Taxation

Tax avoidance exists commonly in many societies and it is well-known that whatever individuals or organizations want to reduce tax payment and gain benefit by tax avoidance. The most common method for them is restructuring arrangements. Therefore, Inland Revenue Department (IRD) uses laws and cases to judge whether these arrangements are tax avoidance.

In this case, tax avoidance is the main problem needs to be discussed. James Smith restructured the practice arrangement, which had a high probably to cause the problem of tax avoidance. The report will show the full processes to judge James’ arrangements according to the Income Tax Act 2007, the Tax Administration Act 1994, previous cases, suggests of the Revenue Alert 11/02 and the Interpretation Statement by IRD and the parliamentary contemplation test.

Issue:
Whether there has been a tax avoidance arrangement.
The effect is on a taxpayer if it is found that a tax avoidance arrangement exists.

Law:
Income Tax Act 2007: s BC 6 Income tax liability of filing taxpayer; s BG1 Tax avoidance; s CB 1 Amounts derived from business; s CD 1–CD 6 Income and Dividend; s GA 1Cimmissioner’s power to adjust; s GB1 Arrangements involving dividend stripping; s GB27-GB29 Attribution rule for income from personal services; s GB34-GB36 Arrangements involving depreciation loss; s GB 44 Arrangements involving tax credits for families; s YA1 Arrangement; Tax avoidance; Tax avoidance arrangement.
Tax Administration Act 1994: s 141D(3) Abusive tax position; s 141FB(2) Reduction of penalties for previous behavior; s 141G(3) Reduction in penalty for voluntary disclosure of tax shortfall.
Revenue Alert 11/02
The Interpretation Statement by IRD on 13 June 2013
Cases:
Ben Nevis Forestry Venture Ltd v Commissioner of Inland Revenue [2008] NZSC 115; [2009] 2 NZLR 289; (2009) 24 NZTC 23, 188 (SC).
BNZ Investments Ltd v Commissioner of Inland Revenue (2009) 24 NZTC 23,582 (HC).
Penny v Commissioner of Inland Revenue (2011) 25 NZTC 20-073 (SC); Commissioner of Inland Revenue v Penny [2010] NZCA 231; [2010] 3 NZLR 360; (2010) 24 NZTC 24,287 (CA); Penny and Hooper v Commissioner of Inland Revenue [2009] 3 NZLR 523; (2009) 24 NZTC 23, 406 (HC) [CB, Chapter 15].
Newton v Federal Commissioner of Taxation [1958] AC 450 (PC).

Application:
The arrangement and its tax effect
According to s YA1, arrangement can be an agreement, contract, plan, or understanding, whatever enforceable or unenforceable, and it is carried into effect by all steps and transactions.

In this case, the arrangements show below: James Smith restructured the practice arrangement. James Smith set up a company named Smith Cardiac Care Limited (SCCL) in April 1998 and became the only director. The Smith Family Trust held all the shares of SCCL and James Smith is the only trustee of the Trust. Moreover, James, his wife and their children and future children and grandchildren are the discretionary beneficiaries. All of James obligations of the company at book value. SCCL decided to pay James $130000 per annum as a salary and the trust was distributed the fully imputed dividends of the company so as to accumulate the profit as a fund for school and university education of beneficiaries.

The revenue of SCCL after deducting cost was divided as two parts. One part was used to pay James’ salary income ($130000) who is the sole director of the company and the salary was fixed each year by him and was returned by him as income, which is much lower than other cardiologists paid by the public sector at $800000 per annum. For this part, James’ taxable income needed to follow the basic tax rate of the Income Tax Act as the multiplier and the top marginal rates for individuals earning more than $60000 per annum during 1998 was 33%. So James needed to pay tax up to 33%.

The rest part of profit as the income of the company should paid 33% company tax to Inland Revenue Department (IRD). After paid the tax, the gross dividend was fully imputed dividends, which was paid to the trust as the trustee income. Due to the trust is the sole shareholder of SCCL and the company had already fully paid the company tax (33%), dividend did not be taxed again. All the trust income were accumulated as fund for education and, after several years, when James’ family wants to use the fund, they do not need pay any tax because it is tax free.

