Chapter 6 - Tax Mitigation, Avoidance and Evasion

Introduction Definitions of tax mitigation, avoidance and evasion Tax avoidance in a policy framework Income tax: the general anti-avoidance rule Interpretation statements, public rulings, and product rulings Loss attributing qualifying companies Contrived depreciation schemes

Is tax arbitrage a policy problem?

6.28 In theory, cases may arise where tax arbitrage is in accordance with the policy intent of tax rules. It might, for example, ensure that the desired high level of investment is diverted to a tax-preferred activity. However, in most cases, it is contrary to the policy intent, which is to provide favourable tax treatment to a specified class of taxpayer. Tax arbitrage gives access to this preference to a much larger class of taxpayer. When taxpayers outside the specified class can access the tax preference in a way that is inconsistent with the policy intent, it is tax avoidance and thus a policy problem.

6.29 Tax incentives, concessions and loopholes in tax legislation create intended and unintended tax consequences for certain types of economic activity. Initially, this result increases the after-tax rates of return from those activities above the ‘normal’ after-tax rates of return produced by other activities, increases the value of those assets that are used by those concessionally taxed activities, and introduces inequities into the tax system by conferring windfall gains on the existing owners of those assets. However, subsequent investors in concessionally taxed activities will have to pay higher prices for those assets, and this result reduces the after-tax rates of return they earn from those activities.

6.30 This process of arbitrage will continue until the after-tax rate of return produced by the concessionally taxed activity is driven back down to the normal after-tax rates of return available from other activities. It is important to note, however, that this process of arbitrage may take some time to occur, during which taxpayers can earn higher than normal after-tax rates of return.

6.31 In other words, tax arbitrage continues until the value of the tax concession is capitalised into the price of those assets that produce the concessionally taxed income. Eventually, this process removes the initial inequities in the tax system created by those concessions. In so doing, however, it also results in a long-term over-investment in the assets required by the concessionally taxed activity. Tax arbitrage, therefore, results in inefficient patterns of investment. Ideally, anti-avoidance rules should act as a deterrent to tax avoidance arrangements.

What is a sensible policy response to tax avoidance?

6.32 The most sensible way to reduce tax avoidance is to target the conditions that make tax arbitrage possible. This approach means broadening the tax base and lowering the variability of tax rates. A number of policy considerations may make variability of rates a continuing feature of aspects of New Zealand’s tax system. As the committee noted earlier, all taxes have less than comprehensive bases. The approach that has been adopted in New Zealand has been to move as far as possible towards a broad-base, low-rate system, in particular, targeting areas in which tax arbitrage is most evident.

6.33 Examples of such measures and the tax avoidance activity they were designed to counter have been:

• Thin capitalisation rules - non-residents minimising their New Zealand tax liabilities through thin capitalisation practices.
• Transfer pricing rules - non-residents minimising their New Zealand tax liabilities through transfer pricing practices.
• Specified lease rules - finance leasing.
• Accrual rules - pre-paid interest schemes.
• Controlled foreign company and foreign investment fund rules - tax haven ‘investments’.
• Inter-corporate dividend exemption (removed) - redeemable preference share schemes.
• Section FC 11 (repealed) - assignments of income using section FC 11 in conjunction with tax-exempt entities.
• Measures relating to films and petroleum mining in the Taxation (Accrual Rules and Other Remedial Matters) Bill introduced on 17 November 1998 - film and petroleum mining investors receiving two tax deductions for, in effect, one amount of expenditure.

6.34 This legislation is a relatively detailed response to tax arbitrage. An alternative response could be to rely instead on the general anti-avoidance provisions, such as sections BG 1 and GB 1 of the Income Tax Act 1994 and section 76 of the Goods and Services Tax Act 1985. The New Zealand approach has been to rely upon the general anti-avoidance rules only as a backstop to the substantive legislation. Some commentators have argued that there is no place for general anti-avoidance provisions.

The value and limitations of general anti-avoidance rules

6.35 The argument sometimes advanced against adopting general anti-avoidance rules is that, because tax bases are less than comprehensive, tax law does not apply to theoretical concepts, but applies to detailed prescriptions of what is taxable and what is not. Income tax, for example, is not applied to ‘income’ in either an accounting or economic sense, but to what the Income Tax Act 1994 sets out to be income. If the Act does not bring something into taxable income, deriving non-taxable income cannot be said to be tax avoidance.

