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The (long awaited) IRD official position on Section BG 1
The passage of the IRD's final Interpretation Statement in relation to the General Anti Avoidance Rule ("GAAR") has parallels with the iconic Mainland cheese advertisement, "These things take time".
1990 marked the last time that the IRD issued a statement in relation to the GAAR. This 13 June 2013 Statement (“the Statement”) has had a series of iterations since its first version in 2004, with each version taking stock of notable tax avoidance cases that have populated New Zealand's courts.
The IRD's newly released official position on tax avoidance and the GAAR is a far cry from its 1990 position, and this jurisprudential journey is the stuff for university theses. The most influential judicial sea change in this area coincided with the abolition of the Privy Council (in favour of New Zealand's own Supreme Court), and also with the prominent decision in the 2008 Ben Nevis Forestry Case. This IRD exposition represents the IRD's view on the Tax Law as it stands today. Court cases will continue to test the tax avoidance boundary, and the ongoing relevance of this Statement will be dependent upon developing judicial analysis of this difficult area of law. On this point, it is with particular interest that the high profile Alesco case will shortly return to court again, with leave to appeal just recently being granted by the Supreme Court to the taxpayer.
As a starting point, we consider it important to review the newly issued Statement against the approach of modern courts to section BG 1. Viewed in this light, the Statement is a highly principled and well articulated exposition of the IRD's view of the GAAR law. It also sets out the process that IRD will follow when investigating transactions and whether tax avoidance may exist.
Following a period of digestion, we consider there to be many subtleties throughout the entire 133 page Statement. Viewing the document as a whole, readers are left with the clear impression that the IRD protects its position on every conceivable front that a tax avoidance dispute could develop on.
Nonetheless, we at EY welcome the document as, at the very least, it gives a point of reference on the potential of transactions being "at risk" of challenge from the IRD.
In the Statement, the IRD very clearly adopts the Ben Nevis Forestry Case, and with it the so called "Parliamentary Contemplation" test. From this, the IRD places enormous emphasis on the "realistic commercial and economic consequences" of transactions. Under these tests, the Statement notes that previous tax avoidance cases may have been decided differently.
In overview, the IRD states that the Parliamentary Contemplation test "asks whether the arrangement, viewed in a commercially and economically realistic way, makes use of the Act in a manner that is consistent with what Parliament would have intended for the provisions that apply (or do not apply)...". This is a two prong test, for which the better approach is to identify Parliament's purpose for the relevant statutory provisions first, and then look at the commercial and economic reality of the arrangement.
Below, we set out a number of features in the Statement that we consider will be of genuine interest to taxpayers. We also include some EY observations and conclusions, where appropriate.
- Determining Parliament’s purpose behind a Tax Act Provision?
- Commercial and economic reality of the transaction
- Classic indicators of avoidance, and substance over form
- Examples of avoidance
- Commentary on choice, on tax positive transactions, relevance of foreign tax , etc
- IRD on lack of certainty, and on the role of counterfactual positions
For more information on any of the points raised in this alert, please contact the following:
| Andy Archer |
+64 9 300 8128
+64 274 899 052
| Kirsty Keating |
+64 9 300 7073
+64 274 899 090
Determining Parliament's purpose behind a Tax Act Provision?
- Parliament's purpose is what result it meant to achieve with any particular provision. This is measured at the time the provision was enacted. There may be multiple purposes for any provision;
- In determining Parliament's purpose, the guidance is to start with the plain words. It may also be useful to reference extrinsic materials (Select Committee reports, IRD discussion documents, etc);
- The approach is a hypothetical one. Had Parliament foreseen transactions of this type when enacting the specific provisions deployed in the transactions, would it have viewed them as within the scheme and purpose of those specific provisions? (Per Wild J, in the BNZ Investments No.2 case);
- To contextualise Parliament's purpose, it is necessary to identify the relevant facts, features and attributes that Parliament would expect to be present, or absent, from the transaction;
- It may not be possible to reach an exhaustive view on what Parliament would have expected - this frequently involves matters of degree and generality;
- How Parliament's purpose is identified for any arrangement will depend on how the Act applies or does not apply by virtue of the arrangement - the enquiry may be as to the specific purpose of a particular provision, or, it may be its broader purpose in light of a particular policy objective(s).