The general arrangements for James’ practice is that, after deducting the cost, all the profit were treated as James Smith’s personal service income so the profit should pay up to 33% as the income tax to IRD. Taxed profit passed to trust as income, which did not need pay tax again. This kind of arrangement fulfills the general attribution rule (s GB27- GB29) shows that 80 per cent or more of the income earns from personal services by an associated service provider or a relevant of the service provider, which personally performed service. In this case, all income of SCCL was attributed by James and all income should ascertain as James personal service income and was paid the individual income tax.

There were several different between these two arrangements. First of all, James set up a company instead of doing personal practice, which includes the company paid too lower salary to James. Secondly, the profit of the company as dividend paid to trust, which paid the company tax instead of individual income tax.

The Parliamentary Contemplation Test
The Parliamentary contemplation test was started in 2008 by the Supreme Court in Ben Nevis.

Parliament intended that: * Any business profit obtained by a company is taxed (s BC 6, s CB 1 and s YA 1); * Avoiding the double tax relied on imputation regime (s GB34- s GB36); * The salary paid to individuals should match his contribution (Revenue Alert 11/02); * The company paid the taxed dividend to the shareholders relied on the amount of shares they had (s CD 1–CD 6); * The trustees based on their income paid the tax; * The accumulated fund is non- taxable for complying trust.

From the provisions identified, the following facts, features and attributes need to be present (or absent) to give effect to Parliament’s purpose: * There is a company; * James was its director; * The company operates its own business and obtains business income; * The taxed profits of the company are paid for shareholder as dividends and employee as salary; * The trust gains the dividend from the company as the trustee income; * All the trustee income was accumulated as educational fund for beneficiaries.

Commercial reality and economic effects
Before the top marginal tax rate for individuals earning increased, James Smith carried on a real business commercially and economically and obtained income from the business. There is no evidence of artificiality, pretence and circularity in the arrangement. James had real assessable income, which was paid by SCCL and his income tax followed the current marginal rate, which set by Parliament. Moreover, the family trust was the sole shareholder of SCCL and the dividend from SCCL was fully imputed dividends, which was paid the company tax. At that time, the top marginal rates for individuals earning and company tax rates were the same. In addition, in Penny and Hooperv CIR case, the Supreme Court held that the taxpayers had the right to choose use the structure of the company or the trust. James built SCCL and the family trust was legal and it was not the reason to judge the tax avoidance.

Therefore, although James restructured arrangements, which had quite different from the general arrangement, there was not any tax saving situation happened in the restructured practice arrangement.

However, after the top individual earning changed to 39%, there is evidence of artificiality, pretence and circularity in the arrangement. In terms of James’ restructured arrangements, only the part of James’ salary over $60000 needed to paid the new tax rate at 39% while for the general arrangements, all profit of SCCL treated as James’ income needed to apply the marginal tax rate, which was much larger amount of income needed to pay 39% tax than James’ restructured arrangements. In other words, the income of SCCL, except James’ salary, paid 33% company rate, which were 6% lower than the tax rate SCCL should pay. In a commercial and economic sense, SCCL rearranged arrangements to effectively enable the income earning from carrying on the business to pay a lower marginal income tax rates and take the advantage by shareholder and beneficiaries of SCCL.

Furthermore, in this case, there was another problem concerning the standard of James’ salary. Based on the Supreme Court 's judgment in Penny and Hooper v CIR, all income of SCCL directly depended on James’ personal skills, experience and reputation so the income should become James’ personal service income and should attributed to James instead of the company.

The salary as a signal revealed the contribution of the employee for the company. For IRD’s view, one of the non-arms-length factors for arrangement is that the employees cannot earn the reasonable salary comparing with the effort and achievement they put into their work and company. If employees’ personal skill and service is more professional and important for the company, they should receive higher salary and wage. For James, he is the only cardiologist of SCCL so that all revenue of SCCL relied on James, hence, James should be paid a high salary.

However, the salary of James was just $130000, which was much lower than the average salaries paid to cardiologist by the public sector at $800000 per annum.

In addition, in Penny and Hooper v CIR case, the Court held that a company director/employee could not adjust a salary of less than one fifth of an appropriate commercial salary while James’ salary was less than one fifth of the average salaries.

