Bloodstock investors finish down the track
Racehorse ownership is a risky enough business. Try to claim a tax deduction for losses on your equine investment and, based on the recent High Court decision of Drummond v Commissioner of Inland Revenue, you truly fall into the ranks of an outsider. While the decision in this case has significant implications for investors in bloodstock breeding syndicates, the decision also provides useful learnings for anyone entering a new venture and seeking to establish whether a business has actually commenced.
The plaintiffs were members of an unincorporated syndicate, called Te Akau Stallion Syndicate (No. 1) (“the syndicate”) which was formed in March 2008 with the stated object of acquiring, training and racing a recently purchased blueblood (Roman Gladiator), “and any other thoroughbred colts acquired by the Syndicate, with a view to increasing their value as thoroughbred Stallions”.
Big things were expected of this colt. By Cambridge Stud’s champion sire, the syndicate outlaid $550,000 plus GST to secure him at the 2008 Karaka Premier yearling sales. The syndicate manager, David Ellis, had a proven record in buying well-bred colts and through carefully managed racing careers promoting those colts as commercial stallion prospects that could eventually be worth several millions of dollars. Despite Mr Ellis’ track record, this was still a highly speculative venture. The Court heard in evidence that fewer than 5% of good pedigree colts sold annually at Karaka end up standing at stud. While Mr Ellis had notably more success in this regard (achieving a success rate of around 25% to 30%), the Court noted that the risk of failure was still high.
While success on the racetrack is not essential to standing a horse at stud, its worth as a stallion would be greatly enhanced if it did prove its worth on the track. With that in mind, the colt was sent to a leading trainer to be prepared for racing. However, that racing career did not unfold as hoped. The colt proved to be an unruly individual and on Christmas Day 2008 attacked and seriously injured his jockey. In his early trials his performances fell well short of his price tag. His temperament worsened to the extent he was considered too dangerous to be kept intact. Any hope of a stallion career for Roman Gladiator was literally cut off in October 2009 when he was gelded.
The investors meanwhile sought to claim some tax relief on what they were now facing as a potentially disastrous investment. In their 2008 tax returns they claimed a deduction equivalent to 75% of the cost price of the colt on the grounds they satisfied the requirements of section EC 39(1)(c), i.e. that they had bought bloodstock:
“... with the intention of using it for breeding in their breeding business”.
A further deduction was claimed in their 2009 tax returns.
In analysing section EC 39, the Court concluded that the provision required a person to already have a breeding business. Without an existing business, the Court concluded the plaintiffs could not bring themselves within the scope of the section. By itself, the acquisition of the colt was not enough to signify that there was any existing breeding business.
An alternative argument was put forward by the plaintiffs to the effect that section EC 39 was not concerned with whether a business existed at the time that bloodstock was acquired, as long as a business was ultimately carried out. They argued that the real focus of the provision was whether the taxpayer has used the bloodstock in their business (as opposed to in someone else’s business).
However, both of these arguments required the existence of a breeding business yet, in a finding that was fatal to the plaintiffs’ case, the Court determined that no bloodstock breeding business had been established.
The Court did conclude that the plaintiffs were carrying on a racing business however that finding was of little comfort. The paltry race earnings earned by the horse were in any event exempt from tax, meaning the costs of racing the colt were non-deductible. [Footnote: as a final post-script the Court heard that with a meagre $8,600 to his name, Roman Gladiator was re-named, sent to Singapore and in a further handful of starts failed to earn a single dollar, effectively bringing to an end his race career].
While the decision follows established principles, the case re-affirms the criteria needed to determine whether a venture constitutes a ‘business’, as that term is used in a tax context. Richardson J in Grieve v CIR (1984) 6 NZTC 61,682 had developed the following test which the High Court, and others, have since followed:
“... the decision whether or not the taxpayer is in business involves a two-fold inquiry - as to the nature of the activities carried on, and as to the intention of the taxpayer in engaging in those activities.”
The fundamental notion is that an activity must be conducted in an organised and coherent way directed to an end result. In looking at the nature of the activities carried on, regard needs to be had to factors such as the period over which the activities are carried out, the scale of operations, volume of transactions, commitment of time, money and effort, the pattern of activity and the financial results.
The fact that a venture may be highly speculative does not prevent a business commencing. However, if the commencement of the business is contingent on other factors then until those factors are present a business is unlikely to have commenced.
In Drummond, from the moment the colt was acquired there was a fixed intention of racing it. By contrast, there was never a fixed intention to stand the colt at stud. That would require a conscious decision by the syndicate (followed by activities aimed specifically at implementing that decision), yet the Court could find no evidence that such a decision had ever been made.
“Buying a colt with the fixed intention of racing it and a contingent intention of one day standing it at stud does not establish a breeding business. If it did then anyone buying a thoroughbred with the intention of racing it and possibly breeding from it would be in the business of breeding bloodstock.
“The evidence establishes that the syndicate members, when acquiring the colt, did so with the desire that it would one day stand at stud and return the members an income in the form of service fees. But I infer there were decisions still to be made which would determine whether, or how, that desire might be achieved. For example, how long would the colt be raced? Who would decide? What if an attractive purchase offer were received? At what stud would the colt (as a stallion) stand?
“The fact that the venture of breeding is speculative does not prohibit a breeding business commencing. If that were the case, then no breeding business would ever exist. But in the face of that risk, a commitment to a plan and structure to get the colt from acquisition to the end point of being able to service mares is to be expected. The syndicate agreement speaks more of an objective that the colt be developed so as to be worth as much as possible when the time came to make decisions about its stud future. The decisions actually made went to the best interests of the colt’s racing career. The decisions as to any potential stud career were left to the future. This demonstrates a lack of commitment to a profit-making structure for breeding. The only structure actually in place was the structure to seek profit from potential race winnings.”
The Court acknowledged that if the plaintiffs had had an established breeding business then all that they did in acquiring and developing the colt would have been recognised as being pursuant to that business. So, when considering whether to proceed with a new business venture, the existence of contemporaneous evidence will be an essential pointer to establishing when that new business has commenced.
If you would like to discuss the issues this case raises, please contact your usual Deloitte tax advisor.
Tax Alert August 2013 contents:
- Tax Alert - August 2013
- Clarity, controversy, or both: Inland Revenue’s finalised guidance on tax avoidance
- Succession and divestment
- Clarifying the tax consequences for deregistered charities
- Research and development expenditure: Deja vu?
- Bloodstock investors finish down the track
- A necessary review of allowances
- Deloitte announces new tax partner