The Farmers' Trading Company Ltd. v. Commissioner of Inland Revenue (N.Z.).
Judges:Prichard J
Court:
High Court of New Zealand
Prichard J.
This is a case stated by the Commissioner of Inland Revenue under sec. 32 of the Land and Income Tax Act 1954. The substantial issue is a question as to the proper method of accounting, for taxation purposes, for instalments payable to the taxpayer on the sale of merchandise when such instalments are not due for payment during the accounting year in which the sale is effected.
The Objector has for many years been selling clothing and soft goods on terms which it calls ``Budget accounts'' or ``20-week sales''. The transaction in each case is simplicity itself - the customer purchasing the goods obtains immediate title and agrees to pay the purchase price by equal weekly instalments spread over the ensuing period of 20 weeks. The total of these instalments equals the cash price of the goods plus a 5% credit charge. There is no security taken. There is no stipulation that in case of default in payment of any instalment the outstanding balance will become due and payable. The Objector's only right, having parted with the title to the goods, is the right to sue for any instalment or instalments actually due and owing.
I am told that this type of transaction is comparatively unusual. It is generally confined to items of merchandise which cannot be the subject of customary hire purchase agreements and to transactions where registered securities are inappropriate. I understand that, despite the lack of security, the Objector's experience is that it encounters no more bad debts under this method of selling than it does in the case of its hire purchase sales of items such as furniture and domestic appliances - a circumstance which the Objector attributes to its good relations with its customers. The budget account sales constitute a substantial item in the Objector's turnover.
Mr. G. Robertson, who is and has been for 20 years the secretary of the Objector company and who has been employed by the company since 1933, said in evidence that this form of retail selling was introduced by the Objector as long ago as 1930 - then on six-month terms - and that to the best of his knowledge these accounts have always been treated as part of the company's hire purchase ledger.
The first issue raised in these proceedings is as to the proper method of accounting for the proceeds of budget account sales for purposes of income tax assessment. No problem arises with regard to sales in respect of which all instalments are paid during the currency of the accounting year in which the sales are made: the issue relates only to those sales which are made during the accounting year but in respect of which all payments do not fall due before the end of the year.
The method of accounting adopted by the Objector - and followed since the inception of the budget account sales - has been to assimilate, for accounting purposes, its budget account sales with its hire purchase sales. In the case of those sales where there are instalments outstanding at the end of the accounting year (whether on hire purchase or on budget sales), a simple formula is used for the purpose of assessing the gross profit content of the outstanding instalments. The gross profit content of the outstanding instalments so assessed is not included in the
ATC 6025
accounts for the year in which the sale is made but in the ensuing year when the instalments fall due - i.e., the profit component is treated as income which is earned only when the instalments are payable. The method is known as the ``profits-emerging'' method. Using that approach, it is, of course, necessary to bring to account in the year of the sale that portion of the unpaid instalments which is not profit - otherwise the accounts will show a depletion in stock with no balancing receipts. As Dixon J. put in Carden's case -C. of T. (S.A.) v. The Executor Trustee and Agency Co. of South Australia Ltd. (1938) 63 C.L.R. 108 at p. 156 -
``The basis of a trading account is stock on hand at the beginning and end of the period and sales and purchases. In such an account book debts represent what before sale was trading stock and it is almost inevitable that they should be taken into consideration upon an accrual and not a cash basis.''
If explanation is required for the expression ``accrual basis'', it is to be found in the same judgment where Latham C.J. said at p. 125 -
``But trade debts which have accrued due in the relevant year but which have not been paid must be included for the purpose of ascertaining whether or not the business has earned a profit for the year, just as stock in trade at the beginning and end of the year must be taken into account for the same purpose.''
And at p. 127 -
``A debt is incurred by the debtor when he becomes subject to an obligation to pay a sum certain in money to his creditor. The debt may be payable forthwith or at some future time. A debt accrues when it becomes due, whether it becomes due immediately or at a future time. When the debt is paid, then the creditor has received the debt, but the debt has accrued when it falls due, even though it has not been received.''
In dealing with the profits-emerging method, convenient terminology, adopted in the Canadian case of Publishers Guild of
Canada Ltd. v. M.N.R. [1957] C.T.C. 1, to refer to that proportion of each instalment which is not its gross profit content as its ``merchandise content''. Amounts owing by way of instalments not immediately due for payment are called ``receivables''.
The formula used in practice by the Objector is simply to treat receivables as being comprising as to 40% of gross profit content and as to 60% of merchandise content. This is, obviously, an approximation but is one which the Commissioner accepts for hire purchase transactions and which may be regarded as sufficiently accurate in the context of the 20-week budget accounts. Evidence was given of a number of ways in which the gross profit content of receivables may be calculated. These are described in a Research Bulletin first published by the New Zealand Society of Accountants in 1973 (R. 105). They include a method using special actuarial tables and the ``sum of digits'' method, also known as ``the rule of 78''. For the purposes of these proceedings, nothing turns on the degree of accuracy achieved by the Objector's superficially simplistic approach: it is not in fact an arbitrary ratio but is based on a calculation which was described in evidence and which seems to produce a result regarded by the Commissioner as a reasonable approximation which he accepts in the case of the Objector's hire purchase instalments: it was not attacked during the hearing and I take it that it is not an issue. It is the Commissioner's case that the profits-emerging method is not applicable to the budget account instalments; but if it is found to be applicable, then as I understand it, the 60/40 apportionment between the merchandise content and the gross profit content is not in dispute.
In the Objector's accounts so far as receivables not due before the end of any accounting year are concerned, the merchandise content - 60% of the total amount of the receivables - is brought to account in that year and 40% (the gross profit content) is not brought to account but is labelled ``Provision for Unearned Profits'' and credited in the year succeeding that of the sale.