Reach a view on whether the arrangement has a tax avoidance purpose or effect
According to s YA1, tax avoidance includes—“(a) directly or indirectly altering the incidence of any income tax: (b) directly or indirectly relieving a person from liability to pay income tax or from a potential or prospective liability to future income tax: (c) directly or indirectly avoiding, postponing, or reducing any liability to income tax or any potential or prospective liability to future income tax”.

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 1 of its purposes or effects, whether or not any other purpose or effect is referable to ordinary business or family dealings, if the tax avoidance purpose or effect is not merely incidental”.

In this case, James changed the arrangements of income and paid the amount to shareholder as trustee income. Both in a commercial and economic sense and Parliament would expect to be subject to the income provisions.

In terms of sections BG 1 or GB 44 of the Income Tax Act 2007,before increasing the tax rate for individuals, the arrangements restructured by James did not enable SCCL get any tax advantage so there was not any tax avoidance.

While after the tax rate increase, the James and this family continue to receive the benefit of all profit distributions from the business. More importantly, the income paid 33% tax instead of 39%, which caused the company reduce the payment of tax.

In a commercial and economic sense, the company paid low salary to James, which was less than a fifth of the salaries provided to cardiologist by the public sector. The arrangement, viewed in a commercially and economically realistic way, does not use the relevant provisions in a manner that is consistent with Parliament’s purpose. Therefore, James fixed the low salary meant that he had a tax avoidance purpose and also, when the individual income tax increase, James actually paid less tax than he should be, which created the effect of tax avoidance. Like the case of Penny and Hooper v CIR,the Supreme Court thought that fixing the salary at low levels to gain the tax advantage was the main evidence to decide the tax avoidance arrangements.

There are four reasons for controller to pay less salary in the Revenue Alert 11/02 including adverse business conditions, financially prudent to retain some profits in the business due to near future possible financial difficulties, profits are set aside to acquire business assets in the following financial year and the business relates to a charity and do not sure get maximizedreturn. In this case, James did not have any reason above so he had intention to avoid the tax when restructured arrangement.

Conclusion: the arrangement has a tax avoidance purpose or effect.

Merely incidental
In the case of Newton, “merely incidental purpose or effect” refers to “something which is necessarily linked and without contrivance to some other purpose or effect so that it can be regarded as a natural concomitant” and “whether or not a tax saving purpose or effect is ‘merely incidental’ to another purpose is something to be decided not subjectively in terms of motive but objectively by reference to the arrangement itself”.

In this case, James changed the arrangements before the tax rate change so he cannot foresee when the tax rate change or it would go up or down. Moreover, after the new tax rate, James did not arrange the new arrangement. Therefore, it is clear that James took the advantage of tax was merely incidence rather than tax avoidance.

However, SCCL paid less salary to James was the key factor to confirm that James’ arrangements were tax avoidance arrangements, which was more than a “merely incidental” purpose or effect and s BG1 was applied.

The effect on a taxpayer if it is found that a tax avoidance arrangement exists. If the arrangement is void according to s BG1, the s GA 1 will be applied, which is the CIR’ power of reconstruction. The s GA 1(2) said that the taxable income arrangement, which helps taxpayers achieve the tax advantage should be adjusted by the Commissioner in the way the Commissioner thinks appropriate.The Commissioner makes adjustments following three stages are negate any tax avoidance purposes or effects that have not been counteracted by the annihilation, reinstate legitimate tax outcomes voided by the arrangement and make appropriate consequential adjustment. The first stage is whether the voiding effect of s BG1 completely counteracted the tax advantages from the tax avoidance, which means that whether the tax advantage of the tax avoidance still have influences. If it still has effect, the s GA1 will be applied and if not, it goes to next stage. The second one is whether the voiding effect of s BG1 removed any legitimate tax outcomes. If the legitimate tax outcomes are removed, thes GA1 will be applied, otherwise, it goes to next stage. The last stage is that whether any consequential adjustments required to be ensure appropriate outcomes. If yes, the s GA1 will be applied while if no, the s GA1 will not be applied.

Not only use the reconstruction of the Income Tax Act 2007, the penalties of the Tax Administration Act 1994 also applies when arrangements is void including s 141D, s 141G ands 141FB.

