Dividend stripping assessments upheld on appeal
2014 case note – Taxpayer's appeal to High Court on dividend stripping assessments dismissed - company restructure, tax avoidance, shortfall penalties.
Income Tax Act 2004, Tax Administration Act 1994
The taxpayers' appeal of the Taxation Review Authority's ("TRA") decision upholding the Commissioner of Inland Revenue's ("the Commissioner's") assessments was dismissed. The taxpayers admitted that the restructuring of their company ownership was a tax avoidance arrangement but challenged the Commissioner's reconstruction of their income as a "deemed dividend" under s GB 1(3) of the Income Tax Act 2004 ("ITA 2004"). The imposition of shortfall penalties for taking an abusive tax position was also upheld.
Impact of decision
This is the first case in which the Commissioner's reconstruction under the dividend stripping rule in s GB 1(3) of the ITA 2004 has been considered by the High Court. The decision also reconfirms established principles around the wide powers of reconstruction under s GB 1 of the ITA 2004.
The taxpayers restructured the ownership of their two companies (Beacham Holdings Ltd ("Holdings") and Beacham Jaguar Ltd ("Jaguar")) by selling their shares in those companies to a holding company, Beacham Group Limited ("Group"). Group was incorporated for that purpose following receipt of tax advice. The taxpayers remained 50/50 shareholders and directors of Group as they had been of Holdings and Jaguar.
Prior to the restructuring, Holdings had retained profits of $1,856,277.19 and Dr Beacham's shareholder current account was overdrawn by approximately $1 million. The purchase price for the shares was $1.84 million and payment for the sale of shares was effected by way of journal entry. Group funded the purchase of the shares with an on-demand interest-free loan from the taxpayers. Following the restructure, Dr Beacham's overdrawn current account in Holdings had been repaid and there was a further $500,000 available to be drawn down in the future. The taxpayers treated the amounts received from the sale of their shares in Holdings to Group as capital.
The taxpayers' income in the 2007 income tax year was assessed by the Commissioner on the basis that:
- the $1,735,000 received from Group was deemed to be a dividend under s GB 1(3) of the ITA 2004; or alternatively,
- the amount received would be reconstructed as the taxpayers' income under s GB 1(1) of the ITA 2004.
The Commissioner also imposed shortfall penalties for taking an abusive tax position under s 141D of the Tax Administration Act 1994 ("TAA").
While the taxpayers accepted they sold their shares in Holdings to Group as part of a tax avoidance arrangement, the taxpayers argued that there was no need for any reconstruction of their income for the 2007 income tax year and that the Commissioner had exceeded the scope of her powers of reconstruction in so doing. The taxpayers argued that s BG 1 of the ITA voided the arrangements and thereby eliminated any tax benefit. The taxpayers submitted there was no outstanding tax advantage to be counteracted because the current account loans from Holdings remain payable by them for income tax purposes.
The appeal was dismissed.
The Court confirmed that s BG 1(1) of the ITA operates to void an arrangement only "as against the Commissioner for income tax purposes" and does not act to void an arrangement as between the parties to an arrangement. Although disregarding some tax avoidance arrangements will be sufficient to negate the tax advantage achieved by a taxpayer, for other arrangements, it may be necessary for the Commissioner to use Part G to counteract a tax advantage obtained from or under a tax avoidance arrangement by using her powers of reconstruction.
The Court found this was a case in which the arrangement being void against the Commissioner did not remove the tax advantage to the taxpayers. In this case the arrangement had the effect of repaying Dr Beacham's overdrawn account in Holdings, leaving the balance of the purchase price for the shares available to be accessed in the future.
Was the reconstruction carried out within the scope of s GB 1(3) or s GB 1(1)?
The only element of s GB 1(3) of the ITA 2004 that was not admitted was whether it was reasonably open for the Commissioner to form the view that the consideration received by the appellants for the sale of their shares in Holdings was "consideration in substitution for a dividend" which the appellants would have derived or might have been expected to have derived.
The Court found that the purpose and effect of the arrangement was to transfer value from the taxpayers' companies to the taxpayers themselves. Had the value been transferred directly, that consideration would have been a taxable dividend. The Court accepted the Commissioner's submissions that the concept of dividend for tax purposes was broader than that under the company law principles. The taxpayers had received the benefit of the consideration for the shares for no economic cost and after the restructure they still own the shares in Holdings (via Group). Therefore, it was reasonably open for the Commissioner to form the view that the consideration received by the taxpayers for the sale of their shares in Holdings was "consideration in substitution for a dividend" and subject to s GB 1(3) of the ITA.
The alternative basis on which the Commissioner made her assessments under the general reconstruction provision in s GB 1(1) of the ITA was also upheld. Where an arrangement is void under s BG 1 of the ITA and the taxable income of any person is affected by that arrangement, the Commissioner is entitled to adjust the amounts included in calculating the taxpayers' taxable income "in the manner the Commissioner thinks appropriate, so as to counteract any tax advantage obtained … under that arrangement".
The Court found that the Commissioner's imposition of shortfall penalties under s 141D of the TAA was correct. The Court determined that the arrangement was entered into with the dominant purpose of avoiding tax. The taxpayers did not lead any evidence to establish any commercial or other purpose for the restructuring of their companies. Goddard J found it relevant that the taxpayers' tax consultant stated the purpose of the arrangement was "to offset Mr and Mrs Beacham's (G&V) value of the shares against the overdrawn current account in Beacham Holdings Ltd …".
Further features that indicated the dominant purpose of the arrangement was to avoid tax were that:
- the structure of the arrangement meant there was no real or economic cost incurred by the taxpayers;
- the taxpayers retained their ownership or control of all the relevant companies;
- Dr Beacham's overdrawn current account with Holdings was repaid in full; and
- there were no longer any retained profits in Holdings available to be paid directly to the taxpayers.