June 2010

Contents:

LATEST NEWS

Court of Appeal allows Inland Revenue's appeal in CIR v Penny & Hooper
The Court of Appeal's decision late last week in Commissioner of Inland Revenue v Penny & Hooper [2010] NZCA 231, upholding Inland Revenue's allegation of tax avoidance, may go down in history as one of the most important tax cases to be decided in many years. more...

The Court of Appeal's decision late last week in Commissioner of Inland Revenue v Penny & Hooper [2010] NZCA 231, upholding Inland Revenue's allegation of tax avoidance, may go down in history as one of the most important tax cases to be decided in many years.  The Court has confirmed that in certain circumstances, even straightforward and commonplace business structures, giving rise to a tax advantage that Parliament must have contemplated would be available, can be caught by the general anti-avoidance provision.   

The case involved two orthopaedic surgeons, each of whom had sold his practice to a company substantially owned by a family trust.  In each case, the company paid a salary to the surgeon.  The salary paid to each surgeon was considerably less than what each would have earned as a sole trader, meaning that a significant portion of the earnings from each practice was taxed at the company rate (33% at the time) rather than the top rate for individuals (39% at the time).  This tax saving led Inland Revenue to argue that the decision to operate through a company and family trust structure, and for each surgeon to receive a salary from the relevant company that was significantly less than a "commercially realistic" salary (based on what each surgeon could have earned directly from a third party) amounted to tax avoidance.¹

The key points to emerge from the decision are:

• By a 2 to 1 majority, the Court of Appeal has upheld Inland Revenue's argument that the tax savings resulting from operating through a company amounted to tax avoidance.
• In so doing, the majority (Randerson and Hammond JJ) accepted that Parliament must have intended that income from personal services would be taxed at the relevant personal tax rates.²  By receiving salaries from their respective companies at less than what Inland Revenue termed a "commercially realistic" level, the taxpayers had avoided the top personal tax rate on a large part of the income from their personal services. 
• The Court has, however, emphasised the limits of its decision.  Randerson J observed that for an individual to receive a below-market salary from a family-owned business will not necessarily result in a finding of tax avoidance, if there are legitimate reasons for paying a below-market salary, or if the divergence from a market salary level is at the margin.³ 
• The majority has interpreted the Supreme Court's decision in Ben Nevis Forestry Ventures Limited v CIR [2009] 2 NZLR 289 as rejecting Richardson J's analysis in CIR v Challenge Corporation Limited [1986] 2 NZLR 513 (CA) (to the extent that approach involved "reading down" the scope of the general anti-avoidance provision) and the Privy Council's analysis in CIR v Auckland Harbour Board [2001] 3 NZLR 289 to the effect that the general anti-avoidance provision is a "long-stop".⁴  Instead, the majority suggests that section BG 1 is a central pillar of the tax system.  Hammond J described the general anti-avoidance provision as a "blanket, code-type provision … thrown over the top of [the] assemblage of [specific] rules".⁵
• Consistently with the majority's more expansive view of the role for a general anti-avoidance provision, there is little if any acknowledgement in the majority judgments of the notion that taxpayers have some ability to plan their affairs so as to attract a reduced tax liability.  In particular, the notion that the Income Tax Act could be viewed as affording a choice, whereby business income derived by a company is taxed at a lower rate than the top personal rate, did not feature in their Honours' reasons.
• The Court of Appeal has acknowledged the uncertainty its ruling may create, but has emphasised that that uncertainty is inherent in a provision like section BG 1, and that clear bright-line rules are impracticable.⁶  As Hammond J stated: "Courts exist to resolve particular controversies".⁷  This is not the first time the Courts have specifically rejected calls to articulate clearer principles in this area of the law.

In the wake of this and other recent decisions of the Courts addressing allegations of tax avoidance, advisors now have the difficult task of assessing the risk that a particular arrangement may be found to involve tax avoidance.  For those advisors who have been asking "when will the Courts provide certainty on section BG 1", the Court of Appeal in Penny & Hooper, like the Supreme Court in Ben Nevis, has answered that question: probably never.

