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April 2009
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High Court rules that tax advantages of professional service companies not subject to general anti-avoidance provision
(Penny v CIR; Hooper v CIR CIV-2007-409-1153, CIV-2007-409-1154, High Court, Christchurch Registry, 19 March 2009, MacKenzie J)
The High Court has rejected Inland Revenue's attempt to apply section BG 1 (the general anti-avoidance provision) to an arrangement whereby two orthopaedic surgeons (Messrs Penny and Hooper) each incorporated their private practices, the decision is especially significant in that it is the first occasion on which a court has had to consider the general anti-avoidance provision in light of the Supreme Court's judgment late last year in the Ben Nevis case (summarised in the January 2009 issue of the Tax Law Update). Ben Nevis was the first decision of the Supreme Court concerning the general anti-avoidance provision since that Court replaced the Privy Council as New Zealand's final appellate court.
Both surgeons originally worked in private practice, and also as employees of the Canterbury District Health Board. The arrangements under scrutiny concerned the private practices. In each case, the surgeon sold his private practice to a company that was wholly owned by a family trust, and became an employee of the company. The company paid the surgeon a salary for services performed. The salary in each case was substantially less than the net income of the company (before deducting the salary) derived from what was now the company's private practice. For example, in the 2001 income year, the net income of Hooper Orthopaedic Limited (before paying Mr Hooper's salary) was $713,904. Of that, $119,990 was paid to Mr Hooper as salary.
The tax benefit resulting from these arrangements was therefore that income from the private practice not paid to Messrs Penny and Hooper as salary was taxed at the company tax rate (33% at the time) rather than the higher rate of 39%, which would have applied had the income instead been derived by them as individuals. Inland Revenue sought to disallow that tax benefit, by contending that the arrangement to establish the company, transfer the practice to it and pay what Inland Revenue described as a commercially unrealistic salary, was a tax avoidance arrangement.
Inland Revenue argued that the formation of a company to conduct each surgeon's private practice was not commercially driven, and that the scheme and purpose of the Income Tax Act required personal exertion income to be derived by the individual performing the relevant services, not by a company. Inland Revenue also argued that the Act required an individual to earn a commercially realistic salary for personal services performed by them.
The Court rejected these arguments. The Court found that, viewed objectively, the conduct of the private practice by the company was "commercially orthodox". The Court also rejected Inland Revenue's argument that the Act intended that personal services income could not be derived by a company. The simple point was that the company derived business income from the practice, and each surgeon continued to derive personal services income.
In relation to the latter point, the Court discussed the personal services attribution rules in the Act, which apply in certain circumstances where personal services income is derived through an associated entity of an individual. A key requirement of those rules is that 80% or more of the entity's income is derived from a single "buyer" of those services. That requirement is not satisfied, and so the rules do not apply, to income derived from multiple "buyers", as is the case for (say) dentists, medical specialists in private practice, tradespersons in business on their own account and so on. The Court referred to explanatory material which indicated that the personal services attribution rules are directed at situations where the relationship with the income provider is akin to an employment relationship. Where multiple buyers are involved, the entity's income is not a substitute for employment income that otherwise would have been derived by the individual in question. Accordingly, the Court found that, not only did the rules not apply on their strict letter, the present situation was not within the intent of the rules, purposively interpreted.
The Court did not accept that there was a legislative purpose, implicit in the attribution rules, that could apply by analogy in situations to which those rules simply do not apply. Rather, the Court concluded that Parliament must have contemplated that tax would apply at different rates to different entities deriving income, if the attribution rules were not engaged.
The Court also rejected Inland Revenue's argument that the Income Tax Act implicitly requires that a "commercially realistic salary" be paid. The Act contains provisions intended to counteract arrangements involving above-market salaries, but contains no provision directed at below-market salaries. The Court was also assisted in rejecting any requirement for a commercially realistic salary by the evidence of a tax accounting expert, John Shewan, who opined that in his experience, there was no concept of a "commercially realistic salary" in the context of a family company.
