RECENT ANTI-AVOIDANCE DECISIONS
This section analyses three recent tax avoidance cases. They are Accent Management, Peterson and Glenharrow. Accent Management is a decision of the High Court concerning deductions claimed in relation to a forestry scheme, Peterson is a decision of the Privy Council on the depreciation of film investment expenditure and Glenharrow is a GST decision of the High Court on the price of a mining license. In Accent Management and Glenharrow the Courts found in favour of the Commissioner while the Privy Council decision found in favour of the taxpayer.
Accent Management Limited v CIR (2005) 22 NZTC 19,027
The High Court held that the dominant purpose of a forestry investment scheme was tax avoidance. The plaintiffs were investors in what was termed the Trinity Investment or the Trinity Scheme. Under the scheme investors claimed deductions against their other income for license and insurance premiums that were incurred in the course of growing of a Douglas fir forest. Over the 50 year life of the forest investors had the potential to claim tax benefits in excess of $3.7 billion. The Court found that the scheme was in the nature of a commercial venture although the prospect of achieving a positive return was remote. The Court confirmed that the arrangement was void against the Commissioner and that the Commissioner was correct in imposing a 100% shortfall penalty on the taxpayers for taking an abusive tax position.
The Court disallowed the deductions for the license premiums on two grounds. First, it found that the combined legal effect of the agreements that had been entered into did not provide a “right to use” land, as required by the legislation, but were agreements to provide a bundle of rights and obligations, one of which was to plant and harvest a forest. The license premium had been paid, therefore, to secure a right to share in the net proceeds of sale of the forest rather than for the use of the land. Secondly, the license premium could only be deductible under the depreciation provisions if it was paid in respect of property that might reasonably be expected to decrease in value over time whereas the value of the forest would normally be expected to increase as it neared maturity.
In respect of the insurance premiums, the Court found that, absent tax avoidance, this expenditure was deductible under the general deductibility provision because it met the test of being “incurred” in that the plaintiffs were definitively committed to this expenditure. They had made payment of the initial premiums in 1997 and were liable for the 1998 and subsequent payments under a promissory note. The Court concluded also that the contractual arrangements prima facie satisfied the requirements for an insurance contract at law and therefore the insurance premiums were prima facie deductible under the regime for items of forestry expenditure.
The Court regarded the insurance payments as “highly unusual” but held that they were not a sham. Evidence was given that no recognised insurer would have taken on the risk, therefore there was no chance of reinsurance. The insurance company had no other business, no office and no staff, and at least in the opinion of one expert witness, would be unlikely to meet its outgoings over the life of the policy. There was no evidence to suggest, and the Commissioner did not submit, that the investors shared a common intention with the promoters that the contracts not create the legal rights and obligations that they purported to create.
In terms of the tax avoidance argument the Court found an arrangement existed between all parties to the transactions and, in the alternative, accepted that even if the plaintiff investors were not parties to the arrangement, they were certainly affected by it and therefore susceptible to the Commissioner’s assessments.
The Court held that whether or not there was tax avoidance required a consideration of the scheme and purpose of the Income Tax Act as a whole, and that required consideration of whether the arrangement:
1. Directly or indirectly alters the incidence of income tax.
2. Directly or indirectly relieves any person from liability to pay income tax.
3. Directly or indirectly avoids, reduces or postpones any liability to income tax.
The Court found that there was a difference between claiming deductions in the first two years and claiming them in the final two years and found that the scheme had been structured to achieve acceleration of the availability of those deductions. At the very least the effect of this was to relieve, reduce or postpone a tax liability. In its simplest form the deductions for the license and insurance premiums resulted in tax savings of $2.8 million for the 1997 and 1998 years and to that extent the plaintiffs had reduced or postponed their liability for income tax in these years.
In determining the purpose of the arrangement the Court considered that the taxpayers were not assisted by the fact that the legislation permitted deductions in advance of income. It noted authority to the effect that tax avoidance often involves strict adherence to regimes set out in the tax legislation. The question was ultimately to be determined by the scheme of the Act.
