Background
The purpose of this report, Mr. Jeremy, is not only to provide a correct solution to the problem that you have encountered regarding your assessable income for the income year ended 31 March, 2018 but to also give a better understanding of the various legal factors which apply in your case, especially ss CA 1, GA 1 and BG 1 of Income Tax Act, 2007 (ITA, 2007), which can apply the legal applications of a Tax Avoidance Arrangement.
As per the definitions given under s YA 1 of ITA, 2007, an Arrangement refers to an agreement, plan, contract or an understanding, enforceable or unenforceable and includes all those steps through which a transaction has been brought into effect. Whereas, Tax Avoidance is:
- Alteration of income and any income tax thereof, directly or indirectly;
- Relieving a person, directly or indirectly, from the liability of paying income tax in the present or from a prospective liability on future income tax;
- Reducing, avoiding or postponing any income tax liability, directly or indirectly, in the present or a prospective liability to future income tax.
Hence, a Tax Avoidance Arrangement, in legal terms is an arrangement, which can either be entered into directly by the affected person (which would be you, Mr. Jeremy, in this scenario) or by a third person on your behalf and which directly or indirectly:
- Becomes cause of tax avoidance in purpose or effect;
- Becomes cause of tax avoidance, in purpose or effect and which can be referred or linked with the ordinary business or a family dealing, provided the purpose or effect of such a tax avoidance is merely incidental.
Reference Case: Penny & Hooper
Significant is the case of Penny & Hooper which was decided by the Supreme Court of New Zealand on 24 August 2011. The decision of the Supreme Court in this case went in favour of the Commissioner of Internal Revenue and the grounds cited by the Honourable Court included that tax benefit was one of the principal purposes of the arrangement entered into by the parties having vested interests.
It would be quite appropriate for you to understand, Mr. Jeremy that the Trust formed by you for managing the affairs of the Agriculture Farm is entirely an independent entity, as far as taxation matters are concerned. Your employment is solely the concern of your family company, M/s. J Mobile Mechanics Ltd. You must note that a salary deduction on your part by J Mobile Mechanics Ltd. and diverting all its profits for covering the loss of the Agriculture Farm’s losses shall be considered as Tax Avoidance by J Mobile Mechanics Ltd. Here, I would like to draw your attention towards another significant case which could find similarities of actions and transactions by the parties concerned.
Reference Case: Ben Nevis
In this case, the central issue considered by the Supreme Court was the relationship found between the specific provisions of the Income Tax Act and the General Anti-Avoidance (GAAR) provisions. The Supreme Court’s decision in the Ben Nevis case, as it has come to be known, has become as an important benchmark in legal decisions. The Supreme Court acknowledged in its decision on Ben Nevis that tax legislations do not always directly address the discerning relationships existing between the allowance of tax concessions, which are suitable under certain arrangements and the appropriate application of the GAAR provisions. The Supreme Court took into consideration which had been adopted by different courts over the last twenty years and it came to the conclusion that in the face of the continuing uncertainty, it has become inevitable for the Supreme Court to once for all settle the approach which is required to be applied for all future reference purposes. Although, the Supreme Court’s adopted approach has been discussed in detail in the Court’s final judgement, in short, it was focussed on the fact whether use of the Income Tax Act was in consistency with the Parliament’s purpose in case the arrangement is previewed in the light of the commercial and economic realistic way.
The purpose of bringing this report to your attention, Mr. Jeremy, is to state the various legal applications and taxation laws which, if not adhered to by you, will lead to heavy penalties and tax obligations for you in the future. The Commissioner of Internal Revenue (CIR) through the Department of Internal Revenue (IR) will initiate legal proceedings against you, J Mobile Mechanics Ltd. and the Trust managing the Agriculture Farm.
Application of ss CA 1, BG 1 and GA 1 of ITA, 2007, combined with s 141D of the Tax Administration Act, 1994 (TAA, 1994) gives the CIR and the IR legal right of not only recovering income tax on the concealed income, from all the stated individual and organisations, but to also recover penalties and costs once the matter is referred to a court of law.