This should not be all that surprising, given the nature of judicial decision-making.  Some commentators and advisors have tended to seize on particular phrases taken from leading tax avoidance decisions and then apply those phrases to different fact patterns, as if a judicial statement had the same status as the words of a statutory provision.  In recent years, commentators have referred to the avoidance/mitigation "test" (based on the Privy Council decision in Challenge Corporation⁸) the actual financial consequences "test" (based on McGechan J's decision in BNZ Investments v CIR⁹) and more recently, the Parliamentary contemplation "test" (based on the Supreme Court's decision in Ben Nevis¹⁰).  These so-called "tests" are not tests at all, however, but rather form part of the explanation for a Court having reached a particular decision on a particular set of facts.  As the Courts have emphasised time and again, in tax and other cases, statements made in judicial decisions must be read in the context of the particular facts the Court is addressing.

Assessing the risk that a transaction may be found to involve tax avoidance therefore requires an understanding of how the Courts have viewed particular fact patterns, and an identification of fact patterns that the Courts associate with tax avoidance.  Having regard to the facts of recent decisions at appellate level, taxpayers should view any of the following features as "red flags":

• A transaction is marketed for its tax benefits or packaged in a tax effective way.
• The commercial return from a transaction is highly dependent on its tax treatment, to the point that the tax benefits are more significant than performance of the underlying investment or business.
• The transaction includes prices, rates or other components that result in tax benefits, but are not subject to market forces.

All three factors were present in Ben Nevis (the "Trinity" forestry investment scheme) which the Courts found to be both artificial and contrived, and a clear case for the application of section BG 1.  The facts in Penny & Hooper are far removed from those in Ben Nevis.  In terms of the three red flags listed above, only the third was present in Penny & Hooper, and even then, the payment of a below-market salary by a family owned company was arguably consistent with the desire to accumulate wealth in a family trust, or a company owned by a family trust - which is the whole point of using a family trust for asset protection purposes.

The dissenting Judge, Ellen France J, noted that the use of a company or company owned by a family trust, to carry on a business, is commonplace in New Zealand.¹¹  Further, the Judge accepted expert evidence to the effect that the family member working in such a business frequently draws less by way of salary from the business than would be paid to an unrelated party, for a variety of reasons.¹²

Ellen France J also made the powerful point that the structure Messrs Penny and Hooper had adopted and the tax savings they had achieved could easily have been contemplated by Parliament.¹³  Indeed, when the top personal tax rate was increased from 33% to 39% in 2000, Parliament enacted measures to prevent personal services income from being diverted through companies or trusts so as to avoid the 39% tax rate.¹⁴  Those measures apply only to situations in which 80% or more of the income in question is earned from services provided to one person, whereas the surgeons' respective businesses earned their fees from multiple patients.

The majority's ruling in Penny & Hooper is troubling, in two respects.  First, Inland Revenue has succeeded in invoking section BG 1 in respect of a relatively straight-forward business structure.  For taxpayers who thought that section BG 1 was there to catch only highly structured, complex arrangements, this decision is a wake-up call. 

Second, if a general anti-avoidance provision has any proper role in a tax system, that role is to protect the tax system from arrangements that are structured to defeat the purpose and intent of the specific taxing provisions in a way that Parliament could not reasonably have foreseen.  In the Penny & Hooper situation, it was well-known and well-publicised at the time the top personal tax rate was increased to 39% that there would be an incentive for self-employed persons to operate through trusts or companies.  Parliament enacted the personal services attribution regime to remove the tax benefits of doing so in certain situations.  If Parliament has identified a form of tax planning, and has made provision denying the relevant tax benefits, but only in certain cases, it does seem inappropriate for Inland Revenue, and the Courts, to invoke section BG 1 so as to redraw the line that Parliament has already drawn, many years after the event. 

It is telling that Ellen France J commenced her dissenting judgment with the statement that "…not all arrangements which produce a tax advantage will constitute tax avoidance".¹⁵  In light of the majority decision, it is difficult to know to what extent that proposition, and the associated freedom to structure one's affairs in a tax effective way, remains as a cornerstone of our tax system.   

To view a copy of the case please click here.

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