Reconstruction under the "dividend stripping" provision upheld
2014 case note – CIR's reconstruction under the dividend stripping rule upheld - tax avoidance, shortfall penalties for taking an abusive tax position.
Income Tax Act 2004, Tax Administration Act 1994
The Taxation Review Authority ("TRA") upheld the Commissioner of Inland Revenue's ("the Commissioner's") assessment to reconstruct the disputants' income under section GB 1(3) of the Income Tax Act 2004.
Impact of decision
This is the first case in which the Commissioner's reconstruction under the dividend stripping rule in section GB 1(3) has been upheld by the Courts and it reconfirms established principles around the wide powers of reconstruction under section GB 1.
The disputants ("Mr and Mrs G") were the directors and shareholders of A Limited ("Holdings") and X Limited ("Specialists").
In the 2007 year, Holdings returned a taxable profit of $558,047 and had retained profits of $1,856,277. Mr G returned taxable income of $49,023 in the 2007 year but funded his lifestyle by drawing down funds from his shareholder account in Holdings. By the 2007 year, his shareholder account was overdrawn by $1,079,657.
Specialists owned a separate business venture and in the 2007 year returned a taxable profit of $653,906 but had accumulated losses of $2,237,166.
In December 2006 (after receiving tax advice), the disputants incorporated Q Limited ("Group"). On 1 February 2007, the disputants sold their shares in Holdings to Group for $1.84 million. Group funded the purchase of the shares by obtaining a loan from the disputants on a payable on demand basis.
The disputants treated the amounts they received from the sale of their shares in Holdings to Group as being capital in nature. Mr G's overdrawn shareholder current account liabilities in Holdings were repaid and funds were credited to shareholder accounts in Group. There was a further $521,913 available to be drawn down by the disputants in the future.
Specialists issued 1,949,900 shares in Holdings at a purchase price of $1,949,900 and capitalised an existing loan of $2,024,900. Specialists and Holdings agreed to set off the purchase price of $1,949,900 against the existing loan debt of $2,024,900. The Commissioner voided the arrangement under section BG 1 of the Income Tax Act 2004 and then assessed the disputants in the 2007 year on the basis that the consideration received for the sale of their shares in Holdings was in substitution for a dividend under the "dividend stripping rule" in section GB 1(3).
The disputants admitted that the sale of their shares in Holdings to Group was a tax avoidance arrangement under section BG 1. The challenge proceedings were filed on the basis that the Commissioner's reconstruction under section GB 1(3) was wrong, because the effect of section BG 1 was to void the transaction in its entirety so that there was no remaining tax advantage to the disputants. The disputants also challenged the imposition of shortfall penalties for taking an abusive tax position.
Sinclair DCJ began by referring to the following relevant legal principles in relation to the Commissioner's power to counteract a tax advantage obtained under a tax avoidance arrangement:
- Pursuant to section BG 1, a tax avoidance arrangement is void as against the Commissioner for income tax purposes; TRA 001/13  NZTRA 04 (the judgment) at , but that section BG 1 does not in itself create a liability for income tax; 
- That the Commissioner may counteract a tax advantage obtained by a person under a tax avoidance arrangement under section BG 1(2); and that, under section GB 1(1), the Commissioner may exercise her reconstructive powers in the manner as she thinks appropriate ; but that she does not have to base the adjustment on a hypothetical arrangement that the taxpayer may have entered into in the absence of the tax arrangement  (see also Accent Management Limited v Commissioner of Inland Revenue (2007) 23 NZTC 21,323 (CA);
- Under section GB 1(3), consideration under a sale of shares is deemed to be a dividend if the sale is part of a tax avoidance arrangement and some or all of the consideration received in the opinion of the Commissioner, represents, is equivalent to, or is in substitution for an amount which the person would, might be expected to, or in all likelihood would have derived as a dividend in that tax year or subsequent years, if the arrangement had not been entered into .
Her Honour rejected the disputants' submission that no tax advantage remained to be counteracted (they submitted that the effect of section BG 1 was that the loans owing to Holdings and Specialists remained owing and to be paid for income tax purposes). Sinclair DCJ held that section BG 1(1) voids the tax effect of the arrangement but does not void the underlying transaction as between the parties.
Her Honour noted that the purpose of section BG 1, and related reconstruction provisions, is to remove the tax advantage. In the present case, the sale of the shares had the effect of crediting the disputants' current accounts so that Mr G's indebtedness to Holdings was repaid. It also enabled the disputants to maintain this pattern of drawings into the future as there were still funds available to be drawn down and this resulted in a tax advantage for the disputants.
The TRA held that the consideration received by the disputant on the sale of the shares was in substitution for a dividend which the disputants "would, might be expected to, or in all likelihood would have derived or would derive" as a dividend in the 2007 tax year or subsequent years, if the arrangement had not been made and that the requirements of section GB1(3) were satisfied .
Her Honour held that the Commissioner's imposition of shortfall penalties under section 141D of the Tax Administration Act 1994 was correct.
Sinclair DCJ rejected the disputants' argument that Parliament did not intend the expression "shortfall" to apply in a case like this. Her Honour held that Parliament clearly envisaged that the exercise of the Commissioner's powers under section GB 1(3) or under section GB 1(1) of the Income Tax Act 2004 would likely result in a taxpayer facing a "tax shortfall" and a shortfall penalty. In this case the requirements for a shortfall penalty have been met.
Her Honour found that the disputants' tax position was an unacceptable tax position and that the arrangement lacked commercial reality, involved a degree of artificiality in the ownership and control of the entities and found that the arrangement had the dominant purpose of avoiding tax. Sinclair DCJ also made reference to the tax consultant's letter dated 31 August 2006, advising on the restructuring arrangement, rejecting the disputants' contention that the advice immunised them from a statutory liability for shortfall penalties.