The result of this accounting method is that, at the end of each accounting year, there is a sum representing 40% of the total receivables not due for payment in that year
ATC 6026
which is not brought to account by the Objector in computing the profit for that year (but which will be brought to account in the ensuring year). So that, as compared with a system where all receivables are brought to account in the year of sale, the figures returned by the company as its income in any fiscal year are always -- (1) Augmented by 40% of those receivables from the previous year's transactions which did not fall due for payment in that previous year; and
- (2) Diminished by 40% of those receivables from that fiscal year's transactions which did not fall due during the fiscal year.
A convenient way of showing this in the accounts is simply to record, each year, the net effect of items (1) and (2). In each year the system will produce a profit figure either augmented or diminished - depending on whether the receivables in respect of that year's transactions but not due for payment in the year are less than or greater than the receivables in respect of the previous year's transactions which were not due for payment in that previous year. Accordingly, in its published profit and loss accounts, the Objector shows the net effect as an item labelled ``Adjustment to Provision for Unearned Profits and Interest on Time Payment Debts''. (The result, of course, is the same as if items (1) and (2) were shown as a credit and debit item in the accounts.)
There is, of course, no question of the company by this method avoiding taxation on any part of its earnings - the system means only that although a proportion of receivables from transactions entered into in any one year is not brought to account in that year, the amount of that proportion is fully reflected in the accounts for the succeeding year.
It is the Commissioner's view that, apart from the 5% credit charge, the whole of the profit on the 20-week credit accounts is derived when the sales are effected: that there is no proper basis in revenue accounting for the Objector's practice of carrying forward any proportion of the receivables in respect of sales made during any accounting year into the accounts for the succeeding year.
As regards the 5% credit charge, the Commissioner concedes that this may be treated as income earned when actually paid and so brought to account in the ensuing year.
These proceedings are in respect of the year ended 31 March 1976. Excluding any arrears of instalments the total of budget account instalments receivable in the year ended 31 March 1976 in consequence of the previous year's credit account sales was $2,350,000. These instalments were in respect of sales made during the period of 20 weeks immediately preceding 31 March 1975. The Objector therefore included 60% of this figure in calculating its income for the year ended 31 March 1975 and brought 40% of the $2,350,000 - a sum of $940,000 - into its calculation of profits for the year to 31 March 1976. By the same token, the Objector omitted from its calculation of profits for the year ending 31 March 1976 a sum of $960,800, being 40% of the amount of the instalments not received prior to 31 March 1976 from budget account sales effected during the 1976 year. According to the views of the Commissioner, the net result was that, subject only to an allowance for 5% credit charge, the Objector had understated its income for the year ending 31 March 1976 by the sum of $20,800, being the difference between $940,000 wrongly brought into that year's accounts and $960,800 wrongly excluded. The Commissioner calculated the allowance for the 5% credit charge on $20,800 to be $2,477. So that, in the Commissioner's view, the Objector's income for the year ending 31 March 1976 was understated by the sum of $18,323 - $20,800 less $2,477.
The Commissioner's calculation of the adjustment to income for the year ending 31 March 1976 was arithmetically correct according to the Commissioner's view as to the proper method of accounting. But, of necessity, it proceeded on the basis that $940,000 - less the allowance of $111,904 for the 5% credit charge - was displaced from the 1976 accounts and relegated to the 1975 year where (according to the Commissioner's view) it properly belonged. This sum - an amount of $828,906 - had not in fact been included in the computation of the Objector's income in the 1975 year - and so, in the absence of a further adjustment, would escape taxation.
ATC 6027
Accordingly, in addition to an adjustment of $18,323 for the alleged understatement of income for the year ending 31 March 1976, the Commissioner invoked sec. 92A of the Land and Income Tax Act 1954, treating the $828,906 as a provision or reserve which was not deductible under the Act in calculating the profits of the 1975 year.
The question whether the Commissioner was entitled to make that second adjustment is the second issue raised in these proceedings.
The Commissioner's calculations of the adjustment to be made to the Objector's income as returned for the year ending 31 March 1976 are as follows -
$ $
Debtors excluding arrears at 31/3/76 2,402,000
40% Reserve: 960,800
Debtors excluding arrears at 31/3/75 2,350,000 **
40% Reserve: 940,000
Amount charged to revenue
Y/E 31/3/75: 20,800 (A)
Northland debtors at March 1975
are not shown separately as H.P.
and 20 week; estimated at 22% of
total in line with earlier months.
Balance of reserve at 31/3/75: 940,000
Less credit charge
5 2,350,000 111,904
---- x --------- -------
105 1 828,096 (B)
1976 Deduction allowable for 5%
credit charge:
Opening balance
5 x 2,350,000 111,904
--- ---------
105 1
Closing balance
5 x 2,402,000 114,381
--- --------- ------- -------
105 1 2,477 (C)
Adjustment under sec. 76:
Y/E 31/3/76:
Amount charged to revenue: 20,800 (A)
Add 1/4 of excess: 207,024 (B)
-------
227,824
Less deduction for credit charge: 2,477 (C)
------- -------
Total for year 225,347
Y/E 31/3/77 - 1/4 of excess: 207,024 (B)
Y/E 31/3/78 - 1/4 of excess: 207,024 (B)
Y/E 31/3/79 - 1/4 of excess: 207,024 (B)
-------
Total Adjustment: 846,419 (A+B-C)
ATC 6028
It will be seen that the Commissioner has allocated the adjustments of $828,096 over a four year period as provided by sec. 92A(2)(b) and that the Objector is assessed to pay income tax in respect of the year to 31 March 1976 on the basis of adjustments totalling $225,347 being $2,477 understated income for the year to 31 March 1976 plus $207,024 being one-fourth of the ``reserve.''
The first question for decision is as to whether the profits-emerging method of accounting used by the Objector is, in the case of the Objector, an appropriate method of accounting for taxation purposes.
