Clarity, controversy, or both: Inland Revenue’s finalised guidance on tax avoidance
Introduction and high level observations
The tax community has at last received the Commissioner of Inland Revenue’s long-awaited finalised interpretation statement on tax avoidance, “Tax avoidance and the interpretation of sections BG 1 and GA 1 of the Income Tax Act 2007” (the Interpretation Statement). The Interpretation Statement has had a nearly 10 year gestation, and comes 23 years since Inland Revenue’s previous policy statement on tax avoidance.
One of the issues affecting timing has been the release of significant court decisions on tax avoidance. The need to factor in the court’s pronouncements has caused delays in producing progressive drafts of the Interpretation Statement. This issue remains even with the release of the final statement - the impending appeal of the Court of Appeal’s much-debated decision in Alesco New Zealand Ltd v Commissioner of Inland Revenue1(Alesco) concerning optional convertible note financing will provide an opportunity for the Supreme Court to again apply the “Parliamentary contemplation” test for tax avoidance established in Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue 2 (Ben Nevis). No doubt tax advisers and taxpayers alike will be interested to see if Justice Susan Glazebrook – prior to her appointment to the bench, a reputable tax lawyer and author of an authoritative text on the financial arrangements rules – is among the panel hearing the appeal.
On the positive side, the Interpretation Statement confirms the framework that Inland Revenue in all its guises (Assurance/Investigators, Litigation Management, the Disputes Review (formerly Adjudication) Unit and Taxpayer Rulings) will apply in considering issues of tax avoidance. We understand Inland Revenue will be taking steps to ensure staff are familiar with the contents of the Interpretation Statement and its approach to analysing avoidance issues, to ensure consistency. This will be helpful for taxpayers in preparing ruling applications or documents as part of the audit/disputes process.
What would have been more helpful is further examples of where Inland Revenue considers the line should be drawn by reference to real-world examples that are not at the extreme ends of the spectrum. These could presumably have been drawn from unsuccessful ruling applications, and avoidance disputes that have not proceeded beyond the Adjudication Unit. However, Inland Revenue does not see their role as giving guidance on issues close to the line.
Much of the Interpretation Statement’s 130 pages comprises a thorough and unobjectionable summary of general anti-avoidance principles, established and evolved by the courts over the years and particularly in more recent times. In developing these principles, the courts have made it clear that Parliament has chosen not to deliver certainty in this area, and so neither should the courts strive to create any greater certainty. It is difficult to argue with the proposition that the court’s task in any particular avoidance case is to resolve the dispute on the facts that are before it. However, the Supreme Court’s core test of “Parliamentary contemplation” (discussed below) has generated significant uncertainty in terms of its precise meaning and application – to be fair to Inland Revenue, the current uncertainty is not necessarily of its making.
That said, in this article we have highlighted some of the more debatable aspects of Inland Revenue’s perspective on those principles. These serve as a reminder that general anti-avoidance is not a static concept (what the courts might have viewed as acceptable 10 years ago is not necessarily immune today), and that avoidance issues turn largely on their particular facts (evidential consistency and credibility are key to successfully defending an anti-avoidance challenge). They also illustrate the value of engaging with Inland Revenue – whether through a binding ruling application, or a less formal mechanism – at the time of implementing a transaction: the aim being to safeguard, to the best extent possible, against what is a persistently murky and fluid avoidance boundary.
Flowcharts from the Interpretation Statement, illustrating the steps that Inland Revenue will take in its general anti-avoidance analysis, are set out at the end of this article.
Contemplating what Parliament contemplated
The Parliamentary contemplation test – established by the Supreme Court in Ben Nevis and now forming the crux of any general anti-avoidance analysis – has proved the most challenging aspect of the courts’ current approach on avoidance issues. This ultimate question was framed by the Court as being whether, looking at the arrangement in a commercially and economically realistic way, the arrangement made use of the specific tax rule in a manner that is consistent with Parliament’s purpose. If not, the arrangement will involve tax avoidance.
Importantly, the Interpretation Statement has confirmed that the first step in this enquiry is ascertaining Parliament’s purpose – prior to considering the “commercial reality and economic effects” of the arrangement. The Interpretation Statement notes that this is consistent with comments in Ben Nevis that the approach must be “firmly grounded in the statutory language”.
This is sensible – the most appropriate starting point in determining what Parliament contemplated must logically be the actual words that Parliament used. The Interpretation Statement also clarifies that identifying economic effects of an arrangement does not involve identifying a different arrangement that is economically equivalent (i.e. an ‘economic substance’ approach).
However, this is in stark contrast to the approach we have seen taken on many investigations, which usually commence with intense fact-gathering. There is no initial interchange of views with taxpayers regarding what Parliament’s purpose appears to be, and information requests do not appear to be guided by that identified purpose, as the Interpretation Statement requires. Often Inland Revenue’s avoidance analysis commences by identifying purported artificiality and contrivance, then asserting a different “economic reality” from the legal form, and finally contending that the tax outcome is therefore not what Parliament contemplated. It is hoped that the revised approach mandated by the Interpretation Statement – assuming it is followed by relevant Assurance/Investigations staff - will result in a more appropriate and measured invocation of the general anti-avoidance provision in an investigations/audit context.
