Default assessments for income tax and shortfall penalties for evasion, abusive tax position and gross carelessness upheld by Taxation Review Authority
2016 case note – default assessments upheld by Taxation Review Authority - suppressed income, tax avoidance, evasion penalties.
Income Tax Act 2007 ss BG 1, GA 1 and GB 27 Income Tax Act 2004 ss CA 1 and GC 14B Income Tax Act 1994 ss CH 3 and GC 14B & Tax Administration Act 1994 ss 141, 141C, 141D and 149A
The Taxation Review Authority (“the Authority”) upheld the Commissioner of Inland Revenue’s (“the Commissioner”) default assessments issued on the basis that the disputant had suppressed income by failing to return amounts paid to him and on his behalf as a condition of his employment, arranging for management fees to be paid to trusts he controlled, and by arranging for his services to be remunerated by loan payments either made to himself or his family trusts. The Authority also upheld shortfall penalties imposed for evasion, abusive tax position and gross carelessness.
The decision provides a useful statement of the standards required for the imposition of tax evasion shortfall penalties, abusive tax position penalties and gross carelessness shortfall penalties. It also reaffirms the principle in Brent v Commissioner of Taxation (1971) 125 CLR 418, that all amounts received for services rendered will be income under ordinary concepts.
The disputant challenged default assessments and separate proceedings were issued in March 2016 for the shortfall penalties issued to him by the Commissioner for the 2001 – 2009 income tax years. The assessments were issued on the basis that the disputant had suppressed income:
- by failing to return amounts paid to him and on his behalf by his employer as a condition of his employment;
- by arranging for management fees for services he performed to be paid to trusts he controlled; and
- by arranging for his services to be remunerated by receipt of loan payments either made to himself or his family trusts.
In addition, the Commissioner imposed shortfall penalties, which the disputant also challenged. By consent, both challenges were heard together.
The disputant is a businessman who was involved in the management and control of a number of companies during the relevant tax years. During this period he enjoyed a comfortable lifestyle and accumulated substantial assets. He achieved this using various payment arrangements and a number of different companies and trusts.
The investigation into the disputant’s tax affairs was complex and took a number of years. The Authority noted that the disputant took an obstructive position and had been convicted of aiding and abetting his wife in obstructing Inland Revenue officers executing a search warrant and he had also been convicted of failing to comply with a notice issued under s 17 of the Tax Administration Act 1994 (“the TAA”).
During the 2001 – 2003 tax years the disputant was employed by GPL. He received a minimal salary and paid a small amount of PAYE. GPL paid the disputant’s personal and living expenses, totalling $220,974.16. The Commissioner assessed these payments as employment income or alternatively as income under ordinary concepts or as part of a tax avoidance arrangement.
After this period the disputant worked for a group of entities controlled by a businessman referred to as Mr Smith. The group of entities, described as the Q/C Entities, involved a complex structure of companies and trusts which grew rapidly in the 2002 – 2007 period.
In the 2004 – 2008 tax years, the Q/S Entities paid various amounts of management fees to the disputant’s family trusts (the AF 2 Trust, AF Trust and Y Trust) for services provided by the disputant. The Commissioner assessed these fees as attributable to the disputant under the personal services attribution rule or in the alternative, as part of a tax avoidance arrangement. The Commissioner also assessed management fees of $40,000 and $180,000 charged by the AF 2 Trust solely as being part of a tax avoidance arrangement.
In 2006, the disputant received $600,000 which he says was a loan from QLL. The funds were paid from a facility that QLL had with X Finance Co. The Commissioner assessed this amount as income to the disputant under ordinary concepts.
Finally in the 2004 – 2009 tax years, the disputant and/or trusts associated with him (his family trusts and R Trust) received loans from the Q/S Entities. The Commissioner contended that these loans were received as part of a tax avoidance arrangement.
The disputant initially maintained that the payments from GPL towards his personal and living expenses were a loan to him or the AF2 Trust. This was in direct contradiction to an affidavit the disputant had sworn during separate court proceedings in 2003. At the end of the hearing the disputant conceded that these payments were employment income but contended that the total amount should be reduced by the sum of $100,000 (which was a repayment by the disputant and the AF 2 Trust under a settlement agreement with GPL and other shareholders of GPL).
The Authority did not accept that the payments made by GPL were a loan or that the $100,000 settlement amount related to repayment of the alleged loan.
The Authority was satisfied that the disputant received the total amount of $220,974.16 over the 2001 – 2003 income years for personal services provided by him to GPL and that these payments were income to the disputant under s CH3 of the Income Tax Act 1994.
