The "More Than Merely Incidental" Test in Tax Avoidance
THE “MORE THAN MERELY INCIDENTAL” TEST
IN TAX AVOIDANCE:
WHAT DOES IT MEAN AND HOW
IS IT APPLIED?
G D CLEWS, BARRISTER
1. It is not possible to determine the scope of the “more than merely incidental test” without first considering what prompted Parliament to enact it. It was enacted in 1974 as an amendment to section 108 of the Land and Income Tax Act 1954. Prior to that time section 108 had been the subject of judicial requests for Parliamentary intervention: see Wilson J in CIR v Gerard  NZLR 280, amplified by McCarthy P in the Court of Appeal. The section was generally thought to lack necessary qualifications and to give the Commissioner no power of reconstruction.
2. Richardson J recorded the progress of the old section 108 in his judgment in CIR v Challenge Corporation Limited (1988) 8 NZTC 5,001 at 5,017-18. He noted the following amongst the way stations of the developing case law on the section:
(a) The Newton predication test (from Newton v C of T (1957) 96 CLR 5770 allowed transactions to escape section 108 if they were capable to explanation by reference to ordinary business or family dealings;
(b) The section applied when the sole purpose or at least a principal purpose was tax avoidance, later confined to transactions which had, as their main purpose, or one of their main purposes tax avoidance: from cases culminating in Europa Oil (NZ) Limited v CIR (No 2) (1976) 2 NZTC 61,066.
3. The amendments to section 108 were undoubtedly intended to clarify a number of matters about the section. Amongst those was to expressly state a threshold tax avoidance purpose necessary for the section’s application. Instead of a Judge made test of “sole or principal purpose” a statutory test was introduced under which it was sufficient that tax avoidance was a purpose that was “more than merely incidental”. Though clarification of the law was the intention, it is doubtful whether the 1974 amendments led to any real or practical change in the test to be applied when determining if an arrangement is sufficiently directed at tax avoidance to be struck down.
4. As noted by Richardson J, the unamended terms of section 108 were considered last by the Privy Council in Europa (No 2). No doubt informed by the 1974 amendment, the majority speech of Lord Diplock, delivered in 1976, used language redolent of the changes already made in 1974. Europa (No 2) dealt with the tax effects of petrol supply contracts for the income years down to 1971. One aspect of the case was whether section 108 of the 1954 Act avoided those contracts.
5. On that issue Lord Diplock noted (at p 61,074) four points about section 108. In summary they were:
(a) It was not a charging section – without a power to reconstruct, the tax result of the section avoiding an arrangement had to be found elsewhere in the Act;
(b) The section did not strike out new sources of income or restrict the right of a taxpayer to arrange his affairs in relation to a new source so as to reduce tax;
(c) The section related only to New Zealand tax and so the location of counterparties to a contract was irrelevant to its operation; and
(d) The main purpose, or one of the main purposes, of the arrangement had to be tax avoidance.
6. As to the last of these, the words chosen by Lord Diplock echoed those in the 1974 amendment to section 108. He said:
Fourthly, the section in any case does not strike down transactions which do not have as their main purpose or one of their main purposes, tax avoidance. It does not strike down ordinary business or commercial transactions which incidentally result in some saving of tax. There may be different ways of carrying out such transactions. They will not be struck down if the method chosen for carrying them out involves the payment of less tax than would be payable if another method was followed. In such cases the avoidance of tax will be incidental to and not the main purpose of the transaction or transactions which will be the achievement of some business or commercial object. (emphasis added)
7. The fourth element of Lord Diplock’s analysis of the old section 108 characterised an incidental tax result as a saving of tax that arose from an “ordinary business or commercial transaction”. He amplified that by referring to the choices of method that exist in carrying out ordinary business or commercial transactions. A choice that led to less tax than another did not involve a “main purpose” of tax avoidance, but incidental tax avoidance to which the section did not apply. An incidental saving of tax was one that arose as an adjunct to the achievement of some business or commercial object.
8. The approach taken by Lord Diplock must be considered having regard to the changes that were made to section 108 in 1974 and which found their way into section 99 of the Income Tax Act 1976. Again, the effects of the new wording were summarised by Richardson J in Challenge (CA, 5,019). Amongst other points, he noted that the predication test of “ordinary business dealing” no longer saved a transaction if any tax avoidance purpose or effect was more than merely incidental. This was because specific words in the new section ousted the relevance of purposes that related to or were referable to ordinary business or family dealings. Those words seemed at the time to place in issue Lord Diplock’s statement that tax results that were incidental to such dealings escaped the application of the anti-avoidance provision. Practically speaking that has not in fact been the result of the 1974 amendments.
