High Court provides guidance on contractual interpretation and a taxpayer win on shortfall penalties
Tax Alert - February 2015
By Emma Marr and Jesse Pene
The High Court recently delivered its judgment in C of IR v John Curtis Developments Ltd  NZHC 3034. This case provides useful guidance on the capital/revenue boundary, interpreting contractual arrangements and some further elaboration on the application of the “unacceptable tax position” shortfall penalty. Although the taxpayer did not succeed on the substantive tax issue, the judgment provides a refreshing view for the taxpayer on shortfall penalties.
In 2000, the taxpayer, a property developer, started developing a retail shopping centre north of Christchurch with the intention of leasing units to retailers. After four years, the project was 65 per cent complete and the taxpayer sold the centre (comprising the developed part of the centre and the undeveloped land) to a third party, AMP. The sale agreement included an “option” that required the taxpayer to use best endeavours to lease and build the undeveloped part of the centre. In return, the taxpayer received “development payments” from AMP.
The main issue for determination was whether the agreement provided for a single supply of a capital asset, or two distinct supplies – one capital (sale of the developed centre and the undeveloped land) and the other revenue (letting and construction services on the undeveloped land). There was $2,615,574 of tax and $261,557 of shortfall penalties at stake. The Commissioner had already accepted that the developed centre and undeveloped land was a capital asset developed for the purpose of holding as a long term investment, and therefore the payment received for the existing buildings and land was not taxable.
The taxpayer claimed that both the purchase price for the land and centre and the development payments were capital receipts, and therefore not taxable. It was asserted that the agreement was for the sale of the completed shopping centre, and that the development option was simply a condition subsequent that the taxpayer had to comply with before AMP would pay the remainder of the purchase price.
The Commissioner argued that the development payments received by the taxpayer from 2006 to 2009 were assessable income (with receipts from earlier years being time-barred). The Commissioner maintained that there were two supplies from the taxpayer to AMP:
- The sale of the partially completed shopping centre, including all the developed units and undeveloped land (sale of a capital asset and therefore receipts not taxable as income).
- Development services to AMP of constructing buildings and supplying tenants for those buildings on land that was undeveloped at the time of sale (development payments that were taxable income to the taxpayer).
The dispute was first heard in the Taxation Review Authority (TRA) which found in favour of the taxpayer.
On the issue of whether there were two separate supplies, the TRA agreed with the taxpayer that there was a single contract for sale and purchase of the completed centre. The TRA found that the development option was not separate from the agreement for sale and purchase of the land and completed units. It was simply a “mechanism... for delivery of the completed centre”.
On the basis that the agreement was for a single supply of the completed shopping centre, the TRA concluded that this was the supply of a capital asset. Accordingly, all consideration paid to the taxpayer under the agreement, including the development payments, was capital and not taxable. As a result, there was no further tax liability and no shortfall penalties were payable.
High Court decision
The Court addressed two preliminary points prior to considering the primary issue concerning interpretation of the agreement:
- The admissibility of certain evidence relating to the taxpayer’s intention;
- Whether the Commissioner was entitled to rely on an argument that the taxpayer considered was not included in her Statement of Position (SOP).
On the first point, the TRA heard evidence from representatives of both parties (i.e. taxpayer and AMP) as to the intentions of the parties during pre-contractual negotiations, and the meaning and intent of the various provisions of the agreement. The Court agreed with the TRA that the evidence should be excluded, as it amounted to “subjective declarations of intent” that should not be taken into account when interpreting the contract.
On the second point, the taxpayer submitted that the Commissioner’s grounds in the TRA impermissibly departed from her SOP in breach of the “issues and propositions of law exclusion rule” in section 138G of the Tax Administration Act 1994. It was argued that in her SOP, the Commissioner relied on there being two separate contracts, rather than a single contract to complete the whole development, whereas in the TRA and High Court, the Commissioner argued that there was one contract, but that there were two supplies under that contract. The Court considered the wording of section 138G and found that, while the Commissioner was limited to the “issues and propositions of law” disclosed in either her or the taxpayer’s SOP, it was enough for this reference point to be an “outline” of those propositions of law, which was in enough detail to “fairly inform” the relevant other party. The Commissioner’s SOP met this level of required detail, and in any case, the argument that there was a single contract was raised in the taxpayer’s SOP, which in itself entitled the Commissioner to make that argument before the TRA and High Court.
