Penny v Commissioner of Inland Revenue HC Christchurch CIV 2007-409-1153
[2009] NZHC 346
•19 March 2009
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IN THE HIGH COURT OF NEW ZEALAND CHRISTCHURCH REGISTRY
CIV-2007-409-1153
IN THE MATTER OF The Income Tax Act 1994 and the Tax
Administration Act 1994
BETWEEN IAN DAVID PENNY Plaintiff
ANDTHE COMMISSIONER OF INLAND REVENUE
Defendant
CIV-2007-409-1154
AND
IN THE MATTER OF The Income Tax Act 1994 and the Tax
Administration Act 1994
BETWEEN GARY JOHN HOOPER Plaintiff
ANDTHE COMMISSIONER OF INLAND REVENUE
Defendant
Hearing: 28-31 October 2008
Counsel: G J Harley and C E Bibbey for plaintiffs
D J Goddard QC and H W Ebersohn for Defendant
Judgment: 19 March 2009 at 2pm
In accordance with r 11.5 I direct the Registrar to endorse this judgment with a delivery time of 2pm on the 19th day of March 2009.
PENNY & ANOR V COMMISSIONER OF INLAND REVENUE HC CHCH CIV-2007-409-1153 19 March
2009
RESERVED JUDGMENT OF MACKENZIE J
TABLE OF CONTENTS
Introduction............................................................................................................... [1] Background facts ...................................................................................................... [3] (a) Mr Hooper ........................................................................................................ [4] (b) Mr Penny........................................................................................................... [7] Tax Treatment........................................................................................................... [8] The rival contentions .............................................................................................. [12] The legal principles................................................................................................. [14] The arrangement ..................................................................................................... [22] (a) The formation of the company ........................................................................ [23] (b) The fixing of the salary ................................................................................... [49] (c) The benefit of the money ................................................................................. [68] Overall consideration .............................................................................................. [73] Result ...................................................................................................................... [82]
Introduction
[1] These two challenges by the plaintiff taxpayers to assessment by the Commission raise similar issues and were heard together. It is convenient to deliver a joint judgment.
[2] Each of the plaintiffs is an orthopaedic surgeon in practice in Christchurch. They practise partly in the public health sector. For a portion of their time, each of them also conducts a private practice, for private fee paying patients. Initially, each
practised on his own account. That is to say, the practice was conducted by them personally, and the income from the practice was the personal income of the surgeon. Subsequently, each incorporated his practice, so that the practice was carried on by a company, and the surgeon provided treatment on behalf of the company, pursuant to a contract of employment. The Commissioner formed the view that the totality of the arrangements involving the surgeon and the company constituted a tax avoidance arrangement, and has issued assessments for a number of income years in respect of each of the plaintiffs accordingly. The plaintiffs challenge the validity of those assessments.
Background facts
[3] I first describe briefly the basic facts as to the practice arrangements in each case. These facts are essentially not in issue. I leave for later discussion some more contentious factual issues on aspects relevant to a determination of the purpose and effect of these arrangements.
(a) Mr Hooper
[4] Mr Hooper has practised as a specialist orthopaedic surgeon in Christchurch since 1985, and has been employed in that capacity by the Canterbury District Health Board (CDHB) throughout that period. CDHB employs specialists for a proportion of their working time, measured in 10ths. Initially, he was employed on a 10/10ths basis. In 1989 he reduced this to 7/10ths. At that time he began to practise also in the private sector, initially by joining a group of specialists in the Leinster Orthopaedic Centre. In that Centre, there were a number of surgeons (five, after Mr Hooper joined the Centre) each conducting their own separate practices, but sharing staff, equipment and facilities under arrangements governed by a Deed of Management. In 1991, Mr Hooper and his wife were each the settlor of a Family Trust, in the form usually described as “mirror trusts”. The Trustees of both Trusts were their solicitor, and their accountant. The beneficiaries were, in each case, the spouse, and their children and grandchildren. The Trusts were set up specifically to buy a half share each of a 1/5th interest in the premises occupied by the Leinster
Orthopaedic Centre, previously occupied under a Deed of Licence. Those arrangements had been intended to take effect when he first joined the Centre, but were delayed.
[5] From 2000, the practice arrangements were restructured. A new company, Hooper Orthopaedic Limited (HOL), was formed with 1,000 shares, owned as to 495 shares each by the Family Trusts and five shares each by Mr Hooper and his wife. Mr Hooper was the sole director. Mr Hooper’s orthopaedic practice was sold to the company for $332,473, which included $330,000 for goodwill. The company assumed Mr Hooper’s obligations in respect of the Leinster Orthopaedic Centre. Mr Hooper was employed by the company to carry out the surgery work. Mr Hooper’s evidence is that after the transfer of the practice to the company his workday remained essentially the same. He continued to practise as an orthopaedic surgeon with the same expertise and skill as before, he saw the same number of patients, he continued to operate on his set operating sessions at the two private hospitals in Christchurch and patients continued to look to him for their wellbeing. While the practice has been conducted by the company, the referral of patients has almost invariably been to Mr Hooper personally, not to the company. Letters are addressed to him personally. That is also the case with patients seen through CDHB, once he is the surgeon on record. Letters which he writes from the practice are written on letterhead which does not refer to the company.
