Court of Appeal confirms Commissioner's broad powers of reconstruction
2012 case note - Commissioner's broad powers to reconstruct assessments - template, income, loss companies, arrangement, tax avoidance, reconstruction.
This case was an appeal from the High Court, which found the arrangements had the purpose and effect of tax avoidance. The Court of Appeal upheld the High Court judgment and further added that the overall scheme was the means by which the profits were laundered, together with other related income without paying income tax. Accordingly, the Court of Appeal concluded that the income is to be attributed to Mr Russell because he was the governing mind of the template arrangements, which were designed to shelter the income earned.
Impact of decision
The Court of Appeal confirmed the Commissioner's broad powers to reconstruct assessments; despite the income not being earned personally. This is a very fact-specific case.
This is an appeal from the High Court (Russell v Commissioner of Inland Revenue (No 2) (2010) 24 NZTC 24,463). In the High Court, Wylie J concluded that Mr Russell was affected by an arrangement having the purpose and effect of tax avoidance by which he obtained tax benefits. The Commissioner's assessment of Mr Russell's income was upheld.
This appeal relates mainly to the Commercial Management Partnership ("CM Partnership") whose activities during the period 1985 to 2000 were conducted by two partners, both were companies.
Both companies were controlled by Mr Russell. In addition, the individual partners would enter agency and management agreements with tax loss companies. The tax loss companies were also controlled by Mr Russell. The partners would account to the loss companies for any income earned and that income would be sheltered by the loss in the loss company. As the tax losses of any particular company were used up, a new tax loss company would be substituted in (using agency and management agreements). However, the cash would be "banked" with finance companies controlled by Mr Russell.
On filing the appeal, Mr Russell raised the four "live issues" that were addressed in the High Court and raised a further five grounds of appeal. After exchanging submissions and further oral submissions, the Court of Appeal considered that the only additional ground for which leave would be granted was the ground dealing with section 99(4) of the Income Tax Act 1976 ("the 1976 Act").
- In relation to the scope of the alleged arrangement, whether the scope of the broader arrangement was as asserted by the Commissioner and in particular, whether an arrangement requires a consensus or a meeting of minds between the parties involved that the other will act in a particular way.
- Was the alleged arrangement a tax avoidance arrangement?
- Was the appellant affected by the alleged arrangements?
- Did the appellant obtain a tax advantage from the alleged arrangements?
- Was the Commissioner correct in reconstructing the income to Mr Russell personally?
- Was the assessment process incomplete because section 99(4) of the 1976 Act had been ignored?
Scope of the arrangement
The Court of Appeal agreed with Wylie J on this issue, that there was an "arrangement" as defined in section OB1 of the 1994 Act and the anti-avoidance provisions of the 1976 Act.
There was an arrangement far broader in scope than the limited form of arrangement which Mr Russell conceded in the High Court and in his submissions. The Court of Appeal held that Mr Russell had put in place one overall arrangement and operated it over the years 1985 to 2000.
The "arrangement" did not need to obtain consensus, it just needed to be a plan, which here Mr Russell created, designed and executed.
A tax avoidance arrangement
Mr Russell sought to characterise the Commissioner's complaint regarding tax avoidance as in reality arising from the fact that the principal partners in the business had tax losses "which they reduced by their share of the profits so they did not actually pay any money to the Commissioner". He contended that if the partners had not carried forward losses, they would have paid tax on their share of the profits and that tax avoidance would not have been perceived.
The Court of Appeal found that the arrangement put in place was "contrived" and "involved pretence". The Court noted that Wylie J in the High Court found "[t]he arrangement was in my view so tortuous that it is hard to escape the conclusion it was put in place simply to obfuscate the situation and to confuse even the most diligent tax inspector".
The Court of Appeal concluded that the arrangement was clearly tax avoidance.
A person affected by the arrangement and obtaining a tax advantage
Mr Russell has always contested that he never entered into a business transaction personally, and did not personally benefit from the arrangement.
The Court of Appeal was satisfied that Mr Russell was a person affected by the arrangement. Mr Russell was a direct party to the arrangement; he controlled all the entities involved; funds were transferred to finance companies to allow him to meet his personal obligations; and he was effectively in control of untaxed money which was generated by the arrangement.
The Court of Appeal was also satisfied that Mr Russell obtained a tax advantage from the arrangement that was more than incidental as he did not pay tax on any income that was derived from the Russell template transactions.
While the Court of Appeal considered it true that the business of the CM Partnership was carried on by means of various partnership and corporate entities, these entities also did not pay income tax because of the artificial introduction by Mr Russell of the various loss companies alongside the partners to offset the net profits earned by the CM Partnership.