Primary issue – one supply or two?
Justice Kos in the High Court overturned the TRA decision and concluded that the agreement contained two “distinct and separately identifiable supplies”, one capital and one revenue. In summary, his Honour noted the following points in arriving at his decision:
- It was clear the agreement encompassed two obligations – the sale of the existing land and development at the time of sale, and the future development services. It was not an agreement for a single supply of a completed development.
- The payment of the two sums – the purchase price and the development payments – did not depend on one another. If the future development did not take place, there was no impact on the purchase price. AMP could have cancelled the development option, which supported the proposition that the two supplies were separate.
- Failure to develop all of the remaining sites would not be a breach of the agreement, unless the taxpayer failed to use best endeavours to do so.
- Once the taxpayer had sold the land to AMP, the nature of the work performed under the development option was services supplied to a third party. They no longer had the characteristic of capital improvements to the taxpayer’s own land as the taxpayer no longer owned the land.
Having concluded that there were two supplies Justice Kos found that the development payments were taxable. His Honour ruled out any arguments suggesting that the payments were merely ancillary, noting that the further development payments were $26.6m, compared with the land and centre sale price of $31.28m.
The question then became, were the development payments business income? Justice Kos answered this in the affirmative. The taxpayer was in the business during the relevant period of finding tenants and constructing retail units. The activity was organised, coherent, and directed to making a profit. That profit was earned by receiving the development payments in the course of that business, and therefore the development payments were taxable income.
This case also provides useful guidance on the application of the shortfall penalty for an unacceptable tax position. The Commissioner argued that this shortfall penalty should apply because the taxpayer had taken an unacceptable tax position (i.e. the tax position failed to meet the standard of being “about as likely as not to be correct”). The Court emphasised that the test is objective, not subjective, and that the taxpayer’s actual belief is irrelevant. If the taxpayer’s argument “can objectively be said to be one that, while wrong, could be argued on rational grounds to be right’ (citing the decision in Walstern Pty Ltd v C of T (2002) FCR 1), then the shortfall penalty for an unacceptable tax position will not apply.
Justice Kos took the view that since the TRA, in a “cogent and careful decision”, upheld the taxpayer’s argument, it was a tax position that a reasonable mind might adopt. On that basis shortfall penalties were not imposed.
So what are some key take-away messages from this case? The first point, and perhaps most obvious, is that parties to a contract need to carefully consider a transaction from a tax perspective. If the intention had been to simply sell a completed development, the parties could have drafted the agreement such that it explicitly provided for a single supply, payment and obligation, with one sale, and provisions to provide consequences for non-performance of post-completion development work. Recognising that each contract is unique, businesses should be liaising with their tax advisers to ensure that agreements are wholly consistent with and achieve the expected tax outcome.
The second observation relates to contractual interpretation. The Court reaffirmed that oral evidence relating to “subjective declarations of intent” is not admissible in interpreting a contract. The exercise of ascertaining intention is purely an objective one, which is another reason for parties to ensure that any agreement is drafted carefully such that it sufficiently accurately records and reflects the collective parties’ intentions.
Finally, the judgment provides useful guidance on the standard for applying an unacceptable tax position shortfall penalty, in particular the meaning of “as likely as not to be correct”. It is useful to re-confirm that an argument can ultimately be found to be wrong, but can still be sufficiently rational to meet the test. In this particular case, the fact that the TRA had found for the taxpayer was enough to establish that the taxpayer’s argument could be argued on rational grounds to be right, and so the penalty did not apply.
February 2015 Tax Alert contents
- Consultation on the land development and subdivision provisions
- Changing depreciation rates – when is it acceptable?
- High Court provides guidance on contractual interpretation
- BEPS - Keeping up-to-date via Dbriefs and BEPS Central
- Introducing the Deloitte tax@hand app