Loans as Income Upheld
Krukziener v CIR: CIV-2010-404-728, High Court Auckland 17 September 2010
The High Court has upheld the TRA decision in Case Z 23. The facts are summarised in the TRA note but essentially the IRD sought to recharacterise as income, loans taken over a ten year period by Mr Krukziener from two development entities he controlled. While he took such loans to support himself (and treated them as non taxable) the income of his development entities was applied in successive developments so no tax was paid on it. The total value of the loans was in the order of $5 million. The High Court permitted these loans to be treated as income under the anti-avoidance provision of the Income Tax Act, generally to supporting the TRA's conclusions but by a slightly different route.
The essential elements of the decision are:
1. There was an arrangement for the purposes of the general anti-avoidance provision in that the taking of loans without any terms for repayment or the charging of interest, and with any repayment actually being made only from non-taxable sources, was a pattern of conduct over time and therefore more than a mere sequence of events.
2. The arrangement altered the incidence of income tax at least in the sense of deferring it to such an extent that could not have been within Parliament's contemplation.
3. Indeed the dominant purpose of the arrangement was to achieve the use of funds by Mr Krukziener without tax falling on them, so penalty as assessed by the Commissioner was also upheld.
This decision is perhaps more perplexing than the TRA decision it upholds. It seems to suggest that when profit emerged from the taxpayer's various developments it should have been distributed to him so that he would then pay tax, even if he intended to readvance the profit (after tax) to a new entity and a new project. Instead of doing this the profit had been distributed in a more tax efficient manner to Mr Krukziener's next development entity and offset against losses it accrued at the start of its development. This is tantamount to saying that tax law now requires reasonable periodic profit-taking and tax-paying.
While the periodic drawings of Mr Krukziener might have been recharacterised as income if not truly loans, that is not the way the IRD fought its case. It probably realised that it would have had a very difficult time showing that the loans were shams. So the loans were conceded as being genuine but the tax avoidance provision was overlaid. To apply that provision properly the Court has to be able to say what the expected tax impost was and why, in order to be able to say there was an alteration or postponement of tax.
In Krukziener we have a decision which seems to assume that tax should be paid periodically and at the first opportunity rather than recognising that in some cases that is simply not reasonable or necessary. That seems to be the expected impost by which the Court compared the arrangement to arrive at its conclusion of tax avoidance. Or perhaps it is simply that Mr Krukziener pressed his luck by a few too many years? The decision certainly seems to say that perpetual (or at least long term) deferral of tax on profit, while living effectively on outside borrowings, will not be acceptable. That seems to be because Parliament would have contemplated profit being booked and tax being paid at least from time to time along the way.
How then has the matter reached this point? Although it is not expressed in as many words, the Court seemed to be using the device of "Parliamentary contemplation" to provide the comparative reference point when deciding if an arrangement involves tax avoidance. The statutory instances of avoidance, such as altering or postponing tax beg the question, "from what?" Instead of examining that question having regard to what the scheme of the Tax Act permits (or does not proscribe) as the expression of Parliamentary contemplation, the answer seems to be "from what Parliament would have thought was reasonable".
Had Courtney J examined the statutory scheme for her comparative, she might well have had to accept that at all times Mr Krukziener had a choice as to how he deployed the resources available in the various development entities he used. Those resources were, on the one hand income, and on the other hand capital from outside borrowings. He could choose whether to deploy income to fund the successive stages of development or to support himself, or both. He could choose to employ outside borrowings to fund development or to support himself, or both. In fact he chose to deploy income only in successive stages of development and used borrowings for a mix of development finance and personal loans. Once one accepts that the choice exists, it is a difficult proposition to say anything is being avoided by the choice being exercised. In short, by providing for that Parliament should be taken as having contemplated that the choice would be exercised.
Nothing in the Income Tax Act predicates the necessary distribution of profits in a manner that subjects them to tax, yet according to the decision of Courtney J that is what was deferred or postponed by Mr Krukziener's arrangement. Indeed it is inherent in her decision to recharacterise all loans over the full period of ten years, that profit taking was expected to have occurred from the very beginning of the period in question, quite contrary to the scheme of the Act. Instead of grounding the tax avoidance comparative in the statutory scheme, the Judge seems to have adopted a notional comparative of what Parliament would have considered was a reasonable deployment of income. In other words, to ask whether, if Parliament had seen the facts of this case it would have contemplated the result achieved by Mr Krukziener.
This is the crucial element of what might be seen as the "new world" of tax avoidance. It eschews a scheme-based comparison when deciding what tax impost has been altered or postponed, in favour of running the ruler over the actual case before the Court to assess whether it has gone too far in terms of what Parliament may have had in mind. A scheme-based comparative requires much more rigour and will often be more difficult to apply. The new alternative is easier for Judges and for the IRD. It means that any extreme tax outcome can potentially be struck down as avoidance because it is easy to conclude that Parliament would never have had that particular result in mind. The outcome in question may be the product of perfectly orthodox (and allowable) tax-related decision-making, such as the decisions made by Mr Krukziener, but if they are applied over what is seen to be to long a time, or for too great a sum, they will move into the realm of tax avoidance because they "couldn't possibly have been contemplated". While this approach holds sway, tax avoidance will be a card game with the deck stacked against the taxpayer.
It is difficult to draw the lines of general application based on this decision except to say that:
1. Loans ought to be documented with repayment and interest addressed.
2. A salary ought to be paid, even a modest one, to reduce the risk that loans will be seen as fundamentally remunerative.
3. A 10 year roll over of profits is way too long. Some profit taking along the way is advisable.
4. It may be prudent to give the Commissioner a "taste of tax" while rolling part of one's profits over or carrying them forward tax effectively.
The Krukziener decision has been appealed to the Court of Appeal.
For additional commentary on Krukziener, click here.