Commercial and economic reality of the transaction
- It is imperative that the commercial and economic reality of the transaction be clearly identified;
- This determination involves a complete and thorough understanding of the facts, and a thorough grasp of the detail and workings of the arrangement as a whole. What are the real commercial and economic outcomes for the parties over the whole of the arrangements life?
To our mind, this is an undertaking by the Commissioner to fully understand the nature of transactions that taxpayers may enter into before applying BG 1. We welcome the IRD achieving a full understanding of all the relevant features of a transaction before the matter is escalated internally within the IRD for BG 1 sign off. In our experience, achieving a full understanding before alleging BG 1 is not a consistent approach across the IRD. It is hoped that this undertaking within the Statement will lead, in all instances, to a detailed period of consultation between taxpayers and the IRD before avoidance is alleged.
Our experience to date is that once an allegation of avoidance is made (having often been signed off without all the relevant facts being considered), the dye is cast and the Commissioner becomes entrenched in her position, making it difficult (if not impossible) to overturn.
In relation to the real commercial and economic outcomes, in the Ben Nevis Forestry Case, the Court held that the obligation to pay the licence premium lacked real force. Also, the so-called insurance premiums were not considered real, as the court considered no real risk was involved. In addition, the court found that there was no economic burden incurred on payment of the insurance premiums, from the use of promissory notes in the facts.
- Noting the Alesco Case, IRD states that "expenditure" requires an actual outflow of money, or an obligation to make payment. The cost must be actually borne.
On the matter of whether an economic cost or burden has been incurred, the IRD is still grappling with what this entails, for example, for non-monetary exchange of consideration, and in group situations where an issue of shares as settlement for a liability to an associated company occurs. In the Alesco decision, the court questioned whether there can be value associated with shares issued in settlement of a convertible note in circumstances where the issuer is wholly owned by the note holder. How the concepts of economic cost, risk, value and burden intermix remains untested.
- The Statement draws on the Ben Nevis Forestry Case in identifying key factors to take into account when ascertaining the all important real commercial and economic effects of an arrangement. These include, the manner in which the transaction is carried out; the role (and relationships) of all relevant parties; the economic and commercial effect of documents; the duration of the arrangement; the extent (and nature) of the financial consequences.
- IRD states that the adopted approach under Ben Nevis Forestry Case differs from previous law in so much as there is an increased focus on the commercial and economic reality of arrangements when understanding whether the use of specific tax provisions is within Parliament's contemplation. This means that previously decided cases may be decided differently under the Ben Nevis approach.
Classic indicators of avoidance, and substance over form
- IRD also approves of the so called "classic indicators" of tax avoidance, such as artificial features; whether elements of contrivance or pretence exist; circular features to transaction flows; the involvement of inflated expenditure, and reduced levels of income; the absence of real risk; and whether an arrangement is pre-tax negative in its financial outcomes.
- In applying the GAAR, IRD regards the enquiry as extending beyond the legal form of a transaction to the substance of the arrangements. "The legal structure cannot shield a transaction from substantive scrutiny" (Per Harrison J in the Westpac Case).
- The existence of commercial rationale and purposes does not preclude the intervention of the GAAR. This goes to whether the impugned tax avoidance is merely incidental.
- The IRD, however, purportedly recognises that not all complex fact situations or undesirable policy outcomes amount to tax avoidance.
It will be intriguing to see how this plays out in practice as at present, there does seem to be a correlation in the mind of the IRD between the complexity of a transaction and the likelihood of section BG 1 being invoked.
Examples of avoidance
- The Interpretation Statement uses 3 examples. However, these are only intended to "illustrate the analytical process or approach that is to be applied when considering the application of section BG 1". The examples are not to be construed as guidance as to what the IRD will consider to be tax avoidance.
This is not ideal, but given the difficulties it had with the more specific examples in the 1990 policy, the IRD is clearly not inclined to go that way again.
Commentary on choice, on tax positive transactions, relevance of foreign tax , etc
- The IRD rejects that the 'choice principle' gives immunity from the GAAR applying. This taxpayer argument posits that by taking advantage of choices recognised in the Act the taxpayer is simply making a choice expressly made available by Parliament (eg. sale or lease), and the GAAR should not be invoked.
- The IRD states that resort to the same test, whether the use of the tax provisions is within Parliament's contemplation when the reality of the arrangement is considered, is always required.
