Taxpayer only able to challenge whether Commissioner's opinion that return is fraudulent or wilfully misleading was honestly held
2015 case note – taxpayer's partially successful challenge in relation to 'insurance payments' - time bar, fraudulent or wilfully misleading, honestly held opinion.
The Taxpayers filed returns claiming deductions for payments described as being insurance payments to a captive insurance company. They subsequently accepted that they were not entitled to the deductions and sought to reverse the "insurance payments" in later years, not in the years the deductions were claimed. The Commissioner of Inland Revenue ("the Commissioner") formed the opinion that the original returns were fraudulent or wilfully misleading and, accordingly, she was not time-barred from reassessing the years when the deductions were claimed. The Commissioner also assessed evasion shortfall penalties. The taxpayers unsuccessfully challenged the time-bar issue but successfully challenged the evasion shortfall penalty.
The impacts of the decision are as follows:
- A taxpayer cannot challenge the correctness of the Commissioner's opinion formed under s 108(2) of the Tax Administration Act 1994 ("TAA") that a return is fraudulent or wilfully misleading and the Hearing Authority may not substitute its own opinion for that of the Commissioner.
- A taxpayer may only challenge whether, objectively, the Commissioner honestly held the opinion that the return was fraudulent or wilfully misleading.
- Knowledge and intention that the tax returns are wrong, or being reckless as to whether or not the returns are wrong, can be sufficient to meet the fraudulent or wilfully misleading test in s 108(2) of the TAA.
The first disputant, Mr AB, is a farmer and businessman. During the relevant period, Mr AB together with his two brothers, held shares in the second disputant, XY Construction Limited ("XYCL"). XYCL was in the business of construction and mining.
The three brothers were also, during the relevant period, in a farming partnership ("XY Partnership").
Sometime in 2004, Mr AB became interested in setting up a self-insurance scheme to provide cover to XY Partnership and XYCL as he was concerned about the increasing cost of insurance they were paying.
Mr AB discussed his proposal with his accountants ("ZK Accountants") who in turn obtained specialist tax advice on the issue.
The tax advice was that, provided the Captive Insurance Company is a genuine general insurance company and in fact can show that it is bearing genuine insurance risk itself, the insurance premium should be deductible. The tax advice also included that the Captive Insurance Company would need to comply with general insurance practices, including the payment of a $500,000 insurance bond to the Insurance Authorities.
An Australian company, CQ Construction Pty Ltd ("CQ Construction"), which was controlled by the brothers, was intended to serve as the Captive Insurance Company.
CQ Construction was not, however, in a position to pay the required $500,000 insurance bond.
It was decided that XY Partnership and XYCL were to immediately start paying premiums by way of promissory notes to the intended Captive Insurance Company (insurance payments) and to register CQ Construction as an insurer once XY Partnership and XYCL were in a position to pay the insurance bond. Mr AB also gave evidence of his intention to change the company name of CQ Construction to CQ Insurers Pty Ltd, although he never got around to doing so.
Between 2004 and 2008, XY Partnership and XYCL claimed deductions in their income tax returns for the insurance payments. ZK Accountants prepared the accounts and tax returns, only questioning whether the promissory notes had been signed but without enquiring into whether the recipient of the promissory notes had in fact been duly registered as an insurer. Evidence was given by the Accountant that she did not believe that issue to be relevant and that she had advised the disputants that they were entitled to the deductions. In hindsight, she accepted that this advice was "possibly incorrect".
For commercial and other reasons, it was ultimately decided in late 2008/early 2009 not to proceed with the registration of CQ Construction as an insurer. ZK accountants advised that the "insurance payments" claimed as deductions would now need to be reversed. This advice was acted upon in the 2008 and 2009 income tax returns.
Following a GST audit in April 2010, it was decided to widen the investigation to include XY Partnership's and XYCL's income tax returns.
The investigator's requests between November 2010 and June 2011 for the disputants to provide information and documents relating to the insurance scheme were not complied with. Eventually in February 2012 the investigator met with the disputants and was told about the intention to set up a self-insurance scheme through an Australian company, but for financial reasons had decided not to proceed as it involved payment of $500,000 to the Federal Government. Mr AB also confirmed that there were no documents relating to the proposed insurance scheme.
