	Home \| Databases \| WorldLII \| Search \| Feedback Waikato Law Review

Home | Databases | WorldLII | Search | Feedback

Waikato Law Review

You are here: NZLII >> Databases >> Waikato Law Review >> 1998 >> [1998] WkoLawRw 3

Wilkinson, Brett; Tooley, Stuart --- "Gains from Share Realisations: Is it Time for a Legislated Capital Gains Tax?" [1998] WkoLawRw 3; (1998) 6 Waikato Law Review 57

GAINS FROM SHARE REALISATIONS:

IS IT TIME FOR A LEGISLATED CAPITAL GAINS TAX?

BY BRETT WILKINSON AND STUART TOOLEY[*]

I. INTRODUCTION

Unlike many other advanced economies, New Zealand does not have an explicit capital gains taxation regime. The distinction between capital and income is therefore of vital significance.

An area in which the capital-income distinction is of considerable importance is that of gains and losses from the sale of shares. Prima facie such gains are of a capital nature and thus not taxable. However, depending on the circumstances, they may well come within the ambit of the income tax provisions. Essentially, gains on share realisation may be taxable where the gain constitutes a business profit, the taxpayer is dealing in shares, the taxpayer purchased the shares for the purpose of resale, or where the taxpayer is involved in a scheme or undertaking for the purpose of profit making.

The potential taxation of gains from share realisations is an issue of particular concern to investment companies. Recent case law would seem to indicate that the share acquisition and disposal activity of such companies might potentially be drawn into the income tax net. There remains, however, a considerable degree of uncertainty in respect of the issue and the Privy Council decision in Rangatira[1] has done nothing to clarify the general position of investment companies. The Inland Revenue Department’s recent private ruling in respect of the TeNZ fund has further fuelled the existing uncertainty.

The current situation in respect of the taxability of gains from share realisations by investment companies serves as a useful illustration of the problems which arise by virtue of New Zealand having what may be described as an ad hoc approach to the taxation of capital gains. Clearly, uncertainty and the costs this imposes on the economy constitute one such problem. Additionally, the fact that some capital gains are taxed and some are not introduces distortions in the behaviour of individuals and firms. This lack of a level playing field also results in the inequitable treatment of different forms of gains.

The appropriate solution, it would seem, would be to introduce a formal, comprehensive capital gains tax. In addition to redressing some of the problems noted above, such a tax would assist in realigning the judicial and economic definitions of income and restore some rationality to the use of income as a basis for imposing taxation.

This article reviews the tax implications of gains from share realisations. Particular attention is given to the position of investment companies. Part 2 discusses the capital-income distinction. Parts 3, 4 and 5 consider in some detail the statute and case law in respect of gains from share realisations. This discussion of the applied law is the central focus of the article.

Having ascertained the legal implications, part 6 reviews current issues and developments relating specifically to investment companies. Some attention is given to the TeNZ fund and the uncertainty that exists in the market regarding taxability of share realisation gains. Part 7 poses the question as to whether the observed problems in respect of investment funds suggest some need for a formal comprehensive capital gains tax. Part 8 provides concluding comments.

II. THE CAPITAL-INCOME DISTINCTION

AND THE RATIONALE FOR TAXING “INCOME”

Like many developed economies, New Zealand makes use of income as a tax base. Tax systems commonly use income as a basis for taxation since it is considered to reflect capacity to pay. Income is merely:

a word used to refer to a subtle, complex concept. It is a manageable surrogate for a less concrete, more amorphous concept, ability to pay.[2]

Problems arise, however, since the tax law does not provide a comprehensive definition of income. It has thus been left largely to the judiciary to interpret the meaning of the term income, as has been the case in other jurisdictions adopting the income tax base.[3]

There is, therefore, a strong incentive for an entity or individual receiving a gain to demonstrate that that gain does not constitute income as reflected in the wording of the statute law, but, instead, is of a capital nature.

Clearly, from an economic perspective, all gains comprise income including those of a capital nature. According to Simons, income:

is merely the result obtained by adding consumption during the period to ‘wealth’ at the end of the period and then subtracting ‘wealth’ at the beginning. The sine qua non of income is gain.[4]

This definition has not, however, been reflected in the approach adopted by the judiciary. Writing in respect of the Australian context, which is equally applicable to New Zealand, Parsons notes that the courts have relied on the definition of income as encapsulated in the law relating to trusts. He suggests that:

The concept of income as it was received from trust law could not be ‘extended’ to include capital gains, for it did not have a notion of income as a gain, or a notion of a capital gain. It knew only a distinction between a flow that belonged to the income beneficiary, and the proceeds of capital that belonged to the capital beneficiary.[5]

Thus, a considerable body of case law has developed which is based around the definition of income and the distinction between capital and income. To the extent that the merit of using income as a tax base depends on its role as a proxy for capacity to pay, this divergence between the economic and the judicial view of income is undesirable.

While gains from share sales would comprise economic income, they may not necessarily comprise judicial income. However, recent legal developments indicate a tendency for the two definitions to move toward greater alignment. Before focusing on the details of the case law, it is appropriate first to review the wording of the applicable statute law.

III. STATUTE LAW

Part C of the Income Tax Act 1994 outlines the items that are assessable for income tax. The items identified are, however, not exhaustive. Sections CD3 and CD4 are potentially applicable to profits arising from the sale of shares. These sections read:

CD3 ... any amount derived from any business.

CD4 ... any amount derived from the sale or other disposition of any personal property or any interest in personal property (not being property or any interest in property which consists of land), if the business of the taxpayer comprises dealing in such property, or if the property was acquired for the purpose of selling or otherwise disposing of it, and any amount derived from the carrying on or carrying out of any undertaking or scheme entered into or devised for the purpose of making a profit: ...

Under the Income Tax Act 1976, these sections pertained to 65(2)(a) and 65(2)(e), respectively.

CD3 essentially requires that the taxpayer be in business and that the profits arising be derived from a part of that business. CD4 contains three limbs, which may be applicable in the case of, profits arising from share sales. These are:

1. the taxpayer must be in the business of dealing in shares; or

2. the shares were acquired with the intention of resale; or

3. the purchase of the shares arises in the context of an undertaking or scheme for the purpose of profit making.

