Abusive tax position (Mar 98) (Withdrawn from 1 April 2003, in relation to tax positions taken on or after 1 April 2003).

Note: Withdrawn from 1 April 2003, in relation to tax positions taken on or after 1 April 2003. The SPS still applies before this date.

Introduction

A shortfall penalty is a penalty imposed as a percentage of a tax shortfall, or deficit or understatement of tax, which results from certain actions on the part of a taxpayer. The law divides these actions into five categories of fault, or breach, with a specified penalty rate for each category as listed below:

These penalty rates are non-negotiable and where a default occurs the applicable penalty must be imposed.  A taxpayer does however have the right to challenge the decision to impose a shortfall penalty but not the amount of penalty.

This statement deals with defaults that fall within the shortfall penalty category of "abusive tax position".

Application

The penalties apply to obligations relating to the 1997/98 and subsequent income tax years and to taxable or dutiable periods commencing on or after 1 April 1997.

Shortfall penalties apply when there is a deficit or understatement of tax, or where a refund or loss is reduced.  Defaults in employers' obligations are also considered under shortfall penalties.

The penalty provision is generic in application.  This means that it applies to all Inland Revenue Acts (but for Child Support and Student Loans, it applies only to employer obligations).

Purpose

The purpose of the abusive tax position shortfall penalty is to penalise those taxpayers who apply an unacceptable interpretation to a tax law that either results in, or would result in, reducing or removing tax liabilities, or gives tax benefits.  The unacceptable interpretation may be the result of either entering into or acting on an arrangement or simply the interpretation or application of tax laws.  The arrangement or interpretation must have a dominant purpose of taking, or of supporting the taking of, the resulting tax position/s.

It is intended that the provision will apply not only to situations where an anti-avoidance provision is invoked, but also where other provisions have been applied.  This is important to ensure that identical conduct is not penalised differently solely because taxpayers are of different levels of sophistication or because Inland Revenue is not required to resort to an anti-avoidance provision.

Legislation

Section 141D of the Tax Administration Act 1994:

Abusive tax position -

1. The purpose of this section is to penalise those taxpayers who, having applied an unacceptable interpretation to a tax law, have entered into or acted in respect of arrangements or interpreted or applied tax laws with a dominant purpose of taking, or of supporting the taking of, tax positions that reduce or remove tax liabilities or give tax benefits.
   
   
2. A taxpayer is liable to pay a shortfall penalty if the taxpayer takes an abusive tax position (referred to as an "abusive tax position").
   
   
3. The penalty payable for taking an abusive tax position is 100% of the resulting tax shortfall.
   
   
4. This section applies to a taxpayer only if -
   1. The taxpayer's tax position involves an unacceptable interpretation of a tax law; and
   2. The tax shortfall arising from the taxpayer's tax position exceeds $10,000.
   
   
5. Section 141B(6) applies for determining the time when a taxpayer takes an abusive tax position.
   
   
6. A taxpayer's tax position may be an abusive tax position if the tax position is an incorrect tax position under, or as a result of, either or both of -
   1. A general tax law; or
   2. A specific or general anti-avoidance tax law.
   
   
7. For the purposes of this Part, an "abusive tax position" means a tax position that,-
   1. At the time at which the taxpayer's tax position is taken, involves the taking of an unacceptable interpretation of a tax law; and
   2. Viewed objectively, the taxpayer takes -
      1. In respect, or as a consequence, of an arrangement that is entered into with a dominant purpose of avoiding tax, whether directly or indirectly; or
      2. Where the tax position does not relate to an arrangement described in subparagraph (i), with a dominant purpose of avoiding tax, whether directly or indirectly.

Criteria to be met

Before a penalty for an abusive tax position can be imposed, three criteria must be met:

• The position taken must be an unacceptable interpretation; and
  
  
• It must involve over $10,000 tax; and
  
  
• There must be a dominant purpose of avoiding tax.

Unacceptable interpretation standard

The unacceptable interpretation standard will first be applied to determine if a penalty is warranted.  This test recognises that there are many uncertainties in law and that more than one valid interpretation of that law is sometimes possible.  It is unreasonable and unfair to penalise a person for an interpretation if there is a reasonable argument that the interpretation is correct.

Threshold

The $10,000 threshold differs from the threshold for an unacceptable interpretation.  The provisions in section 141B(2) relate solely to whether or not a shortfall penalty is charged.  The 1% materiality threshold which applies to the "unacceptable interpretation" penalty therefore does not apply to the "abusive tax position" penalty.

Dominant purpose of avoiding tax

Dominant purpose
Where there is more than one purpose for entering into the relevant scheme, then section 141D(7)(b) requires that the particular purpose is the dominant purpose.

The Australian High Court decision in FC of T v Spotless Services Ltd (unrep, HC Australia, M32-33, 3 December 1996 ) examined the expression "dominant purpose" and equated the term with "most influential and prevailing or ruling purpose".  Accordingly, if there are three purposes in entering into the arrangement or transaction and one of those purposes is to obtain a tax benefit, then if that purpose (obtaining a tax benefit) is the "most influential" of the three purposes, the dominant purpose test would have arguably been met.

The legislation relating to the shortfall penalty refers to a dominant "purpose".  This differs from section BG 1 - core provisions - (formerly section BB 9) of the Income Tax Act 1994, which refers to "Its purpose or effect is tax avoidance".

It is considered that nothing turns on the distinction between "purpose or effect" and "purpose".  In the context of section BG 1 case law certainly supports this view (Tayles v Commissioner of Inland Revenue [1982] 2 NZLR 726,734).

