Taxpayer appeal against capital expenditure decision

Decision date: 28 November 2005

Case: Fullers Bay of Islands v The Commissioner of Inland Revenue

Act(s): Income Tax Act 1994

Keywords: Capital Expenditure, Deductibility, Income Revenue Distinction

Summary

The taxpayer was unsuccessful in appealing the High Court decision that legal fees expenditure was in respect of a capital asset and therefore not deductible.

Facts

Fullers Bay of Islands Limited provides sea and land transport services, engages in the tourist industry and provides a range of services in New Zealand and overseas. In March 1996, Fullers decided to look at ways of expanding its business in the Auckland area and made enquiries to the Auckland Regional Council ("ARC") about opportunities. Fullers became aware that a significant passenger ferry service run between Devonport and Auckland City was to be offered for public tender which closed on 9 April 1996. At that time the Devonport Ferry service was being run by a competitor, Fullers Group Limited ("FGL") (unrelated).

Fullers found out that this ferry run was highly profitable and so submitted a tender because it considered it could run the service without suffering significant infrastructure expansion costs and could use existing vessels. Fullers made the offer on the basis of a ratepayers' subsidy, as it was understood that the current operator, FGL, operated on a subsidy of $250,000.00. Fullers' offer was for an enhanced service at a reduced subsidy of $10,000.00. Fullers understood that, if successful, it would have a monopoly for the duration of the five year ferry service contract. It did not make an offer that included no subsidy at all, known as a Commercial Registration, because Fullers considered that offer would be unsuccessful, as the service could not run profitably on that basis.

At first, ARC found Fullers' offer attractive and notified Fullers that it was the preferred bidder. However prior to final notification of the results of the tender process, FGL submitted a Commercial Registration which was accepted by ARC, so that FGL won the tender. Fullers was not given the opportunity to submit a Commercial Registration which it considered to be unfair, particularly as they had received assurance from ARC that Commercial Registrations would not be accepted.

Fullers commenced proceedings against ARC and FGL, having received legal advice that their case was strong. In the fifth amended Statement of Claim filed in those proceeding, three causes of action were set out. These were:

1. That ARC breached contractual obligations regarding confidentiality, consideration of a Commercial Registration and fairness. The remedies sought were declarations that had ARC not breached those obligations, Fullers would have obtained the Devonport Ferry contract. It also claimed damages for $6.2 million plus interests, being the discounted value of future cash flows which would have been realised from the Devonport Ferry contract. The TRA found that, if the cashflow projections were correct, Fullers' marine division would have increased by 50%, but subsequently the High Court and Court of Appeal found that actually the Devonport contract would have doubled the marine division's operating revenue at that time.
2. That ARC had engaged in misleading and deceptive conduct which resulted in the loss of the contract. The remedy sought was damages of the same amount.
3. That ARC mismanaged the tender process in a number of ways. Remedies sought were declarations including a declaration that, if ARC had properly managed the process, Fullers would have been awarded the contract, and an order that Fullers did hold the contract for five years from the date of the order.
4. That FGL's Commercial Registration was invalid. Remedy sought was an injunction to stop them acting in accordance with that registration and, in a second cause of action against ARC under this head, seeking damages for alleged interference with Fullers' contractual rights.

In a judgment dated 4 June 1999, Paterson J dismissed all claims made by Fullers against ARC and FGL. The legal fees that Fullers paid were shown as an extraordinary item in Fullers' accounts and Fullers claimed a deduction of $612,792.14 in the 1999 income year which the Commissioner disallowed.

Decision

The Court of Appeal gave a judgment in favour of the Commissioner.

Fullers argued that, at the High Court, Baragwanath J had applied the wrong conceptual framework so that his decision was wrong in law. His Honour had concluded that the purpose of the litigation was overall to secure a capital asset. Fullers submitted that the purpose of the litigation, and thus the legal fee expenditure, was threefold. Firstly to establish that there was a preliminary contract between Fullers and the ARC, secondly to prove that contract was breached, and finally to obtain a remedy for that breach.

Fullers' first submission was that it was not correct to ignore the first two key purposes of the litigation and concentrate only on the third. Since a significant amount of the litigation expenditure was spent on those two issues, the expense was revenue in nature. It is important to note that this submission did not plead apportionment but rather sought that the Court find the legal fees in their entirety were on revenue account.

Their second submission was that, since the Devonport Ferry service contract would have required no significant infrastructure expenditure by Fullers, it was temporary in duration (five years in length, but tender would arise again in two years), and would sit alongside other services already being run by Fullers, the contract-if the Court found it was the purpose of the litigation-was not structural.

The last submission for Fullers was that Baragwanath J had wrongly applied the legal tests to determine whether the damages would have been on capital or revenue account. His Honour had endorsed the Commissioner's argument that the damages were based on a lost opportunity to earn profits and if they had been won, would have been on capital account. Fullers submitted that if awarded, the damages would constitute a "hole in the profits" and so would have been on revenue account.

The Commissioner submitted that:

1. Fullers' focus on what was intended to be achieved by the litigation was incorrect as it focused on the relief that could be expected. To do so is a focus on the juristic rights rather than the business objective of Fullers, which is contrary to the Hallstroms and BP Australia decisions.
2. The correct test for whether an item of expenditure is capital or revenue is the one set out in the Hallstroms decision, which is by reference to what the expenditure is calculated to effect from a practical and business point of view.
3. Legal fees can either be capital or revenue depending upon the purpose for which they were incurred. Here the purpose was to secure a monopolistic contract which would have been a major addition to Fullers' business. Whether or not that objective was achieved is irrelevant to the characterisation of the item of expenditure.
4. In this case the Court was not required to descend into the balancing and weighing exercise that is appropriate in borderline cases. However even if one did weigh up the factors, the result is that the expenditure was clearly to secure a capital asset.

The Court confirmed the reasoning by Baragwanath J at the High Court and endorsed the Commissioner's submission. Fullers' submissions were rejected on the basis that they consider the matter too narrowly when examining the objective of the litigation. From a practical business point of view the objective was either to enforce the process contract, as a step to secure the contract itself or the damages equivalent to it. Therefore there was no substantive difference between the process contract and the Devonport Ferry contract itself.

The Court considered it "incontrovertible" that the ferry contract would have been on capital account "in the particular (and rather unusual) circumstances of this case" because it was a long-term monopolistic contract which would have contributed some 60% to Fullers' revenue. The success or otherwise of this objective was irrelevant. The damages were for the loss of a capital asset, the ferry contract. It is not relevant that income from the contract would have been on revenue account because all income from capital assets is on revenue account.

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Date published: 10 Oct 2006

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