The distinction between CD3 and the first limb of CD4 is quite subtle. The CCH New Zealand Master Tax Guide notes:

In practice, any profit or gain assessable under [the first limb of CD4] will almost invariably be assessed as a business profit under s CD3.[6]

Whilst this could generally be regarded as being the case, it will not always be so. In Piers & Ors v CIR,[7] the High Court found that the taxpayers were not in business and hence CD3 did not apply. However, the taxpayers were found to be dealing in shares and hence the profits were taxable by virtue of the first limb of CD4.

IV. PROFITS FROM BUSINESS - CD3

The situation as to when profits or gains from the sale of shares will constitute business profits is not immediately apparent. Some review of the extensive case law is required in order to clarify the meaning of the legislation.

The leading case in respect of this issue is that of Californian Copper Syndicate (Limited and Reduced) v Harris (Surveyor of Taxes).[8] In this case, the taxpayer acquired a copper-bearing property which it later sold for shares in the purchasing company. Clerk LJ commented that:

It is quite a well settled principle in dealing with questions of assessment of income tax, that where the owner of an ordinary investment chooses to realise it, and obtains a greater price for it than he originally acquired it at, the enhanced price is not profit in the sense of Schedule D of the Income Tax Act of 1842 assessable to income tax. But it is equally well established that enhanced values obtained from realisation or conversion of securities may be so assessable, where what is done is not merely a realisation or change of investment, but an act done in what is truly the carrying out of a business.[9] (emphasis added)

In this instance, it was found that the gain made on sale of the property did not arise from a realisation of the company’s investment. Rather, the gain arose as part of the company’s business operations. The company’s articles of association gave the clear impression that acquisition of the property for resale at a profit was a part of the business. Lord Trayner noted:

This is not, in my opinion, the case of a company selling part of its property for a higher price than it had paid for it, and keeping that price as part of its capital, nor a case of a company merely changing the investment of its capital to pecuniary advantage. My reading of the Appellant Company’s Articles of Association along with the other statements in the case satisfy me that the sale on which the advantage was gained, in respect of which income tax is said to be payable, was a proper trading transaction, one within the Company’s power under their Articles, and contemplated as well as authorised by their Articles. I am satisfied that the Appellant Company was formed in order to acquire certain mineral fields or workings - not to work the same for themselves for the benefit of the Company, but solely with the view and purpose of reselling the same at a profit.[10]

In essence, then, this case clearly established the view that a gain, which may generally be regarded as being of a capital nature, could actually be characterised as being of an income nature because of the circumstances in which the transaction took place. The gain came within the income provisions by virtue of it being a profit of the business. The difficulty, of course, is defining the circumstances in which a transaction will fall within the ambit of the income provisions. On this point Clerk LJ noted:

What is the line which separates the two classes of cases may be difficult to define, and each case must be considered according to its facts; the question to be determined being - Is the sum of gain that has been made a mere enhancement of value by realising a security, or is it a gain made in an operation of business in carrying out a scheme for profit-making?[11]

It is not necessary that the taxpayer be carrying on a business specifically dealing in investments. The Privy Council in Punjab Co-operative Bank Ltd v Commissioner of Income Tax[12] articulated this principle in the following manner:

their Lordships do not wish to give any support to the contention that, in order to render taxable profits realised on sale of investments, in such a case as that before them, it is necessary to establish that the taxpayer has been carrying on what may be called a separate business either of buying or selling investments or of merely realising them.[13]

The same principle was outlined by Richardson J (as he then was) in AA Finance Ltd v CIR:[14]

Liability to tax does not depend on showing that the taxpayer is carrying on a separate business of dealing in investments. A transaction may be part of the ordinary business of the taxpayer or, short of that, an ordinary incident of the business activity of the taxpayer although not its main activity. A gain made in the ordinary course of carrying on the business is thus stamped with an income character.[15]

Having said that, it should also be noted that not all gains arising within a business context would constitute income gains. The High Court of Australia noted this fact in Colonial Mutual Life Assurance Society Ltd v FCT[16] and went on to state that:

the definition only refers to proceeds which would be held to be income in accordance with the ordinary usages and concepts of mankind, except so far as the Act states or indicates an intention that receipts which are not income in ordinary parlance are to be treated as income.[17]

Barwick CJ similarly noted in a dissenting judgment in London Australia Investment Co Ltd v FCT[18] that:

Of course, what is produced by a business will in general be income. But whether it is or not must depend on the nature of the business, precisely defined, and the relationship of the source of the profit or gain to that business. Everything received by a taxpayer who conducts a business will not necessarily be income. As I have said, it must depend on the essential nature of his business and the relationship of the gain to that business and its conduct.[19]

Within the case law, a subset of cases has evolved dealing specifically with the situation of profits from share sales arising in the context of the banking and insurance industries. To an extent, it may be argued that the principles so determined are applicable only to the banking and insurance industries. However, this will not always be the case. In London Australia, it was argued on behalf of the taxpayer that the findings in respect of cases such as Colonial Mutual Life Assurance, Punjab and Australasian Catholic Assurance Co Ltd v FCT[20] were specific to the banking and insurance industries. In respect of this argument Gibbs J said:

With all respect I cannot agree. In all those decisions the test suggested in Californian Copper Syndicate v Harris was applied. That test is applicable to any business, and if the sale of the shares is an act done in what is truly the carrying on of an investment business the profits will be taxable just as they would have been if the business had been that of banking or insurance.[21]

It is possible, then, that the situation facing investment companies may be affected by the findings in the banking and insurance industry cases. They should not be discounted as being industry-specific. Some closer review of these cases is therefore appropriate.

It is of course necessary to bear in mind that statutory changes in New Zealand have had considerable implications for the situation faced by banks and insurance companies. Specifically, section CM10 renders life insurance companies liable for taxation on all profits or gains, while the accruals regime has implications for gains arising in the context of financial arrangements.