The Court accepted the evidence that suggested it was unlikely that the investment would turn a profit but what was certain from the outset was the ability to claim deductions and gain very significant tax advantages. The Court then compared this to an expert accountant’s evidence and found the present advantage significant.
The Court concluded that tax avoidance was more than merely incidental to the scheme. It was the dominant purpose.
On the issue of a shortfall penalty, the Court found that the Commissioner had correctly applied the shortfall penalty at 100% on the basis that the taxpayer’s had taken an abusive tax position.
Accent Management has appealed this case to the Court of Appeal.
With respect, there are a number of elements of the High Court decision that are unsatisfactory. First, the Court’s conclusion that the license agreement was not a right to use the land is difficult to accept. The bundle of rights granted to the investors allowed them to have access to and use of the land to plant, maintain and harvest a forest. It seems to be a fine point that this was something different from the “right to use” land that is depreciable intangible property. Secondly, depreciable property is property which might reasonably be expected in normal circumstances to decline in value while being used or available for use. The Court held that was not evident in this case but did so having regard to the crop on the land, not the value of the right itself. Isolated from the trees the license will diminish in value as its term progresses. Arguably the Court should have distinguished between the value of the right and the value of the activity to which the right is applied. Thirdly, its conclusion on value is at odds with its finding that, though this was a commercial venture, the prospect of a positive return from the forest at maturity was unlikely.
As to its tax avoidance conclusions, the most important issue identified by the Court was whether any tax avoidance occasioned by the arrangement was more than merely incidental. It relied on the judgment of Woodhouse P in Challenge Corp Limited v CIR (1986) 8 NZTC 5,001 (CA) for the relevant principle - a consideration of the degree of economic reality in contrast to artificiality or contrivance – and held that the evidence led to a conclusion that avoidance was more than merely incidental. That evidence was essentially:
(a) unlikely positive return on capital;
(b) uncertainty of commercial outcome cf certainty of tax outcome;
(c) size of tax benefits;
(d) relationship and degree of circularity in payments;
(e) apparent acceptance of obligations that did not relate to commercial value of land;
(f) unusual structure in some respects tailored to investors’ tax needs.
Glenharrow Holdings Ltd v CIR (2005) 22 NZTC 19,319
The High Court rejected the Commissioner’s claim that the sale of a mining license was a sham, instead finding for the Commissioner on his alternate argument that the sale was for a grossly inflated price and subject to the general anti-avoidance provision contained in the Goods and Services Tax Act 1985.
Mr Meates had purchased a ten year mining license in 1996 for $10,000. The license had 4 years left to run. In 1997 he was approached by Mr Fahey who was interested in purchasing the license. Mr Meates obtained a valuation from his cousin, who had a valuation degree, that the license was worth $45 million. Mr Meates thereafter entered into an unconditional sale and purchase agreement to sell the mining license to Mr Fahey’s company Glenharrow Holdings Ltd. Glenharrow paid a $80,000 deposit. Vendor finance was provided for the remainder of the price which was secured by way of a debenture over Glenharrow’s shares. Under the terms of the loan interest was charged at 10% after two years, payable as and when demanded. Repayment was required on 31 March 2001.
The Court found that both Mr Fahey and Mr Meates entered into transaction with the intention of following it through and that it was not a sham. While they may have been much too optimistic that did not detract from the fact that their agreement was genuine and that they intended to implement it in accordance with its terms.
The Court accepted that Glenharrow’s principal purpose was in working the license and extracting stone. The next issue that fell to be determined was whether there was a tax avoidance arrangement in terms of section 76 of the Goods and Services Tax Act 1985 as it then was. In order to apply section 76 three elements must be present:
1. An arrangement entered into between persons.
2. To defeat the intent and application of the Act, or any provision of the Act
3. A tax advantage to the registered person.
It was common ground between the parties that the first element was satisfied.
The Court commented that this provision is not often used by the Commissioner and while the wording then varied from the general anti-avoidance provision contained in the income tax legislation, the variation in the wording was immaterial to its application. The underlying purpose was to counter avoidance and the text of the section was clear and capable of such interpretation.
