Orthopods’ Arrangements – Orthodoxy or Avoidance?
On 4 June the Court of Appeal delivered its decision in CIR v Penny & Anor (unrep CA201/2009, judgment 4 June 2010, Hammond, Ellen France and Randerson JJ), the latest in a long line of decisions under the income tax anti-avoidance provision, now found in section BG 1 of the Income Tax Act 2007[1]. The decision allowed (by a 2:1 majority, Ellen France J dissenting) an appeal by the CIR against the High Court judgment of Mackenzie J reported as Penny v CIR; Hooper v CIR (2009) 24 NZTC 23,406.
This article outlines and analyses some aspects of the Court of Appeal’s decision.
Why is this case interesting?
Since a big loss in the Privy Council case Peterson[2] five years ago, Inland Revenue has chalked up some big wins on tax avoidance, especially the Trinity case in the Court of Appeal[3] and the Supreme Court[4], and two cases involving the trading banks[5].
This was the first case at an appellate level since that watershed loss and the succeeding wins that has examined the existence or otherwise of what might be called “organic” rather than “synthetic” tax avoidance – what the CIR says is the use or adaptation of a pre-existing business as or into a tax avoidance arrangement rather than the creation of new business which the CIR says is a tax avoidance arrangement.
It is also significant because rather than being a large scheme with many investors (such as Trinity) or a large single-entity scheme (such as any of the bank transactions) this was the first tax avoidance case for quite some time to reach the Court of Appeal involving relatively minor tax for each arrangement. As such, it represents the first wave of Inland Revenue’s assault against smaller-scale, more individuated tax saving arrangements.
The Judgments
The judgment is summarised mostly with reference to the main majority decision of Randerson J, which occupies paragraphs [1] to [131] of the judgment.
Facts in Penny & Hooper
The taxpayers practised as orthopaedic surgeons. Initially they each practised on their own account, taking the net profit as income and paying tax in their personal capacities. Later, each set up a company to purchase his practice. The companies were owned substantially by the taxpayers’ family trusts. Thereafter, each taxpayer was employed by his respective company at a salary the CIR considered to be artificially low. The balance of the practice income in each case was treated as company income, taxed at the company rate and paid by way of imputed dividend to the family trusts.
Each taxpayer’s practice was consistently profitable, at a high level. At paragraph [12] and [13] Randerson J summarises Mr Hooper’s practice’s pre-tax profit as fluctuating between $516,000 and $712,000 per annum. While the taxpayers had previously taken most of this profit as income; following the reorganisation each received a much smaller salary. In Mr Hooper’s case it was $120,000 per annum.
Mr Hooper’s trust invested the sums it received in cash and bank deposits, and in the family home and holiday home. On the other hand, Mr Penny’s trust lent the majority[6] of the sums which it received to Mr Penny, on an unsecured, interest-free basis with no term specified for repayment.
The tax advantage
The tax advantage claimed by the CIR consisted of substituting the company tax rate of 33% for the top individual rate of 39% in the years in question.
The majority found that the changed structure was a tax avoidance arrangement and the taxpayers were liable to have their personal income adjusted to reflect their practices’ entire profit less a modest discount.
The arrangement
A key concept in the scheme of section BG 1 is that of “arrangement”, defined (now in section YA 1) as “an agreement, contract, plan or understanding, (whether enforceable or unenforceable), including all steps and transactions by which it is carried into effect”. It is a tax avoidance arrangement which is void under the legislation. It follows that absent an arrangement, there can be no tax avoidance.
Although an arrangement does not necessarily need to involve the particular taxpayer as a party – Peterson v CIR [2006] 3 NZLR 433 (PC) – there must still be an arrangement which, in its ordinary meaning and as defined, comprehends a coherent plan. A mere sequence of events, each with knock-on causative consequences, will not amount to an arrangement. The concepts of contract, agreement, plan or understanding predicate some prior planned linking or sequencing or both: AMP Life Ltd v CIR (2000) 19 NZTC 15,940 (HC).