A further more subtle issue with the Parliamentary contemplation test is the precise nature of the inquiry. In its subsequent judgment in Penny & Hooper,3 the Court said that the inquiry is whether the taxpayer altered the incidence of tax in a way that was not within Parliament’s contemplation. This is consistent with the formulation in Ben Nevis, namely whether “it is apparent that the taxpayer has used the specific provision (…) in a way which cannot have been within the contemplation and purpose of Parliament when it enacted the provision”.
The view taken in the Interpretation Statement is different, and more closely aligned with the High Court’s decision in BNZ Investments.4 There, the Court interpreted the Parliamentary contemplation test as asking whether, if Parliament had foreseen the particular arrangement when the tax rule was enacted, the arrangement would have fallen within the scheme and purpose of the rule.5
This is unquestionably the most baffling and problematic aspect of the Parliamentary contemplation test. As the courts have rightly pointed out, Parliament cannot be expected to have actually considered a particular arrangement. The challenge then is to ascertain what Parliament contemplated in a hypothetical exercise.
On the approach taken in the Interpretation Statement, there is considerable room for judicial license in deciding whether Parliament “would have” hypothetically contemplated the particular tax arrangement and tax outcomes in question. We believe this is more likely to result in the general anti-avoidance rule plugging legislative gaps and re-writing defective legislative policy, rather than leaving that task more appropriately to Parliament itself. The proper enquiry should be what did Parliament contemplate and is the tax outcome (through use of the particular tax rule in question) something that therefore “cannot” (hypothetically) have been within the contemplation and purpose of Parliament.
Finally, in terms of judicial application of the Parliamentary contemplation test, it is clear that taxpayers and advisers alike are waiting for a case closer to the boundary to be decided, in order for the courts to provide more fulsome guidance on how to draw the line. The Ben Nevis, Penny and Hooper and Alesco cases all deal with core concepts of income derivation and expenditure incurrence. It will be interesting to see if the courts hear cases going forward dealing with less fundamental concepts and issues relating to regimes that are more specifically prescribed in legislative terms.
This could involve dealing with more complex regimes, which tend to be more heavily prescribed and involve statutory or tax constructs rather than commercial concepts (and therefore, arguably, a clearer articulation in the statute of Parliament’s purpose). Examples could include regimes such as thin capitalisation, look-through company/limited partnership, tax consolidation and CFC/FIF.
In this respect the Interpretation Statement notes that, tax concepts/fictions may not necessarily have any real-world commercial or economic equivalent. This means that ascertaining Parliament’s purpose first assumes particular importance, and reducing an arrangement in that context to its most fundamental level of economic substance will not necessarily aid an understanding of whether Parliament’s purpose for the tax concept is given effect.
The need (or not) for counter-factual analysis
One of the troubling aspects of the Court of Appeal’s decision in Alesco is the Court’s view that a counter-factual analysis is not required in order to determine whether tax has been avoided. Such an analysis involves determining what other arrangement would the taxpayer have entered into, and how does the tax outcome(s) of that arrangement compare with the outcome(s) actually obtained (i.e. is any tax, which would otherwise have been payable, avoided).
The Interpretation Statement, as one would expect, adopts an approach consistent with the Court of Appeal’s decision in Alesco on this issue. This area of Inland Revenue’s framework will need to be revisited if the Supreme Court takes a different view on the Alesco appeal. In this respect, it is noteworthy that a counter-factual approach is required in Australia, and appears to be the method by which tax avoidance will be analysed under the proposed general anti-avoidance rule in the United Kingdom.6
In the absence of a counter-factual, the question of what is ‘tax avoidance’ is left begging and there is arguably a risk of the general anti-avoidance rule being applied to target ‘undesirable’ arrangements in a punitive manner.
Commissioner’s power of reconstruction
The power of the Commissioner to “counteract” tax advantages obtained under a voided tax avoidance arrangement is a broad one.
As the result of a constructive consultation process, the finalised Interpretation Statement valuably recognises that, if the voiding under the general anti-avoidance provision has removed “legitimate” tax outcomes, then the Commissioner must use her power to reinstate those outcomes.
The key issue will be determining which tax outcomes are legitimate. The Interpretation Statement sheds some light on this issue, noting that parts of an arrangement that are “so interdependent and interconnected with the tax avoidance parts as to be integral to them” would not be reinstated. This appears to provide fertile ground for discussion and debate between Inland Revenue and taxpayers in the future.
For a copy of the Interpretation Statement, please click here. If you would like to discuss any aspect of the Interpretation Statement, please contact your usual Deloitte adviser.
Flowcharts from Interpretation Statement: General Anti-Avoidance Analysis Steps
Click on image to enlarge
Click on image to enlarge
Approach to s GA 1
  NZCA 40.
  NZSC 115,  2 NZLR 289.
 Penny v Commissioner of Inland Revenue  NZSC 95,  1 NZLR 433.
 BNZ Investments Ltd v Commissioner of Inland Revenue (2009) 24 NZTC 23,582.
 See paragraphs 18, 26 and 253 of the IS.
 See HMRC’s GAAR Guidance at paragraph C2.5.
Tax Alert August 2013 contents
- Tax Alert - August 2013
- Clarity, controversy, or both: Inland Revenue’s finalised guidance on tax avoidance
- Succession and divestment
- Clarifying the tax consequences for deregistered charities
- Research and development expenditure: Deja vu?
- Bloodstock investors finish down the track
- A necessary review of allowances
- Deloitte announces new tax partner