9. Though the statutory wording changed, the removal of what had underpinned the predication test did not alter the need for Courts still to read down the new section so that it did not apply literally. The problem of an anti-avoidance section with potentially too broad an application predated the 1974 changes to section 108. In CIR v Gerard  2 NZLR 279, McCarthy P had said that section 108 in its original form could not be given a literal application because that would result in avoidance of transactions which were obviously not aimed at by the section (see p280).
10. In Challenge the same was said of the amended section, then found in section 99 of the 1976 Act. Richardson J noted (p5,019) that in a vast range of ordinary business activities, the minimising of tax and the saving of tax could never be regarded as a merely incidental purpose or effect. The same point was made more than a decade later by McGechan J, in the High Court, and Richardson P (as he had become in the meantime) in BNZ Investments v CIR (2000) 19 NZTC 15,732 (HC): CIR v BNZ Investments Limited (2001) 20 NZTC 17,103 (CA).
11. In BNZI McGechan J recognised the reality that most business or family transactions had tax minimisation as one of their purposes or effects and with a degree of significance that cannot realistically be termed “incidental”. He acknowledged that the extreme outcome of the provision avoiding for tax purposes the majority of business and family transactions cannot have been intended by Parliament. Richardson P echoed that when he noted that it is legitimate for commerce to be carried out through a range of entities and in a variety of ways and that tax is an important and proper factor in business decision-making and family property planning.
12. So despite section 108 of the 1954 Act having been amended in 1974, apparently to state that a more than merely incidental purpose or effect of tax avoidance would be sufficient for the section to apply, whether or not any other purposes or effects relate to or are referrable to ordinary business or family dealings, the section has remained in judicial eyes one whose potentially extreme application must be reigned in. In Richardson P’s words in BNZI, that is achieved by “line drawing and setting of limits”, because it is necessary to recognise commercial reality.
13. How to draw the lines is the judicial challenge. As Richardson P said in BNZI, the line drawing that is required by the Legislature is reflected in the terms of the anti-avoidance provision requiring the existence of an arrangement, a more than merely incidental purpose or effect of tax avoidance and the counteracting of a tax advantage obtained from or under the arrangement. These are the internal limitations as to when the anti-avoidance provision applies. What they mean and how they apply in practice is sometimes difficult to discern. However, in most cases the key element is whether a more than merely incidental purpose or effect of tax avoidance exists, whether or not any other purposes of the arrangement in question are referable to ordinary business or family dealings. This is so important because the concepts of “arrangement”, “tax avoidance” and the Commissioner’s reconstruction powers are all so broadly drawn that it is only in rare cases such as BNZI that they are likely to be in issue.
14. Lord Diplock said in Europa (No 2) that avoidance of tax would be incidental if the main purpose of a transaction was the achievement of some business or commercial object; that the section does not strike down ordinary business or commercial transactions which incidentally result in some saving of tax. The Legislature required by the 1974 amendments to section 108 that something more than an incidental purpose of tax avoidance was necessary before the section applied. It is inconceivable that His Lordship was unaware of those amendments, which predated his speech by two years. He had those in mind when distinguishing between the main commercial objects of ordinary commercial transactions and the incidental tax avoidance purposes that those transactions could also involve.
15. However, Parliament said in 1974 that more than incidental tax avoidance could exist even if other purposes of an arrangement were referable to ordinary business dealings. This was to address the Newton predication test. That test focussed on purposes. If a transaction achieved a purpose that could be regarded as an ordinary family or business matter it ousted the application of the old form of section 108. But Lord Diplock was not addressing the predication test when he posed his main purpose/incidental purpose dichotomy. There is a difference between what Lord Diplock said and what Parliament addressed in the 1974 amendments to section 108.
16. His Lordship looked at ordinary business transactions. He said such transactions would have a main purpose of achieving some business or commercial object. Parliament addressed purposes relating to or referable to ordinary family or business dealings, ie purposes that suggested an ordinary family or business focus for what was done. The two are not necessarily the same. An ordinary business purpose might be achieved by extraordinary or unusual transactions. The mere existence of a business purpose might have saved a transaction under the Newton predication test, but it would not necessarily save the transaction after the 1974 amendments. That is because the new test required a consideration of whether, despite any apparent family or business purpose, the transactions in question (ie the arrangement) could be regarded as directed more than incidentally at tax avoidance.