The decision confirms, following the Supreme Court's judgment in Ben Nevis, that taking advantage of structural choices available under and contemplated by the Act for reducing the incidence of tax will not amount to tax avoidance in terms of section BG 1. The choice of entity to carry on a business is one of the most basic choices available to taxpayers, and when Parliament provides for different entities to be taxed at different tax rates, taxpayers should be entitled to take advantage of the different rate structure. As the Supreme Court stated in Ben Nevis (at [129]):
...the use of companies and trusts as separate taxpayer entities will normally be an acceptable mechanism for taking advantage of concessions available under specific provisions, being within what Parliament must have contemplated in enacting them.
Although the judgment does not make the point expressly, the effect of the decision is that if the taxpayer's choice of entity with the attendant tax rate advantage is to be taken away, that is for Parliament to do. For the Court to do so would be to defeat rather than support the legislative policies reflected in the Act. It would amount to the imposition of tax by administrative discretion instead of by law, which was precisely the approach rejected by the Privy Council in its Auckland Harbour Board judgment.
Related to that point, the Court has emphasised an important aspect of the Supreme Court's decision in Ben Nevis (and the Glenharrow decision, released at the same time as Ben Nevis), which is that the general anti-avoidance provision must be applied objectively. The Court stated (at [74]):
Counsel submits that s BG 1 can apply in cases where, on the face of a specific provision in the Act, a taxpayer has a choice, so that the taxpayer's exercise of that choice is not exempt from consideration as possible tax avoidance. That is correct, and is confirmed by the reasoning in Ben Nevis. However, if the tax effect of a choice available under the specific provisions of the Income Tax Act is to be overridden by the operation of s BG 1, there must be a legislative indication apparent from the scheme of the Act of the circumstances in which the choice may or may not legitimately be made.
The Court noted further at [75]:
As Ben Nevis at paragraph [102] indicates, the approach to tax avoidance must ensure that the particular case is examined by reference to the legislative policies, and must enable decisions to be made in individual cases through the application of an objectively focussed process of statutory construction without being distracted by intuitive subjective impressions of morality. The proper application of that approach requires that the legislative policies to which regard must be paid must be able to be discerned from the scheme of the Income Tax Act itself. I have endeavoured to explain why I do not discern, in the scheme of the Act, a general legislative intention to proscribe the choice of the corporate form for a personal services business. Mr Goddard's proposition that it is implausible that Parliament intended to condone income splitting by professionals is not, on my assessment, derived from the scheme of the Act viewed objectively. Rather, it involves an intuitive subjective impression of the morality of income splitting by professionals, and seeks to interpret the Income Tax Act through that subjective lens.
Finally, the Court's decision contains some useful observations on the relevance and admissibility of expert evidence given by tax practitioners in tax cases. Inland Revenue had challenged the admissibility of Mr Shewan's evidence on various grounds, including on the basis that it consisted of his opinions on legal issues. The Court, following the approach taken in the Court of Appeal's recent decision in CIR v BNZ Investments Limited [2009] NZCA 47, agreed that evidence in the nature of legal submissions was not helpful to the Court. Mr Shewan's evidence, however, was considered not to cross that boundary to an impermissible extent. The evidence discussed basic income tax concepts, tax policy changes and the effect of such policy changes on taxpayer behaviour. On that basis, the Court concluded that the evidence was not simply opinion evidence on a question of law, but was, instead, of some assistance to the Court, and should be ruled admissible.
The case also has implications for the approach to be taken to section BG 1 more generally, following the Supreme Court's decision in Ben Nevis late last year. A principle that arguably emerges from the decision is that structural choices that Parliament has made available under the Income Tax Act cannot be taken away by application of the general anti-avoidance provision simply because a taxpayer exercises that choice so as to result in a tax benefit. Denial of the choice in question must be discernible in the scheme of the Act. For many, that principle will be entirely orthodox, but it is useful to now have the principle confirmed in the context of a particular well-known tax planning technique.
The Commissioner has filed a notice of appeal against the High Court's decision. A decision of the Court of Appeal will be at least some months away.