My first observation is that the Commissioner has in fact accepted that the profits-emerging method is appropriate in the case of the Objector's hire purchase accounts. The distinction sought to be made by the Commissioner between the 20-week budget accounts and the hire purchase accounts is said to turn on the fact that, in the case of the budget accounts, title to the goods passes to the customer when the contract of sale is entered into whereas in the case of hire purchase transactions, title is not passed until payment of the last instalment. While this clearly constitutes a distinction in terms of the legal rights and remedies of the vendor and the purchaser, it seems to me that, in a commercial sense, when measuring the results of trading, it is no more than a distinction without a difference. In the case of hire purchase transactions, the strict legal position is ignored for accounting purposes because items sold on hire purchase are treated as sales and taken out of stock without regard to the fact that ownership still remains with the vendor - the hire purchase instalments then being treated as comprising 60% merchandise content and 40% gross profit content. This is exactly the course purchased by the Objector in the case of its 20-week budget account sales.
During the hearing, I endeavoured to elicit from the two witnesses called on behalf of the Commissioner an explanation as to why - for accounting purposes - budget account instalments should be treated differently from hire purchase instalments.
Mr. R.E. Martin, a qualified accountant, who retired in July of this year from his position as inspector for the Inland Revenue Department, said that, in his opinion, the distinction turned on the point of time when property in the goods passes to the purchaser. Pressed to explain why this should call for a difference in the method of accounting, he agreed that if a company sells on hire purchase an item of ``whiteware'' such as a refrigerator, the company does not continue to show the refrigerator as part of its stock - it is treated as an immediate sale but the profit for the year of that sale is reduced by - or, more accurately, does not include - the amount of profit content of any instalments not due during the accounting year: but, he agreed, that for practical accounting purposes, hire purchase and the budget sales are treated alike - the article sold goes out of stock without regard to a legal distinction as to when property passes. He conceded that, leaving aside legal niceties, ``there is really not much difference''.
Mr. G.W. Valentine, of Wellington, who is the chairman of Barr, Burgess & Stewart, chartered accountants, when asked what basic distinction he could see between the hire purchase agreement and the credit sales now in question from the accounting point of view, said -
``I think it is essentially a question of the ownership of the article. The accounting treatment for hire purchase transactions is well documented, and we have heard evidence earlier of a number of alternative bases which are available. They are aimed principally at recognising that the transaction may not be completed and, in the event of non-completion, a portion of the profit on the sale and a portion of the interest charged to the purchaser may be required to be repaid to the buyer. These do not apply to the other 20-week sales that we are discussing.''
Later, he said that the difference between the credit sale and the hire purchase transaction is only really that, in the hire purchase transactions, the trader retains ownership of the chattel. He agreed, however, that when a trader dealing in hire purchase prepares his profit and loss account, he does not include in the stock figure items which have been sent out of the shop on hire purchase. Asked whether the two situations were not very similar, his reply was as follows -
ATC 6029
``Well, I believe they have essentially different characteristics and I would relate the 20-week transaction - I would put it on the same footing - as the ordinary sale transaction where possession is given and the debt is not due until two or five months. Those arrangements are on all fours.''
For reasons to which I will refer later, I consider that it is fallacious to regard the time when property passes on a sale as determining the time when income is derived from that sale, for purposes of tax accounting, while, as regards accounting for reporting purposes, the two cases seem indistinguishable - in both cases the merchandise is taken out of the stock figure and in both cases payment is received by instalments over a period extending beyond the accounting year. I am impressed by the fact that the Objector has for some 40 years been carrying on a successful business assimilating its hire purchase and credit sales accounts in both its published accounts and its tax returns and receiving each year an unqualified audit certificate.
If the profits-emerging method of accounting is accepted by the Commissioner as being appropriate in the case of hire purchase instalments, it appears to me that there is a degree of inconsistency in the Commissioner's present contention - not only when related to past acceptance of the Objector's credit sales account but also in relation to present acceptance of the same method of accounting for its hire purchase sales.
In C. of
I.R. v. The National Bank of New Zealand (1976) 2 NZTC 61,150, Richmond P. accepted that, in New Zealand, proof of long acceptance by the Commissioner of a particular method of accounting may well result in an evidential onus being cast on the Commissioner - as was held to be the case in
B.S.C. Footwear Ltd. v. Ridgway [1972] A.C. 544 and as was mentioned by Lord Reid in
Ostime v. Duple Motor Bodies Ltd. [1961] 2 All E.R. 167, 175. In the present case, not only has the Commissioner apparently accepted over a lengthy period the Objector's method of accounting in respect of its 20-week budget sales instalments but the Commissioner continues to recognise and approve exactly that method of accounting in respect of the Objector's hire purchase sales.
Of course the onus so established cannot be invoked to displace a proper interpretation of the legislation; as Richmond P. said in the National Bank case at pp. 61,156-61,157 -
``... if the Court is in fact satisfied that the method adopted by the Commissioner will produce a substantially better picture of the real profits for the year then the Court should hold in favour of that method.''
I was assisted in my endeavours to resolve this question by the expert evidence of two highly qualified accountants. Mr. Valentine, to whom I have already referred, gave evidence in support of the Commissioner's view; the Objector called Mr. J.C. Hagan, who is the manager for the financial advisory services of Hutchison, Hull & Co., who holds the degree Master of Commerce with honours and who has been on the board of research of the New Zealand Society of Accountants responsible for establishing standard accounting practices in New Zealand. (Hutchison, Hull & Co. are the auditors of the Objector company.)
