The High Court has held that the taxpayer failed to establish that debts were written off as bad at the relevant time or that the debtors were released from making all remaining payments by law. The taxpayer also failed to establish that he carried on business for the purpose of deriving assessable income and that the business included dealing in or holding financial arrangements that were the same as, or similar to, the financial arrangement for which the deductions were claimed.

The background

The taxpayer was a barrister and solicitor in sole practice. In his 2011 income tax return, he claimed deductions for loans he had written off as bad debts of $50,000 and $122,280 respectively. The loans were to two of his legal practice’s clients, facing financial difficulties, out of a fund he had created for that purpose.

The operative provision for the deductibility of bad debts was s DB 31 of the Income Tax Act 2007 which stipulated, except to the extent expressly provided, deductions for bad debts would be denied.

The Commissioner disallowed and reversed the deductions, issuing an amended assessment and further imposing shortfall penalties on the basis that the taxpayer had failed to take reasonable care. The taxpayer’s challenge was dismissed by the Taxation Review Authority (TRA). The TRA found that the deductions claimed by the taxpayer for the two loans he had written off as bad were non-deductible. The deductions did not fall within any of the exceptions allowing deductibility for bad debts provided for in s DB 31 (reported as Case 3/2018 (2018) 28 NZTC ¶4-010).

The taxpayer appealed to the High Court seeking orders quashing the TRA’s decision and declarations he was entitled to make the deductions and was not liable for any shortfall penalties.

The taxpayer submitted that his deductions fell within s DB 31 of the Income Tax Act 2007 and the Commissioner was not justified in imposing shortfall penalties under s 141A of the Tax Administration Act 1994.

High Court’s decision

The High Court dismissed the taxpayer’s appeal and found as follows:

1. The taxpayer had failed to show that, according to his own accounting procedures, the loans had been written off in the 2011 income year.

2. The TRA did not err in finding that the taxpayer’s debtors, both natural persons, had not been released at law from making any further payments, relevantly by reason of being discharged from bankruptcy under s 304 of the Insolvency Act 2006. One debtor was only released from bankruptcy in 2013 and the other had not been adjudicated bankrupt at all.

3. The taxpayer was not carrying on, even in part, a lending business for the purpose of deriving assessable income.

4. There was insufficient connection between the taxpayer’s legal services business and the financial arrangements he sought to deduct as bad debts.

5. There was no error in the TRA upholding the shortfall penalty for failing to take reasonable care pursuant to s 141A of the Tax Administration Act 1994.