17. Looked at in this light Lord Diplock’s view of what amounted to an incidental saving of tax is not a formulation rendered obsolete by the 1974 amendments to section 108. Instead the Courts have continued to acknowledge the need for the general anti-avoidance provision to exist in the real world. Whether that is seen as limiting its application or simply construing the section realistically and purposively is a matter of perspective. The starting point in determining how to apply the “more than merely incidental” test is in the distinction between ordinary business or commercial transactions and the tax savings that arise from them, and tax savings that are a purpose pursued in and of themselves and not incidental to the achievement of some business or commercial object. This is the distinction that Courts have sought to explain and to apply in cases since Europa (No2).
18. Richardson J’s judgment in Challenge dealt with the “more than merely incidental” test by noting that a vast range of business activities occur in which tax minimisation could never realistically be regarded as merely incidental. The uneasy compromise of section 99 against other sections of the Act became the focus of his judgment for the majority. His conclusion on the balance to be struck between sections 99 and 191 of the 1976 Act was eventually overturned by the Privy Council. However, that does not diminish the importance His Honour placed on taxpayers being able to make structural choices and to be able to take advantage of economic incentives, exemptions and allowances provided for by the Act itself, a proposition that was repeated in his judgment in BNZI, and which now finds no serious dissent. His recognition of the tax choices that are available to taxpayers was not unique (Woodhouse P recognised them, though dissenting) but it marked an express acceptance that a decision to pursue a tax advantage provided by the Act does not of itself make the transactions involved any less “ordinary” in the business sense. Indeed it might be argued that the acceptance of tax as an ever present business issue made such choices and transactions quintessentially “ordinary business”.
19. In cases that followed the Privy Council’s judgment in Challenge, the dissenting judgment of Woodhouse P in the Court of Appeal was regarded as providing greater guidance on the practical application of the “more than merely incidental” test. Though His Honour acknowledged that the share purchase agreement considered in Challenge could not be regarded in any way as falling within section 99(2)(b) of the 1976 Act in which the test was stated, his comments on the application of this paragraph of the section were directed to anxieties raised in the course of the litigation over the potential for the section to apply too broadly.
20. A consideration of Woodhouse P’s judgment probably best starts at p5,005 where he said:
Be that as it may sec 99 is… a reflection of the firm and understandable conclusion of Parliament that there must be a weapon able to thwart technically correct but contrived transactions set up as a means of exploiting the Act for tax advantages.
21. From this short passage in Woodhouse P’s judgment it is possible to distil five points about the application of the anti-avoidance section and, more particularly, his view of the characteristics of avoidance to which it is directed. The five elements are:
(a) There will be technical correctness in the arrangement but for the issue of avoidance;
(b) The transactions in question will be contrived;
(c) Something that is contrived is something that is set up to a particular end;
(d) That end is the exploitation of the Act; and
(e) Obtaining a tax advantage from that exploitation
22. As a set of principles these do not really assist without further examination. For example it is difficult to determine whether a transaction has been contrived or set up in the sense that Woodhouse P meant when he acknowledged in Challenge the same tax choices that Richardson J identified. Electing to pursue one available course over another could not have been “contrived” or “set up” as he meant. Similarly there is no real guidance in the passage cited as to what amounts to exploitation of the statute when it offers tax benefits and the Legislature must be assumed to have expected that they would be claimed. In fact a closer examination of his judgement shows that Woodhouse P’s meaning falls not too far from the approach of Lord Diplock, already discussed.
23. Woodhouse P referred to his decision in Elmiger (and to the US Supreme Court case of Higgins v Smith) in which he recorded that if there is any element of unreality in the calculation of income or expenses, it distorts the liability of the taxpayer to the detriment of the entire tax paying group. In Elmiger he went on to say that the former section 108 had been:
Intended to forestall deliberate attempts by individuals to obtain tax advantages denied generally to the same class of taxpayer.
24. It is doubtful whether this is a proper statement of principle in relation to the anti-avoidance provision. It is not so much designed to prevent tax advantages denied generally to the same class of taxpayer but to concentrate on arrangements, ie, transactions and their purposes and effects. The Judge’s comments heralded, however, the importance of reality in the calculation of income and expenditure.