Mr. Hagan described the profits-emerging system in general and, as used in the Objector's accounts, pointing out that the accounts, prepared in this way ever since the 20-week budget sales were introduced in 1938, had each year received an unqualified auditor's certificate and had, up until the present amended assessment, been accepted for tax purposes. He outlined, by reference to a diagram, various methods by which the profit element in instalments of purchase price may be recognised and taken to account. The ``present value'' of the receivables could, he pointed out, only be realised before due date by factoring the book debts to a discount house; the calculation in fact made was a means of measuring income by recognising profit as instalments are actually paid or become payable. He conceded that he was not aware that this method of profit recognition was followed by any other company in New Zealand but said that he knew of no other company which had a credit sale business comparable to that of the Objector. Referred in cross-examination to a number of text-books and publications which advocated immediate recognition of the profit content of instalments, he pointed out that hire
ATC 6030
purchase transactions were treated in this way and said that he did not consider the passing of property relevant to the accounting of the transaction - that if the matter was to be governed by the legal form rather than the substance of the transaction, the method accepted for hire purchase transactions could not be condoned. He considered that the basic principle of instalment accounting is to bring in profit as instalments fall due.Mr. Valentine, on the other hand, stated it as his opinion that the correct accounting treatment in relation to the credit sales is that profit should be recognised at the time when the contract is entered into, this being the system followed by a large Wellington-based company of which he is a director. He referred to this as the ``realisation principle - recognition of the profit when the transaction is complete and the exchange has taken place''. Mr. Valentine was able to refer to a number of publications containing the recommendations of the representative bodies of professional accountants in both America and the United Kingdom which were generally supportive of his opinion, although these dealt with the matter from the point of view of accounting for reporting purposes. An ``Omnibus Opinion'' published in 1966 by the Accountancy Principles Board of the American Institute of Certified Public Accountants stated that the instalment method of recognising revenue is not acceptable unless the circumstances are such that the collection of the sale price is not reasonably assured.
However, it appears that the ``Omnibus Opinion'' referred to accounting for reporting purposes rather than for taxation purposes. The ``Omnibus Opinion'' was the subject of a comment in another American publication, Montgomery's Auditing, 9th ed., as follows -
``The fact that the collection of cash is spread over a long period does not in itself require deferring recognition of revenue. The Opinions and other pronouncements consistently limit application of the instalment method, under which revenue is recognised as cash is received, to transactions in which collectibility of the revenue is not reasonably assured (APB Opinion No. 10, paragraph 12). That is because a schedule of cash collections is seldom related to either sale or performance, the bases in principle for recognising revenue. If the collectibility of the sale price can be reasonably anticipated, revenue should be recognised as soon as an exchange occurs and performance is complete or virtually complete, even though the sale price is collectible over several years and income tax is payable as instalments are collected.''
Mr. Valentine referred also to several textbooks and to a publication of the Institute of Chartered Accountants of England and Wales put out in 1965 as Recommendations on Accountancy Principles (N. 23) which were generally supportive of his view and to a Research Bulletin (R. 105) published by the New Zealand Society of Accountants which is stated to have drawn upon the N. 23 publication ``suitably amended to recognise New Zealand conditions and current trends in financing and retailing operations''. The New Zealand publication, while dealing at some length with methods of apportionment, did so in the context of the transactions of finance companies dealing in hire purchase. Mr. Valentine considered that as the New Zealand publication (R. 105) did not advocate the profits-emerging method in the case of credit sales, it must be assumed that the New Zealand Society of Accountants accepted as correct the views of the Institute of Chartered Accountants of England and Wales. However, it is by no means the case that the New Zealand society's publication has nothing to say on this point. Referring to credit retailers, the Research Bulletin (R. 105) does in fact recognise and advocate, in the following passage, the practice of carrying forward gross profit -
``In practice, the methods of carrying forward finance charges and gross profit used by credit retailers vary greatly. Recent history of several major concerns in Australia suggests that failure to recognise the need to provide adequately against Unearned Profit played a major part in their collapse. There is no doubt that credit retailers involved materially in instalment selling should make adequate provisions. The problem lies in determining the extent of such provisions and a method of assessment which is administratively possible.
ATC 6031
Essentially, this is a matter of judgment based on the nature of the business, the gross trading margins applying, the varying terms, and the other factors outlined above.
Many retailers strike one percentage to embrace both finance charges and trading profit. Whilst this is arbitrary, it has the advantage of simplicity in the volume field.''
The evidence of these eminent accountants leaves me confronted by two conflicting opinions - a conflict which I must resolve as best I can by reference to legal principles. As Dixon J. said in Carden's case at pp. 151-152 -
``The question whether one method of accounting or another should be employed in assessing taxable income derived from a given pursuit is one the decision of which falls within the province of courts of law possessing jurisdiction to hear appeals from assessments. It is, moreover, a question which must be decided according to legal principles.''
And as Viscount Simonds said in Ostime v. Duple Motor Bodies Ltd. (supra) at p. 170 -
``The practice of accountants, though it were general or even universal, could not by itself determine the amount of profits and gains of a trade for tax purposes.''
No decision as to the appropriate system of accounting can be made without identifying the time at which instalments become income within the meaning of the Land and Income Tax Act 1954.
Before turning to case law, I will refer briefly to the statute. The Land and Income Tax Act 1954 always refers to income as being ``derived''. An item of profit or gain is income when it is derived. The Act contains no definition of the term but there is one provision which gives a degree of assistance. Section 92(1) is addressed to situations where some profit or gain which would otherwise be derived by the taxpayer as income is diverted to other uses (beneficial to the taxpayer) which might cause that profit or gain to lose its identity as income. It can safely be assumed that the subsection is designed to throw its net wide enough to catch every species and variety of derivation of income known to the law. From this assumption it follows that the kinds of income derivation referred to in the subsection comprise an exhaustive list - that for the purposes of the statute, income is derived when it has been ``actually paid to or received'' by the taxpayer or when it is ``already due or receivable'' - the punctuation indicating that the words ``due'' and ``receivable'' are both qualified by the word ``already''. To my mind, there is an inescapable inference from sec. 92(1) that income is derived only when it is received or when it accrues - that is, when it becomes due and payable.