In the present case, the arrangement was defined at paragraph [71] and [77] as the adoption of the structure described above, the paying of salary less than a “commercially realistic salary” (as to which, see below) and channelling company profits to the trust, the benefit of which was available to the taxpayer. This can be conceptualised as follows, using a nominal $100 income:
Section 138G
Late in the piece, the CIR wanted to extend the defined arrangement in Mr Penny’s case to the interest free loans which he received from his trust. So rather than the arrangement being as above, the CIR wanted to introduce an extra leg, like this:
Had this indeed been the arrangement, it would have added another dimension to the argument. On the one hand, a loan is of quite different character from income and there are apparently formidable obstacles to categorising one half of a voluntary or involuntary debtor-creditor relationship as being income[7]. On the other hand, the amounts loaned to Mr Penny in each year appeared to be several times his salary, and that would raise the question as to how and when he proposed to repay them. In Richard Walter Pty Ltd v FC of T 96 ATC 4550 the Full Federal Court of Australia found loans to be a sham and, in the alternative, avoidance, when they were paid without the expectation and the ability that they would be repaid.
In the event, a potentially interesting argument was forestalled. The majority upheld the taxpayer’s submission that section 138G of the Tax Administration Act 1994 (the “evidence exclusion” provision) prohibited the CIR from relying on this as part of his claimed arrangement, although these facts could be prayed in aid as helping to show the contrivance and artificiality of Mr Penny’s arrangement.
Randerson J’s Decision
Randerson J found that the taxpayers’ arrangements, as above, were “tax avoidance arrangements” as defined and therefore void against the CIR. His Honour concluded (at para [112]) that a more than incidental purpose or effect of each arrangement was to avoid tax by altering the incidence of tax. He held that the particular reasons were:
- The taxpayers moved their own salaries down, to a noticeable extent, in the 2000 year coinciding with an increase in the top personal tax rate;
- The taxpayers’ salaries were substantially below an independent arms-length salary and “so far removed from commercial reality as to be contrived and artificial”;
- Both taxpayers continued to devote themselves to deriving income exactly as they had before the arrangements in question;
- The surplus profits to the companies went to the family trusts. The effect of that was to benefit the taxpayers and their families;
- The benefit to the family trusts could equally have been achieved by paying salaries to the taxpayers from which trust settlements could have been made;
- Given the taxpayers’ likely exposure was personal to them and/or covered and excluded by the ACC regime, asset protection was an unlikely rationale for the structure;
- The goodwill payments and restraints of trade were uncommercial.
The Internationalist
Hammond J adopted and agreed with the judgment of Randerson J (para [133]). He discussed the tension between the certainty given by “rule-based jurisprudence” and the “rounded” approach mandated by the anti-avoidance provision, colourfully dismissing the former as “what might be termed a purely doctrinal approach to taxation advice on avoidance [which] is thereby left in its twentieth century waste-paper basket”.
Despite what might be taken as apparent disdain for the previous century and all its works, Hammond J then covered some of the high points of 20th century United States and United Kingdom tax avoidance jurisprudence, which is set against Common Law rather than legislated approaches to combating tax avoidance.
With the greatest of respect, it is difficult to see the point of this exercise. The Supreme Court, despite its obviously internationally inclusive approach, found it unnecessary to consider most of this case law in “settling” the New Zealand approach to tax avoidance in Ben Nevis just 18 months beforehand. Does any tax practitioner or tax administrator really want to import, for example, the complexities and uncertainties of the United States “step transaction doctrine” or the United Kingdom “fiscal nullity” approach into our jurisprudence? Let us shudder and move on.
The Dissenter
Ellen France J dissented. She essentially agreed with the High Court judgment of MacKenzie J, for the reasons he gave[8]. She addressed three issues in particular:
- The personal services attribution rules[9] which were enacted effective 1 April 2000 had some significance because they represented an indication of the “mischief” which Parliament envisaged in this area. It required no particular “ingenuity” on these taxpayers’ part to have devised a structure, some years earlier, which fell outside these rules.
- Hadlee[10] was a case which involved assignment of income derived by that taxpayer; this decision involves the change of derivation of income and the concepts are different.
