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The Magnum case and balancing transactions
6.85 Interestingly, some people seem to have adopted that approach in analysing the Magnum scheme in the Winebox papers. It may be recalled that the core transactions in the Magnum scheme were an agreement to sell a promissory note, and another agreement to buy the same note. The Magnum scheme’s pair of transactions were, if anything, less closely interrelated than the put and call options in the exposure draft’s example. The differences are first, that the Magnum transactions were not formally part of a single agreement, and secondly that, while one party was the same in both Magnum transactions, the second parties to the two transactions were not identical but were related companies in the same group.
6.86 On their facts, and to put the matter at its lowest, there is a tenable argument that the Magnum transactions were self-cancelling and did not have the effect that was purported by their authors. In fact, in European Pacific Banking Corporation v Television New Zealand121, the Court of Appeal went further, and, taking into account the secondary facts of the Magnum scheme, held that Television New Zealand had established a seriously arguable case that the whole scheme was iniquitous. In the recent case of Peters v Davison122, the Court of Appeal confirmed its earlier opinion that the Magnum promissory note transaction could be ineffectual because of cancellation of one leg of the transaction by the other.
Difficulties of form/substance analysis
6.87 Comparing the exposure draft’s example with the Magnum scheme illustrates that form/substance analysis is much more subtle, elusive and impressionistic than would appear to be the case to a reader of the draft. The committee is concerned that, although the draft purports to be no more than a draft, and is subject to correction, the ordinary course of events would not necessarily see the necessary corrections made. If there is reliance on the period of exposure of the draft to provoke professional comment that would identify errors, that reliance may well be misplaced. Frequently, the view that the draft espouses will suit the taxpayer rather than the Commissioner. It would be a most altruistic practitioner from the private sector who would seek to correct the draft.
6.88A further cause of the committee’s concern is that, although the draft is subject to revision after exposure, at the moment it states the Commissioner’s current ‘considered views’. Have those views affected any private binding rulings that have been issued in the last few years? Have they influenced decisions about completed transactions that have come to the attention of Inland Revenue investigators? The committee cannot answer these questions, because private rulings are not published, and because decisions about individual taxpayers are confidential.
Interpretation guideline on shams
6.89 Like issues as to form and substance, questions of sham are in practice closely related to questions of avoidance, often arising in the same case. The committee considered an interpretation guideline entitled Sham - Meaning of the Term, that was published in 1997 in the Tax Information Bulletin123, and that remains in force. The guideline is an item of three or four pages much along the lines of a short expository article that one might find in a professional or scholarly journal or as part of a chapter in a text book.
6.90 The guideline mentions relevant law, draws certain conclusions, and gives some examples. However, it suffers from the same analytical shortcoming as the exposure draft on form and substance that the committee has discussed, in that the discussion takes place within an analytical framework that is not adequate. The guideline adopts a simplistic form/substance dichotomy. It does not make the point that in order to discover the true legal rights and obligations that a transaction creates courts may ask two, separate, questions, each apt for a different kind of case: form/legal substance, relevant in cases like Ensign Tankers Ltd v Stokes124, and legal substance/economic substance, relevant in cases like Wattie v CIR125.
‘No half-way house’
6.91 A second difficulty is that the guideline keeps to the framework, ‘There is no half-way house between a sham and an effective transaction.’ There are plenty of dicta in the cases that appear to support this principle, and it is accurate as far as it goes. But the principle must be understood within a wider context. That context is that, above and beyond the doctrine of sham, the courts do in fact decline to accord to certain categories of genuine, non-sham, transactions the effect that those transactions purport to have. In strict logic, these impugnable transactions are sub-categories of genuine transactions. However, their legal effect is such that they are no more effective in achieving their hoped-for tax result than if they were shams. For practical purposes, these transactions do constitute a quasi-half-way house between sham and genuine transactions.
6.92 The main inhabitants of this quasi-half-way house are: mislabelled transactions, self-cancelling transactions, and transactions that, when interpreted in context, have an effect different from the initial impression that the reader gains from one or more of the documents.126
6.93The difficulty with the department’s interpretation guideline is that most readers would take it to be comprehensive in scope, (in the sense of covering or referring to the whole relevant field, rather than in the sense of being a fully detailed analysis). The guideline reinforces this impression by quoting the ‘no half-way house’ principle, which has misled a good many readers of judicial judgments in the past. The problem is compounded by the fact that the guideline appears to be a general, authoritative statement. In contrast, reported judgments can be misleading enough, but at least most readers of law reports appreciate that statements of principle in judgments can be taken as generally authoritative only within limits.