The Court of Appeal differed with Wylie J's reasoning that the monies resulting from the CM Partnership business ought to be characterised as "personal exertion income". Their preference was to rest their conclusion as to the purpose of the overall arrangement and the tax advantage derived from it on a broader basis. Accordingly, the Court of Appeal concluded that the overall scheme was the means by which the profits were laundered together with other related income without paying income tax.
Reconstruction to Mr Russell?
Mr Russell argued that the Commissioner should not have reconstructed the income to him personally. The Judges rejected this, recognising that the Commissioner has broad powers of reconstruction under section 99(3) of the 1976 Act. In Miller v Commissioner of Inland Revenue  1 NZLR 275 (CA), Blanchard J stated:
- Section 99(3) gives the Commissioner a wide reconstructive power. He 'may' have regard to the income which the person he is assessing would have or might be expected to have or would in all likelihood have received but for the scheme, but the Commissioner is not inhibited from looking at the matter broadly and making an assessment on the basis of the benefit directly or indirectly received by the taxpayer in question.
The Court of Appeal considered that Mr Russell "saw to it that he received only nominal income for the provision of consulting services". The Court of Appeal went on to note that substantial funds flowed into the CM Partnership and these were placed on deposit with one of the finance companies controlled by Mr Russell. The Court further noted similarities in regards to the low levels of salary received as in Penny v Commissioner of Inland Revenue  NZSC 95,  1 NZLR 433.
In the High Court, Wylie J considered that it was a decisive factor that Mr Russell was diverting into the CM Partnership the income which he generated by his personal exertions, but as mentioned above, the Court of Appeal had a differing view and said that where the income was earned by the CM Partnership and other entities within the structure that was set up, utilising the staff employed in the entities, this income ought not to be characterised as income earned by Mr Russell personally. Notwithstanding this differing view, the Court of Appeal concluded that the income is to be attributed to Mr Russell because he was the governing mind of the template arrangements, which was designed to shelter the income earned.
Section 99(4) Income Tax Act 1976
This ground of appeal was allowed to be brought despite the fact that it had not been pursued in the High Court. Mr Russell claims that the Commissioner has not completed the assessment process as required by this section. Section 99(4) provides:
- Where any income is included in the assessable income … of any person pursuant to subsection (3) of this section, then, for the purposes of this Act, that income shall be deemed to have been derived by that person and shall be deemed not to have been derived by any other person.
Mr Russell contended that on its correct interpretation section 99(4) is "instantaneous and automatic" and requires the Commissioner to make an adjustment as soon as any income is included in the assessable income of any person pursuant to section 99(3). This is because the income is deemed to have been derived by the person assessed and "shall be deemed not to have been derived by any other person". Mr Russell submitted that the failure by the Commissioner to adjust as required by section 99(4) "vitiates the assessments which should be cancelled as a result". Mr Russell was asserting that other entities had been assessed for the income which was the subject of the Court of Appeal proceeding and therefore pursuant to section 99(4), the Commissioner was prevented from assessing him for the same income personally.
The Commissioner accepted that section 99(4) provided a statutory immunity so that where any income is reconstructed under section 99(3), that income shall be deemed not to have been derived by any other person. However, the Commissioner submitted that for the taxpayer to rely on this section, he would need to show the quantum of assessable income confirmed in the CM Partnership accounts had already been assessed to some other person.
The Court of Appeal considered that if any part of the assessment made by the Commissioner in respect of Mr Russell for the income years 1985 to 2000 included income deemed by section 99(4) to be income of someone else, such an assessment is not void. However, in such a situation, it is open to the Commissioner or the Authority, to remedy the position at a later point.
The Court of Appeal agreed that for the Commissioner to remedy such a situation if he is persuaded that there is a genuine inconsistency, Mr Russell would be the person ideally placed to establish the true position and bring the inconsistency to the notice of the Commissioner.
In any event, the Court of Appeal did not see any inconsistency in effectively taxing the shareholders of the template companies on the fees paid to the Russell group of companies and also attributing those fees to Mr Russell personally for taxation purposes. The Court of Appeal recognised that money paid may often be non-deductible on one side and yet assessable to another party to whom it is paid. Linking it to the present case, the Court of Appeal said the fees paid were treated as non-deductible as they were paid for a tax avoidance scheme. However, that does not make the fees any less assessable when paid to entities established by Mr Russell as payment for services rendered.
As a consequence, Mr Russell was unsuccessful in establishing any merit in the section 99(4) point.
Income Tax Act 1976