1. The banking and insurance cases

The common law relating to banks and insurance companies indicates that share realisations by such companies would generally be regarded as a normal part of business operations. Heron J in State Insurance Office v CIR[22] provided a comprehensive review of the applicable banking and insurance cases, noting that:

the special circumstances of the business carried on by bankers and insurers have often required that the sale or realisation of investments be rendered income in the circumstances of those cases;[23]

and:

The rationale behind the banking and insurance cases is the common business requirement of regular realisation of investments in order to conform to certain ratios or actuarial assessments thought necessary for the purposes of an insurance or banking business or otherwise to carry out the objects of the business.[24]

The comments of the Privy Council in Punjab as regards the business of banking are of particular relevance and clearly enunciate the principle involved. It was stated that:

In the ordinary case of a bank, the business consists in its essence of dealing with money in credit. Numerous depositors place their money with the bank, often receiving a small rate of interest on it. A number of borrowers receive loans of a large part of these depositors’ funds, at somewhat higher rates of interest. But the banker has always to keep enough cash or easily realisable securities to meet any probable demand by the depositors. No doubt there will generally be loans to persons of undoubted solvency which can quickly be called in, but it may be very undesirable to use this second line of defence. If, as in the present cases, some of the securities of the bank are realised in order to meet withdrawals by depositors, it seems that this is a normal step in carrying on the banking business, or in other words, that is an act done in ‘what is truly the carrying on’ of the banking business.[25]

In CIR v Auckland Savings Bank,[26] North P similarly noted that:

it is a well stated principle in dealing with questions of income tax that where the owner of an ordinary investment chooses to realise it and obtains a greater price for it than he originally acquired it at, the enhanced price is not a profit assessable to income tax. But on the other hand it is equally well established that enhanced values obtained from realisation or conversion of securities may be so assessable when what is done is not merely a realisation or change of investment but an act done in what is truly the carrying on or carrying out of a business. This latter principle ... has been applied time and again to banks and other institutions such as life insurance companies which require to invest a substantial part of their funds in readily realisable gilt edged investments in order to meet in the case of banks the demands of their customers and in the case of life insurance companies the claims of policy holders.[27](emphasis added)

In respect of insurance companies, the High Court of Australia in Colonial Mutual Life Assurance referred to the similarity of insurance and banking business, stating that:

In our opinion there is no substantial distinction between the business of an insurance company and that of a bank in this respect.[28]

In delivering the judgement of the Court, Williams J said:

But an insurance company ... is undoubtedly carrying on an insurance business and the investment of its funds is as much a part of that business as the collection of the premiums.[29]

In Australasian Catholic Assurance, the taxpayer purchased blocks of flats as investments. The Commissioner assessed the taxpayer for tax on the profits earned from sales of several of the blocks of flats. Menzies J found that the profits made from sale of the flats arose from the carrying on of the taxpayer’s business and thus were assessable. He stated:

That they were profits from the carrying on of that business is, I think, an inescapable conclusion. The flats were bought as good investments and sold to avoid their becoming bad investments, which was what was intended from the very first, although it was hoped, and indeed, expected that they would both have to be sold until a long time after 1951.[30]

His Honour did, however, make it clear that his decision would not render taxable all profits from real estate sales, and presumably, by implication, from other investments, made by insurance companies. He noted:

It was said here that if the profit which the taxpayer made is taxable, so is every other profit made by a taxpayer when it sells part of its real estate; but my decision falls short of the acceptance of such a conclusion and rests upon the narrower ground that this taxpayer, as part of its ordinary investment business, bought real estate to obtain a high return and sold it profitably when it was found to be producing a low return, and so made a profit upon its buying and selling which I regard as income according to ordinary concepts, because in the ordinary course of carrying on business, the taxpayer must from time to time change its investments to use its funds to the best advantage.[31]

The courts have in fact not indicated that all gains from realisation of investments by banks and insurance companies are income. In the State Insurance Office case, the High Court of New Zealand found that certain share transactions did not comprise part of the business of the taxpayer. In this particular instance, the shares held were regarded as being a part of the taxpayer’s fixed, rather than circulating, capital. This was essentially because the taxpayer was not considered to be likely to need to rely on this investment in order to meet its short-term liabilities. Heron J noted that:

In my view, the fact that shares have not been sold to meet claims is not just a matter of happy coincidence. It is not merely fortuitous that circulating capital has been sufficient to meet current liability.[32]

It was, however, noted that the decision was unusual. Heron J noted:

It will be seen from the conclusion I have reached that State’s case is an unusual one brought about by quite unique considerations and as a result departing from the outcome of most of the banking and insurance cases.[33]

Similarly, in the National Bank of Australasia Ltd v FCT,[34] the High Court held that certain share realisations did not constitute part of the business of the bank. In this case the bank had acquired shares in a pastoral company as a part of a merger with the Queensland National Bank. The shares had been acquired to enable the bank to gain the

benefit of being known to have moved into the same relationship with the pastoral company as the Queensland National Bank had maintained.[35]

Realisations of these shares did not give rise to a business profit.

Perhaps the key point in the insurance and banking cases is whether the investments form part of the fixed or circulating capital. The Court of Appeal made reference to this issue in CIR v Inglis.[36] McKay J noted:

The concept of fixed and circulating capital is a helpful one. It recognises the distinction between what is invested in revenue producing assets of an ongoing nature, and what is invested in goods which are traded or which are manufactured and sold. The money invested in such assets circulates, in that it comes back to the business as cash as the assets are sold, and is reinvested similarly again and again. It is part of the working capital of the business, and is represented by the stock in trade. If a person was in the business of trading in shares, then his share portfolio would be his stock in trade, and his investment in shares would represent circulating capital.[37]

In large part, it seems that investments by banks and insurance companies comprise circulating rather than fixed capital. The same issue is potentially applicable to investment companies.

2. The investment company cases

The investment company situation is of particular interest. Presently, there is some uncertainty surrounding the extent to which gains from share realisations by such companies constitute income.