As far as legal considerations are concerned, tax avoidance needs to be understood as separate from tax evasion. This can be understood from the definition of ‘Tax Evasion’ given under s 143B(1) of Tax Administration Act, 1994. As per this section, an individual or an entity is considered to be committing tax evasion when it is indulging in acts of concealing or not declaring the legitimate income. It is a criminal offence as such actions tantamount to fraud.
Accordingly, as can be expected in cases of criminal offence, the legal standards of defining what will constitute as ‘tax evasion’ are defined quite clearly in majority of cases. Criminal intention of the fraudster can be proved in courts of law beyond reasonable doubt. Hence, in a court of law, tax evasion can be easily proved as a failure by the taxpayer in discharging its legal obligation of fulfilling its social responsibility. On the other hand, tax avoidance is a path chosen by the taxpayer so as to totally hide the tax obligation in the first place.
When tax evasion happens, the quantum of tax obligation is known, whereas when a tax avoidance happens, the tax obligation can only be known when the authorities reconstruct the transaction by bringing into force the tax avoidance rules.
In the present case study, the issue relates to Tax Avoidance on your part Mr. Jeremy. The courts have stated that Tax Avoidance happens when the taxpayer minimizes the tax liability by adopting legal means which are contrived, artificial and are enforced by the taxpayer for the mere purpose of obtaining the tax benefit. In most cases, as would be evident in your case Mr. Jeremy, there is a significant lack of any commercial reality in the proposed arrangement.
Objectives
I have already provided a legal explanation of Tax Benefits and how these are generated. The law relies on two sections of the Act, BG 1 and GA 1 for examining the effects of tax benefits, although the CIR has the benefit of enforcing s 113 of Tax Administration Act, 1994 to tax the taxpayer in conjunction with BG 1 and GA 1. Surprisingly, the current s BG 1 along with definition of tax avoidance arrangement have not been altered since its first enactment under s 40 of the Land and Income Tax Assessment Act, 1891. Since then, barring a few minor changes, s 40 has been used in its elementary form to prove that any agreement which is used by a taxpayer to alter the nature of the land or its interest in it for defeating the purpose of paying tax was considered void and of nil effect.
Section 62 of Land Tax Act, 1878 formed the basis of s 40. Section 62 was enforced for preventing the erstwhile land-owners from passing on their tax burden onto the tenants. Consequently, s 40 basically became a transaction tax and was incorporated in the First Income Tax Act, as an entirely different type of income tax. Later on, s 82 of Land and Income Tax Act, 1900 was enacted to replace s 40 of the Land and Income Tax Assessment Act, 1891. Section 82 specifies that, and I quote –
“Every contract, agreement, or arrangement made or entered into, in writing or verbally shall be absolutely void in so far as, directly or indirectly, it has or purports to have the purpose or effect of in any way directly or indirectly altering the incidence of any tax, or relieving any person from liability to pay any tax or make any return, or defeating, evading, or of avoiding any duty or liability imposed on any person by this Act, or preventing the operation of this Act in any respect.” Unquote.
Since those times, s 82 has been re-written under the Land and Income Assessment Act, 1908 and under the Land and Income Tax Act, 1916. Thereon, s 170 in Land and Income Tax Act, 1923 and then s 108 of Land and Income Tax Act, 1954 too have been based on the old s 82 of Land and Income Tax Act, 1900. Finally, this became the basis of the current s BG 1. The first tax avoidance case which was presented in the Privy Council, became the source of the modern definition of Tax Avoidance. It was honourable Lord Wilberforce who pronounced the following observation, and I quote:
Reference Case: Ben Nevis
“Originating in a desire to deal with the simple matter of incidence of land tax, it had found itself confronted, with only minor changes of language, with all the sophistications of modern tax avoidance.” Unquote.
