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Follow the rules when deducting bad debts

Tax Alert - September 2019

By Emma Marr

A decision of the Court of Appeal has highlighted the detailed and prescriptive rules that allow deductions for bad debts.  In that case a lawyer loaned money to his clients. When two clients did not pay the debt back, he took a deduction for the full amount of the debt. The Commissioner challenged this and won in the Taxation Review Authority (TRA), High Court, and Court of Appeal (Hong v Commissioner of Inland Revenue [2019] NZCA 336).

The Court of Appeal considered whether the High Court had correctly upheld the judgement of the TRA on three key issues, discussed below.

a)    Was the taxpayer entitled to claim the deductions for bad debts in his 2011 tax return? The Court found he was not.

Under s. DB 31 a taxpayer cannot deduct a bad debt unless:

·         the loan has been written off in the income year; or

·         the debtor has been released from making any payments by legislation (due to insolvency or bankruptcy); and

·         where the debt is a financial arrangement, the lender is carrying on a business of dealing in or holding financial arrangements that are the same as, or similar to, the relevant bad debts.

The taxpayer failed to meet any of the requirements.

First, the Court found he had not written the loans off in the relevant year. Rather, the Court accepted evidence that he had created all relevant documents for filing the 2006-2012 income tax returns at the same time, and that was after the end of the 2011 income year.

Second, the debtors hadn’t been released from making payments under the loans, neither having been declared insolvent or bankrupt.

Finally, the Court found that the taxpayer was not in the business of lending money. There was conflicting evidence from the taxpayer about the nature of his lending arrangements, and in particular whether it was a charitable activity or whether it was a commercial lending operation. The taxpayer was in the difficult position of both arguing that he intended to make money from the loans, but also arguing that he wasn’t breaching the requirement that, as a lawyer, he did not have a conflict of interest in relation to his clients. On reviewing the facts, the Court found that the taxpayer did not have a commercial lending operation and was not in the business of advancing loans.

b)    Did the section allowing a deduction for bad debts (s. DB 31 of the Income Tax Act 2007) override the general permission for deductions for business costs in section DA 1? The Court confirmed that s DB 31 overrides the general permission.

The taxpayer attempted to argue that, whatever s. DB 31 said, he could still take a deduction for the bad debts under s. DA 1, which is the general permission for deductions: it allows a deduction for expenditure that is incurred in deriving assessable income or carrying on a business to derive assessable income. However, the legislation is clear that s. DB 31 overrides s DA 1. Section DA 3 states that any provision in subparts DB to DZ can override DA 1 if they expressly say they do.  DA 31(6)(a) expressly says that s. DB 31(1) overrides s. DA 1.

c)    Was the taxpayer liable for a shortfall penalty for failure to take reasonable care? Unsurprisingly, the Court confirmed he was liable for the penalty.

Again, there was conflicting evidence about the lengths to which the taxpayer had gone to determine the correct tax treatment of the bad debts. He told the Court he had researched the legislation and relevant case law, but there was evidence he had previously told Inland Revenue he had not understood the tax law and had asked them to help him research it. The Court found that he had not done what a reasonable person in his circumstances would have done. This included taking steps to understand a complex area of law, keeping adequate records to substantiate the deductions, and filing returns and paying tax on time.

This case highlights the specific and unyielding nature of tax legislation. In this case, the failures to meet those requirements are quite stark given the prescriptive nature of the law.  If you have any questions about this decision or deducting bad debts in general, contact your usual Deloitte advisor.

September 2019 Tax Alert contents

·         What's on the tax policy work programme

·         A stick and carrot approach: FATCA, CRS and QI update

·         Customs is also interested in your transfer pricing 

·         Taxing telecommunication tools

·         Mileage reimbursements revisited - again!

·         Follow the rules when deducting bad debts

·         Recent developments

·         Deloitte Insights app 

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