Recent cases in the Supreme Court, High Court and Court of Appeal have confirmed the correct approach to New Zealand’s general anti-avoidance rule, which has long perplexed the Courts, the application of taxpayers and their advisors. Significantly, the Supreme Court has made clear that it is not enough that taxpayers technically comply with specific provisions of the tax legislation. A “tandem” inquiry is required which considers the general anti-avoidance provisions. If it is found an arrangement contravenes the ‘scheme and purpose’ of the Income Tax Act (or Parliament’s contemplation to use the Supreme Court’s majority’s words), the arrangement can still be struck down under the general anti-avoidance rule.
Taxpayers should carefully consider this approach to the general anti-avoidance rule when making tax planning decisions. This note reviews briefly the following cases:
a) Ben Nevis Forestry Ventures Ltd & Ors v Commissioner of Inland Revenue; Accent Management Ltd & Ors v Commissioner of Inland Revenue (2009) 24 NZTC 23,188 ("Ben Nevis”);
b) Glenharrow Holdings Ltd v Commissioner of Inland Revenue (2009) 24 NZTC 23,236 (“Glenharrow”);
c) Penny v Commissioner of Inland Revenue; Hooper v Commissioner of Inland Revenue (2009) 24 NZTC 23,406 (“Penny & Hooper”); and
d) BNZ Investments Ltd & Ors v CIR HC WN CIV 2004-485-1059 [15 July 2009] (“BNZI”).
Ben Nevis and Glenharrow set out the Supreme Court’s reasoning as to how the general anti-avoidance rule should be applied in the context of both the Income Tax Act and the Goods and Services Tax Act. The decisions represent a shift from the former view (expressed by the Privy Council) that the anti-avoidance rule is a ‘longstop’ provision. They signal the rule should now be considered in tandem with specific provisions. High Court cases Penny & Hooper and BNZI have subsequently been decided and give taxpayers further guidance as to how the Supreme Court's reasoning will be applied. It remains to be seen how the Court of Appeal will deal with those two cases. At least one other High Court decision is awaited in a case similar to BNZI (Westpac) and these two cases are inevitably bound for decision at high levels.
This is the first case in which the Supreme Court has discussed the relationship between the general anti-avoidance rule and specific sections in the tax legislation. The court concluded Parliament’s overall purpose is best served by giving appropriate effect to each and that neither should be regarded as overriding the other.
The Court made clear that the purpose of specific provisions must be distinguished from that of the general anti-avoidance provision. The general anti-avoidance regime is designed to address tax avoidance, whereas the individual specific provisions have a focus which is determined primarily by their ordinary meaning, as established through their text in the light of their specific purpose.
Helpfully, the Court proposed the following two step inquiry when a taxpayer relies on specific tax provisions:
a) Can the taxpayer satisfy the Court that the use made of the specific provision is within its intended scope.
b) 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.
An arrangement includes all steps and transactions by which it is carried out. The Court found that tax avoidance can be found in individual steps or, more often, in a combination of steps, and that even if all the steps in an arrangement are unobjectionable in themselves, their combination may give rise to a tax avoidance arrangement.
The Court noted that a classic indicator of a use that is outside Parliamentary contemplation is the structuring of an arrangement so that the taxpayer gains the benefit of the specific provision in an artificial or contrived way. It is not within Parliament’s purpose for specific provisions to be used in that manner.
Accordingly, in Ben Nevis the application of the general anti-avoidance rule meant that even though the specific provisions allowed a deduction, it was overridden.
The case highlights that the IRD must now consider whether a tax advantage claimed under an arrangement is an advantage that is intended to be conferred upon the taxpayer. There is nothing wrong in a taxpayer seeking out a tax advantage as long as it is one that Parliament contemplates would be obtained in the circumstances. However, if an arrangement uses specific tax provisions within the legislation in a way that was not within Parliament’s contemplation it will be tax avoidance, even if a taxpayer technically complies with the specific provisions.
This case dealt with the general anti-avoidance rule in the Goods and Services Tax Act. Similar to Ben Nevis, the case considered whether, notwithstanding taxpayer compliance with specific provisions of the Act, the Commissioner may set a particular arrangement aside and reconstruct it because the arrangement constituted tax avoidance.
The Supreme Court held there is a two-stage process before the Commissioner can carry out a reconstruction as follows:
a) The Commissioner must have been justified in coming to the view that there was an “arrangement” entered into between at least two persons; and
b) The Commissioner must have been properly satisfied that the arrangement was entered into between the parties to it to defeat the intent and application of the Goods and Services Tax Act or any provision of the Act.
The Supreme Court reasoned that the intention of the Goods and Services Tax Act will be defeated if an arrangement has been structured to enable the avoidance of output tax, or the obtaining of an input deduction in circumstances which are outside the purpose and contemplation of the relevant statutory provisions.
The Court observed the whole premise of the Goods and Services Tax Act is that transactions will be driven by market forces, that their commercial and fiscal effects will be produced by those forces and will not contain distortions which affect the contemplated application of the Act. To that end, the Supreme Court observed that transactions which are driven only by commercial imperatives are unlikely to produce tax consequences outside the purpose of the legislation.
In this case, the taxpayer agreed to pay a certain price for a mining licence. The price was not artificially inflated and the taxpayer accepted the legal obligation to pay the full price. However, in reality full payment would never be made. Artificiality was evidenced by the fact that the taxpayer undertook a liability of $44,920,000, even though it was a shell company with a share capital of just $100. Additionally, because the vendor of the license was unregistered there was no GST payable on that side of the transaction.