Turning to case law, there is some assistance to be gained from two cases decided in New Zealand. C. of I.R. v. The National Bank of New Zealand (supra) is not strictly in point. The question in that case was whether interest which had accrued during the accounting year on the accounts of a number of doubtful customers of the Bank ought to be included in the Bank's income for that year. Although debited to the customers' accounts, the interest had not been received. The Bank's accounts were kept generally on an accrual system (which is the system contended for by the present Objector) but in the case of its doubtful customers, the Bank did not bring to account in its statement of profit and loss the interest on these particular accounts. It was held that, although the interest had not in fact been received, and might ultimately be found to be a bad debt, nevertheless, it had accrued and become due and owing during the currency of the accounting year; it was held that it could not be excluded simply because there was a doubt as to its ultimate recovery. The Court was not concerned with a case, like the present one, where the amounts in issue fell due for payment outside the period of the accounting year. But it is significant that the Court of Appeal regarded as decisive the fact that the interest accrued - i.e., became due - during the accounting year. The Court did not add as a corollary that if the interest had not accrued during the accounting period it ought not to be brought to account in that year; but that seems to follow.
H.W. Coyle Ltd. v. C. of I.R. (1980) 4 NZTC 61, 558 was a decision of Holland J. having to do with the accounts of a partnership engaged in building operations.
ATC 6032
The question was as to the proper method of bringing into the accounts progress payments in respect of work which had been completed and for which the architects had certified payment. Holland J. adopted the approach, which I adopt in this case, of first ascertaining whether the progress payments were income derived during the accounting year. He determined that question by reference to the time when the progress payments became due. It was held that the partnership must bring the amount of the progress payments into its accounts for the year as the relevant work was done and certified for so that the payments became due and owing during the accounting year. Like the National Bank case, the case is distinguishable from the instant case because the payments in question had been earned and the taxpayer was entitled to sue for their recovery. It is the fact that the instalments did not fall due and the absence of a right to sue during the currency of the accounting year which is the basis of the Objector's case. As in the National Bank case the inference, although not explicitly stated, is that had the progress payments not been debts which became enforceable during the accounting year, they would not have been included in the computation of income derived in that year.The third and last decision of the New Zealand courts to which I will refer in this context is
Fincon (Construction) Ltd. v. C. of I.R. [1970] N.Z.L.R. 462. This was a special case relating to an isolated transaction entered into by a building company. The company agreed to accept $6,000 (out of a contract price of $20,000) by quarterly instalments commencing on the third year after the completion of the motel which was the subject matter of the contract. In the course of his judgment, North P. distinguished two builders' cases:
Harrison v. John Cronk & Sons Ltd. [1937] A.C. 185; [1936] 3 All E.R. 747 and
Absalom v. Talbot [1944] A.C. 204; [1944] 1 All E.R. 642, on the ground, inter alia, that the position of Fincon Construction Ltd. could not rightly be compared with the position of the taxpayer in Cronk's case ``where the whole nature of the business of the taxpayer was dealing with poor members of the working class''. I would not identify the present Objector's case with Cronk's case on that particular ground but I do regard the Fincon case as being distinguishable from the present case because of the nature and extent of the present Objector's trading in 20-week budget accounts. North P. concluded in his judgment (in which Turner and McCarthy JJ. concurred) with the observation at p. 473 -
``I do not consider that the appellant is entitled to single out one particular transaction and ask that it be dealt with in a special way for it is plain that if the contention of the appellant is upheld, the profit and loss account of the appellant for the year in question would give a wholly false picture of its trading operations for the year in question.''
In the instant case, so far from the Objector singling out one particular transaction and asking that it be dealt with in a special way, the Objector is asking that accounts relating to a substantial ingredient of its regular trading be dealt with in the manner in which they have been dealt with for the past 30 years. In the Fincon case, moreover, the company obtained a security for the amount owing to it, this security including a debenture over the debtor company's assets. I am in respectful agreement with the learned author of Molloy on Income Tax when he describes the case as one where a company had, against its invariable practice, agreed to finance the erection of a building by leaving in $6,000 because the owner was short of funds and the company had no other work in hand. "The case was a clear reinvestment or capitalisation within the dictum of Lord Trayner (in
Californian Copper Syndicate (Limited and Reduced) v. Harris (1904) 5 T.C. 159);" Molloy on Income Tax at p. 416).