The Court agreed with the approach adopted in Ch’elle Properties (NZ) Ltd v CIR (2004) 21 NZTC 18,618, that proof of intention was not required to trigger the provision. The issue was whether the arrangement was one which objectively defeated the intent and application of the Act. The Court preferred the interpretation of the general anti-avoidance provision delivered by Lord Denning in Newton v CIR  AC 450:
… look at the arrangement itself and see which is its effect … irrespective of the motives of the persons who made it.
The Court found it difficult to interpret section 76 as requiring anything less than that the arrangement must have a dominant purpose or effect to defeat the intent and application of the Act. In that sense the section was acknowledged to be materially different from the income tax anti-avoidance provisions under which, at least, the avoidance purpose must be more than merely incidental.
In order to determine whether the purpose of the arrangement was to defeat Act the Court applied section 76 to sections 20(2) and 10 of the Act. Section 20(2) provides for an input tax deduction and section 10 sets out the statutory definition of the value of a supply. An input tax credit is available to the extent that a payment is made during the taxable period and the value of that supply is the amount of the money paid in consideration for the supply. The Court held that in the instance of a grossly inflated price there could not be any doubt that the registered person had defeated the intent of these sections and obtained a tax advantage.
The Court made a finding as to the credibility of the parties and accepted that as far as the parties were concerned there was no pretence. They were entirely genuine in their belief that they bought and sold the license for $45 million but in the case of tax avoidance their motives did not matter. The issue for ultimate determination was whether the inflated consideration gave an advantage that the legislation did not intend.
The Court relied on the evidence of experts called by both parties including in eminent chartered accountant who prepared an independent valuation at the Commissioner’s request. At the time Glenharrow purchased the license it had just over three years left to run and though significant attempts were made to extend the license, including Court proceedings, no extension was given. The Court considered the suggested available extractable volumes and quality of rock. The Court held that the value of the license was substantially less than that agreed between the parties. The tax advantage was counteracted to the extent of the excess over the new valuation of $8 million.
This case calls into question a taxpayer’s ability to enter into agreements on their own terms and to decide how they choose to structure their business affairs. It suggests that even where parties incur liabilities as between themselves it is open for the Commissioner to assert what they ought to have paid. The overriding factor in this case appears to be the manner in which the purchase was funded. Glenharrow paid the $80,000 deposit and no more. The remainder of the purchase price was secured by way of a debenture over the company shares. Interest was payable as and when demanded. There was no evidence of demand having been made. If Glenharrow did not make payment when due, Mr Meates could only make a call on the company under the debenture and it the there were no funds there was no possibility of payment.
The case, and that in Accent, echoes the approach taken by Lord Templeman in Challenge when he distinguished avoidance from mitigation. In each it is possible to see tax claims being made before it can be ascertained that the economic charge that would justify a tax deduction has or will come home to the taxpayer. In Glenharrow the payment of the purchase price for the license ostensibly occurred but, apart from the deposit, it was wholly financed by the vendor. The vendor’s only recourse was to the shares of its purchaser and its only asset was the license. This was, in effect, limited or non-recourse financing that meant the purchaser had no “real” economic cost which justified the input deduction claimed.
Similarly, in Accent the marked acceleration of deductions compared with the distant obligation to pay costs (and tax on profits) lent an air of artificiality to the arrangements, which led the Court to conclude that an advantage was being sought that was outside the scope intended by the legislature.
Peterson v CIR (2005) 22 NZTC 19,098
The Privy Council allowed the taxpayer’s appeals in a 3/2 split decision against earlier findings of tax avoidance. This case involves two appeals by the same appellant. The issue was whether on the facts found before the Taxation Review Authority and in the way the Commissioner had put his case, the Commissioner could invoke the anti avoidance provision to disallow the tax deductions which Mr Peterson and other investors had claimed for depreciation allowances against the cost of their investment in two feature films. The Board held that while the investors had obtained a tax advantage under the scheme it did not amount to a tax avoidance arrangement.
