Deductions

The importance of deductions:

1.
2.
3.

(Gross income) (all deductions) = net income

Maximization of deductions means minimization of liability to tax.
Deductibility is fundamental to liability
Deductibility raises questions of timing that are difficult in theory and important in practice
Issues of deductibility are central to tax planning

Core Provisions
Timing of Deductions
Every deduction must be allocated to an income year: BD 4

Expenditure or loss can only be deducted once: BD 4(5)

Expenses can be legally incurred before the money is in fact spent: Mitsibishi 63% fail rate
Expenditure incurred to produce future income is deductible: Vallambrosa

If you have a net loss, you can either:

1. Subtract it from your net income for a future tax year; or
2. Make it available to another taxpayer

General permission DA1 & 2(2)

Expenditure is deductible to the extent that it is incurred in deriving assessable income and is of a revenue
nature

Subject to the limitations in DA 2 and specific rules in part D

Depreciation loss is deductible

Expenditure on producing excluded income is deductible

Focus on TPs genuine intention that the expenditure produce assessable income
No requirement that the expenditure actually produce assessable income,

Manifestly unreasonable expenditure may give rise to inference of lack of genuine intent to produce profit: Aspro

director fees inflated

Whether or not expenditure incurred in producing deductable income can come down to fine factual distinctions:

Damages paid by newspaper for defamation held deductible risk of defamation assessed as being part and

parcel of the newspaper producing assessable income: Herald HCA

Damages paid by hotel to injured customer not deductible because on the facts, not incurred in producing
taxable income: Woodifield HL

Apportionment is sometimes required: Case L11 model 50% and Aspro PC

Private / domestic limitation: DA 2 (2)

E.g. clothing, food, childcare, grooming but exception where clothing is required to earn income and not suitable
for day to day use may be deductible

Exempt income limitation: DA 2(3)

Covered by GP only allows excluded and assessable income

Employment limitation: DA 2(4)

Useful GP would allow employees to deduct expenditure i.e. E/ee buying hammer
Applies to employees not employers, fringe benefit is part of the cost of an employee

Withholding Tax Limitation: DA 2(5)

Non-resident passive income
I.e. Dividends, royalties or interest subject to final withholding
Non-residents foreign-sourced income limitation: DA 2(6)

The Capital/Revenue Distinction

Tests for distinguishing capital and revenue expenditure:
Recurrent v Singular Expenditure Test: Rubber Co
Recurrent expenditure tends to be of revenue nature (deductible); once off expenditure tends to be of capital nature
(maybe depreciable).

C.f. Johnson Matthey: Once off payment to remove threat of insolvency held to be revenue payment because on

the true analysis of the transaction payment not made for the purpose of disposing of a capital asset.
Identifiable Asset Test: Granada Motorway
If expenditure relates to the acquisition, disposal or improvement of an identifiable capital asset, it is typically of a capital
nature and therefore not deductible.

Granada Motorway: Lump sum payment in consideration for LL changing the lease. Lease was an identifiable
asset. It was impossible to divorce the payment from the lease.

Enduring Benefit Test: British Insulated

Expenditure that does not produce an asset, but produces an enduring benefit, is typically of a capital nature (and
therefore not deductible).

British Insulated: pension scheme set up to induce employees to stay. Some employees approaching retirement
age bf fund maturation so employer made lump sum payment. HELD: Expenditure held to be capital nature - did
not produce identifiable asset but rather substantial and lasting benefit.

Fixed v Circulating Capital Test: John Smith

Expenditure on fixed capital is typically of a capital nature and therefore not deductible. Expenditure on circulating
capital is typically of a revenue nature and therefore deductible.

John Smith: payment of sum to acquire unexpired contracts held to be non-deductible as expenditure on fixed
capital.

Fixed capital is turned into profit by keeping it within own possession.

Circulating capital is turned into profit by parting with asset e.g. trading stock, stock in trade, and advertising.

Structure/Process Test Sun Newspapers

If expenditure relates to structure of the TPs business as a profit making entity that suggests it is of a capital nature
(not deductible). If related to process of the taxpayers business that suggests it is of a revenue nature (deductible).
Sun Newspapers: T paid $ for interest of competitor to ensure it did not publish in Sydney or w/in 300 miles - capital

Structure or setup of business as a profit-making entity = capital expenditure.