Finally, with reference to the Fincon decision, there was in that case no consideration of the profits-emerging method of accounting which is now in issue. It was a case in which the taxpayer sought simply to exclude the full amount of the future instalments - an untenable proposition which would, as North P. observed, ``give a wholly false picture of its trading operations for the year in question''. Mr. Bridger, for the Commissioner, placed a good deal of reliance on the Fincon decision being, as it is, a decision of the Court of Appeal to the
ATC 6033
effect that instalments resulting from a transaction effected during an accounting year but only becoming due for payment outside that year must be brought to account in the year of the transaction. However, for the reasons I have given, I consider that the Fincon case is clearly distinguishable from the instant case.There are a number of decisions of the Australian and English courts which have a bearing on issues raised in this case. Although the English legislation does not use the term ``derived'' in relation to income, the decisions show that the concept of what income is to be regarded as the income of any particular accounting year is the same as that accepted in both New Zealand and Australia. The provisions of the Australian statute, the Commonwealth Income Tax Assessment Act 1936, resemble the New Zealand provision in that income is always spoken of as being ``derived''. The leading case of C. of T. (S.A.) v. The Executor Trustee and Agency Co. of South Australia Ltd. (1938) 63 C.L.R. 108 - usually referred to as ``Carden's case'' - was concerned with the income of a medical practitioner. In that case distinction was drawn between the case of a trader in vendibles and a taxpayer deriving his income from personal services. The distinction, of course, is that in the case of a trader, an entirely false position will be created if the depletion of stock through sales is not in some way counterbalanced by either money received by way of purchase price or, in the case of receivables not falling due during the accounting year, by some proportion of those receivables which can be related to the cost or value of the stock depletion - the merchandise component of those receivables. In the case of a professional man, there is nothing which corresponds to the depletion of a trader's stock through sales so that no corresponding problem arises; there is, therefore, no occasion to make an apportionment of items of remuneration not receivable during the accounting year for services performed during that year. Thus, in Carden's case, the judgment of Dixon J. (as he then was) contained the following passage, referring to earnings from a profession, at pp. 157-8 -
``Where there is nothing analogous to a stock of vendible articles to be acquired or produced and carried by the taxpayer, where outstandings on the expenditure side do not correspond to, and are not naturally connected with, the outgoings on the earnings side, and where there is no fund of circulating capital from which income or profit must be detached for actual enjoyment, but where, on the contrary, the receipts represent in substance a reward for professional skill and personal work to which the expenditure on the other side of the account contributes only in a subsidiary or minor degree, then I think according to ordinary conceptions the receipts basis forms a fair and appropriate foundation for estimating professional income...''
And at p. 155 -
``... there must be something `coming in'; that is, for income tax purposes, receivability without receipt is nothing.''
Comparing the case of a trader, Dixon J. said at p. 156 -
``The basis of a trading account is stock on hand at the beginning and end of the period and sales and purchases. In such an account book debts represent what before sale was trading stock and it is almost inevitable that they should be taken into consideration upon an accrual and not a cash basis.''
And finally, dealing with the general concept of income, at p. 155 -
``Speaking generally, in the assessment of income the object is to discover what gains have during the period of account come home to the taxpayer in a realised or immediately realizable form.''
In
Arthur Murray (N.S.W.) Pty. Ltd. v. F.C. of T. (1965) 114 C.L.R. 314 at p. 318, the Full Court referred to this last mentioned dictum as follows -
``The word `gains' is not here used in the sense of the net profits of the business, for the topic under discussion is assessable income, that is to say gross income. But neither is it synonymous with `receipts'. It refers to amounts which have not only been received but have `come home' to the taxpayer; and that must surely involve, if the word `income' is to convey the notion it expresses in the practical affairs of business life, not only that the amounts received are unaffected by legal
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restrictions, as by reason of a trust or charge in favour of the payer - not only that they have been received beneficially - but that the situation has been reached in which they may properly be counted as gains completely made, so that there is neither legal nor business unsoundness in regarding them without qualification as income derived.''
In Carden's case Latham C.J., in a dissenting judgment which is particularly relevant to the present issue, at 63 C.L.R. at p. 123, said -
``In the case of traders, where tax is imposed upon the profits of a trade, profits are calculated both in Australia and in England on an earning basis; that is to say, trade debts which fall due to the taxpayer during the year are credited and allowance is made for bad debts.''
And at p. 124 -
``In the case of a trader it is well established that he must take into account book debts owed to him as part of his income, at least where those book debts fall due during the year in respect of which he is making his return.''
And at p. 125 -
``... trade debts which have accrued due in the relevant year but which have not been paid must be included for the purposes of ascertaining whether or not the business has earned a profit for the year, just as stock in trade at the beginning and end of the year must be taken into account for the same purpose.''
(The italics are mine.)
Mr. Bridger, for the Commissioner, relied heavily upon the decision of a Full Bench of the High Court of Australia in
J. Rowe & Son Pty. Ltd. v. F.C. of T., 71 ATC 4157 as being a case completely at odds with the Objector's contention in the present case in that the profits-emerging method of accounting was firmly rejected as appropriate to the case of a retail trader's accounts. This rejection was explicit in the judgment of Menzies J., with which Barwick C.J. concurred.
The judgment of Menzies J. in the Rowe case contains a succinct statement of the facts, but for a more complete account, it is necessary to turn to the decision of Walsh J. at first instance - reported at 71 ATC 4001. The appellant company operated a retail shop in the City of Toowoomba selling household goods such as furniture, television sets and refrigerators on terms. Terms customers were required to sign a formal offer to purchase at the foot of an itemised list of the goods and their respective cash prices. It contained the following printed words -
``To J. Rowe & Son Pty. Ltd. for the Goods Listed above I offer the sum of $... payable by way of a first payment of $... Cash and thereafter by Periodical Instalments of $... every... weeks/month commencing on...
Signed...''
The amount ``offered'' was in excess of the cash price by an amount equivalent to 11% per annum over the period of payment. At the same time as the customer signed the offer, he executed a bill of sale which contained an acknowledgement that the total amount agreed to be paid was ``a valid and enforceable debt due by the grantor to the grantee'' payable by the periodical instalments particularised in the documents. The bill of sale provided that on any default, the whole of the balance secured would become due and payable and that interest at 8% per annum would be payable on overdue payments.
Mr. Congreve for the Objector in the present case attempted to distinguish J. Rowe & Son Pty. Ltd. as being a case where each transaction could be regarded as two severable transactions - a sale for cash and a collateral arrangement for financing the purchase. This concept was expressed by Professor Gynther, called by the Commissioner, his evidence being referred to in the judgment in the following terms (71 ATC at p. 4012) -
``In explaining why he thought it was proper to bring in the normal sale price as revenue at the time of the sale, notwithstanding that the receipt of it would be deferred, the witness said that he saw the trader in two different sorts of business, that is, selling and financing.''
