Tax avoidance update: Inland Revenue finalises guidance

By Campbell Rose and Brad Bowman

On 30 September 2015, Inland Revenue finalised its Question We’ve Been Asked, Income tax – scenarios on tax avoidance – 2015 (QWBA).  The QWBA (QB 15/11) resulted from a panel discussion on the scenarios in question during the 2014 CAANZ Tax Conference.  This article focuses on changes from the draft QWBA originally released.  For our comments on the original draft, please click here.

The QWBA’s overall conclusions have not changed.  However, the facts and analysis in relation to the portfolio investment entity (PIE) scenario have been updated to highlight factors influencing a tax avoidance conclusion.  In addition, there are minor changes to the scenarios concerning limited partnerships and discretionary trusts.  It is pleasing to see that Inland Revenue has taken into account submissions made on the original draft.

Borrowing funds to invest in a PIE

This scenario has been modified to highlight aspects that are likely to lead to a tax avoidance conclusion.  The key factual changes have clarified that Bank A’s lending is for a fixed term of two years (the PIE correspondingly invests in 2-year deposits with Bank A), must be applied towards the PIE investment, is secured over the taxpayer’s interest in the PIE, and PIE income is retained by Bank A in satisfaction of the taxpayer’s interest obligations on the loan from Bank A.

Inland Revenue has (still) concluded that this should constitute a tax avoidance arrangement, but has updated the QWBA to include the following:

• With respect to the PIE rules, Parliament would have intended that investors receive an after-tax economic return resembling what they would receive if they had personally made similar investments to those made by the PIE – but Parliament intends that some investors could pay less tax if investing through a PIE given the capped 28% PIE rate.
• The circularity features have been expanded and emphasised more, such that the commercial and economic reality of the arrangement is that the usual risk associated with borrowing is absent.  The circular elements mean that typical commercial constraints do not apply, and that the arrangement could be scaled-up to any level of borrowing and investing.  This therefore suggests that, as a matter of commercial and economic reality, the investment in the PIE is not part of the taxpayer’s savings and investment activities, and may have been motivated by tax outcomes: the financial consequences of the arrangement are “neutralised” or “distorted” and are “unlike those expected of an arrangement involving borrowing and investing”.
• The arrangement being pre-tax negative and post-tax positive is not determinative in itself in terms of any tax avoidance analysis.  However, that feature is relevant for this scenario because the duration and interest rates of the arrangement are fixed.  Inland Revenue observes that this is likely to preclude any other economic gains arising from the arrangement, which suggests that there is no real borrowing or application of funds in connection with an income-earning activity.  In addition, the taxpayer’s interest obligations not satisfied by the PIE income are “funded by the tax system”.  This suggests that any net investment return “arises from the tax system and not the investment itself”, so that there is “no real savings or investment activity” as contemplated by Parliament.

Tax-influenced distributions from a discretionary trust

Inland Revenue’s view remains that this should not constitute a tax avoidance arrangement.

It is pleasing to see that Inland Revenue has taken on board submissions made on this aspect of the QWBA.

The QWBA has been updated to remove references to the solvency of the corporate beneficiary.  This makes sense given that a beneficiary with tax losses is unlikely to be solvent.  It is also quite conceivable that a trustee would distribute income to an insolvent beneficiary, to bolster their financial position.

Factors relevant to the avoidance analysis have been slightly modified to include whether authorised distributions are paid in cash or credited to beneficiaries’ current accounts (rather than referring to distributions “by journal entry”, which in our view is not a correct or valid concept).

The QWBA originally referred to distributions of beneficiary income within six months of the income year-end, which was not technically correct.  The QWBA now reflects the relatively recent law change which extends the beneficiary income period to the earlier of (a) the date on which the trustee actually files the return of income or (b) the date by which the trustee must file the return (which in practice could be up to 12 months following income year-end).

Finally, Inland Revenue has clarified aspects of the “factual variations” that could lead to a tax avoidance conclusion.  The QWBA now states that there is a risk of tax avoidance where, in commercial and economic reality, there is no realistic prospect of the beneficiaries ever benefiting from the income allocated to them.  Although the QWBA confirms there is nothing inherently wrong with (say) resolving to credit a distribution to account and retain the funds for use within the trust, a reference to Krukziener v CIR (No 3) (2010) 24 NZTC 24,563 has also been added – where the use and benefit of income distributed by trustees was enjoyed by a person other than the beneficiary nominated to receive the distributions, and this was a factor suggesting tax avoidance. 

It is still disappointing that other examples have not been included.  Given that we understand Inland Revenue is looking at a number of trust distribution cases at present, the QWBA could have usefully outlined other factual variants that Inland Revenue has seen in practice, which are considered to involve a risk of tax avoidance (or, at least, would invite more detailed scrutiny).

Structuring using a limited partnership

Inland Revenue still considers that this scenario should not constitute a tax avoidance arrangement.

The only change of note in relation to this scenario is that the tax effects of the arrangement listed in the QWBA should also include the tax consequences of the business sale itself (for example, income may arise from the sale of trading stock or fixed assets). 

Inland Revenue has included a comment that recognises there may be tax effects arising from the sale of the business, but notes however that these tax effects “are not of significance” to the general anti-avoidance analysis.  It seems surprising that Inland Revenue does not accord much weight to the fact that steps undertaken as part of an arrangement give rise to real, and entirely expected, tax consequences (and, indeed, potential tax cost), in addition to other tax outcomes arising.  When enquiring about whether those outcomes could have been contemplated by Parliament, all of the other tax consequences of the arrangement would seem to be important in having regard to the arrangement as a whole.

Concluding remarks

We commend Inland Revenue for their continued participation in (relatively) public tax avoidance related discussions.  Given the Government sees it as important that the tax rules are as clear and certain as is feasible, seeking to clarify Inland Revenue’s approach on general anti-avoidance matters is clearly consistent with that aim.  Publishing appropriately redacted copies of Disputes Review Unit reports on avoidance issues would constitute an even more helpful step in the same direction, but current indications are that this is unlikely to be palatable to Inland Revenue.

If you have any questions in relation to the finalised QWBA, please do not hesitate to contact your usual Deloitte advisor.