The Commissioner alleged that various management fees derived by the disputant’s family trusts were attributable to the disputant under the personal services attribution rule (GB 27 of the Income Tax Act 2007 and GC 14B of the Income Tax Act 1994 and 2004). Following the completion of evidence the disputant conceded that these fees were attributable to him.
X finance co payment
The Commissioner contended that a payment of $600,000 made to the disputant in 2006 was consideration for services rendered by the disputant and is income under ordinary concepts. The Authority recognised the principle that “under ordinary concepts all amounts received from the provision of services whether as an employee or independent contractor is income” and cited Brent v Commissioner of Taxation (1971) 125 CLR 418.
The disputant entered into an agreement to purchase an apartment in 2005 and the balance of the purchase price ($600,000) was paid using funds drawn down on QLL’s loan facility with X Finance Co. The disputant submitted that the sum was a loan from QLL which had been secured by a caveat over the apartment. However, no caveat was registered on the title. In 2005 the disputant borrowed $500,000 from Z Bank, which was secured against the apartment. The disputant stated that this other loan was used to repay the advance from X Finance Co.
The Authority however found that there was no evidence of the $600,000 payment being a loan from QLL.
The disputant also submitted that it was a reasonable inference that the $500,000 loan from Z Bank was used for investment purposes in the Q Group, and was in effect a partial repayment of the $600,000 to QLL. The Authority found that there was no sufficient factual basis for such an inference as there were no records as to where the funds were paid.
The Authority found that the disputant was unable to discharge the onus that the Commissioner was wrong in her assessment that the $600,000 payment was income under ordinary concepts.
Tax avoidance arrangements
The Commissioner contended that there were two discrete tax avoidance arrangements:
- the “Management Fee Arrangement” (limited to the payments of $40,000 in 2003 and $180,000 in 2004 due to the disputant’s concession that the management fees were properly assessed under the personal services attribution rule); and
- the “Q/S Entities Loan Arrangement”, where instead of receiving income that was commercially realistic for the services rendered to the Q/S Entities, the disputant and/or his trusts received loans.
The Authority treated these arrangements individually, applying the two-stage analysis in Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue  NZSC 115,  2 NZLR 289 (“Ben Nevis”).
First arrangement: management fees arrangement
Was there an arrangement?
The Authority accepted the arrangement as defined by the Commissioner, describing the arrangement as: the AF 2 Trust contracted with DML and the QL Trust for the provision of management services which were provided by the disputant. AF 2 Trust charged management fees to these entities. The disputant and his family were beneficiaries of the AF 2 Trust. While the disputant resigned as a trustee in 2003, he remained in control of the AF 2 Trust (including its bank accounts) and made decisions for this trust. The disputant used the management fees paid to the AF 2 Trust for his benefit and that of his family. The tax effect of the arrangement was that the AF 2 Trust derived the management fees and became liable for the tax rather than the disputant. The AF 2 Trust did not return the income and nor did it pay the disputant for his services.
Specific provisions? (Ben Nevis stage one inquiry)
The Authority agreed with the Commissioner that the disputant avoided s CH 3 (employment income) and s CD 5 (income under ordinary concepts) of the Income Tax Act 1994 (and the comparable provisions in the 2004 Act - Sections CE 1 and CA1(2)) by ensuring that the funds that would be his income for services rendered were received by the AF 2 Trust. The Authority also agreed that Parliament would not have contemplated that either of those provisions could be bypassed through the use of an artificial and contrived agreement that lacked commercial merit.
Parliamentary contemplation? (Ben Nevis stage two inquiry)
The Authority acknowledged that the facts were similar to Penny & Hooper  NZSC 95,  1 NZLR 433, and outlined the Supreme Court decision.
The Authority stated that Parliament would not have contemplated that the disputant could divert income earned from his personal exertions to his family trust without being paid a market salary where the disputant still continued to enjoy the benefit of those funds. The Authority did not consider that there could be any commercial explanation for the structure and in all the circumstances, it found the arrangement to be artificial and contrived.
The Authority was satisfied that taking all the factors into account, the purpose or effect of this arrangement was one of tax avoidance.
Tax purpose or effect of the arrangement more than merely incidental
On the basis that the arrangement was contrived and artificial and lacked any commercial reality, the Authority held that the tax avoidance purpose or effect of the arrangement was more than merely incidental to any other purpose or effect.
Counteracting the tax advantage?
The Authority was satisfied that the management fee arrangement was a tax avoidance arrangement, and agreed with the Commissioner’s reconstruction of the disputant’s income on the basis that the management fees paid to AF2 trust were the income of the disputant.
Second arrangement: Q/S Entities loan arrangement
Was there an arrangement?