The Supreme Court held that the effect of the transaction was to produce a GST refund totally disproportionate to the economic burden undertaken by the taxpayer or the economic benefit obtained by the vendor. The Court of Appeal commented the arrangement ‘involved none of the economic sacrifice that the Goods and Services Act is concerned with at its heart”. It could also not be said that the tax advantage was merely incidental to the commercial decisions of the parties to the arrangement. Accordingly, the court held the arrangement to be a distortion that defeated the intent and application of the Goods and Services Act.
Penny & Hooper
In Penny & Hooper the High Court applied the Supreme Court’s ‘scheme and purpose’ approach to a tax structure and held the arrangement in question was not tax avoidance.
The case concerned two surgeons who re-structured their practice with a company and trust. The effect was that tax was paid at 33% instead of 39%.
The incidence of tax was altered by the arrangement because the tax was payable by a different taxpayer and because the tax rates applicable to that taxpayer were different. However, the High Court’s reasoning is that the formation of the company was a valid choice of business structure available to the taxpayer under the scheme and purpose of the Income Tax Act, and a normal and permissible structure for the conduct of a business.
To that end, the High Court observed the scheme of the Income Tax Act is that tax consequences may differ depending on the category of taxpayer deriving income. The Act does not prescribe that some types of structures may only be used by some categories of taxpayers.
Accordingly, the transfer of the surgical practices to companies was held to be a change which was consistent with the specific provisions of the Act and the choices available within it. The structure was not contrary to any principle to be discerned from the scheme and purpose of the Act and the tax effect which resulted from the derivation of income by the company rather than the taxpayer was merely incidental.
This case gives an example of a structure that saved tax, but was found to be a valid choice allowable within the scheme and purpose of the Income Tax Act. It suggests that where normal and commercially accepted structures are utilised by taxpayers, such as the choice between a company, trust, partnership or sole-trader business structure, the choice is more likely to be found to be within the scheme and purpose of the Income Tax Act, and any tax saving incidental.
BNZI is the most recent decision applying the Supreme Court’s two step inquiry to determine tax avoidance. The case emphasises that even where specific tax provisions are complied with and specific tax incentives enacted by Parliament are utilised, an arrangement can still be held to be tax avoidance if specific provisions are utilised in a manner not contemplated by Parliament.
It may follow from such a decision that even if Parliament does not draft tax legislation adequately, where legislation has an effect that could not have been intended having regard to Parliament’s intention and policy, that effect can be counteracted using the general anti-avoidance rule. Taxpayers may well ‘follow the rules’, but this judgement suggests that if they do not also take into account a broader intention of Parliament and the policy behind the provisions they rely on, they can still be caught out.
The Judge reasoned that transactions must be ‘viewed in a commercially and economically realistic way’. It remains to be seen whether the Court of Appeal will decide this is too wide an outlook and the scheme and purpose of the Act should be derived from the words of the statute first, and the policy behind the section’s enactment looked to only when that is unclear.
The case concerned the use of foreign tax credit and conduit tax provisions in the income tax legislation. The BNZ group made a commercial decision to utilise the New Zealand conduit and foreign tax credit rules to borrow money in New Zealand and invest it overseas. There was no doubt the investments were genuine, and the taxpayer was largely held to have complied with specific provisions. However, the High Court looked to the wider scheme and purpose of the Act and found the arrangements were tax avoidance.
The High Court reasoned that the policy behind granting taxpayers foreign tax credits is the avoidance of double taxation. Further, the scheme and purpose of the conduit regime was said to include an intention that at least some of the conduit received income be passed on as dividends by a New Zealand subsidiary to its foreign owner, meaning New Zealand collects non-resident withholding tax at 15%.
The Court found that no tax corresponding to the foreign tax credit claimed in New Zealand was actually paid overseas. Further, the taxpayer did not in fact pass distributions received onto its parent. Accordingly, the taxpayer was held not to be a conduit as contemplated by the conduit relief regime enacted by Parliament and the use of foreign tax credits was found not be valid.
Further, the transactions were held to be contrived and to have no commercial purpose or rationale, because when tax benefits were not taken into consideration, funds were provided by the taxpayer at a substantial loss. An aspect of the case is perplexing. While the Court found that conduit relief policy had not been fulfilled, it struck down the deductions claimed by BNZI, rather than reconstruct the exempt income as taxable. This seems at odds with a logical application of the anti-avoidance rule. The IRD assessed in this way and that may well be correct.
BNZI has notified an appeal. While the decision of the Court of Appeal remains to be seen, the High Court judgment highlights that taxpayers must consider the scheme and purpose of the legislation with regard to Parliament’s intention in enacting specific tax provisions when structuring transactions. If provisions are utilised in a way that frustrates the policy intention behind the enactment of the section, the arrangement may be held to be tax avoidance.
A second bank conduit case has just been heard: Westpac Bank Limited. It is due for judgment shortly. It was argued in a different way from BNZI on several points and may well produce a different outcome. The two cases will inevitably have to be considered (and if necessary reconciled) on appeal.
These cases give a clearer indication of how the general tax avoidance rule in the tax legislation should be applied. The Supreme Court’s two step test indicates that taxpayers should first ensure an arrangement complies with the specific provisions relied on, but must at the same time look more widely to consider the use of specific provisions viewed in the light of the arrangement as a whole. If it is apparent the arrangement alters the incidence of income tax in a way which cannot have been within the contemplation and purpose of Parliament, the arrangement will be tax avoidance. It appears an arrangement is more likely to be tax avoidance where:
a) Transactions are artificial, contrived or do not have a clear commercial purpose or rationale.
b) An arrangement is outside the policy objectives of Parliament when it enacted the specific provisions relied on.
The Supreme Court’s approach requires a careful scrutiny of the facts surrounding a transaction and tax advice should be sought when creating or modifying any commercial or business structure with tax efficiencies in mind.
© G D Clews 2009
This note is intended as general commentary only and not as legal advice.