Wham Bam, It’s A Sham – Taxation Today, December 2007

Nothing is more calculated to raise the temperature of a tax dispute than an allegation of sham, tossed by the Commissioner like a handful of chillies into the slowly cooking stew of a tax dispute.  The recent success of such allegations has been mixed, and well below the Commissioner’s usual success rate in the Courts.  This article considers why it is attractive for the Commissioner to allege sham, and the practical and ethical problems which he faces if he does so with insufficient justification.

Certainty of Contract

In a tax context, to say that a transaction is a sham is to say that it has wholly insufficient certainty to attract the claimed tax reflex.

Tax effects attach to transactions which have a sufficient level of certainty.  Sufficiency of certainty is measured by whether the parties are “definitively committed” to expenditure (see e.g. CIR v Mitsubishi Motors NZ Ltd [1995] 3 NZLR 513 PC) or when all events which fix right to income have occurred (see e.g. Hawkes Bay Power v CIR (1998) 18 NZTC 13,685 HC).

In life nothing is absolutely certain (except, of course, death and taxes). A contract may be genuinely entered into, but its performance may be thwarted in whole or in part by subsequent events, even by foreseen events.  In these circumstances cases recognise the transaction as sufficiently certain, albeit defeasible: AM Bisley & Co Ltd v CIR (1985) 7 NZTC 5,082 HC.  The fact that the limits of certainty are themselves uncertain, was mentioned in CIR v Glen Eden Metal Spinners Ltd (1990) 12 NZTC 7,270 CA per Richardson J:

“In marginal cases the distinction between a defeasible liability under which a taxpayer is definitively committed, and a contingent liability under which it is not, may not be easy to draw.”

If a transaction has sufficient certainty, then the corresponding tax consequences ensue.  If it later transpires that the transactions do not take place, then the Act provides for the necessary adjustments to be made at the time when it becomes sufficiently clear that the transaction will not take place as originally envisaged (e.g. base price adjustments, and deductions on writing off bad debts).

Sham

It is well-understood that a sham transaction is one where the acts done or documents executed by the parties to the “sham” are intended to give the appearance of creating legal rights and obligations different from the actual legal rights and obligations (if any) which they actually intend to create: Snook v London & West Riding Investments Ltd [1967] 2 QB 786 CA.  A transaction may be a sham from its inception or parties’ intentions may change and the originally genuine intention may be replaced by an understanding that the transaction will not take place as portrayed to the rest of the world: NZI Bank v Euro-National [1992] 3 NZLR 528 CA.

As mentioned above, there is no absolute certainty that any contract will be fulfilled; there is a spectrum of uncertainty and for tax purposes a distinction between the taxable and the non-taxable is made at a point in that spectrum.  But to allege sham is to allege that the transaction is at an extreme end of the uncertainty spectrum – that the parties positively do not intend that the transaction will take place (either at all, or at least in the way in which it is portrayed to the rest of the world), and so do not regard themselves as committed at all (let alone definitively) to its ostensible terms. 

Accordingly, the tax treatment of a sham transaction is that, as there is no definitive commitment or fixed right to income, there are no tax consequences.  In addition, if a taxpayer can be shown to have filed a return on the basis that sham transactions are genuine, it almost always follows that the return is fraudulent or wilfully false, such that the time bar in section 108 Tax Administration Act 1994 does not apply.  So the attractions to the Commissioner of alleging sham in a dispute are obvious: it removes the whole basis for a taxpayer’s claim, and it enables the time bar to be avoided.

Sham in the Courts

The Commissioner has had a reasonably recent win on sham in the “ACTONZ” case, Erris Promotions Ltd v CIR (2003) 21 NZTC 18,330 HC, where it was established on the basis of overwhelming evidence that some of the “software” allegedly bought either did not exist or was not owned by the purported vendor, and that these facts were known to all parties.  There appears to have been similarly overwhelming evidence in two TRA cases (TRA No 086/05; Decision No 9 /2007 and Case X10 (2005) 22 NZTC 12,155) where the stark facts required an inference to be drawn.

However, the Commissioner, at least to date, has not succeeded in sham allegations in the following recent appellate cases:

• Peterson v CIR [2006] 3 NZLR 433 PC (sham allegation abandoned by CIR after TRA decision);
• Glenharrow Holdings Ltd v CIR [2007] NZCA 346 (sham allegation abandoned by CIR after High Court decision);
• Accent Management Ltd v CIR [2007] NZCA 230 (sham not found by High Court; upheld by Court of Appeal; judgment for Commissioner on other grounds and leave given to appeal to Supreme Court).  Accent is particularly interesting in that the Court of Appeal appears to have found that the transactions in question had just sufficient certainty to merit the claimed tax consequences.