For application of the law, it is pertinent to understand that the authority can only draw the conclusion that your financial transactions point to tax avoidance when it arrives at a decision in the case where you have already calculated the tax payable as per the provisions of the taxation law. Under such circumstances the most often quoted definition is of Lord Nolan in Inland Revenue Commissioners v Willoughby [1997] 1 WLR 1,071 (HL): “a course of action designed to conflict with or defeat the evident intention of Parliament.”
Now, the Parliament’s intention is based on the legal parameters formulated either as a law or opined by a court of law. The intent of the taxpayers is primarily determined by what is defined under s BG 1 for determining whether the provisions of the Act apply or not. The Parliament interprets the words of the applicable provisions in light of their purpose as explained under s 5(1) of Interpretation Act, 1999. The Parliamentary Inquiry Committee will consider, under s BG 1, whether it is within Parliament’s contemplation to use the Act, if viewed under the prevalent circumstances. Any circumvention of the existing provisions can only be determined by use of s BG 1.
The thin line dividing the general role of s BG 1 and other specific anti-avoidance provisions explained in ITA, 2007 is important from the point of view of the discerning taxpayers and tax practitioners as it protects the Federal tax base from unwarranted schemes and arrangements which are implemented by spurious taxpayers to reduce the payable tax amount. Although ITA, 2007 does have a number of effective anti-avoidance provisions, however, the only time these General Anti-Avoidance Rules (GAAR) are invoked when it becomes clear that other income tax rules have been successfully, albeit improperly, complied with. The paradox arising is that tax is imposed through the use of anti-avoidance provision although the authority cannot otherwise recover it.
This paradox then causes problems for the authorities because it becomes very difficult for them to discern where the line is to be drawn, between an improper tax avoidance and an appropriate tax planning. Tony Pagone J, while writing extra-judicially, clarified the paradox and I am quoting the summary:
“In each case, tax is imposed through, or by application of, the anti-avoidance provisions where tax is not otherwise imposed. The fundamental criteria chosen for this imposition is the successful purpose of avoidance. It must seem very curious to most normal people that tax would be imposed when it is lawfully not payable according to the provisions said to have been avoided, and that the very criteria of imposition could somehow be the success of its avoidance.” Unquote.
Scope
Another landmark observation made in Ben Nevis Forestry Ventures Ltd. v CIR [2008] NZSC 115, [2009] 2 NZLR 289 case by the court and I quote:
“On the ordinary meaning of the emphasised language in s GB 1 [the predecessor to s GA 1], once the existence of a tax avoidance arrangement has been established, all those taxpayers who have benefited from it may be subject to corrective adjustments by the Commissioner in the exercise of the reconstruction power. No question of mutuality or even awareness by a benefiting taxpayer is a necessary element.” Unquote.
The Supreme Court further confirmed the Ben Nevis approach for applying s BG 1 in the case of Penny v Commissioner of Inland Revenue [2011] NZSC 95, [2012] 1 NZLR 433 (known as Penny & Hooper case). Consequently, the CIR has also started considering this statement as it aptly reflects the views of the court in Ben Nevis.
Conclusion
To distinguish between legitimate tax-planning and improper tax-avoidance is a very difficult decision for the taxpayers and their tax advisers. When tax avoidance is widespread, it results in shifting the tax burden to the compliant taxpayers from the non-compliant taxpayers. This causes a loss of confidence in the tax system on the part of the compliant taxpayers. Paying taxes is not a voluntary activity in the society, hence the obligatory rules for paying taxes are defined with great care, so that taxpayers who correctly interpret the provisions of ITA, 2007, are expected to organize their tax matters in accordance with the provisions.
Since the Act has not precisely defined the word income, it is left to courts and experts to arrive at a well-defined meaning. In this respect, the New Zealand courts have even relied on references cases from other jurisdictions so as to arrive at a general concept of the word income. This was done to apprehend the different types of receipt which would comprehend within the meaning of income and to also formulate certain principles which could be applied in ascertaining which of the receipts could be treated as income in accordance with the ordinarily followed concepts of the society.