6.36 While this argument has a theoretical attractiveness about it, it assumes that tax policy makers can identify and deal with all the various arbitrage opportunities inherent in the tax system or live with the results of such opportunities. When this issue was previously considered¹⁰⁷, the response was to acknowledge the practical need for anti-avoidance provisions.

6.37 This approach is consistent with the government’s strategy of broadening the tax base and reducing the variability of rates. The committee recommends that the government should continue to restrict the conditions that make tax avoidance possible by continuing its broad-base, low-rate tax policy.

Income Tax: the General Anti-Avoidance Rule

6.38 In this part of the chapter, the committee proposes several amendments to the general anti-avoidance rule in sections BG 1 and GB 1 of the Income Tax Act 1994. The amendments generally clarify only and do not make any substantive changes to the ambit of the general anti-avoidance rule.

Nature of the general rule

6.39 It is uncertain whether the general anti-avoidance rule in sections BG 1 and GB 1 can be regarded as a code, so ousting common law anti-avoidance rules, such as the fiscal nullity doctrine. This doctrine has developed in the courts in the United Kingdom over the last two decades. In broad terms, it provides that any steps inserted in a related series of transactions for the purpose of avoiding tax can be disregarded by the revenue authorities, and the related transactions can be viewed as a whole.

6.40 The doctrine was first expounded in the judgment of Lord Wilberforce in Ramsay v Commissioners of Inland Revenue¹⁰⁸. It is an example of the court applying a purposive approach to construing tax legislation, and allows the court and the Inland Revenue Department to ‘see through’ a preordained series of transactions. In Ramsay, Lord Wilberforce identified three key features of avoidance schemes which earmarked them as such: their self-cancelling structure, their non-commerciality, and the expectation that all the consecutive steps in the exercise would be performed even though there was no contract stipulating that they would be.

6.41 In a later case, Inland Revenue Commissioners v Burmah Oil Co Ltd, Lord Diplock said:

It would be disingenuous to suggest, and dangerous on the part of those who advise on elaborate tax avoidance schemes to assume, that Ramsay’s case did not mark a significant change in the approach adopted by this House in its judicial role to a preordained series of transactions (whether or not they include the achievement of a legitimate commercial end) into which there are inserted steps which have no commercial purpose apart from the avoidance of a liability to tax which in the absence of those particular steps would have been payable.¹⁰⁹

6.42 The committee considers that the general anti-avoidance rule in sections BG 1 and GB 1 should not have the effect of ousting common law anti-avoidance rules, such as the fiscal nullity doctrine. The committee recommends an amendment to provide that the general anti-avoidance rule in sections BG 1 and GB 1 does not affect the application of any principles of common law. The amendment would, therefore, ensure that the courts in New Zealand would not be precluded from applying common law anti-avoidance rules, such as the fiscal nullity doctrine. A precedent for this approach is contained in section 75 of the Defamation Act 1992 which provides that nothing in the provisions dealing with absolute privilege affects any other rule of law relating to absolute privilege.

Application of the rule

6.43 The committee considers that the general anti-avoidance rule should apply automatically to any arrangement involving tax avoidance. In other words, the application of the rule should not depend on the Commissioner invoking it. The wording of the provisions makes this clear, and the judicial authority for this view is the Privy Council decision in Newton v FCT¹¹⁰.

6.44 Nevertheless, it is a common belief among tax advisers that section BG 1 is not self-actuating, and operates only if and when the Commissioner invokes it. In the committee’s opinion, people should be disabused of this belief. Accordingly, the committee recommends an amendment to make the position absolutely clear. ¹¹¹.

6.45 The automatic application of the general anti-avoidance rule is also consistent with self-assessment of tax obligations. It would provide an effective deterrent to taxpayers entering into tax avoidance arrangements and therefore help to preserve the robustness of the tax system.

Reconstruction

6.46 The committee takes the view that when the reconstruction provisions in section GB 1 are applied by the Commissioner, the effect of the section is that the reconstruction applies from the date of the original transaction that is void against the Commissioner for income tax purposes under section BG 1. The committee again considers that this current position should be made clear in the legislation, and recommends that an amendment to the legislation should be made.

Scope of the rule

6.47 If a general anti-avoidance provision is to be effective, it cannot be precise. Although this feature of an anti-avoidance provision means less certainty for taxpayers, the committee believes that this cost is outweighed by the benefit provided by the flexible wording of the general anti-avoidance rule, allowing the court to address new and different types of tax avoidance arrangements. Again, this helps to preserve the robustness of the tax system.