The facts of each case are similar. They involve the financing of two feature films, one film was entitled “Utu” and the other “The Lie of the Land”. Utu became one of the most successful films in New Zealand while the Lie of the Land was never commercially released. Both films were financed in part by a non-recourse loan that was circular. External funds were provided into the circle in the Lie of the Land but not in Utu. High rate taxpayers were invited to invest in funding of two NZ feature films at a cost of $X + Y. Under the scheme they paid sum $X and funded $Y by way of a non-recourse loan through a third party financier. The depreciation regime allowed them to depreciate the total cost in the first two years of their investment. They had claimed depreciation allowances for the total cost of their investment.
Unbeknownst to the investors the cost of production was only $X. Upon receipt of the investors’ payment of $X + Y the production company forwarded the component $Y back to the finance company. There was no evidence that this had been done at the behest or with the knowledge, or indeed on behalf of, the taxpayers.
Mr Peterson and the other investors were induced to invest in part by the opportunity to fund part of their investment by way of a non recourse loan and by the prospect of obtaining a depreciation allowance. The loans were supported by cheques which were honoured and treated by all concerned as received and applied and had been fully of partially repaid in accordance with the terms of the loan.
Unsurprisingly, the Board found that there was an arrangement that had the purpose or effect of reducing the investors’ tax liability whether or not they were parties to the arrangement, they were parties affected by the arrangement.
The single most important factor for the Board was that the investors were liable for repayment of the loan and in fact the loans were paid in part if not in full. This was an issue that the Commissioner had never challenged, indeed, he had even conceded this point. The Board found that the investors paid $X + Y to acquire the film, they incurred the expenditure which Parliament contemplated should entitle them to a depreciation allowance which they could claim.
The Board isolated the production company from the investors and found that the production company had made a secret profit at the investors’ expense. This, however, did not alter the fact that the investors had incurred a liability to pay $X + Y to the production company in accordance with the contract to acquire the film. No evidence had been given that these monies were applied by the investors for any purpose other than to acquire the film.
The Board found that the investors were entitled to depreciate their full acquisition costs. The depreciation regime was designed to allow the deductions claimed. The investors paid $X + Y to acquire the film and they had incurred a genuine liability under the non-recourse loan. They had repaid the loan in full or in part. Though the payments were circular that did not alter the fact that the investors incurred a liability for $X + Y. They paid $X + Y as consideration to acquire the film, which was a matter that was never challenged by the Commissioner.
In concluding the Board noted that their findings were based on the facts and the manner in which the Commissioner had pleaded his case. Had the Commissioner run his case differently and presented evidence that the loans were made on uncommercial terms and that the payment of $Y was for something other than to acquire the film he may have been successful. Had he contended that the funds were provided for two or more services he would have been entitled to invoke the anti avoidance provision. That is, had he contended that $X had been paid for making of the film and that $Y was for procuring the loan then the amount paid for procuring the loan would not qualify for the depreciation allowance.
What the Commissioner had done in error was to treat the investors in a similar light to production companies. He concentrated on the fact that the film had only cost $X to make, but he real question was, “what did it cost to buy?”.
These three cases confirm that there are no precise lines that can be drawn in tax avoidance disputes. In Glenharrow what as effectively an inflated price based on limited recourse funding was struck down. In Peterson, despite the argument that the film price was “inflated” by the Y element and was financed on a limited recourse basis, the claimed deductions were finally allowed.
The difference between the cases might be one of time. Sufficient time had passed for the film loans to have been repaid at least in part, thereby supporting the genuineness of the obligations that were reflected in the price. In Glenharrow the case proceeded against the prospect that little was likely to be achieved that would see the price/debt tension resolved with genuine repayment. Similarly, in Accent no one could accurately or safely predict the likely outcome to the parties 50 years hence. That is a somewhat unsatisfactory point of distinction, however.
The better basis for rationalising the cases is that in each the relevant Court was asked to decide whether the tax advantage obtained was one that arose naturally from the transactions entered into or not. In Peterson, because of the factual concessions that had been made, there was nothing strained in saying that the taxpayer bought a film and should depreciate the actual cost of doing so, however that was funded. In the other cases, the transactions were structured in a way that had unorthodox features that could really only be explained by the tax outcomes that followed.
© G D Clews, 2005