[6] Mr Hooper is paid a salary by the company. His evidence is that as sole director of the company he had to make a decision about how much he would be paid as an employee. In each of the 2001 to 2004 income years, a salary of $119,990 was fixed. That salary was the amount returned by Mr Hooper as his income in respect of the practice in each of those years. The income derived from fees paid by patients constituted income of the company which was, after deduction of expenses (including Mr Hooper’s salary) returned as the company income. During those income years, each Trust received fully imputed dividends from the company. A portion of the Trust’s income was distributed to Mr Hooper’s three daughters and taxed as their income, the remainder was retained by the Trusts as Trustee income. The relevant figures are set out in the following table:
* See paragraph [8]
Income of
HOL
Salary from
HOL
Salary from
CDHB
Dividends by
HOL
Year
$
$
$
$
2001
593,914
119,990
104,054
227,800
2002
447,915
119,990
104,086
341,700
2003
502,882
119,990
79,455
227,800
2004
140,095
*420,297
87,948
392,205
(b) Mr Penny
[7] Mr Penny is also a specialist orthopaedic surgeon who has worked in that capacity for the CDHB since 1989. Initially he worked on an 11/10ths basis. In
1991 he commenced private practice as a specialist orthopaedic surgeon. Initially he practised on his own account as a sole trader. In 1997 he incorporated Penny Orthopaedic Services Limited (POS), of which he was the sole shareholder, and Orthopaedic Surgical Consultancy Limited (OSCL), all shares in which were owned by A C Penny No 1 Trust (the Trust) which was set up at that time. The Trustees were Mr Penny’s accountant and solicitors and the final beneficiaries were himself and his wife and their children and grandchildren. The premises in which the practise was conducted, which were to that point owned by Mr Penny, were leased by him to POS and then sold to the Trust. His orthopaedic practise was transferred to POS in February 1997 for the sum of $144,310, including $100,000 for goodwill. He entered into an employment contract with POS. In April 1997, OSCL purchased the surgical and medical practice from POS for $1,044,310. Goodwill was set at
$1,000,000. This two-stage process for the transfer of the business to OSCL was part of a single restructuring plan. After the restructuring Mr Penny’s day to day work arrangements remained essentially the same. Patients looked to him personally for their wellbeing. His letterhead was not changed, but invoices were issued in the name of the company. Each year, a salary was fixed, essentially by Mr Penny, and Mr Penny returned that amount as his income from private practise. The fees paid by patients formed the income of OSCL and that income was, after deduction of
expenses (including Mr Penny’s salary) returned as taxable income by the company. The Trust, as sole shareholder is OSCL, received fully imputed dividends from OSCL in each year and the dividends were substantially all retained as Trustee income, and returned as such to the Commissioner. The relevant figures are in the
following table:
Income of OSCL Salary from OSCL
Dividends by
OSCL
Year
$
$
$
1998
299,365
*83,333
1999
432,962
++259,999
2000
432,175
124,829
2001
484,779
99,996
133,064
2002
609,871
99,996
1,175,545
2003
566,183
99,996
348,400
2004
161,746
**485,235
348,400
* plus $100,635 as a director’s bonus
++ plus $42,483 as a director’s bonus
** see paragraph [8]
Tax Treatment
[8] In each case, tax returns were filed returning income for each of the relevant income years in accordance with the arrangements which I have briefly described. In each case, the Commissioner undertook reviews of the taxpayers’ returns, commencing in April and May 2004. A notice of proposed adjustment was issued in respect of the relevant income years, the tax years ended 31 March 2002, 2003 and
2004. Speaking broadly, the effect of the adjustment in each case was to increase the taxable income of Mr Hooper and Mr Penny in each year by an amount equal to the difference between the salary actually paid by the company to the taxpayer, and what the Commissioner assessed as a commercially realistic salary for the services provided by the taxpayer to the company. In the case of each taxpayer, the investigation had commenced before the returns for the 2004 year were due. Both
taxpayers were concerned about the potential penalty consequences if their previous practices as to salary were followed for that year. Accordingly, each taxpayer returned a larger salary than that actually received. However, each also followed the statutory procedure and gave a Notice of Proposed Adjustment (NOPA) seeking an adjustment to reflect the salary actually received. The amount in issue is, for the
2002 and 2003 years, the difference between the income returned by the taxpayer and the income assessed by the Commissioner. For the 2004 years, it is the difference between the income claimed in the taxpayer’s NOPA and the income assessed by the Commissioner. It was not suggested in argument that this procedural distinction between the years would lead to any different outcome.
[9] There would, in each case, have been a consequential adjustment to the income of the company of the same amount, to reflect the additional expenditure which would have been incurred by the company had the salary assessed by the Commissioner been paid. Those adjustments are not directly before me. It was common ground between the parties that such an adjustment would be a necessary consequence of the Commissioner’s approach.
[10] For taxation purposes, the significance of increasing the taxable income of the taxpayers, and reducing the taxable income of the companies, in accordance with the Commissioner’s assessments, arises from the fact that in the relevant years the rates of tax payable on income derived by a company differ from those imposed on the income of an individual taxpayer. Tax was imposed on the taxable income of a company at the rate of 33 cents in the dollar. Tax on the income of individual taxpayers was payable on a graduated scale. The rate applicable to the income in question in these proceedings would in each case have been 39 cents in the dollar. The amounts of tax in issue arising from that rate differential as I understand them to be are set out in the following table. This table is intended by me to set out the practical effect of a determination as to whether or not the arrangements in each case constitute tax avoidance. It has regard not only to the income of the taxpayers, but also that of the companies, in that it assumes (although the position of the companies is not before me) that a corresponding adjustment is made to the income of the company in each case. The “additional salary” in each case is that assessed by the
Commissioner, except that, for 2004, the amount is calculated by reference to the taxpayer’s NOPA, rather than to the salary actually returned (as I have explained).
Hooper
2002
2003
2004
Additional salary
$410,010
$410,010
$310,010
Tax difference (6¢ per $1)
24,600
24,600
18,600
Penny
Additional salary
$561,004
$561,004
$517,004
Tax difference (6¢ per $1)
33,660
33,660
31,020
[11] In each case, the statutory dispute resolution procedures were followed, and a review was conducted by the Adjudication Unit. Very comprehensive Adjudication Reports were issued, dated in each case 22 March 2007. The conclusions of the Adjudication Unit in each case were:
(a) That based on the legal arrangements entered into the income was derived by the company, and that the personal exertion principle argued by the Commissioner did not apply in this context; therefore the income returned by the company could not be attributed to the taxpayer as income under ordinary concepts under section CD 5; and
(b)That section BG 1 applies to the arrangement entered into by the taxpayer; the essential elements of that arrangement involving the carrying on of the orthopaedic practice using the company structure and the fixing of the salary of the taxpayer at a level below a commercially realistic salary.
The proceedings issued by each taxpayer followed these Adjudication Reports.
The rival contentions
[12] The Commissioner contends that the arrangements in respect of the private practice of each of Mr Penny and Mr Hooper constituted tax avoidance arrangements for the purposes of s BG 1 of the Income Tax Act 1994. Mr Goddard QC submits that this is a clear case of tax avoidance. He submits that the tax purpose, and lack of a commercial purpose, of the arrangements is demonstrated by the cumulative effect of features such as the following:
(a) The artificially low salaries paid to Mr Hooper and Mr Penny by their practice companies;
(b)The fact that Mr Hooper and Mr Penny controlled the companies and trusts, and that their families continued to live on the income coming from the same source (being their medical practices);
(c) The availability of such income to Mr Hooper and Mr Penny (and the use of such income by them in such a way that it was not derived as income by them);
(d)Mr Hooper and Mr Penny being prepared to assign away their future earnings for inadequate consideration;
(e) The change in their practices not being commercially driven as demonstrated by the practices continuing in terms of day to day functioning as they had before;
(f) The actual tax benefits that were the effect (and therefore also the purpose) of the arrangement; and
(g) The lack of any other reasonable explanation for the arrangements
Counsel submits that for these reasons the arrangements had a more than merely incidental purpose of tax avoidance and were therefore tax avoidance arrangements. He submits that the Commissioner’s case is, and has always been, that the tax avoidance is constituted by the manner in which the plaintiffs have used their company and trust structures. It is not the Commissioner’s case that the failure to pay a commercially realistic salary is tax avoidance. He submits that the totality and cumulative effect of the arrangements must be considered.
[13] Mr Harley for the taxpayers submits that in neither case is there a tax avoidance arrangement. The contention for both taxpayers is summed up in counsel’s submissions in these terms:
(a) There is no “tax avoidance arrangement” in s BG 1 terms, because the two taxpayers are employed by their Family Companies;
(b)Neither of the taxpayers derives what the Commissioner considers to be employment income at his commercially realistic salary level; and
(c) The Act does not within the purview of its statutory scheme – reflecting the Personal Services Attribution Rules – contain any notion of the commercially realistic salary concept. Rather, the Commissioner has made it up, in an effort to eliminate the Rate Advantage which became evident in April 2000, when the Government increased the maximum personal income tax rate from
33% to 39%.