Following the meeting, the investigator prepared a memorandum to the departmental officer with the requisite delegate authority to reopen the time-barred income tax assessments under s 108(2)(a) of the TAA on grounds that the returns were fraudulent or wilfully misleading and involved an income equalisation scheme.
The Commissioner in later documents considered that the captive insurance arrangements did not amount to such a scheme, but based on other facts set out in the memorandum decided to proceed with opening the time bar and issued a Notice of Proposed Adjustment.
The disputants accepted that the deductions were wrongfully made and they were not entitled to them, but challenged the Commissioner's decision under s 108(2)(a) of the TAA to open the time bar for amending the assessments.
The Taxation Review Authority ("TRA") acknowledged that s 108(2)(a) of the TAA requires the Commissioner to do nothing more than form an opinion that a tax return is fraudulent or wilfully misleading. An opinion is not a concluded state of mind and is not formed as part of an adjudicative process or necessarily with full knowledge of the facts.
Ability to challenge the correctness of the Commissioner's opinion
The disputants argued in reliance on C of IR v Legarth ( NZLR 137 (CA)) that the TRA or High Court must form its own view of whether the returns are fraudulent or wilfully misleading.
The TRA did not accept the disputants' line of reasoning which had been considered in Vinelight Nominees Limited v C of IR (HC Auckland CIV 2005-404-2774, 22 July 2005), Vinelight Nominees Limited v C of IR (No 2) ((2005) 22 NZTC 19,519) and confirmed in Auckland Institute of Studies Limited v C of IR ( 20 NZTC 17,685).
These cases set out that the TAA provides for two distinct steps as part of the reassessment process. First, the need for the Commissioner to form an opinion, and second, for the Commissioner to reassess. It is only the second part of this process which can be challenged in substance.
It is clear that the taxpayer cannot challenge the correctness of the Commissioner's opinion (that the returns were fraudulent or misleading) and the Hearing Authority (the TRA or High Court) may not substitute its own opinion for that of the Commissioner. A taxpayer may only challenge whether the Commissioner honestly held the opinion and the principal issue in this case is whether on the basis of the information available to her, it was reasonably open to the Commissioner to come to the opinions that she did.
Was it reasonably open to the Commissioner to come to her opinions?
The TRA discussed the definitions of fraudulent or wilfully misleading and held that having the knowledge and intention that the returns are wrong or being reckless as to whether or not they are wrong is sufficient to meet the "fraudulent or wilfully misleading" test under s 108(2) of the TAA. The Commissioner was required to form an opinion of the disputants' state of mind when filing the returns on the basis of the evidence before her.
The TRA rejected submissions from the disputant that relevant information had been ignored and that due regard had not been had to the fact that the disputants voluntarily reversed the deductions claimed prior to any audit notification.
It was also argued by the disputants that when the Commissioner rejected the notion of the income equalisation scheme, there was no longer any basis on which to contend that the disputants had been fraudulent or wilfully misleading. This argument was rejected by the TRA which held that the Commissioner was entitled to form the view she did on the basis of the remaining facts in the memorandum.
Based on the evidence before the Commissioner, the TRA held that the Commissioner's opinion had been both honest and reasonably open to her.
Shortfall penalties under s 141E of the TAA or s 141C of the TAA
Under s141E(1)(a) of the TAA, the Commissioner can impose 150% shortfall penalties if the taxpayer evades the assessment or payment of tax.
The TRA held that the required state of mind for an "evasive intent" is a subjective test of whether the taxpayer had knowledge that the act or omission intended was wrong or acted deliberately or recklessly as to whether or not it was wrong. The TRA held that the Commissioner had not discharged the onus of proving that Mr AB on a subjective assessment did have the required evasive intent.
Instead, the TRA was satisfied that the disputants' actions amounted to gross carelessness under s 141C(1) of the TAA and that the shortfall penalty should accordingly be assessed as 40%. The test under this section is an objective one and given what Mr AB had been advised by the tax specialist, he should reasonably have made inquiries to check that the absence of a proper structure being put in place did not prevent the disputants from claiming the deductions.
Tax Administration Act 1994