Te wiki o te tāke; the long historical reach of Inland Revenue; the case for treating landlords differently; and are breast implants tax deductible?

Friday was the final day of the 2022-23 tax year for most taxpayers. One of the more important tasks to achieve that day was filing any outstanding tax returns for the 2021-22 tax year. March 31st is the latest due date for taxpayers with a tax agent and most tax agents, including myself, were busy filing tax returns to meet this deadline.

A key reason the deadline is important is because under the Tax Administration Act, Inland Revenue have four years after the end of the tax year in which a tax return is filed to open any investigation into that return. This is what we call the time bar period. For example, Friday was the last day for Inland Revenue to open a review of a tax return for the year ended 31st March 2018, which was filed during the year ended 31st March 2019. The four-year time bar period expired on 31st March 2023. If the deadline isn't met and you're late, even by a day, then effectively you give Inland Revenue an extra year in which to review a return.

But there are circumstances in which Inland Revenue can reach back beyond this four year period. And a Technical Decision Summary released this week is a good illustration of when that might happen. Technical Decision Summaries come out of disputes which have gone before the Adjudication Unit of Inland Revenue. They're not formal decisions, but they're very good indicators of the type of cases Inland Revenue has been reviewing and how it would approach a case.

The background is that an individual taxpayer had a business and got into a dispute regarding the treatment of deposits made to bank accounts owned by the taxpayer and associates during the 2010, 2011, 2012, and 2016 tax years. Did these deposits represent assessable income. If they were, was the taxpayer liable for a tax evasion shortfall penalty Inland Revenue was also looking for an increase in that shortfall penalty for obstruction. And that last point is not something we've seen very much of before

But before Inland Revenue get to that, the question that had to be decided was whether they were entitled to amend the assessments to increase the amounts, because the years in question were outside the four-year time bar period I just mentioned. Now, this is the most interesting part of this whole case because it is a good background of when Inland Revenue can amend to increase income in a tax return. It’s also worth remembering they may also go past the time-bar to decrease an amount of a net loss.

As noted, all the disputed periods 2010, 2011, 2012 and 2016 would have been time barred unless one of these exceptions applied. And the relevant exceptions are where Inland Revenue or the Commissioner of Inland Revenue, to be exact, is of the opinion that a tax return provided by a taxpayer is “fraudulent or wilfully misleading,” or does not mention income of a particular nature or derived from a particular source.

A key point here is that it is sufficient for the Commissioner to honestly believe on the available evidence and on the correct application of the law that the tax return in question meets the requirements for these exceptions to apply. And if you're going to challenge the Commissioner, that will only succeed if the Commissioner did not honestly hold that opinion or misdirected himself as to the legal basis on which the opinion was formed, or his opinion was not one that was reasonably open to the Commissioner on the available information.

A decision to re-open a time-barred tax return is what we call a disputable decision so it can go before the courts. But the burden of proof rests with the taxpayer to show on the balance of probabilities that a decision made by the Commissioner to reopen time-barred years is wrong.

The adjudicator at the Tax Counsel Office went back to basics in examining the case because it's a fairly serious matter if you're going to reopen tax years. The Tax Counsel Office concluded on the evidence that the taxpayer knew they were breaching their tax obligations by not returning rental and business income. This was also apparent from and could be inferred from the taxpayer's business experience. Furthermore the taxpayer went so far as to proactively provide misleading information about the requirement to file during a phone call with Inland Revenue. The Tax Counsel Office therefore formed the view the taxpayer's returns were fraudulent and wilfully misleading.

However, the Tax Counsel Office also considered there wasn't enough proof to show evasion for the 2011 year. But they did say there should be a gross carelessness shortfall, penalty of 40%. The taxpayer was held to have evaded tax in the other years so Inland Revenue went for tax evasion penalties, which are 150% of the tax evaded (discounted by 50% for previous good behaviour). Bear in mind, use of money interest will also be running on the tax evaded.

What Inland Revenue also did, which I haven't seen much of before, is the shortfall penalties were increased by 25% for obstruction.  This was done because the taxpayers continued and undue delays, misleading statements, clear diversion of income into other relatives’ bank accounts and repeated failure to be forthcoming about with information about deposits and bank accounts delayed and made it more difficult for the Inland Revenue to carry out the audit. This obstruction affected the 2011, 2012 and 2016 years and for each of those years, the shortfall penalty was increased by 25%.

The case illustrates when Inland Revenue can bypass the four-year time bar. Although it felt it was dealing with a case of tax evasion, the Tax Counsel Office also concluded the four-year time bar didn’t apply because no return had been provided and no declaration had been included of income, then the second leg was also available. The 25% increased shortfall penalty for obstruction is one of the first cases where I've seen it applied. In summary, this is a classic example of where the taxpayer screwed around and got found out and would have paid quite a considerable penalty.