25. In the context of “finding a line between what is acceptable and so unaffected by [the section] and what is undeserving and so for tax purposes made void”, Woodhouse P described the qualifying phrase “merely incidental” as “all important”. He asked at p5,006:
Does it have the rather exiguous meaning and effect of excusing only “the casual” or “the minor” or “the inconsequential” tax avoidance purposes? If so, many “ordinary” dealings would probably be caught by sec 99 because inevitably the associated tax purpose could seem stronger than that.
26. This passage makes it clear that Woodhouse P accepted the point made by Richardson J about the continuing need for the section to be tempered by recognition of the real world of tax planning. After noting that whether or not a tax saving purpose or effect is merely incidental must be determined objectively by reference to the arrangement itself, he then said:
As a matter of construction I think the phrase “merely incidental purpose or effect” in the context of sec 99 points to something which is necessarily linked and without contrivance to some other purpose or effect so that it can be regarded as a natural concomitant. Many taxpayers when considering a course of action are likely to appreciate and welcome an opportunity provided by the Act for achieving some tax benefit as an aspect of it but this should not bring the transaction or transactions almost automatically within the avoidance provisions of sec 99.
27. To explain this Woodhouse P went on to refer to the way in which tax is considered in relation to commercial transactions. He said:
By itself conscious recognition and acceptance that a commercial transaction will be accompanied by a degree of tax relief is not the issue. Already I have mentioned the example put forward in this case of goods manufactured in New Zealand and sold overseas in the knowledge that surrounding costs are likely to be assisted by a tax saving which would not be applicable in the case of internal sales. But it could hardly be said in such a case that the trading had been pursued to gain the tax advantage as an end in itself. Conventional exporters do not trade to save tax but to achieve profits. To put the point in another way, among the cost factors to be taken into account one of them, to a greater or lesser extent, would sensibly and properly be the tax factor. So regarded the tax saving purpose intended as a support to the operation could in the ordinary course no more be labelled an end in itself than the purpose of avoiding or minimising any other cost likely to affect the operation. In other words, in the usual case the associated tax purpose ought not to be and in my opinion would not be regarded as more than a “merely incidental purpose”. (emphasis added)
28. The example used by Woodhouse is instructive. He accepted that a business taxpayer could “sensibly and properly” take into account tax as a cost so that if a tax saving could be achieved as a “support” to the trading operation, it would have no greater significance than avoiding or minimising any other cost likely to affect that operation. In that sense the tax saving was incidental to the commercial transactions that gave rise to it or to the broader commercial purpose for which they were undertaken. It is not clear how the Judge would have dealt with the situation where, as was often the case, obtaining tax relief for exports (using the example he referred to) was the difference between achieving a profit and not on export sales and a fundamental element in the viability of many exporting businesses.
29. His reference to acceptable tax avoidance being a natural concomitant of a commercial transaction characterised such tax outcomes as something that “accompanied” or “went together” with the transaction, to adopt Oxford English Dictionary definitions of “concomitant”. By contrast avoiding or minimising tax as an end in itself was not permissible and arrangements to that end would be struck down.
30. The Judge went on at the end of his consideration of the “incidental purpose” test to say at p5,007:
When construing sec 99 and the qualifying implications of the reference in sub sec (2)(b) to “incidental purpose” I think the questions which arise need to be framed in terms of the degree of economic reality associated with a given transaction in contrast to artificiality or contrivance or what may be described as the extent to which it appears to involve exploitation of the statute while in direct pursuit of tax benefits.
31. In saying this he referred back to his five elements (at para 21 above) which emphasise the difference between a transaction “set up” to exploit the Act and one that is not. Woodhouse P then said:
To put the matter in another way, there is all the difference in the world, I think, between the prudent attention on the one hand that can always be given sensibly and quite properly to the tax implications likely to arise from a course of action when deciding whether or not to pursue it, and its pursuit on the hand simply to achieve a manufactured tax advantage. Considerations which would enable an answer as to which side of the line to put a tax purpose in the case of grouped company incomes (as in the present case) would seem to include an assessment as to whether details of the balancing exercise as disclosed by the group accounts could fairly be accepted as a record of real and relevant achievements of what, in practical terms, was the real and relevant group.
32. Again, the considerations he thought were important in that case illustrate the meaning and extent of his general words of principle. What upset the Challenge case from Woodhouse P’s point of view was the fact that the companies acquired by Challenge and “grouped” so that losses were available to it, could not fairly be accepted as a “real” group. Without saying it in quite the same way, the Judge anticipated the approach taken in the Privy Council where an underlying policy as to who should benefit by losses (ie, the real group that bore them) formed the core of the majority’s decision on appeal.