It could be considered that the term "purpose" is more of a "subjective" term than that of "effect", which is an objective term.  However, the new provision is explicit that the test of whether an arrangement has the dominant purpose of avoiding tax is an objective one.  It is also firmly established in case law that the purpose of an arrangement is to be argued objectively for section BG 1.

In short, the word "purpose" means, not motive, but the effect which is sought to achieve - the end in view.

The section is not concerned with the motives of taxpayers or the desire to avoid tax.  It is only concerned with the means employed to avoid tax (i.e., the arrangement).

Avoiding tax
The concept of "avoiding tax" encompasses the deferral of tax and the claiming of tax credits.  It is considered that "avoiding tax" would incorporate "tax avoidance" as defined in section OB  1 of the Income Tax Act 1994.

However, is the term "avoiding tax" wider than the term "tax avoidance"?

The term "avoiding tax" is likely to be read in the light of the other provisions of the relevant tax law which refer to tax avoidance, but will not require them to be applied.  The penalty will also apply to arrangements which fail under a technical provision rather than a general or specific anti-avoidance provision.

The penalty does not explicitly require an anti-avoidance provision to have been applied:

• The penalty applies only when the taxpayer's tax position involves an unacceptable interpretation.  This test applies when the taxpayer fails to correctly apply or interpret any provision of tax law.  It is not restricted to anti-avoidance provisions;
• The penalty applies where the dominant "purpose" is tax avoidance; not when the tax has in fact been avoided;
• The abusive tax position penalty applies, both to arrangements which are reconstituted under an anti-avoidance provision and to arrangements which are caught by another provision but would otherwise have been subject to an anti-avoidance provision.

In addition, the fact that section 141D(7)(b)(ii) specifically provides for situations where there is no arrangement clarifies that the penalty is not restricted to situations involving the application of an anti-avoidance provision.  Therefore, the abusive tax position penalty can apply when there is not an arrangement, but the tax position taken has a dominant purpose of avoiding tax.

Factors to consider

The following are an indication of the some of the factors that must be taken into account when considering whether there is a dominant purpose of avoiding tax.

Artificiality and contrivance
Have the transactions been designed to appear to comply with the legislation? The legal form may not reflect the substance (even though the legal form is effective).

Consideration will be given to the commercial reality of the arrangement.  Are the arrangements or schemes "self-cancelling" (i.e., neutral commercial consequences, leaving only tax effects)?

The importance of the commercial purpose of the transaction as compared to the tax benefit that the relevant taxpayer obtained must be examined.

Circularity of funding
Funding going around in a circle, usually through a tax haven, resulting in income being tax exempt and the related expenditure tax deductible may be considered as an indicator of a tax avoiding arrangement.

Concealment of information and non-availability of evidence
This may occur through the use of a tax haven.  By going through a tax haven disclosure protection may result due to the particular tax haven's secrecy laws.  These laws usually do not allow information to be released to tax authorities, thereby providing an obstacle to the gathering of information to establish whether the transaction or arrangement is artificial or contrived.

Spurious interpretations
Spurious interpretation covers situations where a tax position taken has no or very little basis at law or the interpretation made or position taken is frivolous.  If there is a reasonable basis then it will not be considered spurious (even though this would not be sufficient for the acceptable interpretation standard).

What happens when a Revenue Act has no anti-avoidance provision

As mentioned previously section 141D(6) states that an incorrect tax position may result from either a general tax law or a specific or general anti-avoidance tax law.

The fact that a particular Revenue Act does not have an anti-avoidance provision does not mean that the penalty cannot be imposed.  What is required is that the tax position taken is incorrect under a general tax law and has as its dominant purpose the avoidance of tax.  There must however be a tax shortfall.

If the position involves an arrangement which has the effect of ensuring that the treatment is within the interpretation of the law then there would not be a tax shortfall.  The reason being, that the anti-avoidance provisions work by deeming the arrangement to be null and void, thereby allowing the substantive provisions to be applied as intended.  The anti-avoidance provisions are not an assessing provision in themselves; they are a reconstruction provision.  It is the substantive provisions which result in the reassessment.

Publication of name

Section 146(1)(a) of the Tax Administration Act 1994 requires that the name of anyone liable to pay a shortfall penalty for taking an abusive tax position will be published in the Gazette.

This will not occur however in the case of a voluntary disclosure prior to an investigation commencing.

Burden and standard of proof

A taxpayer has the right to challenge the decision to impose a shortfall penalty through the disputes process.  If the issue can not be resolved through the disputes process the taxpayer has the normal rights of review through the courts.

The burden of proof, in civil proceedings relating to the imposition of shortfall penalties, rests with the taxpayer.  They must show that on the "balance of probabilities" they have not taken an abusive tax position.

Standard rate of penalty

The standard rate of penalty payable for taking an abusive tax position is 100% of the resulting tax shortfall.

This rate may be adjusted by varying rates in the following circumstances:

• voluntary disclosure before or during an audit
• voluntary disclosure at the time of return filing
• temporary tax shortfalls
• obstruction

Other reference

An explanation and examples of shortfall penalties and other offences and penalties can be found in Tax Information Bulletin Volume Eight, No.7 (October 1996).

Summary

Section 141D of Tax Administration Act 1994 provides for a penalty for taking an abusive tax position, at the rate of 100%.

The objective of an avoidance penalty is to deter taxpayers from entering into arrangements which have as their dominant purpose the avoiding of tax.

Before a penalty for an abusive tax position can be imposed, three criteria must be met:

• the position taken must be an unacceptable interpretation; and
• it must involve over $10,000 tax; and
• there must be a dominant purpose of avoiding tax.

Tony Bouzaid
National Manager, Operations Policy
March 1998