The description of s BG 1 does not define apportionment, therefore all tax outcomes from an arrangement, including all legitimate outcomes, are considered as void. This means that s BG 1 does not leave any scope for considering a tax avoidance arrangement in parts. To overcome this anomaly, the CIR has to apply s 113 of Tax Administration Act, 1994 to bring into effect an assessment while avoiding the void. When Subsections GA 1(1) and (2) are used they determine whether an arrangement is void under section BG 1 (Tax avoidance).
Tax Evasion vs Tax Avoidance
Mr. Jeremy, please note that the Commissioner has the power to adjust the taxable income of a taxpayer who is affected by the arrangement. This is done by the CIR in order to counteract any tax advantage which can be availed by the taxpayer from or under an arrangement. Under s GA 1(2), the CIR can review the adjustment in the manner he thinks appropriate so as to counteract the tax advantage being availed by the taxpayer from or under an arrangement. Hence, s GA 1(2) gives the CIR broad powers for making adjustments so as to counteract any tax advantage by the taxpayer.
Reference Case: Peterson
In Peterson v CIR (No 2) (2002) 20 NZTC 17,761 (HC), Lord Millett stated that a taxpayer could be affected by an arrangement, whether or not he is a party to it and whether or not he is privy to its details. I quote:
“Their Lordships are satisfied that the “arrangement” which the commissioner has identified had the purpose or effect of reducing the investors’ liability to tax and that, whether or not they were parties to the arrangement or the relevant part or parts of it, they were affected by it. Their Lordships do not consider that the “arrangement” requires a consensus or meeting of minds; the taxpayer need not be a party to “the arrangement” and in their view he need not be privy to its details either.” Unquote.
It is recognized that the given statutory definition of tax avoidance is not exhaustive. The purpose of Parliament is identified by taking into consideration the meanings of the provisions, their context and their legislative history. Therefore, the Parliament has left it to the discretion of the courts for identifying tax avoidance and to confirm that certain defined circumstances, such as future tax liabilities, do not get excluded from the scope of tax avoidance. In this respect s 141D (Abusive tax position) under Tax Administration Act, 1994 needs to be understood and I quote:
Section 141D(1):
“The purpose of this section is to penalise those taxpayers who, having taken an unacceptable tax position, have entered into or acted in respect of arrangements or interpreted or applied tax laws with a dominant purpose of taking, or of supporting the taking of, tax positions that reduce or remove tax liabilities or give tax benefits”.
Section 141D(2):
“A taxpayer is liable to pay a shortfall penalty if the taxpayer takes an abusive tax position (referred to as an abusive tax position)”.
Issue
Section 141D(3):
“The penalty payable for taking an abusive tax position is 100% of the resulting tax shortfall.”Unquote.
The Supreme Court, through the case of Ben Nevis has set out an approach which needs to be adopted for determining if tax avoidance under the given circumstances exists. The CIR often refers to this cited approach as the Parliamentary Contemplation Test.
References
I L R Richardson, ‘The Impact and Influence of Accounting and Economic Principles on Taxation Law’ (1998) 4 New Zealand Journal of Taxation Law and Policy 18.
ITA 2007, s CE 1. Naismith v CIR (1981) 5 NZTC 61 046 is the authority for this proposition.
Explaining Sections BG 1 and GA 1
ITA 2007 (NZ) s BG 1, s GA 1.
The New Zealand GAAR is contained in ss BG 1 and GA 1 of the ITA 2007 (NZ), with relevant terms defined in s YA 1 of the same act.
Defining Arrangement
Commissioner of Inland Revenue v Duke of Westminster [1936] AC 1, 19-20.
This case has been applied in
Australia: Anderson v Commissioner of Taxes (Vic) (1937) 57 CLR 233;
New Zealand: Commissioner of Inland Revenue v Europa Oil (NZ) Ltd [1971] NZLR 641, Canada: Stubart Investments Ltd v The Queen [1984] 1 SCR 536;
Hong Kong: Commissioner of Inland Revenue v Douglas Henry Howe [1977] HKCFI 65; South Africa: Commissioner of Inland Revenue v Conhage (Pty) Ltd [1999] 4 SA 1149 (Supreme Court of Appeal);
Ireland: O’Sullivan (Inspector of Taxes) v P Ltd (1962) 3 ITC 355.