Interpretation guidelines about legal reasoning
6.94 The committee concludes its discussion of the section 99 statement, the draft interpretation guideline on form and substance, and the guideline on shams, by reflecting on the purpose of guidelines and statements that set out not interpretations of law but, in effect, instructions or information on how to go about methods of legal reasoning. To the extent that users are Inland Revenue Department staff, the purpose is commendable and necessary: it is most important for staff to be educated in methods of legal reasoning. But interpretation statements are an awkward vehicle for such education.
6.95If interpretation statements and guidelines are to fulfil the function that their name implies, they must be reasonably concise and dogmatic. Legal reasoning has many characteristics, but concise dogmatism is not one of them. Where it is a question of education or instruction of officials on methods of legal reasoning, the conventional vehicles of text books, articles, and class instruction may be more appropriate. However, as the committee discusses below, resource constraints make this strategy not altogether practical.
6.96 The committee is also concerned about directing interpretation statements of the kind under discussion to taxpayers and practitioners. Non-specialists who do not know how this kind of statement fits into the total context of the law may be misled. Specialists do not need them, and are apt to turn them against the Commissioner.
Merits of interpretation statements and guidelines
6.97 As is apparent from the foregoing paragraphs, the committee’s discussion reflected grave misgivings about interpretation statements and guidelines that involve approaches to lines of legal reasoning rather than statements of law. The committee considered a recommendation that the Commissioner should not issue such statements and guidelines. In the end, the committee did not follow this course, for three reasons.
6.98 First, there is the question of Inland Revenue officers. The Commissioner will always have to rely on officers who do not have a deep knowledge of tax law and of legal analysis. It will never be practical or economical wholly to remedy this problem by providing enough education to train all, or even most, staff of the Inland Revenue Department as tax specialists. In the end, the committee was persuaded that non-specialists are better off with guidelines, even over-simplified and sometimes misleading guidelines, than with no guidelines at all.
6.99 Secondly, in modern public administration, New Zealanders’ expectations are such if such guidelines are published they must be made available to the public, and not kept within the department, as was the case until the enactment of the Official Information Act in 1982. If guidelines are available, particularly if they contain examples, tax advisers will sometimes rely on them to make arguments detrimental to the tax system.
6.100 Thirdly, tax law, particularly income tax law, will always have areas of uncertainty. This is particularly so for cases that depend on the application of a somewhat flexible form of reasoning rather than on relatively black letter law. Examples of such flexible forms of reasoning include: applying the principles of statutory interpretation; analysing facts according to the form/substance distinction; drawing the line between capital and revenue items; and applying the statutory anti-avoidance rule. Both taxpayers and tax advisers welcome succinct guidelines that try to reduce this uncertainty, even (or especially, depending on one’s point of view) if the reduction of uncertainty is at the expense of some erosion of the tax base.
6.101Bearing in mind the difficulties with the interpretation statements and guidelines that it has studied, the committee recommends that the government draws to the Commissioner’s attention the committee’s view that the department should:
Loss-Attributing Qualifying CompaniesReview existing interpretation statements, interpretation guidelines and public rulings that depend on high-level legal analysis in order to determine whether these statements should be revised.
Immediately withdraw any such statements that are found to be deficient, without waiting until replacement drafts are available.
In particular, immediately withdraw the 1990 policy statement on section 99 of the Income Tax Act 1976.
Where appropriate, and especially for issues involving complex reasoning, seek external expert input into interpretation guidelines and interpretation statements before they are released for public consultation.
Take particular care when including in such statements generic examples that do not incorporate contextual facts, and, in general, incorporate contextual facts in examples so that examples do not inadvertently apply to wider areas than officials intend.
Reconsider and refine the department’s apparent view on how form/substance and sham/genuine analysis should be approached.
Introduction
6.102 Having examined the general anti-avoidance rule and the department’s approach to problems of interpretation, the committee now turns to the use of some particular rules, the loss attributing qualifying companies rules, for tax planning purposes.