In London Australia, the High Court of Australia by a majority held that the realisation of shares at a profit constituted part of the business of the taxpayer. The company invested in Australian securities in order to obtain dividend income. The company had an investment policy of maintaining a consistent 4 percent yield on its capital. Gibbs J noted:

the taxpayer never bought shares for the purpose of profit making by sale, or with the intention of selling them, or simply because their market value was likely to increase. It bought shares to hold as an investment to yield dividends, but it foresaw that it was likely that the shares would increase in market value, and of course hoped that this would occur. If the shares did increase in value, but the dividend rate did not correspondingly increase, the dividend yield would fall, and the taxpayer would then be likely to sell the shares.[38]

His Honour went on to find:

Although the company’s business was to invest in shares with the primary purpose of obtaining income by way of dividends, the conduct of the investment business required that the share portfolio should be given regular consideration, and that the shares should frequently be sold when the dividend yield dropped, which for practical purposes usually meant when the shares went up in value. The taxpayer systematically sold its shares at a profit for the purpose of increasing the dividend yield of its investments. The sale of the shares was a normal operation in the course of carrying on the business of investing for profit. It was not a mere realisation or change of investment.[39]

Similarly, Jacobs J stated:

But when with such an investment policy which envisages regular and frequent sales of the shares acquired, operations are conducted on such a very large scale, the proper conclusion is that the acquisitions and disposals of shares were part of a business of acquisition and disposal.[40]

However, Barwick CJ, dissenting, stated that:

But, as the maintenance of the subscribed capital and of a consistent yield upon it was also of the essence of the company’s business, realisation of shares from time to time became necessary or advisable ... Those realisations could be said, in my opinion, to be a result of the nature of the company’s business but not part of that nature.[41]

3. The Rangatira case[42]

In New Zealand, the situation of an investment company realising shares was considered recently in respect of the position of Rangatira Ltd.

The taxpayer was an investment company that had made gains from share sales over the period 1983-90, which the Commissioner had assessed, for tax. The High Court found for the taxpayer, except in respect of a number of share transactions which were held to be taxable on the basis that the shares had been acquired for the purposes of resale.

The Commissioner appealed, but the taxpayer did not cross-appeal the finding that some of the profits were taxable. The Court of Appeal[43] suggested that the same criteria as applied in London Australiashould also be applied in the current case. The Court dismissed the appeal in respect of the 1986 year, but upheld the appeal in respect of the years subsequent to 1986. It was held that:

at least from April 1985 Rangatira was selling shares as part of its ordinary business, or as an ordinary incident of its business. The sales were not merely a realisation or change of investment, but were done in what was truly the carrying on of a business.[44]

It would appear that whilst the Court of Appeal accepted that many of the share realisations did not in their own right give rise to a taxable profit, the fact that some purchases were motivated by the purpose of resale tended to characterise the entire company as being in the business of share trading. The Court stated that:

The picture which emerges is not that of a passive investor. The sale of part of the share portfolio in order to acquire the interests of the other shareholders in the James Cook Hotel, and the further sales to enable the purchase of the freehold and the car parking building beneath the hotel, do not of themselves suggest that selling shares was an ordinary incident of the business. Nor does the acceptance of takeover offers. The sale of equities in order to balance the portfolio by including in it a substantial holding of Government stock is likewise neutral, when considered on its own. These transactions, however, form only part of a greater whole.

The sales of shares in the Brierley group to supplement income, and the TKM transactions, were held to be income within the second limb of s 65(2)(e). We think they would also fall within s 65(2)(a), as being ‘acts done in what is truly the carrying on of a business’, and as ‘part of the ordinary business of the taxpayer’.

They were not identified as part of some separate and distinct business. They inevitably colour the other transactions, such as sales to fund the purchase of other shares, and the sales made to fund the major acquisitions in respect of the James Cook Hotel and the investment in Government stock.

As a prudent investor, Rangatira clearly reviewed its portfolio of investments and from time to time changed them. When one looks at the totality of the transactions, it is difficult to resist the inference that in selling shares the company was seeking to enhance its position, not merely by achieving a balanced portfolio of income producing investments, but also by making gains from the sales themselves.[45](emphasis added)

The taxpayer appealed to the Privy Council. It was initially hoped that the findings of the Privy Council would clarify the tax position of investment companies. However, while the Privy Council found in favour of the taxpayer, the decision appears to have little or no bearing on the general investment company position. Smith[46] summarises two major points to come out of its decision. First, whilst it was acknowledged that certain share transactions were subject to tax, overall the company had not changed its business emphasis. Second, the Privy Council held that the Court of Appeal could not overturn the decision of the High Court on a question of fact unless that decision was held to be wrong. The Privy Council concluded:

It seems clear that the number and frequency of the transactions during the seven years under review would not alone have persuaded the Court of Appeal to differ in their conclusion from that of Gallen J. It was the change of policy asserted by the respondent to have occurred ... which evidently led the Court of Appeal to conclude that the conclusion reached by Gallen J was erroneous. Yet this conclusion was based upon Mr Steele’s evidence that the Brierley related transactions were exceptional, and did not reflect a change in the policy of the appellant or in the nature of its business as a whole. This was evidence, fully tested in cross examination, which Gallen J had heard and which the Court of Appeal had not ... It was for Gallen J to assess the reliability of Mr Steele as a witness. It does not follow of course that another judge hearing that evidence would have given it the same weight. Looking at the matter in retrospect their Lordships would think that the decision at first instance could have gone either way, but that is not to say that it was wrong. In their Lordships’ view the decision of Gallen J was one which he was entitled to reach, and one which should not have been reversed.[47]

As stated by Davies, it appears that:

the Law Lords based their long-awaited judgement more on a technicality ... than on a principle of tax law, thus disappointing those hoping to see a definitive line drawn between capital and revenue items.[48]

The current position facing investment companies is discussed further in part 6 in this article.

4. The Piers case[49]

A further recent case, which is relevant to the issue of whether a taxpayer is carrying on or carrying out a business, is that of Piers. The case related to the Alexander and Alexander Pension Plan, the investments of which were managed by Westpac Investment Management (NZ) Ltd. The Commissioner assessed the trustees for gains from share transactions on the basis that the transactions were part of the ordinary business of the taxpayers, that the shares were acquired for the purposes of resale, and that the taxpayers had entered into an undertaking or scheme for the purpose of making a profit.