33. Woodhouse P’s approach confirmed that prudent attention can sensibly and properly be given to tax implications likely to arise from a course of action when deciding whether or not to pursue that course. It follows that if tax implications are more beneficial should one course of action be pursued as opposed to another, it is equally sensible and proper to identify that and to make the choice that is more tax advantageous. What he required, however, was that the beneficial tax outcomes should not be “manufactured”. The acquisition of a loss company for the sole purpose of grouping its losses against profit was the manufacturing of a tax advantage in the sense that the loss had not been a “real and relevant achievement” of a “real and relevant group”.
34. Put another way, securing the losses from a hitherto unrelated company was an end in and of itself. The acquisition of Perth in Challenge and the apparent grouping of its losses was not a transaction set up for commercial purposes but for tax purposes. By contrast, if the tax saving was a factor that could be taken into account alongside a number of others affecting the taxpayer’s operation, that tax saving could not be labelled an end in itself and would be merely incidental.
35. Considered in the round Woodhouse P’s references to contrivance and to matters “set up” to “exploit” the Act do not include transactions or structures that are the result of a taxpayer simply electing to adopt one available course of action over another when each is directed predominantly at business ends. All his statements in Challenge are remarkably resonant of Lord Diplock in Europa (No 2) despite the 1974 amendment of section 108. Woodhouse P recognised different ways to carry out transactions. So did Lord Diplock. He noted that merely because one option might lead to less tax being paid than another did not attract the anti-avoidance provision. That statement is echoed in Richardson P’s judgment in BNZI when he noted that something more is required “than the existence of a tax benefit in one hypothetical situation compared with another…”. It is also part of Lord Diplock’s speech. Lord Diplock’s focus on the main business or commercial object of ordinary transactions having incidental tax savings is a counterpoint to Woodhouse P’s manufactured tax advantage that is the object in and of itself of an arrangement. In Woodhouse P’s eyes the acquisition of the loss companies in Challenge had no business or commercial object at all (indeed the taxpayer’s accepted as much). The tax savings in the case could never be considered alongside commercial objects and the acquisition of the companies was in that context per se an extraordinary transaction. What would have raised the prospect of a merely incidental tax saving was the existence of a “real and relevant”, rather than a “manufactured” group; “real and relevant” group losses, rather than “manufactured” losses which had been borne outside the group that sought their benefit.
36. When Challenge was decided on appeal in the Privy Council, the majority’s speech was delivered by Lord Templeman: CIR v Challenge Corporation Limited (1986) 8 NZTC 5,219. He approached the case from a number of different angles. First, he dealt with the tension between a specific anti-avoidance provision in section 191 and the general anti-avoidance provision in section 99 of the 1976 Act and rejected the view of the majority of the Court of Appeal. He concluded that in the circumstances of the case, compliance with the strict terms of the grouping provisions in section 191 made it an instrument of tax avoidance. He said (p5,223):
Section 191 was intended to give effect to the reality of group profits and losses. When one member of a group makes a profit of $5.8 million and another member of a group makes a loss of $5.8 million, then the reality is that the group has made neither a profit nor a loss and that the members of the group should not be liable to tax. Section 191 in these circumstances is not an instrument of tax avoidance. But in the present circumstances the reality is that the Challenge Group never made a loss of $5.8 million. A loss of $5.8 million was made by Perth and that loss fell on Merbank before Challenge contracted to buy Perth. Section 191 in these circumstances is an instrument of tax avoidance which falls foul of sec 99.
37. Lord Templeman then dealt with the argument that too broad an application of section 99 would prevent taxpayers having recourse to those elements of the Act that legitimately gave rise to tax advantages. In relation to this, he discerned distinctions between a transaction which is a sham, a transaction which evades tax, a transaction which mitigates tax and a transaction which avoids tax. The material distinction he said was between tax mitigation and tax avoidance. His Lordship said (at p5,225):
Income tax is mitigated by a taxpayer who reduces his income or incurs expenditure in circumstances which reduce his assessable income or entitle him to reduction in his tax liability. Section 99 does not apply to tax mitigation because the taxpayer’s tax advantage is not derived from an “arrangement” but from the reduction of income which he accepts or the expenditure which he incurs.
