January 2009
Contents:
Introduction
In Ben Nevis Forestry Ventures Limited v CIR; Accent Management Limited v CIR [2008] NZSC 115 (also known as the Trinity case) the Supreme Court has given its first decision under the general anti-avoidance provision, section BG 1 of the Income Tax Act 1994. While the Court has upheld the decision of the lower Courts in the Commissioner of Inland Revenue's favour, the Court has rejected the Commissioner's argument that the provision should have an overarching status relative to the various specific provisions in the tax legislation.
The case involved an arrangement, marketed to numerous investors, for investing in a Douglas Fir forest, located in Western Southland. Investors in the scheme were granted a 50 year licence to use land for establishing a forest. Investors issued a promissory note to pay a fixed premium of $2,050,518 per plantable hectare for the licence. The promissory note was due on 31 December 2048.
Investors also entered into an insurance arrangement under which an insurer assumed the risk for the decrease in the value of the forest at the time of harvest below an amount equal to the licence premium payable in 50 years. An initial insurance premium of $1,307 per plantable hectare was payable upfront, and a further $32,791 per hectare was paid by way of promissory note, due on 31 December 2047. The insurer was a captive insurer established in the British Virgin Islands specifically for the purposes of the scheme, and was controlled by the scheme's promoter.
The Commissioner sought to deny deductions for the licence premium and insurance premium both under the specific deductibility provisions, and under the general anti-avoidance provision. In respect of the licence premium, the Commissioner contended that the per-hectare payment was not a payment for the "right to use land", which was the basis on which the investors had claimed a deduction for the payment. As for the insurance premium, the Commissioner alleged that the insurance arrangements were a sham, and, in the alternative, that the deduction should be spread over the 50 year term of the insurance contract, as opposed to being allowed up-front. To the extent the amounts were deductible under the specific deductibility provisions, the Commissioner said a deduction should be denied under section BG 1 on the grounds the expenses formed part of a tax avoidance arrangement.
The principal judgment in the Supreme Court was delivered on behalf of Tipping, McGrath and Gault JJ. The Court in that judgment upheld the investors' arguments on the specific deductibility provisions, but agreed with the lower Courts that the general anti-avoidance provision applied and also that the investors were liable for penalties of 100% of the resulting tax shortfall.
The general anti-avoidance provision (section BG 1)
The most significant aspect of the Supreme Court's decision is the rejection of the Commissioner's submission that section BG 1 should have primacy over other taxing provisions. The Court of Appeal in its decision had described such an approach as "simpler", and as "undoubtedly more favourable from the point of view of the general body of taxpayers". The Court of Appeal had nonetheless recognised that prior decisions rejecting the primacy of the general anti-avoidance provision (in particular the Privy Council's decision in Peterson v CIR) put it "beyond the power" of the Court of Appeal to accord primacy to section BG 1.1 The Court of Appeal had therefore applied the orthodox approach of seeking to reconcile section BG 1 with the "scheme and purpose" of the specific tax provisions relied on by the investors.
Perhaps encouraged by the Court of Appeal's comments, the Commissioner argued that the Supreme Court, which is not bound by any precedent decision, should hold that section BG 1 has primacy over all the specific taxing provisions, and that whether section
BG 1 applies in a given case should simply depend on whether the relevant arrangement has a "more than merely incidental" purpose or effect of tax avoidance. The Commissioner submitted that the Supreme Court should overrule the Privy Council's decision in Peterson, and depart from the "scheme and purpose" approach, first articulated by Richardson J in Challenge Corporation v CIR, in order to confirm the overriding status of the general anti-avoidance provision.2
The Supreme Court rejected the Commissioner's invitation to depart from the scheme and purpose approach and treat section BG 1 as overarching. The Court held that the general anti-avoidance provision and specific tax provisions should "work in tandem" and that "neither should be regarded as overriding".3 According to the majority:4
When, as here, a case involves reliance by the taxpayer on specific provisions, the first inquiry concerns the application of those provisions. The taxpayer must satisfy the Court that the use made of the specific provision is within its intended scope. If that is shown, a further question arises based on the taxpayer's use of the specific provision viewed in the light of the arrangement as a whole. If, when viewed in that light, it is apparent that the taxpayer has used the specific provision, and thereby altered the incidence of income tax, in a way which cannot have been within the contemplation and purpose of Parliament when it enacted the provision, the arrangement will be a tax avoidance arrangement.