The taxpayers appealed to the High Court and, while the Court held the transactions to be taxable, it was held that the taxpayers were not in business. Temm J stated in respect of the claim that the profits were business profits:

I can dispose of this argument quite briefly. The trustees were not in business at all. They had no customers, they were not trading in the ordinary business sense, and their sole purpose was to discharge the statutory and fiduciary obligations to act prudently in managing the fund.[50]

His Honour differentiated between insurance companies and superannuation funds stating that:

While in both cases it can be said that the predominant consideration ‘in acquiring securities is to obtain the best effective interest yield during the period of the date of acquisition and maturity’, yet the reason for that consideration differs between the two kinds of entity - in the case of a superannuation fund it is to protect the value of the capital, but in the case of the life insurance company it is to enhance the profitability ... the two entities under discussion have quite different reasons for existence.[51]

The implications of such a finding for superannuation funds are significant. Of particular interest in the Piers case is that his Honour went on to find that:

the fund was dealing in shares within the meaning of s 65(2)(e) during the three years in question.[52]

As noted earlier, this would seem to be a somewhat unusual outcome and it would be more common for profits caught by the first limb of CD4 [formerly section 65(2)(e), Income Tax Act 1976] and to also come within CD3. Further consideration of the limbs of CD4 is undertaken in the following section.

V. DEALING, RESALE AND PROFIT MAKING -

THE THREE LIMBS OF CD4

CD4 applies to personal property. The Courts have accepted that shares constitute personal property for the purposes of this subsection. In Inglis, McKay J expressly stated that “Shares are personal property”.[53] To that end, the three limbs of this section may operate to render taxable gains made from share realisations. Each of the three limbs are addressed in further detail below.

1. Dealing in shares

The first limb of CD4 renders taxable profits or gains from sale of property where the business of the taxpayer comprises dealing in such property. Reference has already been made to the fact that most gains coming within this limb will also come within CD3.

The findings of the High Court in Piers indicates that the volume of transactions that have taken place are of considerable importance in ascertaining whether the taxpayer is dealing in shares. Temm J noted that:

The frequency of share dealing is often decisive in deciding whether a taxpayer’s profits are liable to assessment under s 65(2)(e). The purpose or motive for this kind of business enterprise is of less relevance than the extent of it [54](emphasis added)

In dismissing the taxpayer’s objection, his Honour went on to point out that, even though the taxpayer may not have intended to deal in shares, the evidence of the frequent transactions indicated that it was in fact so doing:

While evidence of a taxpayer’s intentions as to financial transactions is admissible and relevant when deciding whether share dealings are covered by the first limb of s 65(2)(e), that is not decisive because the issue has to be decided objectively not subjectively. No doubt the trustees, as they said, did not wish to trade in shares, and no doubt also their intentions throughout were to meet their obligations to act prudently and to protect the fund from erosion. But Westpac’s many share transactions made on the trustee’s behalf lead me to the conclusion that the fund was dealing in shares within the meaning of s 65(2)(e).[55]

Despite the High Court’s comments, it would not be wise to attach too strong an emphasis to the volume of transactions alone as determining whether a taxpayer is dealing in shares. As indicated in London Australia, the volume provides an indication of the existence of a business but it is not necessarily the determinant. Hence, low volumes of share transactions may not necessarily prove a valid defence against a claim that the taxpayer is dealing in shares.

2. The intention of resale

The second limb of s CD4 provides that profits on share sales may be taxable where the property (in this case shares) was obtained for the purpose of resale. The key case in respect of this limb is CIR v National Distributors.[56] The case involved investment of excess capital by the taxpayer company in the sharemarket. The Court of Appeal found by a majority that the taxpayer had acquired the shares for resale. This was despite the taxpayer’s motive being to invest in shares as a hedge against inflation.

Three particular points in respect of this limb warrant mention. The first relates to the fact that “purpose” refers to the taxpayer’s subjective purpose. Richardson J stated:

It is well settled that the test of purpose is subjective requiring consideration of the state of mind of the purchaser as at the time of acquisition of the property.[57]

This subjective test is opposed to the objective test in the first limb, as stated by Temm J in Piers.[58] However, whilst the emphasis is on the subjective purpose, Richardson J also noted:

Where subjective purposes are in issue the statements of the taxpayer, or of someone who can speak for the taxpayer, are obviously important evidence. But for obvious reasons they must be assessed and tested in the totality of circumstances which will include the nature of the asset, the vocation of the taxpayer, the circumstances of the purchase, the number of similar transactions, the length of time the property was held and the circumstances of the use and disposal of the asset. Actions may speak louder than words and the totality of circumstances may negate the asserted purpose of the purchase.[59]

It is also relevant to consider that the:

inquiry under the second limb of sec 65(2)(e) is as to the purpose of the taxpayer at the time of acquisition. Whilst subsequent events may assist in ascertaining that purpose, they do not determine it.[60]

The second point is related to the first and pertains to the onus of proof. Casey J, again in National Distributors, referred to Williams Property Developments v CIR,[61] in stating that the onus of proof rests with the taxpayer. This was also reinforced by Quilliam J who went on to note that:

Unless the taxpayer can show that the main or dominant purpose which lead him or her to acquire the property was not to sell or otherwise dispose of it, then the profits or gains will be taxable.[62]

However, it should be noted that the taxpayer is only required to show that the purchase was not with the intention of resale - the taxpayer does not need to demonstrate some alternative purpose.[63]

The third point is that “purpose” refers to the dominant purpose of the taxpayer. That this is the case appears to be well accepted by the Commissioner (IRD, 1992). In National Distributors, Richardson J stated:

Where there is more than one purpose present taxability turns on whether the dominant purpose was one of sale or other disposition.[64]

However, his Honour also stated that:

The analysis becomes more complicated where different purposes may be more significant depending on whether the focus is on the short term, the medium term or the ultimate objective.[65]

As regards the determination of the dominant purpose, there may be a difference between motive and purpose. As noted above, the Court of Appeal in National Distributors held by a majority that the purpose of the taxpayer in acquiring the shares was resale, regardless of the motive. In this case, the taxpayer’s motive may have been to hedge against inflation - the purpose, however, was resale of the shares. In allowing the Commissioner’s appeal against the findings of the High Court, Richardson J (as he then was), referring to the decision of Quilliam J, stated:

he mixed purpose and motive: the purpose of resale and the motive of protecting capital in inflationary times through the management of a portfolio.[66]

Casey J similarly noted:

It matters not that the purpose of buying shares to sell them later was arrived at in order to increase the taxpayer’s assets, or to provide a hedge against inflation. Those are merely the motives or wider objectives which give rise to the purposeful buying of shares for resale.[67]

In a dissenting judgement, Doogue J stated that:

It is implicit in the language of the subsection, that the purpose of selling must be profit or gain for the dominant purpose of the taxpayer to be able to be ascertained. It is, I suggest, because no-one would naturally postulate a taxpayer purchasing property for the purpose of disposing of it by sale at any price, including a loss, that the Courts have so readily adopted the view that the inept language of the section can be read as if the method or activity by which the object or purpose is to be achieved, is itself the purpose.[68]

In essence, it appears that the suggestion being made is that the legislature intended a tax impost where the purpose of the taxpayer is to make a profit, as opposed to the purpose being, as the section currently reads, to resell the property. In other words, it is suggested that the term “resale:” should be interpreted as “to make a profit through resale”. His Honour went on to conclude that:

The taxpayer’s purpose can be the avoidance of loss in the real value of the money available to the taxpayer by the purchase of an asset which is likely to hold its value in real terms. This is quite a different purpose from the purpose of seeking to achieve a return in excess of the rate of inflation, and quite another thing to acquire a property merely in the hope and expectation that the money used in its acquisition will not lose its real value as a result of the effect of inflation during the period for which the property is held.[69]

The above comments would appear to be inconsistent with the advice of the Privy Council in Holden v CIR.[70] In that case, the taxpayer was entitled to receive some money in English pounds. His money was shifted to New Zealand by purchasing securities that were resold on the day of purchase, but for New Zealand currency. Although the Privy Council found for the taxpayer (by determining that no profit had been made), it was held that the purpose of acquisition was for resale. Lord Wilberforce said:

In the present case it is not relevant to enquire what was the dominant purpose, since the only purpose for which the securities were bought was that they should immediately be sold. The appellants argued that this purpose was only incidental to the wider and more essential purpose ... namely to remit funds from the United Kingdom to New Zealand but that, in their Lordships opinion is irrelevant. There can only be one answer to the question for what purpose the securities were bought, and the fact that the purchases and sale were part of a wider objective cannot affect that answer.[71]

The findings of the majority in National Distributors with respect to motive and purpose seem to sit well with the Privy Council’s judgement in the Holden case.

3. Undertaking or scheme for the purpose of making a profit

Professor Head described the Australian section, which was broadly equivalent to this limb, as a “subjective and uncertain test”.[72] Much the same could almost certainly be said of this limb.

The extent to which an undertaking or scheme must be of the character of a business deal, as suggested in the Australian case McClelland v FCT,[73] is unclear. The CCH New Zealand Master Tax Guide[74] asserts that this principle has been affirmed as good law in New Zealand. Duff v CIR[75] is cited in support of this assertion. However, Mancer and Veale refer to Beetham v CIR[76] and the views of Henry J as to the differences between the Australian and New Zealand laws. Mancer and Veale thus suggest that:

Accordingly, an undertaking or scheme may give rise to an assessable profit even though it is uncharacteristic of a normal business venture.[77]

A useful summary of the requirements of the third limb can be found in the comments of Woodhouse P in Duff. Woodhouse P stated, referring to a forerunner to the third limb of CD4, that:

Quite correctly Mr Goddard analysed the third limb of that paragraph on the basis that there must be: (a) a profit or gain, and (b) the making, carrying on or carrying out of an undertaking or profit making scheme, and (c) a nexus between that profit making scheme and the profit or gain that has been derived so that it can be said that it was ‘derived from the carrying on or carrying out of’ the undertaking or scheme.[78]

Exactly what constitutes a scheme or undertaking is extremely difficult to ascertain. In fact, Gresson P in CIR v Walker[79] quoted the Court in Australian Consolidated Press v Australian Newsprint Mills[80] as saying that “‘scheme’ is a vague and elastic word”.[81]

As noted by Mancer and Veal, the gain must be of an income nature and hence realisation of a capital asset does not come within the limb. In Eunson v CIR,[82] land was acquired for the purposes of farming but later subdivided and sold. Henry J of the Supreme Court held that:

I cannot see by doing this he was carrying on or carrying out a scheme entered into or devised for the purpose of making a profit. He did not enter any scheme at all nor did he devise any scheme. He merely disposed of a surplus capital asset by eight separate sales instead of one sale of the whole.[83]

A scheme was found to exist in Duff. In that case a timber merchant, a real estate agent and an engineering consultant entered a partnership to acquire land, subdivide and sell it. However, the Crown compulsorily acquired the land at some time after the land had been purchased. It was said on behalf of the taxpayers that the gain arose not from the carrying on or carrying out of the scheme but by way of frustration of the scheme. Woodhouse P stated:

there has never been any suggestion that the agreed compensation was based otherwise than upon a realistic valuation of the property ... although the resulting profit came to hand because the land was taken by the Crown it still was derived as the result of influences that had operated prior to the taking, at a time when the scheme had begun to operate, and so within the period during which the scheme was being carried on.[84]

Barker J, also in Duff, arrived at the same conclusion, using different logic. His Honour said:

The intervention of the Education Department was a variation of the scheme with an earlier realisation of profit.[85]

The issue at stake in Piers concerned the use by Westpac (the fund manager) of a computer-based statistical model in portfolio determination. The Commissioner asserted that the evidence indicated a scheme for profit-making. According to Temm J:

The scheme was said to be the Portfolio Optimisation Process mentioned earlier ... It is as plain as a pikestaff that Westpac operated a scheme of management. It was sophisticated, carefully supervised and strictly controlled. Its staff following the scheme had to be well informed, acutely aware of changes in the market place and in the changing fortunes of the trading companies in which shares were held ... But to say this was a scheme ‘entered into or devised for the purpose of making a profit’ is to enter another dimension altogether.[86]

His Honour accordingly found that the profits derived on share realisations were not subject to tax by virtue of this limb.