Krishna notes that over 6000 years ago some Mesopotamian citizens swam across a river to avoid a toll on the use of a ferry: V Krishna, Tax Avoidance: The General Anti-Avoidance Rule (Carswell, 1990) 8.
Hadlee and Sydney Bridge Nominees Ltd v Commissioner of Inland Revenue (1991) 13 NZTC 8116, 8122. 24
Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2009] 2 NZLR 289, 328 [95].
Commissioner of Inland Revenue v Willoughby [1997] 4 All ER 65, 73.
Commissioner of Inland Revenue v BNZ Investments Ltd [2002] 1 NZLR 450, 463 [40].
Commissioner of Inland Revenue v Challenge Corporation Ltd [1986] 2 NZLR 513, 533 (Court of Appeal) cited in Westpac Banking Corporation v Commissioner of Inland Revenue [2011] NZSC 36 [208].
Braithwaite, V. (ed) 2017, Taxing Democracy: Understanding Tax Avoidance and Evasion. Routledge, London.
https://books.google.co.in/books?id=Ea1BDgAAQBAJ&printsec=frontcover&dq=nz+tax+evasion+and+avoidance&hl=en&sa=X&ved=0ahUKEwjl6NSQjqjdAhXYeX0KHaLICBY4ChDoAQgrMAE#v=onepage&q=nz%20tax%20evasion%20and%20avoidance&f=false
Brown, K.B. (ed) 2011, A Comparative Look at Regulation of Corporate Tax Avoidance.
Springer Science & Business Media, London.
https://books.google.co.in/books?id=W6mS7ZTmuigC&pg=PA250&dq=nz+tax+evasion+and+avoidance&hl=en&sa=X&ved=0ahUKEwjxzoztjajdAhXCdn0KHbg6DqcQ6AEIMjAC#v=onepage&q=nz%20tax%20evasion%20and%20avoidance&f=false
CCH New Zealand Ltd. (ed) 2013, New Zealand Master Tax Guide (2013 edition). CCH New Zealand Limited, Auckland.
https://books.google.co.in/books?id=aZkwAAAAQBAJ&pg=PA1437&dq=nz+tax+evasion+and+avoidance&hl=en&sa=X&ved=0ahUKEwjxzoztjajdAhXCdn0KHbg6DqcQ6AEIPTAE#v=onepage&q=nz%20tax%20evasion%20and%20avoidance&f=false
Coleman, J. 2013, Tax Avoidance Law in New Zealand (2nd ed). CCH New Zealand Limited, Auckland.
https://books.google.co.in/books?id=oZgwAAAAQBAJ&pg=PA12&dq=nz+tax+evasion+and+avoidance&hl=en&sa=X&ved=0ahUKEwjxzoztjajdAhXCdn0KHbg6DqcQ6AEILDAB#v=onepage&q=nz%20tax%20evasion%20and%20avoidance&f=false
Hashimzade, N. and Epifantseva, Y. (ed) 2017, The Routledge Companion to Tax Avoidance Research. Routledge, London.
https://books.google.co.in/books?id=wUc4DwAAQBAJ&printsec=frontcover&dq=nz+tax+evasion+and+avoidance&hl=en&sa=X&ved=0ahUKEwjxzoztjajdAhXCdn0KHbg6DqcQ6AEIUDAI#v=onepage&q=nz%20tax%20evasion%20and%20avoidance&f=false
Newbold, G. 2016, Crime, Law and Justice in New Zealand. Routledge, London.
https://books.google.co.in/books?id=vMZJDAAAQBAJ&pg=PA18&dq=nz+tax+evasion+and+avoidance&hl=en&sa=X&ved=0ahUKEwjxzoztjajdAhXCdn0KHbg6DqcQ6AEINzAD#v=onepage&q=nz%20tax%20evasion%20and%20avoidance&f=false
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