Interest deductibility and thin capitaisation

Moving on, earlier this week, an article popped up over whether or not landlords are in business, and on the face of it they are.  But landlords have been complaining that they are not treated like other businesses and are subject to more rules and regulations. One of the sore points for residential property landlords is the question of the interest deductibility, which is restricted.

According to Property Investors Federation vice-president Peter Lewis, and he made the case that it is a business and the interest deductibility compared with other businesses is an example where they're treated differently, however. And Brad Brad Olsen, the Infometrics chief executive and economist, agreed with him on that.

When I was asked this question, my response was it's not technically correct to say no other business is denied interest deductibility. Landlords are not unique in that sense. That’s because of the thin capitalisation rules which apply to New Zealand companies with overseas parent companies. Under these rules, if the debt to asset ratio exceeds 60% then interest deductions above that threshold are restricted.[i] (As an aside, I thought that when it was clear the Government was considering changes to residential rental property, adopting the thin capitalisation regime, which has been in place since 1995, would have been one option. But as we know, they went a different route).

The other point I made is that residential property investors have the ability to leverage quite significantly, and they also seem to get away with expectations of a lower return. In my view that's partly an expectation of the capital gain which drives this behaviour. Brad Olsen probably was coming from the same point where he said the gains should be taxable.

On the other hand, you get do have investors with maybe ten or more properties. Then you quite clearly are running a business. If you are trying to level the playing field, then the question is perhaps whether the restrictions around interest deductibility should apply or rather maybe these investors are a group that are probably more appropriate for the thin capitalisation regime.

You may recall when John Cantin, was on the podcast and we talking about interest restrictions, he made the point perhaps there always should have been some form of interest apportionment would not be remiss because there is a clear expectation of some non-taxable capital gain. As we will find out in the next item, interest is generally deductible to the extent it's incurred in deriving gross income. And if capital gains aren't gross income, why should you get a full deduction?

In my view, when thinking about regulations, while you're in business, you just have to accept they are a fact of life. Some businesses are regulated more than others. For example, food manufacturers and restaurants, they have a fair number of regulations imposed on them for the better health of the public at large.

Anyway, the argument over the treatment of interest deductions isn’t going to go away. Landlords may feel that aggrieved about their treatment at this point in relation to interest, but they're not entirely unique in my view, because the thin capitalisation rules apply to other businesses. It's always worth remembering that if a property does become taxable because of the bright line test or some other provision, generally speaking, interest deductions incurred in relation to that property will become deductible on the disposal.

Capital expenditure?

And finally, this week in a slightly related matter, an interesting story out of the U.K. from the BBC after it emerged an OnlyFans creator had claimed a tax deduction for breast enhancement surgery.

Titillation aside this caused a bit of a stir in the U.K. because the deduction rules in the U.K. around self-employed are actually much more restrictive than here. On the face of it, the deduction seems to be a bit generous. The lady in question incurred the expense because she wanted to boost her appearance and drive up her income from the OnlyFans subscription-based website.

Titillation (ahem) aside, the reason why UK advisers looked a little bit sideways at this case is because the general rule for self-employed deductibility is it must be “wholly and exclusively incurred”. In theory, if there's a private element no deduction would arise, and there would appear to be at least some private element in any breast enhancement.

By comparison as I just mentioned a few minutes ago, the relevant provision in New Zealand allows a deduction to the extent to which the expenditure is incurred in deriving assessable income or in the course of carrying on a business of deriving assessable income. It's quite clear that for New Zealand tax purposes, a deduction of some of that breast enhancement expenditure would be allowed.

So, if you're thinking about the end of the tax year and maximising your deductions, remember expenditure is deductible to the extent it's incurred in deriving gross income and therefore some form of apportionment is available. The question here in New Zealand comes down to determining what proportion is deductible. However, a fellow tax specialist did wonder whether in this case breast enhancement might be capital expenditure and therefore subject to depreciation.

Well, on that bombshell, we'll leave it there. We're going to take a short break for Easter next week, so we'll be back in a fortnight. In the meantime, I’m Terry Baucher and you can find this podcast on my website www.baucher.tax or wherever you get your podcasts.  Thank you for listening and please send me your feedback and tell your friends and clients. Until next time, kia pai to rā. Have a great day.

*Terry Baucher is an Auckland-based tax specialist with 25 years experience. He works with individuals and entities who have complex tax issues. Prior to starting his own business, he spent six years with one of the "Big Four' accountancy firms including a period advising Australian businesses how to do business in New Zealand. You can contact him here.