- The taxpayer’s expert witness, while straying into submission in some respects, was accepted as giving admissible evidence as to what common New Zealand models of running owner-operated businesses included. One of these factors was reduction of exposure to various claims, including negligence claims, creditors and relationship property claims. Ellen France J accepted, and relied upon, Cooke J’s acceptance in Loader v CIR [1974] 2 NZLR 472 (CA) of the normality and propriety of having closely-held companies and trusts in a taxation context.
In the author’s respectful view, Ellen France J’s reads as an orthodox, sensible judgment. It adds to, and relies upon, the orthodox and sensible judgment of MacKenzie J in the High Court. In the writer’s view, its only glaring omission is that it should have dealt (if it could) with the Privy Council decision in Mangin: see below.
Three Issues
No doubt there are scores of different viewpoints and useful things to be drawn from this judgment. Three things seem especially interesting to this author: the (apparently novel) concept of a “commercially realistic salary”, the stated and unstated (but obvious) ways in which other taxpayers can differentiate themselves from these taxpayers’ predicament, and the wider question of whether this judgment represents a new and dangerous precedent or a simple restatement of the law as it has stood since the Rolling Stones were young men.
Commercially Realistic Salary
Mt Lyne, the expert retained by the CIR, assessed the “commercially realistic salary” for the taxpayers as $558,000 for Mr Hooper and $633,000 for Mr Penny. While the Court of Appeal judgments give little detail as to how that was assessed, the following facts emerge from the High Court decision of MacKenzie J:
- Mr Lyne tried to find data on actual salaries paid to orthopaedic surgeons working as sole practitioners in salaried positions in the private sector;
- He could, however, find no comparable market evidence of any sort for orthopaedic surgeons working in such a capacity;
- This led him to suspect that comparable market information does not exist because specialist orthopaedic surgeons work on a self employed basis in the private sector rather than on a salaried basis;
- Mr Lyne considered that the salary received for public practice work would not be a suitable bench mark, because those income levels were artificially constrained by a collective agreement and a number of unspecified (in the judgment) nonpecuniary factors;
- He then concluded that in the absence of any relevant market based information, the assessment of a commercially realistic salary should be made by consideration of the earnings the specialist could derive in private practice being self employed, less the return an arms length third party owner of the practice would expect to receive from the practice to cover expenses, contingencies, and an adequate return on capital for the risks involved.
In other words, the appropriate “commercially realistic salary” was the amount which each surgeon’s practice actually derived, less a discount (it seems the discount was about 15%). That seems to be why, despite the fact that each surgeon appears to be in the same line of work, the “commercially realistic salary” for each was different.
With the greatest of respect to the majority, this aspect seems one of the least convincing parts of the CIR’s case or the majority judgment. What was set seems to be not a salary, but a profit share. A salary is usually struck on the basis of market forces between a willing employer and a willing employee. One of the things the employer wants is a certain profit; one the things the employee wants is certainty and regularity. The notion that a salary will represent the employer’s profit less a modest discount does not make a lot of sense: it would come as some (pleasant) surprise to employed solicitors in law firms to learn that their “commercially realistic salaries” should be their earnings for the firm less overheads and a modest discount, but on the other hand few employees would bargain on the basis of a salary which varied and so could (presumably) only be set and paid at the end of each year. To use words which are over-used (and sometimes abused) in the CIR’s tax avoidance dispute documents and submissions, the setting of the “commercially realistic salary” in this case seems “artificial, contrived and lacking in commerciality”.
An observation which might be usefully be made at this stage is that related party transactions can often have non-market features. Sometimes, no doubt, that will lend them all too readily to being used in a contrived and artificial manner so as to assist tax avoidance: this is why the Supreme Court in Ben Nevis[11] listed the relationship between the parties as a factor to consider in assessing whether tax avoidance exists. But a factor which the Courts need to bear in mind (and which does not, in the author’s respectful view, appear to have been taken into account sufficiently in the majority judgments) is that what will be “commercial” or otherwise as between arms-length parties will not necessarily be the same as between related parties. This is because a greater level of trust and a greater level of willingness to take the common good into account exists when one is dealing with relations between, say, family members or a taxpayer and that taxpayer’s family trust. So an undocumented interest-free loan may be wholly uncommercial in an open market context but may be normal in a family context. This makes it even more problematic to establish a realistic salary, when people in such situations may be motivated by genuine, proper and entirely non-fiscal reasons to take something other than an open market salary.
