of employment but the employee’s entitlement to the commutation payment was nevertheless held to be part of the purchase price rather than attributable to his services to the purchaser company. Whether it was attributable to one or the other was a question of fact. The Commissioner’s argument in the present case is much stronger because the payments in issue were clearly attributable to services rendered to the Crown and, but for the sale, would have been obligations of the Crown. It is, of course, possible to imagine a case in which the purchaser of a business agrees to take on the former employees on the basis that it will honour all accrued leave entitlements without being under any obligation to the vendor to do so. In such a case, the payments are simply additional remuneration for the services they perform for the new employer and will be a revenue expense. But the finding of fact by Salmon J. in the present case was:-

"The [Institute] … took on the employees subject to [the] statutory obligation [to pay Accrued Staff Liabilities to the employees], not because that obligation was the result of a contract negotiated with its employees but rather, because it was obliged to contract with the employees on that basis, both as a result of the statute and as a result of the bargain contained in the transfer agreement."

 

8. Is this finding affected by section 41? The Court of Appeal thought that it was. Richardson P. said that the effect of the section was that the employees must be deemed always to have been employed by the Institute. Therefore, in discharging the Accrued Staff Liabilities, the Institute was not making payments which had become due in respect of service to the Crown. The payments were due in respect of deemed service to the Institute itself. They were accordingly of a revenue nature.

 

9. Their Lordships think that this construction gives section 41 too wide a meaning. The section says that for the purposes of every enactment, law, determination, contract and agreement "relating to the employment" of each employee, the contract is deemed to have been unbroken and his "period of service" with the Crown shall be deemed to have been a "period of service" with the Institute. This means that the rights of the employees as against the Institute, and in particular those rights affected by their length of continuous service, are to be determined as if they had always been employed by the Institute. It does not however mean that this assumption is to be applied to the relationship between the Institute and the Crown. Indeed, the provisions of the Transfer Agreement for the assumption of Accrued Staff Liabilities and the adjustment of the purchase price to take them into account would have made little sense if the employees had never been Crown employees in the first place. Nor do their Lordships think that the assumption can be applied to the effect of the Transfer Agreement upon the Institute’s liability to tax. Their Lordships think that this narrower construction of section 41 is in accordance with the opinion of Eichelbaum C.J. in New Zealand Rail Ltd v. The Accident Rehabilitation and Compensation Insurance Corporation (1995) T.R.N.Z. 790, 793.

 

10. Finally their Lordships should mention an argument advanced by Mr. Milne Q.C. for the Commissioner, in which he contended that the effect of cases such as Commissioner of Inland Revenue v. Lo and Lo [1984] 1 W.L.R. 986 and Commissioner of Inland Revenue v. Mitsubishi Motors New Zealand Ltd. [1996] A.C. 315 was that, if the Crown had been a taxable entity, the Accrued Staff Liabilities would have been a deductible revenue expense in respect of profits earned before the Transfer Date. Therefore it would be wrong for the Institute to be able to deduct them in respect of profits earned after the Transfer Date. To this Mr Clews, for the Institute, riposted that under section 104A(2A)(a) of the Income Tax Act 1976 (accrual expenditure) the liabilities would not have been deemed to have been paid by the Crown unless actually paid to the employee in the relevant income year or within 63 days thereafter. Their Lordships do not consider this argument material to the present problem. A case like Mitsubishi and the provisions of section 104A are concerned with timing: the income year to which revenue expenses should be attributed. The present case, by contrast, is concerned with whether the payments were a revenue expense at all. It is by no means remarkable that acceptance of liability to discharge another person’s obligations to make payments in return for a capital payment or a capital asset should be a capital expense, even though the same payments if made by the original debtor would have been a revenue expense. In this case, their Lordships think there is no doubt that if the Crown had been a taxable entity and had itself paid the Accrued Staff Liabilities, they would have been deductible revenue expenses. But that does not affect the conclusion that the Institute’s acceptance of liability to pay them was a capital expense. In the circumstances, the ascertainment of the income year in which the Crown would notionally have been entitled to deduct the payments is irrelevant.

 

11. Their Lordships will humbly advise Her Majesty that the appeal should be allowed and the order of Salmon J. restored. The respondents must pay the Commissioner’s costs in the Court of Appeal and before their Lordships’ Board.