Rules for imposing penalties are below. First, a single breach may result in both a civil and a criminal penalty. Second, only one shortfall penalty can be imposed for each tax shortfall. Third, if a tax shortfall attracts more than one penalty, the highest is imposed. Fourth, civil penalties can be imposed after prosecution for an offence. Fifth, no prosecution if a shortfall penalty has already been imposed.

In this case, James’ taxable income should be reconstruction. The level of James’ salary should be enhanced consisting with the average level and pay the amount of shortfall during this period and three parts of penalties, which include penalty, use of money interest and late payment penalty.

Conclusion
When considering all facts and using all procedure, the restructured arrangementsby James were tax avoidance arrangements and the main reason was that James’ salary was quite low comparing with average level. Therefore, James should change salary level and pay shortfall and penalties.

(Words:2721)

List of Bibliography:
Cases
Ben Nevis Forestry Venture Ltd v Commissioner of Inland Revenue [2008] NZSC 115; [2009] 2 NZLR 289; (2009) 24 NZTC 23, 188 (SC).
BNZ Investments Ltd v Commissioner of Inland Revenue (2009) 24 NZTC 23,582 (HC).
Penny v Commissioner of Inland Revenue (2011) 25 NZTC 20-073 (SC); Commissioner of Inland Revenue v Penny [2010] NZCA 231; [2010] 3 NZLR 360; (2010) 24 NZTC 24,287 (CA); Penny and Hooper v Commissioner of Inland Revenue [2009] 3 NZLR 523; (2009) 24 NZTC 23, 406 (HC) [CB, Chapter 15].
Newton v Federal Commissioner of Taxation [1958] AC 450 (PC).

Legislation
New Zealand
Income Tax Act 2007
Tax Administration Act 1994
Interpretation Statement by IRD on 13 June 2013
Revenue Alert 11/02
Books and Chapters in books
Robert Vosslamber New Zealand Taxation 2013 (1thed, Brookers Ltd, Wellington, 2013).

--------------------------------------------
[ 2 ]. Income Tax Act 2007
[ 3 ]. Ibid.
[ 4 ]. Robert VosslamberNew Zealand Taxation 2013 (1thed, Brookers Ltd, Wellington, 2013) at [24.8.2].
[ 5 ]. Above [3] at [ 24.4.2].
[ 6 ]. Above [3] at [ 24.3].
[ 7 ]. Above [3] at [16.4.8].
[ 8 ]. Ibid.
[ 9 ]. The Interpretation Statement by IRD on 13 June 2013.
[ 10 ]. Penny v Commissioner of Inland Revenue (2011) 25 NZTC 20-073 (SC);Commissioner of Inland Revenue v Penny [2010] NZCA 231; [2010] 3 NZLR 360; (2010) 24 NZTC 24,287 (CA); Penny and Hooper v Commissioner of Inland Revenue [2009] 3 NZLR 523; (2009) 24 NZTC 23, 406 (HC) [CB, Chapter 15].
[ 11 ]. Ibid.
[ 12 ]. Revenue Alert RA 11/02
[ 13 ]. Ibid.
[ 14 ]. Above [9].
[ 15 ]. Above [1].
[ 16 ]. Ibid.
[ 17 ]. Ibid.
[ 18 ]. Above [9].
[ 19 ]. Above [11].
[ 20 ]. Newton v Federal Commissioner of Taxation [1958] AC 450 (PC)
[ 21 ]. Above [3] at [ 24.7].
[ 22 ]. Ibid.
[ 23 ]. Above [11].

Bibliography: Cases Ben Nevis Forestry Venture Ltd v Commissioner of Inland Revenue [2008] NZSC 115; [2009] 2 NZLR 289; (2009) 24 NZTC 23, 188 (SC). BNZ Investments Ltd v Commissioner of Inland Revenue (2009) 24 NZTC 23,582 (HC). Books and Chapters in books Robert Vosslamber New Zealand Taxation 2013 (1thed, Brookers Ltd, Wellington, 2013). [ 4 ]. Robert VosslamberNew Zealand Taxation 2013 (1thed, Brookers Ltd, Wellington, 2013) at [24.8.2].