Strengthens or preserves entity as a profit-yielding subject
E.g. goodwill, plant, buildings, competitive advantage

If relates to process by which business operates to earn regular returns by means of regular outlay: revenue
expenditure

Factors to consider:

1. Character of advantage sought / disadvantage adverted: lasting quality is relevant (e.g. lower selling price, loss of
circulation, lower advertising rates, more competition)
2. Manner in which advantage was used, relied upon or enjoyed: recurrence will be relevant
3. Means adopted to obtain it: periodical outlay vs final capitalised sum (including instalments) to secure use.
Cases on the Distinction between Capital and Revenue Expenditure
Note: none of the tests are determinative; require judgement OTF.
Outline how OTF presented, which tests are more important

Payments for securing exclusive supply arrangements conflicting cases

BP Australia: Lump sum payments by an Australian oil company to petrol stations in consideration for entering into
exclusive arrangements.
ISSUE: Lump sum payments deductible?
HELD: expenditure was of a revenue nature and therefore deductible. Court considered various tests and guiding

principles (including factors from Sun Newspapers)

Character of the advantage sought: think of lasting qualities / possibility of recurrence and nature of the need /

occasion calling for expenditure

Lasting quality: Take a broad view of the general operation under which the expenditure was incurred
Structure / process: Establishing or extending a business organisation v carrying on the business
Identifiable asset: no conventionally identifiable asset
Circulating vs. Fixed capital: The sums in question were sums, which had to come back penny-by-penny with every
order during the period in order to reimburse and justify the particular outlay.

Regent Oil: Petrol station leased premises to T for nominal rent, T subleased back for same nominal rent; lump sum
premium paid by T to station; covenant in sublease that Ts oil sold exclusively on premises.
HELD: payment = capital expenditure.

Identifiable asset: payments were for acquisition of lease and exclusivity covenant to carry out trade

Premiums for leases are generally regarded as capital

Reconciling this case with BP: Largely unconvincing distinctions

Regent: involved lease and covenant as identifiable asset; BP had no easily identifiable asset
Problem: real economic effect of transactions is the same = secure exclusive agreements for supply of stock. The
two agreements while formally different are in a commercial sense much the same.
Regent: agreement for a longer period that BP. Unconvincing: both could be considered similar to Sun (profit
making structure) or as enduring benefits.
Payment for surrender of a lease held to be capital payment (termination of a capital asset)
McKenzies: TP had 36 years left on lease, terminated by lump sum.
HELD: not deductible, lease was an asset that formed part of capital structure of TPs business

Richardson J looked at the factors identified in BP:

Need or occasion which called for the expenditure
Whether paid from fixed or circulating capital

o I.e. is it part of circulating and recurrent expenditure

Whether once and for all?
Whether expenditure produced assets / advantages of enduring benefit
How the payment would be treated on ordinary principles of commercial accounting
Whether payment related to business structure or process by which income was earned

Losses on sale of shares

Turns on the purpose for which the TP bought the shares
>>Inglis: management consultant, not dealer in shares bought shares for dominant purpose of resale; market crash;
TP sold shares for a loss, sought to deduct loss
CIR: argued that while profit on resale would have been taxable, losses were subject to capital limitation
HELD: loss was deductible, TP bought shares for the purpose of resale for profit in a short time = shares were circulating

capital
Expenditure incurred on obtaining consents and licences = capital in nature
>>Milburn: Part of the cost of creating permanent income producing structure, rather than cost of earning the income
Consents and licences were enduring benefit, no recurrent cost
>>CIR v Trustpower : Expenditure incurred on obtaining resource consents was of a capital nature and therefore
depreciable over the assets useful life

Consent obtained for the purpose of expanding business expanding the profit making structure
Resourse concents were valueable assets from a practical and business point of view
No sufficient nexus between expenditure and earing income of the existing business
While recurrent the consents lasted for 10 35 years which was assesed as being an enduring benefit

Repairs, Maintenance, Replacements and Improvements

Repairs / maintenance (of capital or revenue assets) generally of a revenue nature - deductible

Put asset back into / maintains original state

Replacements / improvements generally of a capital nature - not deductible, may be depreciable

Change the character / add value to asset

Substantial improvement of an asset that changed its character = capital expenditure

Auckland Gas: T inserted plastic pipe into existing cast iron & steel pipes. HELD: insertion of plastic pipes, essentially
replacement = capital expenditure.
Two step test used by PC:

1. Identify the asset being worked on and measure the extent of the repair
2. Assess the nature and extent of the work done
Cost of repairs at time of acquisition

If repair needed to put the capital asset into a useable condition that expenditure will be part of the cost of the

capital asset: Law Shipping

If the capital asset is usable and the expenditure on repair will generally be of a revenue nature: Odeon

Specific Rules for Expenditure Types: DB

DB 1: generally cannot deduct:
1. NZ income tax (including interest, penalties, etc);
2. Foreign income tax

Income tax is calculated on a GST-exclusive basis:

DB 2: a registered person cannot deduct either:
(a) Input tax on a supply of goods or services to them; or
(b) GST payable by them.
This parallels section CX 1: which provides: the following are excluded income of a registered person:
(a) Output tax on goods and services they supply; and
(b) GST payable to them by the Commissioner.

Rules relating to deductibility of financing Costs

Transaction Costs
A person is allowed a deduction for expenditure incurred in borrowing money that is used as capital in deriving their
income: DB 5(1)

This section overrides the capital limitation: DB 5(2)

The general permission must still be satisfied and the other general limitations still apply.

A person is allowed a deduction for interest incurred: DB 6(1)

Limited by DB 1 interest on tax not deductible

This section overrides the capital limitation, other limitations apply

The general permission must still be satisfied expenditure must still be incurred in deriving assessable income

Interest is only deductible to the extent that the borrowed principal is utilized in the production of assessable income (does

not apply to companies): Public Trustee apportionment

Secondary purpose on top of production of assessable income does not render interest non-deductible: Eggers; Pacific
Rendezvous: Borrowing money to pay for improvements to a motel in order to obtain a better capital profit on sale of motel
business and to increase the profitability of the business in the meantime.
Held: whole amount of interest was deductible: all borrowed monies were put into motels: expended on assets that

were fully utilized in the business, therefore went towards producing assessable income.
Richardson J: concern is with how the capital was employed during the period when the interest was incurred.
C.f. Public Trustee

A company is allowed a deduction for interest incurred: DB 7(1)

This section supplements the general permission company can deduct interest payments even when not incurred in
producing assessable income

Overrides the capital limitation

Overrides the exempt income limitation
Other limitations apply

Some Other Rules in Subpart DB

1.

Lease transaction costs are deductible: DB 18;

2.

Cost of revenue account property is deductible: DB 23;

3. The value of property the subject of a profit-making undertaking/scheme (under CB 3) is deductible: DB 26

4. The value of land the subject of a major development (under CB 13) is deductible: DB 27;
5. The value of land affected by a zoning change (under CB 14) is deductible: DB 28;
6. Bad debts are deductible if written off: DB 31;
7. Theft by employees and contractors is deductible: DB 42;
8. Bribes are not deductible: section DB 45;
9. Expenditure on not discharging contaminants is deductible: DB 46;
10. The opening value of trading stock is deductible: DB 49;

11. Payments to a spouse, civil union partner or de facto partner for anything other than services are not deductible
(except with the CIRs prior approval): DB 57;
12. Expenditure is not deductible if denied under section GA 1 (the general anti-avoidance rule): DB 58.
Expenditure in Connection with Employees and Contractors
1. Lump-sum bonuses etc. paid to an employee on retirement are deductible: DC 1;
2. Payments to a spouse, civil union partner or de facto partner for services are not deductible (except with the CIRs
prior approval): DC 5;
3. Employers contributions to employee superannuation schemes are deductible: DC 7;
4. Payments for restrictive covenants & exit inducements are deductible, if taxable to the recipient under CE 9: DC 9.
Specified Expenditures
1. Expenditure on entertainment: DD;
2. Expenditure on motor vehicles: DE;
3. Farming and aquaculture expenditure: DO;
4. Forestry expenditure: DP;
5. Expenditure incurred by life insurance companies: DR;
6. Film industry expenditure: DS;
7. Petroleum mining expenditure: DT;
8. Mineral mining expenditure: DU;
9. Etc.
Specified Entities
Subpart DV sets out rules relating to deductibility for specified entities, including:
1. Superannuation funds;
2. Investment funds;
3. Non-profits;
4. Trusts;
5. Building societies;
6. Maori authorities;
7. Group companies;
8. Amalgamated companies.