38. He went on to give examples where taxation advantages follow from incurring expenditure on settlements, insurance premiums and expenses on export business. His Lordship then said (at p5,226):
Section 99 does not apply to tax mitigation where the taxpayer obtains a tax advantage by reducing his income or by incurring expenditure in circumstances in which the taxing statute affords a reduction in tax liability.
Section 99 does apply to tax avoidance. Income tax is avoided and a tax advantage derived from an arrangement when the taxpayer reduces his liability to tax without involving him in the loss of expenditure which entitles him to that reduction. The taxpayer engaged in tax avoidance does not reduce his income or suffer a loss or incur expenditure but nevertheless obtains a reduction in his liability to tax as if he had.
39. Against that background Lord Templeman noted that Challenge had not suffered any loss (or at least its group had not) because the loss had been incurred by Merbank before its company, Perth, became part of the Challenge group. The only thing Challenge lost was the cost of acquiring the shares in Perth, the company which had actually sustained the loss. The tax avoidance by Challenge lay in the fact that it never suffered $5.8 million worth of loss which would have entitled it to reduce its tax liability. The arrangement gave rise to the tax advantage, not a proper application of the group loss provisions in section 191 of the Act. Section 191 was regarded by His Lordship as an instrument of tax avoidance because it was technically applied in circumstances where the underlying expectations for its application had not arisen.
40. The distinction between tax mitigation and tax avoidance was difficult to apply and has since been described by Lord Hoffman in O’Niel v CIR (2001) 20 NZTC 17,051 (PC) as “unhelpful” (endorsing the views below in the case of Baragwanath J). The distinction emphasised tax advantages arising from income reduction or the incurring of expenditure, but it did not address the language and construction of the anti-avoidance provision. It was an attempt at a broad conceptual framework within which to apply the provision, but it was a framework that left much unanswered. What it required was that a taxpayer’s financial position had genuinely to change in order for the tax outcomes of the relevant transactions to be mitigation rather than avoidance. This need for real reduction of income or real incurring of expenditure is probably the lasting legacy of Lord Templeman’s speech and is a theme taken up and emphasised in BNZI by McGechan J. In that case the Judge made it clear that as long as transactions made real changes to the financial rights and obligations of the parties to them it did not matter that they were simultaneous.
41. One of the most important things not addressed expressly by the Privy Council in Challenge was the “more than merely incidental” test, hence the readiness with which Courts reverted to Woodhouse P’s judgment in an effort to fit the Privy Council’s framework to the statutory provisions. An example of this type of effort is Case L34 (1989) 11 NZTC 1,204. The case involved a major shareholder of a petroleum mining company offering interest free loans to company employees to purchase shares in the company, the cost of which was deductible to the employees.
42. The TRA decision is an amalgam drawn in part from Woodhouse P and from the Privy Council in Challenge. As to the first, the TRA decided that although the tax related purpose of the transaction was more important than could be considered incidental (the Judge seems to have used the word as meaning a passing or casual matter), it was not contrived or manufactured because there were genuine commitments and expenditure that had been entered into. One could set out to achieve tax outcomes without one’s steps being contrived as long as they were genuine, or to use the words of Woodhouse P “real and relevant”. This is the same emphasis on the relevance of genuine changes of financial position that McGechan J advanced in the High Court decision in BNZI twelve years after Case L34.
43. This properly put the emphasis on whether the tax outcome followed (ie as a concomitant of) a genuine commercial transaction rather than on the importance, significance or size of the tax relief in the mind of the taxpayer. On that point the judgment in Case L34 can be contrasted with that of the High Court in Hadlee and Sydney Bridge Nominees Limited (1989) 11 NZTC 6,155. In the latter case Eichelbaum CJ dealt very quickly with the notion of an incidental tax purpose by saying that the tax benefits were “too significant and obvious” to be considered “merely incidental”. This approach was quite contrary to that of Woodhouse P in Challenge who noted that if incidental meant “minor” the avoidance section would have an unintended catchment. With respect, Eichelbaum CJ was simply wrong to have decided the issue in this way but it was not a matter that arose expressly when the case went on appeal. It is worth noting that although he applied the correct approach in Case L34, Barber DCJ seems to have been seduced by the Eichelbaum emphasis on size when he decided Case M72 (1990) 12 NZTC 2,419 after Hadlee. In that case he noted that the tax savings to several accountants who had lent their spouses funds with which to finance their firm, were very minor and therefore incidental. He need not have done. It was sufficient that the loans in that case were made with genuine financial consequences to the relevant parties.