The legal principles
[14] The applicable statutory provisions may be shortly stated. The key provision is s BG 1. That provides:
BG 1 Avoidance
Arrangement void
(1) A tax avoidance arrangement is void as against the
Commissioner for income tax purposes. Enforcement
(2)The Commissioner, in accordance with Part G (Avoidance and Non-Market Transactions), may counteract a tax advantage obtained by a person from or under a tax avoidance arrangement.
[15] The term “tax avoidance arrangement” is defined in s OB 1 in the following terms:
Tax avoidance arrangement means an arrangement, whether entered into by the person affected by the arrangement or by another person, that directly or indirectly—
(a) Has tax avoidance as its purpose or effect; or
(b)Has tax avoidance as one of its purposes or effects, whether or not any other purpose or effect is referable to ordinary business or family dealings, if the purpose or effect is not merely incidental:
[16] The term “tax avoidance” is in turn defined as follows:
Tax avoidance, in sections BG 1, EH 1, EH 42, GB 1, and GC 12, includes—
(a) Directly or indirectly altering the incidence of any income tax:
(b) Directly or indirectly relieving any person from liability to pay income tax:
(c)Directly or indirectly avoiding, reducing, or postponing any liability to income tax:
[17] Where a tax avoidance arrangement is void under s BG 1, the Commission may make adjustments to counteract any tax advantage, under s GB 1(1) of which provides:
GB 1 Agreements purporting to alter incidence of tax to be void
(1)Where an arrangement is void in accordance with section BG 1, the amounts of gross income, allowable deductions and available net losses included in calculating the taxable income of any person affected by that arrangement may be adjusted by the Commissioner in the manner the Commissioner thinks appropriate, so as to counteract any tax advantage obtained by that person from or under that arrangement, …
[18] While the relevant provisions may be shortly stated, the principles governing their application cannot be so shortly expressed. These provisions, and their predecessors, have been the subject of intense judicial scrutiny, and much judicial ink has been spilt wrestling with the essential paradox inherent in the provision: that an arrangement which, on the literal application of the specific provisions of the Income Tax Act, leads to a particular incidence of and liability to pay tax, is nevertheless to be regarded as having the purpose or effect of avoiding some other incidence of and liability for tax. Counsel on both sides addressed at considerable length, and with great skill, the numerous authorities which discuss the approach to be adopted in addressing this paradox. I intend no disrespect to those arguments by not addressing the earlier authorities. Since the hearing before me, the Supreme Court has delivered its decision in Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2008] NZSC 115 and, at the same time, its decision on a related issue, tax avoidance in the GST context, in Glenharrow Holdings Ltd v Commissioner of Inland Revenue [2008] NZSC 116. Those cases had been heard before this hearing. Counsel, in a joint memorandum, have indicated that an opportunity to make further submissions in the light of those decisions is not sought. As the issues were very fully and ably argued, I have not found it necessary to seek further submissions. The Supreme Court has reviewed the relevant authorities in detail. It has restated the principles to be applied and the approach to be adopted when applying the tax avoidance provisions. It will not therefore be helpful for me to examine the authorities to which the Supreme Court has had regard in stating the relevant principles and approach. Rather, it is appropriate for me to apply the principles and approach enunciated to the facts of the cases before me.
[19] The essence of the Supreme Court’s decision is to endorse a ‘scheme and purpose’ approach. The majority (Tipping, McGrath and Gault JJ) discuss the authorities which are consistent with such an approach at paragraphs [84] to [99], and note the uncertainty which arises from a recent suggestion by the Privy Council that the role of the general anti-avoidance provision may be as a long-stop. They then express the approach to be adopted in these terms:
[102]It is accordingly the task of the Courts to apply a principled approach which gives proper overall effect to statutory language that expresses different legislative policies. It has long been recognised
those policies require reconciliation. The approach must ensure that the particular case before the court is examined by reference to the respective legislative policies. It must enable decisions to be made on individual cases through the application of a process of statutory construction focusing objectively on features of the arrangements involved, without being distracted by intuitive subjective impressions of the morality of what taxation advisers have set up.
[103]We consider Parliament’s overall purpose is best served by construing specific tax provisions and the general anti-avoidance provision so as to give appropriate effect to each. They are meant to work in tandem. Each provides a context which assists in determining the meaning and, in particular, the scope of the other. Neither should be regarded as overriding. Rather they work together. The presence in the New Zealand legislation of a general anti- avoidance provision suggests that our Parliament meant it to be the principal vehicle by means of which tax avoidance is addressed. The general anti-avoidance regime is designed for that purpose, whereas individual specific provisions have a focus which is determined primarily by their ordinary meaning, as established through their text in the light of their specific purpose. In short, the purpose of specific provisions must be distinguished from that of the general anti- avoidance provision.
[104]Parliament must have envisaged that the way a specific provision was deployed would, in some circumstances, cross the line and turn what might otherwise have been a permissible arrangement into a tax avoidance arrangement. Ascertaining when that will be so should be firmly grounded in the statutory language of the provisions themselves. Judicial attempts to articulate how the line is to be drawn have in the past too often been seized on as if they were equivalent to statutory language. Judicial glosses and elaborations on the statutory language should be kept to a minimum.
[105]The key statutory concept in the general anti-avoidance provision is of a tax avoidance arrangement, as Parliament has defined it. By means of the definition of tax avoidance, a tax avoidance arrangement includes an arrangement which directly or indirectly alters the incidence of any income tax. It is arrangements of that and allied kinds which are void against the Commissioner under s BG
1(1). An arrangement includes all steps and transactions by which it is carried out. Thus, tax avoidance can be found in individual steps
or, more often, in a combination of steps. Indeed, even if all the steps
in an arrangement are unobjectionable in themselves, their combination may give rise to a tax avoidance arrangement.
[106] Put at the highest level of generality, a specific provision is designed to give the taxpayer a tax advantage if its use falls within its ordinary meaning. That will be a permissible tax advantage. The general provision is designed to avoid the fiscal effect of tax avoidance arrangements having a more than merely incidental purpose or effect of tax avoidance. Its function is to prevent uses of the specific provisions which fall outside their intended scope in the overall scheme of the Act. Such uses give rise to an impermissible tax advantage which the Commissioner may counteract. The general
anti-avoidance provision and its associated reconstruction power provide explicit authority for the Commissioner and New Zealand courts to avoid what has been done and to reconstruct tax avoidance arrangements.
[107]When, as here, a case involves reliance by the taxpayer on specific provisions, the first inquiry concerns the application of those provisions. The taxpayer must satisfy the Court that the use made of the specific provision is within its intended scope. If that is shown, a further question arises based on the taxpayer’s use of the specific provision viewed in the light of the arrangement as a whole. If, when viewed in that light, it is apparent that the taxpayer has used the specific provision, and thereby altered the incidence of income tax, in a way which cannot have been within the contemplation and purpose of Parliament when it enacted the provision, the arrangement will be a tax avoidance arrangement. For example the licence premium was payable for a “right to use land”, according to the ordinary meaning of those words, which of course includes their purpose. But because of additional features, to which we will come, associated primarily with the method and timing of payment, it represented and was part of a tax avoidance arrangement.