The Authority accepted that during the 2004 - 2009 tax years there was a pattern of substantial loans made to the disputant or his trusts by the Q/S Entities, where there were no specific loan agreements, no requirements to pay interest and no provision for repayment. These loans were used to pay the living and other expenses of the disputant and his family. Over the same period the disputant received employment income on which he paid PAYE fixed at a rate which was not in any way commensurate with his various management positions.
The Authority accepted that there was an arrangement involving the steps as identified by the Commissioner.
Specific Provisions? (Ben Nevis stage one inquiry)
The Authority stated that Parliament would not have contemplated that ss CE 1 (employment income) and/or CA 1(2) (income under ordinary concepts) of the Income Tax Act 2007 (and the comparable provisions in the earlier Acts - ss CE 1 and CA 1(2) of the Income Tax Act 2004 and ss CH 3 and CD 5 of the Income Tax Act 1994)could be bypassed in the way that has occurred in this arrangement.
Parliamentary Contemplation? (Ben Nevis stage two inquiry)
The Authority noted that the Commissioner did not dispute that the amounts were loans, before outlining the analogous decision of Krukziener v Commissioner of Inland Revenue (2011) 25 NZTC 20-055 (HC) (“Krukziener”). In Krukziener, Courtney J held that a genuine loan does not necessarily mean that there cannot be a tax avoidance arrangement.
The Commissioner contended that the commercial and economic reality of the arrangement, notwithstanding the legal form, was that the amounts paid as loans were paid because of services provided to the Q/S Entities by the disputant. The Authority agreed with the Commissioner and stated that the disputant’s $36,000 income did not reflect the disputant’s roles and work responsibilities. The loans, totalling $7,302,275, were used as income subsidies to fund the disputant’s living and other expenses. The Authority stated that, though in theory, the loans had to be repaid, the disputant continued to have control of and access to the funds, there was no commercial rationale for the loans (the disputant and/or his trusts would not be able to repay the loans), interest was not charged (except in the 2007 year) or paid, and no provision or efforts were made for repayment.
The Authority agreed with the Commissioner that the disputant received the loans as income substitutes and the fact that they were used to purchase capital assets does not convert those payments into capital receipts.
The Authority was satisfied that viewed in a commercially and economically realistic way, the arrangement circumvents the relevant provisions in a way which Parliament would not have contemplated.
Tax purpose or effect of the arrangement more than merely incidental
The Authority stated that the arrangement lacked any commercial reality, and the only purpose or effect of the arrangement was tax avoidance.
Counteracting the tax advantage
The Authority accepted the Commissioner’s reconstruction of the loans as the disputant’s income as being well within the Commissioner’s discretion and appropriate in the circumstances. The Authority did not accept the disputant’s attempt to raise the issue of apportionment, as the disputant had not established a factual foundation for the issue.
The Commissioner assessed the disputant for shortfall penalties at different rates: evasion penalties in relation to the payments received from GPL; abusive tax position penalties in relation to the loans from Q/S Entities, the payment from X Finance Co and the management fees; and gross carelessness penalty for the DML payment.
Tax evasion shortfall penalties – payments by GPL
The Commissioner argued that the taxpayer was liable to pay an evasion shortfall penalty under s 141(1)(a) of the TAA. The Authority, adopting the Commissioner's analysis, concluded that the disputant was well aware that he was required to pay tax on the income earned by him as an employee of GPL, including on the expenses paid on his behalf by that company, and he deliberately failed to do so.
The Authority stated that evasion requires intentional behaviour or subjective recklessness. Subjective recklessness requires actual awareness of the risk of breaching the obligation. It observed that the disputant was an experienced businessman who has managed and owned a number of companies in different industries. It accepted that he was knowledgeable about tax matters (although it noted that it does not require sophisticated knowledge to be aware of the obligation to pay tax on employment income). The Authority found that the Commissioner had satisfied her onus of proof. The shortfall penalties for evasion were properly imposed.
Abusive tax position penalties - Q/S loan, the X finance Co payment and management fees
The Authority found that, regarding these payments, the disputant took a tax position which, viewed objectively, was not likely to be correct. The Authority was also satisfied that he took these tax positions with the dominant purpose of avoiding tax. The Authority concluded that the disputant took an abusive tax position and that the Commissioner was correct to impose penalties under s 141D of the TAA in respect of these payments.
Gross carelessness shortfall penalty – the DML payment
The Authority decided that a shortfall penalty for gross carelessness was properly imposed, finding that a reasonable person in the disputant’s position, with his experience, would have known that the amount was income and that the disputant showed a high level of disregard for the consequences of not returning the income.