44. The genuineness of the transactions in Case L34 was also sufficient for the TRA to conclude that, in terms of the Privy Council’s approach in Challenge, the necessary expenditure had been incurred to attract the tax relief provided by the Act rather than the tax relief being the product of an arrangement. The TRA’s decision effectively held that tax mitigation existed in genuine commercial transactions involving real changes of financial position with which tax relief travelled as a natural concomitant. Such relief was also “incidental” in the required sense, even if it was an important factor in the taxpayer’s mind and even if taxpayers set out to obtain it. While the Privy Council may not have dealt expressly with the “more than merely incidental” test, the essence of the distinction it made between tax mitigation and tax avoidance lies in the reality of the financial transactions being considered and the changes they bring about, so that the tax consequences that follow are incidental in the sense required by the test.
45. The common factor in both elements of the TRA judgment in Case L34 was the finding that the tax relief sprang in such a case not from any arrangement but from the application of the Act to real and commercial (as opposed to manufactured) dealings. Importantly, the TRA was not prepared to avoid the share purchase for tax purposes simply because the parties had maximised the available deduction. It effectively treated that as an exercise of a choice available to the taxpayers from which there were, primarily, real commercial results and, incidentally, important tax results.
46. The position might have been different in Case M72 had the spousal loans in that case more severely reduced the incomes of the accountant’s concerned. However, given the facts of that case such an attempt would inevitably have raised questions as to the reality of the loans and whether the apparent financial independence conferred on the lender spouses had been qualified or negated by some aspect of the arrangement as the loans became more significant. To take an example, if in that case the whole of the accountants’ incomes had passed to their spouses as interest (to be taxed at a lower rate than otherwise) and that interest had then been split between the recipient spouses and the accountants under relationship property agreements, there is little doubt that the genuineness of the loan would have been called into question. In such circumstances it could hardly be exhorted as a transaction intended to yield financial independence to the spouses in the same way as the actual facts of the case allowed.
47. Despite the difficulties associated with Challenge it is unclear whether, if the Privy Council had applied in Challenge the approach taken in O’Niel any different result would have arisen. The issue that would still have had to be decided is whether, on a true construction of section 191 of the 1976 Act, Challenge would have been regarded as entitled to the benefits of group status.
48. There is some suggestion that Lord Hoffmann might have regarded a tax group as a legal concept only, in the sense that it is a creature of tax law. But it seems equally possible that he could have distinguished between a “juristic” as opposed to a “commercial” group (applying the distinction referred to in O’Niel) on the basis that the grouping provisions could be expected to apply to the latter. Such a distinction seems but a stone’s throw away, if that, from a “manufactured” group (to use Woodhouse P’s word in Challenge). Both are the antitheses of ordinary business transactions (per Lord Diplock) in relation to which a tax saving may certainly be an incident, but only one of a number, and not an end in itself. Each approach has in common the fact that they reflect an arrangement entered into by the taxpayer to bring about a certain state of affairs that has advantageous tax outcomes, and whose other (non-tax) purpose or effects are insufficient to be seen as relegating the tax outcomes to the status of something that (though quite possibly consciously chosen) simply “goes with the territory” that is manifest in a business transaction.
49. The O’Niel decision was one of a recent series in which Lord Hoffmann has propounded his view of the boundaries of tax avoidance. He did so also in CIR v Auckland Harbour Board (2001) 20 NZTC 17,008 in relation to the specific anti-avoidance regime under the accrual rules and in the context of the so-called doctrine of fiscal nullity in the UK, as a member of the House of Lords, in MacNiven v Westmoreland Investments Limited  2 WLR 377.
50. His Lordship’s emphasis has been on a realistic approach to statutory construction as the first line of “defence” (so to speak) against avoidance. By contrast, in O’Niel he described the general anti-avoidance provision as a “long stop” for the Revenue. In that case he compared the Russell template schemes against a course of action which avoids tax and which, upon a true construction of the legislation, was intended to be available as a choice to the taxpayer. The Russell template was, in commercial terms, a “unitary arrangement” designed to enable a sharing of a company’s net profit without tax being paid on it. The fact that, juristically, the profit may first have been routed through other transactions that changed its legal character was able to be ignored by the Commissioner.