[108]The general anti-avoidance provision does not confine the Court as to the matters which may be taken into account when considering whether a tax avoidance arrangement exists. Hence the Commissioner and the courts may address a number of relevant factors, the significance of which will depend on the particular facts. The manner in which the arrangement is carried out will often be an important consideration. So will the role of all relevant parties and any relationship they may have with the taxpayer. The economic and commercial effect of documents and transactions may also be significant. Other features that may be relevant include the duration of the arrangement and the nature and extent of the financial consequences that it will have for the taxpayer. As indicated, it will often be the combination of various elements in the arrangement which is significant. A classic indicator of a use that is outside Parliamentary contemplation is the structuring of an arrangement so that the taxpayer gains the benefit of the specific provision in an artificial or contrived way. It is not within Parliament’s purpose for specific provisions to be used in that manner.
[109]In considering these matters, the courts are not limited to purely legal considerations. They should also consider the use made of the specific provision in the light of the commercial reality and the economic effect of that use. The ultimate question is whether the impugned arrangement, viewed in a commercially and economically realistic way, makes use of the specific provision in a manner that is consistent with Parliament’s purpose. If that is so, the arrangement will not, by reason of that use, be a tax avoidance arrangement. If the use of the specific provision is beyond Parliamentary contemplation, its use in that way will result in the arrangement being a tax avoidance arrangement.
…
[113]Before concluding this section of our reasons, we should recognise that para (b) of the definition of a tax avoidance arrangement refers to cases where the tax avoidance purpose or effect of an arrangement is “merely incidental”. If that is so, the arrangement is not a tax avoidance arrangement. It is apparent therefore that the use of a specific provision which alters the incidence of tax is permitted in two situations.
[114]The first is when the specific provision is used in a manner which is within Parliamentary contemplation, as discussed above. The second is when the tax avoidance purpose or effect of the arrangement is “merely incidental”. It will rarely be the case that the use of a specific provision in a manner which is outside Parliamentary contemplation could result in the tax avoidance purpose or effect of the arrangement being merely incidental. In the present case the appellants did not seek to rely on the merely incidental concept, so nothing more need be said on that subject.
[20] Elias CJ and Anderson J, while agreeing with the majority as to the outcome, express reservations on aspects of the reasoning of the majority. They said:
[2] We write separately to express reservations on aspects of the reasoning adopted by Tipping, McGrath and Gault JJ, not essential to their conclusions on the application of s BG 1 and the consequences. We differ from them in being of the view that the specific statutory allowances under the Income Tax Act are not in potential conflict with the general anti-avoidance provision and that the two do not need reconciliation. Rather, both are to be purposively and contextually interpreted, as is required by s 5 of the Interpretation Act 1999 and s AA 3 of the Income Tax Act. Recourse to the general anti-avoidance provision is not necessary “to prevent uses of the specific provisions which fall outside their intended scope in the overall scheme of the Act”. If the use of a specific provision falls outside its intended scope in the scheme of the Act, the use is not authorised within the meaning of the specific provision. This approach is in our view required by settled principles of statutory construction. It avoids the distortion of overuse and unnecessary expansiveness in application of the general anti- avoidance provision. On this view, we do not think that there are stark differences between the general approach to statutory interpretation of specific tax provisions in New Zealand and in the United Kingdom, at least since W T Ramsay Ltd v Inland Revenue Commissioners and Furniss (Inspector of Taxes) v Dawson. The rejection of literal interpretation described by Lord Steyn and Lord Cooke in Inland Revenue Commissioners v McGuckian applies equally in construing the New Zealand specific tax provisions.
[3]The first question is whether the claimed allowance or deduction falls within the meaning of the specific provision, purposively construed. If it does not, the Commissioner can disallow the claim and, if of the view that it is itself a tax avoidance arrangement (because its purpose or effect is to alter the incidence of tax), can treat it as void under s BG 1. If the claim is within the meaning of
the specific tax provision, purposively interpreted, an arrangement on which it is based may nevertheless constitute tax avoidance if it has the purpose or effect of altering the incidence of tax. If however the basis of claim is not, in itself or as part of a wider scheme, an arrangement with the purpose or effect of altering the incidence of tax, it is not tax avoidance under s BG 1.
…
[8] In Tayles v Commissioner of Inland Revenue, McMullin J (with whom the other members of the Court of Appeal expressed agreement) applied the approach adopted in Newton v Commissioner of Taxation of the Commonwealth of Australia26 that:
The word ‘purpose’ means, not motive but the effect which it is sought to achieve – the end in view. The word ‘effect’ means the end accomplished or achieved. The whole set of words denotes concerted action to an end – the end of avoiding tax.
More recently, Sir Anthony Mason, sitting in the Hong Kong Court of Final Appeal, has also said of the application of tax legislation purposively construed to a transaction or arrangement that it is concerned with “the aim or end in view”. In this case it is not necessary to revisit that approach. Applying it, “effect” is part of a composite term so that the general anti-avoidance provision is concerned with arrangements having the “intended effect” or object of altering the incidence of tax. That is not to say that purpose is to be equated with the motive of the taxpayer or the motives of the architects of the arrangement. It is well established that motive is not determinative, although it may be evidence which sheds light on a purpose of tax avoidance and so is not wholly irrelevant.
[9]Tax avoidance occurs when the object or end in view or design of an arrangement is alteration of the incidence of tax and that object is not incidental to a business purpose. Such assessment does not entail reconstruction of the arrangements entered into. It requires realistic assessment of their purpose or effect. The evaluation required is a “question of mixed fact and law”, as Lord Cooke suggested in McGuckian. The fact that some business effect is also achieved does not prevent a conclusion that the purpose or effect of an arrangement is to alter the incidence of tax. As s BG 1 makes clear, an arrangement tips into tax avoidance if the fiscal effect intended is more than “merely incidental” to the business or family purpose. The fiscal implications of an arrangement that is “merely incidental” to a business purpose may in some cases be substantial and still within the statutory scheme and purpose. “Merely incidental” may properly be contrasted with the end in view, the “purpose or effect”.
[21] I endeavour in the discussion which follows to apply the approach directed by the Supreme Court. I return as necessary to aspects of the reasoning of the Court in considering specific issues.
The arrangement
[22] As I have noted, counsel for the Commissioner submits that it is the totality of the steps taken, from the formation of the company, through the fixing and paying of the salary, and the payments from the companies through the trusts to the beneficiaries which constitute the arrangement. That submission receives support in Ben Nevis, at paragraph [105]. The inquiry into scheme and purpose is to be conducted having regard to the arrangement as a whole, not to its constituent parts. However, where a tax avoidance arrangement is said to arise from the combination of a number of steps, each of which involves consideration of the effect of a different set of specific provisions in the Act, it appears to me to be necessary, in conducting the requisite scheme and purpose analysis, to consider the scheme and purpose of each set of specific provisions. That involves, as an initial step, a separate consideration of each step of the arrangement which is governed by a particular set of specific provisions.