 Alleging Sham

The Commissioner is in an invidious position when he suspects that parties have no intention of carrying out a contract.  Contracts between parties are generally self-enforcing, and the cases where sham is alleged usually involve one party to the contract (who would be in a position to know) denying its genuineness in the face of another party who seeks to enforce it.  For tax purposes, the Commissioner is not in a position to enforce contracts, so cannot force the issue that way, and nor will the Commissioner be a party to the contract so cannot give direct evidence of the genuineness of the parties’ intentions.  Neither party to a suspected sham transaction is likely to be particularly interested in assisting the Commissioner in establishing that there is in fact a sham.  So the Commissioner, an outsider to the contract, has to allege that it is not genuine when the parties say it is.

To prove sham in these circumstances requires rigorous investigation, essentially (in the absence of a taxpayer confession) building an overwhelming circumstantial case that on all the evidence, the taxpayers cannot have intended that the transaction will have taken place in the way in which they pretended it would be.  This rigorous investigation will require full use of the Commissioner’s resources while keeping an open mind to other, innocent possibilities.

Faced with this daunting task if he is to prove sham, it is tempting for the Commissioner to point to the burden of proof (section 149A Tax Administration Act 1994) which requires a taxpayer to prove his or her case in the context of a tax dispute.  Why, the Commissioner may plausibly ask, should I assume the difficult task of proving sham when I can simply allege and let the taxpayers disprove if they can? 

There are two reasons why the Commissioner should not take this apparently easy route: the ethical dimension and the practical one.

The Ethical Dimension

In the writer’s view, it is bad public administration, and hence bad tax administration, to accuse a citizen of sham on insufficient grounds.  Making an allegation of sham (effectively, of fraud) can have devastating effects on a citizen and his or her family.  It is an inherently destructive act and should not be undertaken by the State in a casual or unfounded way.

The New Zealand Law Society’s Rules of Professional Conduct for Barristers and Solicitors say:

A practitioner should not be a party to the filing of a pleading or other court document containing an allegation of fraud, dishonesty, undue influence, duress or other reprehensible conduct, unless the practitioner has first satisfied himself or herself that such allegation can be properly justified on the facts of the case. For a practitioner to allow such an allegation to be made, without the fullest investigation, could be an abuse of the protection which the law affords to the practitioner in the drawing and filing of pleadings and other court documents. Practitioners should also bear in mind that costs can be awarded against a practitioner for unfounded allegations of fraud.

The writer suggests that similar standards should apply to all formal documents prepared by the Commissioner in the disputes process.

The Practical Dimension: Burden of Proof

To say that the onus is on a taxpayer to disprove sham confuses the legal and evidential burdens of proof.  The legal burden of proof determines the party who, absent any evidence, will succeed; but litigation almost always involves evidence.  The evidential burden falls on the party who has to call more evidence to establish an issue at any given phase of a trial and hence describes who will succeed at any point.  The evidential burden in any civil proceeding is hence the more important burden, and it can and often will shift throughout the trial.  It will often be the case that after the witnesses for taxpayer have given their evidence as briefed (and even after cross-examination) the evidential burden has shifted to the Commissioner, in that if the trial stopped at that stage, the Court would find in the taxpayer’s favour on the facts.  So the burden passes to the Commissioner to produce evidence which surpasses the taxpayer’s evidence.

This is especially the case when sham is at issue, because as a matter of common sense and human experience, the vast majority of transactions are genuine.  It is usually the case that even if there are causes for enquiry, a transaction will be found to be genuine and what may initially excite interest will eventually be found to have an innocent explanation.  Boring though it may be, it is nevertheless a fact that neglect, oversight and inadequacy are all more common experiences than calculated criminality.

Therefore a Court will be extremely reluctant to find sham unless it has been clearly proven by the Commissioner.  Any plausible innocent explanation will probably be preferred.

This point is neatly summarised by the speech of Lord Nicholls in Re H [1996] 1 All ER 1 HL at 16-17:

When assessing the probabilities the court will have in mind as a factor, to whatever extent is appropriate in the particular case, that the more serious the allegation the less likely it is that the event occurred and, hence, the stronger should be the evidence before the court concludes that the allegation is established on the balance of probability. Fraud is usually less likely than negligence.

These common-sense factors show how difficult it is to establish sham in an evidential vacuum.  Of course the taxpayer will say the transaction was genuine; so where does that leave the Commissioner absent any contrary evidence?

Summary

In summary, the allegation of sham is a tempting one for the Commissioner to make.  And few would deny that tax cheats should be exposed as such.  But if the Commissioner alleges sham with insufficient enquiry then that is bad tax administration, and it leads to litigation which the Commissioner is unlikely to win.