The Court also recognised that deliberately taking advantage of specific tax rules is commonplace and does not in itself amount to tax avoidance:5
Taxpayers enter into many transactions which have been structured with the purpose of taking advantage of specific provisions in order to reduce tax. While the general anti-avoidance provision is expressed broadly, its purpose cannot be to strike down arrangements which involve no more than appropriate use of specific provisions. On the other hand, strict compliance with the requirements of specific provisions cannot have been intended to immunise all arrangements involving their use against being categorised as tax avoidance arrangements, which it was the purpose of the general provision to avoid.
This statement accords with the Court of Appeal's observation that "tax legislation necessarily creates both incentives and disincentives and it would be perverse to hold that rational and intended taxpayer responses to those incentives (or disincentives) are caught by general anti-avoidance provisions despite being within their letter".6 Richardson J had recognised the same reality in Challenge, when he acknowledged that "in many cases, but for the anticipated availability of the tax benefit the taxpayer would never have entered into the activity or transaction" and that many aspects of the tax system "clearly allow for the deliberate pursuit of tax advantage".7
Applying these principles to the facts, the Supreme Court, like the Courts below, found that there was a general lack of commerciality underlying the arrangement and this heavily influenced the Court's views. In respect of land acquired by the scheme's promoters for approximately $580 per plantable hectare, the investors had agreed to pay $1,946 per plantable hectare upfront for an option to acquire the land in 2048 at half its then market value, and in addition agreed to pay $2,050,018 per plantable hectare as a premium for a licence to use the land in the intervening 50 year period.8 The Supreme Court considered that the disparity between the value of the land at the outset, and the amounts investors had agreed to pay for the purchase option and licence, raised questions over the business purpose of the arrangement.
As for the insurance arrangements, the Supreme Court observed that the arrangements did not have any substantial risk management function. Any insurance payout was to be self-funded from within the arrangement, in the sense that the insurer did not accumulate and invest reserves, or arrange reinsurance. The Court found that "no reputable reinsurer" would have undertaken the risk. In certain circumstances, the payout under the insurance contract would be funded by circular cash-flows.
Given what the Court considered to be the commercially unrealistic amounts payable by investors, the 50 year timeframe for which any obligation to pay the relevant expenditure was deferred, and the fact that the obligations were unguaranteed obligations of closely held companies, the Court considered that the licence premium expenditure would "never be truly incurred".9 The deferred insurance premium was likewise considered not to have been paid in any commercial sense, and in any case the insurance premiums were held to be part of an arrangement that was substantially circular and involved no real risk transfer.10 The expenditure claims were therefore found not to be within Parliament's purpose and contemplation for the specific deductibility provisions. This being so, the Supreme Court held that section BG 1 applied so as to deny a deduction otherwise available for the licence premium and insurance premium expenditure.
The specific tax regimes and the Commissioner's sham allegation
While the main focus of the decision is the application of section BG 1, the Court also had to consider the availability of deductions under the specific deductibility tests. Like the Court of Appeal, the Supreme Court sought to interpret the specific deductibility provisions on the basis of the "legal structures and obligations the parties have created and not… their economic substance…" In this regard, the Supreme Court recognised the need to "respect the fact that frequently in commerce there are different means of producing the same economic outcome which have different tax consequences".11 Applying this approach, the Court concluded that the licence premiums did meet the test for deductibility under the specific deductibility provisions.
As for the insurance premiums, the Court rejected the Commissioner's sham allegation in more definitive terms than the Court of Appeal had. The Court stressed the distinction between a sham (being a situation where the documentation does not record the true agreement of the parties) and tax avoidance (where the documentation accurately reflects the terms of the intended transaction, but where that transaction would give rise to a tax advantage which, for section BG 1 purposes, is unacceptable).12 The Court concluded:13
An allegation of sham, being akin to an allegation of fraud, should not be lightly made. Those engaging in a sham are in reality seeking to deceive others as to the true nature of what they have agreed and are intending to achieve. That is not shown here.