It should also be noted that ‘purpose’, under the second limb, appears to refer to the dominant purpose. However, there is some dispute regarding this matter, as noted by Temm J in Piers:

I mention counsel carefully pointed out there is a divergence of opinion as to whether the purpose must be the ‘predominant purpose’ or the ‘sole purpose’ but as it turns out I need not decide that refinement.[87] (emphasis added)

Whether a single transaction can be broken into sub-components with different purposes applying to each is of interest. In Walker, the taxpayer bought 63 acres of land. His intention was to subdivide and sell 3 acres that were within the City of Invercargill, and add the remaining 60 to his adjoining farm. The Court of Appeal, by a majority, found in favour of the taxpayer. In considering whether the transaction came within the ambit of the third limb, Turner J said:

It may indeed be contended that the transaction amounted to a scheme entered into by the respondent for the purpose of making a profit. This submission, in my opinion must fail ... It may indeed be contended that the transactions, examined as without doubt they must be at the moment of original purchase, could be said to amount to a ‘scheme’ whose essence was that the respondent, in purchasing the land as a whole, intended or contemplated the sale of the city sections to advantage, thereby securing the country land at a cheap net price. But, as has already been held, the fact that the respondent hoped or intended (incidentally) to sell the city sections to advantage is not compulsive to the conclusion that his purpose, or his dominant purpose, in entering into the transaction was to make a profit.[88]

In a dissenting judgement, Gresson P suggested that it was possible to consider the purpose in respect of the 3 acres as distinct from the purpose in respect of the other 60 acres. His Honour stated:

It was manifest on the evidence that the respondent’s intentions in regard to the road frontage land were quite different from those regarding the sixty acres of farming land; it is relevant to ascertainment of purpose the actual use which he proposed to make of the land in question. His purpose in regard to the farm land was entirely different from that in regard to the frontage land which from the time of its acquisition he intended to sell in sections.[89]

While the comments of Gresson P above relate more to the second limb, they are of interest in making the point as to different purposes attaching to a single transaction, as opposed to the majority view that there was only one overall dominant purpose.

VI. INVESTMENT COMPANIES -

CURRENT TAX STATUS AND DEVELOPMENTS

Having considered some of the relevant case law relating to the possible taxation of gains from share realisations, it is appropriate to pause and reflect on the current situation with respect to investment companies.

Following the Court of Appeal’s decision in respect of Rangatira Ltd, it was perceived that many investment companies would become liable to tax on gains on share realisations. Trigg suggested that:

It would be a bold trustee or manager who refused to recognise a potential tax liability when dealing in equities.[90]

According to Macalister:

the industry has been gradually increasing its provision for tax from low levels, or in some cases none at all, through to full provisioning.[91]

A further response within the industry to developments in this area of potential tax liability was the emergence of the somewhat controversial TeNZ passive investment fund with its IRD approved tax exempt status:

TeNZ is a passive investment fund, which will hold a portfolio of securities of the 10-largest listed companies in the same weighting as the NZSE10 index.[92]

TeNZ obtained a private ruling from the IRD that exempts any gains on share realisation by the fund from tax. Gaynor quotes the ruling as stating:

that any gains realised from the sale of shares by the fund, in order to match the composition and weighting of the index or to fund a redemption of units, will not be taxable to the fund.[93]

Referring to the reason for the ruling, Trigg suggests:

the argument - and presumably that put up for the private ruling - was that shares were not acquired for the purpose of selling at a profit, but solely because of the need to maintain all of their securities within the NZSE10.[94]

The implication appears to be that gains on share realisations by passive investment funds will not be drawn into the tax net. This apparent tax benefit appears to be encouraging similar funds.[95] Whether this is a beneficial move in terms of the broader economy is outside the scope of this article. The comments of Gaynor, however, warrant some mention. He asserts that:

From a general economic point of view, resources controlled under a passive fund structure are not reallocated quickly to their most effective use. Consequently a wholesale switch to passive fund management would not benefit the economy.[96]

It certainly would appear that the potential exists for greater than optimal levels of investment monies to be directed into passive funds by virtue of the tax advantage.

The Privy Council’s decision in favour of Rangatira Ltd appears to have changed little in respect of the tax position of investment companies. Whilst it was hoped that the decision would bring some certainty, the opposite would appear to be the case. Initial media reports evidenced some uncertainty amongst tax professionals in respect of the meaning of the decision.

The New Zealand Herald quoted Coopers and Lybrand tax partner John Shewan as saying “This is not the landmark decision people were hoping for”.[97] Hunt, of the National Business Review, reported Mike Lennard, the Inland Revenue Department’s head of litigation, as saying:

It neither clips the wings [of Inland Revenue] nor extends its powers. They [the law lords] have not accepted the conclusions put by either side in the way the law should be developed, neither have they laid down any general principles.[98]

In contrast, Greg Cole, Deloitte Touche Tohmatsu tax practice national director, was reported as saying:

The decision represents a major setback for the Inland Revenue Department ... Effectively, the court has sent a very clear message that the only way that IRD will be able to tax capital gains is if it can convince the government to change the tax law.[99]

Smith also infers that the case represented a setback for the Department:

The decision shows the stubborn attitude of the Department, and its willingness to take taxpayers to court in cases which perhaps should not have been selected in the first place if it had looked at them in an objective light.[100]

A key point to note is the comment that “their Lordships would think that the decision at first instance could have gone either way”.[101] In essence, it would seem that the Privy Council, whilst supporting the right of Gallen J to find as he did, was not endorsing his findings as such. The implication is therefore that other investment companies would be unwise to rely too heavily on the findings of the High Court in respect of Rangatira Ltd.

Perhaps the most apt comments are those of David McLay, the lawyer acting for Rangatira, as quoted in the National Business Review:

People had high expectations for their clients but this was not a case brought on behalf of the managed funds industry. This was Rangatira’s case.[102]

Clearly, then, there remains considerable uncertainty in respect of the tax position of investment companies. The exact manner in which the de facto capital gains tax applies to investment companies remains a mystery, albeit a costly one in terms of impact on the broader economy.

VII. IS IT TIME FOR A FORMAL CAPITAL GAINS TAX?

It is not the purpose of this article to review comprehensively the arguments for and against capital gains taxation. However, the area of gains on share realisations is one that raises several interesting and relevant points in respect of the existing capital-income distinction.