To view a copy of the case please click here.
In Westpac Banking Corporation v CIR [2009] NZCA 24, the Court of Appeal upheld the High Court's decision to strike out Westpac's administrative law arguments against the Commissioner's assessments in relation to certain structured finance transactions. Our March 2009 Tax Law Update features a discussion of the Court of Appeal's judgment (to view a copy please click here).
In its decision released on 8 April 2009, the Supreme Court has dismissed Westpac's application for leave to appeal the Court of Appeal's decision. The Supreme Court considered that Westpac's challenge to the principles applied by the Court of Appeal, namely that judicial review may be available where there is in law truly no assessment at all or where there are exceptional circumstances, could not succeed on the pleaded facts.
To view a copy of the Supreme Court judgment please click here.
The recent Court of Appeal decision in Saha v CIR [2009] NZCA 76 considered the treatment of forfeited shares for the purposes of the foreign investment fund ("FIF") rules. The Court of Appeal dismissed the taxpayer's appeal from a High Court decision, which found that the forfeited shares should be treated as having been disposed of at their market value at the time of forfeiture pursuant to a deeming provision in the Income Tax Act 1994. The taxpayer contended that the forfeited shares had a nil value. Through an analysis that differed from the reasoning of the High Court, the Court of Appeal held that the forfeited shares were deemed to be disposed of at their market value at the time of forfeiture.
The issue before the Court arose from the taxpayer's forfeiture of shares in a French company, Cap Gemini. The taxpayer had acquired his shares from the sale to Cap Gemini of his interest in a consultancy business, and he had been required to continue on as an employee in the consultancy business. As a result of voluntarily terminating his employment in the business prior to the conclusion of a 5 year restrictive period under a deed of covenant, he forfeited the shares. The facts of the case, arguments in and judgment of the High Court are addressed in the December 2008 Tax Law Update (click here for acopy).
The taxpayer argued again at the Court of Appeal that his forfeiture of the shares should be treated as a reduction in the sale price he received for the sale of his interest in the consultancy business rather than as a gain on disposal of shares.
The Court of Appeal rejected the taxpayer's argument, finding that, pursuant to a settlement deed that the taxpayer had entered into subsequent to the deed of covenant, the taxpayer relinquished the relevant shares (as distinct from forfeiting them under the deed of covenant) in return for benefits such as the freedom to undertake other employment: this was a freedom which the taxpayer would not have had under the deed of covenant as originally entered into. The Court held that these benefits were "in kind" consideration received by the taxpayer, and that if the value of this consideration was less than the market value of the shares at the time of forfeiture then the shares would be deemed to be disposed of for consideration equal to their market value under the same deeming provision that the High Court had relied on.
To view a copy of the case please click here.
In Case Z12 (TRA Nos 67 & 70, Dec No 6/2009, 27 February 2009) the Taxation Review Authority ("TRA") found that the Commissioner had acted incorrectly in disallowing GST input tax credits claimed by trusts in respect of legal fees charged to them. The legal fees were incurred by the trusts in relation to litigation between certain beneficiaries of the trusts and the trustees. The key issue was whether the legal services acquired by the trusts were "for the principal purpose of making taxable supplies" in terms of the definition of "input tax" in section 3A(1) of the Goods and Services Tax Act 1985 ("GST Act").
In order for the legal services to have been acquired for the principal purpose of making taxable supplies, the trusts must have first been carrying on taxable activities. The trusts carried on, respectively, the businesses of the bailment of sheep and cattle, and commercial property operation and development. The TRA held that each of the trusts was carrying on a taxable activity.
The Commissioner argued that the legal services were acquired as part of the administration of the trusts and were not sufficiently connected to the taxable activities of the trusts. This was because the legal services were not specifically related (or, indeed, related at all) to the bailment of sheep and cattle or commercial property operation and development. The TRA rejected this argument, holding that unless the litigation was resolved, the relevant taxable activities of the trusts were likely to collapse or, at least, be adversely affected in terms of good trading relations. Thus the legal services were held to have been acquired for the principal purpose of making taxable supplies and deductions for input tax were allowed.