(a) The formation of the company
[23] I use this description as a convenient shorthand to describe all of the steps involved in effecting the decision made by the taxpayer to change his mode of private practice from conducting that as a sole trader to conducting it through a company. Those include the formation of the company and the transfer of the business to it. It is common ground that there is, in the case of each taxpayer, a genuine and substantial business, the principal source of income of which is the fees payable by patients for orthopaedic surgery. It is also common ground that the ability to provide the services to patients for which their fees are payable is personal to the taxpayers. The services are dependent on the skill and training of the taxpayers, and are performed by them personally. The patients regard the taxpayer as their orthopaedic surgeon. It is also clear that the provision of the services to patients requires some resources which are not provided by the taxpayers personally. Mr Lyne’s evidence (which I later discuss in more detail), analysing the accounts of each of the practices, illustrates this. For Mr Penny, external expenses, being those taken into account in calculating earnings before interest, tax and remuneration to
Mr Penny (EBITP), were in the range of 35% to 39% of total income for the relevant years. For Mr Hooper, the equivalent range was 43% to 48%. The business did not need extensive facilities or equipment: surgery was performed in private hospitals, and the fixed assets which were owned by the practice were limited. For Mr Penny, the book value of fixed assets employed was around 6% to 9% of total income, for Mr Hooper 1% to 2%. These facts are sufficient to demonstrate what is an important plank in the Commissioner’s argument, namely that the income derived by the practice is in each case very substantially derived from the personal exertions and the personal expertise of the taxpayer. Indeed, that broad proposition is not challenged by the taxpayer.
[24] On the plain words of the statute, the transfer of the practice to the company altered the incidence of tax. The decision to conduct the practice through the company had different tax consequences from those which applied when the practice was conducted personally. Tax is imposed on income. Here, the relevant income is the income of the practice – in broad terms, the fees paid by the patients. Previously, that income was derived by the taxpayer. After the company formation, it was derived by the company. The incidence of tax was altered by that arrangement, both because the tax was payable by a different taxpayer, and because the rates were different. To that extent then, on a literal reading of s BG 1 the formation of the company and the conduct of the practice by it had the effect of altering the incidence of tax.
[25] However, on the scheme and purpose approach to the interpretation of the anti-avoidance provisions, that alteration is not, of itself, sufficient to bring the situation within the definition of the tax avoidance. It is necessary to consider, in the light of the specific provisions which determine by whom income is derived and what tax is payable by the person deriving that income, whether the incidence of tax is consistent with the intent of these specific provisions, as mandated in Ben Nevis at paragraph [108]. The relevant inquiry, in determining whether the step of incorporating the practice, so that the fee income from patients was derived not by the taxpayer but by the company was, or was part of, a tax avoidance arrangement, must be to investigate whether the alteration of the incidence of income tax which necessarily results from the earning of that income by the company rather than the
individual is consistent with the scheme and purpose of the Income Tax Act, which assigns the different tax consequences to these different categories of person. If it is consistent with that scheme and purpose, then it will not of itself constitute a tax avoidance arrangement, though further inquiry into the purposes of the adoption of the corporate vehicle in the context of the other steps in the arrangement will be necessary. If the formation of the company is not so consistent, then it may have a tax avoidance effect. A more detailed examination of the purposes of that step will be necessary, to determine the true purposes of the adoption of the corporate vehicle, and whether the tax change effect of it is more than merely incidental to some other purposes.
[26] It is clear that that the decision to incorporate the practice was in each case the decision of the taxpayer. It was and is the taxpayer in each case who is in receipt of the referrals. It was the taxpayer who decided that in the future he would not conduct his practice as a sole trader, but would carry on what was essentially the same practice under the different legal arrangement involved. Some reliance was also placed by counsel for the Commissioner on the proposition that while the legal arrangement was different, the practical day to day arrangements did not change. Counsel pointed out (but did not stress) that the arrangements may not have complied with s 25 of the Companies Act 1993, which requires the use of the company name on all communications. It is not however suggested that the transfer of the practice to the company was a sham.
[27] The formation of the company and the conduct of the practice through it was in commercial law terms a valid choice of business structure. The notion that the formation of a company which is under the effective control of one person is a misuse of the corporate form was rejected well over a century ago. In Salomon v Salomon and Co. [1897] AC 22 Lord Halsbury said: (p 33)
My Lords, the learned judges appear to me not to have been absolutely certain in their own minds whether to treat the company as a real thing or not. If it was a real thing; if it had a legal existence, and if consequently the law attributed to it certain rights and liabilities in its constitution as a company, it appears to me to follow as a consequence that it is impossible to deny the validity of the transactions into which it has entered.
Lord Macnaghten said: (p 53)
It has become the fashion to call companies of this class 'one man companies.' That is a taking nickname, but it does not help one much in the way of argument. If it is intended to convey the meaning that a company which is under the absolute control of one person is not a company legally incorporated, although the requirements of the Act of 1862 may have been complied with, it is inaccurate and misleading: if it merely means that there is a predominant partner possessing an overwhelming influence and entitled practically to the whole of the profits, there is nothing in that that I can see contrary to the true intention of the Act of 1862, or against public policy, or detrimental to the interests of creditors.
[28] That fundamental principle has been firmly established from a company law perspective. Its application in New Zealand was specifically affirmed by the Privy Council in Lee v Lee’s Air Farming Limited [1961] NZLR 325, as was the consequential principle that the relationship of employer and employee may validly exist between such a company and the person who is its governing director. The principle was more recently affirmed by the Court of Appeal in Trevor Ivory Ltd v Anderson [1992] 2 NZLR 517.
[29] From a tax perspective, the separate legal identity of a company and the individuals who control it, and the difference between an individual taxpayer and a company taxpayer, are also firmly established. Some provisions of the Income Tax Act apply to both companies and individuals, others apply to each of them separately. Importantly, for present purposes, the rate of tax payable by each is different. Accordingly, while on a literal reading of s BG 1 the structuring of the business through the company has the effect of altering the incidence of tax in the sense that the incidence is different from that which would apply if the person concerned were a sole trader, the effect is not one to which s BG 1 is directed, unless there is some other principle, expressed in or to be implied from the scheme and purpose of the Income Tax Act, which renders the use of the corporate form inappropriate for the achievement of the purposes of the Act. In the absence of some such principle, a choice made by a person who is able to conduct his or her profession, trade or calling either as an individual or through a company controlled and operated by that individual, to do so through a company does not fall outside the intended scheme and purpose of the Act. An important proposition in the Commissioner’s case is that there is such a principle, namely that personal services income derived from the personal exertions of an individual is to be taxed as the income of that person. I turn to consider whether there is such a principle.
[30] The scheme of the Income Tax Act is that it prescribes those items which fall within the scope of income which is assessed for tax. It also imposes tax consequences on that income. Those consequences may differ depending on the category of taxpayer who has derived the income – for example, a company, or an individual, or trustees. The Act does not, in general terms, prescribe that some items of income may be derived only by some categories of taxpayer. The income from the practices here is income derived from a business, governed by s CD3 which provides:
The gross income of any person includes any amount derived from any business.
The reference to “any person” indicates that the Income Tax Act is generally indifferent to the category of person by whom income from any business is derived.
[31] Mr Goddard submits that, in the case of income from personal exertions, the scheme and purpose of the Act is not indifferent as to whether the income is derived by the individual whose exertions are involved, or by a company under the control of that person. He submits that the scheme and purpose of the Act indicate an intention that personal exertion income must be derived by the person by whose exertions the income is earned, so that an arrangement whereby the income from those exertions is derived instead by a company is contrary to the scheme and purpose of the Act. He further submits that the graduated rate structure which applies to individual taxpayers but not to corporate taxpayers indicates a statutory purpose which would be frustrated if income is not derived by the individual taxpayer, so that the effect of the graduated tax scale is avoided.