The discussion so far has demonstrated that gains from share sales, which may otherwise be regarded as being of a capital nature, may in fact be included as income by virtue of CD3 and CD4. These sections may be viewed as widening the income tax net to introduce, in effect, a form of capital gains tax. Casey J stated in National Distributors:

That provision brings within the meaning of ‘assessable income’ profits or gains which in the ordinary commercial understanding would be regarded as accretions to capital. What Parliament has done by it is to impose a limited form of capital gains tax.[103]

Similarly, Richardson J stated:

Section 65(2) is expressed as a deeming provision. The assessable income of the taxpayer is deemed to include profits derived from transactions coming within the respective limbs of para (e).[104]

This raises the issue as to the appropriate definition of income. In essence, as noted in part 1, income is used as a tax base by virtue of the fact that it proxies capacity to pay. The economist’s version of income, reflecting capacity to pay, would include capital gains - it is only the fact that the courts have traditionally relied on the definition of income encapsulated in trust law that capital gains have escaped the income tax net.

While the legislation has gone some way toward including gains which would otherwise be considered to be of a capital nature in the income definition, this partial inclusion and the uncertainty associated with it have given rise to inequity and inefficiency. In respect of equity, Krever and Brooks have gone so far as to suggest that:

Considerations of fundamental fairness provide the main rationale for taxing capital gains. These considerations embrace both of the traditional tax equity criteria: horizontal equity, the need for equal treatment of persons with comparable abilities to pay; and vertical equity, the need for appropriate differences in the tax treatment of persons with different taxable capacities.[105]

The fact that two investment companies, one active and one passive, can derive the same level of gain from share realisations and potentially pay different amounts of tax should be of concern to policy makers. It would seem to be the case that taxpayers with equivalent “economic” incomes may pay different taxes by virtue of the judicial interpretation of “income” and “capital”.

The absence of a level playing field in the capital gains tax arena also has adverse efficiency effects. Some reference to the distortions associated with undue focusing of resources in passive funds was made in part 6 above. Krever and Brooks make some valid points. They argue:

The economic efficiency case for taxing capital gains rests on the most fundamental proposition underlying a market economy: in order to ensure the efficient allocation of resources and to spur economic growth, capital should be encouraged to seek its highest rate of return. If capital gains are not taxed, capital will flow to those assets and sectors in the economy in which tax-free capital gains can be realised and away from investments with a higher rate of return. Such distortions interfere with the efficiency of the economy and thus lower living standards and reduce potential for economic growth. The resulting economic distortions reduce New Zealand’s international competitiveness at a time when its major trading partners are minimising the tax distinctions between income and capital gains, thereby encouraging the most economically efficient allocation of capital in their economies.[106]

As has been noted already, the existing provisions introduce a considerable degree of uncertainty in respect of certain situations. Referring to the Rangatira appeal to the Privy Council, Haas suggested that:

At issue is whether the council’s ruling will remove uncertainty over the taxation of capital gains when buying and selling shares.[107]

Unfortunately, it has not done so. Some practical evidence of the impact of this uncertainty can be seen in the comments of Gaynor, who points out that the:

Bank of New Zealand was so convinced that all funds were taxable last year it closed down passive fund BNZ Blue Chip Equity Trust following advice from tax experts.[108]

There can be little doubt that this uncertainty is imposing an unnecessary cost on the New Zealand economy.

As Mersi and Eady suggest, “in practice the treatment of equity gains may never become certain until legislative changes are made”.[109] The rationality of New Zealand’s partial approach must surely now be questioned by policy makers and some consideration must be given to a comprehensive legislated approach. The political costs of introducing a formal capital gains tax need to be weighed against the economic costs of the current approach.

While a legislated capital gains tax cannot be expected to eliminate all uncertainty - and certainly the experience of other countries such as Australia would suggest otherwise - it can be expected to introduce a more consistent approach than that which has emerged within the context of the existing law. Moreover, it can be expected to enhance the operation of the income tax system itself by more closely aligning the concept of judicial income with that of economic income - the very notion on which income as a tax base is founded.

VIII. CONCLUSIONS

This article has considered the tax implications of profits made from share realisations. New Zealand does not have a formal capital gains tax, so it is of vital importance whether or not such gains from realisation are brought within the income tax net by virtue of either CD3 or CD4. To some extent, the operation of these sections may be regarded as being a limited form of capital gains taxation.

The issue has become of particular importance to investment companies, and, as the article highlighted, there continues to be uncertainty in respect of this issue. The Privy Council Rangatira decision has not assisted in redressing this uncertainty.

What is clear from a review of the case law relating to gains from share realisations, is that there are fundamental problems with New Zealand’s limited and somewhat ad hoc approach to taxing what may generally be regarded as capital gains. Not only is there significant and costly uncertainty, but the fact that some gains are tax free and others are taxed gives rise to distortions in the economy as well as substantial inequities.

While the article has not sought to review comprehensively the arguments for and against capital gains taxation, it has demonstrated that there are features of the current system which suggest a need for reconsideration of New Zealand’s policy stance in respect of capital gains. A comprehensive capital gains tax would go some way to redressing the divergence between the income definitions of economists and the courts. In doing so, it may alleviate some of the problems of the current ad hoc approach, problems that are clearly demonstrated in the case of gains from share realisations.

[*] Brett Wilkinson, BEc (Macq), BBS (Hons) (Massey), Assistant Lecturer, Department of Accountancy and Business Law, Massey University; Stuart Tooley, MBS (Hons), Dip Acc (Tax) (Massey), CA, Lecturer, Department of Accountancy and Business Law, Massey University.

[1] CIR v Rangatira [1997] 1 NZLR 129.

[2] Bittker, Stone & Klein, Federal Income Taxation (1984) 10, cited in Ross, S, and Burgess, P Income tax: A critical analysis (1991) 33.

[3] Ross and Burgess, supra note 1.

[4] Cited in Parsons, ” Income taxation - An institution in decay? (1986) 3 Australian Tax Forum 233-266.

[5] Parsons, supra note 3, at 235.

[6] Commerce Clearing House New Zealand Master Tax Guide (1998) section 5-218.

[7] (1995) 17 NZTC 12,283.

[8] (1904) 5 TC 159.

[9] At 166.

[10] At 167.

[11] At 166.

[12] [1940] AC 1,055.