On the other hand, the adoption of a non-trivial level of salary by each taxpayer in this case may be seen as some concession on their part that a level of salary was necessary so as not to seem too unorthodox. In retrospect, might they have been better to disclaim any salary, perhaps taking instead a minority shareholding in the companies and a proportionate dividend, so as to avoid buying into an argument as to whether the salary fixed reflected a non-existent yet hypothetical “market”?
Some reassurance for taxpayers?
Accepting, as we must at least for the moment, that the majority is correct, there are a number of large crumbs of comfort which taxpayers can take from this decision.
First, Randerson J explicitly accepted at [125] that “It is important to recognise, however, that this decision should not be regarded as establishing a principle that salary levels in family companies which are below the levels which could be expected in an arms-length situation, are necessarily to be regarded, without more, as evidence of a tax avoidance arrangement.” He specifically held at [126] that the factors identified by the taxpayers and listed at para [98] were perfectly legitimate reasons why a family companies could allocate salary to their directors at a less than open market level:
- The company is in a development phase and needs to build up capital;
- The company needs to purchase a substantial asset;
- The director does not work on a full-time basis;
- The company has had a poor financial year and the profits are insufficient to pay a proper salary;
- The taxpayer wishes to donate his or her time to a company engaged in charitable purposes;
- The directors and shareholders of the company wish to maximise the transfer of the profit from the company to trustee shareholders for their benefit
Secondly, taxpayers may well be able to point to real, non-tax, reasons why they need to split business ventures off into separate entities. For example, if one taxpayer is involved in a number of different ventures, then the stakeholders in each venture (say, financiers and/or joint venturers) will want to be insulated from the possible failure of other ventures.
Finally, in the context of trading trusts involving medical professionals, it appears to be a feature of these taxpayers’ practices that there was very little fixed plant or specialist equipment which their practices utilised. Other medical practices will have a considerable amount of specialised and expensive equipment. In such circumstances it would be easier to portray the taxpayer’s contribution as just a factor (albeit, an important factor) in the total package from which the company received income.
Different from Mangin?
Forty years ago the Privy Council considered[12] an arrangement whereby the farmer taxpayer leased the most productive part of his farm in any given year to trustees, who then took the profit (after the taxpayer’s costs of harvest) and distributed it to his wife and children, thereby spreading the taxable income and reducing the overall tax burden on the farm. By a majority the Board found that the arrangement constituted a void tax avoidance arrangement, and the dissent of Lord Wilberforce turned on the inadequacies of the then legislation for reconstruction purposes rather than any doubt that what was done constituted avoidance. While tax avoidance cases tend to turn on their own facts, this long-standing precedent would seem to be a warning against attempting, in at least too artificial a manner, to dissociate a taxpayer’s income-earning structure from the taxpayer and transplant it elsewhere (such as family trusts) in a way that ensures that that income still benefits the taxpayer or at least his or her wider interests.
What are the differences between this case and Mangin’s?
One is an apparent difference of permanence. Farmer Mangin leased only the most productive parts of his farm to the trust each year, and for one year only. These taxpayers permanently divested themselves of their practices. However, to a much greater degree than a farmer who relies on the land to make a living, what is a doctor’s practice if not the taxpayers’ own skill, experience and reputation? If Mr Penny or Mr Hooper were, for whatever reason, to leave his practice and set up again on his own account, what would be left of the company? One suspects that nothing much would remain. And would there be any real enforcement of any restrictive covenants preventing either doctor from taking other work[13]? In short, the author’s view is that the difference in permanence from Mangin’s may be largely illusory.