[32] Mr Goddard places strong reliance, in support of both propositions (namely the proposition that personal exertion income must be derived by the person whose exertions are involved, and the importance of the graduated rate scale), on the decisions at all levels in Hadlee v Commissioner of Inland Revenue. In that case, a partner in a firm of chartered accountants was entitled to income from the partnership in proportion to the number of units of capital he owned in the partnership. He assigned a number of his units of capital to a Family Trust. In the High Court ([1989] 2 NZLR 447) Eichelbaum CJ held that the assignment did not
take effect sufficiently early to prevent the income from being regarded as income of the taxpayer assignor. Alternatively, the general anti avoidance provision applied. On the “personal exertion” issue, Eichelbaum CJ said (pp 463-4):
The "personal services" ground
The Commissioner submitted that income from personal services was incapable of assignment per se, in that such income is always derived by the earner and, for tax purposes, cannot be the subject of an assignment taking effect in advance of its taxability. It was submitted that in New Zealand, the principle derived from Spratt v Commissioner of Inland Revenue [1964] NZLR 272 where Henry J said at p 277:
"No taxpayer can, by way of assignment, escape assessment of tax on income resulting from his personal activities — such income always remains truly his income and is derived by him irrespective of the method he may adopt to dispose of it."
That principle was adopted by Tompkins J as one of several grounds for finding in favour of the Commissioner in Johnstone's case in 1966, see [1966] NZLR 833 at pp 838-839 and likewise by Woodhouse J in Kelly's case in 1969, see [1970] NZLR 161 at p 165. In this country, the principle has never been tested at appellate level.
As a matter of general law it is clear that, legislative prohibition apart, wages or salary may be the subject of valid assignment. Thus the doctrine must be a manifestation of tax law alone. One underlying rationale, at any rate, is not difficult to discern: that it is a premise of any income tax legislation based on a graduated scale of personal taxation, as has always been the case in New Zealand, that income generated by personal services will be "susceptible to the progressivity of the graduated rate structure by being taxed to the person whose personal exertion earned the income": Sir Ivor Richardson, "Appellate Court responsibilities and tax avoidance", (1985) 2 Australian Tax Forum 3,
14.
On behalf of the objector it was submitted that the so-called principle had no basis in logic nor could it be justified by reference to any scheme or underlying objective of the Income Tax Act. On both sides the arguments appeared to take the New Zealand decision of Spratt as the genesis of the doctrine. However, reference to other material submitted to the Court shows that its origins go back much further. According to an article "The alienation and diversion of personal exertion income" by PJ Norman, (1986) 15
Australian Tax Review 209, 212 the principle was adopted by Australian
Tax Review Boards in 1952, in reliance on Smyth v Stretton (1904) 5 Tax Cases 36, as interpreted in Parkins v Warwick (1943) 25 Tax Cases 419. The author commented that the history illustrated how a proposition founded on a somewhat dubious basis can "take on a life of its own" and "become reified in the conventional wisdom of tax jurisprudence". It has some support from Judges of the High Court of Australia, see Peate v Federal Commissioner of Taxation (1962) 111 CLR 443, 446 per Menzies J and Hollyock v Federal Commissioner of Taxation (1971) 125 CLR 647, 653 per Gibbs J. Against this background and in particular, acceptance of the principle as part of New Zealand tax law without dissent and without appellate examination for 25
years, it is in my view inappropriate to review the underlying validity of the doctrine at first instance level. I propose to accept its correctness, and confine my examination to the question of the limits of the principle and its applicability to this case.
[33] That decision was upheld in the Court of Appeal ([1991] 3 NZLR 517). On the personal exertion point, Cooke P accepted as correct the dictum of Henry J in Spratt v Commissioner of Inland Revenue [1964] NZLR 272, which had been cited by Eichelbaum CJ. He referred to Australian and United States authority, in particular the dissenting judgment of Murphy J in FC of T v Everett 80 ATC 4076 at p 4083-4085, and of Holmes J in Lucas v Earl 281 US 111 (1930), and said (at p
522):
Mr Barton urged us not to follow Holmes J or Murphy J and not to endorse the New Zealand decisions at first instance. In my opinion, however, these authorities should be accepted and it should be held that the dictum of Henry J correctly states the law of New Zealand.
The Income Tax Act 1976 proceeds on the footing that all the profits derived from any business (including a profession) and all salary or wages (now subject to the PAYE regime) are part of the assessable income: see sec
65(2)(a) and (b). There is the corollary that, in calculating the assessable income of any taxpayer, any expenditure or loss may, except as otherwise
provided in that Act, be deducted from the total income derived by the
taxpayer to the extent to which it is incurred in gaining or producing the assessable income or is necessarily incurred in carrying on the business: see sec 104. As already indicated, the special section about partnerships interpreted in C of IR v Grover has a similar pattern: the effect is that the taxpayer returns his own gross income but is allowed his own permissible deductions for expenditure. Similarly, under sec 105 there is a standard deduction for every taxpayer who derives assessable income from employment: he is deemed to have incurred a certain amount of expenditure or loss in gaining or producing that income.
These provisions contemplate that income is derived by the taxpayer who earns it. The considerations stated so vividly by Holmes J are cogent in relation to such a statutory scheme. The matter is further discussed in the judgment in this case of my brother Richardson, which I have had the advantage of seeing in draft, and I agree with all that he says about it. This is essentially an illustration of the approach of making the statute work, which this Court constantly tries to follow.
…
The partner is trying to obtain a tax advantage over other chartered accountants and professional people and other earners who pay tax on their earnings. That is contrary to the intent of the Act as a whole and sec 99 in particular.
[34] Richardson J said:
Personal exertion income
There is a further consideration affecting the taxability of the income in this case. It concerns the nature of professional and personal earnings and the manner in which such earnings are derived. For much of its history the New Zealand tax legislation, along with parallel legislation in other jurisdictions, has drawn a clear distinction between earned and unearned income. That distinction has been important when differential rates have applied and in the grant of some exemptions. Underlying the differentiation is the statutory assumption that earned income is of a different nature or quality. In broad terms the distinction is between income from personal exertion and income from property.
…
Personal exertion income of the self-employed
The next question is whether similar overriding considerations preclude recognising income splitting of other personal services income. In Spratt v CIR [1964] NZLR 272 at p 277, Henry J said:
"No taxpayer can, by way of assignment, escape assessment of income tax resulting from his personal activities ⎯ such income always remains truly his income and is derived by him irrespective of the method he may adopt to dispose of it."
Henry J did not articulate his reasons, nor did Woodhouse J in Kelly and Tompkins J in Johnstone in adopting those propositions when discussing the partnerships with which they were concerned. But in policy terms the same general considerations that lead to the conclusion that the Income Tax Act requires wage and salary earners to pay the tax on their earnings, must apply equally to the earnings of the self-employed from their personal exertions. The character or quality of the income which arises is the same in either case. Future wages and future receipts for personal services do not arise without that work. Personal exertion income has been deliberately distinguished from income from property in our legislation and in the legislation of other countries because of that perception that they are quite different in character. If the income is the product of personal exertion that stamp requires that it be taxed accordingly, and that any disposition of a related property interest should take effect subject to that charge for tax.