6.103 The qualifying companies rules form a subset of the company tax regime. The rules address a problem faced by small businesses: if they wish to obtain the benefits of limited liability and perpetual succession that are afforded by the corporate form, they lose the tax benefits of sole traders and partnerships. The qualifying companies rules allow closely held companies to be treated more or less as partnerships for tax purposes. That is, profits may be attributed directly to shareholders, without the need to go through the imputation system. In order to prevent avoidance, the qualifying companies rules are hedged around with certain formalities and anti-avoidance rules.
6.104 Loss-attributing qualifying companies are a further subset of qualifying companies. Standard qualifying companies permit profits to pass through directly to shareholders, but carry losses forward within the company. Loss attributing qualifying companies permit losses to be passed into shareholders’ personal accounts. Because of the potential for abuse, there are additional formal and anti-avoidance rules associated with loss attributing qualifying companies.
Loss attributing qualifying companies as tax planning vehicles
6.105 Tax planning structures that are marketed to the public tend to take one of a relatively small number of basic forms. One of these constitutes structures that offer clients an opportunity to take advantage of accelerated deductions. Many such structures are efficient only if there can be a number of participants. They therefore require a scheme with two characteristics: first, people can combine in groups for investment purposes; secondly, the combination can pass losses through to individual members of the group. Companies have the first characteristic, but not the second. Partnerships have the second, but, because of joint and several liability, have limited appeal for people who need to combine with strangers to join together for investment.
6.106 In the past, New Zealand taxpayers turned to the special partnership, which offered the best of both worlds: limited liability, and the ability to pass losses through to members. During the 1980s, special partnerships were popular structures for investors in films, livestock, and other investments that appeared to offer opportunities from accelerated deductions. People’s ability to use special partnerships in this manner was foreclosed from the start of the 1986-87 income year.127
6.107 Nowadays, partnerships formed of numbers of loss attributing qualifying companies fill the gap left since the demise of special partnerships. This structure can offer investors both limited liability and the pass-through of losses. They can also be large enough to gather together enough investors to obtain sufficient economies of scale to make loss-generating investments worthwhile. Two areas where they are used are forestry and intangible property depreciation schemes. There may be other areas.
6.108 Towards the end of its term, the committee became aware of an aggressive tax shelter scheme that involved the depreciation of intangible property. The marketers of the scheme recommend that customers should invest via loss attributing qualifying companies. This structure is not essential to the scheme’s operation, but there is little doubt that investing via a loss attributing qualifying company makes the scheme more attractive to participants.
Forestry
6.109 At present, in New Zealand, forestry investment enjoys a tax preferred status. That status is a matter of government policy and specific Parliamentary enactment and not an accident. The tax-preferred status is unusual, and perhaps close to unique in the current New Zealand tax system. Loss attributing qualifying companies enable middle-income people to pool funds to invest in forestry, and to take advantage of the tax preference. Without pooling funds, middle income people would find it hard to attain the economies of scale that are needed before one goes into forestry.
6.110 It may be, therefore, that, in the field of forestry, loss attributing qualifying companies are promoting government policy, though if this is so the situation has evolved rather than come about by design. The position is almost certainly otherwise in any other areas where loss attributing qualifying companies are being used to gain access to tax benefits. That is particularly so in respect of schemes that rely on claiming depreciation in respect of intangible property.
The intended role
6.111 Officials were not able to tell the committee the extent of the use of loss attributing qualifying companies for conventional, non-tax shelter purposes. However, the committee is aware that loss attributing qualifying companies do play a useful role, particularly for start-up ventures. In this context, they permit initial year losses to be transferred to business proprietors, which is an example of the reason for establishing this category of taxpayer in the first place.
Simplicity
6.112 In chapter 1 of this report, the committee explained the phenomenon that it has called the ‘fiscal paradox’. This paradox is that the more people try to make tax systems equitable, the more they make them complex. Loss attributing qualifying companies are an excellent illustration. Their objective is to eliminate tax considerations as an element in determining the appropriate structure for closely held businesses, whether company, partnership, or sole tradership.
6.113 The cost in statutory terms is a whole subpart of the Income Tax Act 1994, subpart HG, which occupies 25 pages in the 1998 reprint, not including definitions. The provisions of subpart HG show an instructive contrast to the Act’s next subpart, HH, which covers the taxation of trusts, conceptually a more complex topic, in only 15 pages. From the point of view of simplicity alone, eliminating loss attributing qualifying companies would clearly be a positive step.