The TRA also rejected the Commissioner's two subsidiary arguments that the services were not "acquired" by the trusts as required by section 3A(1) of the GST Act, and that the tax invoices held by the trusts in respect of the legal services were inadequate.
To view a copy of the case please click here.
In Case Z11 (TRA No 017/08, Dec No 5/2009, 24 February 2009) the TRA considered the definition of the term "temporary tax shortfall" in relation to section 141KB of the Tax Administration Act 1994 ("TAA"), which gives the Commissioner a discretion not to impose a shortfall penalty in certain circumstances. Although section 141KB was repealed on 1 April 2008, the case has continuing relevance to the definition of "temporary tax shortfall" in section 141I of the TAA and this is the first case to consider the definition. The discussion below focuses on this aspect of the decision.
The taxpayers were partners in a partnership that entered into an agreement for the sale and purchase of a commercial property. The taxpayers as vendors charged GST on the sale but mistakenly failed to account for the GST in the partnerships' GST return. Although the taxpayers had received a settlement statement from their solicitors indicating that GST had been charged, the GST return for the relevant period was filed on the mistaken basis that the transaction had been zero rated. This resulted in a GST shortfall for the period.
The Commissioner notified the taxpayers of the GST shortfall and issued them with an agreed adjustment form reflecting adjustments for the GST shortfall and a shortfall penalty for taking an "unacceptable tax position". Ultimately the taxpayers agreed that there had been a GST shortfall, but argued that the shortfall penalty should be remitted under section 141KB. This was on the basis that the shortfall resulted from a misunderstanding between the taxpayers and their office manager, and that the shortfall would have ultimately been discovered by their tax advisor and corrected as a result of an audit the taxpayers had initiated themselves before the Commissioner had notified them of the GST shortfall.
The primary issue before the TRA was whether the GST shortfall was a temporary tax shortfall that could qualify for remission under section 141KB(2)(a)(ii) of the TAA. The TRA held that the taxpayers' GST shortfall failed to meet the statutory definition of "temporary tax shortfall" (in section 141I). This was because, even if the taxpayers were able to prove that the audit they had initiated would eventually have resulted in a reversal of the shortfall, the reversal of the shortfall had in fact resulted from the Commissioner's actions, rather than actions of the taxpayers.
The TRA's reasoning in this respect is difficult to reconcile with the apparent legislative intent which, according to the Commissioner's standard practice statement (Temporary Shortfall - permanent reversal INV-231), is that a temporary tax shortfall is reversed where it appears from the taxpayer's actions that steps taken will remedy the tax shortfall, or through operation of law or other circumstances, the matter will reverse itself. The fact that the Commissioner has discovered a tax shortfall before it has been reversed was not intended to prevent a tax shortfall from being a temporary tax shortfall.
However, the TRA also found that the taxpayers had not "objectively proved on the balance of probabilities" that the taxpayers' advisor would have discovered the GST shortfall if it had not been notified by the Commissioner. On this factual basis the outcome of the TRA's decision is consistent with the apparent legislative intention.
To view a copy of the case please click here.
On 25 March 2009 the Minister of Revenue, Peter Dunne, recommended deferring the application dates for many tax reforms in the Taxation (International Taxation, Life Insurance, and Remedial Matters) Bill ("Bill"). The Bill was introduced to Parliament in July 2008 and a number of significant tax reforms in the Bill would, under the Bill's originally proposed application dates, apply before the Bill is reported back from the Finance and Expenditure Committee ("FEC") at the end of June 2009. The Minister noted that it was "simply not realistic to stick to all the application dates as originally proposed".
Of particular note, the Minister has recommended deferring the application date for the new associated persons rules from 1 April 2009 to the date of the Bill's enactment, and deferring application of changes to the international tax rules to the 2010-2011 income year for taxpayers with balance dates before 30 June (the date on which the Minister expects the Bill to be reported back from the FEC). He also recommended deferring significant changes to the life insurance rules until further industry consultation has been completed.
