The Commissioner’s power of reconstruction: No day at the beach for taxpayers

December 2014 Tax Alert

By Emma Marr and Brad Bowman

Generally speaking, the “tax avoidance process” can be broken down into three steps: determining whether there is tax avoidance arrangement, the reconstruction and the consequences (i.e penalties/use of money interest).

The Supreme Court in Ben Nevis and Penny and Hooper has dealt significant blows to taxpayers in determining whether there is a tax avoidance arrangement. Moreover, the Court of Appeal in Alesco has dealt a further blow in the application of penalties to those found to have entered into a tax avoidance arrangement. The recent High Court case of Beacham v CIR discusses the remaining step of the tax avoidance process, the Commissioner’s power of reconstruction.

What is the significance of the Commissioner’s reconstruction?

Taxpayers will be liable for the “tax shortfall”, which is the difference between the taxpayer’s filed position and the correct tax position (i.e. the reconstruction). In addition to the tax shortfall, taxpayers will also be liable for penalties and use of money interest calculated on the tax shortfall.

How did the High Court rule?

By way of background, the taxpayer entered into a dividend stripping arrangement. The taxpayers owned a company that was in profit. They had an outstanding current account liability to the company of over $1 million. Via a series of transactions the taxpayers sold their shares in the company to a new company the taxpayers incorporated, in return for an interest free loan. That interest free loan was satisfied, in part, by the new shareholders’ (assuming by journal entry) current account liability to the company. In effect, instead of the profitable company returning a dividend, the taxpayers sold their shares and received consideration, in the form of their liability being extinguished.

The Commissioner formed the view that this was a tax avoidance arrangement, and the taxpayer conceded this was the case. The Commissioner reconstructed the arrangement on the basis that the consideration received from the sale of shares was a dividend for tax purposes (in the form of a reduction in the taxpayer’s liability to the company). The taxpayer disagreed and argued that by voiding the arrangement for tax purposes, the tax benefit had been eliminated (i.e. the sale of shares would not have happened if it weren’t for the arrangement).  

Goddard J held for the Commissioner and said that “[t]his is self-evidently a case in which the arrangement being void against the Commissioner did not remove the tax advantage; and thus it was open for the Commissioner to reconstruct the [taxpayer’s] income tax assessments”. In this case, the fatal flaw in the taxpayer’s argument was that voiding the transaction for tax purposes does not mean that the transaction had not taken place at all. The taxpayers’ liability to the company was reduced (i.e. there was a transfer of value from the company to the shareholder), and merely voiding this arrangement would not counteract the tax advantage obtained by this reduction.

This is consistent with the tax avoidance interpretation statement released by Inland Revenue in 2013. When voiding the tax avoidance arrangement counteracts the tax advantage, the Commissioner will not be required to use her powers of reconstruction. However, if voiding the arrangement does not counteract the tax advantage, the Commissioner is required to use her powers of reconstruction.

If a taxpayer wishes to dispute the Commissioner’s reconstruction, the onus is on the taxpayer to demonstrate that the adjustment is wrong and by how much it is wrong. That is, for a Commissioner’s reconstruction to be overturned, the taxpayer must prove that the reconstruction is wrong and then must demonstrate what the correct reconstruction should have been. The taxpayer failed to do that in this case.

Deloitte comment

  • While referring to hypothetical situations is of limited use to taxpayers when determining whether a tax avoidance arrangement exists, New Zealand tax law prescribes that the Commissioner can consider hypothetical situations when counteracting the tax advantage of the tax avoidance arrangement. Consistent with the tax avoidance rules in general, the “cards” are stacked in the Commissioner’s favour.
  • For tax avoidance and reconstruction cases, the burden of proof is on the taxpayer to prove that the Commissioner is wrong and, in the case of reconstructions, demonstrate what the correct reconstruction should have been. For taxpayers, the issue becomes, how does one disprove a hypothetical situation?
  • The power of reconstruction gives the Commissioner a broad discretion as to how to counteract a tax advantage. However, the flip side to this is that taxpayers do not have certainty as to how the Commissioner will reconstruct certain tax avoidance arrangements. This adds another layer of uncertainty for taxpayers.

If you would like to discuss this case or its consequences further, please contact your usual Deloitte tax advisor.

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