6.114 The committee recommends that the government should examine loss attributing qualifying companies to determine:
Contrived Depreciation Schemes 6.115 The committee is aware of a tax shelter scheme that offers generous depreciation deductions to participants for a modest price. The scheme depends for its effect on three elements: claiming depreciation on fixed life intangible property; an asymmetry between participants, being on the one hand ordinary taxpayers and on the other hand a tax-exempt charity; and the use of a syndicate of loss attributing qualifying companies as the investment vehicle. Loss attributing qualifying companies are not essential to the operation of the scheme, but make it more attractive for participants.whether the use of loss attributing qualifying companies as tax avoidance vehicles is a threat to the tax base;
whether the use of loss attributing qualifying companies promotes a government policy of preferring forestry investment, assuming that there is such a policy;
whether, taking into account the factors listed and any other matters that appear to be relevant, the provisions as to loss attributing qualifying companies should be amended in order to prevent these companies being used as vehicles for tax shelters or, if necessary, be repealed.
6.116 The scheme provides an excellent illustration of several of the general points made in this report. First, it shows how loss attributing qualifying companies, a concept created to promote equity as to tax between sole traders and closely held companies, can be employed to facilitate the marketing of tax shelters.
6.117 Secondly, it illustrates both in this respect and in respect of fixed life intangible property the operation of the fiscal paradox128. In 1993, Parliament amended the Income Tax Act to enable people to claim depreciation allowances for fixed life intangible property in order to promote equity between businesses that use tangible (and thus depreciable, assets) and businesses that use intangible assets, which were formerly non-depreciable. Parliament’s well-intentioned measure forms the fulcrum for achieving arbitrage between the charity and scheme participants.
6.118 Thirdly, the scheme illustrates how standard approaches to statutory interpretation allow a measure that is enacted for one purpose (here, to promote horizontal equity between taxpayers) to be used for another purpose (in this scheme, to create a tax shelter). The committee discusses officials’ concern about such unintended effects in para 2.38.
6.119 Fourthly, the scheme illustrates the way in which people can take advantage of the tax exemption that is enjoyed by charities129. Indeed, the scheme constitutes a more dramatic illustration of this point than the committee had in mind when writing the part of this report that relates to tax-exempt institutions. The committee is not aware of schemes that turn on arbitrage between charities and taxpayers being marketed in New Zealand in the past, though this activity has occurred in Australia.130
6.120 Fifthly, the scheme may illustrate an unexpected problem with the rewrite’s adoption of the gross receipts approach, discussed by the committee in para 2.110 to 2.119. The problem is that section EG 1(1) allows a deduction for depreciation of ‘depreciable property’. Section OB 1 relevantly defines ‘depreciable property’ to include property that people use ‘in deriving gross income’.
6.121 Before the gross income approach was adopted, arguably entitlement to deduct depreciation allowances turned on at least an intention to derive net assessable income, even though the intention might have been unrealistic from an objective point of view. Now, it seems that an intention to derive gross income is sufficient, even though the taxpayer never expected the venture in question to result in net income that is taxable.
6.122 Sixthly, the scheme is a good example of the archetypal form of tax arbitrage between taxpaying and tax-exempt entities that is mentioned in para 4.1.
6.123 The committee was informed that the department is aware of arrangements of this type and that they are already under investigation.
Footnotes
121[1994] 3 NZLR 43 Back
122Unreported, Court of Appeal, CA 72/98, 17 November 1998 Back
123 Volume 9, No 11, page 7 Back
124 [1992] 1 AC 655, discussed in para 6.68 Back
125 (1998) 18 NZTC 13,911, discussed in para 6.69 Back
126 See Prebble J, 'Criminal Law, Tax Evasion, Shams, and Tax Avoidance: Part II - Criminal Law Consequences of Categories of Evasion and Avoidance' (1996) 2 New Zealand Journal of Taxation Law and Policy, 59, pages 63-66. The interpretation guideline mentions this third category by impli-cation in its discussion of Richardson J's judgment in Re Securitibank (No 2) [1978] 2 NZLR 136, but it does not explore the implications of the category in a manner that is sufficiently informative. Back
127 By the Income Tax Amendment Act (No 4) 1986Back
128 See paras 1.3 to 1.5 Back
129 See para 4.1 Back
130 See, for example, Prebble J, Criminal Law, Tax Evasion, Shams, and Tax Avoidance: Part II-Crimi-nal Law Consequences of Categories of Evasion and Avoidance (1996) 2 NZ Journal of Taxation Law and Policy for a discussion of an Australian scheme. Back
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