However, the Minister noted that his recommendations are not binding on the FEC and therefore, until the FEC responds, the relevant application dates remain unchanged.
To view a copy of the Minister's media release please click here.
The Taxation (Business Tax Measures) Act 2009 was enacted on 30 March 2009. The changes brought into effect by the Act are aimed at assisting small to medium businesses by easing pressure on their cash flows and reducing tax compliance costs. Measures in the Act include relief from the uplift on provisional tax for the 2008-9 and 2009-10 income years, deductions for business-related legal expenditure of up to $10,000 whether or not it is capital in nature, and raising various concessionary thresholds in relation to PAYE, fringe benefit tax and GST.
The FEC's report back on the original Bill on 9 March 2009 recommended minor technical amendments. Most of the FEC's commentary on the Bill was focused on the major issues that they considered impacted on small to medium sized businesses, none of which ultimately resulted in any recommended amendments. These included a further reduction in use of money interest ("UOMI") rates on tax underpayments, clarification of the circumstances in which UOMI is deductible and making it easier to enter into instalment arrangements with Inland Revenue.
To view a copy of the Act please click here.
The Government released its new tax policy work programme on 20 March 2009. This is the first time the tax policy work programme has been formally released to the public. In his media statement the Minister of Revenue emphasised the importance of tax policy that helps New Zealand to be more competitive in international markets, and the desirability of aligning personal, company and trustee tax rates in the medium term.
Some of the more interesting projects in the work programme include the tax rate alignment proposal, review of imputation streaming, the second phase of the international tax review, mutual recognition of imputation credits with Australia, considering the deductibility of capital losses and developing an exemption from non-resident withholding tax for publicly offered debt securities.
To view a copy of the media statement please click here, or to go directly to the Government's tax policy work programme please click here.
In a media release published on 31 March 2009, the Government announced that New Zealand is to sign a bilateral tax information exchange agreement ("TIEA") with Bermuda. According to the media statement, the agreement will cover information on "beneficial ownership of companies in the whole ownership chain; [sic] settlors, trustees and beneficiaries of trusts, and information held by banks and financial institutions". The Minister of Revenue stated that the agreement will enable tax authorities to access information about any persons who are seeking to evade payment of tax and will also help disclose assets that have not been reported in their home country.
The TIEA with Bermuda will be New Zealand's second, and the Minister noted that others are under negotiation. The first TIEA was entered into with the Netherlands Antilles in 2007. The signing of the TIEA with Bermuda is to take place at the New Zealand Embassy in Washington DC on 16 April 2009.
To view a copy of the media release please click here.
Dr Ken Henry, chairman of the review of Australia's tax and transfer system known as "Australia's Future Tax System Review", has described the review as "potentially the most comprehensive policy review ever undertaken in Australia". In a recent speech, Dr Henry commented on the importance of the global economy as a consideration in designing tax policy.
In his speech, Dr Henry made a compelling economic argument that, in a small open economy, the burden of a high company tax rate is likely to fall on immobile domestic factors of production such as labour, rather than mobile international capital. According to this approach, a potential consequence of high company tax rates is lower real wages due to lower levels of international investment.
In his recent speech to the International Fiscal Association conference, New Zealand's Minister of Revenue referred to comments from Dr Henry about the possibility that Australia could trade the benefit of franked (imputed) dividends presently enjoyed by Australian shareholders, for the benefits to the Australian economy that could result from reducing the company tax rate. Although similar arguments may appear to apply in relation to New Zealand's company tax rate, which is above the median for OECD members, it remains to be seen whether the New Zealand Government's degree of reliance on company tax (which the Minister described in his speech as "unusual") may make the prospect of lowering company tax rates an unworkable proposition.
To view a copy of the Minister of Revenue's speech please click here, or to view a copy of Dr Henry's speech please click here.
This publication is included in Russell McVeagh's website on the Internet: www.russellmcveagh.com
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