The Court then considered the timing question in respect of the insurance premiums. The Court of Appeal had upheld the Commissioner's argument that any deduction available for the insurance premiums should be spread over the 50 year term of the insurance arrangement, on the grounds the insurance premiums were accrual expenditure, required to be spread over the period to which the expenditure related.14 The Supreme Court disagreed, and instead held that as the insurance contract was part of a wider financial arrangement, the insurance premiums were expenditure "in respect of any financial arrangement", and so could not be accrual expenditure subject to the spreading regime in section EF 1. In so concluding, the Supreme Court seems to have nonetheless accepted that the spreading regime in the financial arrangements rules would not apply to the insurance premiums either, as amounts solely attributable to excepted financial arrangements (which include insurance contracts) fall outside the financial arrangements rules spreading methods.
The Supreme Court's conclusion on the question of spreading may seem understandable on a purely textual analysis of the legislation. The result, however, seems unintended, as it would seem to leave such expenditure to fall between the cracks, subject to neither the financial arrangements rules nor the accrual expenditure spreading regimes. One assumes that remedial legislation, confirming that such expenditure is within the "accrual expenditure" regime, may be forthcoming.
Penalties
Upholding the decision of the Courts below, the majority held that the 100% penalty for taking an abusive tax position applied. An "abusive tax position" was relevantly defined as one that involves an unacceptable interpretation, and which is taken with a dominant purpose of avoiding tax. Applying that test, the Court focused on the purpose of the arrangement, and not the purpose of the particular taxpayer, in order to determine whether the "tax position" was taken "in respect, or as a consequence, of an arrangement that is entered into with a dominant purpose of avoiding tax".
On one view, the Court's reasoning may conflate the test for tax avoidance under section BG 1 with the test for an abusive tax position for penalty purposes. The shortfall penalties regime was not intended to result in an automatic 100% penalty for cases involving an unacceptable interpretation of section BG 1. Accordingly, the penalties question, like the Court's approach to the accrual expenditure regime, could usefully be clarified by remedial legislation, to ensure that the regime's original intent is upheld in future cases.
The separate judgment of Elias CJ and Anderson J
In a short concurring judgment, Elias CJ and Anderson J agreed with the majority that the general anti-avoidance provision applied to the arrangement, but took a different view on questions concerning the interpretation of tax legislation generally and the relationship between specific provisions and the general anti-avoidance provision. Their Honours considered, in contrast to the majority, that even when considering the application of specific taxing provisions, the Court was not confined to considering legal structures and obligations, and could have regard to the economic substance of a transaction. If the relevant tax advantage survives that analysis, then it is necessary to consider the general anti-avoidance provision. Their Honours, unlike the majority, perceived no need to reconcile the general anti-avoidance provision with the specific tax provisions, because their Honours did not see those provisions as being in conflict.
The separate judgment does not go into sufficient detail to explain how the suggested approach would apply to the facts in the case or its consistency (or otherwise) with the approach taken in prior cases. On the face of it however, the minority's approach, in suggesting that the Court can look to a transaction's economic substance in interpreting specific tax provisions, seems inconsistent with decades of New Zealand law, not only in the tax context, but when characterising commercial arrangements generally. It would be surprising if their Honours were intending to depart from those long-standing principles. In any case, courts in future cases can be expected to adhere to the orthodox approach set out in the majority judgment, which is that specific taxing provisions must be applied having regard to the relevant legal rights and obligations, not the economic substance. Section BG 1 must be approached by considering whether the tax advantage in question is consistent with the "scheme and purpose" (as Richardson J had put it) or "within the contemplation and purpose of Parliament" (as the Supreme Court has put it) for the specific provisions under which the tax advantage arises.
The practical consequences of the decision
Some commentators may be disappointed that the Supreme Court has not demystified the law concerning tax avoidance by laying down some formulation that provides greater certainty as to what does and what does not amount to tax avoidance. This, however, misses the point that Judges decide cases on their particular facts, and case law must be read and understood in that light. As the Court noted:15 "judicial attempts to articulate how the line is to be drawn have in the past too often been seized on as if they were equivalent to statutory language". There is therefore no substitute for analysing the facts of the decided cases in order to ascertain where the Courts have previously "drawn the line" in order to predict where the line may be drawn in future.