A second apparent difference is represented by the creation of a separate company owned by the trust. The separate company puts a level of separation between the taxpayers, their trust and the income-earning structure. Yet that level of separation is not necessary for any obvious reason (in a precursor case to Penny & Hooper, which represented at least a partial win for the taxpayer, TRA Case W33 (2004) 21 NZTC 11,321, the business was carried out by the trust) and again, given the unity of ownership and absence of any convincing reason such as asset protection[14], interpolating another entity may be seen as illusory.
In summary on this point, it seems to this author that the current case represents an incremental improvement in commercial reality over the 40 year old model employed in Mangin, but at least some of that improvement may simply be window-dressing.
Summary
In summary, this case does not seem to mark a great change in the state of the law. If anything, as far as taxpayers are concerned, there are some crumbs of comfort in Randerson J’s judgment. Should these particular taxpayers appeal, and the Supreme Court, perhaps moved by the 2:2 distribution of strong judgments on each side, grant leave, then two apparent issues on the ultimate appeal strike this author quite forcefully:
- The CIR and the Court of Appeal majority’s focus on a “commercially realistic salary” was, it is respectfully suggested, neither commercial nor realistic. The relevant witness’s own evidence apparently made it clear that there is no such thing in this market. Accordingly the attempt to create one was contrived and artificial. The CIR has had a good run in recent litigation in discrediting taxpayers’ attempts to establish spurious (but lily-white) comparators with their chosen position; it ill behoves him to create hypothetical but unreal alternatives which suit his immediate litigation ends. This case should stand or fall on whether the taxpayers could transfer their practice to the company/trust structure regardless of whether they paid themselves any level of salary.
- The more fundamental question seems to be, is Mangin still good law in New Zealand? If the author’s view is correct that this case represents a slight improvement, but little more, on the facts of Mangin, then if Penny is to be considered seriously by the Supreme Court it must be on the basis that the ratio in Mangin is also up for grabs again. This would mean that there is a wider question to be considered: when there is no real justification other than tax, will a taxpayer’s simple movement of his or her income-earning structure from a less tax efficient to a more tax efficient structure never, or always, be tax avoidance, and if sometimes, then under what circumstances?
Once more the tax avoidance battle between the taxpayer and the CIR promises excitement and variety. Who needs the football World Cup?
[1] Previously section 108 of the Land and Income Tax Act 1954, then section 99 of the Income Tax Act 1976, then section BB 9 and later section BG 1 of the Income Tax Act 1994, and penultimately section BG 1 of the Income Tax Act 2004
[2] Peterson v CIR [2006] 3 NZLR 433
[3] Accent Management Ltd v CIR (2007) 23 NZTC 21,323
[4] Ben Nevis Forestry Ventures Ltd v CIR; Accent Management Ltd v CIR (2009) 24 NZTC 23,188, “Ben Nevis”
[5] BNZ Investments Ltd v CIR (2009) 24 NZTC 23,582 and Westpac Banking Corporation v CIR (2009) 24 NZTC 23,834
[6] It appears that the amounts lent to Mr Penny totalled $1,236,350 of the total $2,005,409 in fully imputed dividends which it received in the 2001-2004 period, although later in the judgment Randerson J says that 94% was lent – para [118]
[7] See e.g. “A Taxpayer” v CIR (1997) 18 NZTC 13,350 (CA) and Pattison (Inspector of Taxes) v Marine Midland Ltd [1984] A.C. 362 (HL)
[8] Para [165]
[9] Sections GC 14B to 14D Income Tax Act 1994
[10] Hadlee v CIR [1993] 2 NZLR 385 (PC)
[11] Ben Nevis Forestry Ventures Ltd v CIR; Accent Management Ltd v CIR (2009) 24 NZTC 23,188 at para [108]
[12] In Mangin v CIR [1971] NZLR 591 (PC)
[13] The judgment mentions at [22] that part of Mr Penny’s employment contract with his company included a 10-year prohibition on other work; there is no apparent reference to any restrictive covenant in the case of Mr Hooper although one would expect this to be present.
[14] The case could well be different, for example, if the interests of financiers or joint venturers required that a business structure be quarantined