CIR wins New Zealand's largest tax avoidance case in High Court
2004 case note – tax avoidance and the Trinity scheme - commerciality of investment, depreciable intangible property, forestry.
Income Tax Act 1994
The Trinity Scheme involves investment in a Douglas fir forest growing in Southland, entered into between March 1997 and July 2000. Under the scheme each investor (through a series of companies and a joint venture vehicle) acquired a licence to use land for forestry purposes. The duration of the licence is 50 years, which approximates one Douglas fir growing cycle.
The licence agreement gives no title to the land or the trees but gives a right to proceeds of sale of the trees after deduction of various charges, as well as various ancillary rights, eg rights to production thinnings and biomass/pollution credits.
The investors agreed by promissory note to pay a fixed price for the licence in 50 years' time. The calculations used to fix this price were highly contentious, but were purportedly projected off an initial stumpage figure for 1997, a figure for log price growth over 50 years, and an average annual rate of inflation over 50 years. The calculations produced exponential adjustments on a year-by-year basis, and the consequent licence fee is a huge sum, being $2,050,518 per hectare. The licensee is also liable to pay the planting and maintenance expenses. The up-front fees paid (largely by promissory note) to the landowner exceeded the cost of the land.
A further aspect of the scheme for the 1997 year for Tranche 1 investors was an insurance element. The investors took out a loss of surplus insurance policy under which the insurer assumed risk for a stipulated value of the forest in the year 2048. The value (approximately $2.05 million per hectare) is sufficient to enable the investor to break even, being the amount the investors have to pay for the licence in 2047. Premiums are payable by both the investors and the landowner, with the investors paying both a cash amount in 1997 ($1,307 per hectare) and a further amount by promissory note for payment in 2047 ($32,971 per hectare). The landowner's premium is to be paid in 2047 ($410,104 to $1,230,311 per hectare, depending on the value reached).
Thus payment for the investment overall was largely on a deferred basis. Over 99% of the total expenditure claimed over the life of the investment, and 87% of the expenditure claimed for the first (1997) year is deferred until the year 2047. The two promissory notes (one to the landowner and one to the insurer) for this expenditure are limited recourse to the proceeds of forest harvest.
The investors claimed deductions for the insurance premium and forestry agency fees in full in the first year, being the year in which they were incurred. They also contended that the licence fee is deductible as depreciable intangible property under Schedule 17 of the Income Tax Act 1994. The licence fee cost is the combination of the initial payment and the amount due in year 50, which is amortised over the 50 year duration of the licence.
The Commissioner issued assessments for the 1997 and 1998 years adding back the deductions claimed in relation to the insurance premium for the 1997 year and the amortised licence premium for the 1997 and 1998 years. The Commissioner also fixed penalties in relation to the 1998 year.
The Judge held as follows on each of the issues:
Commerciality - The prospect of a positive return from the forest at maturity is unlikely but it cannot be ruled out.
Depreciation - The payment described as a licence premium is not of itself deductible pursuant to section EG(1) of the ITA.
Insurance - The insurance premiums meet the requirements of deductibility under sections BB7 and DL1(3) of the ITA and are not required to be spread under the accruals regime.
Sham - While CSI (the captive insurance company) was not in a sound financial position and Dr Muir (in particular) and Mr Bradbury had their own reasons for incorporating it and for fixing and controlling the insurance premiums to be paid to it, those factors do not of themselves support a finding of sham tax avoidance.
Tax avoidance - The dominant purpose of the arrangement was tax avoidance.
Penalties - Penalties were properly imposed under section 141D of the TAA on the basis the plaintiffs took an abusive tax position.