Question

Sam is a property investor. He purchased a small commercial building in Sydney for $2,000,000. Sam had to take out a loan from the ANZ Bank to purchase this property and Sam is charged interest on that loan. In order to rent the property, he met William, who is an experienced real estate agent. Sam and William agreed that an upfront lump-sum payment of $8,100 as a management fee is to be paid to William. With reference to the relevant legislation and case law, discuss the issue as to the deductibility of the management fee to William and the bank interest charges.

Answer 1

There is little New Zealand case law on s DB 5 or its predecessors. The only New Zealand case that touched on the provision (when it was s 136 of the Income Tax Act 1976) is Case G50 (1985) 7 NZTC 1,212. In Case G50 Judge Barber considered that the fees and disbursements in question would fall within either the general deductibility provision or alternatively the equivalent of s DB 5. However, the Commissioner considers that Case G50 does not provide any guidance on the meaning of the words “in borrowing money” or the provision more generally

The Australian Federal Court decision of Ure is considered the leading case on a similar provision, namely s 67(1) of the Income Tax Assessment Act 1936–1976 (Cth), which provided that:

Subject to this section, so much of the expenditure incurred by the taxpayer in borrowing money used by him for the purpose of producing assessable income as bears to the whole of that expenditure the same proportion as the part of the period for which the money was borrowed that is in the year of income bears to the whole of that period shall be an allowable deduction.

Section 67(1) of the Income Tax Assessment Act 1936–1976 (Cth) was not identical to s DB 5, as it expressly provided for apportionment. However, the court still had to consider the meaning of the phrase “in borrowing money”, and the Commissioner considers that Ure is relevant authority as to the meaning of that phrase in s DB 5

In Ure, the Federal Court of Australia drew a distinction between what it called the cost of borrowing money and the cost of the money. The court held that the taxpayer was entitled to a deduction under s 67(1) of the Income Tax Assessment Act 1936–1976 (Cth) for an appropriate proportion of valuation fees and legal costs associated with the borrowing. The majority of the court (Deane and Sheppard JJ) said at 4,112:

The words “expenditure incurred … in borrowing money” in the context of sec. 67(1) of the Act, refer in our view, to the “cost” of the borrowing as distinct from the “cost” of the money. The expenditure on account of legal expenses and valuation fees was plainly a “cost” of the borrowing: it was incurred in relation to the actual establishment of the relevant loan. On the other hand, interest payable to the lender represented a “cost” of the money: it was the price payable to the lender for the use of the money lent. The legal expenses and valuation fees were, and the interest was not, “expenditure incurred … in borrowing money” for the purposes of sec. 67(1).

The court considered that the legislative provision in question (equivalent to s DB 5) allowed a deduction only for expenditure incurred in establishing or setting up the loan (which was the cost of the borrowing), not expenditure arising from the borrowed money itself (which was the cost of the money).

Expenditure on items such as interest and the repayment of principal are not deductible under s DB 5. Although the repayment of money is linked to the borrowing of money (borrowing necessarily implies repayment at some time), the expenditure relates to the loan itself, not to the establishment or setting up of the loan

The Commissioner considers that Ure is authority for expenditure incurred “in borrowing money” being expenditure incurred in establishing or setting up the loan. However, the expenditure does not need to be incurred at the time of the borrowing. Expenditure “incurred in borrowing money” could include expenditure incurred during the life of the loan. This will be the case only when at the time of and in the course of establishing the borrowing the borrower enters into an obligation to incur the expenditure during the life of the loan. For example, in Ure it was held that guarantee fees payable on an annual basis over the term of the loan were deductible, because the contractual obligation to pay them arose at the time of, and as an incident of, establishing the loan. That said, loan-related expenditure that is incurred during the life of the loan under a contractual obligation arising at the time of the establishment of the loan would not be incurred “in borrowing money” if it relates to bringing the borrowing to an end (see from [107]). It is not sufficient that the expenditure arises under the original loan contract; the character of the expenditure must also be considered.