51. The distinction between transactions that have a juristic as opposed to commercial reality is not a complete guide for the application of the general anti-avoidance sections. It does not adequately deal with all situations and not all concepts fit neatly into one category as opposed to the other. An example is Lord Hoffmann’s own apparently conflicting treatment of the concept of “payment” in MacNiven (where he said that it is a commercial concept) and Customs and Excise Commissioners v Faith Construction Limited  1 QB 905 (where he said it was a legal concept). While it might be possible to reconcile the two positions on the basis that the same word may have a different meaning in different Acts, such reconciliation is difficult if, as his Lordship did in Faith Construction, one has specifically denied that the word is capable of the alternative application.
52. The difficulties posed by Lord Hoffmann’s approach have prompted Lord Millett to eschew it as anything other than an injunction to construe a tax statute purposively and on the basis that a provision giving tax relief can generally be assumed to refer to transactions undertaken for a commercial purpose and not solely for the purpose of qualifying for the tax relief. In CSR v Arrowtown Assets Limited  1347 HKCU 1 Lord Millett expressly declined to adopt any broader application of MacNiven into the jurisprudence of the Hong Kong Special Administrative Zone.
53. In the New Zealand context this inter-peer jousting is, with respect, of limited importance. The fiscal nullity doctrine that is the focus of these cases is of limited relevance where an express anti-avoidance provision must be construed and applied. Sir Ivor Richardson’s paper following the first trilogy of fiscal nullity cases in the House of Lords makes that clear: I L M Richardson, “Appellate Court Responsibilities and Tax Avoidance” (1985) 2(1) Australian Tax Forum 3-20,17. Similarly, cases dealing with Part IVA of the Commonwealth Income Tax Assessment Act 1936 are of limited assistance given the emphasis that Part places on what would have been the case “but for” the impugned arrangement, a quite different test from our own. The UK cases do, however, have an inevitable affect on our law when judges charged with applying the fiscal nullity doctrine in that jurisdiction have adopted similar themes when asked to consider the scope of our anti-avoidance provision. Such was the case in 0’Niel, though there is enough in the way Lord Hoffman and the Board of the Privy Council decided the case to put the decision in a firmer antipodean perspective.
54. His Lordship’s approach is but another way of asking whether a tax advantage has been manufactured; whether the object of the transactions that make up the arrangement in question is a commercial one in relation to which a tax reflex or consequence is a natural incident of the way the Act applies to the transactions that comprise the arrangement; whether the tax reflex has, on the contrary, been pursued as an object in and of itself so that it is the product of the arrangement and not of commercial dealings . Something that is brought into being “juristically” but not commercially is the most recent expression for something “contrived” or “manufactured”, something artificial as opposed to real. It will be struck down, while those choices of business structure (put by Lord Hoffmann in terms of a course of action) that present themselves as having advantageous tax outcomes will not be when they are directed to business or commercial objects with which tax outcomes are “fellow travellers”, even if they are deliberately chosen and pursued. There is really little new in what amounts to a refreshed expression of an old concept. And if that is the case, then applying the test that poses the threshold for determining whether an unacceptable level of avoidance exists ought to be based on what are now fairly readily discerned principles.
55. Those principles are:
(a) An incidental purpose of tax avoidance exists if the main purpose of an arrangement is the achievement of commercial objects;
(b) That is because in such a case any tax reflex that arises is a concomitant of (in the sense that it goes with) the main commercial objects achieved by the arrangement;
(c) An arrangement may pursue one course of action which achieves more advantageous tax results than would be available under another course of action, as long as it cannot be said to be contrived or to have manufactured those results;
(d) Merely exercising an available choice as to business structure is not contrivance. Something contrived, or a tax advantage that is manufactured, lacks genuineness. A transaction that manifests a choice to pursue a course of action that will lead to less tax being paid than might otherwise be the case will not be contrived and will not “manufacture” a tax advantage, as long as the taxpayer’s financial position is genuinely altered in a way that would ordinarily attract the tax relief or tax advantage that is claimed;
(e) In such a case the tax advantage arises from the application of the Act and not the arrangement. Incidental tax avoidance is that which so arises;
(f) It is irrelevant that the tax advantage may be important to the taxpayer or significant and obvious. What is relevant is whether the advantage genuinely arises from the pursuit of commercial objects or is pursued as an end in itself in that it does not arise as a natural concomitant of commercial objects. The absence of any such objects means that the tax advantage is an end in itself, especially (but not only) when it is significant and obvious.
© G D Clews, 2004