- In the Alesco Case, arguments were mounted that the particular funding instrument (the OCN), resulted in more overall tax being paid than if another debt instrument were used. IRD discounts this proposition as being a defence to a tax avoidance challenge under the GAAR.
- IRD acknowledges that the GAAR is concerned with the avoidance of New Zealand tax, and avoidance of foreign tax is outside this ambit. IRD accepts that an argument justifying an arrangement as reducing foreign taxes can represent a valid purpose. However, this is relevant when looking at the incidental test, and does not, prima facie, preclude the application of the GAAR where a New Zealand tax avoidance purpose exists in itself
IRD on lack of certainty, and on the role of counterfactual positions
- The IRD is unconcerned that the law on tax avoidance is uncertain.
- IRD references several court cases (Ben Nevis, Penny and Hooper, etc). "Parliament has left the general anti-avoidance provision deliberately general. The courts should not strive to create greater certainty than Parliament has [itself] chosen to provide".
We agree that the provision must be wide, but that was designed so that the provision can keep up with the "ingenuity" of taxpayers in novel arrangements. It was not, in our view, the intention that the GAAR should be used to cover up for lazy and ill thought out legislation, the shortcomings of which are often known about for years prior to fixing, if they are ever fixed.
Many of the recent cases involved arrangements and circumstances of which the IRD and tax policy makers had been aware of for a number of years. There was a clear opportunity to fix the perceived problems through a proper legislative change. Without such a policy driven approach in our view the policy makers do not take into account the real effects of policy change on the New Zealand tax base, and (potentially) on the economic policy for this country as a whole.
- The Statement has relied upon Alesco to support the Commissioner's view that there is no need to identify a counter factual (or alternative arrangement) in reaching a view on whether section BG 1 applies.
- This is different than in Australia and what the UK is considering on their respective GAAR where regard is had to the counter factual and the most likely alternative that would have applied "but for" the arrangement when ascertaining whether a tax advantage has been obtained.
Regardless of the Commissioner's reluctance to say so, there is almost always a point of reference when the Commissioner is dealing with cases where tax avoidance is alleged.
Examples of allegations could include the timing is too long or incorrect; the deductions are inflated (say by way of a high interest rate or because a valuation on property is unrealistically large) or a salary drawn from a business it too low.
Logic dictates that if any of these allegations are to be made, it must be shown what the "control" for the allegation is. The reference point might be: what the expected timing should be in the circumstances under a comparable arrangement, what an interest rate should have been in other circumstances, what the "true" valuation should have been, or what the salary should have been or was prior to the relevant arrangement being implemented.
This is critical since any GAAR should counteract the impugned tax benefit and no more. That tax benefit can only be truly identified via determining what the "counterfactual" would have been expected to be. Similarly, if an aspect of the transaction is considered odd, non - market or contrived, in most instances this can only sensibly be argued with a reference point.
In our experience the IRD does routinely argue in this manner but at the same time appears loath to concede that it is doing so. This aspect of the Statement, and of Alesco (to the extent it is upheld on any appeal) is particularly troubling, and allows a sloppy analysis without proper thought to what the truly objectionable feature or benefit is for the application of the GAAR and more broadly from a New Zealand tax base perspective.
Despite criticism of its practical application, and calls for legislative revision of our GAAR, we welcome this well written and presented Statement. Whilst taxpayers and advisers are still left with an uncomfortable degree of uncertainty over the application of BG 1, at least the IRD's version of how section BG 1 should be applied is now visible. Additionally, if this Statement is universally adhered to by all parts of the IRD, it is hoped that much of the inconsistency as to how section BG 1 is applied could potentially be addressed.
However, given the breadth and generality of the statutory language of the GAAR, together with the willingness of the courts to use section BG 1 as a legislative tool to ‘correct’ specific provisions (in the name of giving effect to what their Honours' view of what Parliament would have contemplated), the Statement does nothing to address the concerns of those who think legal reform is needed.
The reality is that tax avoidance is now governed by the Parliamentary Contemplation test, and this is very subjective, and also variable, depending on the viewpoint of the person applying it.
This Statement has been a long time in the making. Like a proverbial aged, fine Swiss cheese, it looks good, but in our view, there are holes in it.
The information contained in this newsletter does not constitute advice and should not be relied upon as such. Professional advice should be sought prior to action being taken on any of the information.