Mr. Congreve contended that the customer's contracts in the present case were in a different form and were not susceptible of the dissection referred to by Professor
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Gynther. I am unable to accept this proposition as a basis for distinguishing this case from Rowe's case. In both cases, there was a sale where property passed immediately to the purchaser and in both cases, the purchase price was payable over a period by instalments calculated to include a credit charge, each instalment becoming due and payable only on the stipulated date. Mr. Congreve also pointed to other differences - the bill of sale, the provision for the balance to fall due in the event of a default and the provision for interest on payment of arrears. In my view, none of these differences is sufficient to distinguish Rowe's case from the instant case.Mr. Congreve pointed also to differences in statutory structure between the New Zealand Act and the Australian Act. However, I do not find the structures of the two statutes to be so incongruous as to afford a basis for distinguishing the Rowe case from the instant case.
There is, however, one marked difference - and that is that in Rowe's case, the taxpayer had in fact deducted not the gross profit content but the whole amount of the receivables from its returns for the accounting year. And it was the taxpayer's primary submission that this was the appropriate method. The result, of course, was a gross distortion of the taxpayer's trading results: by omitting from its returns the whole of the receivables outstanding at the end of the accounting year with no balancing item for stock sold during the year, the accounts produced an entirely fictitious loss of over $100,000 - a result far removed from the profits which appeared in the company's published accounts.
In Rowe's case the taxpayer did advance the alternative submission that if the method it had used was found to be wrong, then some sort of profits-emerging method would be appropriate. But this alternative was very much a secondary submission - entirely unsupported by evidence and put forward in the complete absence of particulars as to how it could be put into effect. This emerges clearly from the judgment of Walsh J. at first instance when he said at p. 4013 -
``As I understood the argument, counsel for the company meant by `the cost to the taxpayer' not merely the wholesale price which the company paid for its stock to those from whom it bought it, but the total of all the outgoings, up to the time of the sale by the company of the goods, which were necessary to enable the sale to be made. It was described as `the costs up to the point of sale'. But no evidence was directed to showing, even in general terms, how that cost was to be ascertained or to showing whether the books and records had been kept in such a manner that the calculations could now be made which would be necessary, if the argument were accepted...
I think that it is incumbent upon an appellant taxpayer to establish with some degree of particularity what the proposed basis of assessment is and to establish that it is probable that it will be practicable to apply it in the circumstances of the particular case. I am of the opinion that there is much force in the submission of counsel for the respondent that the company has not shown that the application of the profits-emerging principle to these transactions is feasible....''
It was expressly for those reasons that Walsh J. declined to hold in favour of the profits-emerging method although he did say at p. 4013 -
``This submission has the merit, as compared with the Company's primary submission, that if it be adopted there would be a balancing in the accounts of outgoings in respect of the goods and a return obtained from the sale of them. In theory it seems to me to be quite possible that the use of some type of profits-emerging formula might produce a result which would be a fairly accurate estimation of the profit made in the trading of a particular year.''
When the case came before the Full Court, only two reasoned judgments were given - those of Menzies and Gibbs JJ. Menzies J. devoted almost the whole of his judgment to the demolition of the taxpayer's primary submission - a submission which was wholly untenable because it had the result of producing a fictitious loss by failing to relate the depletion in stock resulting from sales to any balancing item from receivables. But, when it came to dealing with the taxpayer's
ATC 6036
secondary submission - i.e., the profits-emerging submission - Menzies J. disposed of this in four sentences at 71 ATC at p. 4160 as follows -``It seems to me, however, that the basic scheme of the Act is that taxable income is calculated by deducting allowable deductions from assessable income. It is only when it is expressly authorised that outgoings are taken into account in determining what is to be included in assessable income. An instance where a procedure of this sort is expressly required is sec. 26(a) of the Act where it is provided that a calculated profit is to be treated as assessable income. In my opinion, however, the fundamental scheme of the Act is inconsistent with attempts to calculate the profit element in each transaction undertaken by a taxpayer in the course of its business and to aggregate those profits to arrive at taxable income, or, at something which is neither taxable income nor assessable income, but is a sum from which further deductions would have to be made to arrive at taxable income.''
To my mind, this begs the real question, which is not whether the taxpayer is enabled to make deductions from assessable income but, whether a certain item, namely the gross profit content of receivables, is to be included in arriving at assessable income. In Rowe's case, the laconic dismissal by Menzies J. of the taxpayer's secondary submission failed to give the profits-emerging method the consideration to which I think it was entitled - and which, I have no doubt, it would have received had it been advanced in a more explicit form and with the support of proper evidence.
The other reasoned judgment in Rowe's case is that of Gibbs J. who clearly thought that Menzies J. went too far in his treatment of the profits-emerging submission. After referring to the judgment of Menzies J. he said that he did not find it necessary to go to the same length. He was in whole-hearted agreement with Menzies J. in rejection of the taxpayer's primary submission; but as regards the profits-emerging submission, he declined to say that the income of a trader who sells on terms may never appropriately be determined on such a basis. He preferred, on this aspect, to adopt reasoning similar to that of Walsh J. at first instance, when he held that in the case as presented to him, there was no evidence to show the practical application and effect of the profits-emerging method.
In the present case, on the other hand, the matter has been fully canvassed, the method has been clearly described and has been in use for many years not only in the Objector's taxation returns but also in its published accounts. There has been expert evidence to show that it is a method which does indeed produce a true reflex of the taxpayer's trading results and its application has long been accepted by the Commissioner in the case of hire purchase sales. In my view, the matter calls for much closer examination than it was afforded in Rowe's case and I am not prepared to regard that decision as providing a definitive answer to the issues raised in the present case.
There are two recent decisions of the House of Lords, which clearly support the concept that profit is to be brought into account only when it is received or when it accrues.