…
The graduated rate structure is a basic feature of the New Zealand income tax system. If the income from an income earning activity can be divided between two or more taxpayers the total tax may be significantly less than had it been derived by one taxpayer.
…
There is no justification in principle for differentiating between salary and wage earners and professionals whose income is the product of their personal exertion. In either case the person whose personal exertion earns the income derives the income. It would be wrong to impute an intention to Parliament that income splitting with its inevitable undermining of the
graduated rate structure should be widely available to professional and commercial taxpayers although denied to salary and wage earners. (p 523)
[35] That decision was upheld in the Privy Council (Hadlee v Commissioner of
Inland Revenue [1993] 2 NZLR 385). Their lordships said:
Spratt v Commissioner of Inland Revenue related to an employee but Henry J's dictum was applied to partners by Tompkins J in Johnstone v Commissioner of Inland Revenue [1966] NZLR 833 and by Woodhouse J in Kelly v Commissioner of Inland Revenue [1970] NZLR 161. In relation to these cases Cooke P said at p 522:
"In my opinion, however, these authorities should be accepted and it should be held that the dictum of Henry J correctly states the law of New Zealand."
Richardson J said at 533:
"There is no justification in principle for differentiating between salary and wage earners and professionals whose income is the product of their personal exertion. In either case the person whose personal exertion earns the income derives the income."
Their Lordships are in complete agreement with these comments and therefore conclude that the reasoning in Everett would not normally be applicable to the position of partners in New Zealand. Since no income producing proprietary interest was assigned by the taxpayer the argument fails.
[36] The eminence and high authority of that decision is undoubted. However, its authority does not, in my view, extend to the proposition for which it is relied upon here. Hadlee was concerned with the assignment of income. This case is concerned with the derivation of income. These two concepts are quite different, in tax terms. Hadlee involved a partnership which derived income. As a partnership is not a taxpaying entity, the income of the partnership was that of the taxpayer partners. The issue was as to the effectiveness of an assignment of the income, which continued to be derived by the partnership (and hence by the partners). I do not consider that the case can safely or properly be relied upon in the quite different situation when the income is never derived by the professional person, but is instead derived by the company. Hadlee was concerned with a profession then ordinarily carried on by individual taxpayers, either alone or through partnerships. I would not lightly infer that the Courts there had in mind the possibility that the professional practice might be conducted by a company. If Cooke P’s comments are taken to extend to that possibility, they are difficult to reconcile with his earlier decision at
[69] Counsel for the taxpayers objects to that part of Mr Lyne’s evidence, and challenges the ability of the Commissioner to advance the submissions based upon the access of Mr Penny to the money which was initially derived from the practice income. Counsel submits that the Commissioner’s raising of these matters at this stage is contrary to s 138G of the Tax Administration Act 1994, which limits the parties to the facts, evidence and issues, and the propositions of law, disclosed in their respective statements of position. In the event, for the reasons which follow, I attach little weight to the ultimate receipt by Mr Penny of the income from the Trust. In those circumstances I do not consider it necessary to examine in detail whether, in strict terms, the Commissioner is barred from raising this aspect of the case. It is better (particularly in case this matter goes further) that I address the Commissioner’s broad proposition. That is that the effect of the various transactions allowing Mr Penny to have access to and to benefit from the funds arising from the profits of OSCL without deriving such funds as income supports the contention that there is a tax avoidance arrangement.
[70] Circularity of money flows can be an important indicator of artificiality in an arrangement, and so an indicator of tax avoidance. In this case, what is relied upon is not a circulatory of flows, but a situation where the same economic outcome has been reached by a different legal route, and with different tax consequences from those which the Commissioner contends are appropriate. The Supreme Court in Ben Nevis reflects some difference of view between the minority and the majority on the relative importance of form and substance. The minority, at paragraph [4], described as “a myth” the proposition “that in tax case to an extent unknown in other areas of the law, form prevails over substance”. The majority at paragraph [47] said:
[47]In proceeding in this way, the Court must also respect the fact that frequently in commerce there are different means of producing the same economic outcome which have different tax consequences.
When considering the application of a specific tax provision, before reaching any question of avoidance, the Court is concerned primarily with the legal structures and obligations the parties have created and not with conducting an analysis in terms of their economic substance and consequences, or of alternative means that were available for achieving the substantive result.
[71] I approach the question in this case on the basis that the legal form by which the economic consequence of access to the funds by the taxpayer was effected must be respected, except to the extent that the scheme and purpose of the Act requires that another legal form for achieving that economic substance must be adopted, so that the use of the chosen legal form is a device to avoid the adoption of the correct legal form. The ability of Mr Penny to access, through the Trust, funds which had been paid by OSCL as dividends arose from his status as a discretionary beneficiary of the Trust. The proposition that his access to those funds constituted part of a tax avoidance arrangement, or was evidence which supports the proposition that the steps of formation of the company and fixing of the salary constituted a tax avoidance agreement, is based on the same fundamental premise as underlies the Commissioner’s submissions on those two steps. The proposition is that the income of the practice was Mr Penny’s income, and the diversion of it to the company so that it bore tax at the company rate not the top individual rate, constituted tax avoidance. For the reasons I have given I have held that those two steps did not constitute tax avoidance. My conclusions to that effect are not altered by the fact that, in another capacity, Mr Penny was able to obtain the use of funds derived from the income of the practice, upon which tax had been paid both by the company and, as appropriate, by the Trust in respect of dividends derived from the company.
[72] There are two (or possibly more) potential routes which might be chosen, by which the income of the practice may ultimately be available to the taxpayer. Each of those routes will have different tax consequences. There is no suggestion of tax avoidance in the route actually chosen here: the tax applicable to the money flows has been paid. The fact that Mr Penny has the ultimate benefit of the funds can be an indicator of tax avoidance only if the scheme and purpose of the Income Tax Act is such as to require that, if he is to receive the ultimate benefit, it is permissible for
him to do so only by deriving the funds as personal income. For the reasons I have given, I find that the scheme and purpose do not so require.
Overall consideration
[73] Having dealt with each of the constituent steps relied on as part of the arrangement, it is now necessary to stand back and view the matter overall, to consider whether, although there is no tax avoidance in the constituent parts, there is tax avoidance in the whole. As I have noted, the fundamental proposition which underlies the Commissioner’s contention that the totality of the arrangements constitutes tax avoidance is that income from a business which is dependent on the personal exertions of an individual is intended to be taxed as the income of that individual. That reasoning is an essential element of the Commissioner’s case at all steps. The submission is put by Mr Goddard in these terms:
9.4The provisions that Mr Hooper and Mr Penny are avoiding by these arrangements are those that make a payment/reward for services income, and that provide for payment of tax on income from personal exertions at a graduated rate. Income that would ordinarily be theirs is being diverted, and taxed at a lower rate than would otherwise be the case. These are not incentive provisions seeking to encourage particular types of behaviour. Certainly they are not designed to encourage the sort of behaviour that the two taxpayers have engaged in, in this case.
[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. Mr Goddard submits:
10.3The plaintiffs in essence say that because the Income Tax Act provides different tax rates for different types of taxpayers, and because they have acted in a manner that falls within the black letter law provisions, they are entitled to succeed. Their submissions do not make any attempt to assess what type of choices Parliament
intended the taxpayer to have, or engage with the points made by the Court of Appeal in Hadlee concerning the fundamental nature of the graduated rate structure. Rather the plaintiffs say irrespective of the contrivance and artificiality of the plaintiffs’ choice, Parliament intended that the plaintiffs should have the benefit as they complied with the black letter law.