The Supreme Court's decision does however have practical consequences for how Inland Revenue should approach the application of the general anti-avoidance provision. It is suggested that the following principles emerge from the decision:
- the decision puts an end to speculation that the new Supreme Court would jettison the existing case-law concerning the provision and start with a clean slate. The Supreme Court has clearly decided not to do that. None of the earlier cases have been overruled;
- the majority, consistently with the unanimous decision of the Court of Appeal, has recognised the reality that taxpayers "enter into many transactions which have been structured... in order to reduce tax", and that this fact, on its own, does not result in section BG 1 applying. This point is significant in terms of how Inland Revenue can sometimes approach these matters. The proposition that a transaction depended "on tax benefits", or is structured in a particular way "for tax reasons", is sometimes taken as conclusive evidence that section BG 1 applies. The Supreme Court has confirmed that that is not the law;
- as a corollary to the preceding point, the need to consider the "scheme and purpose" of the specific tax provisions is at the forefront of any tax avoidance analysis. If (having regard not only to legal matters but to the commercial reality and economic effect of the arrangement and its tax consequences) the particular tax benefit is held to be within Parliament's purpose and contemplation for the specific provisions, then section BG 1 is not applicable. Previously Inland Revenue has tended to treat the scheme and purpose of the specific provisions as irrelevant to the section BG 1 analysis, or as, at best, a secondary consideration; and
- finally, in deciding whether a particular tax benefit is within Parliament's purpose and contemplation, it is necessary to view the arrangement in a commercially and economically realistic way. The fact that a taxpayer may use companies or trusts as investment vehicles in order to gain tax concessions in itself will "normally" be acceptable, as Parliament must be taken to have contemplated that outcome in enacting concessions applicable to certain entities.16 The same, one can surmise, must be true of other basic choices available under tax law, such as the differing tax consequences attaching to debt and equity as mechanisms for fund-raising or investing. The facts in Trinity, however, involved more than that, given that the Supreme Court found that tax deductions were claimed for amounts of expenditure that far exceeded commercially realistic amounts, and in circumstances where the expenditure would never be incurred in commercial terms.
To view a copy of the case please click here.
1 Court of Appeal decision, paragraphs [114] and [115].
2 Transcript of argument (available at www.courtsofnz.govt.nz/from/transcripts/transcripts-2008) at pages 284 to 313.
3 Supreme Court decision at paragraph [103].
4 Supreme Court decision at paragraph [107].
5 Supreme Court decision at paragraph [12].
6 Court of Appeal decision at paragraph [111].
7 Challenge Corporation Limited v CIR [1986] 2 NZLR 513 at 549.
8 Supreme Court decision at paragraph [121].
9 Supreme Court decision at paragraph [128].
10 Supreme Court decision at paragraph [148].
11 Supreme Court decision at paragraph [47].
12 Supreme Court decision at paragraph [34].
13 Supreme Court decision at paragraph [39].
14 Under section EF 1 of the Income Tax Act 1994 (now section EA 3 of the Income Tax Act 2007).
15 Supreme Court decision at paragraph [104].
16 Supreme Court decision at paragraph [129].
In Glenharrow Holdings Limited v CIR [2008] NZSC 116 (released on the same day as the Trinity decision), the Supreme Court considered a predecessor to the current general anti-avoidance provision in the Goods and Services Tax Act 1985 ("GST Act"). The GST Act's general anti-avoidance provision (section 76) was amended in 2000 to more closely align it to the general anti-avoidance provision in the income tax legislation, although in view of the Supreme Court's interpretation of the predecessor provision, the amendment now seems unlikely to have significantly altered the test.