In B.S.C. Footwear Ltd. v. Ridgway [1971] 2 All E.R. 534 at p. 536 Lord Reid said -
``The application of the principles of commercial accounting is, however, subject to one well established though non-statutory principle. Neither profit nor loss may be anticipated. A trader may have made such a good contract in year one that it is virtually certain to produce a large profit in year two. But he cannot be required to pay tax on that profit until it actually accrues.''
The dictum cited from B.S.C. Footwear Ltd. v. Ridgway was approved by the House of Lords in
Willingale v. International Commercial Bank Ltd. [1978] 1 All E.R. 753.
I am persuaded that, for fiscal purposes, income is derived only when it ``comes home'', either in the form of actual payment or in the form of an accrual - an immediately enforceable right to receive payment. This is the principle recognised and applied, not only in New Zealand but also in Australia and the United Kingdom. It is, moreover, consistent with sec. 92 of the Land and Income Tax Act 1954.
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Having reached this point, I am in a position to relate the legal principle to the conflicting opinions of the accountants, bearing in mind that I must determine the matter according to the law and not according to the practice of accountants (per Dixon J. in Carden's case and Viscount Simonds in Ostime v. Duple Motor Bodies Ltd.).
From this viewpoint, one can now readily perceive the fallacy inherent in regarding the point of time when title passes to the purchaser as determining the time when the income from the transaction is derived. A trader may well consider, when he effects a sale, that he has earned a profit; but so far as the Land and Income Tax Act is concerned, no income is derived from the sale until there is either payment or an immediately enforceable right to obtain payment. The method of accounting for which the Commissioner now contends, and which Mr. Valentine prefers, may well be appropriate for the taxpayers' purposes and justify reporting to shareholders accordingly - although the warning contained in the Research Bulletin (R. 105) of the New Zealand Society of Accountants suggests caution in this regard; but it is, in my view, a method which is less consonant with the meaning and intent of the Land and Income Tax Act than is a method which postpones recognition of profit until the profits come home, either in cash or in the form of an immediate right to payment.
In distinguishing budget account sales from hire purchase sales, Mr. Valentine attached great importance to the time of giving title - an irrelevant circumstance according to the view I have formed - and went on to say that he regards this as the time when the exchange takes place. But there are two sides to an exchange and so far as the money side of this particular exchange is concerned, it certainly does not take place, either by payment or accrual, at the instant when property in the goods passes: it takes place over a period of 20 weeks and is incomplete until the time when the last instalment falls due.
Once there is an appreciation of the true concept of what is meant by the word ``derived'' in relation to income and, in particular, as to the time of derivation, it only remains to find a system of accounting which will reflect in each accounting year the income derived by the taxpayer in that period. There is nothing in principle, and nothing in the legislation, to differentiate between a trader and any other taxpayer as to the time when income is derived. In both cases, income is derived only from payments actually received and debts which, though not paid, have become due and payable to the taxpayer and it is derived at the point of time when payment is received or the debt becomes due and payable as the case may be.
To devise such a system of accounting, in the case of a professional person, is a simple matter. In the case of a trader, whose trading position can only be established by accounts which reflect stock movements - stock at the beginning and end of the period - and sales and purchases, the exercise is rather more difficult. A trader whose business normally comprises only a minor element of sales on extended credit terms may well elect to simplify the matter by bringing to account in the year of the sale the full amount of receivables irrespective of due date. By so doing, he will create a false picture of his trading results in terms of assessable income but the overall effect will be minimal and will no doubt be acceptable to the Commissioner. On the other hand, a trader whose business involves a very large component of credit sales will produce a significantly incorrect result if he brings into his accounts the full amount of the instalments not due and payable in the accounting year without regard to the fact that income cannot be derived except from payments either received or accruing during the accounting year. Indeed the publication of the New Zealand Society of Accountants referred to in evidence suggests that there is a danger in taking that course even in the area of accounting for reporting purposes. Nevertheless, because of the relevance of stock movements, the trader must balance an appropriate portion of the unpaid and undue instalments against stock items which have been sold - otherwise the accounts will present a grossly distorted picture of trading results. It appears to me that the approach adopted by the Objector in the present case is both realistic and sensible. In effect, the merchandise content of the instalments not payable in the accounting year is set against the merchandise which it now represents, and
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the profit content is returned, where it rightly belongs, in the year in which the income is derived. It is one thing to establish when work is done or a transaction entered into which will produce income; it is another thing to say when income, the reward of such work, or the product of such transaction, is derived.The conclusion I have reached is that the method of accounting employed by the Objector is one which produces a more realistic measure of real profits for the year than does the method for which the Commissioner contends; moreover, it accords with the view I take as to the time when the income from the credit sale is derived in the sense in which that word is used in the Land and Income Tax Act 1954. It is a method which is eminently practical and which evolves from records which can be readily checked and audited.
During the hearing, Mr. Congreve submitted that if the Objector's present method of accounting is not acceptable, consideration should be given to the alternatives of either excluding from income in the year of sale the full amount of instalments not falling due in that year or of including in such income a figure representing the present value of those instalments. As to the former alternative, I have already referred to reasons why it is wholly inappropriate to the accounts of a trading company; as to the latter, I am aware that there have been cases such as Absolom v. Talbot [1944] A.C. 204, in which the valuation approach was upheld. But where there is a substantial volume of credit sales with instalments falling due at frequent intervals, I cannot see that such a method is justified in principle or that it would be practicable.
Without taking into account the evidential onus created by the long acceptance of the Objector's accounting methods, I hold that the Objector's income was originally returned on a proper basis, that the Commissioner acted incorrectly in making the assessment now in question and that, accordingly, the assessment should now be amended so as to be in accord with the Objector's original return. In those circumstances, no question arises as to whether the Commissioner was entitled to invoke sec. 92A(1)(b) of the Land and Income Tax Act 1954.
The Objector is entitled to costs. I reserve the matter of quantum of costs and invite counsel to submit a memorandum should agreement not be reached as to this.
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