6.48 There is a danger, then, in being overly precise in defining the term ‘tax avoidance’, as this precision could restrict the flexibility of the courts in addressing particular tax avoidance arrangements.

6.49 The committee does not favour adopting the 1992 Valabh committee recommendations¹¹² on the general anti-avoidance rule, which sought to define its scope more precisely. The committee considers that these recommendations would make the general anti-avoidance rule less effective and less robust. In particular, the committee considers it preferable to keep the current objective nature of the general anti-avoidance rule, rather than making it more subjective as contemplated by the Valabh committee. A subjective test would make the provision too difficult for the Commissioner to apply. The committee does not endorse the benchmark criteria suggested by the Valabh committee for testing whether an arrangement constitutes tax avoidance, because this proposal could result in the courts having less flexibility to deal with particular cases, even if non-exclusive language were used in the enactment.

6.50 The committee notes that the ‘incidental’ exception in the general anti-avoidance rule did not mean minor in a quantum sense.

6.51 The committee did not identify any readily apparent way of improving the drafting of the general anti-avoidance rule apart from the clarification recommended earlier in this chapter. As discussed in para 6.34, the general anti-avoidance rule is a necessary, but not a sufficient protection of the tax base. It will continue to be necessary to counter particular types of tax avoidance by enacting legislation to address the underlying conditions that make tax avoidance possible. For example, the repeal of the inter-corporate dividend exemption in 1992 put an end to schemes involving redeemable preference shares, which had effectively allowed the trading of company tax losses between unrelated parties.

6.52 Other than amendments to clarify aspects of the present legislation, the committee favours keeping the drafting of the general anti-avoidance in substantially its present form. The committee acknowledges a trade-off in a lack of certainty for taxpayers in knowing when the boundary of acceptable tax behaviour has been crossed. However, the committee notes that this lack of certainty is partly addressed by the binding rulings system, which provides taxpayers the opportunity to obtain certainty.

6.53 In summary, therefore, the committee recommends that first, the general anti-avoidance rule in sections BG 1 and GB 1 should be clarified to ensure that it is not interpreted to preclude the application of common law anti-avoidance rules, such as the fiscal nullity doctrine. Secondly, for the avoidance of doubt, the general anti-avoidance rule should be clarified to ensure that it applies automatically, and does not depend on action by the Commissioner. Finally, an amendment should be made to clarify that any reconstruction under section GB 1 applies from the date of the original arrangement.

Interpretation Statements, Public Rulings, and Product Rulings

Introduction

6.54 The general anti-avoidance rule, among others in the Income Tax Act 1994, is broadly framed. As the committee has noted in para 6.47, it is a necessary feature of the rule that its precise scope is not clear. However, the Inland Revenue Department must apply the legislation, and to this end, from time to time, the Commissioner issues interpretation statements, interpretation guidelines, and public rulings. Incidentally to its deliberations on another topic, the committee had occasion to consider a group of several such statements of law, one of which is as yet only an exposure draft. The statements considered by the committee related broadly speaking to avoidance matters. The committee was concerned about the quality of the analysis in the statements, analysis that no doubt has an impact on decisions made within the Inland Revenue Department. The committee explains its concerns about the statements that it examined in the paragraphs that follow.

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Footnotes

¹⁰⁷ By the Consultative Committee on the Taxation of Income from Capital in Key Reforms to the Scheme of Tax Legislation, Discussion Paper, October 1991 and Final Report, October 1992 Back
¹⁰⁸ [1981] STC 174 Back
¹⁰⁹ [1982] STC 30 at 32 Back
¹¹⁰ [1958] AC 450 at 469 Back
¹¹¹While the general anti-avoidance provisions operate of their own force, at a practical level an ar-rangement will be treated as void only when the Commissioner so determines. In all cases, where the section applies, the arrangement is void for tax purposes from the outset. The Commissioner also needs to decide whether any reconstruction is required to counteract more appropriately the tax avoidance, and to issue an assessment accordingly.Back
¹¹² Consultative Committee on the Taxation of Income from Capital, Final Report, October 1992, pages 20-33 and Key Reforms to the Scheme of Tax Legislation, Discussion Paper, October 1991, pages 6-53Back