10.4 This approach involves two fundamental errors.
10.5The first fundamental error is that it ignores the guidance provided by Richardson J in Hadlee concerning the importance of the graduated rate structure as a feature of New Zealand income tax legislation, and the implausibility of Parliament intending to condone income splitting by professionals.
10.6The second fundamental error is that the entire analysis ignores the role of s BG 1 in the tax legislation.
[75] As to the first of those “fundamental errors”, I have endeavoured to explain, in dealing with the first step in the arrangement, why the principles in Hadlee do not extend to this case, where what is in issue is the derivation of income, not an assignment of income. There is a further, more general, reason why I do not consider that the proposition that it is implausible that Parliament intended to condone income splitting by professionals can provide a proper basis for a finding of tax avoidance. 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.
[76] That conclusion is relevant to Mr Goddard’s second “fundamental error”. Section BG 1 is indeed an important element of the scheme and purpose of the
Income Tax Act. However, its function is not to supplement the specific provisions by proscribing arrangements which fall within the scheme and purpose of the Act objectively construed, but which are contrary to some notion of morality external to the Act.
[77] It is convenient to address here two decisions of the Taxation Review Authority on issues similar to these here which were the subject of close attention in submissions. They are Case V20 (2002) 20 NZTC 10,233 and Case W33 (2004) 21
NZTC 11,321. Despite their different names both cases are concerned with the same taxpayer, for different years. The taxpayer was a dentist, practising in partnership with another dentist under a group name. The taxpayer set up a family trust, with a company as trustee. The dentist’s share in the practice was sold to the trust, and the taxpayer entered into an employment contract with that trading trust. That arrangement was challenged as tax avoidance.
[78] Judge Barber said:
[101]Frankly, the restructuring undertaken by the dentist seems to me to be no more than a prudent format for being a dentist. The tax consequences are not in any way contrived or brought about by any artificial steps, and are not particularly great for the years now in issue. In any case, the tax consequences seem no different from those allowed non-professional persons in running their businesses through trusts or companies and, apparently, are no different from those allowed for professional persons starting up business in their particular profession. However, I shall now proceed to deal with the salient issues put to me by each party in this particular case.
…
[105]In any case as I have covered above, s 99(2) requires the tax avoidance purpose of the taxpayer to be more than "incidental". I am well aware that not only were the taxpayer and his advisers well aware of the tax savings available under the trading trust structure, but also that at least one adviser emphasised this factor to the disputant dentist's bank; although, probably, without the disputant dentist's authority. Nevertheless, standing back and looking at the evidence as a whole and bearing in mind that I find the evidence of the disputant dentist and his witnesses (and, indeed, all the respondent's witnesses also) credible, I do not regard the tax avoidance, or saving, purpose or effect to be more than "incidental" for 1995 in all the circumstances of this case.
[106]Having said that one wonders whether a tax saving is merely incidental to the arrangement if the disputant dentist controls the
income allocation between himself and his family. However, that aspect needs to be looked at in context.
…
[123]Insofar as Mr Beck submitted that the transaction must have been implemented in the particular way it was in order to achieve tax advantages, it seems to me that if a person structures his/her business activities on a corporate or trust model rather than that of a sole trader, which a businessperson must be perfectly entitled to do, it is standard practice to place some ownership of assets with the person's family whether by way of a family trust or by their holding shares in the trading company or a holding company or whatever. These situations are matters of degree bearing in mind the Commissioner of Inland Revenue v Duke of Westminster [1936] AC 1 case concept of being able to order one's affairs from the best point of view in terms of liability to income tax, and the need for there not be tax avoidance as defined by statute. I accept, of course, that the Duke of Westminster principle is abrogated by statutory provisions such as s
99.
…
[134]It is not for me to analyse precisely the type of professional and personal liability situations of concern to a dentist. However, the techniques taken after professional advice by the disputant dentist seem consistent with endeavouring to obtain asset protection and liability protection. It seems that tax saving was merely incidental for 1995.
[135] In more simple terms, I find that, prima facie, there is a tax avoidance arrangement but that for 1995 its effect is merely incidental. However, with regard to 1996 there is, presently, insufficient evidence for me to re-adjust income under s 99(3) or, put another way, it is not yet clear to me what tax was avoided for 1996 because the proper comparison may be with a corporate structure rather than with the previous sole trading situation.
[79] The next case, W33, was concerned with the 1996 year. That case was focussed to a considerable extent on the issue raised in Case V20 at paragraph [135], namely a comparison between the trading trust structure and a corporate structure. It was held that the trading trust restructuring was an arrangement, and that, for the
1996 year, the tax avoidance effect was not merely incidental, because it had been achieved by fixing the salary at an artificially low figure. Judge Barber said:
[75] Essentially, it seems to me that while, in severing himself from the structure of a two-dentist partnership, the dentist is entitled to order his affairs to minimise the incidence of income tax in terms of the Duke of Westminster principle, he needs to take care that any income tax saving from the previous business structure is "merely
incidental", and this cannot be so when he is paid an artificially low salary. …
[80] Dealing with both cases together, I agree with the thrust of Judge Barber’s reasoning in Case V20 in the passages I have cited, with one qualification. His remarks, particularly when read together with Case W33, might be taken to infer that a significant factor in holding the tax avoidance purpose or effect in 1995 to be merely incidental was the small amount of tax involved. If that is the intent of his remarks, then I would respectfully differ. In my view, the quantum of tax involved is unlikely to be, on its own, a reliable indicator of whether the tax avoidance purpose or effect is merely incidental to some other purpose. Tax avoidance may be a merely incidental purpose even though the tax advantage is large, or it may be a central purpose even though the tax advantage is small. I do not consider that, where the same arrangement is in place over multiple years, an arrangement is likely to be properly seen as merely incidental in one year but not in another, simply because the quantum of the tax advantage is different. As to the reasoning in W33, I would, for the reasons I have given, differ from Judge Barber as to the effect of paying “an artificially low salary”.
[81] For these reasons, and those I have given in considering the constituent parts of the arrangement, I have reached the view that the arrangement as a whole is not one which has the purpose or effect of tax avoidance, or, alternatively, if it does so, the that purpose or effect is merely incidental to the purpose of adopting the corporate form of practice.
Result
[82] The outcome is that the taxpayers have established that the Commissioner’s assessments are wrong, and that they are entitled to relief pursuant to s 138P of the Tax Administration Act 1994. There will be orders in each case cancelling the assessments dated 29 March 2007 (in the case of Mr Hooper) and 30 March 2007 (in the case of Mr Penny) and directing the Commissioner to make an assessment in accordance with the amounts returned by the taxpayer in each case and, in respect of the 2004 year, in accordance with each taxpayer’s NOPA. In case some more
detailed description of the appropriate relief is necessary, leave is reserved to both parties to apply further.
[83] Costs are reserved. If the parties are unable to agree, memoranda may be submitted.
“A D MacKenzie J”
Solicitors: Tomlinson Paull, Christchurch for Plaintiffs
Crown Law Office, Wellington for Defendant
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