The taxpayer company had acquired a mining licence for $45 million. As the vendor was not GST registered but the purchaser was, the GST consequences of the transaction (anti-avoidance considerations aside) were that Glenharrow as vendor could claim a GST input tax credit of 1/9th of the purchase price, while the vendor would not have to pay GST on the supply of the licence. Glenharrow paid a deposit of $80,000 with funds sourced from its shareholder but the balance was financed by way of loan from the vendor. The vendor financing was secured by a debenture over the taxpayer's assets and a mortgage over its shares, but was not supported by a personal guarantee from the company's shareholder.
The Commissioner allowed an input tax credit only in respect of the $80,000 actually paid by the taxpayer. He argued initially that the arrangement for payment of $45 million for the licence was a sham. However, that argument was rejected in the High Court, and not further pursued. The Commissioner's alternative argument based on the general anti-avoidance provision in the GST Act was successful. The $45 million price agreed to be paid in 1997 far exceeded the prices at which the licence had previously changed hands: $5,000 in 1993; $100 in 1994; and $10,000 in 1996. Chisholm J had accepted that the $45 million amount was a genuine price the parties intended to be paid out of revenue from exploiting the licence, but nonetheless held that, viewed objectively, the price was inflated far beyond any realistic market value, and for that reason would defeat the intent and application of the GST Act. The Court of Appeal upheld the High Court in a 2 to 1 majority decision.
A key issue for the Supreme Court was how the Commissioner's argument (that, in terms of section 76, the arrangement had been "entered into... to defeat the intent and application" of the GST Act) could be reconciled with the High Court's finding that the price agreed reflected a genuine bargain between the parties. The Supreme Court held that the test in section 76 was an objective test, and that the personal motives of the parties in entering into the arrangement would not determine whether or not section 76 applies. In its decision on the tax avoidance issue, the Court focused on the amount of the purchase price the taxpayer paid in cash as opposed to the vendor financing:
...in reality the only part of the price which in economic terms would ever be paid...was such as could be funded from sales during the third year.
On this basis, the Court upheld the Commissioner's reconstruction of the arrangement, allowing input credits only in respect of the $80,000 deposit and subsequent instalments of $210,000 actually paid by the taxpayer. The Court seemed to acknowledge that its approach did not respect the bargain struck between the parties, but stated that any consequent uncertainty for taxpayers is a feature inherent in a general anti-avoidance provision.
To view a copy of the case please click here.
The Taxation (Urgent Measures and Annual Rates) Act 2008 ("Act") was introduced into Parliament on 9 December, passed on 11 December and received Royal Assent on 15 December. The Act gives effect to personal tax cuts, a new independent earner tax credit, the removal of the research and development ("R & D") tax credit and certain amendments to KiwiSaver. We outline each of these changes below.
The personal tax cuts will be effected by reducing the top marginal tax rate (from 39% to 38% on 1 April 2009 and to 37% on 1 April 2010), reducing the current 21% tax rate to 20% (from 1 April 2011) and adjusting tax rate thresholds. The Act introduces a new independent earner tax credit with a stated purpose of providing an incentive for part time workers to move towards full time work. The credit is worth a maximum of $520 per year for the 2009-2010 year increasing to $780 for the 2010-2011 year. Individuals earning between $24,000 and $44,000 who do not receive an income-tested benefit, New Zealand superannuation or Working for Families assistance are eligible for the full credit. The credit abates at the rate of 13 cents for every dollar of income over $44,000.
R & D tax credits that were introduced from the 2008-2009 income year are repealed from 1 April 2009. Savings from the repeal of R & D tax credits will help to fund personal tax cuts, which the Government considers will have a greater growth enhancing potential.
The changes to KiwiSaver, which apply from 1 April 2009, are as follows:
- The minimum employee contribution rate will decrease from 4% to 2%. New members will be automatically enrolled at the 2% rate but members currently paying at the 4% contribution rate will continue to do so unless they notify a change in rate.
- Compulsory employer contributions will be capped at a maximum of 2%.
- The employer tax credit will be discontinued.
- The exemption from employer superannuation contribution tax will only apply up to 2% of the employee's salary and wages including superannuation contributions.
- The $40 per year fee subsidy will be removed.
The Government has stated that these changes will help fund the personal tax cuts, make KiwiSaver more affordable for lower income earners and ensure KiwiSaver remains viable in the long term.
To view a copy of the Act please click here.
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